Economist Channel

Source: Wall Street Journal

So, what's up with Bitcoin? Is it a "bubble?'' A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some "excess valuations" in stock markets, gold and commodities, and money itself.

Let's put the pieces together. The first equation of asset pricing is that price = expected present value of dividends. Bitcoin has no cash dividends, and never will. So right off the bat we have a problem -- and a case that suggests how other assets might have value above and beyond their cash dividends.

Well, if the price is greater than zero, either people see some "dividend," some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called "convenience yield," the latter is a "rational bubble."

"Rational bubbles" are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The "greater fool" or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let's think about "convenience yield." Why might someone be willing to hold bitcoins even though their price is above "fundamental value" -- equivalently even though their expected return over a decently long horizon is lower than that of stocks and bonds? Even though we know pretty much for sure that within our lifetimes bitcoin will become worthless? (If you're not sure on that, more later)


Well, dollar bills have the same feature. They don't pay interest, and they don't pay dividends. By holding dollar bills, you are holding an asset whose fundamental value is zero, and whose expected return is demonstrably lower than that of, say, one-year treasuries. One year Treasuries are completely risk free, and over a year will give you about 1.5% more than holding dollar bills. This is a pure arbitrage opportunity, which isn't supposed to happen in financial markets!

It's pretty clear why you still hold some dollar bills, or their equivalent in non-interest-bearing accounts. They are more convenient when you want to buy things. Dollar bills have an obvious "convenience yield" that makes up for the 1.5% loss in financial rate of return.

Also, nobody holds dollar bills for a whole year. You minimize the use of dollar bills by going to fill up at the ATM occasionally. And the higher interest rates are, the less cash you hold and the more frequently you go to the ATM. So, already we have an "overpricing" -- dollars are 1.5% higher priced than treasurys -- that is related to "short-term investors" and lots of trading -- high turnover, with more overpricing when there is more trading and higher turnover -- just like bitcoin. And 1999 tech stocks. And tulip bubbles.

Some of the convenience yield of cash is that it facilitates tax evasion, and allows for illegal voluntary transactions such as drugs and bribes. We can debate if that's good or bad. Lots of economists want to ban cash (and bitcoin) to allow the government more leverage. I'm less enthusiastic about suddenly putting out of work 11 million undocumented immigrants and about half of small businesses. The US tends to pass a lot of aspirational laws that if enforced would bring the economy to a halt. To say nothing of the civil liberties implications if the government can track every cent everyone has ever spent.

But US cash is largely stuffed in Russian mattresses. It is even less obvious that it is in our interest to enforce Russian laws on taxation or Russian control over transactions. Or Chinese, Venezuelan, Cuban, etc. control.

And more so bitcoin. This is the obvious "convenience yield" of bitcoin -- the obvious reason some people are willing to hold bitcoin for some amount of time, even though they may know it's a terrible long-term investment. It certainly facilitates ransomware. It's great for laundering money. And it's great for avoiding capital controls -- getting money out of China, say. As with dollars there is a lot of bad in that, and a lot of good as well. (See Tyler Cowen on some parallel benefits of offshore investing.)

But good or bad is beside the point here. The point here is that there is a perfectly rational demand for bitcoin as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth -- even if people holding it know that it's a terrible long-term investment.

On top of this "fundamental" demand, we can add a "speculative" demand. Suppose you know or you think you know that bitcoin will go up some more before its inevitable crash. In order to speculate on bitcoin, you have to buy some bitcoin. I don't know if you can short bitcoin, but if you wanted to you would have to borrow some bitcoin and sell it, and in the process you would have to hold some bitcoin. So, as we also see in high-priced stocks, houses and tulips, high prices come with volatile prices (so there is money to be made on speculation), and large trading volumes. Someone speculating on bitcoin over a week cares little about its fundamental value. Even if you told him or her that bitcoin would crash to zero for sure in three years, that would make essentially no dent in their trading profits, as you can make so much money in a volatile market over a week, if you get on the right side of volatility.

Now to support a high price, you need restricted supply as well as demand. There are only so many bitcoins, as there are only so many gold bars, at least for now.  But that will change. The Achilles' heel of bitcoin's long term value is that there is nothing to stop people from creating bitcoin substitutes -- there are already hundreds of other similar competitors. And there is nothing to stop people from creating private claims to bitcoin -- bitcoin futures -- to satisfy speculative demand. But all that takes time. And none of my demands were from people who want to hold bitcoin for very long.  Ice cream is also a fast-depreciating asset, but people hold it for a while. In this view, however, Bitcoin remains a terrible buy-and-hold asset, especially for an investor who plans to pay taxes.

In sum, what's going on with Bitcoin seems to me like a perfectly "normal" phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and limits on short-selling, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand -- no annual reports on how much the Russian mafia wants to move offshore next week -- that's plausible too.

This view says that price surges only happen with restricted supply, and accompany price volatility, large trading volume, and short holding periods. That's a nice testable link, which seems to hold for bitcoin. And other theories, such as madness of crowds, no not explain that correlation.

Bitcoin is not a very good money. It is a pure fiat money (no backing), whose value comes from limited supply plus these demands. As such it has the huge price fluctuations we see. It's an electronic version of gold, and the price variation should be a warning to economists who long for a return to  gold. My bet is that stable-value cryptocurrencies, offering one dollar per currency unit and low transactions costs, will prosper in the role of money. At least until there is a big inflation or sovereign debt crisis and a stable-value cryptocurrency not linked to government debt emerges.

(This view is set out in more detain in a paper I wrote about the tech stock era,  Stocks as Money in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003. Alas not available online, but the link to my last manuscript works.)

Update: Marginal Revolution also on bitcoin today.

This is a talk I gave for Hoover, which blog readers might enjoy. Yes, it puts together many pieces said before. This post has graphs and uses mathjax for equations, so if it isn't showing come back to the original. Also here is a pdf version which may be more readable.

Background

As background, the first graph reminds you of the current situation and recent history of monetary policy.

The federal funds rate is the interest rate that the Federal Reserve controls. The funds rate rises in economic expansions, and goes down in recessions. You can see this pattern in the last two recessions. Since about 2012, though, when following history you might have expected the funds rate to rise again, it has stayed essentially at zero. Very recently it has started to rise, but very slowly, nothing like 2005.

