Archive for April, 2012



Guardians of Our Liberties

In an oral argument before the Supreme Court on Tuesday March 27 in the case Dept. of Human Services Et Al. v. Florida Et Al. about the Constitutionality of the individual health-insurance mandate, Justice Anthony Kennedy made the following statement expressing deep skepticism that the power claimed by the Obama administration to compel individuals to purchase health insurance against their will is a power compatible with our traditional understanding of the relationship embodied in the common law and our jurisprudence between an individual citizen and his or her government.

JUSTICE KENNEDY: But the reason, the reason this is concerning, is because it requires the individual to do an affirmative act. In the law of torts our tradition, our law, has been that you don’t have the duty to rescue someone if that person is in danger. The blind man is walking in front of a car and you do not have a duty to stop him absent some relation between you. And there is some severe moral criticisms of that rule, but that’s generally the rule.

And here the government is saying that the Federal Government has a duty to tell the individual citizen that it must act, and that is different from what we have in previous cases and that changes the relationship of the Federal Government to the individual in the very fundamental way.

Following Justice Kennedy’s pronouncement, the Justices and the lawyers kept referring to the existence or the non-existence of a “limiting principle” that would prevent the government, if its power to impose an individual mandate were granted, from exercising an unlimited power over the economic decisions of individuals under the “commerce clause.”  By all accounts, Chief Justice Roberts, and Justices Scalia and Alito expressed similar concerns to those of Justice Kennedy.  Justice Thomas, as is his wont, remained silent during the oral argument, but he has already written skeptically about the extent to which the “commerce clause” has been used in earlier cases to justify government regulation of private economic activity.

A few days later in the case Florence v. Board of Chosen Freeholders of County of Burlington Et Al., Justice Kennedy, writing for a majority (Chief Justice Roberts, and Justices Scalia, Thomas, and Alito) of the Court, upheld the power of jail officials to strip search detainees arrested for any offense at their own discretion, regardless of whether there was probable cause to suspect the detainee of having contraband on his person.  According to press reports, a nun arrested at an anti-war protest was subjected to a strip search under the discretionary authority approved by Justice Kennedy and his four learned colleagues.  Here is an excerpt chosen more or less randomly from Justice Kennedy’s opinion.

Petitioner’s proposal―that new detainees not arrested for serious crimes or for offenses involving weapons or drugs be exempt from invasive searches unless they give officers a particular reason to suspect them of hiding contraband―is unworkable. The seriousness of an offense is a poor predictor of who has contraband, and it would be difficult to determine whether individual detainees fall within the proposed exemption. Even persons arrested for a minor offense may be coerced by others into concealing contraband. Exempting people arrested for minor offenses from a standard search protocol thus may put them at greater risk and result in more contraband being brought into the detention facility.

It also may be difficult to classify inmates by their current and prior offenses before the intake search. Jail officials know little at the outset about an arrestee, who may be carrying a false ID or lie about his identity. The officers conducting an initial search often do not have access to criminal history records. And those records can be inaccurate or incomplete. Even with accurate information, officers would encounter serious implementation difficulties. They would be required to determine quickly whether any underlying offenses were serious enough to authorize the more invasive search protocol. Other possible classifications based on characteristics of individual detainees also might prove to be unworkable or even give rise to charges of discriminatory application. To avoid liability, officers might be inclined not to conduct a thorough search in any close case, thus creating unnecessary risk for the entire jail population. While the restrictions petitioner suggests would limit the intrusion on the privacy of some detainees, it would be at the risk of increased danger to everyone in the facility, including the less serious offenders. The Fourth and Fourteenth Amendments do not require adoption of the proposed framework.

One can’t help but wonder what limiting principle these five honorable justices would articulate in circumscribing the authority to conduct a “reasonable search and seizure” under the Fourth Amendment to the Constitution.  But I really don’t want to go there.

Why Low Marginal Tax Rates Might Have Harmful Side Effects

My post last week about marginal tax rates has received a fair amount of attention on the web, being mentioned by Noah Smith last week and today by Andrew Sullivan and Kevin Drum.  (Drum, by the way, was mistaken in suggesting that I intended to link reduced marginal tax rates with the financial crisis; I was talking about a long-run, not a cyclical, effect.)  As a couple of commenters on that post noted, I didn’t fully explain why reducing marginal rates would have led to such a big expansion of the financial sector. Kevin Drum raised the point explicitly in his post. After quoting a couple of passages in which I explained why reducing marginal rates on income might have led to the expansion of the financial sector, Drum registers his conflicted response.

Count me in! I’m totally ready to believe this.

Except that I don’t get it. It’s certainly true that marginal tax rates have declined dramatically since 1980. It’s also true that the financial sector has expanded dramatically since 1980. But what evidence is there that low tax rates caused that expansion? Does finance benefit from lower taxes more than other industries, thanks to the sheer number of transactions it engages in? Or what? There’s a huge missing step here. Can anyone fill it in?

