Banking and Excess Reserves

After yesterday's post, I received a question about cash.  More specifically, what does it mean to "sit on cash?"  The complete answer is more complex than you may realize.  One of the aspects of our economy that I intentionally excluded from yesterday's post is the role of banking.  Because the parable of the broken window does not consider a bank loan as an option, I too excluded banking in my analysis for simplicity sake.  The question I received, "what does it mean to sit on cash?" cannot ignore the role of banks in our economy.  Moreover, introducing banks into the parable of the broken window helps explain in greater detail what "hoarding cash" really means.

In yesterday's post, I said:

Because our economy is still emerging from a recession, some people and corporations are hoarding money.  This is what happens in a recession.  The demand for money increases while the demand for productive assets decreases.  For evidence, consider that Apple was sitting on $76.2 billion in cash as recently as July.

Is Apple sitting on giant mountains of $20 and $100 bills?  No.  To do so would mean that Apple is sitting on $76.2 billion in currency.  The term "cash" has several uses, but in a business setting we typically mean currency and extremely liquid assets such as money in a checking account.  It's important to make a distinction between currency and bank deposits because banks will take the deposit and then make a subsequent loan.  When the bank makes a loan, they are injecting money back into the economy.  Therefore, if a corporation hoards cash, it doesn't automatically mean that they are pulling money out of economic distribution. 

Banks, however, do not actually lend out 100% of the money they hold as deposits.  Banks are required to retain a specific percentage of deposits in reserve which are simply called "required reserves." Required reserves help ensure that the bank will be able to pay depositors when they withdraw funds from the bank.  In a normally functioning economy, the bank will lend out virtually all the deposits in excess of the required reserves in order to maximize their profit. 

Banks are not required to lend out all the money they hold above the required reserve level.  Additional reserves over the required reserve threshold are called excess reserves, and they are a strong indicator of a bank's demand for cash.  If a bank is concerned that withdrawals are going to be exceedingly high (meaning depositors want currency over deposits), they will keep a higher level of reserves than is required.  Additionally, if interest rates fall too low, then banks lose the incentive to lend as it is not profitable.  With no incentive to lend, banks accumulate excess reserves as well.

The Federal Reserve provides information on banks' excess reserves, and currently they are extremely high.  Our banks are holding almost $1.6 trillion dollars in excess reserves right now.  Compare this to pre-crisis levels that typical remained below $10 billion!  Are the banks hoarding cash?  Yes, but only to a point.  The large amounts of excess reserves are primarily a result of expansionary monetary policy by the Federal Reserve coupled with extremely low interest rates.  This means that the Federal Reserve is effectively pushing cash into the banking system, but the individual lenders have no reason to lend the money out.  The banks' demand for cash is greater than their demand for loans, and so the money is not reaching the general economy. 

What does this mean in terms of the parable of the broken window and our current economy?  Well, for starters, parables about broken windows probably shouldn't be used to explain banking.  However, we can still conclude that cash is being hoarded in our economy.  Businesses are hoarding cash primarily in the form of deposit instruments, which does not directly take money out of the economy.  Banks are hoarding cash in the form of excess reserves, though, which limits the amount of money moving throughout the economy. What isn't so obvious in this equation is that banks are primarily hoarding cash coming from the Federal Reserve, not from depositors.   Fiscal policy does not have the same limitations as monetary policy in low interest rate environments, but that topic will have to wait for another post.

Krugman and the Parable of the Broken Window

Paul Krugman sure does seem to piss off a lot of conservatives.  Krugman's ability to set America's right on their ear was on full display recently when a fraudulent Google+ account under his name posted this: 
People on Twitter might be joking, but in all seriousness, we would see a bigger boost in spending and hence economic growth if the earthquake had done more damage.

Vast numbers of right-wing writers immediately attacked the post as evidence of Krugman's heartlessness and lack of understanding of basic economics.  The stock response to the faux-claim has been to cite "The Parable of the Broken Window."  If you're not familiar with the parable, it goes like this:

A shopkeeper's son breaks a window.  The shopkeeper must replace the window, which costs $50.  Lamenting his loss of $50 to a friend, the shopkeeper's naive friend tells him that the $50 spent on the window went to the glazier, who now has $50 more to spend in his shop!  The money will come back to the shopkeeper and everything will work out in the end.  The shopkeeper, though, realizes the fallacy of his friend's logic and says, "What you forget is that I was going to spend that $50 on a new coat!  The clothier now will no longer have the $50 to spend in my store!  While I may be able to replace the window, I'm still out the coat!"

Thus, the parable of the broken window concludes that destruction is not beneficial to the economy.  Even though the impostor who posted the statement attributed to Krugman  has since revealed himself, it seems that he has managed to bring forth the parable as an argument against Keynsian economics.  It's not an original argument, and I have no doubt it will be trotted out again many times in the future.

There's are multiple problems with using the parable of the broken window, though, when viewing our current economy.  Before describing those problems, I have to lay down some basic ground rules.

