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The economic arms race 

This is a corrected version of the story.

It's a mixed metaphor of major proportions: the country's headed for the fiscal cliff, with the debt ceiling closing in.

And Robert H. Frank, professor of economics at Cornell University's Johnson Graduate School of Management, says we might have to go off that cliff before Republicans realize they're holding a losing hand.

Frank writes the monthly Economic View column in the New York Times and is a distinguished senior fellow at Demos, a progressive think tank. If you think of economists as buttoned-down, conservative types, Frank will turn that image upside down.

While most economists consider Adam Smith to be the father of modern economics, Frank's latest book, "The Darwin Economy: Liberty, Competition, and the Common Good," says that the ideas of naturalist Charles Darwin are more important to economic theory than Smith's.

When Frank analyzes an economic problem, such as why the middle class is falling behind, he doesn't just study the financial aspects; the psychology of status becomes a major part of the equation. And when it comes to self-made millionaires, Frank agrees that hard work counts, but says there's another often-overlooked factor: dumb luck.

Frank cuts through nonsense quickly. The Republican talking point on why taxes shouldn't be raised on the rich — they're the job creators — is, in Frank's view, ridiculous. And he says there should be more taxes on harmful behaviors like drinking alcohol and smoking.

As for another Republican scourge, "Obamacare," Frank says the Affordable Care Act is the logical and inevitable way out of the current private-insurance oriented health-care system.

The following is an edited version of a recent conversation with Frank.

CITY: When we last spoke, in 1999, the economy was so rosy that our headline was "We're rich." What happened?

Frank: We're still rich, but there was the big financial crisis which threw everything into a tailspin.

We're more or less on the way back from that. But even in the time you're talking about, what was true then and is still true is that a handful of people near the top have gotten very rich and for most other people there has not been much gain.

What can happen if this imbalance becomes too large?

There have been violent revolutions in many countries over issues of just this sort. We seem to be way slower to kindle to anger on this issue than other countries so I'm not thinking it's imminent, but I like the great Herb Stein remark: "If something can't go on forever, it will stop." At some point, if you stretch things too tight, they do break.

One reason middle-class families are struggling is what you call an "expenditure cascade." Can you explain?

People in the middle have a little more money than they did 30 years ago, so why are they hurting so much more? The answer is what they have to spend to achieve their basic goals has escalated much more than their income.

How much do you have to spend to get the average-size house for your area? I calculated a toil index. Thirty years ago, if you were the median earner, you had to work 40 hours a month to get enough to cover the cost of the median-priced house, which is what you need to do if you're going to send your kid to the average-quality school.

By 2007, you had to work more than 100 hours a month to get the median-priced house.

The median income went up maybe 15 percent over the last 30 years. That's a huge bite, so what are families going to do: send their kid to schools [in the bottom 20 percent]? Most families won't do that. If other families are spending more and they've got to spend more to keep pace, they're going to do that.

They're going bankrupt more often, they're saving less for retirement, they're driving longer distances in commutes. So it has become much harder for people in the middle to make ends meet, and it's because standards have cascaded down from the top.

The people at the top built bigger mansions. Then there's a group near them who built bigger, too. It cascades down one step at a time so the median new house is 50 percent bigger than it was in 1970.

In "The Darwin Economy" you say that Darwin is a more important figure in economics than Adam Smith. Why is Smith important?

Smith is most often mentioned for his invisible-hand theory: the idea that under some conditions, if you just turn people loose and charge them with pursuing their own narrow interest in the marketplace, you'll get results that are attractive from the perspective of society as a whole.

Sometimes that does happen, but I think Smith himself was aware of things that could go wrong. The kinds of things he thought could go wrong are more like the things you'd hear from a modern liberal: not enough competition, firms with market power that will exploit consumers and workers. He wasn't anywhere near as uncritically enthusiastic about his theory as many of his modern disciples are.

One of the key premises of your book is Darwin's idea that the interests of individuals are often in conflict with those of broader groups. How does this apply to the economy?

This would apply to any economy under any circumstances.

