Conversable Economist

This year was the 50th anniversary for Warren Buffett in running Berkshire Hathaway. Each year, he writes a letter to his shareholders, and this year\’s letter has the theme of looking back over the past 50 years and looking ahead to the next 50. Over the years, Buffett has the knack of saying things in these letters that are willing to admit past mistakes and often wryly humorous. (Here\’s a snippet from last year\’s letter, where Buffett of all people extols the virtues of index fund investing.) Here are a few snippets from Buffett\’s 50th anniversary letter that caught my eye.

Apparently, Buffett originally took over Berkshire in a fit of pique, because he felt that the earlier owners tried to chisel him out of one-eight of a point:

\”On May 6, 1964, Berkshire Hathaway, then run by a man named Seabury Stanton, sent a letter to its shareholders offering to buy 225,000 shares of its stock for $11.375 per share. I had expected the letter; I was surprised by the price.  Berkshire then had 1,583,680 shares outstanding. About 7% of these were owned by Buffett Partnership Ltd. (“BPL”), an investing entity that I managed and in which I had virtually all of my net worth. Shortly before the tender offer was mailed, Stanton had asked me at what price BPL would sell its holdings. I answered $11.50, and he said, “Fine, we have a deal.” Then came Berkshire’s letter, offering an eighth of a point less. I bristled at Stanton’s behavior and didn’t tender. That was a monumentally stupid decision. Berkshire was then a northern textile manufacturer mired in a terrible business. The industry in which it operated was heading south, both metaphorically and physically. And Berkshire, for a variety of reasons, was unable to change course. …

\”The price that Stanton offered was 50% above the cost of our original purchases. …  Instead, irritated by Stanton’s chiseling, I ignored his offer and began to aggressively buy more Berkshire shares. By April 1965, BPL owned 392,633 shares (out of 1,017,547 then outstanding) and at an early-May board meeting we formally took control of the company. Through Seabury’s and my childish behavior – after all, what was an eighth of a point to either of us? – he lost his job, and I found myself with more than 25% of BPL’s capital invested in a terrible business about which I knew very little. I became the dog who caught the car.

After struggling for some years, Buffett argues that his investment philosophy evolved between two different kinds of value investing, a change which he attributes to advice from his long-time associate Charlie Munger: \”Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.\”

For many economists and finance professionals, Berkshire Hathaway is an anomaly and even an anachronism, because it looks a lot like an old-style conglomerate firm. Such firms have gone out of favor, with the argument that it\’s better for firms to focus on their \”core competence.\” In response, Buffett argues:

\”Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it. Let me first explain why they are in the doghouse, and then I will go on to describe why the conglomerate form brings huge and enduring advantages to Berkshire. Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s. … The resulting firestorm of merger activity was fanned by an adoring press. Companies such as ITT, Litton Industries, Gulf & Western, and LTV were lionized, and their CEOs became celebrities. (These once-famous conglomerates are now long gone. As Yogi Berra said, “Every Napoleon meets his Watergate.”) …

\”At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry. Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That’s not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. \”

With regard to the investing in Berkshire Hathaway, Buffett offers various warnings:

 \”If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth. …  Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. Those who seek short-term profits should look elsewhere. …

\”The bad news is that Berkshire’s long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won’t be great. Eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both.

Back in 2011, I amused myself for a few months at this blog by posting examples about of international organizations that had come out against subsidizing biofuels like ethanol. For example, in a June 2011 post, \”Everyone Hates Biofuels,\” I pointed out a report in which 10 international agencies made an unambiguous proposal that high-income countries drop their subsidies for biofuels. I followed up with \”The Committee on World Food Security Hates Biofuels\” in August 2011 and \”More on Hating Biofuels: The National Research Council\” in October 2011.

The main arguments were the same: 1) subsidies for biofuels added to demand for corn and grain products in a way that pushed up food prices worldwide, with an especially harsh economic effect on the poorest people in the world who spend a large share of their incomes on food; and 2) the purported environmental gains from biofuels weren\’t happening, in part because after taking the environmental issues involved in plowing additional cropland into account, there was no overall reduction in carbon emissions.

Over the years, I have become accustomed to the sad reality that global policymakers do not kowtow to my will. But I cannot forbear from noting that biofuel subsidies remain a mistake in both economic and environmental terms. Here are a couple of recent examples.

Kimberly Ann Elliott has (optimistically) written  \”The Time to Reform US Biofuels Policy Is Now\” as a May 2015 \”Brief\” for the Center for Global Development. It draws upon her longer January 2015 CGD \”Policy Paper,\” called \”Biofuel Policies: Fuel versus Food, Forests, and Climate.\” I\’ll draw on both papers here.

