Category Archives: Economics

Mises Defines Deflation

Many Austrians like to define inflation as “an increase in the money supply,” and for the most part ignore the demand for money. But, how did Mises define deflation?

Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the braoder sense) for cash holdings. This may be properly called deflation.

Human Action (Mises Institute: Auburn, 1998), p. 566.

An Austrian Take on Piketty

One thing no reader can complain about, Piketty’s empirical work is superb. The effort he puts into disaggregating the data goes a long way in helping us to explain the contingent causes of income inequality. In Capital, he provides data on the composition of the top decile’s income. Here is the data for France (2005) and the U.S. (2007),

Composition of Top Decile Income (France 2005) Composition of Top Decile Income (U.S. 2007)

One thing these graphs show is when income from capital becomes more important than income from labor. (Mixed income is analogous to a business, where it’s difficult to distinguish between the marginal products of the owner’s labor and her capital.) You can’t see it here, because I am not uploading the same graphs depicting data for the interwar years, but the intersection of the two curves occurs much later today than it did 80 years ago. Piketty distinguishes between two types of societies with extreme inequality: “hyperpatrimonial” and “hypermeritocratic.” Inequality today is as much due to inequalities in the distribution of wages as it is from inequities in the distribution (and return on) capital.

These graphs also show that income from labor becomes comparatively less important as the person becomes wealthier, on average. Inversely, income from capital grows in importance. On average, the lower half of the upper decile accrue ~5 percent of their income from capital and 90 percent stems from labor. The top .01 percent, on the other hand, earn a little under 35 percent of their income from capital, and less than 40 percent from their labor. This has a lot to do with the fact that top incomes own a very large chunk of capital, but also results from differences in the types of capital owned by various agents. 99 percent of the top decile earn much of their capital income from real estate; the top centile, on the other hand, earns large returns on the large stocks of financial assets they own, such as equity and bonds.

Justified or unjustified, doesn’t monetary policy play a big role in determining inequality, then? For an Austrian, it’s easy to blame central banking for the growth in value of real estate, specifically during the boom. But, this is controversial, so let’s focus exclusively on financial assets — or the top .01 percent. It should be less controversial to argue that monetary policy, directly and indirectly, affects asset and equity prices. Indeed, this is one possible channel of counter-cyclical monetary policy: higher asset prices creates a wealth effect. Neither is it far-fetched to argue that, if central banks issue an excess supply of money (which they possibly did during this past decade, in response to a positive supply-shock), asset prices are likely to be affected disproportionately. While Piketty’s data does not include capital gains, the implication is that monetary policy can actually make those in the top .01–1 percent less dependent on labor than they already are. It’s a subsidy to the rentier class.

Let’s go down the controversial route now, and see what Austrians can tell us about inequality. If money is non-neutral, it means that some or all are affected disproportionately by changes in the supply of and demand for money. Austrian business cycle theory (ABCT) says that excess supplies of money can be spent in two ways: investment and consumption. The assumption is that excess money is invested, on net. Think of productive assets as inputs and outputs. But, inputs have inputs of their own. To distinguish between all of these, Austrians talk about stages of production. The very last stage, consumption, uses the second-to-last stages’ output as input, and this penultimate stage uses the ante-penultimate stage’s output as input. If money is non-neutral, each stages’ prices level will lag behind the one in front of it. This is a disequilibrium, creating opportunities to profit. Booms, caused by excess money, attract heavy investment into sectors with relatively high profitability, and the economy as a whole becomes more capital intensive.

Hayek and Mises argued that wages lag behind capital goods’ prices; it’s the eventual receipt of wages, and their spending of these wages on consumption, that causes the economy to shift back to the equilibrium is was at before the boom. For simplicity, assume that the wage level remains constant for some period of time t, which is also characterized by a rising price level for capital goods. Doesn’t this imply an increasing share of income from capital? Total income is defined as: Y = wL + rK. Suppose Y doubles. W is constant, and we can assume L is constant as well. R, however, increases as the “false” value of capital increases and capital owners accrue an entrepreneurial profit. If Y doubles, rK increases, and wL stays the same, then wL/Y shrinks and rk/Y grows. This helps to explain Piketty’s r>g (and an elasticity of substitution between capital and labor greater than one).

Who else benefit? Stock- and bondholders, who are earning interest, dividends and capital gains. These are exactly the type of people, at least those who hold these assets in significant quantities, who make up the top centile of the income distribution.

According to Piketty, somewhere between 99–99.9 percent of the top decile earn most of their capital income from real estate. As the period between 19952006 shows, real estate prices can be very sensitive to excess money. While it is true that land ownership is now much more common — ~65–67 percent of Americans are homeowners, for example (although, homeowners equity has fallen) —, higher incomes earn greater rents on average. Real estate booms benefit the very wealthy much more than they do the moderately wealthy, and come at the expense of the worst-off, who typically rent. That seems like another strong force for inequality that Austrians can explain very well.

