Category Archives: Public Policy

Economics, Public Policy

On the “optimality” of inequality

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Suppose there exists a one period society consisting of n identical individuals, each of whom is capable of producing output worth $1/n. Suppose that this society’s central planner imposes the following sharing rule: all n individuals in this society receive equal shares of total social output.

How much wealth will be created by this society? We already know that the maximum possible value for social wealth is $1. This outcome is only possible if we impose some highly restrictive behavioral assumptions. One possibility is that all n individuals’ objectives are to maximize total social wealth, and that no individual in this society suffers any “disutility” associated with putting forth the effort required in order to produce his or her maximum output. This outcome is also theoretically possible in a society consisting of self-interested individuals who suffer disutility from expending effort, so long as the central planner can not only perfectly and costlessly monitor effort, but also perfectly and costlessly enforce a “maximum effort” mandate for everyone in this society. In either case, total social wealth is $1, and everyone’s share is $1/n.

Now, suppose that there are costs to monitoring effort, and that self-interested individuals suffer disutility from expending effort. What happens then? The obvious answer is that shirking occurs, which reduces total social wealth as well as everyone’s per capita shares. Consider this problem from the perspective of one such individual who decides to shirk entirely; i.e., produce no output whatsoever. However, assume that the remaining n-1 individuals do not shirk. Then social wealth falls by $1/n, going from $1 to $(n – 1)/n; yet the shirker’s personal wealth falls by only $1/n2, going from $1/n to $(n – 1)/n2.  Thus the net benefit of shirking is substantial; the shirker only has to forgo the utility of $1/n2 in order to avoid the disutility (or, equivalently, utility “cost”) associated with expending effort. This is commonly referred to as the “free rider” problem. Therefore, it is not possible to have a free and prosperous society without some level of inequality in the distribution of income.

I became interested in this topic from listening to George Mason University economist Russ Roberts’ podcast featuring Cornell University economist Robert Frank. Although Professor Frank “…argues for a steeply rising tax rate on consumption that would reduce disparities in consumption” (cf. http://www.econtalk.org/archives/2010/11/robert_frank_on_1.html), he concedes that inequality is inevitable in a free society, based upon a similar thought experiment to the one provided here.

Economics, Financial Crisis, Foreign Policy, Public Policy

Political economy and the (inflationary) future

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A particularly important “political economy” topic these days is the unprecedented extent to which the US federal government is spending money it doesn’t have.  The federal government has historically collected about 18.4% of gross domestic product (GDP) in tax revenues and spent roughly 21% of GDP on average.  Currently, tax receipts are lower than the long run historical average, thanks to the “Great Recession” (probably around 15-16% of GDP), and federal spending is much higher than the long run historical average (upwards of 25% of GDP).  The gap between what the government takes in and what it pays out is commonly referred to as the “deficit”; for the fiscal year just ended (on August 31, 2010), the total deficit was nearly $1.6 trillion.  The annual fiscal deficit gets added to the total “national” debt, which as of October 31, 2010 stands at $13.6 trillion (cf. http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds102010.pdf). 

The national debt of the United States (as of 10/31/2010) is split into two categories:

  1. Public Debt ($9 trillion)
  2. Intragovernmental Holdings ($4.6 trillion)

Public debt is any money that is owed to investors, foreign governments, mutual funds, hedge funds, pension funds, foreign investors, etc.; i.e., in the form of US treasury securities.  “Intragovernmental holdings”, on the other hand, is money that the government borrowed from itself.  The major “source” for this is the so-called Social Security trust fund, as well as  other government-administered programs which happen to run “surpluses” in an accounting sense.  Of course, this money will have to be repaid in the future, and demographics ensure that the Social Security trust fund surplus will soon turn into a growing deficit in the absence of any meaningful reforms (e.g., the imposition of a higher age for eligibility, allowing for private accounts, etc.). 

I’ll finish by focusing attention on the public debt.  Nearly half of the $9 trillion in public debt (actually, $4.2 trillion) is held by foreign investors (cf. http://www.ustreas.gov/tic/mfh.txt).  China is the biggest holder of U.S. public debt – 21% of all public debt held by foreigners, in fact.  One can only wonder how this fact influences US foreign policy (since we “need” China’s dollars very badly), but I digress.  Lately, the US has been putting huge political pressure on China to allow its currency (the yuan) to appreciate substantially (cf. “China Currency Bill Advances”, 9/25/2010 WSJ).  If this happens, US products will become more competitive vis-à-vis Chinese products in global markets, but it will do so at the cost of leaving the Chinese with less dollars for buying our bonds.  Since we are in the process of exhausting China’s appetite and ability to fund our deficits, we now turn our attention to the Federal Reserve.  By buying public debt from the US Treasury, the Fed is effectively expanding the money supply while also providing the US Treasury with the dollars that it needs to finance the deficit; indeed, last Wednesday the Fed announced that it would purchase up to $600 billion in US Treasury securities as part of its so-called Quantitative Easing (QE II) program.  However, this Faustian bargain will most likely come at the cost of a return of inflation at some point in the future.  The good news right now is that there is hardly any inflation at all in the economy, so the Fed is betting that the future inflation related to its large scale purchases of Treasury debt won’t be “bad”.  I hope they’re right, but history and Milton Friedman tell me that this kind of movie has been played before and that it usually turns out rather badly (in the form of inflation; see “Milton Friedman vs. the Fed”).

Economics, Financial Crisis, Public Policy

Hayek vs. Keynes Sequel "Sneak Peak"

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‘Fear the Boom and Bust’ Hayek vs. Keynes rap video“, I reference and link to the very clever (and popular –  more than 2 million views on youtube.com) video production by filmmaker John Papola and economist Russ Roberts which compares and contrasts the ideas of two “famous” dead economists, John Maynard Keynes and Friedrich von Hayek.  Here’s a “sneak peak” of the “sequel” (hat tip to Russ Roberts): ]]>

Economics, Financial Crisis, Public Policy

Hayek vs. Keynes Sequel “Sneak Peak”

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In an earlier (January 27, 2010) blog posting entitled “‘Fear the Boom and Bust’ Hayek vs. Keynes rap video“, I reference and link to the very clever (and popular –  more than 2 million views on youtube.com) video production by filmmaker John Papola and economist Russ Roberts which compares and contrasts the ideas of two “famous” dead economists, John Maynard Keynes and Friedrich von Hayek.  Here’s a “sneak peak” of the “sequel” (hat tip to Russ Roberts):