1) Economics is an amoral scientific analysis of human behavior and wealth.  Note that I do not say immoral, just amoral.  There are no basic moral assumptions in economics.  For example, the drug trade, prostitution, and murder-for- hire are all examples of activities commonly (not universally) viewed as immoral.  However, economics does not consider the moral weight of any of these actions.  An economist can draw many conclusions about these activities without making any moral judgment on them.  Black markets exist, and an economist can study these markets without condoning them. 

2) An amoral economic conclusion, even if it is economically beneficial, is not necessarily an endorsement of a specific economic activity.  For example, most people attribute a highly expansionary effect on the economy due to World War II.  Few people, though, believe that World War II was beneficial to mankind.  Moreover, no one of conscience advocates simply going to war as an good economic solution. 

With these ground rules in place, I will affirmatively state that I do not condone or advocate property destruction, whether caused by man or nature, as an appropriate economic tool in any circumstances.  The conclusions that I draw are merely an amoral economic analysis and predictions of outcomes based on theoretical scenarios.

Now, back to the parable of the broken window.  Why doesn't the parable provide us proper insight into the economic effect of natural disasters?  Also, why is it an inappropriate comparison to Keynsian economics?

To begin to answer these questions, we have to look at the assumptions of the parable.  The "naive" friend assumes that the $50 spent on a new window is $50 injected into the economy.  Therefore, he believes that the money will ultimately "come back" to the shopkeeper when the glazier uses the money to make purchases in the shopkeeper's store.  In the parable, this assumption is false because the shopkeeper was planning on purchasing the a new coat.  Therefore, the total purchases in the economy in dollar amounts has not changed at all, and the shopkeeper no longer can afford his new coat.  The important assumption is that the shopkeeper was going to spend the money elsewhere, and this is why the shopkeeper is correct in the parable.

If the parable of the broken window is to have any truth when applied to a natural disaster, we must consider the basic assumption that the money used to replace the window was going to be used for other purposes.  Perhaps this seems like common sense to you.  It shouldn't be.  The shopkeeper always has the option of simply hoarding the $50.  What if the shopkeeper intended to bury the $50 in a jar?  If this is our new assumption, the "naive" friend begins to seem a little less crazy.  Instead of burying the $50, now the shopkeeper must spend it.  With this new assumption, total purchases do increase.  The economy has effectively grown, though the shopkeeper is still without his $50 in a jar.

What if the shopkeeper didn't have $50 to spend at all?  Unless someone is willing to give the shopkeeper $50, nothing happens.  The shopkeeper loses his window, the economy doesn't grow, and no one is better off, least of all the shopkeeper.  If someone is willing to give the shopkeeper $50, then we have to consider what the generous benefactor was going to do with that money.  If they had planned on spending the money, then the shopkeeper's logic holds.  Total purchases do not grow.  However, if the benefactor was simply hoarding the money, then total purchases do increase, and the "naive" friend's logic is not so flawed.

Given these different assumptions, it becomes clear that the original use of the $50 is paramount to any conclusion we may draw about the effect of the broken window.  If the $50 would be hoarded absent the broken window, then the parable's conclusion is incorrect.  If the $50 is earmarked for a different purchase, then the shopkeeper's logic is sound. 

Back to our natural disaster.  Which of the above assumptions most closely resembles our current economy?  In truth, a combination of all the assumptions is closest to our economy.  Consider the city of New York.  New York consists of poor people and rich people as well as many businesses.  Because our economy is still emerging from a recession, some people and corporations are hoarding money.  This is what happens in a recession.  The demand for money increases while the demand for productive assets decreases.  For evidence, consider that Apple was sitting on $76.2 billion in cash as recently as July.  However, not everyone is sitting on mountains of cash.  Poor people, in particular, would have no ability to replace lost assets without private or public assistance.  Would a generous benefactor sweep in to replace the lost assets?  Don't hold your breath.  If the relief efforts after Hurricane Katrina are any indication, some public and private assistance would be given, but not enough to replace the total lost assets of those without wealth.  So some of the citizens of New York resemble the shopkeeper with the jar in the backyard, some resemble the shopkeeper who wanted the new coat, and others resemble the shopkeeper without $50 at all.

With this new framework, what happens to New York after a theoretical natural disaster?  Let's start with the wealthy who are hoarding cash.  In order to replace their lost assets, they dip into their cash reserves.  This will grow the current economy.  The individuals with money that would be spent on other goods redirect their funds towards replacing their lost assets.  This is a wash for the size of the economy, but a loss of assets for the individuals.  The poor, however, must rely on assistance to replace lost assets which typically is not enough to cover their losses.  They lose assets, and any economic effect complete relies on the intentions of their benefactors.

To our final economic conclusion:  what is the effect of a natural disaster on the total economy?  Because some people have cash reserves that are redirected into the economy, the size of the current economy grows.  However, these individuals still lose assets.  Moreover, the economic stimulus of the event is only in proportion to the amount of cash reserves redirected into the economy, not in proportion to the total economic activity needed to replace all lost assets.  Finally, the damaged assets of the event may be replaced, but the total value of the assets is completely lost.  Thus, natural disasters may increase the current size of the economy at the expense of valuable assets.