Modern inequality has as much to do with a very unequal distribution of capital ownership as it does with wage inequity. The U.S. and France are “hypermeritocratic,” according to Piketty. What type of job do we think of when we think high income? Manager. Not just any manager. The guy with a summer home in the Hamptons is not running a local 7/11. Rather, big-money management is in industries like finance and real estate. These people manage not only their own and their firm’s wealth, but the wealth of all their firms’ clients — these are people earning a share of r from the capital of all their clients. Even corporate management in very large corporation has a lower income level than finance management. These are the managers who are the best at pursuing profits — or they’re lucky to be in the right place, at the right time —, and who work in industries sensitive to excess money.

If Austrians are right, institutions do matter a lot in determining the distribution of income and wealth. Specifically, monetary institutions matter a lot. An excess supply of money can explain a growing capital share of income and a rate of return greater than the rate of growth. Specific income groups, usually higher on the spectrum, receive benefits from excess money, often at the expense of the other income groups, typically the worst-off. While capital owners benefit from an increased r, renters lose, and those buyers (namely, homeowners) who have negative equity will typically lose in the bust, because their asset will probably depreciate in value. Furthermore, the rules of the game that are fault are exactly the rules of the game Austrians (and some others) would like to change.

What Does a Football Manager Do?

I am watching the Benfica–Juventus match, and I couldn’t help but notice some of the behavioral patterns of members of both teams. The players are clearly following rules that they learn during their training, and that are both generalized (for all matches) and specific (to deal with specific qualities of the opposing team). It reminded me of a comment Atlético de Madrid manager Diego Simeone said a couple days ago. He said that managing is not so much about motivation, because all top division players are winners; rather, managing is about providing players with a specific set of instructions, to help them along with their own skills and intelligence. What characterizes a good football team?  A good set of instructions, or rules.

There is a similarity between what makes a good football team and what makes a well-off society. My discussion on rules and football serves as an analogy for rules, or institutions, and coordination between society’s members. Likewise, it may serve as a more direct analogy for what makes the firm what it is.

A football manager is similar to an entrepreneur, in that this person is responsible for finding the best way of allocating the inputs (the players) at his disposal. He is responsible for finding and producing along some demand curve. The way the manager does this is by imputing on to his team a set of tactics. Tactics specifies how the different players interact between each other, and therefore how they are allocated. But, it’s not enough to just organize your players on the field — i.e. decide on a formation —, and then let your players simply decide for themselves what to do on the field. Well, a manager could do this, but he wouldn’t be very successful (and they rarely are).

Good teams are well drilled. There are decision-making heuristics that players must known by second-nature. Defenders have to know when to challenge for the ball, and when only to harass the opponent; it might be that by challenging they can break their own defense, if they make a mistake. Players need to know when to press and when to track back. They need to be drilled on how to decide when to launch ambushes, to try to swarm an opposing player and rob the ball. In football, the team is greater than the sum of its parts. These rules are to in place to guide decision-making such that it is mostly congruent with the general tactics the manager has imposed. For the team to work the manager wants it to, the individual has to choose in certain ways that make the team work well.

Juventus provides one piece of evidence. Dominated by Benfica, they formed two lines of four, with Tévez and Vicinic looking for the counter-attack. Benfica’s midfield was passing it between themselves in front of the Italian team’s defensive lines. You could see Paul Pogba and, I think, Andrea Pirlo trotting back and forth as Benfica’s men passed it in front of them. In fact, the entire defense was synchronized. These players have internalized a set of rules that help them the display a high degree of unity and discipline as a team, oftentimes at the expense of the individual. In a Europa League semifinal, this type of intensity is to be expected, but an average team does not display this degree of tactical rigor in an average game — because they are not well drilled, that is they don’t always follow the rules.

Rules are important in attack, as well. Players are taught how to coordinate counter-attacks with each other, by passing into open spaces ahead of them and relying on their individual strengths to beat their rivals to the ball. They develop heuristics on who to seek, and what the best way of providing a teammate the ball is. A team, for example, might have a distributor, which other players might seek. This player is the lynchpin in the transition from defense to attack, because he distributes the ball to wingers or strikers. The decision to seek out a specific player to set up the counter-attack is based on a rule, because that rule leads to the best outcome on average.

