On the Surprisingly Apolitical Nature of the Fed

The eternal question about the civil service is its level of competence. At one end of the spectrum is the curmudgeonly woman at the DMV. At the other is the Hollywood depiction of the CIA. Reality seems to vary by department, and is usually somewhere in between. I think a lot of conservatives tend to be skeptical of government in general partly because the bits of government that they are forced to interact with are so woeful. Waiting hours in line at the DMV to fill in a form that should be able to be done online, for instance. The ridiculous and inefficient security theatre of the TSA, staffed by inept, surly, disgruntled buffoons. The post office managing to screw up deliveries at a far higher rate than FedEx or UPS. It’s only natural that this perception is extrapolated to all the bits of government that we don’t actually interact with personally.

But to a large extent, this is a function of the types of people these places hire. There’s some aspects of government that will inevitably involve distorted incentives and poor performance from a lack of competition. But even if the difference with the private sector is always there, the level doesn’t have to be appalling. In Singapore, government jobs seem to be viewed as prestigious and well-paying, and so attract relatively talented and competent people. Or, to go back further, you would give your left nut to have Evelyn Cromer administering the USA, rather than any of the leaders we’ve had since I’ve been alive. In other words, it certainly doesn’t always have to be as bad as the modern US.

When the US scrapped the civil service exams, it ended up having the biggest effect on low level jobs that you can’t sneak in other requirements like college degrees. This is how the DMV and the TSA got so awful – it turns out that IQ matters, even in low level clerical or customer service jobs. In this respect, the Fed has held out incredibly well by virtue of the fact that a lot of its jobs require a PhD in finance or economics from a top university. PhD programs have so far mercifully been largely spared the wrath of the Cultural Marxist need to bring in diversity even at the cost of competence. Moreover, even if you get in, you still need to pass, and convince the hiring committee that your thesis is actually good. In this sense, the Fed is largely drawing on a fairly talented pool of people who are pretty well versed in current economic research (for what that’s worth).

So if the Fed has avoided the obvious failure mode of being staffed by imbeciles, how does it fare on other measures? The interesting one is regulatory capture. Like any regulator, it can be captured by its employees, by politicians (which, ironically, is how the system is meant to work, but which in practice is usually treated as a design defect), or by the companies and groups that it’s meant to be regulating.

In terms of being captured by its own employees, this is hard to discern clearly, but I think that this has happened less than at most agencies. The biggest reason is that, other than the Fed Board, the regional Feds are notionally private, and so can set their own salaries and hiring/firing conditions. Even the Board seems to pay approximately market rates for the people it hires. This seems to gets rid of a decent amount of the insanity of the public service working conditions. When you can’t pay employees more, they extract concessions in the form of goofing off, unions to make it so they can’t get fired, etc etc. But they’d probably rather take the costs just in the form of more cash. This doesn’t have the deleterious effect that them simply being lazy has – it’s at least a transfer, rather than deadweight loss.

The biggest surprise about the Fed, however, is the fact that it seems to have been able to maintain relative political independence up to now. Independent central banks were a radical idea in the 19th century, where monetary policy was hot button political issue. William Jennings Bryan effectively wanted loose monetary policy (in the form of bi-metalism) to inflate away the debts of farmers. Letting a bunch of PhDs just run the show was probably not likely to be viewed as a compromise answer. But oddly, this kind of redistributive aspect of monetary policy doesn’t get thought about a ton anymore. Instead, the main effect seems to be about what monetary policy does to people’s 401K plans via the level of the stock market. This may be dumb short-termism, but at least everyone is on pretty much the same side.

In the modern ear, Donald Trump has decided, at least via twitter, to talk derogatively about the Fed’s policy, and suggest that they need lower interest rates. I don’t think the Fed takes this especially seriously. Which is fortunate, to be honest. Whatever you think about the Fed’s monetary policy since the great recession, you’d have to be incredibly optimistic to think that Congress or the Presidents would have done a better job. Instead, you can see exactly what the pressure would have been – lower interest rates before an election, consequences be damned. If it creates inflation, well too bad for the next guy. In other words, we could have the same level of far-sighted statesmanship that we currently observe with the US fiscal deficit, but with monetary policy as well. What a delight that would be.

At least on the monetary side, part of the reason the Fed seems to have stayed largely professional and apolitical is that it really has only one main button it can press – interest rates up, or interest rates down. And while people debate furiously over the relationship between that and the state of the economy, most people are agreed on at least the outcome they’re aiming it, namely high growth, low unemployment, and price stability, currently taken to mean low but positive inflation. It seems likely that the Fed has only an approximate idea of the relationship between the variables in question. But then again, it doesn’t seem like most of the public has any better idea either, and so are largely content to let them do what they think is best as long as things aren’t collapsing.

The main people with strong views on the matter seem to be people that want the Fed abolished and US dollars replaced with gold or bitcoin. I tend to think monetary policy when implemented sensibly is a useful tool, and giving it up for a fixed money supply would probably cause more harm than good. That said, my priors are pretty wide on what a fixed money supply would actually do for an economy. I found the Friedman case pretty convincing that letting the banks fail in the 1930s was one of the worst things the government did, and contributed significantly to prolonging the depression. But even if you disagree on this (and plenty of smart Austrians do) the Austrians’ view seems especially far-fetched on a political economy basis. When the world is melting down, governments are always going to do something, even if that something turns out to be significantly counterproductive. Even from an Austrian perspective, lowering interest rates is probably among the less harmful knee-jerk policies one could imagine, compared with, say, nationalizing industry or applying across-the-board price controls.

The more interesting question, and the one that’s harder to answer, is whether the Fed has been captured by the banks. In terms of the broad question of monetary policy, and whether and how to intervene during financial crises, there’s probably not a lot of disagreement between major banks and the Fed. If you think that they’re both wrong, this understandably looks like collusion and regulatory capture. But I think it’s more likely that both groups tended to come from the same business schools and economics departments, and this is largely what gets taught there. And while there is reasonable agreement between banks and the Fed on what should happen ex-post in a crisis (grumblingly bail out failed banks), the ex-ante question is not nearly so clear. In particular, most banks would probably like to see capital requirements cut significantly, and scrap the various costly stress tests that the Fed does on major banks. I’m not saying this is a major bone of contention, but it’s not exactly like banks get everything they want either. 

The stronger case, however, seems to involve some of the current implicit subsidies given to banks. I’m not even talking about deposit insurance, which is related to the “letting the banks fail” question above. Rather, the decision since the crisis to start paying interest on reserves looks a lot like a back-door bailout and subsidy. No no, they say, it’s just an important aspect of unconventional monetary policy. Great! So can I, as an individual deposit my own money at the Fed to take advantage of this same policy? Ha ha, no, of course not! Also, we’ll continually shut down any bank that tries to just operate as a pass-through entity to enable this, a proposal called narrow banking. When even John Cochrane is saying this makes you as the Fed look dumb and crooked, you should probably take heed.

But that’s the messy nature of regulation. You’re never going to get all of what you want, and sometimes dumb things happen anyway, usually for a mix of motives. In other words, the Fed isn’t the Hollywood version of the CIA, but it’s a hell of a lot better than it could be. I almost keep expecting it to get gutted and politicized at some point, and end up as some social justice economic group like the CFPB. It could be worse. It probably will be worse.

Contra Chinese folk wisdom, may you continue to live in uninteresting economic times.

War-gaming the Chinese Nuclear Option with US Treasuries

[ In the quite useful parlance of Scott Alexander, the epistemic status of this post is fairly uncertain, so take with a grain of salt.] 

As the economic tension between the US and China slowly ratchets up, I've found myself thinking recently about the financial nuclear option that China has, and how it might play out. 

What I mean by the nuclear option is China strategically using its large reserves of US Treasury Bonds and Bills to cause maximum economic and financial chaos in the US. This is something one occasionally hears about, but the discussion seems to be split between serious economists who blithely assume it will never happen, and doomsayers that think it will be the end of the world. As you'll see, I'm somewhere in the middle. 

Then again, I'm not a macroeconomist, so take my views as just an educated guess. Perhaps the easiest way to do it is just to assume that I'm playing the Chinese, and that I wanted to cause maximum carnage. What would I do, and how would it play out? I am almost certain that I'm not giving the Chinese any new ideas here, and since I'm John Q. Nobody in any case, I don't feel particularly guilty at writing this publicly. For instance, here's a recent statement from a Chinese diplomat [Update: Cui Tiankai is actually the Chinese Ambassador to the US, so this is pretty close to the official position of the Chinese Government]:

Cui said he did not believe Beijing was seriously considering using its massive US Treasury debt holdings as a trade war weapon, citing concerns that such a move would destabilize financial markets.

