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The Darwin Economy: Liberty Competition and the Common Good

November 2, 2011

Introduction

JOANNE MYERS: Good morning. I'm Joanne Myers, director of Public Affairs Programs, and on behalf of the Carnegie Council, I'd like to thank you all for joining us.

Our speaker, Robert Frank, is the Henrietta Johnson Lewis Professor of Management and a professor of economics at the Samuel Curtis Johnson Graduate School of Management at Cornell University. He is also a contributor to the "Economic View" column, which appears every fifth Sunday in The New York Times.

Today he will be discussing his book, The Darwin Economy: Liberty, Competition, and the Common Good. For those of you who are fans of his earlier works and the widely acclaimed The Winner-Take-All Society, in which he wrote about how decisions that are economically rational for individuals can make all of us collectively worse off, you will be pleased to know that The Darwin Economy is a continuation of that argument.

Now, some of you may be thinking, Darwin? What does Charles Darwin have to do with the economy? Well, according to our speaker, plenty. While most of us may consider Adam Smith as the intellectual founder of modern economics and the one we most often refer to when describing market conditions, Professor Frank says when it comes to describing competition in the marketplace, it's Darwin's Theory of Evolution which is more to the point.

Accordingly, he predicts that in time—not necessarily this year or the next—there will come a day when Charles Darwin's vision of the competitive process will be seen as a lot more accurate and descriptive than Adam Smith's ever was. The reason, Professor Frank argues, is that Darwin's understanding of competition describes economic reality far more accurately than Adam Smith, and the consequences are profound.

In The Darwin Economy our speaker debunks popular panaceas of both the left and the right and takes particular aim at the notion that a well-functioning competitive market system will necessarily produce socially optimal results. He writes that "Competition can act against the interests of the group, sometimes causing enormous harm with little lasting advantage. Indeed, with recent demonstrations under the banner of Occupy Wall Street giving voice to a widespread sense of economic injustice, Adam Smith's theory of the "invisible hand," which holds that competition channels self-interest for the common good, just doesn't seem as relevant today." "On the other hand, Darwin's insights, if applied properly," argues Professor Frank, "could help us resolve a host of seemingly intractable economic problems that we are now facing."

While you may find that these theories are interesting, you're probably thinking that today it's more about the solutions needed to solve our financial woes. You've come to the right place, as our speaker offers both.

Please join me in giving a warm welcome to our guest this morning, Robert Frank. Thank you for joining us.

Remarks

ROBERT FRANK: Thank you so much. I'm very honored to be able to speak to this group. I don't know most of you, but I can tell just by looking at you how distinguished you are. [Laughter]

I'll tease you by starting off with a kind of "snake oil" pitch. I'm going to try to persuade you that a simple change in the tax system could free up $2, $3, maybe even $4 trillion dollars a year of additional resources, way more than enough to pay down debt, rebuild crumbling infrastructure, and the like, all without anybody having to give up anything that he or she cares deeply about—no required sacrifice in cherished political freedoms, no down-side.

It's an alchemist claim—I'm going to transform lead into gold, it sounds like I'm saying—and, so, if you're skeptical, I don't blame you. But I think I'll be able to persuade you that the argument the claim rests on is undergirded by very simple logic—if you see a flaw in the logic, I'd be eager for you to step forward with it—and the evidence for the empirical assumptions behind the argument, I think no one in this room would seriously want to take issue with. So it's a good message in the end. This is the kind of message I think everybody should be glad to hear.

When I've spoken in other venues about the book, the organizers have usually said the audience will want to know what got you off the couch to write this book. And that is always the hard part, getting started on a book.

For me it was easy this time. I felt such a deep sense of frustration about what I will charitably call the political dialogue in the United States that I felt somebody's got to write a book pointing out why what people are saying doesn't make any sense at all. I'm sure many of you already knew that it didn't make sense, just to attack it systematically.

I have taken a slightly different tack from the usual critic of the current dialogue. I think most of the roadblocks to progress are coming from simplistic slogans mainly from the right. I hope I don't step on any toes. It was very hard to figure out what tone to take in the book.

I have many friends who are libertarians. I respect them. I tell them I think of myself as a libertarian. They often scoff at that. "How could somebody who favors the breadth of government interventions I favor think of himself as a libertarian?" they ask me.

But I think there is a meaningful sense in which I am very opposed to government regulation. Especially, if there should be any government regulation, it should always take the lightest possible touch that is consistent with achieving the objectives, and then only to prevent me or others from causing unacceptable harm to other people. If it's not for that purpose, then I think the government does best to hang back.

But as you'll see, I have a rather more expansive notion about what constitutes harm to others than most of my libertarian friends. So I want to be respectful toward the libertarian right, but at the same time I want to go after a spokesman I'll call the "movement libertarian." This is a political moron who shouts slogans whose effect basically is, "I want to do whatever I want to do whenever I want to do it, consequences to others be damned."

This guy gets up on the stump every April and says, "All taxation is theft." What an odd remark if you try to parse it. What's the alternative—voluntary taxation? Has that been tried? I don't know if it has been tried. I imagine somebody has tried it in some country somewhere.

What would happen? I don't know any historical record about this, but what would happen would be some people might start off paying taxes, but then they would notice that their neighbors weren't paying any and they would say, "That's not fair. I'm not going to pay any either." And then there wouldn't be any tax revenue. Then there wouldn't be a government, there wouldn't be an army. You'd be invaded by a country that had mandatory taxes that financed its army. Then you'd pay mandatory taxes to that government.

So "all taxation is theft"—if you get up on the stump in April and say that, it's like having a sign around your neck saying, "I'm not a serious person." But they say it, and the media sits silently by.