If the ball is lost, a good, title-winning team needs to be drilled on how to press, and how to track-back the defense if they can’t recover the ball soon after losing it. A well drilled team will shave a good number of seconds in the amount of time it takes to recompose their defense if their counter-attack is cut short. Players need to be given instructions on how to judge when to press, when to ambush, when to track back, and how to maintain cohesion. In fact, a great example of the advantage of a well-drilled defense is Benfica’s defense during this semifinal with Juventus: their defense responded as quickly as Juventus’ counter-attack.

This Benfica–Juventus match provides yet another example of how rules are used in football. In the first half, Benfica managed to essentially nullify Juventus’ midfield. They did this by minimizing Pirlo’s interaction with the ball. How? The Benfica manager, Jorge Jesus, instructed his midfield to organize in what almost looks like a box, with four men surrounding Pirlo and moving to block passing spaces. Remember, the manager has to think about how to best associate his inputs with each other, to produce the highest value product possible. Jorge Jesus is denying Juventus the use of one of their most important inputs, their playmaker. Juventus’ manager, Antonio Conte, did not provide Pirlo, and other players, a set of rules to deal with these kind of situations. The Juventus midfield is doing better this second half, so maybe Conte has issued a new set of instructions.

Why are rules so important? A player can respond to a situation in many different ways. If he does not consider anything else but his own circumstances, there will be some optimal decision that he will come to. But, there may be circumstances which matter, but which he does not consider because he’s not aware of them. The player has an imperfect set of knowledge. Rules help him overcome this “ignorance.” Rules are informed by disparate circumstances. Good rules guide individual decision-making for the good of the team, because they help the player decide as if he held knowledge on circumstances other than his own.

The more complex a system is, the more difficult it is to plan and impose a set of rules. Rules have to be informed by many different circumstances, and the less of these any one person is aware of, the less any one person is capable of designing a set of good set of rules for the system. In complex societies, many rules may arise spontaneously. They may be developed by players, but they become popular because they work — it’s a sort of institutional evolution, of the kind Hayek had in mind. But, orders of lower complexity can be well understood, and once abstract rules come to be well-known, they can be imposed. A good manager is a good central planner, because he can devise a set of rules that allows his inputs to work best with each other and produce the most value product.

Unemployment’s Demand Side

About four months ago, I wrote on a for-fun empirical model, to test whether cyclical unemployment is predominately supply- or demand-driven. At the time, the results suggested that aggregate demand was the main determinant, although “labor freedom” (the only statistically-significant supply-side factor) could explain quite a bit in countries where unemployment is highest. I wanted to come back and see what the results look like if I try to incorporate the Phillips curve. Also, it would be interesting to know whether a demand shortage’s effect accumulates as “labor freedom” decreases.

The model is,

Unemployment Rate = β0 + β1Labor Freedom + β2Business Freedom + β3Fiscal Freedom + β4Property Rights + β5%ΔMoney + β6%ΔMoney2 + β7%ΔMoney×Labor Freedom + ε

Unemployment data is from the IMF, money growth data is from the World Bank, and the Heritage Foundation provides the rest. Definitions and rationales for the variables,

(a) Labor freedom: A proxy for labor market flexibility. Where labor regulations increase hiring costs, we expect greater unemployment.

(b) Business freedom & property rights: These were included to test the regime uncertainty thesis. According to the theory, lower business freedom and ambiguous property rights are disincentives to investment (and indirectly, employment).

(c) Fiscal freedom: This is a measure of tax burden. One belief is that higher taxes are a disincentive to invest. There is also a related argument that reducing taxes is stimulating, because it increases private spending. Either way, the supply-side argument expects positive correlation between tax burden and unemployment.

(d) Percent change in the money supply: This is the aggregate demand variable — and the data i for base money. I agree, maybe NGDP may have been a better choice. I’m not entirely convinced, because I think changes in money supply might test aggregate demand as a policy more directly. There is probably a choice that’s better than both of them, because changes in aggregate income can be caused by both supply- and demand-side factors.

Unemployment v. Money Growth (version 2)

The Phillips curve is introduced through the quadratic. The accumulation effect is represented by the interaction term %ΔMoney×Labor Freedom. Surprisingly, the interaction term is statistically insignificant. At least, it was surprising to me, because, for countries with very high unemployment rates (e.g. Spain and Greece), the coefficients for the linear approximation did not seem able to explain, on their own, the extent of their unemployment. So, when these two factors interact, maybe their effect is much worse than simply their sum. The data says no.

The two statistically significant variables are the quadratic term and labor freedom.

