Rethinking Inequality and Redistribution in a Free Society

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Inequality has become a hot political topic these days and may be most contentious issue of the 2016 presidential election (unless a geopolitical crisis occurs before then). The study of economic inequality and what to do about it has a long history though, and not much has changed.

In this post I would like to suggest some different ways of looking at the problem and what to do about it from a policy perspective. Many people look at the distributional outcomes of success in a winner-take-all society and declaim the results as unfair. It probably is unfair, just like it is when all the tallest kids get chosen to play on the basketball team. But, more seriously, fairness is not an objective measure by which we can set policy.

Most people think they can define what’s fair and what’s not. I would tend to agree, but mine probably departs from the common sense definition. When looking at results in life, one person’s fairness (the winners’ bracket) is another’s unfairness (the losers’ bracket). So, should fairness be determined by who has the most political power and influence in society, even if that is a tyranny of the majority? I fail to see how that would be fair.

Fairness can actually be defined by the legal idea that consequence should follow action. In other words, the guilty, not the innocent, should pay for their sins. In finance, this idea of fairness is couched in the concept of risk and reward: he who takes the risk, reaps the reward (or the loss).

The question is how do we apply this objective idea of fairness (I would prefer the word “justice”) to policies to mitigate unequal outcomes? Or even should we?

I will argue that we should, but that we’re devising all the wrong policies because we are trapped in a conceptual maze. Economic inequality is truly a maze of confusion. There are many different factors that lead to unequal results and it’s quite easy and common to focus on the wrong ones. The factors that have become politically salient today are related to the diverging returns between capital and labor. This is at the root of all the hullabaloo over French economist Thomas Piketty’s work, a work that has been politicized to confirm the worse fears of labor advocates.

In short, globalization and technology has led to wage repression for the 99%, while increasing the returns to capital (the 1%). The keen-jerk solution is to tax capital after the fact and redistribute the funds to labor. The POTUS stated this proposal explicitly in his recent SOTU address: “Let’s close the loopholes that lead to inequality by allowing the top 1 percent to avoid paying taxes on their accumulated wealth.” In effect, he was advocating for tax reform, but he failed to specify details. But we have a good idea on what kind of economic policies Mr. Obama favors: free community college tuition, minimum wage laws, family childcare and education credits, paid sick leave. One can argue the pros and cons of these policies, but none of them really addresses the growing problem of inequality. My guess is that is because the administration really doesn’t have any new ideas about what to do about inequality except to wave it as a red flag during election season.

There is a serious problem with trying to tax capital to redistribute to labor that I would like to present here in the simplest of terms. Capital has dominant strategies to win any conflict with labor in a free society. If we tax capital, it can instantly move elsewhere to avoid the tax. Financial capital is fungible, it can change it’s use. Or it can lie dormant in the bank vault or a mattress. Labor enjoys none of these advantages: we can’t easily get up and move, we are specialized by skills and education, and we can’t be idle for long because we have to eat. In a class war between capital and labor, labor must capitulate, at least in a free society.

The political measures that seek to prevent this – such as repatriation laws, tax penalties, capital controls, crackdowns on tax havens and accounting rules – are largely ineffective because capital enjoys these freedoms that are partly incumbent to its nature. Eliminating capital mobility would require the complete coordination of the international community, which implies state control over the deployment of capital. This would be contradictory to a free society, as much as the complete state control of labor mobility would. In other words, state coercion is incompatible with a free society and thus any tax costs will fall mostly on labor. This is not the result we want.

So, are we stuck in an impossible situation where those who own and control capital dominate those who don’t? I don’t believe so, but the solutions lie outside the present constellation of policies.

The first lesson is that if capital dominates the distribution of returns, then success in capitalism requires access, ownership, and control of capital.  Simply put, in a capitalist society, why aren’t we all clamoring to become capitalists? (You don’t have to run a business to be a capitalist, you just need to buy into public corporate share ownership and control.)

The next objection is that capital ownership and control cannot be pried from the hands of the rich and powerful without coercion by a democratically-elected government. In other words, we’re back to tax coercion. It is certainly true that we can tax physical capital and wealth through property and estate taxes. A mansion cannot be moved or disappear because it is taxed and the tax cannot be avoided by selling the property since the sales price will instantly reflect the tax liability. Wealth taxes are probably necessary due to the massive transfer of wealth under the misguided policies of the past two decades, but we’re missing the larger point if we focus solely on this redistribution of wealth after the fact. (My proposal for estate taxes is that they could be avoided entirely if the estate distributed the capital in limited amounts voluntarily according to the wishes of the principal. This happens to a certain extent with charitable gifts, but I would broaden the idea to cover any beneficiaries.)