The media is very afraid. The media doesn't want to seem like they are taking a position in anything. So they will report somebody says, "All taxation is theft and others demurred" and, "Some say the Earth is flat, but others had a competing view." It's not like there's a right answer to these questions.

So I thought it would be useful to adopt a framework—and it's the one I adopt in the book—that takes as seriously as possible the libertarians' view of how the world works and then try to deconstruct it and see where does it take you.

So, unlike most social critics coming from the left—I'm a Democrat; I voted all my life for Democrats—I'm also an efficiency hawk, and there are a lot of things that the Democrats do that make me cringe. So I don't think of myself as an uncritical Democrat.

But the whole idea that we would try to look at the world through the eyes of the person who believes in markets and thinks that they have something valuable to contribute is a very important step to take when we are trying to parse what the right is saying.

So I grant the assumption made by people on the right that markets are perfectly competitive. Of course, they're not perfectly competitive, but they are way more competitive than they were in Adam Smith's day. I don't think anybody can quarrel with that.

There is a software company that is huge. They spend hundreds of millions of dollars on ads. But they can't make me buy their products. I have had experience with their products. I know they are not any good. There is a competing software company and hardware company whose products I buy with great excitement. They are better than the products of this other monopoly.

I think now if there is a customer who is being sold a bad product at too high a price, rival firms can figure out where those customers are, they can get the message out to those customers.

Smith worried about monopoly. In his day, it probably was a much more significant problem. Today that's not the problem. Monopoly, if there is a problem, it's that they buy favors from the government.

If you read the Winner-Take-All Politics book, and before that Bob Reich's nice book, Supercapitalism, you'll come away thinking there has been an enormous outpouring of campaign contributions whose purpose has been to invest in buying legislative favors from the government. That's a problem.

But the idea that consumers will be ripped off, workers will be ripped off, that is not on my radar screen as one of the big things to worry about.

Again, it was Smith's worry. Smith was more like a liberal social critic of today. He wrote that men of the same trade seldom gather, even for merriment, but the conversation quickly turns to some conspiracy to exploit workers or rip off the public.

The conservatives I think are right when they say markets are competitive. I grant them that. I'm going to grant them too that people are rational. I am a behavioral economist, so I do not believe that they are completely rational. Behavioral economics has mostly been inspired by the work of the late Amos Tversky and Danny Kahneman. Kahneman has a nice new book out [Thinking, Fast and Slow].

Tversky was a Stanford psychologist. He said, "My colleagues, they study artificial intelligence. Me, I study natural stupidity." [Laughter]

The many times that people have exactly the information they need to come up with the right answer, yet they make systematic errors—that's a problem too. But I don't want to go there. I think that is the kind of problem people can, with some effort, solve on their own. You can hire an advisor if you can't figure out what to do.

So I am going to assume perfectly competitive markets, I'm going to assume that people are rational and well-informed—not perfectly informed, obviously. Those are the two core assumptions of Adam Smith's modern disciples, the ones who say, "Just get the government out of the way and markets will take care of everything." So I grant there are two core assumptions.

I make one more assumption—only one more assumption—and that is Darwin's assumption that life is graded on the curve in many domains. Would anybody want to quarrel with that assumption? It's not how fast you are, he observed correctly; it's not how strong you are; it's not how smart you are. What matters in the tournament to get into the next round is how you do compared to your closest rivals with whom you are competing directly. If you are better than them, you win. If you are worse than them, you lose. So I add that assumption.

That's the linchpin of the argument, because whenever you are competing for scarce slots in a rank ordering, you get what Darwin recognized were behaviors that were mutually offsetting. They are very much in the interests of the individuals to take these behaviors, but not so much in the interests of the group.

Think about the antlers of the bull elk. That's the signature example in the book. The cover shows two big bulls with their horns locked. They are fighting for access to females. Their antlers are four feet across in the modern animal. They weigh 40 pounds. That's a horrible handicap for the bulls to lug around. If they are chased into the densely wooded spots by wolves, they are easily surrounded and killed.

Why are their antlers so big? Darwin's premise was that traits are selected in nature for their capacity to confer reproductive advantage to individuals. Those traits may benefit larger groups or they may not. If they do not, then individual interests trump.

So the bull elk, he recognized, were like males in most other vertebrate species—they take more than one mate if they can. The "if they can" qualifier is important, because if some take more than one, others don't get any mates at all, which of course makes them in the ultimate loser position in the Darwinian scheme. They don't pass any copies of their stuff along into the next round. So, of course, the males would fight bitterly for access to females. That is the whole prize at stake in this game.

Antlers were their weapons. If there was a mutation that coded for larger antlers, it would be very heavily favored. It would spread quickly into the next generation. Then another mutation would come along, and the mutations accreted one upon another, and we are left with these huge antlers that the bulls carry around. If you didn't have them, you would never win a mate.

So you can't solve the problem, you can't eliminate the handicap that they make you immobile, by unilaterally disarming in that arms race, any more than you could in a military arms race solve the problem. If you are spending imprudently much on bombs, you can't solve that by unilaterally disarming.

If they could take a vote on the matter, if at the count of three they could push the red button and every rack of antlers would shrink by half, they would have compelling reasons to do that. It's relative antler size that matters in their battles with each other, and if the antlers were all smaller by the same proportion, the fights, each and every one of them, would be resolved as before, but the animals would be better able to escape from predators. It would be a win-win move for them.

Of course they can't do that. Animals in most species have not the cognitive or communication skills to negotiate collective solutions to problems like that. So those weren't a big focus of Darwin's as he studied plants and animals, nor should they have been.