Translated back from Diplomat language, this means: We'd like to remind you that we could use our massive US Treasury Debt holdings as a trade war weapon. 

So without further ado, here's how I'd play the Chinese side. 

The first thing to realize here is the poker mindset. You don't want to be thinking of your chips as money. The money is spent when you walk in. Once you sit down, the chips are ammunition, used to defeat other players at the table. What you get at the end is the prize, but if you're thinking on every raise about the rent money, you're toast.

So it is here. If I were China, I would assume that the current holdings of US Treasury debt are like an ICBM. We're no longer trying to maximise the value of the holdings, or even preserve the value of the holdings as a strategic asset of China. We're treating the assets as already worth zero. Because, as we shall see, the policies designed to keep the value of the assets high are almost the exact opposite of the ones aimed at causing carnage.

US Treasury obligations play a very important role in the financial system. In many applications, we need to know a "risk-free" interest rate, and typically the rate on short term (i.e. 30 day ) US Treasury Bills is used as a proxy for this. They're denominated in dollars, which are fiat, so the Treasury can just print as many as it wants. Even "print" is a euphemism - press a button, and the dollars electronically appear. So there's very little reason why the US ever couldn't pay its short term obligations. It might choose not to, either because it went crazy (e.g. during the Clinton government shutdown, or the debt ceiling debate), or because the amount of dollars required to print would cause massive inflation whose cost would be worse than defaulting on the debt, but again, it nearly always could pay. And in practice, it always has paid. Which is why short term US T-Bills are treated as a proxy for the risk-free rate in lots of financial models, such as those used by banks.

But this interest rate is determined by supply and demand in the market for Treasury assets. China has accumulated a ton of them, and could dump them on the market at any time. In bond terms, the yield or interest rate* is inversely related to the price (assuming a zero coupon bond, as is the case for short term obligations like T-Bills, though the logic is similar for coupon bonds). Dump lots of T-Bills on the market, the price drops, and the interest rate rises. When the interest rate rises, every bank who has a short term financing gap that they were planning on covering on the overnight lending market is suddenly in a huge hole. Chaos ensues. 

So I'm China. As a preparatory step, beforehand I'd take all my own financial institutions and ensure that they're not holding any US treasuries privately as collateral on anything. Slowly switch to safe stuff for my own accounts - gold, Euro bonds, whatever. The point is that we're going to screw everyone holding treasuries, and everyone else too. But we definitely want to minimise our own banks' exposure. We want to try to get the financial side of the Chinese economy as close to self-sufficient as possible. 

The basic step is dumping Treasury assets. If we do it right, the first asset dump will be a surprise attack that will spook the market as much as possible. To ensure maximum carnage, I'd begin my sales at maybe 3pm EST. The aim is to do it shortly before market close in the US, when lots of financial institutions have to mark their accounts to market at the end of the day. 

So, first step, I would start with a massive dump of Treasuries on the market. Not the whole amount  - one must always keep troops in reserve. But enough to cause a big spike in short term interest rates, and enough to panic everyone in the market.

So, this happens at say 3pm. The other reason to do it close to the end of day is as follows. We cannot raise interest rates forever. Indeed, we may not even be able to raise them for very long. The reason is that whoever is playing the US Fed has an obvious countermove. As soon as they realise what's going on, they'll step into the Treasury market themselves and start buying treasuries to raise the price and lower the interest rate. Remember, they're doing this with printed dollars, which are in an almost infinite supply, up to the point of causing inflation. And if you're the Fed, the tradeoff between inflation versus short term market chaos is like worrying about becoming addicted to morphine when you've just been shot in the leg. The choice is obvious - they'll buy, in whatever quantity needed to prevent interest rates from going through the roof.

If they can do this, what's the play? Well, first of all, there's the surprise attack. We're gambling that they don't necessarily have a plan set up to immediately deal with this and implement the massive purchases necessary. Maybe they do, in which case the first round effects aren't as dramatic as we'd hoped. But we can help ourselves by giving them a limited amount of time before market close - just enough time for everyone to react and price in the carnage, but ideally not enough time for them to respond properly.

The aim is that every bank who's long in Treasury assets and has borrowed against them (which is a lot of them) was accounting for this collateral at a low interest rate, and a high price. Suddenly, with minutes left on the equity clock, they realise they're on track to be insolvent by the end of the day, as the collateral on their obligations is rapidly dropping. Loans get called in. Prices of their equities fall, making everyone else panic, making the market as a whole crash. 

So, that's the aim. How would I ensure this gets played up?

Having done the initial dump at 3pm, I would make an announcement at 3:15 or 3:30 or so. The Chinese government is planning to liquidate all its remaining US Treasury obligations and US Dollar denominated assets, immediately. Moreover, we will be switching to Euro Bonds and Euros.

What's the point of this?

In normal trading times, this would be crazy. You're just inviting people to front run your trades, selling before you sell so you get a worse price and then buying back off you later at a profit.

But in chaotic times, this is ideal. We're trying to maximise price impact, not trying to maximise value. By announcing our intentions, we tell the whole market - lots more treasury sales are on the way. What will they do? Start dumping their own Treasury assets, pronto, and switching to Euro ones. In this way, we're not just using our own Treasury reserves. Now the second round of selling is coming from every other financial institution with a fast-moving trader and a desire to stay solvent. Of course, this still doesn't count for squat if the Fed puts in an infinitely large buy order, but there's a long term point. We want as many financial institutions as possible to stop holding US Treasury assets, so the Treasury is basically having to hold the whole lot themselves. This is functionally equivalent to just printing money to cover the entire deficit. They'll do it if they have to, but they don't really want to.

And in the mean time, now the Fed is not only trading against us, but trading against lots of other people in the Treasury market as well. Which makes it harder for them to just take steps that would somehow freeze us out of the market. 

Anyway, let's assume we're playing against a highly competent Fed. Unbeknownst to us, they have contingency plans in place to send enormous buy orders if the price drops sufficiently, and so we don't get anywhere much in terms of disrupting the Treasury market. What then? Has the plan failed?

No. The Treasuries are only step one. The real action is in the foreign exchange market. The Fed is going to have to provide me as China with lots of US Dollars to purchase all the Treasury assets off me. As they do, what's my response? Immediately start selling those US Dollars and buying Euros. In large quantities, as fast as possible.

In other words, we're trying to tank the US dollar. And this is something the Fed has a much weaker position on. Why? Because while they can print up an infinite amount of US Dollars to purchase treasuries, they can't print up any Euros at all to buy US Dollars. Sure, they have some reserves, and you can bet your ass they'll use them. But now there's a finite target. We may even have some idea of how much we're having to trade against, yet in any event, it's a finite and achievable task. And the more they support the T-Bill, the more they give us ammunition to attack the currency.

Which gets to the other point - why buy Euros? Why not buy Renminbi?

Because China wants a weak dollar, but it doesn't really want a strong Renminbi. When the dollar weakens, the US gets imported inflation on its many foreign goods. It also makes it easier for US exporters, so it's not all bad (we have to assume that trade between the US and China will be totally frozen, so it's just other countries we're thinking about). So a big drop in the US Dollar will cause significant inflation in the US.

China relies on exporting industries, so it generally wants a weak Renminbi. Instead, the aim is to make the Euro strong instead.

You might wonder, would the Europeans actually want this? What if they started printing Euros to resist it? 

Well, they might. But I'm not so sure. What we're really trying to accomplish as China is a shift in the question of who gets to be the global reserve currency. It's not going to be China. But it may easily be Europe. A large part of the Euro project was trying to set up a global counterweight to US financial hegemony. There are probably a fair number of Euro policy-makers that would be quite pleased to see the US dollar get displaced. The main advantage of being the global reserve currency, when we're talking fiat, is getting to run enormous ongoing deficits without creating inflation. If the US can't sell its Treasury debt to global investors any more, it runs a real risk that printing more money will result in inflation. As the reserve currency, so far this hasn't happened. 

Indeed, this was surprising to many people during the financial crisis - the Fed was printing like crazy and buying up all sorts of things. Why didn't it result in lots of inflation? Well, part of the reason is that the dollars weren't circulating back into the US economy in the same way. Foreigners buy up the debt. If they bought Euro debt instead, European countries would face much lower borrowing costs, the famous exorbitant privilege that the US currently has. Not only that, but being the reserve currency means that other countries want to invoice in your currency, and hold assets in your currency to hedge against this risk, and have banking services with your country. So being the global reserve asset fosters the development of your financial sector. If the US Dollar goes out of fashion, expect New York to become significantly less important relative to Frankfurt and London as the place of global financial markets. 

It's not just me that thinks this, by the way. This is approximately the argument in the recent Gopinath and Stein paper. They' don't say as much on the question of how one might shift between equilibria, but they more or less agree on the effects of being the dominant currency for trade, invoicing and financial development.

