When Everything Else Is Free

Since the Great Recession in June of 2009, the United States economy has failed to produce the kind of catch up growth necessary to return to its pre-recession trend of growth (also known as potential GDP). Two percent growth in real GDP, which is roughly what we’ve experienced since we reached the trough of the business cycle, is just not getting it done. Many economists view this as a problem, and rightly so, because slow growth means fewer jobs for workers and fewer goods and services for people to enjoy. But all is not doom and gloom and, in the spirit of the holiday season, I want to point out a new economic trend that may put a positive spin on the recent sluggish growth. Put simply, we don’t pay for anything anymore. That may be a bit hyperbolic, but it gets at the core truth that “free” is an option for many more goods and services than it ever has been before.

A quick survey of a few industries will reveal the prevalence of this trend:

Entertainment: In addition to the old AM/FM radio, music listeners now enjoy free music streaming on Spotify and free custom radio stations on Pandora. Movies and shows are available to stream for free from websites like Hulu and Youtube, and sometimes even from the networks themselves. Consumers with e-readers or tablets can read almost any book in the public domain for free thanks to Project Gutenberg. Zynga is the hottest company in video games, especially social gaming, but they offer their wares for free through Facebook.

Communication Technologies: Instead of paying for postage and envelopes, we now send emails and instant messages over the internet for free. If we would rather see the people we’re communicating with, we can use the free videoconferencing service from Skype. Facebook and Twitter both allow you to stay in contact with hundreds of people simultaneously. Both are free. Text messages are now free through Apple’s iMessage app and soon people may be allowed to make phone calls over the internet for free (the technology already exists), instead of paying for a cell phone plan.

News: It’s difficult to find an industry that has been hammered harder than the newspaper industry over the last 10 years by falling revenue. Basically, their business model has imploded because the bundled product they traditionally sold is now unbundled and the new competition charges zero dollars. The old business model relied on a combination of physical newspaper sales, general advertising, and classified advertising. Craigslist has singlehandedly wiped out the classified advertising market for newspapers with its free online platform. With the rise of tablets and smartphones, it’s now much easier and more convenient to access the news on the go without actually buying a physical newspaper. And that’s only possible because they are giving away the exact same content from the physical newspaper for free online. The only major newspaper with an ironclad paywall is The Financial Times. The other major U.S. papers, such as The New York Times, The Wall Street Journal, and The Washington Post, either give away all their content for free online, or have extremely porous paywalls that are easily bypassed. That leaves the newspaper industry with only general advertising as a means of generating revenue. Worse yet, the newspapers are only able to charge a fraction of the price for the same ad in digital form than they would in print form because marketers are still skeptical of how effective online advertising is. These developments, among others, have lead to the event in the graph below:

There are two important things to consider along with this emerging trend. First, many “free” goods and services depend on the internet for delivery, so having an internet connection is necessary to access them. Though there are free places to access the internet, it is still very common for people to pay a monthly bill for the privilege. Second, and this should be the alarming part, is that all the companies that offer “free” products make their money from advertising. But the competition for advertising revenues is usually a zero-sum game. Corporations tend to set their advertising budgets for the next year in advance and they spend that money in the as advertising opportunities arise. Most new companies that have an advertising-based revenue model will be taking that money away from other businesses that also need it to survive.

Finally, the substitution effect will most likely drive down revenues in any industry with a competitor offering the good or service for free or at a low-cost. Consumers make relative comparisons on prices offered by suppliers, and it sure is hard to pass up free. This phenomenon creates a race-to-the-bottom type mentality for producers, who reasonably feel like their only option is to give away their product and make money on the backend through advertising. Furthermore, consumers who have been trained to expect free or near-free pricing may be hesitant to pay for luxury goods in other markets where they still charge you for the goods. Time is a finite asset and there are many ways to fill it with things that don’t cost any money.

This new free economy is great for consumers, who get to keep all the economic surplus of the exchanges, but it’s horrible for headline GDP numbers. After reading the news, it may feel like we’re not much better off than we were ten years ago, but don’t forgot about all the wonderful things you can get for free!