But humans are different. Humans have more than enough cognitive skill and communication ability to figure out that individual interests add up to a whole that is not consistent with the group's interests, and try to take steps to attenuate the incentives that are leading individuals to act in the ways that they are.

Let me give you another example that is, I think, very much in the same spirit. I read about this for the first time from my intellectual hero, Tom Schelling, a Nobel Prize-winning economist. He won the prize in 2005. 

He described the behavior of hockey players. Hockey players, he realized from watching NHL and other hockey leagues over the decades, invariably skate without helmets when they are permitted to make their own decision about that. If you go back to the old NHL tapes, you will see that the goalies didn't wear masks in the early going, if you can imagine that. There wasn't a goalie in the league with any teeth. They didn't wear helmets, they observed. But then, they would vote in a secret ballot, often unanimously, for a rule requiring helmets.

What's going on? If helmets are so great, he asked, why don't you just wear one? Why do you need a rule? His explanation is exactly in accord with Darwin's observation; that individual interests and group interests are not one and the same.

He said that if an individual hockey player takes off his helmet, he gains a competitive edge—not a big one obviously, but a slight competitive edge. If you have been an athlete, you know that's pretty much all you care about, is getting an edge. You can see better, you can hear better, maybe you can intimidate your opponents more effectively because you're nuts enough to skate without a helmet. So you get an edge and that serves your purpose. Yes, you might be injured—but that's not now, that's in the future, and it's maybe. So they find that a compelling move to make.

Their rivals know how to respond to that—it's to restore the competitive balance by taking their own helmets off. The equilibrium is everybody is skating without a helmet, nobody has a competitive edge, and there you are. They realize that it would be better if everyone wore a helmet, but they know as well that you're not going to get there unless you have a rule requiring that.

It's not that they're stupid. Remember, I am assuming people are rational. So that's not the problem here. They understand that it is risky to skate without a helmet.

If you read the Nudge book, a very wonderful book written by two friends of mine [Richard H. Thaler and Cass R. Sunstein]—I endorse every recommendation they make—they view safety regulation as being needed because people are not well enough informed about the risks they are about to take.

I don't think that is the case with the hockey players. If you put a sign up in the locker room saying, "Caution: Skating without a helmet might lead to serious injury," that would not solve the problem. They would still skate without helmets. You need a rule to solve that problem.

Think about the direct analogy to safety regulation. Here, I think, looking at things through the lens of the conservative critic is very illuminating. The company wants the worker to be careful and is willing to pay the worker more if he is willing to be careful, because then they don't have to install quite as much safety equipment on the machines, and they can both pay him more and earn higher profits if they can reach that agreement. The worker steps forward and says, "Yes, I understand the risks. I'm willing to take them in return for the higher pay."

Then the government steps between them and says: "No, you can't do that. We decree henceforth that risk-taking at that level is against the law. You've got to have safer equipment than that."

The conservatives, I think, make a compellingly powerful rhetorical point when they say, "Where does the government have the right to tell those two consenting well-informed adults that they can't do what they want to do?"

I would agree with that—except for one thing. If it were true that what they want to do imposed no harm on anyone else, go ahead. We all take risks. You took a risk getting here this morning—you could have been mugged or hit by a taxi crossing the street. You've got to take risks to live in this world. So yes, we can't rule out prudent risk-taking. Let people who know what the risks are decide whether to take them—unless the risks they take impose unacceptable harm on others.

Here is the harm that I see in this situation. Suppose I'm a worker and it's my goal to send my kids to the best possible school. I'm going to just imagine that every worker who has kids holds that goal. We'd think ill of a parent who didn't hold that goal, I dare say. So I want to send my kids to the best possible school.

Does anyone not know that the good schools are in the more expensive neighborhoods? That's the truth in every country I've ever been in or read about. It doesn't matter that the school budgets are different across neighborhoods, which they often are, and that contributes. But what is really important is that the smarter kids, the kids with the better backgrounds, are in the schools that are serving more expensive neighborhoods. That's where you want your kids to go.

If I am the median earner, what does that mean? To send my kid to a school of at least average quality, right in the middle of the quality distribution, I've got to outbid half of all other parents for a house in the middle of the price distribution.

If I want to do better than that, I've got to get some more money. One way I can get more money is by taking an extra risk on the job. I can get paid extra for doing that. To me that makes compelling sense, just like it makes compelling sense for a hockey player to take off his helmet to get an edge.

But there is nothing stopping you and other parents from taking that same step. You can take jobs that risky for higher pay too. When you do that, we each bid against one another in mutually offsetting ways. It's the effect, once the dust settles, that we have succeeded only in bidding up the prices of the houses in the more expensive school districts. The same 50 percent of kids go to bottom-half schools as before.

Rather than settle for that outcome, we step in and say, "No, we're going to regulate safety in the workplace." We haven't necessarily offered this explanation for why we do it, but this is the only explanation that I think fits the observed facts—that markets are very competitive and we would otherwise be making workers worse off if we prevented them from signing contracts that they saw as mutually advantageous to them and their employers.

Every country on the planet regulates safety. The workplace is much safer because of that. And because we all pay extra for safety, it doesn't compromise our efforts to bid for the things that we want and need. That depends on relative spending.

I had a colleague who watches a lot of Fox News. He and I were having lunch together one day. He was very angry. Did I know, he asked me, that Obama planned to raise his income taxes? Yes, I had heard that there was a proposal to eliminate the Bush tax cuts on people like you and me and everyone else in this room, and I didn't think that was a bad idea since we needed more revenue.

