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check out my vertical integration. and my beard. and my gun.

Noah Smith mused about a subject I’m interested in – the fundamental conceptual issues at the nature of saving – in a way I like to muse about it – thought experiments – so how could I not deconstruct his post in excruciating detail?

Specifically, I’d like to focus on the economy of his deer hunter (one of many, in his example, but just one for this purpose): a man who lives, alone, in the woods, hunting deer. I’m going to break this down as much as I can while abstracting away the non-deer parts of his economy (shelter, clothing, tools, etc). Because the deer hunter is an economy – and while he might be an economy of only one human, who we’ll call Vronsky -, we can productively and fruitfully view him as a vertically-integrated economy, and break him down into four sectors:

1) A firm that hunts deer. The firm locates as many deer as possible and kills them, then sells them to the next sector. It has most fixed costs (labor to hunt deer) and therefore pays relatively fixed wages, the rest collected as profit.

2) A firm that processes dead deer into venison. This firm always purchases all the deer killed by the first firm, and always sells all of its venison to the next two sectors. It has more variable wages (because it has variable labor as its primary input) and takes the rest as profit.

3) A firm that stores processed deer. This firm always buys all the surplus venison produced by the processing firm, salts it, and stores it until there is a market for it. We will discuss its economy in more detail below.

4) The consumer. It always buys a certain amount of venison (let’s call it C) no matter what.

Now, in actuality, all these firms are the same person – Vronsky, who owns all the firms, provides all the labor, and collects all the wages and profits (which he then proceeds to, largely, eat). But we can break the internal economy of his life away from Williamson-ian integration and imagine a market that works something like this:

There are flush years and lean years – periods, that is, in which D (the amount of deer caught by the hunting firm) is either greater than or less than C. Let’s see what happens in a flush year.

The first firm kills some amount of deer, D, that is bigger than C (we’ll call it C + S). It sells C + S deer to the second firm, pays its wages, and collects profit (let’s imagine the firm breaks even in years when D = C).

The second firm processes all the deer into venison, and sells C venison to the consumer and S to the third firm. This firm always breaks even because its labor varies in direct proportion to its production which varies in direct proportion to the available venison.

Now, the third firm. What should be clear is that the third firm is the closest this economy has to a financial sector – it buys venison when it’s plentiful and sells it when it’s, er, dear. This means it, essentially, stabilizes the internal price of venison (and also raw deer). It also is a very different firm from the other two, since labor is a minimal input – it is a capital-intensive firm that specializes in storage and market mastery (we’re assuming it inherits all the capital, physical and intellectual). Assuming our flush year is t=1, the firm has costs – purchasing the venison, salting it, and storing it – but no revenue. Which means it has to borrow. From whom? The consumer’s wages should always = C, so it must borrow from the profitable sector of the economy – the first firm, who has profited from a plenty of deer to kill. Essentially, the amount of raw deer necessary to produce an amount of venison = C costs exactly the wages of a year’s worth of deer hunting, and the wages of processing the deer into venison are equal to the mark-up of venison over deer, meaning all the profits flow to the first firm – the hunting firm. So it loans the money to the third firm, the storage firm.

This works in reverse in lean years. In a lean year (let’s say t=2 is exactly as lean as t=1 is flush, so C-S) the hunting firm is in the red, since it pays wages beyond it’s revenue. However, it can call in a loan from the storage firm, which has almost no costs incurred but suddenly tons of revenue from selling its surplus! So it can pay back the loan to the first firm. So there are now no net savings, nominally or physically. Balance. Om.

But let’s say there isn’t long-term balance. That creates two potential scenarios – one of long-term scarcity, whose end is obvious and really quite sad for poor Vronsky. But long-term plenty is more…interesting.

If there is long-term plenty, a couple things could happen. If we are speaking strictly ceteris paribus, then we would see larger and larger imbalances between the accumulated bonds of the hunting firm and the accumulated debt of the storage firm, ending in…financial crisis! Salted venison doesn’t last forever, so it would be essentially squatting on toxic assets it would be loathe to revalue without the projected revenue to pay off it’s accumulated debt. It would go belly-up, and basically need its loans forgiven – by which we mean, of course, that Vronsky has to write off a lot of old, stinky venison into the river.