However, beyond wealth taxes, there IS a way to incentivize someone to surrender at least some of their capital voluntarily. In fact, we all do it all the time when we buy insurance. By paying insurance premiums we surrender capital wealth in order to reduce risk and preserve the remainder. The rich have long practiced capital preservation strategies to protect their wealth. So risk is exchanged with capital.

This is also how Wall Street bankers get rich – they assume risk, manage it successfully, and then reap the rewards. So, if those without capital assume the equity risks going forward, and their property rights are vigorously defended, they can reap the rewards of economic success through their labor and their capital accumulation. The rich willingly give up some of their control in return for reducing their risks. As a society we can redistribute wealth by redistributing and managing risk.

This happens now when we save and invest in new business ventures, or accumulate a portfolio of financial assets such as stocks and bonds. But to really make a dent in inequality we must broaden and deepen capital ownership with a range of policy reforms that consistently reward working, saving, investing, accumulating capital, and diversifying risk. In a free society the government was never meant to do all of this for us, especially when we can do it better ourselves. I also would not expect most politicians in Washington to someday wake up and discover these reforms by themselves.

 

 

 

 

Banking Vegas-Style: Casino or Golf?

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Banking has a long, colorful history – in fact, it’s probably the world’s second oldest profession and created as much controversy as the first. Banking in modern times was largely a sedate affair, characterized by what is known as the 3-6-3 rule: pay 3% on savings deposits, lend at 6%, and be on the golf course for a 3 pm tee time. But more recently banking has undergone a radical transformation, one that viciously came to light during the 2008 global financial crisis.

This transformation can be noted in the explosive growth of two asset markets: foreign currency exchange (FOREX) and the markets for financial derivatives. Let us consider first some of the changing metrics of the foreign currency exchange market (source: Wikipedia):

The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The FOREX market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global FOREX and related markets is continuously growing. According to the Bank for International Settlements,[4] the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in FOREX markets averaged $5.3 trillion per day in April 2013.

Compare this to the total value of global trade in real goods and services for the entire year of 2013, which was only $37.7 trillion. Obviously, there’s a lot of action in foreign currency trading. Why? Because of the volatility of floating currency rates. The original idea of moving from fixed exchange rates to floating rates was that policy differences between countries would be forced to converge on efficient fiscal and monetary policies because of the discipline imposed by currency fluctuations. In other words, bad policies would harm the domestic economy and the markets would sell off the domestic currency, forcing politicians to correct those policies.

Unfortunately, the opposite happened. Bad economic policies caused currency values to fluctuate widely, creating price volatility that attracted the attention of traders into the game, creating the exponential increase in trading volumes (with the economic consequences). And guess who are the major traders of foreign currencies, otherwise called speculators? You guessed it: the major global banks that today are Too Big To Fail.

The volatility of FOREX markets then created the opportunity for financial innovation to create numerous new markets for those wonderful financial derivatives we’ve all heard so much about. To give an idea of the size of the derivatives market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.

Don’t misunderstand this – financial derivatives have been around for a long time to hedge the uncertainty of price changes over time. In other words, they can provide insurance against the risk of loss associated with those price changes. This is what commodity futures are about, where farmers can lock in a price for their products, be it corn or pork bellies, before they invest in new production. There is a productive financial role for derivatives, which is why they exist. However, newly created volatility in asset markets can be highly leveraged in derivatives markets (think 100 to 1), to offer gambles with incredible pay-offs. Often this just becomes a highly leveraged play on risk with OPM (Other Peoples’ Money) yielding little economic benefit. In other words, a casino.

The problem is that gambles don’t always pay-off and somebody gets saddled with the losses. As these markets have grown, national governments have had to become heavily involved in assuring the integrity of these markets. Consequently they have been forced into the breach to backstop the losses with bailouts that eventually fall on taxpayers – either in the form of accumulated debt and increased taxes, but also through the slow devaluation of the currency. This helps reduce the value of debts incurred by speculators in the FOREX and derivative casinos.

The upshot is that banking is no longer a boring but secure backwater for the country club crowd. It’s become a hot-bed of furious trading and living on the edge, with incredible pay-offs to the winners and taxpayer bailouts for the losers. We’ve essentially turned finance, which is supposed to fund the real economy with prudent capital investment, into a trading casino where winners and losers result from the throw of the dice.

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How do we sober up? That’s a good question that we’re going to have to ponder at some point. It certainly would be nice to send the bankers back out on the golf course. Hopefully before the next global financial crisis wipes us out.