A Chill in the Air as Summer Approaches

Open dialogue is a great thing, and the Internet has helped to create a lot more of it.  Unfortunately, governments, ours among them, discourage the expression of certain ideas.

I hold back from discussing many ideas on this blog because I worry about potential consequences.  There are tax and regulatory issues that I would love to discuss, but there is always the chance that open discussion of them might invite government backlash against my businesses.

I have wondered at times whether I am too paranoid about these things.  But yesterday's story about IRS targeting of political groups, and today's news that senior IRS officials were aware of what was going on is a reminder that the world might not have changed so much from the days when President Nixon ordered tax audits of his political opponents.  Aggressive tactics by federal prosecutors, moves to allow revocation of citizenship, as well as moves to prevent Americans from voluntarily relinquishing their citizenship all add to the feeling that government, already too powerful, is pushing the limits.

Left and right doesn't really matter - both are targeted by officials of both political parties.  The solution is not to elect people we might think are friendly - it is to reduce the power of government so neither party has the ability to make serious mischief.

It's nearly summer again, and so I will take another break from blogging.  My guess is that the world will stay relatively calm, and the economy will continue to slowly recover from the crash of '08.  Off election years are calmer than election years anyway, and the beginnings of second terms are less eventful than the beginning of first terms.  In addition, President Obama seems weak politically, and the Republicans control the House, so I wouldn't expect any big political breakthroughs.  This is all good - the less activity in Washington the better.

Sand in the Gears

An economy works best when people are free to exchange goods, services, means of production, and money.  The reason is that people differ in their ability to make productive use of these things, and these abilities change constantly.  If I own some lumber, and you have figured out an important thing to build, it would be best for everyone if I gave you the lumber in return for some compensation.

I own real estate, but because the world and my situation constantly changes, the optimal composition of my portfolio changes frequently.   The world economy would function just a bit more efficiently if I traded properties from time to time.  In fact, constant wheeling and dealing would help to make sure that my properties were in the hands of people who could make the most efficient use of them.

Two things hinder this process:  capital gains taxes and real estate brokerage.  The second factor, brokerage, is changing rapidly and becoming much more efficient.  The first factor, taxes, is getting worse.

Real estate brokers perform the important function of bringing buyers and sellers together.  Brokers have colluded, however, to require licensing of their profession.  This raises the cost of becoming a broker, which raises commissions, and makes it harder for real estate to change hands.  My research on this topic is here.

Recent innovations like LoopNet, however bypass the broker cartel.  I recently sold $13 million worth of real estate on LoopNet, paying negligible fees.  Traditional brokers are responding by improving service and cutting fees.  This development, undercutting a long-standing regulatory structure, is creating large efficiency gains for the economy, and benefits for huge numbers of people.

The capital gains tax, however, is only getting worse.  Real estate is depreciated over time for tax proposes.  In reality, real estate often appreciates.  The difference between the depreciated value declared to the IRS and the sales price is taxed.  As a result, many people hold on to investment real estate for decades, even though another owner would make better use of it, and the real estate owner would make better use of cash than the potential buyer.

The capital gains rate recently increased from 15% to 20%, significantly increasing the impact of the tax.  Because gains due only to inflation are also taxed, property owners pay even when they have received no real profit.

There is a loophole in the capital gains tax: the 1031 exchange.  If real estate is sold and the money is held by a third party, then spent on other real estate that is identified within 45 days and purchased within 180 days, no tax is due.  But this only creates another inefficient situation - sellers of real estate are often desperate to buy new real estate before the deadline, and often make poor decisions.  Whole industries cater to these sellers, and real estate is built to accommodate them instead of the actual end users of stores, offices, and apartments.

In addition, 1031 exchanges must be for U.S. property, which hinders international capital flows that would make the entire world economy more efficient.  I believe that the losses in income and employment that result from these inefficiencies are huge.

Academic economists are good at a lot of things, but many of them are clueless about the effects of taxes on business.  Larry Summers, for example, makes the ridiculous comment in the New York Times Magazine this morning that "I don’t think Bill Gates, in his garage, was calculating his marginal tax rate."  What idiocy!  As if millions of business decisions are not driven by tax calculations every day!   Our tax system is a huge burden on the economy, and growth would be significantly higher if business was freed from the absurd rules under which it is forced to operate.

Underground

There is new evidence that the underground economy in the U.S. is growing rapidly.  The most important reason for the increase is persistent unemployment, which has driven many people to accept off-the-books work.  Other factors include stricter occupational licencing, more welfare benefits tied to low income and unemployment, the payroll tax increase that took effect in January, and lower IRS budgets for enforcement.  If the new Internet sales tax passes, it will encourage more underground activity.