But assuming non-ceteris paribusitywhat we would actually see is that, as salted venison becomes plenty, prices decline to the point where no amount of hunting can support the wages of the hunting firm. To skip the boring stuff, what happens is that Vronsky consumes more leisure as he eats down his stock of salted venison and takes up whittling or something.

Now, over the truly long term, endless plenty absent productivity increases is impossible for Malthusian reasons unless you want to assume a Children of Men kind of deal. But even there, we wouldn’t see infinite saving because Vronsky would, sitting on a giant pile of meat, only hunt to the extent he wanted to, not needed to.

The key, in the end, is this – that saving is just as much about production than consumption, and it’s really about the future-orientation of production. In a world where Vronsky is alone, and has no reason to invest in future growth, he won’t endlessly stockpile venison because of diminishing returns and will therefore shift to other forms of spending his time. But in a world where Vronsky was future-oriented, at least minimally, he might spend his savings to create extra time he could use to develop more efficient hunting tools, thus saving even more time in the future. Or he could develop a game that would amuse him. Or he could pack a sack full of salt venison and go on a quest to find a friend, or at least a basset hound.

The real point, in the end, is that nominal savings (which always equal nominal debt) are very disconnected from whether current production is creating value for the future. In the 00’s we simply invested too much of our productive capacity in building overly-large houses in low-cost but low-value locations, which created a lot of nominal debt and therefore nominal savings but didn’t enable the United States to be more productive in the future. On the other hand, higher taxes that built high-speed rail wouldn’t show up as saving, but from the perspective of society, we would be deferring fleetingly pleasurable consumption of movies and candy and craft beer and what have you towards building valuable infrastructure that would make us richer in the future. That’s not nominal savings, and in the short-term GDP looks the same, but that’s true saving in the modern world.

David Andolfatto and Tyler Cowen are confused:

In grandma’s liquidity trap, the real interest rate is too high because of the zero lower bound. Steve argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries.

If this latter view is correct, then "corrective" measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors.

My reaction to this is two-fold:

1) Umm…what?
2) OK, here’s how it goes – there are two interest rates at work here, the "true" interest rate, ie, the rate at which people would be willing to invest; and the "prevailing" interest rate, what you’re actually getting in the market. The former reflects the sum of underlying preferences, the latter a mix of the expression of those preferences along with a helping dose of central bank regulation. A liquidity trap is when the former is less than zero. That’s it. What is the difference between the two liquidity traps they discuss? In the former scenario, the prevailing rate cannot be brought below zero to match the true rate, and therefore: liquidity trap. In the latter scenario…the true rate is lower than zero, and the prevailing rate is stuck at zero. Same scenario. In both scenarios, the key is low growth expectations and low inflation expectations means a flight to safe, liquid assets with a low real rate. When the prevailing rate is 5%, and the true rate declines to 3%, then the Fed cuts their rate to 3% and everything is fine. When the true rate goes below zero, though, then the central bank’s ability to guide the economy through the signal of the prevailing interest rate is handicapped and therefore you need something else (debt-financed public spending, QE, NGDPLT, whatever).

I really don’t get this. If I’m missing something, please tell me.

So Radley Balko brought up on Twitter a "Challenge To Lefty Bloggers" that he published back in 2009. Some of his questions are perfectly reasonable: I think we should target NGDP in a way commesurate with 4% inflation, for example; I’m also in favor of marginal (not total or average) tax rates of ~90% under certain circumstances. Some of his questions are irrelevant (the "unfunded liability" of Social Security is a non-sequitur), confused (I think he scrambles marginal and average tax burdens), or just silly (our average tax rate is close to the median – what greater suffering dare you inflict!?).