The black line is reserves. These are accounts that banks have at the Fed. Crucially, these bank accounts now pay interest. Starting in 2008, reserves grew dramatically from about $20 billion to $2,500 billion. The three cliffs are the three quantitative easing' episodes. Here, the Fed bought bonds and mortgage backed securities, giving banks reserves in exchange.

Inflation initially followed the same pattern as in the last recession. It fell in the recession, and bounced back again in 2012.Inflation has been slowly decreasing since. 10 year government bonds have been quietly trending down, with a bit of an extra dip during the recession.

The next graph plots US unemployment and GDP growth.

You can see we had a deeper recession, but then unemployment recovered about as it always does, or if anything a little faster. You can see the big drop in GDP during the recession. Subsequent growth has been overall too low, in my view, but it has been very steady. If anything, both growth and inflation are steadier in the era of zero interest rates than they were when the Fed was actively moving interest rates around.

These central facts motivate my heresies: Inflation, long term interest rates, growth and unemployment seem to be behaving in utterly normal ways. Yet the monetary environment of near-zero short term rates and huge QE is nothing but normal. How do we make sense of these facts?

Heresy 1: Interest rates

• Conventional Wisdom: Years of near zero interest rates and massive quantitative easing imply loose monetary policy, "extraordinary accommodation,'' and "stimulus.''
• Heresy 1: Interest rates are roughly neutral. If anything, the Fed has been (unwittingly) holding rates up since 2008.

What does a central bank look like that is holding interest rates down? Such a bank would lend money to banks at low interest rates, that banks could turn around and re-lend at higher interest rates. That's how to push rates down.

What does a central bank look like that is pushing rates up? Such a bank takes money from banks, offering to pay banks a higher interest rate than they can get elsewhere.

What's our central bank doing? In bigger format, the top panel of the next graph presents excess reserves. This is money that banks voluntarily lend to the Fed, and on which they receive interest.

Top: Reserves. Bottom: Interest on excess reserves, Fed funds rate and 1-month Treasury rate

The bottom panel is the interest that the Fed pays on excess reserves, along with the Federal Funds rate and the rate on one month treasurys, to give a sense of market rates. As you can see, the Fed pays more than banks can earn elsewhere. So, on this basis, the Fed looks like a central bank pushing rates up, if anything.

Now, as we used to say at the University of Chicago, ok for the real world, but how does that work in theory? How can it be that zero interest rates -- lower than we have seen since the great depression -- are not an unusual stimulus?

Well, it's certainly possible. Remember, the nominal interest rate equals the real interest rate plus expected inflation. If the real interest rate is, say negative 1.5%, and inflation is +1.5%, then a nominal interest rate of zero is neutral.

And, there are plenty of reasons to suspect that the "natural'' real rate has been negative for much of the period since the financial crisis. More savers than investors, low marginal product of capital in a real slow growth environment, and so on are easy stories to tell.

In this view, by the way, as the real rate recovers along with the economy, if the actual nominal interest rate is stuck at zero, then inflation should gently decline. That is also what we see.

Plus, after 8 years, if monetary policy were really "stimulating'' quite so much, where is the inflation and boom?

Heresy 2: Quantitative easing

As we have seen, in its quantitative easing (QE) the Fed bought nearly $3 Trillion of Treasurys and mortgage backed securities, giving banks interest-paying reserves in return.

• Conventional Wisdom: QE lowered long-term interest rate rates, and provided a big stimulus. QE's stimulative effect is permanent and continues to this day, so unwinding QE is vital to "normalizing'' policy.
• Heresy 2: QE did basically nothing to interest rates, or to stimulus.

The next graph is a plot of ten year rates and mortgage rates along with reserves. Again, the steep rises in reserves are the QE episodes.

Ten year treasury rate, 30 year mortgage rate, and reserves

Maybe the first QE is associated with a one percentage point drop in rates. But it bounces right back. Large transactions can move prices, but in the rest of finance we see these as temporary, not permanent movements. In the second and third QE, interest rates rise during the QE episode, exactly the wrong sign.

The bottom panel takes a longer view of interest rates Here you can see that interest rates have been on a steady downward trend since 1985. Can you see any difference in the behavior of these interest rates during the QE period from the late stages of the last three expansions? I can't.

Well, again, so much for the real world, how does it work in theory. As Ben Bernanke himself recognized, QE "works in practice'' or so he thought, but not in theory. We should worry about any proposition that has no theoretical basis. Sometimes facts are ahead of theory, but not often.

The Fed is in essence a huge money market fund. Banks sell bonds to the Fed, and get a money market account, backed by the Fed's holdings of the bonds. Just how much difference does it make for banks to hold treasurys through the Fed rather than directly?

We can think of them as open change operations. Reserves are government debt. So it's as if the Fed took a bunch of your $20 bills and gave you 2 $5s and a $10 in exchange. It's hard to see that having a big effect on your spending.

QE is catch 22. The usual story told is that bond markets are "segmented.'' The 10 year treasury market is cut off from other markets. Then, if the fed buys a lot of them it can raise the prices of 10 year treasurys. But the point of QE was not to lower Treasury rates, it was to lower rates that might influence investment. To affect the economy, the markets must not be segmented. For the Fed to affect the 10 year rates, they must be segmented, and the rates don't spill over to the rest of the economy.

Finally, the Treasury has been selling faster than the Fed has been buying. The next graph has all Federal debt, and federal debt less the part bought by the Fed. That bottom line is still growing. So, the Fed did not remove any bonds from the market. Overall, markets held more debt.

Federal Debt held by the public, and the same less debt held by the Fed.

Moreover, the Treasury was trying to move to a longer maturity structure. Treasury debt is much like your mortgage. If you take the 30 year fixed, you protect yourself against interest rate increases. If you take the floating rate ARM, you get a lower rates, but if rates go up you might be in a squeeze. The Treasury chose the fixed rate, trying to move to longer bonds. The Fed bought those long bonds right back up, issuing short term debt (reserves) instead, and undoing the insurance that the Treasury bought. Fed and Treasury need to get together and decide who is in charge of the maturity structure!

Heresy 3: Low rates, QE and financial markets

• Conventional Wisdom: QE and low interest rates set off a "reach for yield,'' "asset price bubbles,'' though artificially low risk premiums.
• Heresy 3: The risk premium is not unusually low for this stage of the business cycle. In any case, the Fed has nothing to do with risk premiums.