Unemployment Rate = 23.05 + –0.1021Labor Freedom + –.5726%ΔMoney + 0.0138%ΔMoney2

Introducing a Phillips curve actually very slightly decreases the effect of monetary policy. The prediction is that a one percentage point increase in rate of growth of the money supply will reduce the unemployment rate by –.5576 + .0276(%ΔMoney) percentage points. What this implies is that there are diminishing returns to monetary policy, and that as monetary policy growth rates become smaller, the negative effect becomes greater. The data is in line with the position that the worst monetary policy — whether public (central bank) or private (e.g. a clearinghouse issuing its own emergency notes) — is pro-cyclical, but that excess supplies of money at first have only a relatively minor negative effect on unemployment and then a gradually growing positive effect. Here, negative and positive have reverse meanings, because a positive coefficient implies a growing unemployment rate.

The marginal effect of labor freedom has also slightly increased, from –0.0961 to –0.1021. The original test, therefore, slightly underrepresented the role of inflexible labor markets. Still, labor inflexibility explains relatively little. For example, 2012 U.S. had a ranking of 95.5 out of 100; the most it could increase its labor flexibility is by 4.5 points, or a decrease in the unemployment rate by –.4595 percentage points. For cases like these, the coefficient is probably overstated, because it’s probably not the case that an increase in labor freedom from 95 to 96 is as significant as a change from 50 to 51. Likewise, if Greek labor markets were as flexible as U.S.’, the 2012 Greek unemployment rate would be 5.4521 percentage points lower. Even in cases where labor inflexibility is significant, it cannot explain even the majority of cyclical unemployment.

Because it’s interesting to some, that neither business freedom or property rights are statistically significant suggests that regime uncertainty is not a relevant explanation for cyclical unemployment — at least, not in this recession.

Stagnation and Technology

One line of reasoning tells us that growth is stagnating, because we have picked the majority of “low hanging fruit” and we haven’t been adequately reproducing it through technological invention. Tyler Cowen and Robert Gordon may, for example, claim that the internet is incomparable to the railroad, the automobile, et cetera. On the one hand, maybe their judgment on the value added by the internet is flawed; on the other, maybe their judgment of 19th century inventions is too,

On this basis the social saving made possible by the 59,000 million ton-miles of non-agricultural freight service provided by railroads in 1890 was $189 million. The last figure added to the ” pure ” agricultural saving yields a total of $329 million on all commodities. Thus, the availability of railroads for the transport of commodities appears to have increased the production potential of the economy by about 3% of gross national product.

— Robert W. Fogel, “Railroads as an Analogy to the Space Effort: Some Economic Aspects,” p. 40.

Institutional Discrimination Against North American Football

Why don’t Spanish teams recruit heavily from Spanish-speaking leagues in North America (all those north of, and including, Panama)? While these countries produce the occasional star, the average quality of their players is relatively lower than that of South America and Europe. Panamanian, Nicaraguan, even Mexican (the strongest league in North America), players do not attract the lucrative offers that many South American players do. Why is that? Because the way regional football associations are organized. The average quality of their continental tournament is much, much lower than South America’s. Thus, their players are exerted less as they develop, and their average quality is lower when compared internationally.

It makes sense to recruit from countries with lower transaction costs. There are, for example, many African players who leave for France early in their careers. 19 out of 20 Ligue 1 (top flight) teams have African players on their roster (for Paris Saint-Germain, few transaction costs are high enough to impede them from signing players). France’s national team’s last roster include two players born in Africa. 20 out of 20 Belgian Pro League teams include African players in their roster. English Premier League clubs also buy relatively heavily from African leagues, but often French clubs act as intermediaries. Spain recruits heavily from Argentina, and has started to increase recruitment in Chile and Colombia; countries which have built strong national teams without (originally) having access to strong players playing in strong European leagues.

Why are transaction costs lower? Countries with shared history — namely, colonialism — form “linkages,” such as a widely known common language, oftentimes looser immigration laws — especially for those with high MVP (marginal value product) —, strong immigrant communities in receiving states, et cetera. Apart from the attractive relative real cost (weighing for average skill) of African players, linkages also make assimilation within teams easier. A team with relatively perfect substitutes performs better than those with relatively imperfect substitutes on average, because the strength of the relationship between the players matters a lot in football (it’s a common characteristic in teams with high discipline, relative to other teams in their league).

Although Spain colonized much of North America, including most of the geography between the western United States and Panama, it does not draw on players born in these countries nearly as often as those originating in South America. I suspect the reason for that is that the average quality of the North American player simply cannot compete with those of the South American and African leagues (growing African migration to Spain also creates a network effect through migrant communities, lowering transaction costs). The reason this is the case is because of the way continental FIFA associations are organized: CONCACAF is one of the weakest associations. It is one of the weakest associations because of the countries which make it up.