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How to Stimulate an Economy in the Age of Debt: Tax Cuts vs Government Spending

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According to the National Bureau of Economic Research, the official arbiter of when recessions begin and end, the Great Recession began in December 2007 and ended in June 2009. For the millions of Americans who still cannot find a job, the recovery that began in July 2009 has been disappointing, to say the least. Now that we are approaching the fiscal cliff, which is a set automatic spending cuts and the expiration of the Bush tax cuts, recessionary forces are looming once again. Sadly, economists are still debating the exact causes of the last recession and what the optimal response to it would have been. For the purposes of this post, I will focus on the use of fiscal policy as a way to stimulate the economy. More specifically, I will address the optimal balance of tax cuts and spending increases that the federal government should implement to get the economy back on track when it has slipped off the rails. I will put aside the issue of monetary policy, though it remains a very strong tool for combating recessions.

After receiving input from his team of economists and other advisers, President Obama proposed the American Recovery and Reinvestment Act (ARRA) of 2009 as a way to boost the flagging economy he encountered upon taking office. Though other government programs, such as the Troubled Asset Relief Program (TARP), were already underway to counteract the financial crisis and economic downturn, the ARRA represented arguably the strongest action taken by the federal government to fill output gap caused by the recession (here, output gap is defined as the difference between potential GDP and actual GDP). One of the most contentious aspects of any stimulus package is how to balance tax cuts and increase in government spending. In the case of the ARRA, Obama chose a balance of about 2 to 1 for spending increases to tax cuts.

The strongest case for including more tax cuts in the package at the time was that they would take effect immediately and boost consumer spending in short oder. This stands in contrast to government spending programs, which normally take months or even years to fully go into effect because of the scarcity of true “shovel-ready” projects at any point in time. In fact, the argument for more tax cuts could be made by just looking at the title of the Act: the American Recovery and Reinvestment Act of 2009. The ARRA was signed into law on February 17th, 2009 by President Obama, but by that point the economy had already been contracting for almost fifteen months.

The argument for tilting a stimulus package toward government spending has always been that this type of stimulus has a larger fiscal multiplier than tax cuts do, meaning for each dollar spent there will be larger boost to national income. Fiscal multipliers are notoriously difficult to measure, but most economists believe the multiplier for government spending is higher than the multiplier for tax cuts (they mainly disagree on the magnitude of this difference).

So if tax cuts are the faster form of economics stimulus, but government spending has a larger impact, how should policymakers respond to recessions? What’s the optimal balance? I believe the debate over this issue is missing one key element that would change the calculus: deleveraging. At the time of the debate over the ARRA, critics of the tax cuts approach argued that people would just pay off debts with their free money, rather than spend it on goods and services. This, they said, is why tax cuts have such a low multiplier and are the inferior method of economic stimulus. But deleveraging is exactly what the economy needed to achieve an enduring recovery, as opposed to the occasional “recovery summer” or “recovery winter.” In an article for the Washington Post about the role of mortgage debt in the recovery, Zachary Goldfarb cited the work of economists Atif Mian and Amir Sufi to explain how debt effects consumer spending:

“But Mian and Sufi’s research showed something more specific and powerful at work: People who owed huge debts when their home values declined cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the less they spent. People with little debt hardly slowed spending at all.”

Also, in a must read piece for the Boston Review, Mike Konczal laid out the argument for why what we went through can best be described as a “balance sheet recession”:

In the housing bubble prior to the economic crisis, households took on significant amounts of mortgage debt. But homeowners judged the debt to be manageable because it was balanced by double-digit growth in housing values. Those housing values started to crash in 2006. Households then began to pull back on their consumption in order to pay down debts and restore their balance sheets.

If we are to trust the work of Mian and Sufi and the analysis of Konczal, then the biggest critique of favoring tax cuts in the 2009 stimulus package, that they would be used to pay down debts rather than spent in the economy, turns out to be one of their most appealing qualities. Since we now know that consumer spending, which accounts for roughly two-thirds of our economy, is highly sensitive the an individual’s level of indebtedness, the optimal response in a balance sheet-type recession would be to help along the deleveraging process as much as possible. Hopefully after the next recession, “mostly used to pay down debts” will be listed in the “pro” column and not the “con” column for tax cuts.