Darwin's central insight was that big portions of life are graded on the curve. It's not how smart you are, how fast you are, how big you are, how strong you are; it's whether you're smarter, faster, bigger, or stronger than the people you're competing directly with. If you're going to get your stuff into the next round, you have to out-compete the organisms that are most like you.

That incentive is so strong that it almost always produces an arms race as individuals try to outperform their rivals. Like in any arms race, most of the investment tends to be mutually offsetting and hence essentially wasteful.

So hedge funds and programmatic traders invest tens of millions of dollars in fast quick-trade computer equipment or models that will predict where an asset price is headed five seconds before the second-fastest model will do it. If you can come in first in races like that, you score huge private gains. But if everybody can predict more quickly where a stock price is going, there's essentially no gain.

But if you think you can out-gun your opponent in an arms race, it may look attractive to you. If you look at [former New York Yankees owner] George Steinbrenner, it was very clear that he didn't want to have salary caps in baseball, even though that would have meant he'd have to pay less for the talent he hired. He knew he had the massive cable revenue from the New York cable market and he thought in a salary arms race the Yankees would win. And they did pretty well.

In the last three presidential elections, Republican said raising taxes on top earners would harm the economy because top earners are job creators. It's become a central meme in the argument.

It's frustrating because I've written about this three or four times and yet I just heard Steve Inskeep interviewing Mitch McConnell on NPR. And McConnell says we can't raise taxes on the top earners because many own small businesses, and small businesses are the big engine of job creation.

It's a completely nonsensical argument, because if you look at the cost-benefit decision that a business faces when it's deciding whether to hire somebody, what are the issues? If you hire somebody, he'll produce some extra output or services for you. You're going to sell those, so you get some revenue by hiring somebody. That's the upside. The downside is you've got to pay him.

You want to know if the upside is bigger than the downside. If he's going to bring in more revenue than you have to pay out to him in salary, then you want to hire him. It doesn't matter if you're rich or poor. So for them to say that giving you a tax cut is going to make you hire, that's complete nonsense.

Are Grover Norquist and his never-raise-taxes-under-any-circumstances pledge on the way out?

Let's hope. He seems a little desperate if you read his pronouncements lately, and he's got reason to be worried. He's built a pretty cushy spot for himself with his anti-tax pledge. It didn't make sense in the first place so it was always on a shaky foundation, and things on shaky foundations tend to unravel in a big hurry once the first brick is pulled out.

The housing bubble was an example. It didn't make sense for houses to be that expensive and the moment there was any hint that they might fall, they came tumbling down in a hurry.

The conventional wisdom is that high-earners got there through hard work. You say luck plays a major role.

The more we study labor markets the clearer it becomes that the amount of talent and work ethic you put out have always been important, so the more you have of both of those qualities, the more likely you are to succeed. But it's become clearer and clearer that those qualities by themselves don't explain the huge variance in income that we see.

Bill Gates was really smart and he really worked hard and he took risks and did all the things that success stories imagine, but there are tens of thousands of people who are as smart and who worked just as hard, who didn't end up with any appreciable success at all. So getting a right break early in the process can be self-reinforcing.

I think what most people don't see intuitively or clearly even when it is pointed out is how easily history could have unfolded in a different way. Whenever you arrive at a certain position you think it was inevitable that you would be there and you build your explanations around that assumption of inevitability. But once you see how contingent some of the steps in the process really are, you see the world in a different way.

Conservatives speak negatively about stimulus plans, but you point out that declining services and a crumbling infrastructure hurt the rich, too.

You would think that would be obvious, wouldn't you? I participated in a debate with [conservative pundit] P. J. O'Rourke about what to do about the ailing American economy. I said, why even get into an argument about the abstract merits of stimulus policy? There are all of these things that everybody agrees we need to do. It will be cheaper if we do them right away than if we wait.

The Republican message machine has been very effective: taxes on the wealthy hurt the economy. Government spending is bad, bad, bad. The effect of hearing something over and over again is that it has an impact even if you have good reason to believe it's not true.