Having concluded that amoral analysis, should we wish for natural disasters to save us?  The obvious answer is no.  Even though the current size of the economy may grow, we lose valuable assets.  Furthermore, the lost assets will hinder long-term economic growth.  Simply put, cash hoarders will not always want to sit on their money.  Eventually they will want to place their money in productive assets or use the money for consumption which will grow the economy more in the future.  So the immediate benefits of an expanding economy are offset by the long-term loss of assets.  Furthermore, the greatest effects of the disaster will be disproportinately felt by the poor who do not have the means to replace their assets.

If you are wondering why the "Parable of the Broken Window" is used as a counter-argument to Keynesian economics, you have to go back to the shopkeeper's assumption.  The shopkeeper realizes the additional spending on the broken window isn't an economic gain because he was going to buy that new coat.  Therefore, increasing spending on the window doesn't help the economy.  The flawed logic therefore concludes that Keynes' assertions about government spending are wrong.  What Keynes realized, and we see through empirical evidence, is that cash is hoarded in a recession.  Therefore, mechanisms that inject additional cash into the economy such as deficit spending and* expansionary monetary policy do* can have a stimulating effect by allowing the demand for cash to be met without a corresponding reduction in productive assets. The parable is simply a false counter-argument based on improper assumptions applied to a recessionary economy. 

If you are curious about Krugman's personal response to his impostor, you can find it here.

*edit:  in my attempt to keep this post from running too long, I originally condensed some of Keynes main points too much.  I've made these changes to better reflect a recessionary economy that does not enter into the Keynesian "liquidity trap."  However, our current economy might likely best be defined by the liquidity trap in a Keynesian model.

New Ideas to Combat Poverty

While the Federal Reserve System's primary role may be to control our nation's monetary policy, one of the lesser known functions of our central bank is as an economic research center.  To keep the public informed of current work in the field, a number of publications are made available covering a wide variety of topics, as well as specialized publications for educators* and students*.  If you have never seen the Federal Reserve's offerings, I highly encourage you to take a look*. If you are reading this blog, there is something there for you.

In the winter edition of Bridges, a quarterly publication distributed by the St. Louis branch of the Federal Reserve, Ray Boshara discusses new innovations in savings for America's impoverished.  Through exploration of the American Dream Demonstration and Individual Development Accounts, Boshara highlights how many commonly held beliefs about the plight of those in poverty turn out to be quite wrong.  People in poverty can save money, given some basic education and appropriate financial tools.  Additionally, some findings were quite shocking.  Households earning 200% of the poverty line saved about 1% of their income, while families only making 50% of the poverty line saved about 3%.  Furthermore, controlling for factors such as age, gender, race, employment status, or welfare receipt showed that savings occurred across the spectra of these categories.  In the American Dream Demonstration, "every hour of financial education was correlated with greater saving, but only up to 10 hours."

The results of the American Dream Demonstration are important on many fronts.  For the politically minded, it is refreshing to see conservative ideas used for social benefit.  Boshara takes a minor swipe at "left-leaning academics" who doubted the viability of the ideas, but it is a swipe the left should gladly take.  The mechanisms described by the article promote asset growth among our poorest citizens.  This growth in net worth correlates to greater financial stability, greater ability to survive financial distress, and of particular importance, improved outcomes for children raised in poverty.  The mechanisms are cost effective and do not require billions in federal funding.  The American Dream Demonstration may not solve all the problems of those in poverty, but it's a tremendous step in the right direction.

*I have linked to the St. Louis Federal Reserve publications, as this is the bank in my home region.

More political support for ABC theory

Though Ron Paul may lay claim to being the godfather of ABC theory in the GOP, it appears that at least one of his opponents is brushing up on the ideas as well.  Expect to hear much more about credit cycles, monetary policy, and the gold standard as we head deeper into the primary season.  I will be surprised if we hear anything about praxeology, though.  I imagine that the methodology of ABC theory plays against media narratives entirely too much for sufficient press coverage.

Warren Buffett, Socialist? Really?

The Daily Show has a nice segment on the reaction to Warren Buffett's editorial.

Ron Paul, the Gold Standard, and ABC Theory

Ron Paul seems to have made headlines recently for not making headlines.  The attention (or lack thereof, depending on viewpoint) has brought Paul back into the media's eye for another moment, and along with stories about Ron Paul come stories about the gold standard.    For advocates of the gold standard, there is no greater ideal than a return to gold-backed currency.  They believe this will solve the problem of economic "bubbles" and the subsequent "busts" that create recessions and economic turmoil. 

If it sounds fishy, that's because it is.  The theory behind Ron Paul's view of money is a school of economic thought called "Austrian Business Cycle theory,"  or more simply, ABC theory.   In order to understand why Paul thinks we should return to the gold standard, we're going to have to visit the strange and unusual world of the ABC theorist.  Be warned:  this is a world of crazy.

The first thing you need to know about ABC theory is that it denies empirical evidence can be used in economics.  Von Mises, one of the founding fathers of ABC theory, establishes this principle in his work, Human Action.  Von Mises surmises that man has free will, and therefore we can never make predictive judgments on the actions of man based on observation.  Each individual man choses for himself what his goals and actions will be, and observing one man or action tells us nothing about future actions or the actions of other men.  Therefore, the study of economics must only be the study of human behavior using pure theory and logic.  This specific methodology used by the ABC theorist is called praxeology.

