The Coase theorem and methodological nationalism

When I calculate or read about these astonishing numbers regarding wealth concentration in Russia (top decile holds 85% of all assets; see p. 33 of the Credit Suisse  Global Wealth Report), I cannot but think about the people who made all of this possible. I was then working on “transition countries” in the Word Bank research department, and was able to see what was happening. I travelled to Russia, knew lots of people who worked there and “advised” the government and had a chance to witness the overall disarray and dissolution of the country. But leaving aside the economists who found in all this chaos their own financial interests, most were driven by economic ideology which, when it came to privatization, argued three things. 

(1) Be a revolutionary. We need to privatize fast because “the window of opportunity” is now and Communists may be back any moment. Do like the French revolution did with Church lands: give it or sell to anyone because it would be hard to nationalize later. 

(2) Coase theorem. It does not matter for efficiency to whom the assets go. For sure, assets will be given for free to the people close to Yeltsin and the “family”, and who really do not know what to do with them, much less manage them efficiently, but this is a distributional matter. The efficiency will not suffer. The newly rich will sell these assets quickly to the entrepreneurs who  know how to manage them. Everything will end in the best possible manner. 

(3) Demand for the rule of law. Once you do that, there will be immediately demand for the rule of law, even if privatization is done in the most lawless and non-transparent fashion. The new millionaires will, like the robber barons in the United Stares, demand the rule of law because they need to protect their newly acquired wealth.

It is clear that if your hold these three views, you would do exactly as the privatizers did in Russia (and Ukraine) in the mid-1990s. Why did economists hold these views? 

I think because of a wrong paradigm which first, disregarded distributional  issues by simply relegating them outside economics, and second, because they failed to take into account globalization. Their views were based on “methodological nationalism”. 

Consider points  (2) and (3). They go together. Point (2) says that the distribution is immaterial, and that the market left to itself will ensure efficiency however distribution goes. But for dynamic efficiency you need point (3): you need people who would, even if originally they stole the assets, turn around and demand the rule of law. And presumably, who will be politically sufficiently strong to get it. 

(2) is wrong because once the rules are broken in such an egregious and unjust manner, this will for a long time remain a political problem. There would be temptation to break the rules again, and to seize the assets that were once stolen, or to give them to the others. This is exactly what Putin is doing now when he simply redistributes assets from the plutocrats  he does not like to those he does.  And interestingly, there is no much protest because nobody believes that these assets rightfully belong to the people who have them. So, Putin takes from A and gives to B, and it really does not matter to the public who A or B are. For most people, they are equally corrupt.

Point (3) is wrong because it failed to take into account that with globalization you do not need to fight a dubious struggle for the rule of law in your own country. A much easier course of action is to take all the money, and run away to London or New York where the rule of law already exists and where nobody will ask you how you got that money in the first place.  A number of Russian plutocrats, and increasingly Chinese, are taking this route. It makes total sense from the individual point of view. And it also shows  how our economic thinking has not caught up with the economic reality. 

In the 19^th century, it made sense for the Rockefellers et al  to fight for property rights in the United States because there were few places where they could go and squirrel away their money. Moreover, how ever much robbery the barons did, they were industrialists, that is engaged in some kind of business. But people who became suddenly rich in Russia were political cronies who were totality uninterested in running steel mills or nickel “kombinats”.  They did not even care if they run them aground, so long as they could cash out, and move to the Riviera.

The lesson: do not think that distribution and efficiency can be neatly compartmentalized, kept as it were in different boxes; and check if your theories work when you have a world where capital movements are almost entirely free and difficult to control, and where the rich can easily move from one “jurisdiction” to another. Our methodological  nationalism is getting more obsolete by the day.

PS. Those who harbor some doubts about what I wrote or disagree with my description of the Russian privatization should read this article by Black, Kraakman and Tarassova, the best piece on the topic that I have read.
 

Some prefer land: Stiglitz on income and wealth inequality

A couple of days ago I was invited to give comments on Joe Stiglitz’s presentation of a new paper on theoretical models of evolution of wealth and income inequality. The other two commentators were Duncan Foley and Paul Krugman. Stiglitz’s paper is not, as far as I know, on the Internet yet, so I cannot give the link. (I also had my own slides; they can be seen here.)

Stiglitz’s is a long paper (some 60 pages) and is in reality composed of two independent papers. The first one, on which I mostly commented, is a continuation of the discussion started by Piketty’s “Le Capital…”. Stiglitz points out to several very important puzzles that cannot be easily accommodated in the current neoclassical framework: broadly constant rate of return despite massive capital deepening, rising share of capital incomes even if the production function studies tend to find elasticity of substitution between capital and labor of less than 1, and stagnant wages despite the increase in K/Y ratio. The second paper is the extension od Stiglitz’s 1969 paper on the theory of wealth and income inequality whose objective is to model the long-run distributions among households that differ in terms of labor and capital incomes and savings  behavior.