In other words, we're potentially peeling off the Europeans from the Americans. We're saying, hey, don't just instinctively support Uncle Sam here. We think it's probably in your interests to play along with us.

Why might this also be important? Because the other thing that the Fed will probably do in this scenario is call up every other Central Bank in the world and demand that they start buying US dollars with their own currency reserves. Assume that lots of serious threats are made here. If we're China, we can't overwhelm everyone. But if we can convince the Europeans to think twice before buying dollars, then maybe Japan thinks twice too, and India, and Australia, and before you know it, suddenly everyone is holding Euros instead. Russia certainly would be pleased to see the change, so you can count them out. Bye bye US financial hegemony.

Ideally, if I were China, I'd implement this plan when the US was in a recession, or near it. Because this means it's a lot more costly for the US to take the other option to support the currency - let the bond sales go on and interest rates rise. Because this will almost certainly tank the US economy if they do. 

That's the basic play. I think. As I said, I have a lot of uncertainty as to how large the effects would really be, even under the Holmes plan. Maybe global investors believe China won't be able to displace the US, and so don't sell many Treasuries or US Dollars. Maybe they do, and USG threatens their governments that they'll get Color Revolutioned if they don't demand their banks fall into line. This is pretty close to an act of war, so you'd be crazy to do this as China without expecting serious repercussions. And if the aim is to displace the US Dollar as the global reserve currency, you've pretty much only got one shot at it. Once you've fired all your missiles, they're gone. If people stick with the US, in the long run China might end up weakened, and you've destroyed the value of a substantial foreign currency reserve in the process. 

Anyway, this is a guess. Maybe I'm totally wrong, either in what they'd do, or what the consequences would be.

But let's assume for the moment that I'm approximately correct. One obvious question is, would they actually do this?

It's like a nuke. Generally speaking, no. Firstly, the main aim will be short term chaos. The effect on interest rates will likely be temporary, and the Fed will find some excuse to declare that all the financial institutions aren't actually insolvent at 5pm, no matter what market prices say. The currency play is harder for them to deal with, but also speculative as to how big the effect will be, and if its actually worth it. Maybe the US decides its okay with a weak dollar after all? Many other places are okay with this policy. Stranger things have happened.

Actually, it's not even like a nuke, as much as being like two guys in a bar fight, and one of them is threatening to burn the whole bar down, but he's standing closer to the door, so he won't get burned as much. Chinese financial institutions will suffer too. Chinese exports will suffer, big time. And it's a large gamble to see who else goes along, somewhat like a leadership challenge in a parliamentary system. The votes are taken by all the other countries. If you win, you can win big, but if you lose, you're off to the back benches or worse.

But thinking about it in this way misses a larger point. Are nukes pointless simply because in equilibrium its unlikely they'll get used? Wrong. As long as the threat to use them is somewhat credible, they can make excellent negotiating chips.

And this isn't just hypothetical. This actually happened. 

In 1956, during the Suez Canal crisis, Britain, along with France, decided to implement a military initiative to take back the Suez Canal, which Egypt's President Nasser had recently seized off them.

They felt that, as sovereign countries looking out for their own interests, they could just go ahead and do it.

Wrong answer. 

You know who was annoyed at not being consulted? Dwight Eisenhower. So what did he do?  He called up Sir Anthony Eden, and among other things, he threatened to dump the enormous US holdings of British War Debt, while simultaneously cutting Britain off from borrowing. The pound would tank in value, and Britain would be in chaos. The chaos didn't have to be permanent, necessarily, though it might be. But it would certainly last long enough to permanently end the political career of Sir Anthony Eden.

And so Eden backed the @#$% down.

If there was one day where it became completely clear to all concerned that the US was now the world's financial and military hegemon, this was it.

Maybe the Chinese will never do it.

But you'd be a bolder man than I to think that they'd never threaten it. 

All I can say is that I hope some of the smart people at the Fed are thinking about this more than I am.

They have our soul, who have our bonds.

The other counterfactual to wasteful childhood spending

In the modern world, much parental investment in their children is wasted. Parents would almost certainly be better off investing less per child.

They overinvest relative to what the twin studies reliably tell us we should do. Genetic influence is large for most things we care about (e.g. 62% for core educational achievement in the UK. Or if you want a wider sample of traits, look at Table 1 here and see how many are in the category of "high heritability"). Not only that, but most parenting is in the category of common environment, in the language of twin studies - non-genetic factors that are common to both twins in a family. And shared environment generally doesn't do very much, particularly for outcomes measured in adulthood. Which means that all the things you do in common for your children, whether it's the choice of school district, or commonly instilled values, or not having a TV in the house, or whatever... none of them do that much. The components of that which cost you money are probably money spent in vain. The environment terms that do seem to matter are mostly idiosyncratic environment: the non-genetic factors that differ between two twins in a family. Unfortunately, we don't really know what these are. People like to talk about peers at school, but it's also parasites, and head trauma, and infectious diseases, and measurement error, and lots of other weird things.

To sum all this up - parenting doesn't matter very much. It certainly doesn't matter nearly as much as people these days think it does. The main reason nobody notices this is that parenting is nearly always correlated with genetic variation. What matters is if you have the kind of genes that would make you want to read a book to your children each night. Whether you actually read the book or not is far less important. Outside of twin studies, adoption studies, and a few other places, these things are very difficult to tease apart.

But I suspect a lot of people will instinctively resist this conclusion. Am I really saying parents should spend less on their children? People being what they are, they will resist the scientific validity of the above claims because they sound like they're implying parents should be more stingy towards their children. How could I be so heartless and selfish!

First off, if you're ever tempted to deny basic facts just because you don't like the conclusions that flow from them, you're so many levels deep in shonky motivated reasoning that I don't know how to help you.

But more importantly, you're assuming a particular counterfactual, one which I never stated.

I said that parents should spend less per child. And that's true.

When I say that, you're assuming that the relevant tradeoff is "take the money you were going to spend on maths tutoring, and spend it on a fancy new car for yourself". In other words, you make the choice between altruism and selfishness, and then declare yourself righteous by advocating on the side of altruism.

But spending-per-child has both a numerator and a denominator.

People only seem to think of the numerator, to spend less in total. Of course, there's another way to reduce spending per child. Namely, hold total spending constant, and have more children.

And it's bizarre that this is almost never the tradeoff that people think of, even though they should. The real tradeoff should be "skip the maths tutoring and have one more child".

When phrased this way, the choice is much harder to feel righteous about, because now altruism is stacked on both sides of the ledger. And the altruism is actually quite jarring when considered explicitly.

"I'm saving for my child to have a debt-free college experience at the best university possible! What could be more noble than that?", asks John Q. GenXer. Well, let's phrase it differently. Suppose that you have two children, and you want to pay for both of their college. You're setting aside, what, $400K or so? In practical terms, that would go an awfully long way towards funding the entire existence of child #3. Suppose you had to confront the actual child #3, in some hypothetical universe. You have to tell him, "Sorry, son, I chose for you not to exist so that your older brother wouldn't have to have college debt."

Put that way, it doesn't sound nearly so noble, does it? In fact, it sounds downright disturbing and shallow.

And yet that's the actual alternative being faced. It doesn't feel that way, because the children you don't have aren't salient, or even fully real. But if they were, they'd be much harder to treat so callously.

The "aborted daughter" meme made this point very powerfully:

The late, great Gary Becker made a similar point, in the language of economics. People don't love their children, as much as they learn to love them. Because exactly as above, at some point people typically make a choice to stop having more. And yet if the children came along by accident, they'd love them anyway, very intensely, and would risk their lives to save them. But ex ante, they go to considerable lengths to make sure the children don't exist in the first place.

People aren't perfectly altruistic, of course. Surviving on zero sleep for 10 years, instead of 4 years, is a non-trivial difference to one's quality of life over the period. If a couple decides they simply can't do any more, so be it. Let he who has donated all his wealth to charity cast the first stone.

But there is a group of people for whom the alternative counterfactual is crucially important. These are the couples who feel that they might like to have one more kid, but they just can't afford it. Those are the people who are making the wrong choice. The piano lessons and the maths tutoring don't matter. If endless driving the kids to weekend soccer is too hard, just don't put them on the soccer team. They'll survive. If you don't have a huge house, then maybe they'll have to share a bedroom. People have turned out just fine, starting with much worse.

Have one more child, and spend less on each one.

The spending doesn't matter. The child does.

For the world, firstly. And for the child themselves.

On the time-series, the cross-section, and epistemic humility

One of the advantages of the economist's training is just the ability to instinctively think in terms of empirical tests. There's a reason that economists have tended to colonise other fields like sociology, law and politics - as much as anything, it comes from knowing about how to design proper empirical tests, and what good identification is.