What does this mean in practice?  It means that ABC theory will reject any use of historical data, scientific studies, or statisical analysis. This aspect of Von Mises work caused the economic historian, Mark Blaug, to quip, "his writings on the foundations of economic science are so cranky and idiosyncratic that one can only wonder that they have been taken seriously by anyone."  It is a fair criticism.  Without any ability to "prove" conclusions empirically, ABC theory borders on a faith-based approach to economics.  Additionally, it's virtually impossible to "disprove" ABC theory to a supporter, as evidence does not matter in their framework. 

Beyond the basic framework of praxeology, though, ABC theory has come to many conclusions about how the economy works.  Remember, real world evidence is not needed for these conclusions.  The first conclusion is that increases in the money supply create economic "bubbles."  The logic is simple (though erroneous):  given more money, individuals will invest in new things.  Given enough money, individuals will run out of "good" investments and start investing in "bad" investments.  This is the description of an economic bubble, and ABC theorists believe that the root cause of such a bubble is an increase in the supply of money. After a time, all bubbles "pop" and a recession occurs as the "bad" investments go away, the capital is reallocated to good investments, and workers adjust to the new economy with new labor demands. 

The current appeal of ABC theory should be apparent.  The recent sub-prime mortgage debacle appears to closely resemble the the "bubble" and "bust" paradigm.  Our monetary policy, primarily controlled by the Federal Reserve System, did provide for an increasing money supply leading up to the financial crash.  The heavy investment in sub-prime loans did resemble "bad" investment.  These simple correlations have lead many to believe that ABC theory might be onto something.  Finally, the solution to the problem of recessions in this framework is to contain the money supply.  That's where the gold standard comes in.

Ron Paul and his disciples believe that by pegging the value of the dollar to the value of gold, the money supply will therefore be fixed.  With the return to a tightly controlled money supply, bubbles will no longer be able to form.  Without bubbles, there won't be any busts.  Our economic woes will be over.  Aren't most of the world's problem this easy to fix?

The oversights of this logic become apparent once any sort of scientific analysis is introduced.  Let's start with the historical record.  America experienced recessions beginning in: 1796, 1802, 1807, 1812, 1815, 1822, 1825, 1833, 1836, 1839, 1845, 1847, 1853, 1857, 1860, 1865, 1869, 1873, 1882, 1887, 1890, 1893, 1895, 1899, 1902, 1907, 1910, 1913, 1918, 1920, 1923, 1926, 1929 (the Great Depression), 1937, 1945, 1949, 1953, 1958, 1960, 1969, 1973, 1980, 1981, 1990, 2001, 2007.   It's a long list, and I include it in it's entirety to demonstrate how often recessions have historically  occurred.  It's particularly notable that the United States has only experienced six recessions of varying intensity in the forty years since abandoning the gold standard.  Forty recessions, including the Great Depression, all occurred before this abandonment (with notable exceptions during war time).

What about more scientific studies and historical analysis?  Ben Bernanke delivered an illuminating speech in 2004 that discusses the effects of the gold standard during the Great Depression.  Relying on the work of the economists Milton Friedman and Anna Schwartz, Bernanke discusses how a constrained money supply slowed America's ability to emerge from the Depression.  Bernanke's speech expands on this idea by addressing the international community's use of the gold standard during the Depression.  As Bernanke states:

Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985).

In light of such evidence that debunks ABC theory, many are not deterred. Of course, for the pure ABC theorist, evidence does not matter.  For them, evidence only tells you what happened one time and has no application to what will happen in the future.  This is why Ron Paul and his gold standard rhetoric is so frightening.  It has no basis in history.  It has no basis in scientific observation.  It is only how the world should work inside his own head.  Such reasoning should not be involved in our economic problem solving.

Beyond Marginal Tax Rates: LIFO

While much of the nation's tax debate centers on marginal income tax rates, a slew of deductions, incentives, loopholes, and accounting tricks escapes the attention of media and the electorate at large.  These lesser known tax issues can amount to huge tax breaks for their recipients--sometimes by design, but sometimes not.  In an effort to further understanding of the tax system in place, I will periodically be posting on these lesser known issues and what they mean for American tax policy.

If you've never heard the term LIFO, you are not alone.  LIFO is the acronym for "Last In, First Out," which is simply an accounting method for valuing inventory, and the term is typically reserved for some of the most technical accounting discussions that can take place in a business environment.  However, LIFO means big money for some of America's largest corporations.  Here's how it works:

Imagine that you are a large oil company.  Every year, you must prepare financial statements and file a tax return like any other company.  One of the largest expenses your company will incur is "cost of goods sold."  Calculating the cost of goods sold can be complicated though.  As a large oil company, you maintain a large reserve of oil as a course of business.  Additionally, you continue to purchase oil throughout the year.  You encounter a problem when you must calculate the cost of goods sold because your reserves and the oil you purchased throughout the year were purchased at varying prices.  It is impossible to determine exactly  the cost of the specific oil that was sold throughout the year, as the oil mixes together in the reserves tanks and is completely homogenous.  In order to solve this problem, accountants developed a number of ways to account for the cost of goods sold.  The two most important methods are LIFO and FIFO.

