Micro, Macro, and the Minimum Wage

Meme showing man in office with coffee mug looking skeptical saying "Yeah, I'm going to have to go ahead and disagree with you there."Economists disagree. It’s so common that there are jokes about.  For example,

If all of the economists in the world were laid end-to-end they would scarcely reach a conclusion.


Economics is the only field in which two people can get a Nobel Prize for saying the opposite thing.

Why?  I can’t explain all of economists’ disagreements here (I don’t have enough pixels!), but I can explain some of the disagreement over questions of raising the minimum wage.  There are numerous calls for Congress to raise the minimum wage, yet Congress has remained bitterly divided on the issue. Their disagree to a large extend reflects the disagreement among economists. To non-economists, the disagreement seems to either indicate that there really isn’t any science in economics and it’s all opinion, or that some economists must be lying or deliberating obfuscating.  In truth, though, there’s another reason for the apparent disagreement: the difference between micro and macro level economic analyses.

First, let’s establish some historical perspective on the debate. I want to clarify the difference between “normative” and “positive”.  Positive arguments are statements or conclusions about what the predicted effects of a proposal will be without taking a stand on whether those effects are desirable or tolerable. (note that the word “positive” here denotes “factual or likely”, not “good”) Normative arguments are when someone argues whether a proposal should be done. Normative arguments typically are based upon a combination of predicted outcomes and a value judgement as to whether those outcomes are desirable or tolerable compared to the alternative.  For a long time in economics, economists were actually largely in agreement on the positive science, or the predicted effects, of a rise in the minimum wage.  It was generally agreed that raising the minimum wage would give larger incomes to those who continued to work at minimum wage (i.e. low skilled) jobs but that the rise would decrease the numbers of those jobs and thus raise unemployment rates among those seeking low-skilled jobs. Historically the disagreement over minimum wage hikes was over the normative aspects: was the rise in unemployment and loss of jobs worth the increased incomes to others.

The agreement over the predicted positive effects wasn’t always unanimous. There have always been some dissenters. But in the early 1990’s Card and Krueger studied a “natural experiment” by comparing fast food restaurants on two sides of a state line when one state raised the minimum wage and the other didn’t. Their results started a fierce debate that still rages over the predicted effects of rises in minimum wages.  On one side there are now many economists who side with Card & Krueger in saying that raising the minimum wage, even if raised very significantly such as to $15 per hour from less than $8, will not decrease employment and will have a very large increase incomes. On the other side, maintaining the older stance are those such as Don Boudreaux who doggedly argue that any rise in minimum wage must increase unemployment significantly.  Like most topics in economics the practicality of measuring and analyzing the empirical data is somewhat equivocal.  Although there have been numerous studies since Card and Krueger that have buttressed their results, the empirical data along always leaves enough room for some argument.  So what does the theory say?

Don Boudreaux and others of the “increases in minimum wage MUST increase unemployment” camp, would have use believe that theory is unequivocal. The essence of their argument is that low skilled labor is a commodity sold in a market. It has a demand (firms want to buy it) and a supply (low skill workers want to sell it and get paid).  The wage that gets paid is the price of this labor commodity. The most basic supply-and-demand analysis tells us that if the government forces the price up somewhat artificially by setting a price floor (i.e. a minimum wage) below which transactions cannot occur, then there will a smaller quantity of hours of labor demanded. In other words, firms will hire and pay fewer workers. There’s often an appeal to the concept that if the price (cost) of an input or resource goes up, then the firm’s profits will go down and the firm will be less inclined to produce that good or service and therefore will buy less (hire fewer workers).

How can good theory-toting economists dispute this?  Isn’t it supply-and-demand, the most basic micro economic concept as taught in the first few chapters of any principles of econ text?  It’s easy actually. The key is that this supply-and-demand theory as argued against a rise in minimum wage has three major flaws. Two flaws are the result of the theory as applied being too simple (there’s more chapters in the micro text!) and the other  flaw reflects the difference between micro and macro in economics.