A quote from one of my otherwise favorite financial analysts expresses the view nicely:

"QE and negative interest rates manipulated prices of risk-free assets, and by artificially boosting risk-free assets central banks have sent investors on a hunt for yield, which in turn artificially boosted prices of risky assets and significantly distorted prices in financial markets.''

Again, this story gets passed on and on, but does it line up with the facts, and does it make any sense?

Risk premiums are about the spread between borrowing and lending. You take on risk by borrowing to invest. Now, if you borrow at 1 % and lend at 3%, that is exactly the same thing as borrowing at 3% and lending at 5%. Risk taking depends on the spread between risky and risk free rates, not the level of rates.

Yes, we can cook up stories, involving the affairs of specialized intermediaries. But recognize those are second-order stories, and hard to get risk premiums on widely traded stocks and bonds to go substantially wrong for years.

Let's look at the facts. Are there unusually low risk premiums or high asset prices, and are those tied to low interest rates or QE?

Spread between BAA and 10 year Treasury rate

This graph is the interest rate spread between Baa corporate bonds and 10 year Treasuries, a sign of the premium for holding the risk of corporate defaults. The premium is low now. But we are in the late September of the business cycle, and the corporate spread was even lower in each of the last three business cycles.

Risk premiums are always low in late stages of the business cycle. Risk is low, people are doing well, and willing to take risks despite low premiums. In fact, corporate premiums are still if anything surprisingly high for this stage of the business cycle, a fact often attributed to bank's unwillingness to trade much under the more stringent capital standards.

The next graph presents Bob Shiller's long-run price/earnings ratio. The price/earnings ratio is high. But it's also always high at the late stage of expansions, as people are more willing to take stock market risk in good times.

Price-earnings ratio on S&P500. Source: Robert Shiller

Moreover, looking at this century of data, the current time period with zero rates and massive QE does not stand out as particularly different from events we have seen many times before.

(Not: ignore the interest rate in the chart. It is the nominal interest rate, which reflects inflation, and is not relevant to the question here. I just copied Shiller's chart so didn't remove the line.)

Even so, it still seems high, but the price earnings ratio reflects the level of interest rates as well as the spread. The classic Gordon growth formula states that the price / earnings ratio equals one divided by the stock's rate of return minus the growth rate of dividends. We can also break down the stock rate of return into a real risk free rate and a risk premium. \[ \frac{P}{E} = \frac{1}{E(r)-g} = \frac{1}{r^f + E(r-r^f)-g} \] Now, suppose the real risk free rate goes down by one percentage point, leaving the risk premium alone. If the price/earnings ratio starts at 25, or expected returns four percentage points above growth, \[ \frac{P}{E} = 25 = \frac{1}{0.04} \] a 1% decline in real rate gives \[ \frac{P}{E} = 33 = \frac{1}{0.03} \] with no change in risk premium. That's just about the amount by which the price/earnings ratio is unusually high

Heresy 4: Real rates

All of my heresies revolve around the question of low interest rates, and you might object that yes, interest rates are low, but that's because you think the Fed is keeping interest rates low.

• Conventional Wisdom: The Fed is the primary force behind movements in the real rate of interest and GDP growth rates.
• Heresy 4: The Fed has little to do with real interest rates or economic growth rates (past $\approx$ 1 year).

This is just economics 101. The two most basic economic descriptions of interest rates are \[ \text{real rate} = \text{impatience} + (\approx 1-2) \text{growth rate} \] \[ \text{real rate} = \text{marginal product of capital} \] If people are impatient, you have to pay them higher interest rates to get them to save. If the economy is growing quickly, and people know they will be better off in the future, you have to pay them higher interest rates to get them not to consume today. And the interest rate is determined in the end by companies' ability to make real returns from borrowed money.

As we go in to an economic expansion, with higher growth, real interest rates will naturally rise, Fed or no Fed. As we go into a period of low or no growth and poor investment opportunities, real interest rates will be low, Fed or no Fed.

And after a few years, growth comes from productivity only, not anything the Fed can arrange.

Now, there are many stories told for low growth and low "natural '' real rates -- a "savings glut,'' a demographic bulge of middle age savers, low investment productivity from distorting taxes and regulation, and so on.

Moreover, real rates are low everywhere in the world. It isn't specific to the Fed.

In sum, the Fed is nowhere near as powerful as conventional wisdom suggests.

Heresy 5: Is the economy stable?

• Conventional wisdom: If interest rates are stuck or pegged, inflation or deflation will spiral out of control. The economy, on its own, is unstable. The Fed must constantly move interest rates, like the seal must move his nose, to keep inflation under control.
• Heresy 5: The economy is stable. If interest rates don't move, eventually inflation will adjust to that interest rate minus the natural real rate of interest.

Conventional wisdom makes a clear prediction. When the interest rate gets stuck at zero, deflation will spiral out of control. The next graph gives a simulation of a standard (adaptive expectations, ISLM) model. A deflationary shock hits, and inflation declines. The Fed lowers interest rates, but soon runs in to zero. When the interest rate hits zero, the deflation spiral breaks out.

The model in this figure is: \begin{align*} x_t &= -\sigma (i_t - \pi_{t-1} - v^r_t)\\ \pi_t &= \pi_{t-1} + \kappa x_t; \\ i_t &= \max[i^\ast + \phi (\pi_t -\pi^\ast),0] \end{align*}

Simulation of an old-Keynesian deflation spiral at the zero bound.

The facts deny this central clear prediction. Remember the lesson of the first graph, on what happened when interest rates hit zero and stayed there. There was no spiral.

Modern theory and fact agree: Inflation and economy are stable with fixed rates.

That does not mean that fixed interest rates are a good thing. They are possible, but not necessarily desirable. Remember \[ \text{interest rate} = \text{real rate} + \text{expected inflation} \] If interest rates are fixed, then as real rates vary -- remember, real rates should be low in recessions and high in booms -- inflation must vary, and in the opposite direction. Prices are a bit sticky and volatile inflation is not desirable. So even in the view that inflation is stable with fixed interest rates, it is still a good idea for the Fed to raise rates in boom times and lower them in recessions. The Taylor rule is alive and well. But the zero bound or slightly slow to move rates are not a spiral-tempting disaster.

Heresy 6: How does this thing work anyway?

• Conventional wisdom: Raising interest rates lowers inflation, & vice-versa.
• Heresy 6 (Implication of stability & modern theory). After a short run negative effect, persistently higher interest rates raise inflation.
• Are we past bump, at the point that persistently low rates have led to low inflation?