Perhaps more importantly, it comes from knowing what poor identification is, including basic issues of endogeneity, reverse causality and omitted variables. For instance, knowing that you cannot infer almost anything about the relationship between prisons and crime just by looking at the variation over time in the total number of prisoners and the total number of criminals in a society.

The gold standard for identification, of course, is pure randomisation. When that isn't available, as it usually isn't outside a laboratory, you go for natural experiments - where something almost exogenous occurred. This gets used as an instrument - in the prisons and crime case, for instance, Steve Levitt used ACLU prison overcrowding litigation as a quasi-random shock to the prison population.

Of course, the pendulum swings back and forth. If the initial identification push corrected the free-for-all of 1980's empirical work (regressing the number of left shoes on the number of right socks!), the subsequent view seems to have gone towards 'identification uber alles'. In other words, the only question of interest is whether you've really truly identified totally exogenous variation, not the importance of the underlying topic. Plus, oddly, very few people seem willing to learn from an imperfect instrument. It seems to me that if there are 100 potential explanations, and an imperfect instrument rules out 90 of them, then we've learned something quite valuable - the answer is either the main hypothesis, or one of the remaining 10. But making the perfect the enemy of the good seems to be the way of things these days.

These questions end up being most important when you actually run empirical tests. Me, I'm lazy - there is a large hurdle for me to actually download a dataset and start fiddling with it. I'm always impressed by people like Audacious Epigone and Random C. Analysis who do this stuff all the time.

But there is another aspect of empirical training that ends up being even more useful for the computationally lazy - helping you sort through hypotheses just by knowing the panel nature of the dataset.

In particular, a lot of questions that purport to be about a time-series are really about a panel. That is, it's not really about a single variable over time (the time-series), it's about a group of different individuals over time. And thinking of the cross-section simultaneously with the time series greatly clarifies a lot of things. That is, instead of just coming up with hypotheses about why the average of some variable as changed over time, think about whether this hypothesis would also be able to explain which individuals would change more or less, or would be higher or lower on average.

One of my favorite examples is birthrates. The classic question is about the time-series : why have birthrates, on average, declined over time?

But there is also a cross-section - whose birthrates? This could be of individuals, or countries, or characteristics. Moreover, the cross-section exists both today, and in the past. If you're too lazy to run a regression and just wanted to sort through hypotheses about the time series with help from your friend William of Occam, one rule of thumb might be as follows: A good variable explains both the time series and the cross section. A mediocre variable explains the time series, but not the cross-section. A bad variable explains the time-series, but predicts the cross-section in the wrong direction.

For instance, suppose I wanted to know why birthrates in the west had declined overall. Here's the US Total Fertility Rate over time

You might look at that graph, and notice a big decline starting in the early 1960s. Certain hypotheses start suggesting themselves. What was going on in the 60's? Feminism? The Pill, approved by the FDA in 1960?

Quite possibly. But what hypotheses would come to mind if instead I showed you this graph:

The US is now in green. But we've also plotted New Zealand, in purple, Sweden, in light blue, and Japan in pink.

I personally would be astonished if your reaction isn't at least partly like mine, thinking that the world is actually quite a lot more complicated than you'd bargained for. Sweden was actually rising in the early 1960s, and New Zealand was higher than the US for a long time. Japan, meanwhile, has a completely different picture altogether.

You can add any number of these together at the excellent World Bank website to test whatever theory you have.

But there are other cross-sections within countries which can be used to test theories further.

Suppose I were primarily interested in the west, and my theory was about a rising cost of having children. It's a lot more expensive to raise children than it was in the past, as you have to pay for daycare, and "good schools", and all this other stuff, because societal expectations are higher.

I certainly hear people with kids complaining about cost all the time, which tells me that maybe there's something to it.

In the first place, I don't think this hypothesis stands up well to an actual examination of the data above. It turns out there's nothing quite like downloading the bloody data and plotting it to explode a lot of preconceptions. This probably actually is the most basic economist's tool of all, to be honest. Because the US graph above shows that not only did birth rates in general go down, but they went down precipitously starting in the 1960s, hit their low point around 1975, and have been slightly rising since then. Of course, since the graph only starts in the 1960s, you have to be wary of giving prominence to this date alone for the initial decline. But still, does this look like a graph of what you expect the cost of raising a child was?

I'd guess not, but with something hard to measure like "the cost of raising a child", who knows, maybe it is. After all, the aggregate time series is always hard. We only have one run of history, and lots of things are changing at once. But the cross-section has a lot more data.

For instance, consider the cross-section of rich and poor. At least in 2000, here's how they looked:

In other words, the poor have more children than the rich.

This immediately doesn't sound like a cost story. Even if the cost has gone up for everyone, why are the rich less able to bear it than the poor? Even if you think that the poor are on welfare so they don't care about the cost, as long as the rich have more money, they still are better placed to be able to deal with it. Are children some sort of inferior good, getting substituted for jetskis as income rises?

And there's another aspect - there's a historical cross-section as well. I suspect, though it turns out to be harder than I thought to find an easy citation for this, that this disgenic pattern in birthrates with respect to income is a relatively recent phenomenon. Certainly in pre-history or in polygamous societies, only the rich could afford to have large large families (or multiple wives, in the polygamy case). When the Malthusian limit binds, access to resources matters, and the rich outbreed the poor.

I've written before about how I think improved birth control is a big part of the story. But doubt it not, this does not much better at explaining the current cross section as a cost story. That is, it approximately fails to predict it at all (making it mediocre by my rule of thumb), rather than predicting it in the wrong direction like costs do. To get birth control to explain the cross-section of income as well, you'd need to believe that the poor are unable to afford birth control, but are able to afford the resulting children. Seems hard to square to me.

Cost, incidentally, also has similar cross-sectional problems when it comes to the increase in obesity. Leftists love the 'food desert' explanation, whereby the poor are forced to become obese because the stores in their area don't have enough fresh fruits and vegetables, and hence the only options to them are potato chips and coke.

Again, from a cross-sectional point of view, this is possible. But it's a disaster from the time-series point of view. As society in general has gotten richer, we've also gotten fatter. How is it that the poor today "can't afford to eat healthily", but the poor in the 1930's could?

So explanations have to get more complicated. There's no rule of nature that everything has a single explanation. I've picked fertility and obesity because they are two of the most stubborn problems facing the west today, which suggests, but does not guarantee, that they may not be amenable to a single simple explanation.

I think there's something quite humbling about looking at the totality of the data, because it rarely looks like any one neat explanation of anything. It reminds you that your models of the world are just that - models. You include what you think are the most important parts, but you leave out lots of other stuff too. Even if you're right on what's important (a big if), the world is a large and complicated place.

The economist's case for at least agnosticism about Bitcoin

As far as I can tell, the primary problem with Bitcoin is that after you've bought it, you become medically incapable of shutting the @#$% up about Bitcoin. So it goes.

It took me a long time to buy any bitcoin, but I should have done it about three years ago. This isn't cheap talk, by the way. I know exactly why I should have bought it back then, based on the knowledge I had at the time (which is the only criterion by which you ought to regret any decision). To wit: I considered myself a Bitcoin agnostic. This made me more optimistic than perhaps 99% of finance people I spoke to. But then again, 99% of finance people I spoke to also couldn't easily explain why Bitcoin existed in the first place. 3 years later, all of the above is still true, but I finally got off my butt and did something about it, albeit after an enormously costly delay.

The standard economics textbook description of money says that it tends to arise because it helps facilitate exchange. If we need to barter goods with each other, it's hard for me as a blacksmith to obtain wheat unless I can find a wheat farmer who also coincidentally needs blacksmithing services. But if I can exchange my blacksmithing services for some asset money (as yet undefined as to what that is) and then turn the money into wheat down the line, this greatly allows us to trade more and grow the economy. So far so good. But what exactly makes something money?

The standard economics textbook definition of money says that it has to fulfill 3 purposes, namely

#1. It has to be a unit of account - a way of measuring how much of something you have

#2. It has to be a medium of exchange - a means for people to transact amongst each other and exchange goods and services indirectly, rather than directly through barter

#3. It has to be a store of value - that is, have some worth derived from an alternative use other than the monetary aspect itself, to ensure that people will be willing to hold it.

Under this standard narrative, bitcoin fails. #1 is fairly easy to meet, but bitcoin's big strength is in #2, which it passes with flying colours. Importantly, however, it fails badly on #3. Digital bits have no inherent value, and no external use to make them a store of value. Ergo, it should have no value above zero, and anything else is a bubble about to collapse. So goes the standard story.