The first flaw in the simple supply-and-demand model application to minimum wage type jobs is that there’s really very little evidence that labor markets behave like commodity markets or that they conform to the assumptions necessary to use a supply-and-demand model.  Most jobs, including minimum wage jobs, are more like long-lasting relationships. They aren’t commodity, transaction based like a market for selling widgets or apples or even theatre tickets.  There are dramatic transaction costs involved. Put another way, it’s expensive to hire people (and to fire them and then replace them). Minimum wage jobs aren’t homogenous (they aren’t all the same) the way the theory requires.  Further, the wage paid affects the productivity of the worker, which in turn affects the value of that worker’s output to the firm. When the wage is boosted, workers work harder, stay longer on the job, quit less often, and gradually acquire more productivity and skills. Firms often find that when forced to pay the higher wage, the firm’s total costs, including hiring costs, etc, stays level or even declines.  This is the essence of Arindajit Dube’s studies.

The second flaw is in focusing on the cost of the worker’s wages as if it were the sole consideration in the firm’s decision of how much to produce. The standard theory of the firm and production, which is covered in-depth just a few chapters later in the same economics textbooks after the supply-and-demand model makes it clear:  a firm will produce whatever quantity makes it the most profit. The primary constraints on the output are the demand for the end product, the pricing of the end product, and the core technology used. In other words, if the firm can still sell the output to consumers, it will produce it and the technology (means of production) will require it to hire the necessary labor. A rise in the price of a particular input does not necessarily mean a drop in the quantity produced.

The other two flaws in the arguments against minimum wage increases require shifting to a macro perspective. Micro economics is often described as studying individuals and individual products/markets.  That’s only partially true. Actually micro is a methodology. It’s more properly called “comparative statics using partial equilibrium analysis”.  Micro theories and models explicitly focus on only one particular shifting variable (the wage in this case) and it assumes that all other variables or influences are held constant or unchanged. (Economists call this the ceteris paribus assumption).  In contrast, macro theories are often described as focusing on large aggregate phenomena such gross national product or the inflation rate or the national unemployment rate.  But again, there’s actually a methodological difference. Macro theories require a general systems approach accounting for multiple effects and ripples of many variables that are interrelated.  Let’s look at minimum wage increases as an example of these differences in methodology between macro and micro.

In micro, there’s really only the price (i.e. the wage itself), the quantity of jobs offered, and the quantity of workers available, all of it in the low skill arena.  That’s it. So the micro analysis sees that when the minimum wage is boosted, the firm pays more per worker and each employed worker gets more. End of story.  The only micro question is how it all affects the quantities of jobs.

Macro, however, recognizes that nothing happens in isolation in the economy. There’s a circular flow. Workers are also simultaneously customers. So when the minimum wage goes up, yes, the workers get paid more and firm pays out more money. But what do those workers do with the additional money income? They buy things. Who do they buy them from? Firms that sell and produce products. So the firms not only pay out more money to workers, the firms also get to collect more money by selling more to the increased consumer demand.  But, you say, Acme’s newly enriched minimum wage workers don’t buy that much stuff from Acme. Doesn’t matter. The workers spend it somewhere. And that firm uses the additional money and additional demand to buy more inputs and pay more profits. And those firms and workers then experience income increases and so on and so on as the money circulates throughout the economy. Eventually even Acme sees an increase in sales and revenue collected which in turn helps pay for the wage boosts.  Macro looks at the whole system.

In recent years, many cities and some states have taken it on themselves to raise the minimum wage, often to a so-called “living wage”.  The empirical results have pretty clearly supported the macro analysis. Rises in minimum wages tend to not depress employment and actually tend to stimulate the local economy.  This is the macro analysis.

Sometimes economists just disagree and sometimes they let their ideological and political biases color their professional arguments. Some of that happens in the debates on minimum wage increases.  However, much of apparent disagreement arises from the choice of whether to view the issue through a micro lens or a macro lens.

