David R. Henderson  

John Cochrane Views the World

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One of the big advantages of having been an economist for a long time and having been at the Council of Economic Advisers 30 years ago is that I've gotten to know and follow a lot of people and their thinking. I started at the CEA in August 1982 and finished in July 1984. During that first academic year, I had as fellow senior economists Paul Krugman, Lawrence Summers, Larry Lindsey [almost senior: he was ABD at the time], and Ben Zycher, to name four and as junior economist colleagues Greg Mankiw and John Cochrane, to name two.

Of course they all went on to bigger and better [or, at least, more powerful] things. One of the people in the above list that I am most impressed with, and somehow I informally mentored about dealing in the public debate arena, is John Cochrane, now the AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

His thinking about a wide range of economic issues is on display in a recent lengthy interview done by Aaron Steelman for the Richmond Federal Reserve Bank's publication Economic Focus (EF). I highly recommend the whole thing, which is not to say I agree with the whole thing: I agree with almost all of it.

The size of the financial industry

EF: Many people have asked whether the finance industry has gotten too big. How should we think about that?

Cochrane: We shouldn't. The role of economics shouldn't be to pronounce whether something is too big or too small. Central planners tried that and failed. Our role should be to look at an industry and see if it's working right. Where are the distortions, where are the subsidies, where are the market failures, where are the things that push it to function well or not? Then the pronouncement isn't that finance is mysteriously too big, it's that there are specific, documented distortions present. That's a more useful statement.

I agree that too many people and institutions pay way too much money for active management, which doesn't seem to me to add much value. But I think people spend too much money on cars, houses, and cellphones, too. That's a judgment, not a distortion. And the cure may be worse than the disease. When has more regulation made an industry smaller and more efficient? A bigger and bigger chunk of finance is devoted to regulatory compliance, a fruitful place to ask if a distortion is causing useless size!


Blocks to Economic Recovery
EF: What do you think are the biggest barriers to our own economic recovery?

Cochrane: I think we've left the point that we can blame generic "demand" deficiencies, after all these years of stagnation. The idea that everything is fundamentally fine with the U.S. economy, except that negative 2 percent real interest rates on short-term Treasuries are choking the supply of credit, seems pretty farfetched to me. This is starting to look like "supply": a permanent reduction in output and, more troubling, in our long-run growth rate.

Long-term growth is like a garden. You have to weed a garden; you don't just pile on fertilizer -- stimulus -- when it's full of weeds. So let's count up the weeds. A vast federal bureaucracy is going to be running health care and has cartelized the market. Dodd-Frank is another vast federal bureaucracy, directing the financial brains in the country to compliance or lobbying. The alphabet soup of regulatory agencies is out there gumming up the works. Then there are social programs. The marginal tax rates that low-income people face, along with other disincentives to move or work, mean that many of them are never going to work again. When the economy was steaming ahead, this didn't really cause much trouble, but now many recovery mechanisms have been turned off. If a Martian economist parachuted down, would he not be struck by the vast number of disincentives and wedges the government places between willing employer and employee? Would he or she really say "the one big wedge between you hiring someone to make something and sell it is the zero bound on nominal Treasury rates"? Finally, uncertainty is surely a part of it. Investing and hiring has some fixed, irreversible costs, and the chance that policy could be even worse gives people an incentive to delay.

This is all really hard to quantify, and it's time somebody did. Unfortunately, it's much easier to focus on "demand," or the zero bound, or fiscal stimulus -- one big magic bullet, and not the thousands of weeds.


Policy Challenges for the Fed
I think the big issue for the Fed is going to be "macroprudential policy" and the temptation to turn that into financial dirigisme. The Fed is now expected to micromanage "financial stability" in addition to inflation and employment, and it has a vastly enlarged regulatory toolkit that enables it to tell everyone in the financial system what to do.

In the above, he's pointing out what Jeffrey Hummel pointed out in some detail three years ago here.

The Alternate Maximum Tax

The alternative maximum tax is not my favorite nor a perfect tax code. It's a Band-Aid. Our current tax code is a chaotic mess and an invitation to cronyism, lobbying, and special breaks. The right thing is to scrap it. Taxes should raise money for the government in the least distortionary way possible. Don't try to mix the tax code with income transfers or support for alternative energy, farmers, mortgages, and the housing industry, and so on. Like roughly every other economist, I support a two-page tax code, something like a consumption tax. Do government transfers, subsidies, and redistribution in a politically accountable and economically efficient way, through on-budget spending.

But that isn't going to happen anytime soon. In the meantime, our tax system puts in place much higher marginal rates than most people acknowledge. People keep focusing on federal income taxes alone, where marginal rates top out around 40 percent. But that leaves out state, county, and local income taxes, plus sales taxes, estate taxes, excise taxes, property taxes, corporate taxes, and many others. If you earn an extra dollar for your employer, how much do you actually get when it's all added up? I have not been able to find any decent comprehensive calculations of marginal tax rates. In a New York Times column, Greg Mankiw came up with 90 percent for himself, and he left out sales taxes and a bunch of other taxes.

The idea behind the alternative maximum tax is this: Choose any rate, even say, 50 percent or 70 percent. Whatever we decide is the "enough is enough" point. If someone could show they've paid that percentage of their income in tax to some level of government, they don't have to pay any more. If the people who say that nobody pays that much are correct, great, then it can't hurt.


I like it. I would point out, though, that there's a basic enforcement problem. With current tax rates in place, you, an individual taxpayer, are about to go over the maximum. Ok. So which level of government do you get to reduce your tax payment to? The feds, state, and locals will fight over that.