Gold originally fulfilled all three purposes. You could weigh it, and trade accordingly. Turning gold into gold coins helped with 1 and 2, so drove out raw gold. It was easier to transact and measure in coins. Of course, the problem with coins is that they could get filed away at the edges to steal some of the gold, but still be worth approximately one coin. So eventually the coins got replaced with pieces of paper that were claims on gold in a government vault. At the start, you could actually make the conversion. Then conversion became increasingly a fiction, before FDR decided to do away with the pretense of convertibility, suspending the conversion and limiting the ability of private individuals to hold gold.

 At this point, you may be wondering how US dollars continue to meet the 3 definitions above. After all, they kept being used as money, and economists didn't all seem in a raging hurry to update their definitions. So the standard answer is that the 'store of value' aspect is that the government, who has guns, will accept USD as a means of paying taxes (and indeed demands that form). Because they have a guaranteed value for that, they have a guaranteed value for everything else.

To me, this seems to have a definite flavour of ex-post rationalisation. My hunch is that if you asked people 100 years ago whether they would still be equally willing to hold dollars if they were backed by nothing at all, they would have answered strongly in the negative. In the end, they were prohibited from switching into gold at the time, so it was a moot point. But what about now, when they could switch? I highly doubt that many people today would explicitly state that they're willing to hold dollars because they can pay their taxes in them. 100 years ago, they probably would have laughed you out of the room.

The economists are right in a narrow sense, of course (as they often are). Bitcoin does indeed fail as a store of value, and, technically, the dollar does not.

And yet, here is some evidence that ought give you pause, assuming you're not an economist in the midst of full-blown cognitive-dissonance-induced denial:

This is Bitcoin today, stubbornly refusing to prove economists right by ceasing to exist. As a matter of fact, since the coinbase time series starts in January 2013, it's up some 19,000% or so.

Don't look at the graph and ask if you think it's about to drop. Look at the graph and ask how much it would have to drop to get to where it was in 2013 (let alone 2009).

At a certain point, it seems prudent to at least consider the possibility that there might be something going on here, but you don't know what it is, do you Mr Jones? Or at a minimum, ask the following question - what level of future growth would you need to see to change your mind? Another 100%? Another 1000%? Can we agree on it now, so that if it eventually happens, you might reconsider the question?

The null hypothesis here is not in much doubt. Bitcoin is a bubble, and will eventually collapse.

Actually, the true null hypothesis is a little more specific, at least if you believe standard economics. Bitcoin should have a price of zero. It has no value except as a currency, and it is worthless as a currency.

So what is the alternative hypothesis?

The alternative hypothesis is that Bitcoin is likely to stay at a non-zero value for quite a long time, if not indefinitely, and moreover may end up being worth a lot. That may sound woolly and hand-wavy, so let me explain.

First off, how many things can you name that truly have a value of zero?

It's surprisingly hard. If you don't believe me, here's a photo of cans of air from the top of Mount Fuji selling for ¥500

And things like rubbish or nuclear waste have definitively negative prices - you have to pay to get rid of them. They're still not exactly zero.

The point is that "fundamental value" is a concept that, in my opinion, creates at least as much confusion as it dispels.

The primary value of an asset today is what you think someone will pay for it tomorrow. If they can use the asset for some external purpose, and you have a guide to what that external purpose is likely to be worth to them, you have a guide to what it will be trading at tomorrow. But that's all it is. If you have some other way of estimating what people will pay for the asset tomorrow, then you don't need the intermediate heuristic of fundamental value. (This is especially true for assets which don't directly produce cash flows - for ones that do, there's a better case that you should just value the cash flows, but even then, you still need to know tomorrow's willingness to pay unless you're able to hold the asset to infinity to collect all the future cash flows).

So in that case, what should Bitcoin be worth? Whatever people are willing to buy it for tomorrow. And what number is that? Well, that's the rub. But at least we know the right question to ask now.

As a consequence, we can begin to formulate an alternative definition of requirement #3 for money that we started with. Specifically:

#3A - If you accept the asset today in exchange for giving up valuable goods or services, you have to have a very strong belief that you will be able to exchange said asset tomorrow for someone else's goods and services, and receive approximately the same value as what you exchanged today.

Viewed from this angle, we can see that requirement #3A is at heart a co-ordination problem. Once we all agree on something being money, it becomes money. More importantly, we can see why people mistakenly viewed #3 as being the requirement. In essence, being a store of value is one way of solving the co-ordination problem. If it's common knowledge that some people will be willing to accept gold because it's useful for jewellery, most people who don't value it for jewellery are nonetheless willing to hold it.

But this isn't a strict requirement. Once the belief is established, it becomes self-fulfilling. When you accept US dollars, you aren't doing the iterations and thinking that it will eventually be exchangeable for taxes. You're just accepting it because you can buy your groceries with it tomorrow. Now, in the long run, it's true that if the US government collapses, you don't want to be holding US dollars, so in that sense the economists are right. But this is a long way from most people's actual calculation.

In the case of Bitcoin, a belief that Bitcoin will retain some value tomorrow can justifiably be sustained as long as I know that there's a decent number of drug dealers and corrupt Chinese officials who want to hold Bitcoin because it's (sort-of) anonymous and can be easily taken out of the country when the porridge hits the propeller. But in the short run, I hold Bitcoin because I think that people tomorrow will hold Bitcoin.

In fact, it's stronger than that. Like a classic bubble, people actually believe that more people will want to purchase bitcoin tomorrow, and at higher prices. In other words, the supply is fixed, and the more the price goes up, the more people begin to think "Huh, maybe I should hold at least a few grand worth of Bitcoin, just in case." If more people begin to think that, the price will indeed keep rising. Of course it can't rise like that forever.

But even if you think of Bitcoin as a bubble, it behooves you to notice something rather different about it from most bubbles, like the tech boom. In the case of Bitcoin, it seems to me from anecdotal experience that many, if not most, of the people buying bitcoin today are planning to hold it for a long time, if not forever. And this is definitively not true for most bubbles. People generally ride bubbles planning to get out once it's gone up enough, then go back to holding cash, or houses, or whatever. If that's what most people are thinking, the belief structure becomes very unstable, as any dip in price suddenly might cause a lot of people to switch to selling. Even if Bitcoin is a bubble, if most of its adherents plan to hold onto it for a long time, regardless of current price levels, then this reduces the likelihood of a complete collapse when everyone rushes for the exits.

In other words, even if this is a bubble, it may be a surprisingly durable one.

And the reason that "bubble" here is not necessarily a pejorative term is a point made by Moldbug - that money is the bubble that doesn't have to pop. In other words, there will be at least one good that is held in excess of its demand for other uses, because of its use for transactional purposes.

It may seem strange to reference Moldbug, since he comes out as a skeptic, based on his guess that the government will outlaw it.

But there is a counter-argument to that - the Uber problem. Namely, the government has a limited amount of time in which it can easily ban Bitcoin. The reason is that as the price gets high enough, enough people have enough to lose that it becomes politically costly to ban it. And so at some point, you get a compromise answer, like Coinbase seems to have done - you have to submit ID, it's linked to your bank account, and you have to give a social security number. The US Government levels capital gains taxes, everyone is happy. Why ban something if you can make more money by taxing it instead?

Because there is one rhetorical claim about Bitcoin made by its proponents that I think has caused more confusion than any other. It was this realisation that made me change my mind and invest in it. (Which, to emphasise, I'm not encouraging you to do. I'm some stranger talking smack on the internet, and this is not financial advice. But still)

It is this:

Bitcoin is not going to be a substitute for the dollar.

Bitcoin is going to be a substitute for gold.

Which is to say, the reserve asset that you hold in some amount as a hedge against the @#$% hitting the fan. This is of course, mid-level @#% hitting the fan, such as large-scale financial instability - if things really get hairy, the only worthwhile assets will be guns, ammunition, antibiotics, water purification tablets, and that kind of thing. But again, the same holds true for gold. If you honestly think that in a post apocalyptic New York there's going to be a vibrant demand for gold for jewellery purposes, perhaps you would do better investing your savings in shares in the Brooklyn Bridge.

Put another way, the case for Bitcoin in concise terms is that Bitcoin is to gold what neocameralism is to monarchy.

That is to say, it's what you get if you took an old but existing arrangement, and instead of trying to mimic it exactly, you thought about how you would design a modern version of it that a) retained the essential strengths while b) utilising technological innovation since the early form to overcome its weaknesses. (Some thoughts of mine on the neocameralism vs monarchy comparison are here).

In the view of Bitcoin, the essential aspect of gold is its relatively fixed supply. So let's go one better, and make a mathematically fixed supply. Rather than gold coins, let's create highly divisible bitcoins that can be traded across borders costlessly. Rather than measure purity over and over, let's create a blockchain to solve the problem of double-spending and transactions between mutually suspicious parties. Meanwhile, the fact that it can be mined by anyone easily at first, but only with more difficulty later, encouraged people to get in on the action early.