But some of them are conceptually flawed in a way I think is interesting. Firstly, his "size-of-government" metric is hopelessly flawed. More interestingly, though, are the questions about income inequality and progressive taxation – what are the optimal levels of each? The trick here is that claiming to have a theoretic or empirical basis for an exact number is a fool’s errand. The real answer to this question is "less and more than we currently have, respectively." So let’s use a little more of the latter to alleviate some of the former, and see what happens! It doesn’t have to be radical – we could just nudge up top marginal tax rates, perhaps create a new millionare’s bracket, and use the money to expand the EITC (which I know doesn’t directly affect pre-tax income inequality on either end but just roll with me here). Will that devastate innovation? Will Atlas shrug? Meh – I doubt it. In fact, Galt’s Gulch was a rather lonely place even when top marginal tax rates in the United States were 90%+. So rather than demand anyone decare a single optimal point, let’s agree that "too few people claim too large a share of national income" and nudge it a bit and see what happens. That’s what democracy is for!

So Ashok and I sparred a bit on Twitter re: the meaning and effect of taxation and spending (and probably pestered the heck out of James Pethokoukis and Joe Weisenthal in the process). I’m not sure how to embed Twitter conversations (if anyone knows how, I’m all ears), but the long-and-short of it is that the actualities of taxes and spending are weirdly different from the optics.

The trick is to remember that every policy change is a change from some baseline. So, from whatever the baseline currently is, there is no fundamental or economic difference between:

1) Cutting taxes by X on some activity, and
2) Spending X subsidizing that activity

assuming that they are both funded identically (though identical tax hikes, spending cuts, or debt incursions).

Now, in practice, there will be differences. Scott Sumner’s thought experiment about the society that taxes 100% of GDP by taxing 100% of income then writing welfare checks equal to taxed income demonstrates that, since we would expect that society really would look different than the one that taxed nothing at all (if only because such a program would have some overhead). But those differences would be based in behavioral economics, not classical or neoclassical economics.

And the same in real-world examples. There would definitely be differences between these two alternative scenarios:

1) A 2% payroll tax cut (debt-funded).
2) A check mailed to every American for the exact same amount (debt-funded).

But those differences would be instutional, not economics (the check-cashing industry, for example, would obviously prefer the second policy to the first). But there’s no reaosn to think they would "crowd out" (or for that matter, "crowd in") different activities.

The real point is, as Matt Yglesias says, the tax share of GDP is a very poor to think about the “size of government.”

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Steve M. has a really great post totally eviscerating the right-wing trolling of the office and compensation of White House Calligrapher which ends, unfortunately, on a false note:

Oh, and that $277,050 salary expense? If you fired all the calligraphers and pocketed their salaries, that would give you approximately one one-millionth of the $28.7 billion in cuts this year to domestic discretionary programs from the sequester.

I don’t want to pick on Steve here because this is a common trope in the leftwards blogosphere, but I think it’s a really bad one, for a couple reasons. Firstly, eventually you can get a big cut from aggregating lots of little cuts. If you took all the little seemingly-goofy-sounding-but-actually-probably-valuable-and-useful things the government does and cut them all you probably would have a decent chunk of change when all is said and done.

But secondly I just think this is a weak talking point because waste is waste and value is value. Steve spends the whole poist making a great argument for the value and traditional nature of the program, then concludes by undercutting himself by saying "well even if we did cut it it wouldn’t save us much anyway." A program that brings a net benefit to society that oughtweighs the cost of funding it is a good program that we should keep! If deficits are a problem but all of our programs are valuable than we should raise taxes.

The reason right-wingers dig for these anecdota is that they perpetuate a story that goes "government spending is rife with waste so we should cut it deeply." If left-wingers respond to each individual instance of right-wing trolling with "and this would only cut 3.7 gazillionths of the deficit so it hardly matters" they will convince exactly nobody. Convince people that good government is worth spending money on. Is calligraphy absolutely vital to good governance? Probably not. Is it befitting the office of the President of the United States that formal invitations sent to the Prime Minister of India aren’t laser-printed on white letter paper from awful and goofy MS Word templates? Absolutely.

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