Let\’s start with a big-picture overview of how government subsidies and mandates drove up biofuel use, and what happened with global food prices at about that time. As biofuel consumption rises, global food prices rise, too.

Of course, the correlation taken alone doesn\’t prove causation, but more detailed studies make the case. As one example, Brian Wright discusses \”Global Biofuels: Key to the Puzzle of Grain Market Behavior,\” in the Winter 2014 issue of the Journal of Economic Perspectives. (Full disclosure: I\’ve worked as Managing Editor of the JEP since the first issue back in 1987.) Wright discussed a basic model of supply and demand for grain markets with two tweaks: 1) he includes effects arising from substitution between corn, wheat, and rice; and 2) he takes into account the possibility of storing surplus crops from year to year into account. He writes:

\”The [grain] price jumps since 2005 are best explained by the new policies causing a sustained surge in demand for biofuels. The resulting reduction in available per capita supply of food and animal feed could not be accommodated by drawing on  available stocks, as they had in the past when there were temporary shortages created by yield shocks. Instead, the necessary adjustments included an expansion of global net acres planted to grains, especially in Latin America and the former Soviet Union, and by reduced per capita consumption of grains and products from animals fed on grains.  … The rises in food prices since 2004 have generated huge wealth transfers to global landholders, agricultural input suppliers, and biofuels producers. The losers have been net consumers of food, including large numbers of the world’s poorest peoples. The cause of this large global redistribution was no perfect storm. Far from being a natural catastrophe, it was the result of new policies to allow and require increased use of grain and oilseed for production of biofuels.\”

If the rise in global food prices had been accompanied by environmental gains, at least there would be some offsetting benefits. But the environmental benefits of biofuels have turned out to be much oversold. Elliot writes:

Estimates of GHG [greenhouse gas] emissions over the full life cycle of today’s food-based biofuels vary widely, depending on how and where the crops are grown and how they are processed. Even when biofuel production is efficient, however, the net effect on climate change can be negative if it leads to direct or indirect land use changes. Thus, if producers chop down tropical forests in Brazil, Argentina, or Indonesia to grow sugar, soybeans, or oil palm to make biofuels, then the GHG emissions associated with the resulting fuels could well be higher than those of gasoline or diesel. In addition, to make up for the food and feed crops going into fuel tanks, either people must eat less or farmers must produce more. Some increased production could come from using existing farmland more productively. But if farmers respond to higher prices by cultivating virgin lands or converting forests, then those indirect land use changes will create additional GHG emissions that further undermine the case for biofuels.\”

In a similar spirit, Wright notes: \”Environmentalists have grown skeptical of the claimed reductions in greenhouse gas emissions associated with biofuels; indeed, the net effects of biofuels on emissions are now more widely believed to be at best dubious, due to inevitable induced  land use changes …\”

Even as the economic costs of biofuels subsidies have risen and the environmental benefits have proved dubious, the practical aspects of implementation have become troublesome, too. Elliot writes:

In addition to not achieving Congress’s energy security or environmental goals, implementing the Renewable Fuel Standard (RFS) is becoming ever more complex. On the supply side, advanced biofuels that do not use food crops and are more climate friendly have not been developed as expected. Thus, refiners cannot blend fuel that does not exist. On the demand side, the bulk of the US automobile fleet cannot safely use gasoline with more ethanol. So the overall mandate target cannot be met. The assumptions undergirding US biofuel policy have not held.

For a sense of these issues, consider this figure from Elliot. The area to the left of the dashed line shows what has happened in the past, while the lines to the right show the mandate levels imposed by the government for renewable fuels. A couple of problems become clear.

There are legal mandates for using relatively large amounts of cellulosic biofuels in the future, even though little is being produced now. (\”Cellulosic\” biofuels are produced from plant material that is not a human food crop, including certain grasses as well as wood and the nonedible parts of plants.) Indeed, as Elliot points out, a farcical situation arose in which the Environmental Protection Agency fined oil companies $7 million a couple of years ago for not buying enough cellulosic-based biofuels to meet the mandate–at a time when it was not yet technologically possible to produce that quantity of cellulosic biofuels. Paying penalties for a standard with which it was impossible to comply understandably led to lawsuits.

Moreover, discussions of renewable fuel discuss the \”blend wall,\” which is the physical fact that ethanol is corrosive, and if most US cars use more than 10% ethanol, it will damage their engines. As shown in the figure, the \”blend wall\” is the amount of ethanol that could be used, given the amount of gasoline purchased, without breaking that 10% ceiling. However, the current mandate for ethanol is higher than the \”blend wall,\” and it\’s not clear how this can be accomplished.