Consider the size of national football markets in CONCACAF nations. Most of Latin American enjoys football as its major sport, but most Latin American countries have very small national economies — they are not comparable to those of larger South American and European nations —, and in the two largest economies, United States and Canada, football (i.e. soccer) is not big compared to rival sports (basketball, American football, hockey, and baseball). In other words, the football market in CONCACAF is very small, and therefore much less competitive (assuming the football industry enjoys increasing returns to scale). In less competitive environments, the motivation to innovate  is relatively low, and top leagues do not have to very internationally competitive to be regionally competitive. Think of Mexico’s domination of CONCACAF (on the league level especially), but the relative paucity of Mexican players in Europe.

Inter-regional competition matters. European leagues are strong because the UEFA Champions League is strong. The Copa Libertadores is a much more difficult competition than the CONCACAF Champions League — the latter almost exclusively dominated by Mexican clubs. Being inter-regionally competitive is attractive because it means higher revenue flows, largely as a result of prize money. Atlético Madrid, in Spain, has an average revenue between 120–140 million, and typically makes a loss (and has to sell players, on net, to make a profit). So far, UEFA will pay them ~40€ million for participating in the Champions League, a 33 percent increase in revenue. Most teams do not earn that much, but the prize money is lucrative and all participants draw from the cash pot. Regional competitions are strong when national football markets are large in association member countries. UEFA benefits from England, France, Portugal, Spain, Italy, Germany, Belgium, Netherlands, et cetera (the list is long); strong local economies, where football is the main sport.

Size of the market matters because of the assumption of increasing returns to scale. A few implications are,

  1. Larger markets will enjoy lower average costs, shifting the long-run average cost schedule down, and increasing the amount of firms in an imperfectly compMonopolistically Competitive Marketetitive market. In the football industry, this can mean stronger overall football associations, because of stronger competition between national leagues (stated another way, Spain’s second division is much better than Mexico’s). This creates a good environment for innovation and progress. Most groundbreaking tactical discoveries are made by UEFA teams — e.g. catenaccio, total football, and tiki-taka;
  2. Returns to scale internal to the firm will increase profits as average cost falls (and output increases). Relatively wealthy clubs have a broader recruitment base, as they can offer higher salaries (and often a wealthy life in the receiving state) than local competitors. They also typically have better youth programs, so they can better exploit the qualities of non-national players;
  3. If there are external economies of scale, lower average costs bring with them a cumulative advantage relative to competing regional industries. These industries attract more investment, at a higher rate than clubs in associations with relatively high average costs.

CONCACAF simply cannot compete with UEFA or CONMEBOL (yea, FIFA abbreviations are absolutely horrid) in average quality. I reckon that CAF (Africa) is marginally more competitive than CONCACAF. But, it’s not because their local markets are strong — well, that explains comparatively little. However, most of Africa enjoys strong, and exclusive, linkages with many European nations (France, England, Belgium, Netherlands, Italy). These same European countries do not recruit as heavily from Spanish-speaking countries (except for Brazil and Argentina, because of the strength of their leagues — CONMEBOL is the second-most competitive association in FIFA). Likewise, France, England, and Belgium recruit more Africans than Spanish team do on average. Spain often serves as an intermediary for South American players, who pass through Spanish clubs and then move on to other European squads. Thus, African players have a large market for their labor that is exclusive to them. National teams draw on their players who play for European clubs, and therefore perform more strongly than what the strength of their leagues suggests.

But, CAF also has decently sized economies where football is the primary sport. Africa might be the poorest continent in per capita income, but it has several large countries in population. Many of these countries also have large deposits of highly valued raw materials. Their national associations are most likely subsidized, and in absolute terms subsidies (and cash prizes) are likely to be higher in larger economies. CAF clubs have done better than CONCACAF clubs in the FIFA Club World Cup. The CAF Champions League is relatively competitive. Mexican teams have won six out of ten of their continental competitions. If the MLS is slowly improving it’s not because of CONCACAF, it’s because of the growing market for the sport in the United States.

Another piece of evidence is Australia’s national football association’s, the FFA, 2006 decision to leave the OFC (Oceania) confederation for AFC (Asia). While Australia dominated the OFC, not only enjoying the major share of regional cups, but almost virtually guaranteed entry into the World Cup finals, it judged that it could simply not grow in quality unless it benefited from stronger competition. And, the A-League and the Australian national team have benefited from this change. Regional competitions matter. They determine the total size of the market. Regional associations, or what are also known as confederations, which have large markets will be stronger than those which have small markets.

I originally asked why Spain recruits much more from South African than it does from North America, While there are many countries in CONCACAF that have strong linkages with Spain, the low average quality of their confederation makes CONCACAF players relatively less attractive. Where soccer as a sport is strong, the national economies are usually very small. Mexico is an exception to the rule, but neither is Mexico as wealthy as England, Germany, France, Italy, and Spain. Canadian soccer is probably the most uncompetitive in the region. And, the market in the U.S. is still comparatively small (although growing). Therefore, Spanish clubs prefer to recruit from South America and Africa. The geographic fate of North American Latin America has condemned it to facing an extreme inequality in football quality, from the perspective of the worst-off (excepting AFC and OFC). Only very exceptional North American players are recruited by European teams, and its the rules which determine membership within regional associations that are fault.

