Monthly Archive: October 2015

It’s that time of year again.  Pumpkins festoon front yards.  Horror movies abound in theaters.  Candy is sold by the ton.  And costumes, scary, sexy, and just plain crazy are purchased, modified, and tailored just for the bacchanalia of the that most weirdest of nights in the fall – Halloween.

But what can Halloween actually say about economics?  After all, this is a column on economics, wealth, money, and time.  Well it turns out that Halloween night, after the trick-or-treaters have returned with their loot, provides the ideal setting for playing a game that illustrates how trade builds wealth.  The name of the game is called the candy trading game.

The basic mechanics of the game is as follows.  Take the trick-or-treaters to a big room and ask them to sort their candy into piles of similar types:  M&Ms with M&Ms, Kit Kats with Kit Kats, Spree with Spree and so on.  Then ask them to value each of their pieces of candy on a scale of 1-10, with 1 being the least liked and 10 being the most liked.

Since the valuation of candy is an individual and subjective thing, most likely each participant will have a pile of favorites (say Snickers) and a pile of yucks (say Black Licorice Twizzlers).  Given a mostly random distribution of candy that results from going door-to-door, each costumed candy collector will find that the value that they ascribe to their haul will be somewhere around the 5 mark.

Now, without adding or subtracting any candy, allow the make-believe menaces to freely trade with each other.  Soon Lik ‘Em Aids will be changing hands for Black Cows; Pixie Stixs for Reeses’ Peanut Butter Pumpkins, and so on.

Finally, stop the trading (albeit temporarily) and ask the crew to reevaluate their stash.  Generally, the results will show that all groups report an increase in the value of their candy holdings even though no candy has entered or exited the economic ecosystem.  The increase in value is, or course, variable, but when this game is played in more controlled settings (say a classroom), the increases can be quite dramatic.  Increases of 30 to 60 percent have been seen in all groups simply be re-arranging who has what.

This is perfectly expected.  Anyone who has ever trick-or-treated, or has chaperoned those who have, know that a time-honored tradition upon returning home is to trade with each, eat what you like, and hold onto what you don’t (either until you can justify throwing it out or until you get desperate enough to eat it).

The only mystery and horror is why, when we grow up, are we confronted with businesses and governments hell-bent in stopping free trade.  I guess devils can be found even outside Halloween.

Some economists have argued for a long time that the establishment of a minimum wage would have a negative impact select segments of the economy or on society as a whole but there haven’t been controlled experiments that I am aware of that try to support this claim.  That is up until now.

As of April of 2015, we may finally have a Petri dish in which to examine the role of price fixing in the labor market and we have a man by the name of Dan Price to thank.

Dan Price is the CEO of Gravity Payments, a Seattle-based credit card processing company of about 120 employees [1] who has decided to set an-across-the-board minimum salary of $70,000 for each of his employees.

According to the article by Riley and Harlow entitled Gravity Payments CEO defends $70,000 minimum salary, Mr. Price had read a study that concluded that employees have substantial increases in their personal happiness until they reach a salary of $75K, after which the gains are less pronounced.  Citing this study as motivation, Price then decided to unilaterally set the minimum salary resulting in significant raises for 70 employees, 30 of which will see their yearly earnings essentially double.  To cover this expense, Price has cut his own salary from $1 million down to the minimum set by his own rule.

While the long-term results are yet unknown, the immediate results speak volumes about human nature, incentives, and the realities of the economy as Gravity Payments has seen some positive effects, some unintended consequences, and a heap of negative outcomes.

As cited in the Business Insider article by Rachel Sugar, some employees are ecstatic about the raise.  One member said that the extra money would allow him to fly his mom from Puerto Rico to Seattle for a visit – something he was never able to do before because of the relative relationship between his earnings and the price of air travel.  In addition, scores of new businesses have flocked to Gravity Payments due to what is viewed as their progressive stand. Sugar also notes that there may be some incentive for employees to work harder to justify their new, higher wages.

This kind of enthusiasm was no doubt anticipated by Price but other outcomes were no doubt unforeseen.  In his article Why A $70,000 Minimum Salary Isn't Enough For Gravity Payments, David Burkus points out that the company was inundated with emails, phone calls, and social media posts that have proved a distraction to the day-to-day operations of the company.  In addition, they’ve been flooded with job application from people seeking employment in this brave new world.

But all of this is overshadowed by the strong, negative elements that resulted.  The New York Times had a lengthy article entitled A Company Copes With Backlash Against the Raise That Roared in which its author, Patricia Cohen, presents the responses of two key employees who quit over Price’s move.

