Does the Marginal Elasticity of Substitution Have an Ideology?

In my column at The Week, I noted that Capital in the 21st Century argues capital accumulation threatens higher inequality by increasing capital's share of income. And even if capital's share of income doesn't rise due to capital accumulation, as Matt Rognlie and other critics have highlighted, that would be because additional capital is useless. Hardly an argument for making accumulation a policy priority.

In response, Rognlie repeated something he's said before: that a left-wing ideological commitment to a high elasticity reverses the historical valence. In the past, lefties generally highlighted low estimates, precisely because they invalidate arguments in favor of a tax preference for capital.

This morning it occurred to me that this change is more significant than simply an inconsistency in the ideological time series. Specifically: the main contribution of Capital in the 21st Century to economics as a field, beyond the superlative empirical (and some theoretical) work Piketty's done in his papers, is the unification of inequality with macro. This is something that Branko Milanovic has pointed out, in his initial review of C21 and many times since on his blog. If all we had was a representative agent and inequality is completely unmodeled, then estimates of the Marginal Elasticity of Substitution are all that matter for even hinting at the impact of macroeconomics on inequality and assessing policy proposals like a tax preference for capital.

But if we get to bring inequality out into the open, then we can set up what I've come to call the Piketty Puzzle: the best estimates of the Marginal Elasticity of Substitution, interpreted as an actual parameter in production, are that it is less than one. But historically, the capital-output ratio and capital's share of income move together, with the latter driving inequality dynamics.* The adjustment of the price of capital to its quantity dynamics is less than one-for-one. And I personally think it's highly unlikely that the rentier will be euthanized any time soon. As my friend, the brilliant Mike Konczal, said, is it really likely that in 30 years, the wealthy will all be lamenting how poor they are now that their wealth has become worthless?

*As Piketty and almost everyone in the IGM poll pointed out, inequality in the US to date has been driven anomalously by inequality in labor incomes. More on that in future posts. (And in past ones.)

So what resolves the Piketty Puzzle? My guess: simply, that macroeconomics based on pricing factors of production according to the representative firm's first order conditions isn't a very good model of reality. Whether we call it K or W, capital or wealth, whatever, as the pile grows, its value grows too. And since wealthy people own the pile, as it grows, inequality increases.

So, among other things, we need a new macroeconomics that doesn't start with first order conditions (even if it does continue on from there). We need to abandon them entirely and get comfortable talking about and modeling power.

Consumption Taxes Are Not a Good Idea

I have a tax day piece in The Week making that point. To elaborate: the theoretical economic argument for taxing consumption and/or exempting saving from personal income taxation is that full-income taxation penalizes savers by taxing them twice (the first time they earned the money, and the second time they received an income from accumulated capital), while economic growth depends on expanding the capital stock through saving. There is a wide range of economic models that are based on one or both of these two essential ideas. They have nothing to do with reality, and Mike Konczal demolishes them here.

It's pretty clear there's a value judgment going on here, against "irresponsible" people who don't save. It's evident from this blog post by AQR Capital Management Professor of Finance John Cochrane, in which he compares his “thrifty poor” in-laws to Michael Jackson, with his $100 million amusement park and petting zoo. 

 

Finally, on the policy side, doing social policy through the tax code, with a proliferation of tax-sheltered savings accounts for retirement, healthcare, college tuition, etc, 1. hasn't worked as policy in each  of those cases, and 2. contributes a great deal to rising inequality. I also think the policy-making paradigm that says that sort of thing is better than, you know, actually taxing people to pay for programs that do these things, is premised on a kind of economics ideology. Supposedly it's better if people freely choose to save for retirement than if they're forced to do so via Social Security. It's a major case of making policy on the basis of economics-esque "free market" philosophizing, rather than empirical reality, and if we're going to have good policy (or go back to having good policy) in this country the economists are going to have to be the ones to point out where this thinking goes off the rails.

 

A Tiny Addition to Mullainathan on Rent-Seeking in Finance

Sendhil Mullainathan has a nice piece in the Upshot on the mixed feelings he has about the popularity of financial careers among undergraduates at elite universities, especially among economics majors. I feel the same way, and as far as I can tell from my Facebook feed full of econ grad students and junior professors, Mullainathan's piece hit a chord in at least some precincts of the field.

But I want to add one thing to Mullainathan's list of the ways in which the finance industry makes money without serving the public interest, or in fact through actively harming it. And that is by financing payouts to shareholders. JW Mason's paper on this is a must-read. As Mason put it, finance was once a way of getting money into firms. Now it's a way of getting money out, into the hands of shareholders, who are overwhelmingly the already-wealthy. The more time I spend on inequality, the more important I think this dynamic is and the more obvious it becomes that this is the opposite of a functioning free market.