I will mostly describe and comment on Stiglitz's first paper. The puzzles that I mentioned can however be solved if one distinguished capital and wealth which Piketty treats interchangeably. Piketty’s treatment of wealth as capital has already attracted attention, and I also wrote about it here. What I called the Pikettian “transformation problem” is the use of the results that come from the production function world, the K world, into the results that come from the world of personal income distribution, the W world. Combining the two, and linking the theory of growth to the theory of distribution was one of key Piketty’s contributions. But that conflation leaves several points (“puzzles”) unanswered, and can be solved either by (i) arguing that the K world behaves really very differently from what we believe to know (e.g. marginal product of capital does not decline even if K/L or K/Y increase), or (ii) by arguing that K and W are two different things.

Stiglitz takes this second route. K is productive capital, the number we put in a production function (I leave aside here all the issues linked with the Cambridge controversy), and W is private household wealth which includes not only productive capital but housing, paintings etc. Now, Stiglitz argues, W can increase, as shown in Piketty’s data, while K remains constant or even declines. Then the puzzles disappear: the return on capital need not decrease if K is constant; wages too can now be stagnant.

What created the wedge between W and K is, according to Stiglitz, land. Suppose that land (valuable real estate) is owned mostly by the rich. Suppose also that most of it does not enter the production function. Let then this land be suddenly demanded by other  rich, say the rich living outside the country with whose income distribution we are concerned. Clearly, as the real estate becomes more valuable, the average wealth of the country increases, and also becomes more unequally distributed. This happens because the asset, predominantly held by the rich, has gone up in price and made the distribution of wealth more skewed.

Moreover, more unequal wealth distribution spills into a more unequal income distribution because income includes (as per Piketty but also as per common sense used in all empirical studies of income distribution) higher imputed rent for the real estate owners whose housing has gone up in price and who have not sold it. (Just to be clear: if I own an apartment in New York whose price has doubled because Chinese oligarchs have bought scores of similar apartments in New York, both my income and wealth are up.)

Stiglitz provides a number of caveats and nuances to that story, but its essential contours should have been clear by now: (1) the puzzles disappear because capital is not wealth, (2) greater demand for an asset owned by the rich increases wealth and income inequality, and (3) long-term production potential remains the same. The increase in wealth thus does not imply that there would be an increased output forthcoming in the future. (This, of course, is very different from the situation where rich people invest in productive assets.)

I think that Stiglitz’s story represents a very reasonable attempt to both save the neoclassical production function and explain the increase in the empirical wealth/income ratio evident in Piketty’s numbers. Implicitly, the paper raises a number of important issues about the nature of economic progress. If the demand of the rich were, over the longer-term, directed mostly toward non-productive assets, that is, to the Riviera and Manhattan real estate, old paintings or similar luxury items with fixed supply, we would go back to a pre-capitalist system, justly criticized by Adam Smith, for having led the people  (mostly because of insecurity of property) to bury huge sums into unproductive assets like gold. The prospect for further increases in output will thence be limited. Rich countries could end up with both greater wealth and income inequality, and stagnant real output of goods and services.

Now, the real important question is, why would the rich prefer to invest in non-productive assets? A simple answer is that they do so because the expected return on such assets is greater than the expected return on equities or direct investment. But the broader question, to which I have no answer, is whether such expectations simply partake of the usual bubble phenomenon, where eventually, the price of the asset will have to go down, or are we witnessing a shift in the preferences of the rich, away from production and into old cognacs, Picassos, Rothkos, and Riviera real estate? And what does it imply for real economic growth, let alone the various theories of the trickle-down economics? For if there is no growth, there is nothing to trickle down.

Does inequality today hurt future growth of the poor?

Here is the paper written by Roy van der Weide and myself on inequality and growth in the US. It is obviously a topic of key importance  (does inequality help or hinder growth?) and the literature of the 1990s and early 2000s came to a dead-end mostly because of inadequate data and because they looked only at synthetic measures of both inequality (overall Gini) and growth (mean growth, like in GDP per capita). 

Roy and I “unpack” both growth and inequality, and, for example, look at the growth rates at different percentages of income distribution in function of inequality overall, inequality among the poor and inequality among the rich. We use six large US microcensuses (American Community Surveys) that cover the period 1960-2010 at decennial intervals. We find that high inequality now lowers the future growth rate of the poor, and raises that of the rich. The summary of our data, methodology and findings was published by VoxEU.