As earlier stated, LIFO stands for "Last In, First Out."  This means that the latest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  FIFO stands for "First In, First Out," and it means that the earliest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  You must chose one of these methods.  Is there an advantage to either method?

The answer is a resounding "yes."  Because a normal economy experiences incremental inflation, LIFO presents a clearly superior option for companies with large inventory reserves.  Consider an oil company that has been around for 40 years.  The price of oil in 1971 was around $18/barrel.  Because your company has maintained a large supply of oil over the course of its existence, LIFO allows you to continue valuing your reserve inventory at much older prices, perhaps as low as $18/barrel!  The additional ramification of this decision is that your "cost of goods sold" is shown on your tax return at much larger current purchase prices, currently around $87/barrel.  This means that your "cost of goods sold" is higher than reality so long as inflation keeps prices above your historic purchase levels.  The increase in the COGS reducing your net taxable income.  The lower net taxable income means you pay less in taxes.  Thus, in a normal inflationary economy, the choice of LIFO will lower your total tax bill.

For some of you, this may seem grossly unfair.  Remember, though, that either accounting method has been legal since the 1930s.  Additionally, should the economy experience severe deflation, FIFO becomes the preferable accounting method to reduce taxation.  Because we normally see modest inflation, companies with very large inventories do tend to elect LIFO accounting methods.  While it's understandable why a corporation would make this election, is it in the best interest of society to allow for either option to exist?

The debate over the appropriateness of LIFO has been quietly going on for years.  Most recently, Democrats proposed the elimination of the LIFO accounting method during the debt ceiling negotiations.  The anticipated result of such a decision is projected to generate $72 billion in additional taxes from these companies which would reduce the federal deficit.  Republicans balked at this proposal claiming that it is a tax increase on business that would hurt jobs, and that LIFO is actually a more appropriate method as it better reflects economic gains over inflationary gains.  For the time being, Republicans have won out, and LIFO is still a legal accounting method.

The assertion that LIFO is more appropriate than FIFO due to economic gains is dubious.  Companies are charged with maximizing shareholder value, and LIFO is simply a better method for doing so in a normal economy.  Should America enter a long and severe deflationary cycle, many companies would switch to the FIFO method when possible to continue maximizing shareholder value.  This is their job.  When have large corporations ever advocated for legislation on the grounds of appropriateness over profitability?  Because of this, the arguments for keeping LIFO don't pass the smell test.

There is still a problem, though, in that companies can chose an accounting method to lower their tax bill.  To maintain parity between businesses, one standard accounting method should be adopted.  Standardizing the accounting method is not a tax on all business, as not all businesses chose the LIFO method.  Moreover, FIFO more closely resembles reality.  Older inventory does get sold--it doesn't simply sit on a shelf while newer inventory cycles in and out of the business.  Truly, the use of LIFO is simply a tax loophole created by accountants and should be eliminated in America. 

The elimination of LIFO would not be an innovation or place us at a disadvantage.  LIFO is already illegal in Europe and other westernized countries like Australia.  The arguments supporting LIFO accounting are flimsy and transparent.  Most important, though, the elimination of LIFO will make taxation across businesses inherently more fair.

Game Theory and Warren Buffett, part 2

Warren Buffett does, in fact, understand game theory.

Game Theory and Warren Buffett

Warren Buffett wrote in the New York Times today advocating for a higher tax burden on the mega-rich.  Initially reactions seem to have divided along partisan lines--Democrats are praising Buffett for his courage, while Republicans are berating him for his cowardice.  The Republican argument follows that if Buffett really thinks the mega-rich should be paying more in taxes, he would simply write a check for the difference in his current tax rate and what he believes is appropriate.  This simple moral argument appears to have numerous supporters, as demonstrated by this slightly older piece by Gregg Easterbrook.  There is a problem with Easterbrook's logic, however.  He assumes that by voluntarily paying more in taxes, any rich person who advocates for higher taxes would appear more sincere and that this would lead to an appropriate increase in taxes being raised by law.

I'm personally at a loss as to why Easterbook thinks voluntarily payments by wealthy individuals would make a Congress more likely to raise taxes on the rich.  Perhaps he believes that Congress will feel guilty and "do the right thing."  This view of Congress is so painfully naive that I can't imagine this to be Easterbrook's argument.  It resembles evil Disney villains who realize the error of their ways only in the humbling light of the sweetness and light that is the Disney hero.  This is not an American Congress. 

The fact of the matter is that Easterbrook is not truly considering how Congress operates.  He is simply calling into question the sincerity of President Obama, Bill Gates, Warren Buffett, and any other wealthy person who might advocate for a tax increase on their own tax bracket in an attempt to discredit their position.  Easterbrook hardly touches on the merits of such an increase (he seems to indicates it's a necessary along with other measures, but that point is certainly muddled among all the ad hominem attacks on these men), and he relies on incorrect notions of how individuals affect social decisions to come to his bizarre conclusion that unless Obama, Gates, Buffett, and other start voluntarily paying more in taxes, our deficit problem will get worse. 

It is worth examining what effect, if any, the voluntary payment of excess taxes would have on society.  Mathematically we have tools to do just that.  The field of game theory provides the means to model the effect of individual behavior on the behavior of a group, and simple game theory models provide some insight on Easterbrook's erroneous conclusion.