Total U.S. Household Debt (not adjusted for inflation) 

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What Germany Owes the Eurozone

The euro crisis has been with us for more than a few years now, but there are still some fundamental questions left to be answered before there can be stability in the eurozone. In case you haven’t been following the news out of Europe, here’s some brief background on the situation: After the introduction of the euro in 2002, eurozone member countries enjoyed historically low interest rates on their government bonds. Investors were willing to loan their money to these countries at such low rates because they believed there was an implicit guarantee behind every government bond denominated in euros. That is, they believed German bonds carried equivalent risk to Greek bonds because they were both members of the eurozone and therefore had similar default risks. Once the global recession hit in 2008, many countries in the periphery of the eurozone started to run substantial budget deficits (and revealed that past deficits were larger than previously reported), which quickly disabused investors of their one-size-fits-all approach to risk valuation. That lead to the increasing interest rates shown in the graph above. The rapid rise in interest rates subsequently made it more expensive for these governments to service their debt, adding to their already ballooning deficits. Larger deficits spurred higher interest rates, and the vicious cycle continued until the European Central Bank (ECB) took decisive action to put a ceiling on certain countries’ interest rates, temporarily halting the crisis.

Before the crisis can be permanently put to rest, Germany needs to decide how much austerity (i.e. spending cuts and tax increases) and reform it ultimately wants from the periphery countries, Greece, Italy, Portugal, Spain, and Ireland. In an ideal world for Germany, these heavily indebted countries would slash their national budgets quickly and severely to repent for their previous fiscal sins. Unfortunately for the Germans, and for the other strong eurozone countries, like Finland and the Netherlands, the first steps toward austerity in the periphery have been a drag on those countries’ GDP growth, further deteriorating their debt-to-GDP ratios and making already hesitant international investors more skeptical of their ability pay off their debts. Furthermore, German fears about hyperinflation, which they experienced during the interwar period of the 1920’s, have prevented the ECB from pursuing looser monetary policy. If the ECB were to announce that it would tolerate inflation closer to 4 or 5 percent, rather than 2 percent (see graph below), then periphery countries could inflate some of their debt away and, more importantly, real wages would fall more quickly, bringing them closer to their market clearing level.

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As of November 2012, unemployment in the eurozone was 11.6%, while Spain and Greece had 26% and 25% unemployment, respectively. With such a large percentage of their labor forces sitting idle, these countries are failing to achieve their potential economic output, which only exacerbates their debt problems.

Germany is determined to make the budgets of the periphery countries as austere as possible to atone for their past profligacy. This seems somewhat reasonable, given that those countries committed to running small deficits as a condition of joining the eurozone. But if fiscal consolidation is a rational demand to make of these countries, that only leaves looser monetary policy as a way to prevent a breakup of the eurozone. The important question is this: why should Germany, especially given its intimate history with hyperinflation, tolerate a rise in the inflation rate? Put simply, it must do so because it has benefited the most from eurozone-wide low and stable inflation. Prior to the creation of the eurozone, countries like Italy, Greece, and Spain would devalue their currencies to make their exports more competitive in the global marketplace. German workers are notoriously more productive than their counterparts in Southern Europe, so currency devaluation served as a convenient way for those countries to level the playing field in the export market. Now that there is a single currency, that option is off the table.

The New York Times recently ran an op-ed by Gunnar Beck that made the argument that Germany did not benefit the most from the creation of the eurozone. His main data regarding the import/export market, which we would expect to be most affected by the move to a single currency, was this:

“German exports rose most — by 154 percent — to the rest of the world; by 116 percent to non-euro E.U. members; and least of all, 89 percent, to other euro zone members. In 1998 the euro zone still accounted for 45 percent of all German exports; in 2011 that share had declined to 39 percent.”

Though this information may appear to imply that Germany does not in fact owe the other countries in the eurozone anything, it neglects to account for the most significant global economic trend of the past twenty years: the rapid and sustained growth of the emerging economies (e.g. Brazil, Russia, India, China, etc.). Those countries, and many others included in the “rest of the world” category, have experienced years of double-digit growth in the past couple decades. When you measure growth in German exports to countries using 1998 as the base year, of course the increase in exports to the rest of the world would be larger than the increase in exports to other eurozone countries — the rest of the world was growing extremely fast!