To read more about the economic analysis of minimum wage increases see these earlier posts:



Some Links on Economics of Immigration

These are some links and key points on the economics of immigration for a guest talk I’m giving to a class tomorrow.

Links on Minimum Wage

A few minimum wage links to use in my guest lecture/discussion with Professor Reglin’s classes tomorrow:


Taxes, Incentives, and Being Poor

Now Updated with proofreading!

Political debates about taxes and tax rates in the U.S. often focus on the rich and claims about the incentive effects of different tax rates. Rarely mentioned these days are the poor.  Indeed, the Republican demands in the last few years that tax rates should be cut  for the high-income rich are primarily about claims of incentive effects. And, no, high-income rich isn’t redundant; it’s precise.  There are at least two types of “rich”: High-income rich, which pay income taxes, and the high-asset, low income rich which pay much less. (I suppose there’s another type, the spiritually-rich, but that’s the domain of some other blog.) The claim is made that if tax rates are raised or raised too high, then that provides a disincentive to work and the rich will not work as much. It is often asserted that this is simple micro-economics–that people respond to incentives–and should be obvious.

There’s a problem with the claim, though.  Actually there are two problems. First, there’s very little empirical evidence of higher tax rates on the highest end, the rich, actually reducing their efforts to earn income.  Indeed, numerous studies (I don’t have time at the moment to look for citations) have found in “natural experiments” that the rich really don’t respond to higher tax rates by working less and earning less. Several studies have found that in situations where a large metropolis straddles two or more states, such as NYC, and different neighboring states changed their tax rates on the rich, the rich did not in fact do what they threatened or what would appear “rational”: move to the lower tax state in the same metro area.  There’s also substantial longitudinal evidence in the U.S. and other countries that shows when tax rates on the rich were a lot higher, such as in the 60’s and 70’s, effort and incomes were no less than in more recent times.

The other problem is the whole idea that the “rational” response to higher tax rates is to reduce one’s effort and income actually doesn’t hold microeconomic water.  It’s actually irrational to respond that way unless the marginal tax rate is truly so high that it approaches or exceeds 100%. The average tax rate, the percents you normally hear on TV, isn’t what affects incentives. Instead, it’s the marginal rate, or how much an extra dollar earned is taxed, that changes how we behave. Even then, a raising a marginal tax rate might reduce the incentive or attractiveness of additional effort and gross income, but won’t become a true dis-incentive until it becomes very, very high. An example:  Let’s suppose someone makes $1,000,000 a year and is taxed $400,000. Such a person is said to pay a 40% average tax rate or effective tax rate. But averages and effective rates tell us nothing about incentives.  Incentives deal with changes in behavior at the margins – the incremental changes.  If micro is clear about one thing and has been since the 1870’s, it’s that decisions and changes in behavior depend on changes in marginal costs and marginal benefits.  What matters is the taxes on the marginal, the incremental, change in income.  What matters is the marginal tax rate.  The only reliable way to figure the marginal tax rate is to compare two different amounts of income, preferably with only a small difference between them, the taxes paid and the after-tax-income that results.  What people work for is to get after-tax, spendable income.

So let’s continue the example.  Suppose the existing tax code, with all of its exemptions, deductions, rates, credits, etc, says that $1,000,000 income pays $400,000, but that $1,010,000 income pays $405,000 in taxes, then we have an increase in income of $10,000 of which $5,000 is used to pay the additional taxes. After-tax income rises from $600,000 to $605,000, leaving a net increase in after-tax income of $5,000. This means we have a marginal tax rate of 50%.  There be a disincentive effect only if opportunity cost (usually leisure) of the additional time/effort needed to generate the higher income is judged to be greater than the $5,000 increase in after-tax income.  Empirical evidence indicates that is not likely.  On the other hand, if the marginal tax rate were 100%, it would mean that $1,010,000 in income requires $410,000 in taxes. At a 100% marginal tax rate none of the additional effort results in more after-tax spendable income, so obviously it doesn’t make sense to exert the extra effort.