If inflation is stable around fixed interest rates, then if you raise rates and leave them there, inflation must eventually rise to meet the interest rates.

It's not as nutty as it seems. Most of our experience is the short run relationship, which is negative.

However, this possibility -- this consequence of stability -- suggests that after 8 years near zero, we have gotten over any negative response of inflation to rates, and low interest rates are attracting low inflation. And that if the Fed raises rates, it will eventually cause the inflation that it will, in the event, pride itself for foreseeing.

Consistent with this view, consider Japan and Europe in the next plot. Both of them have lower -- negative -- interest rates than we do. And inflation is drifting down in both places. Which is the chicken, and which is the egg?



Heresy 7: The Phillips curve

Conventional wisdom, largely reflected in Federal Reserve statements, has a clear view of where inflation comes from.

• Inflation comes from "tight markets,'' principally tight labor markets.

As I write, conventional wisdom says that the low unemployment rate, and other measures such as many unfilled job openings presage wage inflation, which will be passed through to price inflation. This view motivates the hawkish case for raising interest rates, even though current inflation remains below the Fed's 2% target, and accounts for the fact that the Fed has raised rates at all.

The conventional view of monetary policy acts through this causal channel. Lower interest rates will stimulate aggregate demand, which will stimulate output, which will cause companies to hire more people, which will tighten labor markets, which will lead to higher wages, which will lead to higher prices.

Sometimes, the correlation between inflation and unemployment is read the other way. (We economists seem to specialize in reading correlations as causal relationships, and forgetting that there are two curves that may shift in any set of observations.) In the recession, if only the Fed could raise inflation, the story went, it could thereby reduce unemployment. Bring on the helicopters full of money.

In any case, even the Phillips curve correlation has vanished, if it ever was there.

Core inflation and unemployment. Top: time series. Bottom: Inflation (y) vs. unemployment (x) since 2007

The top panel of this graph shows the time series of inflation and unemployment through the last two recessions. You can see inflation blip down and unemployment rise in the bottom of a recession. Even that correlation vanishes though in the subsequent expansion and most of all in the last one. Inflation quickly bounces back to a bit below 2%, while unemployment remains high. There is just no relation all between the level of labor market "slack'' and the rate of inflation.

The bottom panel shows the data since 2008 as a scatterplot, with inflation on the left and unemployment on the bottom. Your eye may wish to draw a negatively sloped line. But really the evidence there is on the right hand side -- inflation dipped down and came back up while unemployment stayed high. The traditional scatterplot is a bit misleading because the points are not randomly chosen, but follow each other as you can see in the first plot.

The plot really shows that there is essentially no relationship between inflation and unemployment -- the line is flat. Furthermore, there is a lot of vertical scatter -- the line isn't really a line.

(A clever Fed economist once parried, yes, the line is nearly flat! That's great news. It means if we could only get inflation up half a percent we would instantly cure unemployment. The vertical scatter emphasizes that the line is really just mush, not an exploitable flat line.)

Well, once again, so much for the real world, how does it work in theory? Nothing seems more obvious than the proposition that if labor markets are tight, if there are more jobs than people who want to work, that employers will offer higher wages, right?

No, as a matter of fact. If employers want to attract more workers, they must offer higher wages relative to prices. Saying "I'll pay you in pennies'' doesn't do any good. Both prices and wages rising at the same time does nothing to attract workers. If wages are "sticky'' then the only way to have wages rise is for product prices to fall -- we should expect tight labor markets to result in less inflation in goods prices!

Likewise, perhaps inflation comes from tight product markets, and what could be more natural than the idea that if there is more demand than supply that companies should raise prices. But that also only works for relative prices.

This is one of the first, most important, and most forgotten lessons of macroeconomics. What works for an individual market does not work for the economy as a whole. The overall price level is a different object than (relative) prices or wages. (And, similarly, trying to raise everyone's income by raising everyone's relative income, handing out protections to each industry and to labor, is equally doomed. No, we cannot pull ourselves up by our bootstraps.)

Now (of course) there are economic theories of the Phillips curve, and good ones. To get the overall level of prices and wages to correlate with labor or product market slack, you need some second-order effect, some "friction.'' The easiest one to understand is Bob Lucas' classic theory. In this context, employers can fool people into working harder for a little while by posting higher wages. If the people don't know that prices are going up too, they will think the real wage (relative to price) is higher, and not realize they are just being paid in devalued currency. Once they figure it out, of course, the boost to employment vanishes. (Also, this is a theory of causality from unexpected inflation to higher employment, not the other way around.)

The point here is not that there is no theory of the (apparently vanished) Phillips cure. The point here is that the simple commonsense idea that tight markets cause inflation is wrong. If you want a theory, you need to go past obvious supply and demand and add some friction to pricing or to information processing, and then you need to think the Fed understands and can exploit this friction to guide us to better outcomes than we get to on our own.

Maybe that's not how the economy is wired. Maybe labor market "tightness'' and "slack'' is not the root of inflation.

Heresy 8: Inflation Dangers

Source: CBO

• Conventional Wisdom: The danger of inflation comes if the Fed does not raise rates quickly enough. Then we have a positive spiral.
• Heresy 8: The inflation danger comes from fiscal policy. A Greek unwind. As past low-rates and pegs evaporated due to fiscal problems. And then Fed will be powerless to stop it.

If inflation is indeed stable, then small mistakes in monetary policy will not lead to spiraling inflation.

Inflation, like all crises, usually comes from unexpected sources. Our fiscal situation leads to a chance of inflation. If interest rates rise to 5%, our government will have to pay $ 1 trillion per year of additional debt service. It can't. This event could pile on top of a new financial crisis and recession occasioning a few more trillion dollars of borrowing, on top of unreformed taxes and entitlement spending. People seeing that crisis coming will unload government debt, try to buy real things, and drive inflation. If that happens, there is nothing the Fed can do about it.

This possibility is not a forecast. It's a risk, and a small risk, like living above an earthquake fault that breaks every few hundred years. That doesn't mean you should rush out of the house right now. But that doesn't mean we're safe either. Bond markets still trust the US to sort out our fiscal mess. But if they ever lose that faith, we get inflation -- stagflation -- that will seem to the Fed, and to conventional wisdom, to have come from nowhere.