The data put forth by Mr. Beck obfuscates the real and significant benefit Germany receives from the euro: control of a significant number of its trading partners’ inflation rates. Countries like Greece can no longer run double-digit rates of inflation to make their exports more competitive relative to Germany’s. To give you an idea of how dramatic of a paradigm shift this is, look at the chart below of Greece’s inflation rate history:

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Prior to its adoption of the euro, Greece depended heavily on currency depreciation to offset the low productivity of its labor force and to maintain the competitiveness of its exports on world markets. Now Greece, and every other country struggling with burdensome debt levels, is committed to 2% inflation forever because Germans neither need nor want the price level to rise more rapidly. But if Germany wants to safeguard the progress made toward European unification, it needs to let the ECB pursue a higher inflation target, possibly in conjunction with an unemployment target similar to the one adopted by the Federal Reserve this month. Germany owes the eurozone at least that much.

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The Market for Lemons — and Financial Products

Elizabeth Warren recently won the Massachusetts Senate election against incumbent Scott Brown, receiving about 54% of the vote. One of the key issues in the race was how the federal government should regulate the finance industry, specifically with regard to Dodd-Frank and the Consumer Financial Protection Bureau (CFPB), Warren’s brainchild. Senator Brown favored giving Wall Street more leeway in regard to government oversight, a position which earned him significant campaign contributions from the finance sector. Warren, on the other hand, is a liberal academic who is well known for her criticisms of Wall Street. Most notably, she formally put forth the idea for a CFPB-type government agency in a 2007 article for Democracy: A Journal of Ideas, an article that launched her into the political arena.

I was first alerted to the article by Ezra Klein via Twitter on election night, and after reading Warren’s work, I am happy to see that she won election to the Senate. The piece is a cogent argument for why we need to regulate financial products just like we regulate any other products —  to protect consumers from harm. The crux of her argument is easily grasped from the following excerpt (though do read the whole thing):

Consumers can enter the market to buy physical products confident that they won’t be tricked into buying exploding toasters and other unreasonably dangerous products. They can concentrate their shopping efforts in other directions, helping to drive a competitive market that keeps costs low and encourages innovation in convenience, durability, and style… Just as the Consumer Product Safety Commission (CPSC) protects buyers of goods and supports a competitive market, we need the same for consumers of financial products–a new regulatory regime, and even a new regulatory body, to protect consumers who use credit cards, home mortgages, car loans, and a host of other products.

Warren goes on to give a brief history of consumer finance and how the industry has become more complex over the years. Though her argument in favor of tougher regulation is persuasive and well thought out, Warren misses the key economic insight on which her argument is based: asymmetric information. Economists say that a market has asymmetric information whenever the buyer or seller knows more about the product than the other party. We generally assume the seller has more accurate information than the buyer because it makes intuitive sense that the owner of a product would know more about it than a prospective customer. This idea about an imbalance of information was first proposed by George Akerlof in 1970 in his famous paper The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, in which he cites the used-car market as prime example of this phenomenon. He finds that:

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller… As a result there tends to be a reduction in the average quality of goods and also in the size of the market.”

The resulting reduction in the average quality of goods and the size of the market implies there is a role for government intervention to increase total welfare. If through government regulation the information known to buyers and sellers becomes more symmetric, then the adverse effects previously mentioned will be reduced.

This is exactly the problem that has been growing in the finance industry over the years. When Warren says that lengthy credit card contracts with footnotes and legalese are bad for consumers, she really means that they increase the gap between what the sellers (banks) and the buyers (consumers) know about the product. As shown by Akerlof’s work, this asymmetry of information hurts both buyers and sellers in the end because people will be more hesitant to engage in exchange. In other words, if you want to sell me that collateralized debt obligation so badly, then why would I want to buy it? Something must be wrong with it, right? And when people don’t have the education or expertise to properly evaluate financial products, they will either make poor decisions or no decisions at all (i.e., abstain from exchange). A new regulatory regime of common-sense rules for banks and investment firms, as outlined by Warren, would decrease information asymmetry, thus strengthening the market and improving consumer welfare.

Now we just have to wait and hope that Warren gets a seat on the Senate Banking Committee so she can affect this change.