Another factor is loss of faith in government.  If people believe that government is an evil institution, then they will not feel guilty about failing to report income.  If they do not trust Social Security to be there for them in retirement, then they will have less incentive to report income and pay payroll taxes.  The fraction of the population who believe that they "can trust government in Washington to do what is right," "just about always" or "most of the time" declined steadily from 60% in 2002 to 19% in 2010.

I wrote a paper several years ago about occupational licencing, using real estate brokerage as an example.  I found that stricter licensing does nothing to improve public welfare, but it does raise commissions and increase broker incomes.  As more occupations are licensed, and requirements become stricter, the public increasingly sees these rules as illegitimate and is willing to work around them.

Another paper I wrote describes the largest episode of underground economic activity in U.S history outside of trade in illegal drugs and alcohol.  Unemployed coal miners during the 1930s dug illegal mines on idle coal company land and produced huge quantities of coal, which they sold out of trucks in large cities.  As the business grew it became more and more accepted, with local sheriffs refusing to enforce laws against theft and trespassing, and juries refusing to convict offenders.  It eventually took violent action by state authorities and unions to put an end to bootleg operations, along with increased demand for coal resulting from World War II, which create legitimate employment opportunities for former bootleggers. One lesson from this episode is that once underground activity becomes established and accepted, it becomes very difficult to eliminate it.

I am becoming convinced that smartphones and social media will prove to be the most disruptive technologies we have seen in many decades.  Connecting people, as these technologies do, also means connecting buyers and sellers, employers and employees, borrowers and lenders, in ways that will be difficult for governments to track.

A combination of technological and economic factors caused parents to lose control of their children over the course of the '50s, '60s, and '70s.  Other factors allowed parents to reassert control over the '80s, '90s, and '00s.  My guess is that parents are now in the process of losing control again because of social media and smartphones.  As parents lose control of their children, governments might lose control of their citizens.

Bitcoins and Gold

Paul Krugman has done the bitcoin industry a favor by writing about it in his column this morning.  By dismissing users as "bitbugs" and the significance of the currency as "basically nil," he will convince thousands of anti-Krugmanites to consider investing in bitcoins.

Here is his conclusion:

So do we need a new form of money? I guess you could make that case if the money we actually have were misbehaving. But it isn't. We have huge economic problems, but green pieces of paper are doing fine -- and we should let them alone.

You don't like the uniform products issued by the state?  What is the matter with you?  They work just fine!  There is no need for innovation at all.  Just like these beautiful Ladas.  They stop, they go, why would you ever want anything different?

Today's gold crash also has Krugman fired up.  The fact that gold has fallen to $1350, over four times the inflation adjusted 2000 price, is supposed to demonstrate that the "goldbug view of the world" is "all wrong."

The gold market ran ahead of where it should have been, but it is still way up over the past several years.  It isn't crazy to worry about disasters, and gold is a way to buy a little insurance.

Decline of the Middle Class

Recent economic news is puzzling.  The stock market is up, corporate profits are skyrocketing, average house prices are up, etc., but unemployment and median income show very little improvement over the past few years.

Means are up, medians are down.  Capital is doing well, labor not so well.  For generations, conservatives have argued that profits trickle down from the top, but the argument is losing credibility.

Evidence that large numbers of people are losing ground is strong.  In 24 states, real median household income is lower today than it was in 1989.  National real median income is lower today than it was in 1996, and poverty rates are rising.

In 1983, studying at the London School of Economics, the first inkling I had that the Soviet Union was in trouble came from a lecturer who surprised a very well-informed audience by telling them that life expectancy had begun to fall there.  Now the same thing is happening in the United States.  Since 1990, life expectancy has fallen by 4 years for whites without a high school degree.  Hundreds of counties in the U.S. have seen average life expectancy fall or stagnate.

Technology has increased the value of skilled work, and lowered the value of unskilled work, and many people are incapable of acquiring valuable skills.  The cost of taxing skilled people enough to provide a high standard of living for the unskilled would be extremely high, and since political power is now in the hands of the skilled, it won't happen regardless of whether it would pass an academic cost/benefit test.

Substituting capital for labor is good for business, and for perhaps 40-60% of the population.  For what used to be called the working and middle classes, however, times are hard, and there is nothing that can be done about it.

Some argue that immigration is the culprit, and that the flow of new arrivals could be stopped.  I suspect that immigration has helped to push down wages of the least skilled, but that technology is a stronger competitor for unskilled workers than immigrants.  Besides, the U.S. has lost the will to stop immigrants from crossing the border, and I don't think that will change any time soon.