If you thought an essential aspect of gold was its value in jewellery, then you'd be a skeptic.

Rather, the other essential aspect of bitcoin was its first-mover advantage. Sure, someone else might invent other coins (and they have), but because Bitcoin was the first to market, it already has the advantage of incumbency. And in a co-ordination game, that's a huge deal.

And I think phrasing the question this way to economists helps to clarify the issue. In other words, if you're a Bitcoin skeptic and think its a bubble that's inevitably going to burst, I would ask you: is gold a bubble? This is harder to prove than in the case of Bitcoin, because it does have a fundamental value from other uses, so its value shouldn't go to zero. As a consequence, evaluating whether it's a bubble is much more thorny and more subjective. But it seems pretty clear to me that central banks aren't holding gold because they're about to turn their bullion into wedding rings. As Moldbug points out, in 2011 gold reserves were 50 times annual production. For silver, they were twice annual production. Assuredly there is something unusual about people's desire to invest in gold. So if you think that this is creating excess demand, surely this is pushing up the price, no? Supply is pretty fixed in at least the short term, if not the medium term too. And isn't excess demand pushing up prices the definition of a bubble? The point, of course, is that with gold this state of affairs has persisted for an extraordinarily long time. Is there any particular reason to assume that gold is about to disappear as a hedge asset? Not to me.

But I know my economist friends well, and I know their objection to the above reasoning, which makes Bitcoin different from gold. Which is to say, without a fundamental source of value other than as a money-like good, isn't the whole thing liable to unravel really quickly? Put differently, you and I might be willing to hold Bitcoin because we assume that there's reserve demand from Chinese officials and drug dealers, but why are the Chinese officials and drug dealers themselves willing to hold it?

This is another way of saying, why don't we all iterate backwards and realise that without an ultimate holder of the good from some other source, the value to everyone should be zero? Suppose we have a game where if we co-ordinate on a good being money, it gives value to both of us, but in the final round whoever is holding it ends up with a worthless asset.

If the game is finitely repeated, the economists are absolutely right. If everyone correctly performs backward induction, you'd predict a) Bitcoin should never have a positive value to begin with, and b) even if it does, this should be rather fragile. If it's an infinitely repeated game, then the Nash Equilibrium has more possibilities, as it usually does. In this case, if there is no final period, then it seems more like a straight one-shot co-ordination game where if we both agree, we both benefit. But let's take the finitely repeated version with a penalty for holding in the last round, as the logic is stricter there. And the logic dictates that since no-one is willing to hold in the last round, they don't want to hold in the second last either, and so on.

But here is the trillion dollar question - how much do people actually perform backward induction? And if they don't, how should you act in response?

The classic version of this is the iterated Prisoner's dilemma. Suppose two people are playing against each other 100 times in a row. The economist's answer is that if we're only playing a finite number of times, there's only one Nash Equilibrium to this game. We both defect in the last round. Knowing this, we both defect in the second last round, and the third last round, and thus in all rounds.

And yet... people don't. They routinely co-operate, and only begin defecting towards the end. This is why tit-for-tat works so well in practice. Because most people don't actually do backwards induction for more than a few iterations. This is why they don't start defecting until close to the end.

And bear in mind that, unlike Prisoner's Dilemma, Bitcoin is a co-ordination game, meaning it actually is a Nash Equilibrium for us all to believe in Bitcoin, at least in the one shot version. In the case of Prisoner's Dilemma, you can mathematically prove that people aren't acting rationally, and yet they still do it just the same. Here, it at least can be rational.

Now, bear in mind, the economists aren't wrong on the bigger picture - it still might collapse, for all the reasons they say. But that's not the same as saying that it has to collapse. I would guess, rather, that the opposite is likely to be true. The longer it goes without collapsing, the stronger the self-fulfilling aspect of the belief becomes, and the more stable it becomes.

Mainstream economists and finance types are looking at Bitcoin continuing to rise in price, yelling that this is a stupid and unstable equilibrium and that people should all start defecting immediately.

This is just like the economist watching two people play prisoner's dilemma and continue to co-operate round after round. You can laugh and call them morons, but a betting market just opened up. It's round 43 of 100. They both co-operated last round. Rubber to the road, what would you bet they're going to do this time?

After eight years of people continuing to not defect in Bitcoin, perhaps, dear economist, it's time to re-examine your assumptions.

Updated: On the other hand, if you wanted to make a concise case for a bubble, just check out some of the bizarre creations down at the lower market cap end of the cryptocurrency list. $10 million of FedoraCoin, you say? It's woefully underperforming PepeCash at $13 million. Hmm.

An Economist's Cautionary Note on Free Trade

Among most economists (among whom I count myself as one), free trade is a pretty strongly favoured policy.

The reasons for this are fairly good, and fairly straightforward, in the standard case for free trade.

Under the standard theory, the main basis for the benefits of free trade is comparative advantage. If Australia is relatively more efficient in producing iron ore (that is, if it has a comparative advantage in iron ore), and China is more efficient at producing manufactured goods, then at the country level both Australia and China are better off if Australia specialises in iron ore, China specialises in manufactured goods, and the two countries trade with each other. Then both countries are able to obtain more consumption of each good than they would alone, given whatever initial resources they have. This is an economic benefit, understood since David Ricardo wrote about it in 1817.

If one thinks of the economic units in terms of countries, free trade between China and Australia is Pareto improving. Both countries are made better off, and no one (in this limited model) is made worse off. This is the Holy Grail of economic policy. The optimal level of tariffs is thus zero, as restrictions on free trade harm both countries.

But if one thinks instead at the level of individuals within a country, then free trade is no longer Pareto improving relative to tariffs. In the example above, if I'm a worker in an Australian manufacturing firm which was previously protected by tariffs, and these get eliminated, then I really do get screwed. It's not just complaining - as my firm goes broke, I lose my job, and the previous skills I have are no longer economically useful in my country. Even if I get another job, I likely will have a lower future wage for quite a while, if not permanently.

The steel workers in Ohio complaining about free trade aren't just making it up. Things really did get a lot crappier when tariffs were eliminated.

But economics has an answer here. Free trade isn't Pareto improving, but it is Kaldor Hicks improving. In other words, the total gains to the economy are sufficiently large that the beneficiaries could organise a transfer payment to those who lost their jobs which would made the Ohio steel workers also better off. 

As a matter of political economy, this transfer doesn't actually happen. You'd have to pay the losers from free trade a very large sum of money if they have to transition to years of unemployment, or a permanently lower future income. 

Of course, this isn't really a problem of economics, more just politics. Is it the economist's fault that his prescriptions don't get followed?

So much for the standard theory. It's actually pretty good, as far as it goes. Like good economic proofs, it flows from assumptions to conclusions. If it's wrong, it's because there's something in the model that's being left out, or one of the assumptions is questionable.

There are a number of possible extensions one can make, like depreciating human capital. But to me, it's the base assumptions that are the most interesting. What are they?

We have the following:

1. Consumption is a good. You're better off consuming more goods and services than fewer goods and services, all else equal.

2a. Leisure is a good, or equivalently

or 

2b. Work is a bad.

In other words, for any given level of consumption, you'd rather work less than work more. 

These are not terrible assumptions. #1 seems probably true. You may hit a point of satiation with consumption, but over most ranges of wealth that people operate on, having more stuff beats having less stuff, unless the stuff poses other costs (like screwing up your children, in which case all else isn't equal).

But what about #2?

Going from a 14 hour work day to a 10 hour work day, with the same wages and consumption, is surely an improvement in welfare.

Going from a 10 hour work day to a 6 hour work day, with the same wages and consumption, is also almost surely an improvement in welfare. 

But the big question is the following: is it still an improvement in welfare to go from a 6 hour work day, to a zero hour work day in perpetuity?

In other words, if your consumption stayed exactly the same, would you prefer to have some sort of job, or no job, ever?

You may think work sucks, but be careful what you wish for.

What if it turns out that people actually need some sense of purpose, some reason to get up in the morning?

Admittedly, having a job isn't always a fun purpose. But it's a structure, and a discipline, and a set of people you can interact with, and a routine that, if it works well, results in the satisfaction of providing for yourself.

What would life look like if you had basic consumption needs provided for you, no strings attached, without any need to work?

Well, as it turns out, we have many decades of data on that question. They're on display in a housing estate or ghetto near you. And the results ain't pretty. Ask Theodore Dalrymple, who wrote about this extensively: 

Every few months, doctors from countries like the Philippines and India arrive fresh from the airport to work for a year's stint at my hospital. It is fascinating to observe their evolving response to British squalor.