In game theory, a matrix of possible outcomes based on each individual's decision is constructed and a weight is assigned to each outcome to allow for the maximization of "utility."  Without going into too much detail about the nature of game theory, some simple examples can be used to approximate various scenarios of voluntary excess tax payments by individuals in society.  For the first example, let's assume the total relevant population consists of Warren Buffet, whom we will simply call "Mr. A," and one other super-rich person who doesn't share his views, whom we will call "Mr. B."  In this scenario, Mr. A would like for everyone to pay $500 more in taxes.  These tax dollars will then be used for the benefit of the total population (n=2 in this scenario).  The resulting matrix of outcomes looks like this:


                     B's choices

                      pay more        don't pay more
A's choices

pay more      -$500, -$500       -$500,   -$0
                    +$500,+$500      +$250, +$250
Totals:            $0    ,   $0          -$250,   $250

don't pay      -$0,      -$500       - $0,  -$0
more            +$250, +$250       +$0, +$0
 Totals:           $250, -$250          $0,   $0

The first line of each cell is the individual costs of their decision.  -$500, -$500 indicates that Mr. A and Mr. B chose to pay $500 more in taxes in the top left cell.  The second line of each cell is the benefit received in the form of government services due to the increase in voluntary taxes paid.  +$500, +$500 indicates that each individual gains $500 in extra government services.  The totals line indicates the combined cost in additional taxes as well as the individual increase in benefits.  Mr. B's motivation is to maximize his personal total gain in the matrix.  To calculate this, we must simply find the cell(s) with the largest total benefit for Mr. B, which is the second entry in each cell.  Looking at our outcome matrix, we see that Mr. B maximizes his personal benefit in the top right cell.  This means that Mr. B is hoping for Mr. A to voluntarily pay more, while he pays nothing extra. 

Mr. A has chosen to pay additional taxes because he believes, similarly to Mr. Easterbrook, that by doing so, this will lead to Mr. B paying more in additional taxes.  However, Mr. B considers the graph above and wants to maximize his personal gain, therefore he pays nothing extra.  This results in a personal gain of $250 for him, the best he can hope for under any circumstance. 

After paying extra taxes, Mr. A is now angry that Mr. B did not follow suit.  Therefore, Mr. A now STOPS paying additional taxes the next year.  Mr. B, always looking to maximize his personal benefit, goes back to the outcome matrix.  He can still choice to pay more, but why would he?  This results in a total loss of $250.  His best move is to simply continue to pay no additional taxes.  Now, however, he simply maintains the status quo and no one gains anything.  As it turns out, Mr. A cannot persuade Mr. B to pay additional taxes by paying more taxes in this overly simplistic scenario.

Having gone through that tedious exercise, now let's expand the model.  Let's include a "Congress" and a federal deficit of $1,000.  Mr. A and Mr. B will continue to be the only taxpayers though.  In this scenario, Congress must come up with an additional $1,000, but they are reluctant.  Mr. A decides to pay an additional $500 in taxes hoping that this will persuade Congress to raise the rates on everyone.  Because we have introduced a deficit, our matrix now has no additional government benefits, and the total benefit for each individual is now equal to the individual cost only, or the top line in each cell of our matrix.  What happens now?

After Mr. A pays his additional $500, Mr. B must decide what maximizes his personal gain.  It still appears that paying no additional taxes is his best bet.  Here's where the analysis gets tricky.  Congress now has a deficit of only $500.  Congress must raise the base tax rate only enough to collect $500 total.  Therefore, Congress raises taxes on both Mr. A and Mr. B by $250 each.  Mr. A is now pissed!  He wanted taxes to be raised by $500 each!  Therefore, he stops making an additional voluntary payments after Congress raises taxes by the lesser amount.  Only then does Congress have the need to raise taxes again to the full amount Mr. A thought was appropriate.  Mr. A could have continued to pay an additional $500 to balance the federal budget, but then he's paying $750 more than the original base, while Mr. B is only paying $250.  This is not what Mr. A wants. 

In fact, the only way that Mr. A can have Congress raise the tax rate to the amount he wants is to not pay any additional taxes.  Until Mr. A stops paying additional taxes, Congress will never have the incentive to completely raise the tax rate for everyone.  The rational decision for Mr. A then becomes simple.  His best decision to maximize personal benefit and eliminate the federal deficit in our model is to never pay voluntary additional taxes in the first place so that Congress must raise the tax rate by the full amount. 

While this model is overly simplistic, the logic holds in larger, more complex scenarios like the one addressed in Mr. Buffett's article.  By paying additional taxes voluntarily, Mr. Buffett and all the mega-rich who think like him would be creating a disincentive to Congress to fully accomplish their goal.  Paying extra actually acts as a hindrance to their goal, and the rational conclusion is to never pay additional taxes voluntarily.  With that being said, Mr. Easterbrook is simply wrong. 

Suggestions Welcome

Is there a specific issue in American economics or politics that you would like to read more about?  Feel free to leave a comment with a question or suggestion for future posts.  If it's something I don't know much about, I'm happy to learn more!  And it may just be a topic that I have already planned to discuss, so let me know and I'll do my best to accommodate you.