Kevin Volpp, University of Pennsylvania, is the Janet and John Haas President’s Distinguished Professor of Medicine and Medical Ethics and Policy at the Perelman School of Medicine and Health Care Management at the Wharton School. He is also the founding Director of the Center for Health Incentives and Behavioral Economics (CHIBE), Vice Chairman for Health Policy for the Department of Medical Ethics and Policy, and Director (with Karen Glanz) of the Penn CDC Prevention Research Center.

Dr. Volpp’s work focuses on developing and testing innovative ways of applying insights from behavioral economics in improving patient health behavior and affecting provider performance. He has done work with a variety of employers, insurers, health systems, and consumer companies in testing the effectiveness of different behavioral economic strategies in addressing tobacco dependence, obesity, and medication non-adherence. He has competitively been awarded more than $60 million to lead or co-lead studies funded by the NIH; the Center for Medicare and Medicaid Innovation; the CDC; VA Health Services Research and Development; Robert Wood Johnson Foundation; the Hewlett Foundation; the Commonwealth Foundation; the Aetna Foundation; Mckinsey; CVS Caremark; Horizon Blue Cross Blue Shield; Hawaii Medical Services Association; Merck; Humana; Aramark; Weight Watchers; and Discovery (South Africa).

His work earned him the 2015 Matilda White Riley Award, issued by the National Institutes of Health Office of Behavioral and Social Sciences Research (OBSSR). The Matilda White Riley Award is given in recognition of an outstanding behavioral or social scientist whose research has contributed to both the deepening of knowledge and its application in a manner that furthers NIH’s mission of improving health.

See https://hcmg.wharton.upenn.edu/profile/volpp70/ or https://chibe.upenn.edu/ for more details about Kevin’s work. An excellent overview of his work including an interview with Kevin is available at https://obssr.od.nih.gov/kevin-volpps-alchemy-turning-principles-of-behavioral-economics-into-healthier-people/

Professor Volpp is visiting Galway to speak at the MedTech Rising conference that will take place at the Radisson Hotel on December 6 and 7. See http://www.medtechrising.ie/#Agenda for more details.

Applications are invited for positions as Lecturer\Assistant Professor in the UCD School of Economics. Applicants must have an active research track record and be an effective communicator capable of excellence in teaching at undergraduate and postgraduate levels. Applications from all fields of Economics are welcomed though priority for one of the positions will be given to applicants with expertise in macroeconomics, financial economics or econometrics.

Note: Representatives of the School of Economics will be available to meet with potential candidates at the ASSA Meetings in Philadelphia over January 5-7, 2018 and at the RES PhD Meetings in London over 19-20 December, 2017. Please contact Professor Karl Whelan, Head of the School of Economics (karl.whelan@ucd.ie) for further information.

95 Lecturer/Assistant Professor above the bar Salary Scale: €51,807 - €79,194 per annum

To illustrate MV = PY. (It was MV=PT then.)  In  Irving Fisher, "The Equation of Exchange 1896-1910," The American Economic Review Vol. 1, No. 2 (June, 1911), pp. 296-305, via JSTOR.

Mind the Gap is an extraordinary blog post on land use regulations. (HT the dependably excellent Marginal Revolution.) It is great for its detail, but most of all for its fresh voice. Sure, send one of my free-market economist friends in to examine the pathologies of any city, and we start almost reflexively on land use regulations. But the author is clearly from a different background -- the sort of person who "was in Hamtramck, Michigan a couple of years ago to participate in a seminar about reactivating neighborhoods." Lessons discovered the hard way, from different backgrounds, are often the freshest.

The big point of the blog post is how land use regulations force a steppingstone pattern of urban decay. It's hopelessly expensive to convert any building "up" the economic foodchain of uses, so bit by bit buildings get used for less and less productive uses, that don't attract the attention of regulators, until they become vacant lots, or until a large commercial developer can come in, demand tax subsidies, and rebuild the whole neighborhood.

The post starts with the story of a family that

bought an old fire station a few years ago with the intention of turning it in to a Portuguese bakery and brew pub.

Alas,

Mandatory parking requirements, sidewalks, curb cuts, fire lanes, on site stormwater management, handicapped accessibility, draught tolerant native plantings… It’s a very long list that totaled $340,000 worth of work. They only paid $245,000 for the entire property. And that’s before they even started bringing the building itself up to code for their intended use. Guess what? They decided not to open the bakery or brewery. Big surprise.

(The post is full of great photographs like this one.) So instead,

the space has been pressed in to service as a printing shop for the family’s specialty advertising business. It’s a productive and profitable use of the existing space that doesn’t require structural changes or special regulatory approval. But it’s significantly lower down on the economic food chain, creates less taxable revenue, employs far fewer people, and does nothing to activate the town’s social or cultural life. And if anything were to happen to the building it wouldn’t be cost effective to rebuild so the lot would most likely remain vacant. There are plenty of empty parcels all around that attest to this reality.

The conundrum

Individually it’s impossible to argue against each of the particulars. Do you really want to deprive people in wheelchairs of the basic civil right of public accommodation? Do you really want the place to catch fire and burn? Do you want a barren landscape that’s bereft of vegetation? 

Here I think the blog missed the central problem -- understandable since it's not from an economist. "you" -- we, the town, really does want these things. These are important, and desired, public goods. The problem is, these things we want cost a lot of money. $340,000 for one firehouse. The town wants them, but is not willing to raise general taxes to pay for them.  It's sane enough to realize that it cannot make owners of existing properties fork over $340,000 per firehouse. So it passes, what is in essence, a lump-sum tax on people who want to start new businesses, or use the property up the economic foodchain. Alas, the people second-most-unlikely to be willing or able to pay such taxes are small-scale entrepreneurs trying to start a marginally better business in a run down neighborhood.  So nothing happens until either the town reverts to wasteland, or until nearby prospects brighten enough that a large commercial developer can move it back to the top of the food chain, and also extract enough tax breaks so that in essence the city does pay for the public goods from general taxes in the first place.

The post though, is about this big lesson in urban decay:

There is zero chance that any of these laws and procedures will be changed in my lifetime. However, it’s highly likely that before I die this gas station will close and the property will work its way down to a series of lesser uses until it remains vacant....And before I shuffle off this mortal coil the cost of maintaining the road and associated sewer and water infrastructure will outstrip this town’s tax revenue. 

(The post also emphasizes the dehumanizing aspect of parking and street regulations.)