You favor taxes on negative things: large vehicles, driving in congested areas, tobacco, alcohol. But you might be accused of creating a nanny state.

You'd want to tax those things even if you didn't need extra revenue. You tax them and then give the money back in the form of lower taxes on other things. But given that you need extra revenue, you're killing two birds with one stone if you tax behaviors that cause harm to other people.

Nanny state? How is that the nanny state if I force people to take into account that their presence on the congested highway makes everybody else take longer to get where they're going?

That sounds like an example of one of the new terms in your book. Can you explain what an "ignoramitocracy" is?

It's the idea that you have politicians voting in ways that can only be understood if you believe that they're being willfully ignorant about the issues that are up for a vote. Tax rates for the wealthy, climate science denials, the complaint that if you tax vehicles by weight you're running a nanny state. These are willfully ignorant statements.

Do you think Republicans and Democrats in Congress will reach an agreement before the county goes over the so-called fiscal cliff?

I think there's a good chance we'll have to get to January 1 before it will happen. It's a shame. If the Republicans were rational, they would recognize that their negotiating position is weak and try to get the best deal they can. I think they'll be able to get a better deal from Obama now than if they wait.

So we go over the cliff, what then?

Then Obama's in the driver's seat. He proposes tax cuts for the middle class and what are [Republicans] going to do, say no? He proposes to restore critical programs that are going to be defunded, the Republicans say no?

Republicans think they can use the leverage of not raising the debt ceiling to get their way.

The debt ceiling shouldn't be a blackmail device each and every time it comes up for renewal. There are some credible constitutional arguments that the president has the option of just going around Congressional approval. If it's a debt we've incurred through Congressional action, he can order it paid. And I think he should do that if they insist on blackmailing him

Was it a good idea for Obama to reform health care?

The idea of using private insurance markets to provide health care is just a woefully bad idea from the start, and it was a total historical accident that we started doing it that way.

It was from World War II when they had caps on wages and everybody had labor shortages and, for some reason, there were no caps on fringe benefits. So firms tried to recruit the labor they couldn't get any other way by offering them benefits like health insurance.

Private insurance is such a bad vehicle for delivering health care. No private insurance company wants to sell you insurance if there's any evidence you're going to need a lot of care. They want to screen you out and insure a lot of healthy people. But for employer-provided insurance to get the favorable tax treatment they got — it's not taxable as income — they had to agree that the insurance would be available to every employee irrespective of condition. Still, if you lost your job and you had a condition, you couldn't get a new job because they'd screen you out.

It was imperative to abandon that system, but you can't tell people "We're going to take your employer-provided insurance away from you," because most who have it like it reasonably well. So it was a given in the Obama administration that you had to build something on top of the employer-provided health-care system.

I think, in time, the employer-provided component of the health-care system will atrophy and we will see in its place nonprofit, broad-range clinics like Cleveland Clinic and Mayo Clinic become the providers. But you don't get from here to there without some policy to bridge you from the current system to the new system.

And I think if you're going to require companies to offer insurance to everybody irrespective of condition, you have to have the mandate to buy insurance. And you need subsidies because there are a lot of people who couldn't meet the mandate if they weren't given a subsidy.

So, if you begin with the recognition that they had to build a transitional system on top of the employer-provided health insurance system, there really wasn't much they could have done besides what they did.

You once got a sort of fan letter from the late Milton Friedman who agreed with you about the idea of a consumption tax. As the champion of free-market economics, would Friedman agree with many of your ideas today?

Friedman would have recognized the need for stimulus in the current economic downturn. The irony is he was way more evidenced-based than the people who have come in his wake.

He thought private institutions would emerge to solve a lot of the problems that regulation is meant to solve.

An airline doesn't want the plane to crash because it's bad for business. But to think that those incentives are always strong enough to get you the best results, I think is an unwarranted leap.

Do you think Friedman would've approved of regulating Wall Street after the crash?

I think he'd recognize the structural incentives that led to [the crash].

Milton Friedman was not a foolish ideologue. He had blinders about some things, but I think he was fairly receptive to evidence.

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