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Maslow’s Hierarchy of Needs and Economic Growth

Note: This post was motivated by the comedian Rob Delaney’s twitter comment that Obamacare will help satisfy the base of Maslow’s hierarchy of needs, which will lead to a stronger economy. This idea has an intuitive appeal, so I decided to flesh out the argument in a longer format than twitter allows.

Maslow’s hierarchy of needs, first proposed by Abraham Maslow in his 1943 paper “A Theory of Human Motivation,” is often illustrated as a pyramid like the one above. The idea is that human beings will not be able to focus on satisfying their higher level needs, such as creativity and respect, until they have satisfied their most basic needs, like food and sleep. Once they have taken care of their physiological needs, they can move on to worrying about their safety needs; once those have been met, they move on to their love/belonging needs, and so on.

Economists have already shown that economic growth can help people reach higher levels on the pyramid (The Wealth of Nations Revisited: Income and Quality of Life, 1995). This makes sense because as national income grows, people can afford to buy more food, water, housing, and other basic necessities. Rich nations can afford to build sanitation systems and basic infrastructure that people depend on to pursue their life goals. Clearly, causation runs one way, but it does it go the other way too? In other words, if the government were to design its domestic policy to meet all the physiological and safety needs of its citizens, then would its labor force be more productive?

A cursory look at the world GDP per capita rankings, as determined by the World Bank, reveals much about what types of policies might lead to higher productivity (GDP per capita is a measure of productivity). In the top ten, there are five countries that can aptly be described as social democracies, i.e. countries whose governments provide generous, universally-accessible public services, including education, health care, child care, and workers’ compensation. These five countries are Norway, Australia, Denmark, Sweden, and Canada. The other five are very small countries that depend on a single industry for outsized incomes. There are the petrostates, Kuwait and Qatar; the financial centers and international tax havens, Switzerland and Luxembourg; and the East Asia gambling mecca, Macao. If the United States, currently ranked 14th, wants to improve its workers’ productivity, it should look to the five large countries, rather than anomalous small countries, for guidance.

Note that all I have shown so far is that there is a correlation between GDP per capita and the level of public services provided by the state. Some people might even argue that a few of the social democracies would be more appropriately placed in the “anomalies” category. There is an argument to be made that Australia’s wealth is derived from the combination of its abundant natural resources and China’s insatiable thirst for raw materials. But then again, maybe not. The Scandinavian countries have their fair share of natural resources as well, not least among them oil, so maybe that’s how they manage to fund a generous welfare state while maintaining a high GDP per capita.

To make the case for causation, we need to examine one of the basic principles of economics: risk aversion. Economists observe that in the presence of uncertainty, people are usually risk averse, meaning given the choice between investing in a risky investment with a high rate of return and a less risky investment with a relatively lower rate of return, they will choose the less risky option. This risk aversion is compounded by the relatively new discovery from behavioral economics that people have a loss aversion bias, which means they care more about preventing losses than acquiring gains. For example, one study showed that if you want to motivate students to perform well on tests, you should give them the reward before the test and then threaten to take it away if they fail to achieve a certain score. The study found that this incentive is more powerful than telling the students they will be given the same reward after the test is completed if they meet the threshold.

So people inherently don’t like taking risks and they don’t want to lose what they already have. This presents a clear and present danger to economic growth, as most economists believe entrepreneurship, also known as risk taking, is an important driver of innovation and increases in productivity. To help illustrate this theory, let’s consider the hypothetical case of Joe the Plumber. Let’s assume Joe works 40 hours a week at a mid-sized plumbing company in Cleveland, Ohio. Joe currently makes enough money to feed his family of four, maintain their health insurance coverage, and save for his kids’ college education. Now suppose that Joe wants to start his own plumbing company. To do this he will have to take business classes at a community college, take out a loan from the bank, and decide which tools, office space, technology, and transportation to invest in, just to name a few. Joe will also have to devote a lot of time to working on the new business, so he will need to spend more money on child care services. If this business were to fail, it would be a serious financial hardship for Joe’s family and he would have to discontinue the family’s health insurance and stop adding to his children’s college funds. Not wanting to lose what he already has by taking unnecessary risks, Joe forgoes the opportunity to start his own business. The economy stagnates.