Another example, on trying to convert an old bank to new uses,

 the fire marshal happened to drive by and noticed there were people – a few dozen actual humans – occupying a commercial building in broad daylight. In a town that has seen decades of depopulation and disinvestment this was an odd sight. And he was worried. Do people have permission for this kind of activity? Had there been an inspection? Was a permit issued? Is everything insured? ...

There was already a kitchen in the back of the building from when the place had been a Chinese restaurant. But the current rules required a long list of upgrades including a $20,000 fire suppressing hood for the stove and new ADA compliant bathrooms. It could all be done, but at a price point that would grossly exceed both the purchase price of the building and any conceivable cash flow the business might generate.

One work-around was to have a certified and inspected food truck park in the back alley and deliver food into the building for temporary events. ADA portable toilets could be rented as needed. The building – now called Bank Suey – has continued along these lines as a rental hall for pop up events..

Clearly a move down the economic food chain. Cell phone antennas on the roof of a neighboring empty building are the next example.


Our author has learned an important lesson.

On a walking tour of town officials and development consultants pointed to empty buildings and described all the things that could be done to bring them back to productive activity: open up the blank walls and re-install windows, incubate all kinds of new businesses, paint, outdoor seating… I rolled my eyes. None of those things make any economic sense given the regulatory hurdles involved and the likely negative return on the up front investment

The pattern instead, and the bottom line:

anonymous blank inscrutable structures ... could quietly contain storage facilities or a non retail live/work space under-the-radar without attracting the attention of officialdom. If the inhabitants were really discrete they might be able to carry on unmolested for a number of years. 

Meanwhile the usual big money developers might buy enough of the neighboring buildings and vacant land – with the accompanying subsidies and tax breaks – to rapidly transform Main Street at a much higher economic level. 

There’s no in-between. You either get permanent stagnation or massive redevelopment. Baby steps are essentially illegal.  

The WSJ has two good and related opeds on energy and transport subsidies recently, Randall O'Toole on Last Stop on the Light-Rail Gravy Train and Lee Ohanian and  Ted Temzelides write on energy and transport subsidies

O'Toole:

Last month, Nashville Mayor Megan Berry announced a $5.2 billion proposal that involves building 26 miles of light rail and digging an expensive tunnel under the city’s downtown. Voters will be asked in May to approve a half-cent sales tax increase plus additions to hotel, car rental and business excise taxes to pay for the project.

Just in time for self-driving Ubers to arrive.

I love trains. But we have to admit practicalities. One transportation economist summed all there is to know about transit with "Bus Good. Train Bad." (With a few exceptions, such as Manhattan.)  And light rail, worse. Trains are expensive, and once built, immobile. If people want to go somewhere else, tough. Rolling stock lasts around 50 years, meaning they bake in technical obsolescence. Trains carry far fewer people per lane-mile than busses. And a fleet of self-driving Ubers linked by computer will be able to use bus lanes.

Actually, even buses are more and more questionable. As I wait for the interminable lights on El Camino to cross to Stanford (on bicycle), I have taken to counting passengers on the well-subsidized bus line. The modal number is zero.

As Randy has pointed out elsewhere, the main beneficiaries of light rail are suburban largely white commuters with a nostalgia thing for trains. The main people paying for it are inner city minorities who don't get bus service anymore.

To pay for new light-rail lines that opened in 2012 and 2016, Los Angeles cut bus service. The city lost nearly four bus riders for every additional rail rider.

Congestion got you down? Real time tolling, adjusted minute by minute, will either cure traffic congestion forever, or will bail out indebted local governments with massive revenues, or both. Or, let people live somewhere near where they work!

Lee and Ted consider the transition from horse to auto and truck,

‘In 50 years, every street in London will be buried under 9 feet of manure.” With this 1894 prediction, the London Times warned that the era’s primary source of transportation energy—the horse—would soon create an environmental crisis. ...

The enormous demand for a cleaner and more efficient source of energy led to remarkable innovations in the internal combustion engine. By 1920 horses in cities had been almost entirely replaced by affordable autos and trucks...

And to be honest, horse manure replaced by auto exhaust -- but as bad as auto exhaust is, it's a lot better than horse manure.

Suppose governments in the 1890s, desperate to replace the horse, had jumped on the first available alternative, the steam engine. Heavy subsidies would have produced more steam engines and more research on steam technology. This would only have waylaid the development of the far superior internal combustion engine. 

Source: Obtainium works.

(Actually, the government did subsidize railroads a good deal, and perhaps by doing so did stall the development of the truck.)

More than horse manure, I love the image of an alternate reality steampunk America...At left a cool  steampunk RV. (Image source)

Which brings us back, I'm afraid to the main force behind rail subsidies, which Randall has pointed out before: Nostalgia. Nostalgia for what seems like a simpler age. I understand that too. I love trains. But that doesn't make them practical, especially at billions of dollars per mile.

If we're doing nostalgia, how about doing it full time -- high speed stagecoach lines? Bring back the horse! It's all renewable!'

The real questions the Fed should ask itself.  This is a cleaned up and edited version of a previous blog post, commenting among other things on Janet Yellen's Jackson Hole speech in favor of most of Dodd Frank, that appeared in the Chicago Booth Review. When you think of the Fed, think more of the giant regulator than about where interest rates go.

Naturalistic monitoring and behavioural economics

Behavioural economics has identified a multitude of decision making biases and these insights have had a substantial influence on economic theory as well as public policy making. At the same time, researchers in various fields have begun to measure behaviour and experiences in the real world using naturalistic monitoring tools such as experience sampling and the Day Reconstruction Method (DRM). Our research group aims to combine these areas and investigate behavioural economic concepts “in the wild”. This can be done in observational studies, field experiments, or natural experiments. For a description of the DRM click here and here and for a recent application of the method to study self-control click here. Indicative projects using naturalistic monitoring are below.


Self-control and everyday job search

This project uses naturalistic monitoring to better understand the determinants of job search intensity. Since job search has immediate costs and delayed benefits, the project will focus on the economic and psychological literatures on inter-temporal choice and self-control. The project will explore whether low levels of job search are related to self-control problems and identify behavioural interventions that can help job seekers to overcome self-control problems. Additionally, the project will investigate the momentary experiences job seekers feel in their everyday lives and identify situational factors that influence these experiences.