Crony Capitalism, Crony Communism, and Crony Anarchism

Over at Bleeding Heart Libertarians, Matt Zwolinski poses a challenge to libertarians who defend capitalism by suggesting that its current iteration is “impure.” He shows that there may be some hypocrisy if we also critique communism because it has historically led to oppressive dictatorships — that communism could be just as “impure” as current capitalism. This is not the first time I have read this challenge, and I feel that it has been largely ignored by libertarians — but, I think there is an intuition behind that choice.

In the comments, I wrote,

You can make a case that the “pure” communist society leads to an authoritarian, extractive dictatorship. You can also make the case that a capitalist system leads to a liberal society. I think the empirical evidence is broadly in favor of this interpretation.

But, I’m not entirely satisfied with my answer. I believe that a welfare state, of a size determined endogenously, is perfectly compatible with capitalism (which does not mean that all welfare states are compatible). But, those who disagree with me will still consider that a state of “impure” capitalism.

One way to look at social change is to interpret (part of) history as a gradual improvement of institutions. These institutions make our weaknesses less relevant, and they promote coordination between agents. Consider institutions such as property and contract rights, the rules that make bad people less relevant in government (there are positive outcomes, regardless of the intentions of a single agent), et cetera. Economists interpreted these institutions, but only within a narrow time frame: ~1700–present. They called the institutional framework they saw “capitalism,” referring to a narrow set of institutions that define “the market.”* Government was seen as exogenous to market institutions, but this probably isn’t right. Institutions of governance form part of the process of social change just as much as institutions of markets, and the often are interrelated.

A critique of communism could be: communism disrupts this process of change for the worst, causing institutions to deteriorate, rather than improve. Capitalism, on the other hand, embraces the process of change, causing institutions to improve. I think the first is right, and the second is wrong. What we define as capitalism today is the product of institutional change, and if we force the process towards a defined end — what some may call “pure” capitalism (anarcho-capitalism?) — we will end up with institutional deterioration. In that sense, “pure capitalism” and “pure communism” may not be that different. Both “pure capitalism” and “pure communism” are ideals we construct, but as such they are both equally weak to the accusation of a “fatal conceit.”

* Marx, however, did not interpret market institutions so narrowly. He thought that capitalism led to a deterioration of political institutions, or crony capitalism.

Piketty’s Meat and Bones

I have yet to finish reading Capital in the Twenty-First Century. There are many reviews already out, many of them very much worth reading. Two critical reviews by Ryan Decker and Josh Hendrickson. There is also Paul Krugman’s, probably the most widely discussed review to date; Krugman makes some good points against Piketty, but also covers some of the book’s strengths.

The heuristic the book sells to the reader is r > g. That is, if the return on capital is greater than the rate of economic growth, inequality will increase. The concept, explained like that, is somewhat cryptic. It’s an easy heuristic for those who don’t want to get bogged down in the theoretical argument. The theoretical argument is actually not that complicated (theory makes up a very, very small minority of the book). Piketty makes it near the end of the sixth chapter of his book. His argument is that if the elasticity of substitution between capital and labor is > 1, the share of income accruing to capital will grow relative to that of labor.

You actually don’t have to buy the book to access the theory. In my opinion, the theory is not well communicated in the book. It’s available in the free technical appendix. Here is that appendix for chapter six (in case it doesn’t take you directly, the meat and bones starts on page 37),

Download the PDF file .

China: Future Migration Hotspot?

China is still a sending state, more migrants leave than come in. According to the World Bank, about 1.5 million people emigrated from China in 2012, on net. I am not sure how much of that includes emigration to Hong Kong and Macau. Still, compared to the United States, which received, on net, 5 million immigrants, China does not seem like a major attraction to migrants. But, will China always be a sending state, or will it soon begin to receive net immigration? Immigration is already an important facet of the Chinese economy, and there is reason to suspect that China, like Western Europe and the United States, will, down the road, become a receiving state.

Historically, China has always been a sending state. The World Bank measures net migration as the number of immigrants minus the number of emigrants. China has had a negative figure since 1962, which is when the data I have starts at. But, net emigration does not imply no immigration, and, as their economy continues to grow, with a growing demand for labor, immigrants have turned into vital means for growing productivity. While the amount of net emigration remains significant — although, the data includes emigration to Hong Kong and Macau (two important net recipients of Chinese migrants) —, the number has been steadily decreasing since the early 2000s: from 2.2 million immigrants, on net, to 1.5 million.