At the start, they are uniformly enthusiastic about the care that we unsparingly and unhesitatingly give to everyone, regardless of economic status. For a couple of weeks, they think this all represents the acme of civilization, especially when they recall the horrors at home. Poverty—as they know it— has been abolished.

Before very long, though, they start to feel a vague unease. A Filipina doctor, for example, asked me why so few people seemed grateful for what was done for them. What prompted her question was an addict who, having collapsed from an accidental overdose of heroin, was brought to our hospital. He required intensive care to revive him, with doctors and nurses tending him all night. His first words to the doctor when he suddenly regained consciousness were, "Get me a fucking roll-up" (a hand-rolled cigarette). His imperious rudeness didn't arise from mere confusion: he continued to treat the staff as if they had kidnapped him and held him in the hospital against his will to perform experiments upon him. "Get me the fuck out of here!" 

My doctors from Bombay, Madras, or Manila observe this kind of conduct open- mouthed. At first they assume that the cases they see are a statistical quirk, a kind of sampling error, and that given time they will encounter a better, more representative cross section of the population. Gradually, however, it dawns upon them that what they have seen is representative. When every benefit received is a right, there is no place for good manners, let alone for gratitude.

By the end of three months my doctors have, without exception, reversed their original opinion that the welfare state, as exemplified by England, represents the acme of civilization. On the contrary, they see it now as creating a miasma of subsidized apathy that blights the lives of its supposed beneficiaries. They come to realize that a system of welfare that makes no moral judgments in allocating economic rewards promotes antisocial egotism. The spiritual impoverishment of the population seems to them worse than anything they have ever known in their own countries. And what they see is all the worse, of course, because it should be so much better. The wealth that enables everyone effortlessly to have enough food should be liberating, not imprisoning. Instead, it has created a large caste of people for whom life is, in effect, a limbo in which they have nothing to hope for and nothing to fear, nothing to gain and nothing to lose. It is a life emptied of meaning.

"On the whole," said one Filipino doctor to me, "life is preferable in the slums of Manila." He said it without any illusions as to the quality of life in Manila.

I skipped the most striking descriptions of the problem, because if I started, I'd end up quoting the whole thing. Read it all, if you haven't before.

A question, dear reader.

Do you think the problems of the people described above stem from a lack of consumption? They don't have to do any work, so in a standard model, the only problem left is that they must be consuming too little.

Suppose that Dalrymple is describing his subjects in the above article honestly, and you have two policy choices to consider for the above recipients.

Option A - Increase their welfare payments by 50%

Option B - Find them a not unpleasant job for 6 hours per day, and require them to do honest work in order to receive the same welfare payments as before.

Which of these two policies would result in a larger improvement in human welfare for such people?

In the standard model, the answer is obvious. Given our assumptions, Option A is far preferable. Do you believe that?

Would it change your mind to find out that lower class whites in America (especially in rust belt parts of the US that have been worst hit by job losses from free trade) in recent decades have been so despondent that their life expectancy has actually been dropping as they kill themselves with alcohol, opiates, and suicide?

The standard answer to this is that we have an opiate problem. And a drinking problem. These are "substance abuse" issues. But why now? Alcohol was always there. Why is it only now that people decide there is no other purpose or hope in their lives, and start drinking themselves to death?

To turn these concerns back into the language of economics, the Holmes conjecture is that if leisure is not always a good, and work is not always a bad, then it is no longer obvious that the optimal level of tariffs is zero.

Sometimes, you might prefer to have some restrictions on trade in order to keep jobs in America.

But you have to be honest about why you're doing this.

Targeted tariffs won't raise consumption. They won't spur economic growth. They will lead to more expensive goods, and less consumption. David Ricardo was right on all that. Comparative advantage still exists, and be very wary of anyone who talks about free trade without acknowledging this.

But they might also lead to more employment. And this may well be worth it in terms of the quantity that the economist's social planner is meant to care about, namely total welfare.

It might lead to fewer rust belt whites killing themselves with opiates, because their communities are totally hollowed out with everybody sitting around on welfare without any purpose in their lives.

If steel products cost slightly more as a result, personally that doesn't strike me as the end of the world.

Of course, this is a cautionary note, not a case for tariffs-a-go-go. To say that the optimal level is not zero does not imply that the optimal levels is high, or across-the-board. And it's also not clear that tariffs versus free trade is the only solution to this, or even the best one.

I personally think that automation is a much bigger worry in this regard than free trade. I have similar questions about automation, which also doesn't strike me as everywhere and always welfare improving.

These aren't straightforward questions. If you ban the automobile, we get stuck with horses and carts forever.

And yet... and yet...

The Deaton and Case finding seems to me to be one of the most important findings in social science in recent years, and portends an enormous and growing problem. There are lots of workers who simply do not seem to be economically useful anymore, and in communities where lots of these people have ended up on welfare as a result of the endless grind towards replacement by robots, life is purposeless and miserable.

There are many other purposes that can be fostered - community, charity, art, religion, family.

But until we have a handle on how to solve the torrent of lives being sucked into the abyss of misery, as large as the AIDS epidemic, I remain open to a range of different policies in response.

At the Rescue Mission

Poverty, to an economist, is mostly an abstract matter. Just like GDP is a number and unemployment is a number, the poverty rate is also mostly thought of as a number. It’s a very important number, and one that we work hard to try to reduce. But the essential nature of the task is mostly thought of as a technical problem to be solved, like a constrained optimisation – consider the variable to be minimised and the policy variables that can be altered to achieve this, check that the Lagrange multipliers on all the constraints are satisfied, check the second order condition to make sure you haven’t found a maximum instead of a minimum etc. Out comes optimal policy.

But real poverty, when you see it up close and in the flesh, is raw and visceral.  It is shocking, in fact. This may sound melodramatic, but bear with me. Like anyone living in a large US city, I see poverty mostly in the form of the shambling figures of the homeless walking around downtown areas. But they tend to feature as the Banquo’s Ghost at the fringes of whatever otherwise pleasant social function I’m attending, or the nice area of town I’m walking around in. They are, in other words, an aberration – the puzzling exceptions left behind in the sea of prosperity.

No, to actually see what abject indigence looks like at the coal face, one must venture to where poverty is not the exception, but the norm. I was at a homeless rescue mission the other day, with an out of town friend of mine. His family was dropping off a large order of dinner for Thanksgiving and helping out in the serving. If I had not been spending the day with him, I would never in a million years have headed there.

They say that one of the important things that you are taught in the Marines is to overcome one’s instinct to run away from the sound of gunfire. Everyone has this instinct, but to an army, it is disastrous. A soldier must run towards the gunfire. In a less dramatic way, driving into the really poor part of town is like that. The onset of tent cities and strung out hoboes on the street is mostly experienced in life as a sensation that a) one has wandered into the wrong part of town, b) one should change routes, if possible, and c) a back of the mind feeling of hoping one’s car does not break down. Driving to the mission, in this metaphor, is the equivalent of having left the greenzone altogether and heading for the Fallujah of poverty. Of course, everyone else in the car has done this before and is relatively at ease – it’s only me seeing it for the first time.

Both in the car, and when I arrived inside the mission, we are the exception. Dysfunction is the norm, and the norm is all around us. To someone who generally associates homelessness with either drug use and/or mental illness, it is initially quite disconcerting to experience the sensation of being vastly outnumbered by the homeless. The instinct for self-preservation battles with the obvious cowardice and shame that such feelings generate. This is not a hostile army, and everyone here ought to be an object of pity. But the law of large numbers holds nonetheless – how many unstable people can one have in a room before the left tail of outcomes becomes dangerous? And yet here is this 5’4 blonde lady smiling and greeting me, seemingly unconcerned.

And, of course, it isn’t actually that bad, just unfamiliar. When we ascend the levels to meet people who have successfully gone through the programs to get their lives back on track, they seem relatively normal. We meet a man who is studying for a computer degree, and tells us he’s now been clean for 15 months. It’s really quite heartening. A lot of the people at the mission will only be in and out of the ‘emergency food’ section, where assistance is given without any questions. But for the ones that are trying to get their life back on track, I’m very glad to see that there are programs ready to help them.

The other fact that becomes very apparent is the reason the whole enterprise exists, evident from the signs on the walls and the people helping out at the center. The rescue mission is not staffed by economists or government social workers. It is staffed by Christian volunteers, as the various posters on the wall and the Chaplain in charge indicate. I am not a Christian, but I am glad they are there, toiling away at this kind of thankless task. If one ever needed a reminder that Christianity is not the problem with America, this was one. It motivates genuine selfless charity in a way that the default of consumerist secular humanism simply does not achieve. Of course, even the selfless often have personal reasons for being there. My friend’s brother in law ended up becoming very involved in the mission and donating a lot of money there after his own brother, who had been a drug addict, went through their program. The homeless live at the outskirts of society, and are easy to just look past, unless you have a particular reason to seek them out.