So what are the marginal tax rates for the highest brackets in the U.S.?  Even if all income comes from wages, the highest marginal rate is now around 38%.  Even if you include state or city income taxes, the marginal rates faced by the rich aren’t greater than 50% even in the most onerous tax-happy states. For the really rich, most income comes from capital gains and not wages.  Capital gains have a much lower marginal tax rate of close to 23-24% (including the 2013 Medicare tax on capital gains).  Evidence is pretty clear that such marginal rates do not provide a disincentive to additional work.

But, now I want to return to the poor.  We often assume that the poor don’t pay much in taxes.  That’s true in total  since they’re poor–there’s not much there to tax. But, marginal tax rates still exist. And they affect incentives.  In fact, it’s the working poor that face the most serious disincentives to work and earn income.  Our tax code is actually set up to make it rational for the poor to not try to earn more income!  As University of Southern Cal Professor Edward McCaffery notes on CNN.com,

…some of the working poor face marginal tax rates “approaching 90% as they lose benefits attempting to better themselves.”

Readers were incredulous, asking how it could be that in a nation with a top federal income tax rate of 39.6% on individuals making more than $400,000 a year, anyone could face a 90% rate.

It is true. Marginal tax rates, especially for those below the top rate brackets, are chaotic, confusing, and all over the map.

As a result, some of the working poor face extremely high rates on their next dollar earned. Tax scholars and economists have long known this. Dan Shaviro of NYU published a study in 1999 showing marginal tax rates above 100% on the working poor; specifically, he illustrated that a single parent earning $10,000 would lose over $2,500, after taxes, by earning another $15,000, pushing her income to $25,000.

Obviously, this is a policy failure.  We want to support the working poor, but we want them to be able to increase their incomes, join the middle class, and leave dependency behind.  Yet the way most welfare and aid to working poor programs are structured, a working poor person can find themselves in a situation where working additional hours or getting a modest raise in wage will actually result in less after-tax spendable money.

The problem is even worse, as Professor McCaffery points out.  The tax code exerts a genuine disincentive to getting married or to staying married if you are among the working poor.  Yet, we know that stable marriages and two-income households are often the key to escaping poverty for both the present and next generations .

It’s appropriate to talk about the incentive effects of tax rates.  Incentive effects should be part of the thinking when writing the tax code, just as reasons for government revenue should be a part.  But when we talk about incentive effects of tax rates, we must focus on the marginal rates and we really should be talking about the poor.  Not the rich.

Student Debt + Stagnant Real Wages = Colleges Need to Focus On Student Success

Today’s post is an excerpt of something I wrote for another site.  This year, in addition to my teaching duties at the college, I’m leading a project to update our college strategic plan.  As part of that project I’m writing and editing a series of “briefing papers” (long blog posts, actually) about issues of strategic importance to the college’s future.  When those papers cover a topic that I think might be of interest to econproph readers I’ll cross-post them. Last week I wrote the following about the student debt explosion in the U.S., the stagnation in hourly wages for those for with less than college degrees/credentials, and the implications for those of us who work in higher education.  The full original post is here.

America has a student debt problem.

And it’s growing. According to the statistics assembled by the New York Federal Reserve Bank, theU.S. Dept. of Education, and other sources, total student loan debt outstanding is nearing $1 trillion, easily exceeding the $791 billion in total credit card debt.  As disturbing as the total might seem, the growth rate of student debt is even more distressing.  This graph, first published by The Atlantic last summer from NY Federal Reserve Bank statistics shows the relative growth  (not amounts) of outstanding student debt since 1999 compared to total household debt including mortgages. FromThe Atlantic:

The red line shows the cumulative growth in student loans since 1999. The blue line shows the growth of all other household debt except for student loans over the same period.

crazy student loans 2011-q2.png

This chart looks like a mistake, but it’s correct. Student loan debt has grown by 511% over this period. In the first quarter of 1999, just $90 billion in student loans were outstanding. As of the second quarter of 2011, that balance had ballooned to $550 billion.