Elliot concludes in this way:

In sum, American and European policies to promote first generation biofuels are failing to significantly contribute toward any objective other than providing additional subsidies to relatively well-off farmers in rich countries. The oil production boom in the United States is making biofuels practically irrelevant for US energy independence, albeit with troubling effects on greenhouse gas emissions. And poor consumers around the world are less secure as a result of higher and more volatile food prices. By pitting fuel against food, first generation biofuel policies are also creating incentives to convert forests to cropland, and that undermines the goal of reducing GHG emissions. Because of the relatively large, and growing, role that transportation plays in global greenhouse gas emissions, continued public investment in research and development on second and third generation biofuels is worthwhile. But current biofuel policies are doing little to promote advanced biofuels, and are helping little, if at all, with climate change mitigation in the meantime.

As a practical person with an office in Washington, DC, Elliot offers a number of reasonable suggestions for moderate change in the renewable fuel standards, but her suggestions are prefaced with \”[i]f elimination of the RFS [renewable fuel standard] is not possible.\” As an impractical person far outside the Washington beltway, I just emphasize that eliminating these rules would be the best policy. The primary government role in alternative fuels and biofuels should be to support financing of research and development. Perhaps someday cellulosic biofuels will become a practical reality. Other energy technologies like improved batteries or fuel cells or methanol also deserve research and development funding. But federal mandates to use certain quantities of biofuels–quantities that will either harm existing car engines or which in the case of cellulosic biofuels don\’t even exist–are a counterproductive policy tool.

Claudia Goldin is interviewed by Jessie Romero in the Fourth Quarter 2014 issue of EconFocus, published by the Federal Reserve Bank of Richmond. The whole interview is worth reading, but here are a few of her comments that caught my eye.

How the contraceptive pill altered perspectives of women on the labor market

\”One of the most important changes was the appearance of reliable, female-controlled birth control. The pill lowered the cost to women of making long-term career investments. Before reliable birth control, a woman faced a nontrivial probability of having her career derailed by an unplanned pregnancy — or she had to pay the penalty of abstinence. The lack of highly reliable birth control also meant a set of institutions developed around dating and sex to create commitment: Couples would \”go steady,\” then they would get \”pinned,\” then they would get engaged. If you\’re pinned or engaged when you\’re 19 or 20 years old, you\’re not going to wait until you\’re 28 to get married. So a lot of women got married within a year or two of graduating college. That meant women who pursued a career also paid a penalty in the marriage market. But the pill made it possible for women who were \”on the pill\” to delay marriage, and that, in turn, created a \”thicker\” marriage market for all women to marry later and further lowered the cost to women of investing in a career. …

\”That meant these young women could engage in different forms of investment in themselves; they attended college to prepare for a career, not to meet a suitable spouse. College women began to major in subjects that were more investment oriented, like business and biology, rather than consumption oriented, like literature and languages, and they greatly increased their attendance at professional and graduate schools.\”

The Last Chapter of the Grand Convergence

\”Women and men have converged in occupations, in labor force participation, in education, where they\’ve actually exceeded men — in a host of different aspects of life. One can think about each of these parts of the convergence as being figurative chapters in a metaphorical book. And this metaphorical book, called \”The Grand Convergence,\” has to have a last chapter. But what will be in the last chapter? … So I went looking for facts, and I found two big pieces of information suggesting that the last chapter, which is about gender equality in pay per unit of time worked, must have greater temporal flexibility without large penalties to those who work fewer hours or particular schedules. …

\”Across the wage distribution, the vast majority of the gender gap is occurring within occupations, not between occupations. There\’s considerable discussion about occupational segregation, but you could get rid of all occupational segregation and reduce the gender gap by only a small amount. …

\”So then the question is, why are there some occupations with large gender gaps and others with very narrow gaps? There are some occupations where people face a nonlinear function of wages with respect to hours worked; that is, people earn a disproportionate premium for working long and continuous hours. For example, someone with a law degree could work as a lawyer in a large firm, and that person would make a lot of money per unit of time. But if that person worked fewer than a certain number of hours per week, the pay rate would be cut quite a bit. Or someone could work fewer or more flexible hours as general counsel for a company and earn less per unit of time than the large-firm lawyer. Pharmacy is the opposite — earnings increase linearly with hours worked. There\’s no part-time penalty.\”

[I blogged about this line of Goldin\’s research back in January 2014.]

