Tuesday, January 31, 2012

Is Economics Useless?

I had a long exchange of emails with a friend about this topic. I am not a trained economist, but I play one in these debates. It is hardly a new topic, and I have little new to add, so I won't report on the discussion itself.

However, I think these blog posts by Rajiv Sethi and Adam Ozimek are good examples of the pleasures of counter-intuitive thinking which are available to those who know a little Economics.

Rajiv Sethi's point is simple and important
What I was trying to do in that post was to evaluate two incompatible statements: Warren Buffet's declaration that he pays a substantially lower tax rate at 18% than any of his office staff, and Mitt Romney's conflicting claim that his effective tax rate is close to 50%, the sum of the corporate tax rate and the rate on long-term capital gains. I argued that since the corporate tax is capitalized into prices at both the time of purchase and the time of sale, it ought not to be simply added to the capital gains tax to determine an effective rate.
As I now understand it, thanks to Rajiv's post, if we eliminated the capital gains tax, the owners of those assets would receive a windfall as prices go up, but then the long term trend in their value would be unchanged from before. This is an economic argument, and not a matter of accounting. It is also very simple: with (very!) little knowledge of economics, anyone can understand it, but to actually think of this for yourself is another matter. I am impressed! For contrast, this post by Steven Landsburg.

As an aside, since asset prices are now going to be higher at every point in the future, what happens to their ownership? I haven't thought that through, but this certainly seems to be a one-time transfer of wealth to those who own assets today from those who don't, and it probably will have no effect on capital formation, etc. Why? Because what really matters is what Adam writes about in his blog post.

In his post, Adam Ozimek writes about the long run employment level, and points out that at full employment (almost by definition) you can only create jobs by destroying others.
But if output has doubled at Capitalist B’s factory, then surely he has taken market share from his competitors, which means his competitors have most likely had to lay workers off, perhaps half of them. The fact is that direct jobs creation that we see can often be completely offset by job destruction that we don’t, and in the long run it pretty much has to be.
So when you hear a capitalist-politician boasting about his track record in creating jobs
By all means, point out that his claims are unjustified at best. Score the political point that the politician has opened himself up to. But the job of the economist is not to accept false terms of debate because doing so is the best way to make the politician look bad. An economist should point out that in the long run job creation doesn’t matter, it’s productivity and innovation that matters, and declare that if the politician wants us to judge his contribution as a capitalist he should tell us about the productivity and innovation he delivered.
What the posts by by Adam Ozimek and Rajiv Sethi have in common are that they are both about the long run equilibrium, and about how the aggregate can be different from the individual. The real value of economic thinking is in getting us try and think in this fashion. Its is a very unnatural way of thinking. In many ways, it is like studying fluid dynamics, and I don't mean hydraulic macro! The evolution of the system is very sensitive to initial conditions, and so its future is impossible to predict in any detail, and we can at best work out some of the features of its final state. There is a reason there is a million-dollar bounty on the Navier-Stokes equation.

The great Thomas Schelling wrote an essay "What do Economists know?" in which he praised accounting identities as being analogous to the invariants which Physicists find so valuable: they are valuable precisely because they are what remain unchanged amidst the chaos of economic change, and they offer a point from which to start thinking about what is going on.


James Oswald said...

Abolishing capital taxation would produce a windfall for current owners of capital, but it would also lower the lifetime cost for new capital. There's a substitution effect (more new capital) as well as a distribution effect (more valuable old capital).

Rajeev Ramachandran said...

Very good point.