The country, however, is going through a structural change. It is going through a process similar to that of the U.S., between 1820–1910. Industrialization has brought with it one of the largest internal migrations in the world, as large amounts of people move between provinces. This includes movements from rural areas to the cities, and movement from poorer (typically, rural and agricultural) to wealthier regions. While there are not always known opportunities for higher paying jobs in the cities — migrants are often displaced by a falling demand for labor in the rural areas —, it is true that Chinese industry is a sponge, in need of a growing labor supply.

Domestic labor is not always enough, especially given China’s low population growth rate (0.5 percent, in 2012). If the demand for labor increases, and the labor supply is more-or-less stable, we should expect higher wages. According to the “neoclassical” theory of migration, where changes in relative wages cause migration between countries, we expect rising Chinese wages to attract migrants. This does not necessarily mean, though, that immigration will occur up until wage rates between countries are equalized — in fact, emigration to China may push wages up, inviting even more immigration.

If there are economies of scale, larger populations mean higher real wageMonopolistically Competitive Markets. As population grows, all else equal, so does output. This lowers the average cost and price, raising the real wage. Larger population also means a larger amount of firms, greater product diversity, and the accompanying welfare gains to the consumer. This result was formalized by Paul Krugman, in his work on trade theory.

Trade, or the movement of goods and capital, creates the same effect as an increase in population: an increase in the division-of-labor. But, if trade is restricted, or if bad policies elsewhere leads to low growth and high unemployment, the movement of labor may replace the movement of goods. Consider some of the “stylized facts” of sending states: history of low growth, extractive political institutions, and relatively low wages. Sending states each have a division-of-labor which is significantly isolated from the world’s. While China’s political climate may still be unattractive to many, the economic factors may grow in relevance. The country is surrounded by many others which are worse-off, and growing Chinese wage rates will become increasingly attractive.

Other factors, besides relative wages, that determines migration are “linkages.” Think of a linkage as a shared history. For example, many Indians migrated to the United Kingdom, because India is a former colony. Similarly, Spain attracts a disproportionate amount of South American migrants, because of their shared history. Countries with linkages are more likely to be involved in a migration pattern than countries without them, all else equal. China has shared histories with not only its neighbors (many of which, however, are also growing and/or prosperous), but also with populations one might at first suspect. The Chinese have invested heavily throughout Africa, and many Africans have migrated to do business in China. As African networks in China grow, this might attract larger flows in the future.

Growth, however, does not always mean less emigration. The evidence shows that growth may actually lead to increasing emigration rates, below a certain threshold per capita income,

Emigration Flow to GDPPC

In early stages of development, other factors may dominate the marginal increase in relative wage. Since the poor are typically credit constrained, rising incomes will help them finance migration decisions. Networks in other countries may also attract large emigration flows. If early flows were restricted by asymmetric information, where potential migrants were simply unaware of the opportunity, growing networks in receiving states will correct this asymmetry and increase the flow of migration. Changes in relative income are important to consider, too. If early growth raises certain incomes disproportionately, the relative wage rates between countries for the non-affected income groups remain the same. Maybe this explains, in part, why China attracts high-skilled labor from South Korea and Japan, but exports low-skilled labor.

But, China’s GDPPC (GDP per capita) is just about at the threshold in the data. According to the World Bank, China’s 2012 GDPPC, in current U.S. dollars, was about $6,000. Net emigration has fallen since the early 2000s, and real wages in China continue to grow. Is China poised to become an important receiving state in the future? This will bring with it interesting problems. An immigration shock provokes hostility amongst a homogenous local population, leading to civil rights issues — issues the Chinese government will have to deal with. It will also have a significant effect on the global economy. The U.S. became a major industrial power in large part thanks to immigration. But, the U.S. started out with a relatively small population. China is already the largest country on Earth and there is still a growing demand for labor, despite the already large labor force. How will the Chinese government approach the “immigration problem?” How will this affect the United States and Western Europe? By 2070, or sooner, we might see large communities of American workers in Beijing!

Rules of Inequality

Two economists, Chris Dillow and Randall Holcombe, discuss income inequality and Joseph Stiglitz’ The Price of Inequality. For those who have not read the book, you can read my review. Dillow wonders why some libertarians — surely, not me! — do not oppose inequalities caused by rent-seeking. As if in direct response, Holcombe reviews Stiglitz’ book, showing how similar the liberal and libertarian positions on inequality can be. Both Holcombe and Dillow reference Stiglitz’ comment on the rules of the game. Stiglitz writes that inequality “is not the result of the laws of nature or the laws of economics. Rather, it is something that we create, by our policies, by what we do.” Those sentences can be hard to interpret. Stiglitz is not claiming that market forces will not create income inequalities. Rather, what he means is that the laws of nature and economics are not necessarily binding, and what is binding is our legal structure — we, as a democracy, can decide what the proper distribution of income should be. Put this way, Stiglitz’ argument is much more difficult for some libertarians to swallow.