The chart  is striking for another reason. See that blue line for all other debt but student loans? This wasn’t just any average period in history for household debt. This period included the inflation of a housing bubble so gigantic that it caused the financial sector to collapse and led to the worst recession since the Great Depression. But that other debt growth? It’s dwarfed by student loan growth.

Roots of the Problem

The student loan debt problem has many roots, most of which [colleges] cannot change or directly affect.  Causes of the explosion in student debt include:

  • A long-term shift in U.S. political opinion away from thinking of higher education as a public good with direct funding support from government toward thinking that students should pay for their own educations with loans guaranteed by the government.
  • Tuition and fee increases in higher education (particularly at 4 year schools and especially at private schools) have outpaced inflation for at least 3 decades, driven by cost increases, stagnant productivity, and reduced government direct funding.
  • Middle class real incomes have been largely stagnant or only modestly increasing for those same 3 decades, limiting the ability of families to pay dependent students’ tuitions.
  • The collapse of the housing price and mortgage bubble in 2006-07 which limited the ability of many middle- and working-class families to finance college education through home equity loans.
  • High unemployment rates since 2008 have limited the ability of students to work while in college and have also sent increased numbers of unemployed back to college.

 most community colleges can be a partial solution to the nation’s growing student loan burden.  After all, [community colleges are] one of the most cost-effective providers of the first 2 years of a college education.  Indeed, students can graduate with a bachelors’ degree with less total indebtedness if they take their first two years at community college and then transfer.

But the growing student loan problem when combined with another trend has even more significant implications the community college mission.

The Long Term Trend on Real Incomes – A Closing Middle Class

Long term trends in incomes in the U.S. including increasing income inequality have become a news headline topic in recent months.  …  Cumulative Growth in Hourly Wages, 1979-2009, by Level of EducationAs this graph from  the Congressional Budget Office (via Paul Krugman) shows, over the past 30 years the clear trend in hourly wages for workers with less than high school or only high school education has been negative. A high school graduate now earns 10% less per hour in inflation-adjusted dollars than they did 30 years ago.  Even workers who only have some college but haven’t completed a formal degree or credential are either negative or at best, even with 30 years ago.  The data in the graph is from 2009 and labor market conditions have not improved since then.  Indeed, most labor market economists, myself included, expect little to no improvement in wages or employment rates for many years to come.

So what does this mean?  It’s clear that for young and middle-aged people, the route to a rising income and participation in the middle class requires either a college credential or advanced degree.  Yes, anecdotal exceptions are always possible such as the stellar young person who becomes a big success in sports or entertainment. But the numbers are clear – for virtually all, membership in the middle class in the future requires succeeding at college not just attempting college.

Implications for LCC and It’s Mission

The mission of LCC and community colleges in general since they were created has been to provide access.  The great post-World War II expansion of community colleges in the U.S., of which LCC was a part, was based on the idea that broad, democratic access to higher education was important.  Community colleges provided access to college for millions who otherwise couldn’t attend, either because of costs, lack of family support, family/work obligations, location, lack of preparation, grades, or other circumstances.  Over time community colleges have expanded programs to help  increase access to even more individuals.  Indeed, this open-door, democratic access mission is a large part of the motivation for many who work at LCC.  Providing access is something we could feel good about.

But let’s consider how access has traditionally worked.  LCC, like most community colleges, has focused on providing the same basic instruction and learning that was available at 4 year institutions.  The difference was we had an open-door. We provided access.  We provided a chance at college and greater income and success in life. But it was always considered up to the student to succeed. The historical model is the college provides the student a chance at success. If they didn’t succeed that was their problem.  We measured our success by our enrolments as an indicator of the number of people to whom we had provided access.  Thirty years ago, if a student attempted college and didn’t succeed it didn’t carry the consequences it does today.  Thirty and forty years ago, a student who failed at college or simply didn’t complete could always get a job in a factory or a trade. They could still make a middle-class life despite not succeeding at college.