Prospect theory in the wild

Prospect theory is one of the most popular models in behavioural economics. This project uses naturalistic monitoring tools in order to measure whether people use reference points in their everyday lives, and whether negative deviations from these reference points loom larger than positive ones. The project builds on Boyce et al.’s (2013) finding that losses in income have a larger effect on evaluative subjective well-being than equivalent income gains, and tests whether similar patterns can be observed for experienced subjective well-being in everyday life. The project also investigates the effects of loss aversion on decision making in everyday life and tests whether anticipated losses or anticipated regret predict everyday decisions more effectively.

Social preferences in the wild

Humans are social, as economists have learned from experimental settings such as Dictator, Ultimatum, and Public Good Games. This project tests the external validity of these experimental lab measures of social preferences by investigating whether the lab measures correlate with social behaviours in everyday life.

Identity economics in the wild

Many economically relevant decisions are influenced by self-image considerations and thoughts about who we are, which social categories we identify with, and which norms we should adhere to. Akerlof and Kranton (2010) introduce the concept of identity to economics, and this project aims to test how identity considerations shape the experiences and behaviours in peoples’ everyday lives.

Everyday Consumption

This project combines the DRM with a spending diary. The spending diary will provide information about what individuals spend money for and the DRM will help to understand why people spend the money. For example, the project can test whether online shopping is particularly prevalent when individuals are tired and exhausted as has been shown in laboratory experiments before. The project will map subjective preferences to consumption decisions and investigate differences in this mapping across the socio-economic spectrum.

Sustainable travel mode choices

The transport choices people make in their everyday lives are an important contributor to individual quality of life as well as an important influence on the global climate. Behavioural economics and happiness research suggest that many situational factors can affect peoples’ decisions to take the car, bus, train, bike, or other forms of transport. This project will develop and evaluate behaviourally-informed policy interventions that aim to facilitate sustainable travel mode choices.

The effects of smartphones on decision making in everyday life

Smartphones have become an essential part of our everyday lives, and recent research has explored the associations between smartphone use and momentary subjective well-being. This project aims to explain the high use of smartphones using behavioural economics concepts (e.g. visceral influences, self-control, social preferences) and identify the consequences of smartphone use for everyday decision making. The project will test whether the well-being effects of tech and social media use are moderated by the various decision-making styles.

The everyday effects of work email policies

Many companies strongly encourage employees not to send emails after work hours and remove moral obligations to respond to messages during free time. This project’s aim is to implement a randomised control trial on email-out-of-work policies. Building on the literature examining links between email, social media usage, well-being, and employee productivity, this project will explore the extent to which email-out-of-work policies influence time-use and subjective well-being. The project focuses on effect on stress, intensity within working time, and other compensating behaviours, and tests whether email-out-of-work policies are particularly beneficial for people with poor self-control.

The effect on alcohol display restrictions (“Booze curtains”)

In 2018, restrictions on alcohol displays will be implemented in Ireland. This policy aims to reduce the temptation and social pressure to consume alcohol by installing screens in front of the alcohol displays, informally known as “booze curtains”, in all retail outlets selling alcohol. This project evaluates this policy. The project uses naturalistic monitoring in order to evaluate this policy. In particular, we focus on the role of self-control and test whether the policy is particularly beneficial for people with poor self-control.

Medical adherence in everyday life

A major problem in most health systems is that people – despite their better intentions – do not take their medicine when they should. Not adhering to one’s prescriptions has increased the financial and health costs of medication. Using naturalistic measurement, we will identify the feelings, desires, and thoughts that predict medical (non-)adherence.

The validity of the DRM as a tool to measure everyday decision making

This project aims to test the validity of the DRM by comparing DRM data to equivalent experience sampling (mobile phone) data and identifying whether the reports from DRM match reports taken from real-time tracking. The project will also conduct detailed cognitive testing across all phases of the DRM to develop and improve the method. The project will generate a document that will facilitate the adaptation of the method by other researchers.

Please see details on this this link of postdoctoral fellowships funded by the Irish government. The deadline is the end of November. We are happy to speak to people interested in pursuing postdoctoral work in the area of behavioural science and behavioural economics.

The newspapers report today that President Trump has decided to nominate Jerome Powell to replace Janet Yellen as Fed Chair.

The Federal Reserve's mandate is to "promote maximum employment, stable prices, and moderate long- term interest rates." Ms. Yellen can look back with pride on these outcomes during her term:



All three variables are doing better than they have in half a century. Many people complain about many things at the Fed, including me, but relative to the stated mandate, she has every right to put these charts on the wall of her new office.

One could complain that Ms. Yellen didn't face any particular challenges. As presidents are tested in wartime, so Fed chairs are tested by events. Ms. Yellen didn't face a recession or financial crisis. In this quiet late summer of the business cycle, her job was largely to do nothing, and resist calls from people who wanted her to take big steps. The Fed's major tool is the federal funds rate, has barely moved.


True, but she did not screw up either. So much of monetary history consists of unforced errors, that not making one is an accomplishment. The late summer of business cycles has historically been a time when central bankers over or under react.  And there has been no lack of loud voices calling for drastic action one way or another. In particular, the siren song of "macro prudential policy" that the Federal Reserve should manipulate stock and housing prices has been strong. Her predecessor, Ben Bernanke, will be much more written about for the Fed's management of the 2008 crisis and recession, as well for its failure to see it coming in 2007.  Not screwing up doesn't earn you as big a place in history, but perhaps it should.

No matter how one feels about monetary policy, and the more important (in my view) question of Fed financial regulation, President Trump is breaking with tradition by not reappointing her. The tradition that if the Fed chair has done a reasonable job, he or she is reappointed is a good one for maintaining the independence of the Fed. Let us hope that it is not gone for good.

Good luck to Ms. Yellen in her next endeavor. And to Mr. Powell in this one.

The tax discussion is moving to personal income taxes, and the world is waiting to hear the actual Republican proposal, due tomorrow (Thursday).

With apologies to blog readers who know all this in their sleep, I thought I might explain just why (some) economists keep chanting "broaden the base, lower marginal rates," or why I keep saying that taxes don't matter, tax rates matter to economic growth.  This is grumpy economist, Saturday morning cartoon edition. Perhaps a colorful graph will help as you try to explain taxes to relatives this Thanksgiving.

Start with the blue line. Suppose you work 40 hours a week, and make $100,000. Suppose the government wants half of it. One way to get that is with a flat tax -- for every dollar you earn, send 50 cents to the government.  The government gets $50,000.

