Known Unknowns

Guten Tag!

Welcome to Known Unknowns, a newsletter that comes to you every other week (this week from Zurich!), despite the fact that the author receives no financial incentives.

Incentives Matter

When you learn economics, the first thing you are told is that people respond to incentives. This is what makes economics models interesting and policy hard. Incentives create scope for greater efficiency but also harmful unintended consequences.

But now some prominent economists are questioning how powerful financial incentives really are. If people will work and save at the same rate, no matter what, maybe we can jack up taxes and add in a wealth tax while we are at it.

Now, it is certainly true that people don’t always respond to incentives the way we think they will. They also don’t respond to small incentives as much as large ones. They sometimes have more diverse preferences than we realize. This may explain why extremely high earners fled California after a tax increase but regular higher earners did not. The bigger your income is, the easier it is to relocate and the larger your tax liability. I think this result suggests that we can’t assume that, just because small changes in incentives don’t have an impact on behavior, we can make huge changes to the tax code without any adverse effects.

Also, many of these macro and applied micro models underestimate (or just ignore) how risk factors into people’s decisions. Sometimes people don’t respond to incentives the way we expect because they are hedging against some source of risk. Take the argument that UBI doesn’t deter people from working because Alaskans work despite receiving a dividend payment from the state. Well, that dividend payment can vary more than 100% year-to-year, if you rely on that dividend for income, it is a huge source of risk. I also observed that, during a summer I spent selling incense in an Alaskan fishing village, local labor income was incredibility volatile because it is so tied to natural resources. You’d be surprised how much halibut prices can impact incense demand. So, of course, Alaskans still work, dividend payment or not. People also perceive risk in unpredictable ways, and this can alter their behavior.

And about wealth taxes … So, I hear lots of justifications for them from economists and people on Twitter. Back when I studied public finance, the goal of taxation was to raise necessary revenue while creating as few distortions as possible. Now it seems economists want even more from tax policy – some think its explicit goal should be to make the economy more equal and stable by reducing inequality.

Mostly, however, there is a popular argument that wealth taxes would be growth-enhancing because it takes money away from rich people who “hoard” their money and gives it to low-income people who will spend it on productive things. As someone who spent many hours in graduate school solving growth models, this strikes me as an odd argument.

I was taught that savings increases the capital stock, which means more growth (and potentially) more innovation. Juicing consumption may boost growth initially, but over time your economy will shrink because your capital stock will too.

Now, maybe this is wrong or the world has changed. More capital stock should result in higher wages – and it didn’t. Maybe the United States and Europe already have too much capital. Maybe an economy more reliant on intangibles changes the dynamics – but again – this is all speculative.

But the argument I hear most often is that rich people don’t do anything productive with their wealth. So, more consumption and less billionaire investment will grow the economy.
How could rich people’s wealth be wasteful? I can think of a few reasons.

  1. They make unproductive, bad investments.

  2. They don’t take enough risk and keep their money in cash – I’ve seen this one a lot on Twitter – and it strikes me as maybe not true, and even if it is: Since when did people become concerned that hedge funds and private offices aren’t introducing enough risk into the economy?

  3. They just park their money in the stock market and that it is not creating real value; money is just sloshing around and driving up prices.


I actually heard some variants of these arguments (and the implication that we need to put more money in the hands of poor people who spend more) at a media briefing at a large investment bank last week. Seriously. Isn’t it their job to help rich people find productive investments? If they don’t think rich people’s wealth adds to the capital stock then what hope do we have?

Does anyone know if any of these things are true? I am open to the idea, but first I need to see some evidence. I think we need to understand this better before we throw out decades of public finance/growth theory, overhaul the tax code, and implement 6% wealth taxes.

Labor markets and gig work

Like all life-cyclists, I look at labor income as an asset that has its own risk characteristics, just like a financial asset. This means I live in a state of perpetual dismay that most people don’t see the world this way. This is why the Pension Geek community is my safe space. Because when you see human capital as an asset – the world looks very different.

For example, the evidence has been trickling in for a long time – and now we have even more that gig work is not replacing traditional jobs. It is supplementing them to hedge and insure against income volatility risk. I suspect this may be why income variability has been declining over the years. This is mainly good news because, like most financial economists, I like complete markets.

The desire to manage income risk from a primary job is why the flexibility of being able to work when you want is so critical to gig work, and why policy that aims to make gig work more like regular work is so misguided. It will increase income risk for many low- and middle-income households.

Risk also can explain shifts in structural unemployment. During the recession, Erik Hurst speculated that young men weren’t joining the labor force because they were playing video games in their parents’ basements (he had data to back this up). But now that unemployment is low, it may appear he was wrong – there was no structural change.

I see it a bit differently. Better leisure opportunities increase the risk-free return on not working, so your reservation wages may be higher, or you’ll put a higher premium on flexible work. If wages go up, and you have more flexible work options, you may eventually join the labor force if wages are high enough. But just because unemployment is low doesn’t mean a structural change didn’t occur.

Does monetary policy work anymore?

JP Morgan is now taking the position that, in a low-rate environment, loose monetary policy (or rate cuts) may in fact be contractionary. As the population changes, so will the channels of how monetary policies work and the risks people take. Raghuram Rajan also questions if the unconventional stuff works. So, what’s the point of any of it?

It seems like the whole point is expectations. Or it is to convince markets that monetary policy is doing something to ensure a recession never happens again, and this boosts confidence, spending, stock prices, etc. I agree, expectations are a powerful tool. But expectations need to be realized eventually in order to be credible. And it is worth wondering: If monetary policy doesn’t work through real channels, will the expectations channel continue to work, too?

People don’t trust economists

According to the FT, economists are the least-trusted profession in the United Kingdom. Many Brits believe economists just push ideas that suit their political preferences. Can you blame them? After all, we now assume people are fools who don’t act in their best interest, and we can trick them into thinking we have power that we don’t.

In other news

The reach for yield results in pension funds doing some crazy things.
The origins of modern socialism

Until next time, Pension Geeks!

Allison