So start with the feds. Have a maximum tax rate of 25 percent for your federal taxes of all types (except federal excise taxes because computations and enforcement get messy and federal excise taxes are a tiny % of federal tax collections anyway.) Why 25? Because that's actually the number that polling data some years ago showed that was the median choice for people in every demographic category for the maximum % you should pay in all taxes, not just federal. If that was the median, then, presumably, a majority would support having 25% as the maximum at the federal level. So you could get wide support for it. The feds are the main threat anyway because it's relatively easy in America to move to a state that taxes you less than those greedy governments do in California, New York, and New Jersey.

Income Distribution

EF: Can transfers really help the bottom half of the income distribution?

Cochrane: This is a good question, because it gets at one of the central calumnies directed at relatively free-market economists like myself: "You're just heartless. If you cared, you'd support bigger transfers." I think you care more if you advocate policies that actually work to help people, rather than policies that make you feel good.

The answer to your question depends on what one means by "help." People like money. People enjoy winning the lottery, and they reward politicians who send them checks. But that doesn't mean transfers actually work to achieve their stated objectives. As economists, we need to look deeper. Does a society that gives people income-based transfers, with inevitably high marginal taxes, do better? Do the people they're trying to help end up going to school, investing in human capital, starting businesses, working their way out of their troubles, getting richer, and joining the tax-paying class? Or do societies that do that sort of thing end up with a permanent underclass that gets economically and socially more dysfunctional? And does the society as a whole also slow so that the size of the pie gets smaller?

My impression is that the latter conclusions are true. When many European countries allowed prime-aged men to be on the dole, the result was not, "Thank you for the money, now I'm going to medical school." The result was staying on the dole for many years. Transfers do not end up producing a happy equality; they end up producing a permanent underclass.

We're told that income disparity is bad and societies will get along better and grow faster if we institute broad-based transfers through the tax system. That seems to be made-up economics. First, how does a poor man picking vegetables in California know whether a hedge fund manager flies in a Gulfstream or a 737? Why would it possibly affect his decisions in life? You may feel incensed that there are such people while others labor to pick vegetables, but the question is the factual, cause-and-effect claim that large inequality lowers overall growth. Second, even if there were convincing evidence of an empirical negative link between inequality and growth, it does not follow that an economy would grow more with a tax-based redistribution system. For example, it's plausible some societies are unequal because there is a lot of rent-seeking from the government, which also leads to sclerotic growth. If you add a distortionary tax system on top, you just create further disincentives to the few honest entrepreneurs out there, you raise the incentives to lobby for special favors in the tax code, and the whole thing gets worse.

In sum, I do not see evidence that societies whose inequality comes, like ours, primarily from the economic returns to skill, can add high taxes and large transfers mediated by central government, and the result will be for them to grow faster, become more homogenous and peaceful, or provide better long-run outcomes for the people whom advocates of such schemes say they wish to help.


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COMMENTS (11 to date)
Eric Falkenstein writes:

Alas, I had to look up 'dirigisme.'

David R. Henderson writes:

@Eric Falkenstein,
I first heard the adjective version (“dirigiste”) in 1975 or 1976 when Al Harberger used it to criticize a report put out by a Latin American organization called, I think, ECLA.

Maniel writes:

Excellent post. Clear thinking - unfortunately, not the type likely to influence politicians.

Chris Koresko writes:

Maniel: Clear thinking - unfortunately, not the type likely to influence politicians.

I bet it'd influence the Tea Partiers. It's close enough to their way of thinking, but deeper and better informed than most of theirs.

Maniel writes:

@Chris
I take your point. I guess I'd better because my son and daughter are huge Ron Paul fans.

Brad writes:

How far from free-market capitalism can we stray and still be considered a market economy? Government restrictions on labor, production, immigration, and the like continue to grow every year. Is there a point of decreasing returns on regulation, and have we reached it? How do economists inform policy makers in such a way to make meaningful reforms?

ThomasH writes:

It seems to me that the biggest distortion in Federal taxes are the (capped) wage tax, the corporate income tax, the use of deductions rather than partial tax credits to promote tax-favored expenditures. And the biggest obstacle to removing these distortions is resistance to increasing taxation on high-earning individuals through the personal income tax. Even with the tax code as it is, I think a much higher EITC to replace minimum wages financed with some combination of higher marginal rates and substitution of tax credits for deductions would be distortion reducing while decreasing after tax income inequality.

David R. Henderson writes:

@ThomasH,
Your view of “distortion” is different from that of economists. The economist views distortion due to taxes as deadweight loss. And the deadweight loss is due to the way taxes change people’s behavior. So actually capping the income on which the Social Security payroll tax is collected, which, I presume, is what you’re referring to, makes the payroll tax less distorting than otherwise. Now, when people’s income hits that upper limit, they know that they can earn additional income with no additional tax. So the Social Security tax does not distort incentives for people making over that amount. The cap, therefore, is a feature, not a bug.

ThomasH writes:

Henderson is correct that capping the payroll tax removes the distortion of the tax on those higher incomes, but for any given amount to be raised by that tax, capping it means higher rates and more distortion on the infra-cap income.

But he is also correct in discerning that THAT was not my real complaint about the payroll tax, capped or uncapped, but rather that it makes Federal taxes less progressive. I could made that point without calling the payroll tax a "distortion."

Steve Y writes:

Both John Cochrane and Chauncey Gardiner use the garden metaphor. What does it say about me (us?) that it makes a lot of sense?

Roger McKinney writes:

Nice! And I like the garden metaphor, too. Fertilizing the weeds sounds like the Austrian econ equivalent of malinvestment. I'm a bigger fan of Cochrane.

His 2010 President's address to the American Finance Assoc was brilliant. He forced economists to look at the changing risk tolerance of investors as a key to asset prices, which shows that there is more to values the stock market than NPV. Subjective value plays as much a role in the stock market as it does in the markets for goods and services.

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