"Well, that's not all," and then he went on to list five or six other taxes. And David Paterson, who was then the governor of our state, had plans of his own, and he listed all those.

I told him I hadn't heard about any of that. He seemed shocked and even more agitated that I hadn't heard about it.

I said, "Do you know why I don't follow that very carefully? Because I don't think it matters very much."

He's a very prosperous guy. I'm way more prosperous than I ever dreamed I would be. We each have successful textbooks and other sources of income that rain down on us that we hadn't anticipated.

I said, "Is there any chance the legislature is going to do anything that is going to compromise your ability to buy what you need?"

He said, "They wouldn't dare do that, of course."

"Well, then the only thing left to worry about is, are they going to compromise your ability to buy what you want?"

He said, "Yes."

"Well, what determines whether you can buy what you want? The kinds of things you want when you are at our income level are the kinds of things others like us want. They're in scarce supply." (For people in this room, you want an apartment with a view of the park, I guess, or a view of the river, of the bridges.) "There are only so many of them to go around. You've got to outbid people like yourself to get them. If they raise taxes on the people you are bidding against and on you, what's the effect on who gets those things?"

He was forced to concede, "Well, I guess there's no effect. The same things go to the same people as before."

I said, "That's why I'm not worried about this. We've got things we need to do. The roads are riddled with potholes, the infrastructure is decaying all around us, there are sewer systems that are failing in most cities (New York had a big failure just recently), water systems are failing, bridges. During the last campaign, Ed Rendell had a press conference. He identified 6,000 bridges in Pennsylvania that were structurally deficient. The motorists who were on that bridge on I-35 that collapsed into the Mississippi, some of them were poor but others were rich.

"People like you and me," I told him, "have an interest in doing that work. The political dialogue doesn't let us even talk about doing that work."

I propose that we spend a lot of money fixing the infrastructure. That is, as far as we know, the surest way out of the current downturn. The current downturn is problematic because there is not enough spending.

That is what always happens in the wake of a financial crisis. Consumers hold back. They have debt to work down. They are afraid they will lose their jobs. They are not going to spend.

Businesses hold back. Why should they invest? They've already got more capacity than they need to sell what people want to buy.

What does that leave? If you took macroeconomics years ago, you remember Y = C + I + G; consumption plus investment plus government spending, that's the national income. C and I aren't going anywhere. That leaves G.

Keynes was an academic. I wish he hadn't used this example. He said it would be better to hire people to dig holes and fill them back up again, than to do nothing. But I think that example kind of planted the idea: Oh, government stimulus, that's wasted money.

There are pressing things that need to be done. The American Society for Civil Engineers did a report card on American infrastructure recently. They identified $2.2 trillion of projects that need to be undertaken, just to get caught up with deferred maintenance.

One of my favorite examples is a 10-mile stretch of Interstate 80 in Nevada. If you fix it now, according to the State Department of Transportation, it would cost you $6 million to fix that road, to repave it. If you wait two years, the truck traffic just drives the cracks deeper into the roadbed, the frost heaves the roadbed up; you've got to spend $30 million to fix it.

And that estimate takes no account of the fact that if we fix it today we are hiring unemployed workers who know how to do those jobs. We are using equipment that is sitting idle in the yards. We are using material that is cheaper than it will ever be in world markets. We are financing the project with money borrowed at 1.7 percent—there has never been a lower interest rate available to do these jobs.

Why shouldn't we do these jobs, I ask? The political slogans coming from the right say, "That would impoverish our grandchildren."

I sent an email to Joe Biden's chief economist. I said: "Have a press conference every week and do another infrastructure project and have cutouts of Mitch McConnell and Paul Ryan there. Ask them, 'How is it, senator'—hold the mike up to the cardboard; better still, let them come if you invite them—'How is it that spending $6 million now to fix I-80 is going to be impoverishing our grandchildren if the option is to spend $30 million if we wait two years?' That's not going to impoverish our grandchildren. Any business would leap at the opportunity to fix it now rather than later, if it had to be fixed anyway."

This is the dialogue that we have in the country now. I fault the media in large part for that. The media is not calling people out when they say things that make no sense whatsoever. They are so afraid that they'll be called partisan. It's not partisan to say that what somebody is saying is wrong. There are right answers in the world. The media has an obligation to do a little digging and offer their best interpretation of the facts and arguments.

So that's what got me up off the couch to write the book. I wrote a book in a similar vein long ago, in 1985. It was published in January. [Choosing the Right Pond.] I was very excited about the ideas. I thought, "Okay, it will take a while. Maybe by October or November there will be bills wending their way through the House and Senate to incorporate all the suggestions that I've made here." So far—it has been 30 years almost—nothing has happened.

I'm not naïve enough to think that writing this book is going to make a huge difference. But I feel better. I took a few swings at what I think are really just inane commentary that is passing for political debate today.

There really are much better options on the table. I'll close with the core policy recommendation in the book, the one I teased you with in the beginning.

Scrap the current income tax. Throw it out. In its place adopt a steeply progressive tax on annual consumption expenditure by the household. This is not a 9/9/9 tax or a flat tax, like we hear every four years from the candidates on the right. This is a progressive consumption tax.

The way it works: We would simplify the calculation of disposable income. The flat tax proponents say, "Oh, this will be so simple you can do your tax return on a postcard." No. What's complicated is how to compute your adjusted gross income. Once you've got that, you just look in the tax table. So simply that, yes. We need to get rid of all the loopholes and exemptions and deductions that have silted up in the 3.4-million-word IRS Tax Code, yes. So report your income in this simplified form. Then report how much you saved during the year—we know how to do that from 401(k) plans and IRAs. The difference between those two numbers, your income minus your saving, that's how much you spent during the year. That's the key step that makes this doable.