Women Working Longer

\”My current project is called \”Women Working Longer.\” I\’m working with a group of people who study aging, retirement, and health. We\’re interested in the fact that labor force participation rates for younger women peaked in the 1990s, but that participation for older women has increased enormously. Among college graduates today, about 60 percent of those aged 60-64 and 35 percent of those aged 65-69 are in the labor force. Even among those aged 70-74, about 20 percent are in the labor force.

\”This raises all sorts of interesting questions about why. Is it because these women were hit with divorce shocks? Do they want to retire but then they look at their savings and realize they can\’t retire? Or is it that the world of work has changed and they love what they\’re doing? There are a host of issues to study concerning family, occupations, education, health, financial resources, and retirement institutions.\”

It\’s fairly straightforward to list the events leading up to the Great Recession of 2007-2009, and to argue which events had greater or lesser importance. Perhaps not surprisingly, such arguments tend to mirror the political beliefs already held before the recession: that is, those who favored more regulation in 2000 or 2005 tend to believe that lack of regulation set the stage for the Great Recession, while those who think government actions and guarantees often work out badly tend to believe that earlier government actions were the main cause. But a step behind this kind of partisan infighting, economists are struggling to enunciate the deeper economic lessons of what went  wrong.
Bengt Holmstrom offers a notable contribution along these lines in \”Understanding the role of debt in the financial system,\” published as a Bank of International Settlements working paper (#479) in January 2015.

As a starting point, Holmstrom raises this question: \”How could Wall Street trade in securities that they knew so little about? Why did no one ask questions?\”

It\’s of course easy to point out that some folks in the financial industry have a profit motive to be obscure and opaque about risks involved. But that set of incentives has been true for a long time. A usual assumption is that other folks in the financial industry are drilling down into complicated financial deals. Thus, even though some folks are fooled some of the time, a combination of hard-headed investigation, legal and regulatory requirements for disclosure, and people who care about their reputation will tend to keep such behavior in check.

Notice that this explanation of how financial markets function relies on availability of information and on detailed arguments and analysis about that information. Holmstrom offers a much different answer. His argument is that healthy debt market function best, most of the time, with a high degree of opacity and a \”no questions asked\” mindset. In making this argument, Holmstrom draws a sharp contrast between the functioning of stock markets and \”money markets\”–which are markets for short-term borrowing and lending, where the loans are often backed by a high level of collateral. Holmstrom offers this table as a framework for discussion, contrasting the functions of stock markets and money markets, and arguing that intuition about stock market doesn\’t work well when applied to money markets.

For example, stock market most of the time are not a way for most firms to obtain funding. When one party buys or sells a share of stock, the firm doesn\’t get the money. Even when the original owners of a company sell stock in an initial public offering, a large part of the motivation is so that the owners can share the risk of financing the company in the future, rather than bear that risk themselves. Stock markets are famously sensitive to new information, with stock prices bouncing up and down based on news affecting the company and quarterly income reports. But debt markets are mostly not very sensitive to  specific information about a company, unless the company is actually likely to go broke. Most of the time, the reasonable working assumption is that short-term debt will be repaid. As long as the firm has posted collateral, there is little need to investigate further. Thus, stock markets are characterized by legions of analysts drawing up financial projections of future earnings and crunching the data under various scenarios. Debt markets have comparative modest investments. Stock market have many traders on exchanges; debt market operate with relatively few.

The last two characteristics in the table may be a bit counterintuitive, but they cut close to the heart of the issue. Even though stock markets tend to have more information and investigation, they are not usually very urgent. If you think a stock is a great buy today, most of the time the odds are it will still be a great buy in a few days or a week. But short-term borrowing is different, because it often involves rolling over past borrowing. If a bank or firm has been rolling over large amounts of short-term borrowing for months or years, and suddenly finds that it cannot do so, the shock to that organization is large–even conceivably fatal. The volumes traded in stock markets can bounce around, but the volumes trade in short-term debt markets are usually pretty stable, and a working definition of a financial crisis is when many actors in the economy suffer a sudden inability to borrow in the short-term markets.

With this dichotomy in mind, a set of fundamental economic tradeoffs that reach beyond the details of the 2007-2009 start to become clear. Most of the time, Holmstrom argues, short-term debt markets function so well precisely because they are somewhat opaque and insensitive to information. As he writes; \”The quiet, liquid state is hugely valuable.\”

A financial crisis arises when those in the financial sector begin to raise questions and to demand information about  short-run debt, and to start trying to separate worthy and unworthy borrowers. Holmstrom writes ( citations omitted):

Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt … A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility. … These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested …

Holmstrom points out that when a financial panic arises, the answer is often not more information, but instead persuading markets that they don\’t need additional information. For example, in the aftermath of the US recession, the policies that calmed the financial markets in 2009 didn\’t involve going to through all the collateralized debt obligation securities backed by subprime mortgages and trying to figure out how much each one was really worth, and which financial institutions had exposure to losses. Instead, it was to require that banks hold more capital and face \”stress tests\” to create confidence that they would be able to withstand future problems. As Holmstrom write, the idea was \”getting us back to the liquid, no-questions-asked state.\”

Or in the financial problems over the last few years involving the euro and the EU debt markets, a major turning point happened in July 2012 when Mario Draghi, president of the European Central Bank, said in a prominent speech: \”the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.\” As Holmstrom comments on this episode:

This is as opaque a statement as one can make. There were no specifics on how calm would be re-established, but the lack of specific information is, in the logic presented here, a key element in the effectiveness of the message. So was the  knowledge that Germany stood behind the message – an implicit guarantee that told the markets that there would be enough collateral, but not precisely how much. A detailed, transparent plan to get out of the crisis, including rescue funds, which were already there, might have invited differences in opinion instead of leading to a convergence in views. Explicit numbers can be put into spreadsheets and expertise and ingenuity can be applied to evaluate future scenarios. “Whatever it takes” cannot be put into a spread sheet and therefore promotes liquidity of the “symmetric ignorance” variety.

The policy implications of this view are still being thought through, but Holmstrom offers some preliminary thoughts. Higher capital requirements and more frequent regulatory \”stress tests\” are useful, because they offer a general reassurance that short-term debt markets are fundamentally sound. If and when a panic arises, the goal should be to recapitalize financial  institutions, again to offer reassurance that financial markets are fundamentally sound. There is a lot of room for discussion of the details of how these policies should be enacted. But it helps to enunciate the fundamental tradeoff of debt markets, as Holmstrom describes it: 

The Economic Journal, one of the grand old journals of economics, is celebrating its 125th anniversary. The Royal Economic Society (40% of its membership is in the UK, the rest around the world) is collaborating with the publisher, John Wiley & Sons, to make the March 2015 birthday issue freely available online. The theme of the issue is that current top economists look back on classic papers published in the EJ, and offer reflections and analysis. Here are the titles of the papers in bold, with the reference to the classic EJ paper under discussion and weblinks underneath. For those who recognize the original papers and the current authors, no further recommendation is necessary.

_____________

\”Economic Journal 125th Anniversary Special Issue\” (pages 203–208)
Abstract
Full Article (HTML)
Enhanced Article (HTML)
PDF(176K)
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Those who find the rise in income inequality over the last few decades to be concerning, like me, can find themselves facing the \”so what?\” question. Is my concern over rising inequality an ethical or perhaps an aesthetic judgement, and thus a personal preference where economics really doesn\’t have much guidance to offer? Faced with this possibility, the temptation arises to claim the following syllogism: 1) We have experienced greater inequality, which is undesirable. 2) We have experiences slower economic growth, which is undesirable. 3) Therefore, greater inequality causes slower economic growth.

A variety of studies have undertaken to prove a connection from inequality to slower growth, but a full reading of the available evidence is that the evidence on this connection is inconclusive. For example, the OECD has recently published a report called \”In It Together: Why Less Inequality Benefits All,\” and Chapter 3, titled \”The Effect of Income Inequality on Economic Growth,\” offers an OECD analysis seeking to connect the two. But before presenting the new study, the OECD report has the honesty and forthrightness to point out that the full body of literature on this subject is inconclusive as whether such a relationship even exists–and if so, in what direction the relationship goes.

The report first points out (pp. 60-61 that as a matter of theory, one can think up arguments why greater inequality might be associated with less growth, or might be associated with more growth. For example, inequality could result less growth if: 1) People become upset about rising inequality and react by demanding regulations and redistributions that slow down the ability of an economy to produce growth; 2) A high degree of persistent inequality will limit the ability and incentives of those in the lower part of the income distribution to obtain more education and job experience; or 3) It may be that development and widespread adoption of new technologies requires demand from a broad middle class, and greater inequality could limit the extent of the middle class.

In passing, it\’s worth noting that the first reason falls into the category of \”frustrated people killing the goose that lays the golden eggs.\” In other words, finding a correlation between rising inequality and slower growth could be a sign of dysfunctional responses to the rise in inequality.

On the other side, inequality could in theory be associated with faster economic growth if: 1) Higher inequality provides greater incentives for people to get educated, work harder, and take risks, which could lead to innovations that boost growth; 2) Those with high incomes tend to save more, and so an unequal distribution of income will tend to have more high savers, which in turn spurs capital accumulation in the economy. The report doesn\’t mention a third hypothesis that seems relevant in a number of developing economies, which is that fast growth may first emerge in certain regions or industries, leading to greater inequality for a time, before the gains from that growth diffuse more widely across the economy.