But if Joe were to start his business in say, Norway, he wouldn’t have to worry about many of these downside risks. His whole family would be entitled to health care, education, child care, and other public services, no matter the fate of his new business. What does Joe do then? He takes the plunge and signs up for business classes, knowing that failure won’t irrevocably harm his family. The economy now has one more entrepreneur hoping to strike it rich. If he succeeds, the economy will grow larger than it otherwise would have been able to.

Now many would argue that the possibility of grave personal financial hardship is an important motivator for a businessman to succeed. This may be true on some level, but let’s not exclude the other reasons people start businesses. Being the owner of your own business merits a certain level of respect in the community and gives you a sense of achievement that is difficult to find elsewhere. Furthermore, a successful business would undoubtedly boost its owner’s confidence and self-esteem. There are myriad reasons to work toward making a business successful, aside from avoiding personal financial catastrophe.

This simplification is not meant to be a dispositive example of the effects of social democracies on economic growth in all cases, or that the total economic benefits of a large welfare system outweigh the total economic costs. I merely wanted to show that by securing the lowest levels of Maslow’s hierarchy of needs, it is possible there will be more, not less, economic growth than without doing so. Indeed, there seems to be much evidence to recommend this framework for domestic policy and proponents of a stronger welfare state would stand to benefit from adopting it.

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A Twist on the Misery Index

The Misery Index, which is simply the sum of the inflation rate and the unemployment rate, was first created by economist Arthur Okun in the 1960’s while he was an adviser to President Lyndon Johnson. The index is intended to measure the economic well being of people in a country during a given period of time.

When I first came across the Misery Index, I was intrigued by the idea, but thought that it could use some tweaking to more accurately measure how poorly an economy was performing. After doing some research, I think I’ve come up with a superior method of measurement. As always, the hope is that if we provide our policymakers with better data about the state of the US economy, they will be able to make better decisions going forward. In that vein, here is what the Stapp Misery Index looks like:

Instead of just summing the inflation rate and the U3 unemployment rate, like Arthur Okun, I summed the U6 unemployment rate and the inflation rate, and then subtracted the percent change in real GDP from the previous year. I plan on doing a full length post on the differences between the different measurements of unemployment in the future, but a quick description here will suffice. In essence, U6 is just a broader measurement of unemployment than U3. U3 is the percentage of the labor force that is unemployed and has looked for work in the past 4 weeks. U6 is equal to U3 plus discouraged workers (those who want a job but aren’t currently looking because there aren’t many available), marginally attached workers (those who would like a job, aren’t currently looking, but have looked within the past 12 months), and part-time workers (those who are working part-time because they can’t find a full-time job).

I decided to use the broader measure of unemployment because recent research has shown that unemployment has a bigger effect on people’s happiness than the inflation rate. Rafeil Di Tella, Robert J. MacCulloch, and Andrew J. Oswald published a paper in 2001 called Preferences over Inflation and Unemployment: Evidence from Surveys of Happiness, in which they estimated “people would trade off a 1-percentage-point increase in the unemployment rate for a 1.7-percentage-point increase in the inflation rate.”

Lastly, I decided to subtract out the percent change in real GDP because it is the most commonly cited indicator of economic growth. Consequently, a positive value for real GDP should lower, not raise, the Misery Index. The main conclusion I would draw from looking at this index is that we are still very far from reaching our pre-recession trough of roughly 8.5. The current value of about 14 implies that economic policymakers should keep the pedal to the metal on both fiscal and monetary stimulus. There is still too much misery out there to pull back now.

P.S. I plan on revisiting this index again at a later date. I think it still could be improved and I’m not done tweaking it yet. One additional change I am considering would be to measure inflation as the deviation from 2%. Most economists agree that in the long-run a 2% rate of inflation is optimal and therefore any deviation from that rate would add to economic misery. On a technical note, I would add the absolute value of the deviation to the index because deflation is at least as grave as concern as excessive inflation when it comes to impacting economic well being.