Then we take off the standard deduction—let's say $30,000 for a family of four—and that's your taxable consumption. The rates start off very low, but then they rise steeply, much, much more steeply than under the current progressive income tax, as consumption expenditure rises over the course of the year. So that if, for example, you were already spending $4 million a year, the marginal tax rate might be—hold your breath—100 percent, which means simply that if you spend an extra dollar you'd have to spend not just that dollar but an extra dollar for the tax on that dollar.

So you're thinking about putting an addition on your mansion, $2 million. What we know is that if it were more expensive, you would consider scaling back. New York is the evidence for that. Many people in this room could afford to build a much larger living space than you have, but you don't because in New York living space is expensive per square foot, and everybody scales back because of that. So if you were thinking about building an addition onto your mansion and you suddenly confronted a big tax on the expenditure, you would scale back. You and others like you would scale back.

And here's the magic step, the fiscal alchemy implicit in the tax: If everybody scaled back on his mansion, the smaller additions would serve exactly as well as the bigger ones would have, since it's relative mansion size that matters beyond some point.

Can I entertain in the manner that is expected for people in my circle? That's the question. I'm going to guess, if somebody knew the right answer, I'd be willing to bet my whole retirement account that if we compared two worlds—one where everybody's mansion was 70,000 square feet, one where it was only 30,000 square feet—the second-world people would be happier.

Think of the hassle of managing a property so big, all the tell-all memoirs you have to worry about, the security issues. If the only reason you need a bigger mansion is that people like you have one, then you can step back, all of you together, and be better off and put those dollars to better uses.

Don't cut the expenditures for the Energy Department's program to round up loose nuclear materials in the former Soviet Union, materials that are guarded by soldiers who drink too much, who don't get paid regularly. Those materials are going to end up here in New York if we don't get them locked down. We cut the budget for that program.

We can pay for all that stuff without giving up anything we value.

What about the CEO who had a $10 million coming-of-age party for his daughter here in New York a few years ago? Let's be charitable. Let's say he just wanted her to have a memorable occasion. Well, I guess he succeeded in grand style. But he raised the bar that everybody else has to meet now.

When I was at NYU [New York University] a few years ago I saw a clown going into one of the faculty apartment houses. What, we have clowns on the faculty now? I said, "No. That's a faculty member's ten-year-old who is having a birthday party, and the parents know that if they don't hire a professional clown or a magician the kids will be disappointed, because that's what they have become accustomed to."

The whole process of extra spending at the top spawned by extra income at the top has cascaded down, and now everybody has to spend more just to meet the standards of ordinary existence. The house you need to buy to get your kid into the average-quality school is 50 percent bigger now than it was 30 years ago, even though people in the middle don't have more real income than they did 30 years ago. That's waste.

It's exactly like shrinking the antlers, if you take steps to make it less attractive to spend in those ways and steer resources into other directions.

So it's a libertarian welfare state that I have in mind here. We are going to let the government get involved in trying to steer people's behaviors. We're going to just listen to the complaints about social engineering. Go to any right-wing website and you'll see invective about social engineering—"The government is trying to steer my behavior in ways I wouldn't have chosen."

That's what we do in society. When your interests are in conflict with the interests of the broader group, we try to steer your behavior in ways that are less in conflict. Stop signs, that's social engineering. Homicide law, that's social engineering.

If you are going to do social engineering, do it with the lightest possible touch. Tax people. Make the things that are too attractive to them less attractive by taxing them.

This worked in the environmental domain. When we taxed pollution, we got the cutbacks we were looking for at one-eighth the cost that it was going to take if we did command-and-control regulation.

So the fact that we are doing things so badly now is actually good news. It's bad news and good news. There is a huge bundle of cash on the table that we could harvest and put to better uses just by taking some simple steps to alter people's incentives about how they spend their money.

So that's the argument. I said I was going to do an argument on behalf of some fiscal alchemy. It rests on simple assumptions plus the extra observation that life is graded on the curve. If you have objections to any of those, I'm keen to hear them.

Anyway, I'm again grateful for the chance to speak to this august group. I welcome questions for whatever time we've got left.

Questions and Answers

QUESTION: Susan Gitelson.

Thank you for making the so-called dismal science so much fun.

But how would you apply this whole Darwinian approach of "survival of the fittest" to our current situation, where over the past 30 years or so the disparities between the rich and the poor have expanded so greatly and where there are incentives for financial types and corporate officials to compete with each other to get higher and higher and higher and higher returns, and at the same time most of the people in the middle and below are getting less? This is very disturbing, and we have riots in the cities and so forth. How do you explain this? What can we do?

ROBERT FRANK: That's a great question. The earlier book, The Winner-Take-All Society, was about why incomes have been concentrating so much at the top.

I think it won't do just to wag your fingers at the pay boards and urge them to hold back, any more than it would do to tell the hockey players, "Pull yourself together and wear helmets." I think these are for the most part market forces that are doing this.

I'll give you one example of it that illustrates the crux of the problem. We hired a new president at Cornell University a few years ago. His main job—and this didn't used to be the main job of our president—was to head the $4 billion capital campaign that was just launched.

We looked at hundreds of candidates. There was one in particular—his name is David Skorton—who stood out. He was charming. He was a distinguished scholar, a pediatric research cardiologist with a whole library of influential papers. He's a professional-level jazz clarinetist. The first time I met him he was playing with the New Orleans Jazz Orchestra in the State Theater in Ithaca.

We thought he would be better than anybody else we interviewed at leading that capital campaign. What does that mean? We wouldn't have had an opinion about the matter unless he'd be 3, 4, 5 percent better. We wouldn't have noticed.