Given the competing theoretical explanations, what does the actual evidence say? The OECD writes
(pp. 61-62):

The large empirical literature attempting to summarize the direction in which inequality affects growth is summarised in the literature review in Cingano (2014, Annex II). That survey highlights that there is no consensus on the sign and strength of the relationship; furthermore, few works seek to identify which of the possible theoretical effects is at work. This is partly tradeable to the multiple empirical challenges facing this literature.  

The report then goes on to discuss issues like: 1) variations in estimation methods, including whether the analyst looks at one country over time, multiple countries at a point in time, or multiple countries over time, along with the statistical tools used; 2) in many countries around the world, the data on income distribution is not measured well, not measured consistently over time, and not measured in ways that are easily comparable to other countries; 3) in empirical studies the already-weak data on inequality is often boiled down into a single number, like a Gini coefficient or a ratio between those in the 90th and 10th income percentiles, a simplification that might miss what is happening; 4) the connections between income inequality and growth might differ across groups of countries (like high-income and low-income countries), and looking at all countries together averages out these various effects; and 5) whether (and how) the researcher should take into account factors like the extent of progressive taxation and redistribution, the extent of financial markets, or the degree of economic and social mobility over time.

There\’s an old saying that \”absence of evidence is not evidence of absence,\” in other words, the fact that the existing evidence doesn\’t firmly show a connection from greater inequality to slower growth is not proof that such a connection doesn\’t exist. But anyone who has looked at economic studies on the determinants of economic growth knows that the problem of finding out what influences growth is very difficult, and the solutions aren\’t always obvious. For example, the OECD study argues that inequality leads to less investment in human capital at the bottom part of the income distribution. If this result holds up in further study, an obvious answer is not to focus on inequality directly, but instead to focus on additional support for human capital accumulation for those most in need.

There are a few common patterns in economic growth. All high-income countries have near-universal K-12 public education to build up human capital, along with encouragement of higher education. All high-income countries have economies where most jobs are interrelated with private and public capital investment, thus leading to higher productivity and wages. All high-income economies are relatively open to foreign trade. In addition, high-growth economies are societies that are willing to allow and even encourage a reasonable amount of disruption to existing patterns of jobs, consumption, and ownership. After all, economic growth means change.

On the other hand, it\’s also true that fast-growing countries around the world, either now or in the past, show a wide range of levels and trends of inequality, as well as considerable variation in the extent of government regulation and control, patterns of taxation and redistribution, structure of financial sector, and much more. Consider the pattern of China\’s fast economic growth in recent decades, with rising inequality and an evolving mixture of private initiative and government control. At least to me, China looks like a situation where growth is causing inequality, not where inequality is slowing growth. It may be that the question of \”does inequality slow down economic growth\” is too broad and diffuse to be useful. Instead, those of us who care about both the rise in inequality and the slowdown in economic growth should be looking for policies to address both goals, without presuming that substantial overlap will always occur between them.

The nickname \”the sharing economy\” seems like a triumph of public relations artistry. The term refers to firms based on software that allows people to rent a room in someone\’s house (like Airbnb) or pay for a ride in someone\’s car (like Uber or Lyft). At least in the kindergarten where I learned all of my sharing values, being compensated was not a form of \”sharing.\” As an alternative title, I\’ve proposed the \”finding ways to get paid for excess capacity\” economy, but it doesn\’t quite trip off the tongue. Better is the \”matching economy,\” which captures the idea of using the web to match up a potential buyer and seller who would otherwise have had no way to connect.

Firms like eBay can be thought of as the first generation  of the matching economy, but people selling stuff to each other displaced relatively few existing workers and raised relatively few public policy issues. Tim Sablik offers an overview of the current issues in \”The Sharing Economy: Are new online markets creating economic value of threatening consumer safety?\” in the Fourth Quarter 2014 issue of EconFocus, published by the Federal Reserve Bank of Richmond. He points out that in some industries, the growth of supply as a result of the matching economy has been quite substantial:

\”The Bureau of Labor Statistics reports that there were 233,000 taxi drivers and chauffeurs in the United States as of 2012, but new services are substantially adding to that number. According to a recent study by Uber\’s head of policy research Jonathan Hall and Princeton University economist Alan Krueger [discussed here], the company had more than 160,000 active U.S. drivers in 2014. That alone nearly doubles the supply of short-term transportation, not counting Uber\’s competitors like Lyft and Sidecar. Similarly for the hotel industry, Airbnb boasts over a million properties in nearly 200 countries, surpassing the capacity of major hoteliers like Hilton Worldwide, which had 215,000 rooms in 74 countries in 2014.\”