Now the trends tell a different outcome.  If a student doesn’t attempt college at all, they are likely not going to stay in the middle class at all and will likely experience declining real incomes.  The big change is if the student does attempt college but simply doesn’t succeed or complete, today their prospects for staying in the middle class are slim.  Successful completion of a college degree or credential has become a requirement now for a middle class future. It’s necessary for young people in particular to attempt and succeed at college now.

But now let’s add the student loan issue.  Suppose a person attempts college today but doesn’t succeed. Not only are they faced with the prospect of flat to declining real income, they have a significant burden – their student debt. Under current law there are really only two ways to discharge student debt – either pay it or die. Student loans cannot be discharged in bankruptcy. There’s no asset to sell or foreclose. So today’s student is facing a higher risk environment than their predecessors did in previous generations.  Instead of access to college being a chance at a better life, it’s now a high-risk necessity.  So it’s not just access; it’s success that matters.

The governments, both state and federal, are paying increasing attention to success rates.  As mentioned in the first briefing paper, state governments, including Michigan, are increasingly looking at funding for higher education in terms of how many successful credentials or degrees does it produce, not just how many seats in classes were offered.

Beyond what the government is requiring, the success issues pose a challenge to our understanding of our core mission and how we measure our institutional success. In today’s environment, providing access to large numbers of students without regard for their success is playing a cruel joke on them.  It’s teasing them with dreams of a future many of them won’t achieve and then punishing them with a burden of debt.  For those of us in the institution, that’s not the motivator that the original access mission was. We need to adjust our sense of the mission.  Yes, access is important, but it needs to be successful access.  Successful access as a mission changes many things.

It changes our most basic metric of institutional success. Instead of simply enrollment growth showing institutional success at providing access, we now need to consider whether that access was successful. …But measuring success and access are one thing. Improving them is another. The shift to successful access calls for many changes in the organization, it’s processes, systems, the curriculum, teaching methods, support services, and attitudes. It is not easy or simple. It is very challenging.

Religion, The Stock Market, and the Search for Meaning

People want to understand phenomena.  We want explanations for what happens. Journalists, especially TV and radio journalists, want explanations that can be summarized in 1-2 sentences in a sound bite.  Randomness is pretty scary.  And anything that’s too complex to understand easily looks a lot like randomness.

So what triggered this little nugget of metaphysical social observation in an economics blog?  Reporting on the stock market!  Everyday we (those of us who read, listen or watch the news) are treated to not only reports of what the major stock market averages have done that day, but we’re always given a simple and easy explanation.  Just look at today in the NYTimes.  I’m not trying to pick on The Times, it was just the first thing showing on Google Finance as I wrote this – any source, any time and you’ll get similar simplistic explanations.

The move announced by central bankers on Wednesday to contain the European debt crisis led to euphoria in global stock markets…

Krugman posted this evening that he didn’t understand it.  But he approached it from the standpoint of “does this action by ECB make economic sense that should improve stock prices?’.  I think he’s right that it doesn’t make sense, but I think he misses a bigger point.  It’s foolish to try to attribute the movements of stock market averages on any given day to the any particular sentiment of investors or any particular logic of rational investors.

The markets are huge.  We’re talking hundreds of billions and trillions of dollars in trades. Daily volume is in the billions of trades everyday. It’s complex, folks. The reasons these trades happen and why they happened at the prices they did are really, really complex.   It’s kind of like ancient peoples trying to understand the stars and without even a telescope or any calculus! Unfortunately, like them, we want simple explanations.  So we invent them.  And like ancient peoples we make sure our explanations support and reinforce whatever religious or superstitious beliefs we have.  [readers are advised not to try to decide what my spiritual beliefs are based on that sentence – it’s complicated].

There is a belief that supports much of this daily “this is what the market did and why” reporting. It’s actually based on the theory that markets are rational and “efficient”.  There’s an economic theory that holds that prices in financial markets accurately reflect the current state of all known information and news regarding the future flow of earnings and profits from firms.  It’s demonstrably false, but it has quite a following among neoclassical economists.  It cannot be proven and evidence exists to contradict the hypothesis (see Quiggin’s Zombie Economics), yet it’s taken as article of faith among many, many economists.  So much so that some non-believing economists have begun to refer to neoclassical economics as theo-classical.