So we hired him. Now I've heard him speak in front of alumni groups probably a score of different times. He is every bit as good as I imagined he would be. So if he is 3 percent better than the next-best candidate, $4 billion, that's $120 million difference on Cornell's bottom line. He doesn't get paid that much, I know that, and people are outraged that he is paid as much as he is, whatever that number is—which also I don't know, but I know what the number is for many other university presidents.

But the real mystery is how the bidding stops where it stops now. If you are talking about a corporation with $10 billion worth of annual earnings, somebody who is 1 percent better at guiding that ship is worth $100 million a year extra to the company.

So there is a going rate for the highly leveraged jobs. The going rate is very high. Now they fire you if you don't perform well in those jobs. You used to be able to keep them when the rate was lower, but they get rid of you quickly.

The only lever we have, I think, is the tax system. We could have much, much higher income taxes. People say, "Oh, then they won't come in to work." What a strange view of human nature that is. The 40 vice presidents who want to be CEO are going to knock off on Fridays and play golf if the tax rate goes back to what it was in the Clinton era? Come on, that's not the world we live in. We can tax them more.

The consumption tax, which I favor, would be an even more direct instrument to level the differences in consumption. I think it's consumption differences more than income differences that take a toll on populations.

So we could afford to have health insurance for everyone, we could afford to have better schools for people in the bottom half of the income distribution, if we had more revenue. I think the consumption tax is the best way I know of to get more revenue.

That, plus taxes on other harmful activities—carbon dioxide, congestion. New York, why don't you have a congestion tax? This silly thing, "Oh, then the poor can't get into New York." The poor don't drive in New York anyway. Have a congestion tax. Give them vouchers that they can sell on Craigslist that would let them drive into New York for free.

There are ways around the distributional concerns that are properly on people's minds.

QUESTION: James Starkman.

I would suggest that your system, if instituted, would be immediately regressive on the low-income people, who actually spend slightly more, run up their credit card bills, spend more than they earn or consume. I would suggest a progressive income tax allowing three deductions—mortgage interest, charitable deductions, and state and local bond interest. Eliminate all other loopholes. The $450 billion of uncollected taxes under the present tax system would virtually disappear. One-third of the budget deficit would disappear overnight under that system.

ROBERT FRANK: I'm very sympathetic to your suggestion. I think that tax simplification ought to be job one when we get to the question of how to reform the current system. That's the encouraging thing.

What was it that Herb Stein said? If something can't go on forever, it won't. The current situation is just not sustainable. We need more revenue. We need to simplify the tax system. So we will get to this.

But the whole point of the $30,000 standard deduction is to cushion the blow of this tax for the families you were worried about. They wouldn't pay any tax, people at the bottom of the consumption distribution. It's true they consume most of their income, or maybe even more than their income. But the $30,000 standard exemption is to cushion that.

Plus, the European countries all have a heavy value-added tax, which is regressive. The way they try to compensate for that is to put expenditures in place that are progressive. So you can make up for it in that way.

The other thing that I'd propose would be, as the first step, to adopt a progressive consumption surtax. Keep the income tax in place, simplify it as you suggest. But for families earning more than $1 million a year, consuming more than half a million dollars a year—and this is Larry Seidman's proposal at the University of Delaware—have a surtax on consumption above $500,000 a year. So that would be a step that we could take to ease this in.

And we wouldn't want to take that step now. The economy is in the toilet now. We don't want to curb any form of spending right now. Pass this law now, announce that you are going to phase it in gradually once the economy is back under 7 percent unemployment.

That would kill several birds with one stone.

    • You would send a signal to the deficit hawks, among whom I count myself as one, that you are serious about generating revenue to pay down government debt. It doesn't have to be today that we pay it down; it's a long-run problem.
    • You would as well stimulate a transfer of resources away from consumption that is not doing much for people into investment that would help the economy grow. That's a second benefit.

 

  • A third benefit would be that once people saw that this tax had been enacted and was coming, they would stumble all over themselves to build the additions they were thinking about building onto their mansions before the tax took effect. So you would get hundreds of billions of dollars of economic stimulus in the short run without the government having to spend a nickel.

That's a long-winded response, but basically I'm sympathetic to your point.

 

QUESTION: Robert James.

I'm an ex-professor but for 50 years I've been in business. So you can guess what my questions might be. I actually have a question, but would you believe I'm going to make a couple of comments about what you said before that?

You say that libertarians believe that taxes are theft and markets are perfect. I know a lot of libertarians. I know a lot of businessmen. I don't think that's what they say at all. I think what they say is that, "Taxes are irrational frequently and this is the way it should be changed."

I think that, dealing with markets, most businessmen and libertarians say: "Ah, markets are irrational and I'm going to work hard on it and change"—which is exactly what Smith says. And it makes the markets more efficient.

You also had something to say about Darwin. I'm no expert in Darwin. But you say, if you are better you win and if you are not better you lose. I read a different Darwin. A different Darwin said, "If you are losing you change; and, amazingly enough, you change fairly fast and you survive"—which also sounds very Smith to me.

So my question comes to this then: What alternative, in a few sentences if you can, do you have to Smith?

ROBERT FRANK: I should repeat that my target is not the libertarian but the movement libertarian. They are not one and the same person. The movement libertarian really does say the stupid things I attribute to him. Not your libertarian, I'll grant you that, or my friends the libertarians. But there is a lot of influence from the movement libertarians and their slogans on the current debate.