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How to Cure Baumol’s Cost Disease: Turn Services into Goods

Baumol’s Cost Disease is a phenomenon that was formally observed by William J. Baumol and William G. Bowen (history snubs poor Mr. Bowen) in their 1965 paper, On the Performing Arts: The Anatomy of their Economic Problems. Baumol and Bowen point out that it takes the same number of musicians the same amount of time to perform a Mozart string quartet today as it did when Mozart was alive. This implies that the productivity of classical musicians, or how much output (music) they produce per hour of labor, has remained constant over time. Meanwhile, productivity in sectors that employ more technology, like manufacturing, have seen productivity rise significantly over the years. This is where Baumol and Bowen’s work gets really interesting.

In addition to their observation that productivity has not increased in some sectors of the economy, like the robust Mozart string quartet industry, they also noted that real wages, meaning wages adjusted for inflation, have still increased in these sectors over time. This second observation is in direct contradiction with one of the basic tenets of classical economics: wage equals the marginal productivity of labor. In other words, at the margin, employers pay their employees based on how much they produce. But if the productivity of musicians hasn’t gone up, then why have their wages? The answer, say Baumol and Bowen, is that wages rise in stagnant sectors of the economy because producers must compete for labor by paying a competitive wage rate. If the real wage of a classical musician were the same as it was in Mozart’s time, no one would choose to be a classical musician. The opportunity costs, in this case the wages of other available jobs, would simply be too high.

This phenomenon is known as a “cost disease” because it has dire implications for the economy at large. As real wages increase in sectors of the economy that do not experience productivity increases, a larger share of the economy will be devoted to producing these services. And since the government disproportionately supplies many of them – e.g. health care, education, law enforcement – Baumol’s cost disease also predicts the government’s share of the economy will rise as well.

The string quartet example can be loosely extrapolated to the whole service sector of the economy because the defining characteristics of services describe a string quartet as well. There are generally considered to be five such characteristics: intangibility (you can’t hold it in your hand or store it in a warehouse), perishability (they cannot be reused once delivered), inseparability (they are dependent on the person providing the service), simultaneity (they are delivered and consumed at the same time),  and variability (every service is unique and cannot be replicated exactly). For the purposes of this essay, you can think of these five characteristics as barriers to increasing productivity. Before we talk about overcoming these barriers, let’s contrast services with goods. Goods are tangible, relatively nonperishable, separable from the provider, and consumable after delivery. For these reasons, the provider of a good is less critical to how and when it is consumed. Furthermore, goods can be mass-produced in factories, which are amenable to technological advancements in production processes. Services tend to resist technological innovation because the person providing a service must be present while it is consumed and he is the main determinant of its quality. Much of what we call technological innovation involves removing the human from the production process, e.g. robots on an assembly line. Since most service work is non-routine, it is difficult to take out the person delivering the service.

If services are resistant to increases in productivity and goods are not, I argue that we can cure Baumol’s cost disease by transforming services into goods. I will use the education industry as a prima facie case for how to achieve this type of transformation. There is a revolution going on right now in higher ed regarding online education. Companies like Coursera, MRUniversity, and Udacity have created online platforms for delivering college level classes. Their approach differs from other experiments in online education, like MIT OpenCourseWare and Edx, in that these companies are not merely videotaping professors giving their normal classroom lectures. They are creating classes from the ground up that are optimized for the online experience. For example, many of the classes emulate the format used by Khan Academy, which combines notes, pictures, and diagrams with a disembodied voice narrating the lesson. They claim this allows students to focus on the material and follow along more comfortably. In any event, the key technology all of these online platforms exploit is the same: video.

Though video technology has been with us since 1951, education innovators are just now using it to effectively disrupt higher ed. It is the perfect technology for this task because it flips the five characteristics of education that make it a service. Video enables lectures to be “reused” after they have already been delivered (perishability); it allows them to be delivered without the provider present (separability); it permits viewing to occur after a lecture is delivered (simultaneity); and it makes the service homogenous (variability). Once the college class has finished the transformation from a service to a good, it can be mass-produced (at a marginal cost of zero) and sold to the public. According to the statistics on the Khan Academy website, Sal Khan, the company’s founder, has delivered more than 200,000,000 lessons to students across the globe. Talk about productivity.

P.S. I realize that online video does not directly address tangibility. Though this characteristic is irrelevant to increasing productivity in higher ed, if it is an important feature to you, I suggest you download the videos, burn them to a DVD, and clutch it tightly.

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