This empirical question has recently acquired added relevance because of the slowdown of growth in rich countries and the simultaneous rise in inequality. It has inspired extensive debates over the years, and also today the opinions among economists (and politicians) about the importance of inequality for future growth are still very much divided. The responses to our study too have been very diverse. Compare for example a recent op-ed in the Salon to a recent op-ed in Forbes.

In the latter, Tim Worstall points out that our findings may be biased because the nature of redistribution income received by the poor has changed over time. In the past, most of government transfers received by the poor, writes Worstall, were in cash while now a lot of it is in-kind (like food stamps, Medicaid, Earned Income Tax Credit); and in-kind transfers are not included in our measure of income. So, is Tim Worstall correct?

For clarity sake, let’s start with the definition of income we use. Our income data are gross income or what is called here in definitions given by Current Population Survey, Post-Social Insurance income, that is market income (the same concept as used by Piketty and Saez) plus government cash social transfers (meaning social security, unemployment benefits and whatever transfer you receive from the government in form of cash). 

Post-Social Insurance Income does not include direct taxes paid by households nor in-kind benefits like food stamps received mostly by the poor. Earned Income Tax Credit is not included because its inclusion requires two steps: first, to find out who, among the surveyed population is eligible for it, and second, to find out who indeed took it. This can be done only through tax simulations. But note that food stamps, at their money equivalent, are included in CPS disposable income, as they are in LIS data for the US available here (up to and including for year 2013).  

I agree with Worstall that it would be better if our data included all non-cash transfers, like food stamps and housing vouchers. But Tim Worstall is not correct that this would alter our results and that the rate of income growth of the poor would be higher than what we find in the paper because food stamps have been in existence since 1961 (reminder: our data start in 1960) and are thus not included throughout the duration of the study. In other words, there was no change in what the income concept we use covers.    

Let’s move to other non-included benefits. Medicaid, that people often mention in discussions these days, is not included, no more than government-funded medical or education services are included in other countries. It is just extremely difficult to do imputation of public health and education benefits (you have to have simultaneous estimation of people’s incomes and use of health and education and knowledge of what services are subsidized and what not). Moreover the imputation for health services depends on who has been sick during the survey year and has received such government-funded help. But if I was not sick, having a potential access to such services, is still surely good for me, but it will not be recorded in the survey. 

Nora Lustig and a number of associates have recently been working on such more comprehensive concept  of income that would include among transfers all government-funded health and education and would also deduct indirect taxes (like sales taxes) that are normally regressive. (In order to do the latter, you need to have an integrated income and consumption survey to know who purchases what and how much in sales taxes they pay.) 

The bottom line regarding the inclusion of these benefits In the US.

1) Tim Worstall is right that the inclusion of some in-kind transfers (food stamps and housing vouchers) in income would provide a better estimate of income. 

2) He is probably not right that this has an influence on our results because these was no change in the treatment of these transfers during the entire period that our paper covers.

3) The inclusion of other in-kind services like health and education should also be (ideally) done, but this is not an easy matter. Note also that while their inclusion, might show that inequality increase in the United States was less than we currently think  (because spending on such health services for the poor increased over time), the  inclusion of the same health and education benefits in international cross-sectional data, would lead to a relative decline of the US median income because such benefits (which are currently not included anywhere) are much greater in European countries than in the US.

Should Germany pay?

I read this piece "The pathology of Europe's debt" by Benjamin Friedman in NYRB yesterday. It is about the predicament of the South European countries. Friedman makes two key non-technical points.

1) Debt issue is not a morality play as Germans seem to believe. And to help his case, he quotes 19th century Protestant obsession about never being in debt, never borrowing etc.

2) He then describes at length how Germany benefited from not repaying in full its obligations under the Versailles treaty, and had finally practically all of it nullified by UK, US and France in the early 1950s. And then of course Germany benefited from the Marshall plan.

The clear, albeit unstated, conclusion is that Germany should now be more flexible and generous with Greece, Spain etc. because she herself was a major beneficiary of Western largesse.

But Friedman makes, in my opinion, three mistakes.

1) He neglects to engage with the view that the Versailles Peace Treaty that exacted significant reparations from Germany was inequitable. The German delegation signed it under duress, practically with the gun pointed to its head. (They disagreed with the war guilt clause in the Treaty and the enormous reparations that flowed from that clause.) 

Now, I am not blindly defending Germany here because I am aware that Germany just a year earlier imposed on Russia under Brest-Litovsk peace agreement far worse terms than those about which  she complained in Versailles.  And it is also true that Germany made France pay an unreasonable amount after the 1870 Franco-Prussian war. It was nevertheless short-sighted and unjust from the Allies to have applied the same unscrupulous approach to Germany in 1918-19 that Germany applied to them and to the Russians before.  This should have stopped. And we know, it also backfired.