The Darwin I read is not the Darwin that celebrates anything that competition gives us as morally praiseworthy. I think there were a lot of people who missed Darwin entirely on that point. The social Darwinists of the 19th century, in particular, seemed to think Darwin thought that anything that survives in competition is good and we ought to celebrate it.

No. Darwin was a very humane man. He saw that the behaviors that were strongly favored by competition were often brutal and quite likely to cause misery for many individuals.

You think about—now I'm going over your two-sentence limit here—the alpha lion. The first thing the alpha lion does when he ascends to the leadership of the pride is he murders the cubs of the previous alpha male, just kills each of them. That brings the females into heat more quickly and serves his genetic interest. But it is a brutal thing to watch footage of.

Darwin knew that. So you can think about Darwin's theory as a theory of morality. All morality is about trying to rein the individual in when what the individual is wanting to do is harmful to the group. So I think we have a much clearer theory of why certain things are harmful to the group by reading Darwin.

Darwin's framework gives us a reason to doubt this general presumption that markets get it right. Markets reward what is in the individual's interest.

What is in the individual interest of somebody in the financial sector isn't necessarily in the country's interest. The sooner we abandon this a priori presumption that whatever the individual firm or person wants to do is presumptively in the public interest, the more quickly we will be able to think clearly about what sorts of incentives we want to confront people with.

QUESTION: Robert Shaw.

Given what you were saying about consumption and disparities in consumption being in your view a bigger social evil perhaps than disparities in income, and the necessary tendency for a consumption tax to be regressive, at least in terms of accumulation of capital, because the very wealthy won't be spending as much or consuming—

ROBERT FRANK: That's right.

QUESTION: —what are your views about estate taxes, the accumulation of wealth in one generation?

ROBERT FRANK: I wrote a piece about the estate tax years ago. I think it's one of the best taxes we have. You pay it after you're dead. It's painless, basically.

I think a good way to think about it is it's like a lawyer's contingency fee: you've got a good case against somebody who injured you; you don't have the money to hire a lawyer; the lawyer says, "Okay, I'll take your case, and if we win I get 30 percent, and if we lose you don't have to pay me anything."

So I want good public services, I don't have a lot of money, I'm in favor of the estate tax. Let the estate tax pay for some of the public services we all enjoy. Then, if I win, if my ship comes in, I'll be a contributor and I won't complain about that. But if I lose, I've gotten all these nice services that we all benefit from.

So I think the estate tax is an essential ingredient. I think it is widely believed to be unpopular for no good reason. I read the study by the political scientist Larry Bartels, titled "Homer Gets a Tax Cut." Why are 67 percent of the people in the bottom fifth in favor of eliminating the estate tax? That was the finding he reported.

I had Cornell's Survey Research Institute do a survey of my own about the estate tax. The first wave, I said, "What do you think about the estate tax?" They were told what it was and that there had been proposals to eliminate it. Seventy-five percent of the people we called in that survey said, "Yeah, it's a good idea to eliminate it."

Then I had them do a second wave, where they explained how much revenue would be lost after you describe what the estate tax, how much revenue would be lost if we eliminated it, and that that would require some combination of three things: (1) raising sales, income, or other taxes; or (2) cutting back on government services, and then some examples of ones that had recently been cut back; or (3) borrowing more money from the Chinese, Japanese and Koreans, which would have to be repaid in full with interest. "What do you think about eliminating the estate tax?" Seventy-five percent said, "No, don't eliminate it."

So I think when you ask a question like that, all you're learning is that people have a negative valance about the word "tax." "What do you think about the estate tax?" "Bad."

I think we should have a bigger estate tax. I'm guessing most of the people in this room think about the estate tax the way Warren Buffet thinks about it. If you have a kid who knows he's going to get a $10 or $20 million trust fund when he's 25, that kid is going to have a hard time taking the difficult steps you need to take to get a career off the starting line. It's tough to make your way in the world in a competitive market. It takes a lot of sacrifice and discipline. If you know you've got that money coming, you're not doing your kids any favor if you promise them all that. You can still leave a lot of money though. It's a good tax.

QUESTION: Jim Traub, New York Times Magazine.

First, I love the idea that I was thinking about the estate tax the way Warren Buffet does. That's a beautiful idea. I don't know that all of us here think that way.

Here's my problem with your very elegant consumption tax idea, which is there is a certain whiff of moral disapprobation about consumption. It's like a sin tax. We tax alcohol and cigarettes and so on, things that are not productive, like building another 10,000 square feet in your living room is not productive. So I suppose if you did this you would then eliminate a lot of this nonproductive consumption. People would save a whole lot more. They would consume a whole lot less.

But would that be good? That is, given how much we have a consumption-driven economy, given that we know of examples of countries that actually have too high a savings rate—like Japan, where you actually want more consumption—wouldn't you actually wind up driving people to do economically harmful things?

ROBERT FRANK: That's a question I often hear in response to this proposal.

I think the perception that you need a very high level of consumption to keep an economy vibrant is just incorrect. If you are in a downturn, we want to stimulate spending of any type. If you had a consumption tax like the one I recommend on the books, you would have a way more powerful instrument to do that when there was a downturn.

Suppose I have a consumption tax and we have a recession and I'm in the legislature. We say, "There is going to be a temporary suspension of the consumption tax. Money you spend this year won't be taxed under the consumption tax." Then people rush out and spend right away.

If you give a temporary reduction in the income tax, where does it go? Under the mattress. It's mostly saved because people are worried about the future. When you're in a recession, they don't spend their money.

China consumes 49 percent of its GDP; 51 percent is saved and invested. The household savings rate in China is 39 percent. They are growing 9 to 10 percent a year. You can have a vibrant economy based on investment. If you phase this tax in gradually, you would gradually see a shift.