What kind of distribution of income does economic theory predict? At its most basic, differences in income are caused by differences in marginal productivity. Your productivity is measured in how much value the marginal person in your profession produces, determined, in part, by the demand for final products. Medical services are worth more than grocery services, so a doctor will make more than a grocer. If you tried to explain the growth in income for management, especially in finance, in this fashion, you might make the claim that the productivity of management, at the margin, has increased. Managerial talent is in high demand.

Holcombe, Dillow, and Stiglitz discuss the role of rent-seeking in causing income inequality. When libertarians think about rent-seeking, they think about monopoly rents, in the sense of decreasing competition. A corporation, for example, might lobby government to introduce a law that hurts the firm’s competitors. Corporate subsidies is a clear example of rent-seeking. But, a broad definition of rent-seeking can also include opposition to restrictions on competition, which is not so obviously wrong. For instance, the NYSE might lobby government to lower the capital gains tax. Energy companies might spend money to pressure Congress to allow oil drilling in parts of Alaska. This kind of rent-seeking produces outcomes which are justifiable within a libertarian framework (and in general, too: there are many non-libertarians who think the capital gains tax should be zero). Yet, Stiglitz does not discriminate. He criticizes rent-seeking across the board.

Much of rent-seeking is “reactionary,” in that it responds to legislated laws which override marginal productivity. That rent-seeking can return income distributions to how they would be in the free market is an important point, because it is what differentiates the argument Stiglitz is making from the less controversial argument that Holcombe endorses. Few liberals, apart from some libertarians, support an income distribution based on marginal productivity alone. A liberal polity may agree — as has been the case so far — to redistribute some fraction of income or wealth to its worst off, because there are other concerns that override the justice of marginal productivity theory. Government can also change the income distribution through regulation. Businesses lobby to lower taxes and regulatory costs. To those who see these taxes and regulations as necessary, businesses who fight them are seeking additional rents. Stiglitz’ complaint against rent-seeking is not an implicit endorsement of an income distribution based on marginal productivity.

This brings me to something Dillow quotes,

And that this inequality is not inevitable.  It is not, as Rich said yesterday, like the weather, something that just happens to us. It is not the result of the laws of nature or the laws of economics. Rather, it is something that we create, by our policies, by what we do.

— Stiglitz, “The People Who Break the Rules Have Raked in Huge Profits and Wealth and It’s Sickening Our Politics.”

At the end of the day, the rules of the game which are binding are those which are legislated. Distributions caused by differences in marginal productivity can be changed. Inequality is not like the rain, something out of our control. No, we can decide, as a society, what the proper distribution of income ought to be. We will tax some and give to others. We will regulate industry, increase the workers’ bargaining power. There exists a gamut of tools a liberal society can employ to redistribute income, each with its costs and benefits. At least, that’s Stiglitz’ message.

Something else to consider is how little inequality rent-seeking may cause. “Crony capitalism’s” role in inequality is easy to exaggerate. Our GDP is ~$15.6 trillion. How much is spent on lobbying? One source puts the 2011 figure, which is a maximum in their data, at $3.5 billion. How much does the U.S. spend on corporate welfare? I’m not sure what year this figure is for, but Aljazeera cites $110 billion. Putting both of them together, and assuming the figures for 2013 are similar enough: .7 percent of GDP. We can assume that the estimate is below the true number. But, the amount of income directly redistributed through rent-seeking is still relatively small. Further, much of that income is distributed to the employees of those firms, not just management — rent-seeking does not always distribute between income groups.

There are other theories that may have more explanatory power. How much inequality does inheritance explain? Think about that question in the context of low growth and high rates of return on capital. More importantly, how much do productivity differences explain? If it explains 90+ percent of the income distribution, then the progressive and libertarian views on inequality do not match very much at all.

Holcombe writes, “there is a substantial consensus that government is the cause of many of the problems people perceive.” He is saying the same thing as Dillow, “It is just silly for libertarians to pretend that inequalities are fair.” Both are assuming that opposition to rent-seeking creates a large common ground between libertarians and progressives. But, the types of collusion some progressives, such as Stiglitz, want to include are more than what most libertarians, and many non-libertarians, would be willing to concede. And, ultimately, rent-seeking may not explain very much inequality at all. There may be more important causes of inequality, where the question of justice is more ambiguous. The common ground between libertarians and progressives is much smaller than the battlefield.