Sablik points to evidence that the additional competition has led to better deals for consumers, not just the consumers who use matching economy firms, but also because the traditional competitors offer better deals, too. The matching economy firms can be especially useful when there is a spike in demand–like a city hosting a Super Bowl or a political convention. Moreover, the idea of the matching economy is taking on many forms. Here\’s a list of some sharing economy firms from Sablik:

 

Only a few countries around the world have gone so far as to \”dollarize\” their economy–that is, using  the US dollar as a predominant legal currency. According to an IMF characterization of exchange rate regimes, the dollarized economies include some small island nations with close historical or economic ties to the US, but also Ecuador, El Salvador, Panama, Timor Leste, and Zimbabwe. However, in a number of other countries the US dollar plays a very substantial role in bank deposits and lending. The IMF has been offering some comments and reports on the tradeoffs of dollarization, often with a strong hint that it might be beneficial to do less of it. For example, Naoyuki Shinohara
Deputy Managing Director of the IMF, made these comments in a February 2015 conference:

[M]any Frontier and Developing Asian economies are also highly dollarized. In some cases, high dollarization can facilitate trade. But there are drawbacks, such as limiting exchange rate flexibility to mitigate against external shocks, and constraining the central bank’s ability to be the lender of last resort. Under such circumstances, consideration could be given to actively promote de-dollarization. But de-dollarization is a long process and requires a commitment to strengthen policies and institutions.

An IMF staff team led by Mauro Mecagni and Rodolfo Maino has published a May 2015 report on \”Dollarization in Sub-Saharan Africa: Experience and Lessons.\” Along with specific information about the extent of dollarization across this region–other than the official dollarization of Zimbabwe–the report does a nice job of reviewing the tradeoffs involved.

What economic factors that often lead to dollarization? The IMF team lists four main causes:

• Large macroeconomic imbalances and high inflation. Several countries around the world (for example, Chile, Colombia, and Peru) became dollarized following periods of macroeconomic turbulence and high inflation that encouraged the substitution of domestic currency with the U.S. dollar. Dollarization may thus result from a legacy of severe economic disruption.
• Financial repression and capital controls. Many Latin American economies in the 1970s and 1980s as well as many SSA [sub-Saharan Africa] countries (for example, Democratic Republic of the Congo, Liberia, and Nigeria) have become dollarized following periods of financial repression and the imposition of capital controls.
• Use of the dollar as anchor for macrostability. Some countries (for example, Ecuador, El Salvador) adopted the dollar as legal tender in order to escape from a long history of monetary and financial disorder by “importing” the credibility of the U.S. monetary institutions.
• Underdeveloped financial markets. In several countries, domestic borrowers contract debt in foreign currencies in response to the lack of domestic currency alternatives in incomplete financial markets.

Although dollarization arises as a response to economic problems, it brings tradeoffs of its own. A dollarized economy by definition has no control over its own monetary policy–and there is no particular reason to think that decisions made by the US Federal Reserve will suit the economic needs of  other countries. A dollarized economy is also vulnerable to rises and falls in the exchange rate of the US dollar. A particular problem can arise in a partially dollarized economy when the government, or large banks and firms, have borrowed in US dollars, planning to receive funds in the local currency of the country, convert to US dollars in the foreign exchange markets, and repay the US dollar loans. If the exchange rate moves sharply, it can become impossible to repay those US dollar loans (a dynamic that was one of the roots of the East Asian financial crisis in 1998).

The IMF study chooses a threshold in which if the ration of a foreign currency deposits to total deposits is more than 30%, an economy is said to be \”dollarized.\” Here\’s the picture for sub-Saharan Africa as of 2012, with the extent of dollarization shown as a share of bank deposits and a share of bank loans. Moving clockwise from east to west, an arc of countries including Angola, Congo, Uganda, Tanzania, and Mozambique are relatively heavily dollarized.

The IMF researchers look for past examples of de-dollarization in recent decades, including Israel, Poland, Bolivia, Peru, and Angola. Overall, they sum up the de-dollarization efforts in this way:

Experience also shows that dollarization is often difficult to reverse. While the use of a foreign currency as a store of value or for domestic transactions has increased sharply in several countries over time, there are fewer cases in which this trend has been significantly reversed. Memories of macroeconomic instability and hyperinflation—the key factors that encourage dollarization—do not wither away easily, encouraging economic agents to maintain foreign currency denominated assets even when macroeconomic conditions have stabilized and policy credibility has been established.