So Drum wants to know why it is that reducing marginal rates might have caused an expansion of the financial sector. Obviously multiple causes may have been working to expand the financial-services sector; I was focusing on just one, but did not mean to suggest that it was the only one.  But why would reduced marginal tax rates have any tendency to increase the size of the financial sector relative to other sectors?  The connection it seems to me is that doing the kind of research necessary to come up with information that traders can put to profitable use requires very high cognitive and analytical skills, skills associated with success in mathematics, engineering, applied and pure scientific research. In addition, I am also positing that, at equal levels of remuneration, most students would choose a career in one of the latter fields over a career in finance. Indeed, I would suggest that most students about to embark on a career would choose a career in the sciences, technology, or engineering over a career in finance even if it meant a sacrifice in income. If for someone with the mental abilities necessary to pursue a successful career in science or technology, requires what are called compensating differences in remuneration, then the higher the marginal tax rate, the greater the compensating difference in pre-tax income necessary to induce prospective job candidates to choose a career in finance.

So reductions in marginal tax rates in the 1980s enabled the financial sector to bid away talented young people from other occupations and sectors who would otherwise have pursued careers in science and technology. The infusion of brain power helped the financial sector improve the profitability of its trading operations, profits that came at the expense of less sophisticated financial firms and unprofessional traders, encouraging a further proliferation of products to trade and of strategies for trading them.

Now although this story makes sense, simple logic is not enough to establish my conjecture. The magnitude of the effects that I am talking about can’t be determined from the kind of simple arm-chair theorizing that I am engaging in. That’s why I am not willing to make a flat statement that reducing marginal income tax rates has, on balance, had a harmful effect on economic performance. And even if I were satisfied that reducing marginal tax rates has had a harmful effect on economic performance, I still would want to be sure that there aren’t other ways of addressing those harmful effects before I would advocate raising marginal tax rates as a remedy.  But the logic, it seems to me, is solid.

Nor is the logic limited to just the financial sector.  There is a whole range of other economic activities in which social and private gains are not equal.  In all such cases, high marginal tax rates operate to reduce the incentive to misdirect resources.  But a discussion of those other activities will have to wait for another occasion.

Reading John Taylor’s Mind

Last Saturday, John Taylor posted a very favorable comment on Robert Hetzel’s new book, The Great Recession: Market Failure or Policy Failure? Developing ideas that he published in an important article published in the Federal Reserve Bank of Richmond Economic Quarterly, Hetzel argues that it was mainly tight monetary policy in 2008, not the bursting of the housing bubble and its repercussions that caused the financial crisis in the weeks after Lehman Brothers collapsed in September 2008. Hetzel thus makes an argument that has obvious attractions for Taylor, attributing the Great Recession to the mistaken policy choices of the Federal Open Market Committee, rather than to any deep systemic flaw in modern free-market capitalism. Nevertheless, Taylor’s apparent endorsement of Hetzel’s main argument comes as something of a surprise, inasmuch as Taylor has sharply criticized Fed policies aiming to provide monetary stimulus since the crisis. However, if the Great Recession (Little Depression) was itself caused by overly tight monetary policy in 2008, it is not so easy to argue that a compensatory easing of monetary policy would not be appropriate.

While acknowledging the powerful case that Hetzel makes against Fed policy in 2008 as the chief cause of the Great Recession, Taylor tries very hard to reconcile this view with his previous focus on Fed policy in 2003-05 as the main cause of all the bad stuff that happened subsequently.

One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.

In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008.

A bit later, Taylor continues:

[T]here is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.

Moreover in a blog post last November, when targeting nominal GDP made a big splash, receiving endorsements from such notables as Christina Romer and Paul Krugman, Taylor criticized NGDP targeting on his blog and through his flack Amity Shlaes.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Taylor does not indicate whether, after reading Hetzel’s book, he is now willing to reassess either his view that monetary policy should be tightened or his negative view of NGDP. However, following Taylor post on Saturday, David Beckworth wrote an optimistic post suggesting that Taylor was coming round to Market Monetarism and NGDP targeting. Scott Sumner followed up Beckworth’s post with an optimistic one of his own, more or less welcoming Taylor to ranks of Market Monetarists. However, Marcus Nunes in his comment on Taylor’s post about Hetzel may have the more realistic view of what Taylor is thinking, observing that Taylor may have mischaracterized Hetzel’s view about the 2003-04 period, thereby allowing himself to continue to identify Fed easing in 2003 as the source of everything bad that happened subsequently. And Bill Woolsey also seems to think that Marcus’s take on Taylor is the right one.

But, no doubt Professor Taylor will soon provide us with further enlightenment on his mental state.  We hang on his next pronouncement.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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