And it's not finger-wagging about the big mansions. We have tried identifying specific luxury goods as being not important or things that we want to discourage. That's always a recipe for failure. Since the Middle Ages, governments have tried that. They outlawed gold buttons, so people just switched to fancy carved ivory ones. There's always something you can do instead of the thing that you tax.

This is a general tax on expenditures. If the eight-grade teacher loves Oriental rugs and wants to spend $30,000 on a specimen that she has saved her whole lifetime to buy, it's not taxed at a high rate. It's based on total expenditure, which would still be low for her.

All the tax presumes is that if you are already spending $3, $4, $5 million a year, the next dollar you were about to spend probably isn't very urgent. Does anybody think that's wrong? I mean deep in your heart, do you think that's wrong? That's not a judgment that consumption is bad or frivolous. It's just that when we all consume more in those kinds of categories, what we do mainly is raise the bar that defines what constitutes "adequate" for ourselves and others. So no, it's not a moralistic tax.

I like cool stuff. I buy cool stuff. The question is: How much do you have to spend to feel like you have something that's cool? That depends on how much others spend.

I remember driving a 1955 Thunderbird when I was a teenager and how thrilled I was to drive it. I went back and looked up the performance of that car last year when I was writing the book. It gets to 60 miles an hour from a standing start in 11.9 seconds. That would be considered laughably poor performance in today's environment. But I remember how thrilled I was at the time. In the 1920s, if your car got to 60 miles an hour eventually you'd be thrilled, never mind how long it took to get there. [Laughter]

Context matters. I lived in a two-room house in Nepal with a grass roof that leaked, no plumbing, no electricity. I never for a moment felt that the house was inadequate. I was a Peace Corps volunteer teacher. It was a nice house in that environment. If you lived in a house like that here, you'd be ashamed of it. Your kids wouldn't want their friends to know where you lived.

Context matters. It's not a judgment about your being a bad person because you spend a lot. No. I say that the people who wag their fingers at the consumption of the rich just suffer from a lack of perspective. They don't understand that every social circle has local standards that seem normal. If people have a lot of money, they consume more.

QUESTION: Edward Marschner.

I wonder if you would address the impact of your approach on the debate over social entitlements, health care and other kinds of so-called entitlements, that is such a trigger for the debate right now between the left and right.

ROBERT FRANK: We really do have a budget problem. Most of my closest political friends aren't as worried about it as I am. But if you keep on borrowing year after year, then you have to pay interest on that money, and pretty soon, if the debt gets big enough, a big chunk of your national income goes out the door before you have even bought anything for yourself. So I think getting expenditures in line with revenues is absolutely essential to do in the long run.

The right says they want to do that by cutting wasteful government spending. Every president in my lifetime has campaigned on a pledge to do that. Many of them tried sincerely to do it, some with more success than others. But every in single administration I witnessed, government spending went up.

Programs get adopted because constituents want them. They are very hard to cut. We should cut wasteful ones. But if you are forced to make across-the-board cuts, you cut ones that shouldn't be cut. I mentioned a few earlier.

The National Science Foundation budget was cut for basic research. That's our basic competitive life blood. We shouldn't be cutting that.

The whole infrastructure cuts, it's ridiculous that we are doing that. We need more revenue.

Six Republican members on the super committee. Each of them signed a pledge: "No new taxes under any circumstances."

The eight presidential candidates on the Republican side in the first debate—I listened—were asked: "What would you say to a proposal of $1 of tax increases for $10 of spending cuts?" One by one they said, "No good."

This is an economic train wreck scheduled to happen. And it doesn't have to happen. We can do better than that. But not until we are willing to talk about what to tax. We need to tax something.

Tax harmful activities, that's what we should be doing, activities whose spillovers cause injury to other people—congestion, pollution, noise. High-end consumption raises the bar that makes others have to meet a tougher standard given their income.

There's enormous amounts of revenue. These are taxes we ought to have, even apart from the need to balance the budget. We could give them all back as citizens' rebates if we didn't need to balance the budget. So whether or not we need it to do that, we should be taxing these things.

But we can't talk about it in the current political climate. If you talk about trying to make Medicare more rational, you get death panel insults shouted at you. You shouldn't be paying at public expense for open-heart surgery for 95-year-olds; that's not a good use of public funds. If you want to buy your own open-heart surgery you can, but it shouldn't be on the public nickel that you get that. But you cannot propose that or else you're a death panel advocate.

So yes, we need to get to the point where we can have a rational conversation about this, one that is dominated by a dispassionate weighing of the costs and benefits of the different alternatives we face, not one where the issues are simply dismissed by shouting a slogan. That was my goal in writing the book, to encourage that kind of conversation.

I must say I've met way less resistance from the right wing than I expected on this. They are quite willing to engage. I think they are surprised to see somebody from my side of the aisle willing to engage on their terms. So I give some ground, they give some ground.

P.J. O'Rourke and I have an op-ed coming out in USA Today in the coming days where we advocate sending a bipartisan commission into a room with the American Society for Civil Engineers' Report Card on America and telling them to identify the projects they don't think we should do right away, and then all others get the green light—$2.2 trillion worth of infrastructure. And then states and local governments scramble to get their programs funded first. They all get the green light.

So that's progress to me. It's not going to make a whole lot of difference in the short run. But I think you've got to try to change the conversation when you can. I don't have the kind of money the Koch brothers do, where I could change the conversation by giving out grants. But I can write and I can urge people to think in a different way about it.

At the very least, it felt good to do it.

JOANNE MEYERS: And we enjoyed listening to you. Thank you very much.

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