The Federal Reserve System

While most Americans are likely aware of the existence of the Federal Reserve System, few can accurately describe the structure and role of this immensely powerful organization.  It is our central bank, acting as the "banks' bank."  It determines our monetary policy.  It even issues our currency that we carry in our wallet.  The power that this organization wields leads many to believe that it is part of a master conspiracy, evil in design, and a detriment to our society.  In reality, the Federal Reserve System is a complex entity composed of public and private interests and decentralized throughout the country.  The specific structure and design of the Federal Reserve System is worth exploring, as it is uniquely American and exceedingly socially capitalistic. 

The Federal Reserve System is not America's first central bank.  In fact, it's not even the second.  Agrarian interests and a national fear of centralized power brought to an end our first two central banking systems.  The Federal Reserve Act of 1913 created the Federal Reserve System as we know it, and the tensions of American politics left clear fingerprints on the design.  Because Americans have typically feared large, centralized institutions removed from much of the nation by thousands of miles, the Federal Reserve Act created twelve regional banks to decentralize the power of the central bank and to ensure a distribution of oversight across regional lines.  Additionally, these banks were established as quasi-public institutions.  Thus, ownership of the banks is shared between the federal government and the private commercial member banks in each district.  By dividing the bank into twelve regional banks that are mutually owned by the government and private banks, power was divided between the public and private sector and further distributed throughout the country.

It would have been possible to stop with the regional distribution of the banks and the quasi-public ownership to ensure a reasonable distribution of power, but the Federal Reserve Act went further.  A Board of Governors was established to oversee the activities of the banks.  The Board is composed of seven members appointed by the President and confirmed by the Senate.  However, once appointed, the Board of Governors has tremendous autonomy from the government as they are appointed to long fourteen year terms.  The appointment by the President reflects the public need for input into the leadership of the bank.  The fourteen year terms, however, insulate the Board from political pressure and allow for long-term decision making.

For each regional bank, another layer of hybrid oversight was established.  The twelve regional banks each are headed by nine directors.  Six of these directors are elected by the (private) member banks of the Federal Reserve System.  The remaining three directors are appointed by the Board of Governors.  Of these nine directors, there are three categories of directors:  A, B, and C.  The three A directors are professional bankers and are elected by the member banks.  The three B directors, also elected by the member banks, are chosen from private industry, labor, agriculture, or consumer organizations.  The three C directors are the appointees from the Board of Governors, and they are prohibited from being an officer, employee, or stockholder of any bank.  The nine directors determine the president and officers of each bank.  This complex mix of public and private election and appointment that mixes bankers, industrialists, and public advocates adds one more layer to the checks and balances of the entire Federal Reserve System.

Although the Federal Reserve System created twelve banks, there is still a need for a centralized component of the system that handles specific monetary policy decisions.  Therefore, the Federal Reserve System also has the Federal Open Market Committee (FOMC).  When you read about actions of the "Fed" in the news, it is likely that you are reading about the specific actions of the FOMC.  The FOMC makes decisions that influence interest rates and the money supply, so their decisions receive much more attention than the actions of the individual regional banks.  The FOMC includes the seven members of the Board of Governors, as well as five presidents of the regional banks.  The president of the New York Federal Reserve Bank is always a voting member of the FOMC to reflect New York's unique position in the financial industry.  The remaining four presidents are determined on a rotating basis among the remaining eleven regional banks.  However, when the FOMC meets, all regional presidents attend.  Only the current voting members have voting rights on decisions.  This allows for input from all regional members, but restricts final decisions to a limited body.

Contemplate for a moment the complex consideration of various interests that went into the design of our central bank.  Regional distribution provides decentralized control.  The Board of Governors are appointed by the President, but still insulated from politics due to their long appointments.  The directors of each regional bank are composed of bankers, leaders of industry, and public advocates to distribute power among the finance sector, non-finance sectors, and the general public.  Finally, the FOMC represents both the public appointees of the Board of Governors as well as regional presidents appointed by the nine directors of each bank.  The alchemical mix of capitalism and social protection expressed in this uniquely American institution is truly marvelous in design and execution. 

The individuals that serve in the various roles of the Federal Reserve System are still fallible.  Improvements to the structure of the system will likely occur over time.  However, the values expressed in the design of our central bank are clear.  Our preeminent capitalist institution shows a careful weighing of regional and social values.  There is no clearer proof that we are, in fact, a social capitalist nation.

Risky Business

One of the basic concepts of capitalism is that of risk.  Investors must decide if they are willing to possibly lose their money in return for possibly making money.  Increasing risk means that the potential profits are increased, but the probability of losing everything increases as well.  The financial services industry makes billions every year performing risk management for their clients, and when performed correctly, this is a boon for society.  This is one of capitalism's many virtues.