One such employee is Grant Moran, a webdeveloper, who left Gravity Payments saying

More troubling is the story of Maisey McMaster, who Cohen describes as ‘one of the believers’ in Price’s business approach.  McMaster join Gravity Payments when she was 21 and in her five years of employment had gain the position of financial manager by putting in long hours that left little time for her husband and her family.  Originally onboard with the raises, she began to have her doubts.  When she approached Price about her concerns she said he accused her of being selfish.  She eventually quit Gravity Payments saying

Other negative side effects have included clients who left due to worries about the prospect of higher fees that they believe will be needed to cover the increased labor costs or because of the discomfort of the political statement they perceived.  In addition, Price has alienated segments of the Seattle entrepreneur set who see this move as setting a dangerous precedent.  Steve Duffield, the chief executive of the DACO Corporation, is quoted as saying

Those are the facts.  But what to make of them.  As Riley and Harlow note, Price thinks any company can match his model but does that really make sense?

First, let’s take a look at that ecstatic employee with the mother living in Puerto Rico?  Would he really be able to fly his mother into Seattle if everyone in the United States had a $70K minimum salary?  Of course not!  The cost of plane travel would also have to increase to cover the higher labor associated with pilots, mechanics, flight attendants, and service workers.

How about the large marginal increase in happiness as a result of the higher salaries.  Here there are two sides to examine.  For the employees who receive a huge bump up it isn’t at all clear that happiness will follow.  As Sugar points out, many have begun to worry that their performance doesn’t merit the extra money.  They will obviously split into two sets – the first rising to the occasion and working even harder and the second taking their windfall as a gift and changing nothing associated with their work ethic.  Will the first set be happier?  Maybe…but it is likely that some of them will long for the days where they had less money and fewer responsibilities.  Those in the second set will then antagonize those who are actually earning the money, especially those who didn’t receive much of a bump in the first place.   In addition, it is a reasonable concern to wonder if the minimum salary is simply too much money too early in the careers as many of the employees are 30 and under.  Doesn’t this minimum salary hurt their competitiveness in the labor market should they want or need to move to ‘less progressive’ companies?  After all, it is reasonable to suppose that the gains in happiness that correlated with the rise in salary to $75k were as much a product of the employee’s achievement – the realization that they were ahead of their peers through fruits of their efforts.  Also to what hope of future success can the employee look if there is nowhere else to rise?

Burkus suggests that the way to understand this dynamic is through the equity theory of motivation as proposed by the organizational psychologist J. Stacey Adam.  According to equity theory every employee in an organization is always analyzing their outlay in effort against what they get in return in relation to what others are doing.  This model fits the complaints leveled by Moran and McMasters that led to their departure from Gravity Payments.

So with all this negative outcome, why did Price do what he did?  Steve Tobak grapples with this question in blog for Entrepreneur entitled The Sad Saga of the $70,000 Minimum Salary Company.  To summarize, Tobak thinks Price acted impulsively without considering he bad incentives he would be instilling.  I, however, have a much more cynical interpretation. As discussed in the Times article, Lucas Price, Dan’s brother, and co-owner of the business filed a suit prior to this minimum salary initiative citing that

I can’t help thinking that this whole episode really comes down to sibling rivalry – a chance for Dan to stick it to Lucas in a way that Dan look like some kind of folk hero.

A recent article by Larry Summers, entitled The global economy is in serious danger, recently caught my eye.  For those who don’t know, Lawrence (Larry) Summers is a professor at Harvard and served as the Secretary of the Treasury from 1999 to 2001.  No doubt the inflow of cash into the treasury during his tenure, a fact many economists credit to the ebullient spirit associated with ‘the new digital economy’ and the automatic stabilizers in the economy, did much to give him a reputation as an economic seer.  But generally, I tend to take what he has to say with a huge shaker of salt mostly based on such idiotic sentiments as

This current ‘chicken little’ prophesy of doom is really no exception.  Although, to ‘be fair’, he does make some valid points in some areas but the bulk of his analysis is repackaged Keynesianism, which, oddly enough, may actually work in the particular situation the global economy is in.

In a nutshell, Summers warning center on secular stagnation where slow growth in the developed world hurts the emerging markets which, in turn, hurts the industrial countries.

To support this claim, Summers cites the IMF’s revision of growth forecasts for the US, Europe, and China downward.  On the surface, this seems to be a slam dunk of a pronouncement but looking under the veneer one should ask if the IMF foresaw the global financial crisis of 2008.  If they didn’t, which I suspect they did not, why start believing them now?

Summers also cites a curious statistic to make us feel all scared inside about the slowdown in growth in China.  He points out that China poured more concrete in the time span from 2010 to 2013 that the United States did in the entire twentieth century.  This statistic, which is explained in more detail here, seems genuine but who cares.  Again, without any context whereby the statistic is put on level footing it is hard to know what to make of it.  During the bulk of the twentieth century concrete was not the chosen material for building.  Only in the last third of that century did steel reinforced concrete really rise to a common building material, with granite and brick being much preferred prior to that time.  A more meaningful comparison would have been to show how much the US used in the span between 2010 and 2013 and even then the comparison would be misleading as the US isn’t trying to catch up to the developing world nor is it trying to lift over a billion souls up to a higher standard of living almost overnight.

In another curious meandering of his thought made manifest in print, Summers writes

Okay, which one is it Larry?  Should we ignore the market because it is inefficient and often wrong about economic fundamentals or should we listen to the adverse signals that originate from it?