2) When the Western allies forgave all of German previous debts at the conference in London in the 1950s,  it was not only because they did it out of the goodness of their hearts but because they needed a  strong West Germany as a bulwark against Communism in Europe and more specifically against Soviet influence in all of Germany. Thus, they did it as much for themselves as for Germany.

And finally the biggest mistake of all:

3)  While Friedman first makes the case that borrowing  should not be a subject of moralizing he then turns around and starts moralizing Germany about the need to repay for the largesse that she has received from the Western allies by being “nice” to the Southern European countries in trouble now. Well, either one or the other. If economics (or debt) is not a morality play then it is not a morality play period; for anyone. If it is, on the contrary, all about interests, short-term or long-term, the argument needs to be made why it may in German long-term interest to restructure Greek debt, forgive a part of it, or agree to the issuance of Eurobonds, jointly guaranteed by all Euro countries (but of course principally, by Germany). Be consistent if you want to convince.

Why individualism does not necessarily imply preference for a minimalist state?

It is often thought that individualism as a philosophical position must go together with dislike of state involvement in economic life. Radical individualists must like a small state, or no state at all. I think it is an utterly wrong point of view: being a radical individualist does not predispose one to be in favor of a small or big state, to favor state-provided social transfers or to be against them.

Where does this erroneous view come from? We have at least three possible sources.

The first is associated with Ayn Rand and her identification of “rugged individualism” (of “creators”) with people who are basically wronged by the state that transfers whatever they have produced to the “moochers” and  thus, of course, the creators must be against the state. Ayn Rand’s view is so extreme (never have people divided so neatly into two categories, and never has the state spoliated all the “creators”) and a caricature of any real society that her views need not detain us any longer.

More serious is Mises’ view (and that of many Austrian economists) who similarly associate individualism and preference for a small state.  (Mises does it explicitly in “Human Action”) Individualists not only want to be left alone by the state, but (and this is a crucial addition) they also do not care about the state transferring money to others, or the state taking on an insurance role (through a pension system, unemployment benefits, or social assistance to the poor). Thus, individualism would seem to be compatible only with the “night-watchman” state: a state whose function is limited to the protection of property and life. Even the judiciary system run by the state and state’s monopoly over fiat money are disliked by many Austrians: private courts and private monies can do the job, they believe, even better.

Hayek’s position, particularly in “Law, legislation and liberty” is much more nuanced, realistic and worth of a consideration. (It is also different from his simplistic “Road to Serfdom”.) He allows for a number of state functions, including a guaranteed minimum income. So, Hayek, to a large extent, modifies the earlier view that by being individualistic one must necessarily (a) not only be against state interference into one’s affairs but also (b) indifferent to the fate of the others.

It is this crucial point (b) which is false. If one does not want anyone (and especially not the state) to meddle into her  affairs does not imply that she does not care at all about the fate of people who live near, who may be compatriots, or, even more broadly, who are just people like her wherever they are. But if  one does care, there are only two ways to help them. One is to rely on private charity, another to transfer that function to the state.

I will not discuss here which one is more efficient (I believe that, because of the economies of the scale, the latter is). But relying on private charity means, in reality, that a person wants to establish relations of hierarchy between herself and those whom she is helping. At the minimum, there is a paternalistic relation where help may be forthcoming or not, depending on whether the “givers” like the recipients, or approve of their actions. Such a relationship, whether of hierarchy or of paternalism, is profoundly demeaning for the recipients of aid. Thus, while on the one hand, a person is helping them, she is, on the other hand, reducing their human dignity. There is an unhealthy trade-off there: the more a person gives, the more he wants to exercise influence over their lives, and the more their dignity is impugned. Perhaps, on balance, giving may become counter-productive: one loses mores through trampling of one’s dignity than one gets through money.

The other option is to delegate this function to the state. Now, people who receive aid receive it not from another individual (who just happens to be luckier than them, or to have been born into a rich family) and to whom, personally, they ought to be grateful, but they receive it as full-fledged citizens of a country that guarantees that they do have the _right_ to such assistance. The situation of the poor totally changes: they are not at the mercy of an individual’s whim. They are receiving something which is their right, no less than a person who receives wages is getting something which is his/her right. Poor person’s human dignity is preserved.

But to see decisively which situation is preferable,  change your perspective, and assume that you are a recipient of aid: would you prefer to get it from an individual whom you must constantly please in order that she continues with the aid, or from the state, as a free citizen? I think the answer is obvious.

So, in conclusion,  if a radical individualist is (1) not indifferent to the fate of people with whom she lives, and (2) does care about their human dignity, there is absolutely no reason why she might not prefer to have the state play a strong income redistribution role. The equation individualism=small state is a wrong one, in a general case. There is no necessary association between the two.