In a corporate setting, one of the many risk factors that must be weighed is leverage.  Leverage is simply the amount of money a corporation borrows to conduct their ongoing operations.  By borrowing money, a corporation is inherently increasing the risk for investors.  Here's why:

Suppose you are an investor with $100,000.  You have determined that you are going to use this money to begin a business called "Acme Industries."  When this company begins operations, it has $100,000 to work with.  This money is used to create metal anvils.  After one year, the company makes a profit of $20,000.  $20,000/$100,000=20%, a tidy return.  What would have happened if the business did not do so well, though?  Suppose that the business loses $20,000.  -$20,000/$100,000=-20%, an unfortunate, but not catastrophic, loss.  A mathematical analysis of these possible outcomes is how we measure risk.

Let's re-examine the same scenario, but now we are going to introduce leverage.  Instead of simply using your $100,000 to start a business, you are now going to ask a bank loan for a loan.  The bank lends you $90,000 so that you can start your business. You still invest $10,000 of your own money.  $10,000 equity +$90,000 =$100,000.  You happily march off to start Acme Industries.

What happens under our two scenarios now?  Under our profitable scenario, the business earned a $20,000 profit.  However, you now have only invested $10,000 to earn this money.  $20,000/$10,000=200% return.  This is awesome!  But what about the negative scenario?  The loss of $20,000 is now catastrophic.  Because you only invested $10,000 to begin with, this money is now gone.  Moreover, you now owe the bank $90,000, but the business only has $80,000 left to repay them!  The bank will likely call the loan to recoup what money they can before you lose even more.  The business closes, your employees are laid off, but at least you have your $90,000 that you never invested!

This example is similar to many that you might find in a basic finance textbook.  However, there is a problem with the basic reward structure implied by this capitalist model.  Note that the investor/owner is able to completely dictate the level of risk to meet his/her investment goals.  However, the downside risk of his/her decisions is shared with his employees.  The effects of leverage have definite ramifications on the future cash flows of the employees as they may lose their jobs if the business fails, yet they are not inherently rewarded for any increase in risk.  This point will undoubtedly not be accepted by traditional capitalists, but it is an argument I am willing to have.  While wages have remained stagnant for decades, investor wealth has soared.  Leverage has played a large part in these wealth gains, and because there is an element of risk sharing, there should be an element of reward sharing as well. 

Social Capitalism: An American Tradition

"What Americans should by now be able to see is that neither the laissez-faire marketplace nor strong government has given them a satisfying or permanent resolution. The problem is not the marketplace and it is not government. The problem originates in the contest of clashing values between society and capitalism and, since this human society cannot surrender its deepest values, it must try to alter capitalism's. As we look deeper for the soul of capitalism, we find that, in the terms of ordinary human existence, American capitalism doesn't appear to have one."  -William Greider, The Soul of Capitalism


Capitalism has many virtues.  As an economic system, it has so far been unmatched in its ability to generate wealth.  Moreover, the American form of capitalism has been the envy of the world for decades.  Historically, industrial scions amassed great wealth while wages increased, cheaper goods became available, and general welfare increased.  These advances in society were the bedrock principles of history's prominent capitalist idealogues.  Ayn Rand stated:


 "America's abundance was created not by public sacrifices to the common good, but by the productive genius of free men who pursued their own personal interests and the making of their own private fortunes. They did not starve the people to pay for America's industrialization. They gave the people better jobs, higher wages, and cheaper goods with every new machine they invented, with every scientific discovery or technological advance -- and thus the whole country was moving forward and profiting, not suffering, every step of the way."


This ideology culminated in America with the Reagan Revolution of the 1980s.  "Reaganomics" promised a host of benefits for all Americans by promoting economic initiatives aimed at the wealthiest among us.  The increase in the wealth of the elite would "trickle down" to all society.  This was the promise of the laissez-faire capitalists. 


Thirty years after Reagan's election, we can now effectively say that the laissez-faire ideal has not worked according to the measures provided by Rand.  Real wages have stagnated.  Innovation has not been able to produce cheaper goods and services in many critical industries, most notably health care.  The vast number of unemployed workers currently will attest to the lack of "better" jobs produced by the free market.  For all that capitalism has given us, where did it go wrong?


The answer is evident in Rand's flawed logic.  The laissez-faire capitalist, she argued, did not operate with any notion of altruism.  However, her measures of capitalism's success are inherently altruistic.  Rising wages, cheaper goods, and better jobs created a "whole country moving forward."  The ideology called for no altruism in the naive thought that altruistic results would still occur.  The inherent cognitive dissonance of Rand's ideal has infiltrated the American politic, and what is good for the wealthy has become good for everyone by virtue of the ideology, regardless of results.  This is not inherently capitalistic; this is inherently selfish.  The two are not the same.


Look back on American history and the things that have made us great, and you will see not just a capitalist society, but also a strong thread of altruistic tendencies and successes.  The values of our nation have not been inherently selfish.  Social Security and Medicare are prime examples that cut against the grain of laissez-faire capitalism and the ideals of Rand.  These programs are widely popular and have had clear benefits to society.  I do not posit that they are perfect programs, but they demonstrate strongly a moral fabric in our society that is not aligned with the selfish tenets of Rand.  Moreover, these programs have been institutionalized while maintaining the basic framework of a capitalist society.  This is the reality of our history.  Though we have valued the capitalist model, we have done so because of the perceived benefits to society at large.  This is our history.  This is our heritage.  By reclaiming our moral compass, we can restore and improve the system that has made our nation great.