Friday, August 08, 2014

Does Inequality Lower Economic Growth?

Both Paul Krugman and John Cochrane have recently demonstrated that they continue to be among our top .1% economists.   As they raise their game, this increases inequality among academic economists (as measured by idea generation) and it has slowed down my own economic growth because I'm not working on my five revise and resubmits at journals and instead I'm going to blog about their thoughts.

I do not know Paul Krugman but one of his life goals seems to be to nudge Greg Mankiw.   Greg has written a great textbook.  For reasons I can't explain, I keep a copy of his 5th edition of his Principles book in my living room.  On page 258 of this text,  Greg states that there is an efficiency/equity tradeoff.  Will he need to rewrite this section?  Have we been teaching Econ 101 students the wrong stuff for 9000 years?

In his NY Times piece today,  Dr. Krugman takes a step towards Jim Heckman's human capability work and suggests (without explicitly saying this) that poor kids do not choose their parents and that many of these kids have been under-invested in so that they do not achieve their full potential.  In a counter-factual world where we tax the rich and invest in the Heckman Equation agenda, these kids will accumulate more human capital and in aggregate we will be a richer nation.

John Cochrane is an excellent Chicago Economist and wants to "see a model" that links rising inequality to lower economic growth.   Here is  a great quote from his blog in which he is not directly commenting on Krugman but instead is offering his thoughts on a related strange report by some business economists;

"OK, so the idea in this report is that somehow, truck drivers in Las Vegas found out that hedge fund managers in Greenwich CT were upgrading from Gulfstreams to 737s. This made them feel bad, so they went out and took out huge mortgages that they had no chance of repaying. When house prices went up, they refinanced and bought TVs giving them even less chance of paying off their mortgages. Now they're broke and not spending a lot. And "spending," not productivity is the key to long-run growth.

At best this is a theory of boom and slow recovery. But growth and inequality is about the long run. Why were we growing too slowly in the 2000s?"

He writes well!    Note that the key point that Dr. Cochrane is pursuing is to use the tools of micro economics to analyze the broad Krugman conjecture that inequality is slowing down US economic growth.    What is it about inequality that chokes off growth?   In Dr. Krugman's piece he appears to have a Robert Frank rat race vision that elite institutions such as his Princeton have a finite number of slots and that as the rich get richer they purchase the key inputs that give each of these fat cat's kids a probability of 1 of getting admitted to the Ivy League.  With these fat cat's kids accepted, there are no slots for the Horatio Algers and they suffer defeat. This waste of talent adds up to our becoming a poorer nation because Horatio could have been the next Krugman or Zuckerberg if only he had gotten into the Big Leagues.

Note the strong belief implicit in Krugman's setup  that the supply curve of elite slots is highly inelastic.  We only have finite slots of Ivy League education. We only have a finite set of slots to live in San Francisco.   A key micro economic question is how can we reconfigure capitalism to make the supply curve for such goods more elastic!  Less regulation and more innovation would achieve this.  Dr. Krugman seems to be taking the "zero sum game" notion as a law of physics.    I hope that he is wrong here but he may not be.

Consider the rise of the MOOCs.  If there is some very talented poor person in India (think of the Mathematician Ramanujan), such a guy may not get into Princeton but he can now assemble a pretty close substitute using the Internet for free.  This is an empirical question.   Ignoring the beer, the football games and social life,  how close do MOOCs approximate the intellectual experience for a motivated person?

While I don't fully believe this example, my point is that MOOCS create a more elastic supply curve (for those of you who don't know economics this means that more slots at elite schools now exist at the same price).    This is an example of how induced innovation solves a social challenge.

If Paul Krugman is going to embrace the Heckman agenda, he must explain why the public sector should be trusted with the extra tax revenue collected from the rich to fund the universal pre-K that Heckman (and I) support.  Why won't public sector unions simply grab this $ in terms of higher than market wages?

Is Dr. Krugman willing to simultaneously endorse massive increases in pre-K investment and a Milton Friedman style private voucher program?    Together these policies might achieve his goal of creating a fairer and richer society.