I drive back in the car, having mostly just been a silent observer during my time there. Going from the relative function of the program graduates back to the chaos of the tent cities outside, blending back into relieving normal society, reinforces the scope of the problem. How did all this happen? And was it always thus? George Orwell wrote of the tramps in ‘Down and Out in Paris and London’, and Dickens wrote of it even earlier. From talking with my friend’s sister, my preconception that a lot of the problem was mental illness is apparently overstated – a lot more of it, according to her, is just substance abuse. Some of the people who seem crazy actually just need to dry out, and they’re hallucinating at the moment.

It is tempting to see tent cities seem like an enormous failure of governance, and there is definitely a decent amount of truth to this. Whether the failure is a lack of money and support or a lack of police presence is a matter upon which people will disagree wildly, but the unsatisfactory nature of the status quo is hard to ignore.

Unfortunately, the narcissism of our age mistakes the feeling that ‘something ought to be done’ for the belief that as long as we vote for the right person (whoever that is) the problem will resolve itself. But does anyone really know how you deal with whatever it is that makes people start taking meth? Especially when they took it up even after seeing other meth addicts losing their teeth and turning into barely living skeletons (and then non-living corpses).

The lazy but satisfying response is outrage – substitute the feeling of pity and disgust for one of anger at some political force that is deemed to be responsible. Insufficient money. Lack of institutionalization of the mentally ill. Greater funding for substance abuse treatment. Stronger police action against vagrancy. Pick your chosen policy. They all make great soundbites and feel satisfying, but when you drive past the tent cities outside the rescue mission (and not for lack of space at the missions, either), it becomes apparent that there are a large number of real people in front of you who cannot find a reason in their life to stop taking self-destructive quantities of mind-altering substances, and this is actually an extraordinarily difficult problem to solve.

After all the policies are proposed, and some are even tried, few people today will tell you what was once considered received wisdom – the poor you will always have with you. When society as a whole was poorer, it used to be easier to convince ourselves that economic growth would take care of the problem. But it turns out the Biblical observation was wiser than we knew. If only the problem were just money. Money, we have now have substantial amounts of. What we do not have is a way to give purpose to the lives of those at the bottom of society. And if we have gotten any closer to solving the problem in the past few decades of growth, it is hard to see it.

First World Problems: Immigration

There exists a continual tension among respectable social scientists when trying to understand what influence culture plays on the world. One must navigate between the Scylla of assuming that only that which is easily measured is real, and the Charybdis of seeing nothing but the unmeasured everywhere.

The Scylla is that of the uber-economist who denies that ideas like culture are meaningful, testable, or important. Human behavior is pretty much reducible to incentives. If he’s feeling a little bit expansionist in his gaze, said uber-economist might admit that psychological biases and market frictions sometimes prevent the proper response to incentives. But other than that, there’s very little else important that determines variation in human behavior. Social changes are best understood as merely changes in technology, cost structures, and resources.

One version of this, which sounds almost like a straw man (but I assure you is not), is that policy should treat people as wholly economic units. When setting immigration policies, there are no differences whatsoever of any importance between a thousand laborers from El Salvador, a thousand laborers from Sudan, or a thousand laborers from South Korea. The variation in visa requirements for nationals from such countries to enter the US suggests that the powers that be do not appear to wholly share this view. The fact that, notwithstanding setting policy based on the presumption of some differences, nobody in any position of authority is willing to publicly assert the existence of such differences, let alone elaborate on exactly what they are, tells you everything you need to know about how policy in this area ended up in such a mess.

The Charybdis, by contrast, is the non-economist, who sees only cultural decline and progress. This can take a variety of forms. There is the progressive who sees nothing but the glorious march of social justice in every economically deleterious policy from affirmative action to the rise of public sector unions, for instance. But there is also the cultural conservative who sees nothing but a steady rise in depravity and degeneracy in modern culture, often to the point of almost rhetorically waving away the enormous increases in material welfare and life expectancy over the past several centuries. Both the progressive and cultural conservative agree, however, that if we could only get people to hold the right beliefs, nearly everything could be fixed in the world.

Between these two extremes, the man of judgment must navigate a path that best approximates his understanding of reality. I vary day by day on much I lean towards each extreme. My training is that of the Scylla, but my personal reading is that of the Charybdis.

One aspect that tends to get largely ignored all around, however, is the interaction between the two ideas. How often, for instance, does technological or economic change end up driving cultural shifts? Or indeed the reverse?

As one candidate phenomena that may have a depressingly economic cause (from the cultural conservative’s perspective), consider the problem of mass illegal immigration of third world populations to the west. Whether in Europe or America, there appears to be a complete inability (and unwillingness) to enforce the border against arbitrarily large numbers of incursions from illegal third world economic migrants. The blindness of the modern left to the potential problems of this phenomena is a source of both incredulity and immense frustration to reactionaries and conservatives alike. As I have written before in these pages, the west has taken an enormous bet that it can resettle large numbers of people from countries that share very little in the way of common culture, language, or values. Moreover, it wagers that from this it can somehow produce a society that retains the strengths that made it a desirable place for people from the third world to move to in the first place. Let us take it as given that the outcome of this bet is not yet written. What, would you say, are the odds though?

Of course, if this problem were merely political stupidity by blank slate cultural Marxists in positions of power, then it is at least conceivably soluble by convincing enough people in positions of power of the potentially disastrous consequences, then the mistaken policies can be reversed.

But what if the big increase in illegal immigration is driven by mostly economic factors? Then, dear cultural conservatives, we have a larger problem on our hands.

I have to conclude, rather depressingly, that I think it is.

Why were the populations of Europe mostly stable for thousands of years? Other than the occasional invasion which radically upset the cultural and genetic balance, there’s a reason that 23andMe can say with a high degree of certainty whom your ancestors were. It’s because they mostly stayed as a culturally homogeneous group in a fairly circumscribed area.

Okay, so why did they stay in a single area, when today we move all around the place? Is it because of a firm cultural value that one should mostly mingle with one’s extended kin and clan? Partly. But I think it’s far more to do with the fact that it was both technologically infeasible and economically prohibitive for the vast majority of people to move very far from their place of birth.

In the case of seafaring voyages, this is easy to understand. Sailing any large distance was risky and difficult, and when you arrived you’d have absolutely nothing but what you brought. If the place you landed was inhabited by people who were hostile to you, they’d probably try to kill you, and they’d probably have the advantage of resources, numbers and local knowledge. Faced with that choice, you’d probably just stay put in your village too. But even travelling large distances over land created similar problems. Someone else is already on that land, you can’t speak their language, and they probably won’t be glad to see you. A single family just packing up and moving to a wholly alien land was extraordinarily unlikely.

The point is, societies in the past simply didn’t have to think about how they’d treat the problem of mass immigration. The only form of mass immigration was a military invasion, and the desirability of averting that didn’t have to be explained to people. The issue of how one should treat an influx of culturally different foreigners who came to work probably didn’t even arise to the level of philosophical speculation. I’d guess that lots of people spent their whole lives never meeting any foreigners.

The simple fact, however, is that the west is caught in a pincer movement between two economic forces. First, technological improvements in transportation have made the cost of long-distance travel get cheaper and cheaper over time. And second, the rising wealth of the third world, even when starting at very low levels, has put this journey in reach of more and more people. It’s the same question as with nuclear weapons. If they can be developed with technology and wealth available in America in 1945, sooner or later lots of countries are going to cross that threshold.

In the case of immigration, this doesn’t mean that it’s impossible to enforce the border as a western country. Israel does it quite successfully, for instance. But it does mean that the cost of doing so, in both dollar terms and political will to take actions that will strike some as uncharitable, continues to rise. It is perhaps not surprising that many countries no longer have any meaningful national will to enforce their borders.

Costs and practicality also explain why the countries with the most sensible immigration policies are the ones for which geography still presents non-trivial cost obstacles to illegal immigration. Australia continues to be hard to get to illegally (New Zealand even more so), and Canada is a long way from anywhere in the third world (and most need to cross the US to get there, at which point in the journey they’ll probably just stay where they are).

If you’re a progressive, this is all great news. We’re on our way to our cultural Marxist multicultural utopia, whatever that proves to be like in practice.

But if you’re a conservative, there isn’t much uplifting news to be had. Illegal immigration is primarily a problem of wealth and technology, and neither of those look like abating any time soon.
The only grim solace is that cultural conservatives are at least well used to depressing news by now. It’s not for nothing that John Derbyshire’s book was titled ‘We Are Doomed’.