Sigh…

Despite all this intellectual-sounding fluff, the odd thing is that I think Summers has a point.  Currently the amount of money in the economy is high and inflation is low.  More dollars should be chasing the same amount of goods leading to growth and, perhaps, inflation.  But it isn’t happening.

Summers doesn’t seem to venture a guess as to why but he comes close to a hint.  He mentions that China is suffering from a hangover due to unproductive investment.  What a surprise – a Keynesian actually suggesting that economic activity is not enough – that an economy needs to invest wisely.

And so finally, we arrive at the only useful nugget to be found in Summers’ analysis.  Governments, businesses, and households all have to be prudent and wise in their investments.  In the late 90s through to 2008, they were generally overly enthusiastic and made stupid investments and took on unsupportable debt.  Post financial crisis, governments have layered even more burdensome regulation on the economy; regulations that they continually tinker with to show how responsible they are.  Businesses are sitting on cash timidly afraid to take risk.  Households have hunkered down and are waiting to see what their so-called leaders will do.

Someone has got to get the ball rolling again and perhaps Summers is right in saying that it is government that needs to do this. But if this is the case, then businesses and household need to be vigilant in making sure that increased government spending is done wisely.  We don’t need anymore hangovers.

Although the hurricane season for calendar year 2015 began on June 1 and ends on November 30, there really is no denying that the meat of the season falls in the middle to the latter end of that time span, particularly heating up (or is it raining down?) in late September if you are in the mid-Atlantic states.

They say all politics is local and so is best analyzed from that point-of-view.  I don’t know about how true that is but I do know that all weather is local and the local weather here in the mid-Atlantic region could be a lot better.  As I am writing this post, Tropical Storm Joaquin is dumping lots of rain and the lights in my house have flickered a couple of times.  Local television programming is festooned with crawlers that display a warning from the National Weather Service warning of the possibilities of flash floods.

Now, I don’t live in a flood zone but I am familiar with the struggles of those who do.  I grew up in western Pennsylvania where floods were common and people I knew routinely lost personal property, entire houses, and even their lives, when the rivers crested above their banks.  I am sympathetic to the poor and lower-middle class who were forced to live near the rivers since that was where cheap housing was available.  And every kid who went to school in my day was told cautionary tales about the great Johnstown Flood in 1889 that killed over 2,000 people in that small town in central Pennsylvania when a dam failed after days of heavy rain.

We were also taught about the importance of that wonderful safety net that is federally funded flood insurance to help those who live in flood zones and, therefore, need the protection.  For many years I believed this claim without any skepticism, subjecting it to no critical analysis, but later in life I was introduced to the idea of a moral hazard, which changed my outlook.

The National Flood Insurance Program (NFIP) was established in 1968 with the express purpose of protecting people by providing what private insurance could not – flood damage protection.  Homeowners and businesses in these areas could obtain flood insurance under the program, and, over its nearly 50-year history, NFIP has paid out over $43 billion in claims to over 5.5 million people (source).

Under the program, homeowners or business located in federally designated flood plains are required to buy the insurance, although the full burden of the premium is not typically borne by the insured.  According to Mary McGee of Colgate University, in her article entitled Moral Hazard and The National Flood Insurance Program, homeowners and businesses pay only 10% of the actual actuarial cost of the premium.  Other sources put the percentage paid closer to the 35-40% range, but everyone agrees that the insured doesn’t foot the entire bill.

On the surface, this seems okay, since the target group to be insured was originally conceived to be the economically disadvantaged who could not afford housing on safer ground.  But because homeowners and businesses don’t bear the full cost of this risk, they are encouraged to build in flood plains.  In other words, rather than assisting lower-wealth people who couldn’t settle on higher ground, the NFIP encourages people on the higher end of the wealth scale to take risks that they would ordinarily shun because someone else bears the cost.  This behavior is a textbook example of a moral hazard.

According to a CBO report on the NFIP (page 2), about 40 percent of subsidized properties are worth more than $500,000 and approximately 12 percent are worth more than a million. Rather than protecting the most vulnerable amongst us, federally-subsidized flood insurance is promoting risky behavior by those in society who can easily afford to avoid it.  Both the Washington Post and the New York Times have called attention to this in articles about the unintended consequences of the NFIP.

Even the stalwart champion of responsible governance, John Stossel, has admitted to the fact that his very expensive home was replaced on our dime by the NFIP

In the course of that debate, the fundamental fact surfaced that the NFIP encouraged people to build expensive homes on coastal property because they knew that, should they suffer a loss, they would be restored.  This is exactly the trend found by a group at NOAA.  In the article Normalized Hurricane Damage in the United States: 1900-2015, the authors point out

So until such time as the moral hazard caused by the NFIP is removed, each natural flood of water will be accompanied by an unnatural flood of dollars leaving taxpayer’s hands ending up in the hands of people who built in a flood zone because they didn’t bear the cost of such risky behavior.