The situation might change if political power passes from the skilled to the unskilled.  This has happened before.  Perhaps it is one reason why the elite increasingly favor gun control, and the non-elite are increasingly resisting it.

A Chart That Won't Get Much Attention

There is a sense that the economy is picking up, and that first quarter 2013 GDP growth will be much stronger than growth was in late 2012.  Since 1st quarter data won't be available until April 26, today's release of February personal income data is of interest.  The release shows modest improvement, but nothing dramatic.  The release prompted me to have a look at the monthly personal income data since the beginning of 2007, the first year of the financial crisis.  Here is a chart:

The spike up in 2008 is the stimulus package, and the spike in late 2012 is the result of people maneuvering to declare income in 2012 instead of 2013 because of impending tax increases.

Over more than 6 years, real income per person hasn't increased, making this the longest period of stagnation since the Great Depression.  It is not news that the Obama administration wants us to see, and the news media are doing the president a favor by reporting non-inflation-adjusted stock market records instead of meaningful data.  (see here for an exception)

The interesting thing is that GDP growth really is accelerating.  As I wrote earlier, business is picking up, but there seems to be very little trickle-down so far.

Isolationism

Next Tuesday is the 10th anniversary of the U.S. invasion of Iraq, a good time to think about where U.S. foreign policy is headed.

I don't think the invasion and war were crazy ideas at the time.  After the U.S. victory in the Cold War, anything seemed possible.  The U.S. was so much stronger than any country or potential coalition that it could afford to experiment with the limits of its power.  After WWII the U.S. remade Germany and Japan, so why couldn't it do the same with Iraq?  The events of 9/11 seemed to show that the old system of Middle Eastern dictators supported by U.S. aid had failed, and it seemed reasonable to try something new.  Plausible sounding estimates showed that the cost of a war was likely to be less than the ongoing costs of containing Iraq.

The primary goal of the war (along with the war in Afghanistan) was the prevention of terrorist attacks on the U.S., and so it can be said to have succeeded.  The broken Middle East seemed to need shaking up.  The war was like giving a broken TV a slap - Americans reasoned that it might work, and things couldn't get any worse than they already were.

The region has certainly been shaken up.  The image of the toppled Saddam Hussein may have inspired the Arab Spring, which has fundamentally changed the politics of the Middle East.  It is too early to say whether the new situation is an improvement, but at least there have been no major successful terrorist attacks. 

The problem is that the war was far more expensive than anyone predicted 10 years ago.  Not only were casualties and direct monetary costs much higher than expected, but oil prices have increased, partly because of uncertainty about the region caused by the war.  The inflation-adjusted price of oil is triple what it was before the war.  Although the war was begun primarily with benefits to the U.S. in mind, there was some hope that it would benefit Iraqis, and it still isn't clear whether the war has been a net benefit for Iraq.

To the American public, the costs of recent conflicts are much clearer than the benefits, and they are tired of constant war. 

Democrats, still traumatized by the defeat of George McGovern in 1972, always try to portray themselves as hawks.  Even the anti-Iraq War candidate Barack Obama felt he had to say that the war was a mistake because it was a distraction from the more important war in Afghanistan.  He has taken drone warfare to new levels, and is even now threatening war with Iran over its nuclear program.

With voters tired of war, and neither party offering a peace platform, an opening has been created for Rand Paul.  He is offering traditional Republican isolationism, which the party abandoned during the Cold War.  A new coalition of young anti-war voters, fiscal conservatives, and pro-life voters could win in 2016. 

In an article this morning about Rand Paul's foreign policy role in the party, the New York Times takes it as given that we are in "an increasingly unstable world." Is that really the case?  While there may be internal turmoil in many Arab countries, the Arab revolutions seem to be focused on internal problems, not on stirring up trouble abroad.   Other than the United States and its allies, no major world powers are engaged in any wars.  Measures of conflict around the world are down dramatically over the past couple of decades.

U.S. security would not be compromised if China ruled Taiwan.  North Korea is probably best ignored.  Russia poses no threat to any countries except for a few in strategically insignificant central Asia.  South and Central America are more stable than they have ever been.  Al Qaeda was inspired to act because of U.S. intervention abroad - a lighter global footprint might prevent future movements like it.   

It increasingly appears that the Iraq War represented the high point of U.S. military intervention abroad.  U.S. power and influence will decline over the next decades.  Politicians who resist this trend will lose elections, and those who embrace it will win.