Now consider the red line. This line can represent a progressive tax: Exempt the first $50,000 of income, so people who make less have to pay a smaller share of their income in taxes, and charge a 100% tax rate on the rest. Equivalently, this line represents $50,000 of tax shelters and deductions -- employer-provided health care, charitable contributions to a foundation that employs your relatives and flies you around on private jets, a deduction for home mortgage interest, credits for the solar cells on your roof, and so on.

At first glance, this tax system raises the same amount of money. (That's "static scoring.")

You can see the hole in the argument. If we tax the marginal dollar after $50,000 at 100%, you won't bother working the second 20 hours, and the government will get no revenue. More deeply, slowly, and insidiously, in my view, people choose easy college majors that lead to $50,000 jobs, not harder ones that lead to $100,000 jobs, or they don't start businesses.


The green line is an economists' ideal tax.  Everyone pays the first $50,000 no matter what and then keeps everything after that. People would choose to work more than 40 hours a week, and the economy would take off.

Of course, that's not realistic as an income tax, but it's the idea behind "land" taxes, the recent fashion for "monopoly" taxes, and so on. Find something to tax that has no disincentive effects, and tax the heck out of it. One of my graduate school professors explained (in jest!) that we should tax kidney-dialysis machines. If you need it, you really need it and you'll pay anything to get one.

But at least we can move from something like the red line to something more like the blue line. Broaden the base, lower the marginal rate.

Here I think we have gotten to an unproductive argument. See the next graph

If we broaden the base, and lower the rate, we increase incentives to work. Then, to raise the same revenue, we don't have to make the lines cross at the old revenue. The new line can lie below the old line at the old work effort, but greater growth will make up the revenue, as shown.

The argument is not whether "tax cuts pay for themselves." That's an extreme possibility. But tax rate cuts do partially pay for themselves, so one can raise the same revenue from a tax system that appears, on static scoring (ignoring that the points move to the right) to raise the deficit instead.

This argument is correct, but it leads to a huge fight over just how much growth will increase, and when. It is hard to quantify. It is especially hard, in my view, because most government analysis ignores all the important channels. We focus on labor effort. But once we have chosen careers and jobs, most people work the same amount. The damage is more insidious. Slowly, people drop out of the labor force. Slowly, people chose easier college majors. Slowly, people choose safe and steady but not well paying jobs rather than risky high reward business startups. Slowly, people invest in  complicated lawyer-intensive tax-avoidance strategies. This all takes time.

And we have a huge deficit. So, I would prefer not to fight this argument. Broaden the base and lower the rates on static scoring. When money starts roaring in, cut the rates. Agree on the structure of the tax code for a generation, and let rates adjust as needed. Yes, many readers will worry that lots of revenue will lead to lots more spending. OK, let's write in that rates go down further if and when the revenues increase, rather than cut them now.

Furthermore, if we had to make a revenue-neutral reform, I think the pressure to get rid of the deductions would be much stronger. These mostly benefit the rich anyway (class warriors, why are you so silent on the regressive effects of home mortgage, charitable, employer health care, and state and local deductions??) You just can't get significant rate reductions on a revenue neutral basis without really cutting the deductions, tax expenditures, and with them much of the complexity and corruption of the code.

Alas, this eminently sensible idea -- broaden base, lower marginal rates, redistribution-neutral, and revenue-neutral, growth-oriented reform -- does not characterize much of what I'm hearing about the upcoming personal income tax changes.

One thing we are hearing more of is expanded deductions, for example for child care.  This is supposed to give a "tax cut to the middle class." Well, again, a tax cut and a marginal tax rate cut are entirely different things, and have different effects on growth.

The next graph gives the "middle class" a "tax cut" in two different ways -- by lowering the marginal rate, or by offering a new deduction or credit, and keeping the old rates intact. At the blue dot, our taxpayer has received the same "tax cut." But notice that by adding a deduction, we have done nothing to improve our taxpayer's incentives. In fact, we have made matters worse. There are offsetting "income" and "substitution" effects in provoking effort. As we get wealthier, we choose to work less. As opportunities are larger, we work more. This is all income effect, and no substitution effect.

It gets worse. The budget impact of this deduction is obviously large. Everybody in the US gets the deduction, all the way up the income scale. For that reason, most of these deductions phase out. Sure, "gazillionaires don't need help with their childcare expenses." (A good example of bad economic thinking all around.) So the credit phases out. The next graph shows what happens if we add a deduction or credit that phases out with income:



The steepest part of the line -- the greatest disincentive to work -- is in the phaseout region. In fact, the Americans facing the highest marginal tax rates are those precisely in the "middle class," where earning an extra dollar phases out credits, health insurance subsidies, food stamp subsidies, and so forth. On average, pretty much from 0 to $60,000 there is very little incentive to work -- or, again, to study, to choose harder professions, to move to take a job, to start a business and so on.

This is a little bit unfair. The credits and deductions do have incentive effects. That's half of why they're there. The mortgage interest deduction gives people an incentive to buy rather than rent, to borrow rather than save, to buy bigger rather than smaller, and to refinance frequently. (Interest payments are tax deductible, principal payments are not.) The childcare credit gives people an incentive to have children. (That this incentive is inversely scaled with income is another interesting issue.) The health care deduction encourages us to spend a lot more on health insurance and less on solar cells and electric cars. The solar cell and electric car deduction encourages us to spend more on those and less on food. And so forth.  If these activities encourage economic growth, perhaps it's worth suffering the disincentive to work, study, save, or start businesses.

An honest economist must admit that for economic growth, taxes do not matter. Marginal tax rates matter.  If there were a way to "tax the rich" without raising the disincentive to all the socially useful activities that becoming rich, or working to pass wealth on to your children entails, and if our society decided it wanted such redistribution, we would have much less argument against it. We would do the world a favor, I think, to harp most on incentives, which the world seems to ignore, and much less on our personal moral feelings about redistribution, pro or con.

How high are our marginal rates? Another important principle: All taxes matter, not just federal income taxes, and benefit phaseouts are just as important as actual taxes. Add to the Federal 43% top marginal rate the state income tax -- 13.5% in my California -- plus sales taxes on everything yo buy -- 9% in lovely Palo Alto. Pundits' habit of only quoting the federal income tax in isolation is profoundly wrong. And if you're one dollar below the medicaid cutoff, you face an essentially infinite marginal tax rate.