The whole idea that there’s a single sentiment or key piece of news that drives the stock market each day is made even more absurd when we realize that most trading isn’t even being done by humans!  The significant majority of all trades are done by computers based on algorithms such as “buy this if the price has moved x in the last y seconds”.  Even more of the trading is done by casino-oriented short-term trading by large banks and hedge funds who are only trying to figure out what they think the other traders are going to do a few seconds before they do it. (also known as Keynes’ beauty contest).

Markets are the collective, sum judgement of lots of complex decisions.  Even if all the individual decisions were rational, there’s still no reason to believe the aggregate outcome can be represented as the decision of some hypothetical rational being.  So next time you hear or read some talking head pontificate that “the markets are saying…..”, just remember there’s little difference between that modern commentator and some ancient priest in long gown claiming that “the gods are saying….”

Is The Fed Corrupt or Captured?

Yesterday I responded to a reader who asked if “The Fed is out of control”.  In short, I said no, not in the sense that critics have charged them with “out of control printing of money” that could produce inflation.  But I left the post with an acknowledgement that the secrecy of The Fed carries some risks.  I said:

…it is unseemly for The Fed to be able to make large loans on favorable terms to banks, loans that save those banks’ managers from failure, without any sunshine or transparency.  It makes fertile ground for corruption.

Today I want to look at the question of whether The Fed, as it is currently constituted, is corrupt.  The Fed has generated a lot of populist anger.  A quick Google search for “end the fed” turns up over 8 and 1/2 million results.  A lot of people seem to feel there’s something wrong here with The Fed, even if they can’t pinpoint what it is.  Typically the charge has been that The Fed has been guilty of creating (“printing”) money too fast and producing inflation.  We’ve seen that’s not true.  Inflation is not our problem and hasn’t been for 20-30 years. Nevertheless, many people feel there must be something wrong.

I tend to agree. First, let’s define corrupt.  From Webster’s online, we see two possible meanings for corrupt:

1…   b : characterized by improper conduct (as bribery or the selling of favors) <corrupt judges>…

3.  : adulterated or debased by change from an original or correct condition <a corrupt version of the text>

Going by this definition, The Fed is corrupt.  It’s characterized by improper conduct and it’s debased from a correct condition (although the original condition wasn’t much better).  Let’s take a closer look to understand problems better.

I’m not accusing The Fed or Fed officials of outright petty bribery.  I don’t think anybody has directly paid off Fed officials or promised personal gains in return for Fed decisions.  It’s more complex than that.  The Fed has become the subject of regulatory capture.  Regulatory capture occurs when an agency of the government is initially established to regulate or control the excessive behavior of some industry.  But then, over time, the industry captures the hearts, minds, and ideologies of the regulators.  The regulators come to function as the protectors and servants of the industry they were supposed to regulate.  Regulatory capture is common anytime the industry involved is complex and technical.  Experts have to be hired as regulators but the best source of experts on the industry is the industry itself.  The problem is made worse when the regulated industry is able to pay much higher salaries than the regulatory agency.  Wikipedia tells of a few examples from The Fed:

Federal Reserve Bank of New York (New York Fed)

The Federal Reserve Bank of New York is the most influential of the Federal Reserve Banking System. Part of the New York Fed’s responsibilities is the regulation of Wall Street, but its president is selected by and reports to a board dominated by the chief executives of some of the banks it oversees.[39] While the New York Fed has always had a closer relationship with Wall Street, during the years that Timothy Geithner was president, he became unusually close with the scions of Wall Street banks,[39] a time when banks and hedge funds were pursuing investment strategies that caused the 2008 financial crisis, which the Fed failed to stop.