As one might expect, the main steps to reduce dollarization focus on controlling inflation and achieving macroeconomic stability, so the main incentives behind dollarization are reduced. Passing laws and regulations to outlaw dollarization doesn\’t tend to work well; it only emphasizes the desperate problems of the local currency, thus making dollarization look more attractive. But the IMF team points out that when a country has its macroeconomic fundamentals under control, it can also nudge its economy along the de-dollarization trajectory in other ways. For example, it can set financial regulations for local banks that require them to take the foreign exchange risks of lending in US dollars into account–which pushes the bank toward holding more reserves and doing more lending in the local currency.

In a globalized economy, banks and firms in all countries are going to be involved in foreign currency exchanges. There can be a reasonable economic case for similar nearby countries to link their currencies together. But when dollarization becomes highly prominent, it\’s typically a signal that the government\’s economic policies are mistrusted or incompetent or both.

The single largest federal program for providing cash assistance to those with low incomes is the Earned Income Tax Credit, which in 2014 reduced taxes owed by the working poor by about $3.6 billion while transferring to those households an additional $60.8 billion (according to Table 14-1 in the Analytical Perspectives volume of the proposed US budget. This isn\’t as much as programs with non-cash benefits, like Food Stamps and Medicaid. But it\’s more than what is spent on welfare, or on the Supplemental Security Income program for the low-income disabled and elderly. In \”Earned Income Tax Credit in the United States,\” which appears in the Journal of Social Security Law (2015, 22:1, pp. 20-30), Elaine Maag provides a useful overview of the program.

For economists, the big selling point of the EITC is that it rewards work. The classic problem that arises when government provides assistance to those with low income levels is that as a person works to earn an extra $100, they often find that the government benefits are then reduced by nearly that same amount or sometimes even more. As a result, many low-income people who work are saving the government some money, but not much increasing their actual after-benefits, after-taxes standard of living. In contrast, the EITC is set up so that the work disincentives are greatly reduced. Maag offers a graph familiar to those who know the program that shows how it operates.

The different lines in the graph represent single-earner families with different numbers of children. Maag explains the situation for a family with one child:

\”In 2014, a family with one child was eligible for a subsidy of 34 cents for each dollar earned up to $9,720—a maximum credit of $3,305. A family qualified for the $3,305 credit until its income reached $17,830. At that point, the EITC declined by almost 16 cents for each additional dollar of earnings; the credit phased out completely once earnings reach $38,511 (figure 1). Larger credits are shown for families with more than one child, as well as the small credit available to a family with no custodial children.\”

Thus, a low-income person with one child who starts working gets a bonus of 34 cents on the dollar up to a certain level of earnings–which helps to offset their declining eligibility for other government benefits. For this family, the credit does phase out above $17,830 in income, so each $1 earned above this amount means that the amount of the credit falls by about 16 cents. This represents a lower incentive to work–but losing only 16 cents in benefits for every $1 earned is a lot better than losing, say $1 in benefits for every dollar earned. And any means-tested program has to be phased out in some way as income levels rise. Along with the federal EITC, 23 states have also added their own versions of the EITC to their state-level income tax codes.

Maag reviews the empirical evidence that the EITC does seem to encourage greater levels of work participation in the phase-in range, although it doesn\’t seem to have much effect on average hours worked and doesn\’t do much to discourage work hours in the phase-out range. She writes (footnotes omitted): \”The official measure of poverty in the US does not include changes in resources due to taxes. If it did, scholars have determined that the EITC wouldhave been credited with lifting 6.5 million people out of poverty in 2012, including about 3.3 million children. Changes in income as a result of the EITC are associated with better health, more schooling and higher earnings in adulthood.\”

Overall, I think one can make a plausible case for a dramatic increase in the amount spent on the EITC. But honesty compels me to point out that the EITC has two well-known shortcomings and problems that need to be mentioned.

• The program is heavily focused on families with children. Thus, it doesn\’t help the situation of a childless person who is below the poverty line and working for near minimum-wage. EITC benefits are also lower for married couples. Any government program where the benefits are  higher for those who are unmarried with children deserves a closer look to see if the incentives can be structured differently. 
• The EITC adds a lot of complexity to the tax forms of the working poor, who are often not well-positioned to cope with that complexity, nor to hire someone else to cope with it. About 20% of EITC payments go to those who don\’t actually qualify, which seems to happen because low-income people hand over their tax forms to paid tax preparers who try to get them signed up. Of course, there\’s another group, not well-measured as far as I know, of working-poor households who would be eligible for the EITC but don\’t know how to sign up for it. 

These issues don\’t have neat and tidy answers, but they do have messy and practical answers.