Monday, November 21, 2011

The Problem with Wealth

The paradox of wealth

Didn’t know there was a problem, did you? But, there is. Wealth from the perspective of individuals doesn’t match wealth from a society’s perspective. That’s a problem.

The posting, “The 99%ers: Part 4, WEALTH DEFINED” provided a number of ways wealth can be defined and measured from the perspective of individuals. They all boil down to ways to value a future income stream. That’s fine for individuals.

Problem is: when a government starts handing out entitlements to income streams, they are creating wealth from individuals’ perspectives. That sounds great, but there’s a problem. They haven’t created an income stream from a society’s perspective. Economic growth, a society’s income stream, is the product of the inputs (factors of production in economics speak). Adam Smith’s WEALTH OF NATIONS used the idea to make his argument against the crony capitalism of his era. Embedded in his thinking one finds the idea of the productivity of the population (i.e., their ability to generate an income stream) is the wealth of a nation.

Here’s the paradox: some government actions that create wealth from individuals’ perspectives, actually decrease society’s wealth if not structured properly, and they seldom are structured properly. Clearly, we have entitlements that discourage work (e.g., facilitate retirement and reduce the urgency of work) and reduce capital formation (i.e., promote consumption and subsidize borrowing), and hold resources out of economic use (e.g., inhibit some uses of the environment and regulate working conditions). These all make sense, but if done without any thought to how their negative impacts can be offset or mitigated, they’ll fail.

All well and good you say. However, think for a minute: have you ever heard the people advocating the entitlements discuss how to structure them in a way that increases labor, capital, or even efficient resource utilization? To the contrary, they usually emphasize the opposite.

The economy has always had a secret weapon. Actually it’s not very secret to economists. Its significance has been measured. It appears as a residual in some classical production functions (i.e., the growth not explained by labor and capital). In alternative specifications of the production function is appears as a technology variable. Given the ambiguity associated with measuring labor and capital in ways that take into account quality changes, the uniformity in estimates is surprising. Any way one approaches it, the conclusion is the same: it is important, more important than the amount of labor or capital.

Despite volumes of debate and lots of analysis, how much various different factors contribute to the growth that labor and capital don’t explain is still an open question. Rule of law, scientific research, private ownership of the returns to effort, public health, literacy, even the rates of change in labor and capital, and a raft of other factors all contribute. So, policy makers get to rotate between different pet policies of the moment.

Ultimately, capital and labor are the only resources that one knows will have an unambiguous, direct connection to growth. Yet, policymakers find allocation entitlements much more enticing. So, much so that the policymakers will risk destroying society’s real income-producing capital for the temporary high of misleading the population into believing the policymakers have actually done something productive. The only thing stranger is the people let them do it (at least until the house of cards collapses).

However, the biggest paradox of all is politicians’ collective inability to realize Adam Smith was talking about the wealth of nations. Somehow, perhaps it’s the air in national capitals; politicians became unable to distinguish between the wealth of the nation and the wealth of the national government. They’ve proven amazingly effective at cultivating a similar line of “thinking” among academics and media elites. That, however, doesn’t eliminate the inevitability of the eventual failure of policies based on such nonsense.

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