In the wake of the financial meltdown, Geithner became the “bailout king” of a recovery plan that benefited Wall Street banks at the expense of U.S. taxpayers.[39] Geithner engineered the New York Fed’s purchase of $30 billion of credit default swaps from American International Group (AIG), which it had sold to Goldman SachsMerrill LynchDeutsche Bank and Société Générale. By purchasing these contracts, the banks received a “back-door bailout” of 100 cents on the dollar for the contracts.[40] Had the New York Fed allowed AIG to fail, the contracts would have been worth much less, resulting in much lower costs for any taxpayer-funded bailout.[40] Geithner defended his use[40] of unprecedented amounts of taxpayer funds to save the banks from their own mistakes,[39] saying the financial system would have been threatened. At the January 2010 congressional hearing into the AIG bailout, the New York Fed initially refused to identify the counterparties that benefited from AIG’s bailout, claiming the information would harm AIG.[40] When it became apparent this information would become public, a legal staffer at the New York Fed e-mailed colleagues to warn them, lamenting the difficulty of continuing to keep Congress in the dark.[40] Jim Rickards calls the bailout a crime and says “the regulatory system has become captive to the banks and the non-banks”.[41]

Regulatory capture isn’t limited to only the possibility that a regulators’ decisions might be influenced by their personal future employment prospects.  It also involves ideology and group think.  The regulators spend their time, both professional and personal, mixing with the regulated.  They come to think alike.  Professor Steven Davidoff writes at Deal Book:

Instead, we have ideological and social capture of the top regulators. This is an issue that trumps what can be a model regulator at the bottom where the line people are quite competent, able and uncaptured, but the message from the top skews their effectiveness….

For an example of social capture at the top, one need only look at the publicly available calendars of Treasury Secretary Timothy F. Geithner and his predecessor, Henry M. Paulson Jr. The people regulating the financial industry largely come from that industry or look to that industry for their social interactions. They play squash with them and dine with them, and these are the peers they look to when they have issues to discuss. Jo Becker and Gretchen Morgenson of The New York Times documented this ably in their April 2009article on Mr. Geithner’s social interactions during his time as head of the Federal Reserve Bank of New York.

Lawrence H. Summers may not be as social, but even he worked at a hedge fund in the year leading up to his current position in the White House.

Among these people, there is no evil or nefarious plot to regulate in favor of the banks. These men and women may believe they are doing their best, but their worldview is affected by the people they interact with. This is a problem that can be exacerbated by a revolving door between finance and regulators.

This social influence can be affected by an additional factor: ideological capture also at the top. This occurs when regulators are appointed who share the same beliefs and ideas as their industry. A prime example of this is Alan Greenspan, the former Federal Reserve chairman, who was a devotee of Ayn Rand and objectivism and a fierce devotee of free markets. He no doubt was acting in good faith and true belief; the financial industry benefited from the fact that he shared their ideology

James Kwak and Simon Johnson, the authors of the book 13 Bankers, have written extensively about the regulatory capture of The Fed and the resulting improper conduct and debased condition of the world’s largest central bank. The book is worth checking out, as is their blog The Baseline Scenario.  Bill Moyers interviewed them for PBS on these topics. You can watch the video or read the transcript here.

The evidence is extensive that The Fed has become captured by the very banks it is supposed to regulate.  The Fed now sees it’s mission as first and foremost as protecting Wall Street, the banks, and the financial system.  The audit of The Fed in July 2011 confirmed that problems existed with conflicts of interest:

The audit also found that the Fed mostly outsourced its lending operations to the very financial institutions which sparked the crisis to begin with, and that they delegated contracts largely on a no-bid basis. The GAO report recommends new policies that would eliminate such conflicts of interest, and suggests that in the future the Fed should keep better records of their emergency decision-making process.

It was evident before that.  I March 2010 I recounted how Nobel-prize winner Joseph Stiglitz accused The Fed of being corrupt and said if a developing nation had a central bank like The Fed, we’d pressure them to change.  So, yes, The Fed is corrupt because it has been captured.