Economics usually assumes that all players in the economy act rationally. This is surely a fallacy but it’s not entirely wrong either. Certainly there is some sort of logic to the way people act, though every person may have her own logic based on the context of her life.

This introduction of context into economics is advocated by Robert H. Frank which is why I’m currently digging his work. Indeed my own work involves creating tools to track context in the “soft” sciences (to a degree: medicine, sociology, climatology, economics, etc.).

Clearly the value of goods depends on context. Many goods we would value as substandard in the US would be prized possessions in most of the rest of the world. A bedroom might seem too small in suburban America and too big in Tokyo.

However, our valuation for some goods depends more on context than for other goods. This can be illustrated with a thought experiment:

Say you can choose between two worlds. In world A, you will live in a 4000-square-foot house while the median house size is 6000 square feet. In world B, you will live in a 3000-square-foot house while the median house size is 2000 square feet.

Despite the fact that the absolute size is smaller in world B, many people would still choose it due to its relative size. People don’t buy bigger houses for the space so much as they buy the benefits of better schools, neighborhoods, perceived social rank, etc. that come from having a bigger house than everyone else.

But now consider this choice: In world A you have a 30 minute commute while the median commute is 20 minutes. In world B you have a 40 minute commute while the median commute is an hour.

Now most people would pick world A because it’s better in absolute terms, despite being worse relative to everybody else.

Obviously it’s not black and white like this, but the idea is that for some goods, context matters a lot and for others context matters less. Maybe a better example of the latter would be health care. If you could choose between a world where your life expectancy was 80 while the median life expectancy was 120, versus a world where your life expectancy was 60 but the median was 40, I think almost everyone would choose the first.

Frank calls the goods where context matters a lot, positional goods. His thesis is that positional goods lead to expenditure arms races which divert resources from non-positional goods, resulting in widespread welfare losses (that is, an inefficient use of our resources).

This certainly seems to be the case in the US. Goods whose value is largely determined by what everyone else has demand more and more of American consumption. Spending on houses, cars, clothing, home entertainment systems, etc. increases while spending on public transit, public health, education, etc. decreases.

This is not to say that consumers should have a moral responsibility to spend less on positional goods. We ourselves can choose to spend less but we can’t force others to spend less. And if buying the more expensive house is essential for a good education, or buying the more expensive suit is essential to land a job, then we certainly can’t blame the buyers.

In fact, we can’t even change the system. People will always compete, always find new ways to “keep score”, even if we were to ban houses above a certain size or the wearing of certain clothing at job interviews.

Instead what we want to do is keep the scoring systems, but just shift down across the board how much we spend on them.

To do this, Frank proposes a highly progressive consumption tax. This is absolutely not like FairTax, sales tax, VAT, etc. which are consumption taxes but which are regressive. The whole point of this tax is that as you spend more, your tax rate increases drastically. In Frank’s example, all money spent over $4 million in a year would be taxed at 200%, meaning you’d need $3 for every $1 of consumption above this amount. Rich people will still buy fancy stuff, but they’ll have an incentive to spend a little bit less. Frank argues that this will not cause them distress, since the money is being spent on positional goods. You can live with a 40 room house instead of a 50 room house, as long as all your peers are doing the same. And this wouldn’t just apply to rich people, everyone would cut down on conspicuous consumption.

Implementation of this tax system is surprisingly simple. All that would need to be done is to make savings exempt from income tax. We already do this for 401(k) accounts. Any money you put in the account is untaxed, and only when you take it out of the account is it taxed.

In other words, every year you report your income and you report your savings (as you would for a 401(k)). You pay tax on the difference (your consumption).

Such a tax was actually introduced into the Senate in 1995, and even had the obligatory cheesy acronym (Unlimited Savings Allowance tax), but never came to a vote due to Clinton vs. Republicans budget battles.

What would the effects of such a tax be on the current recession? Less money would be spent on consumer goods, but more money would be spent on capital goods (means of production) due to more money being saved/invested. Such a transition would certainly be delicate. The way to go would be to phase the system in gradually, by slowly increasing the maximum amount a family could put into their tax deferred savings account.

And once the system’s in place, the government would have a much more powerful fiscal tool to prevent future recessions than the current income tax. As it is now, government can temporarily reduce income tax (like last year’s “stimulus”) to try to incentivize consumer spending. But most of the money people get back goes into savings or paying off debt (which is just savings on a negative balance).

Contrast this with the consumption tax. In this scenario, when the government temporarily reduces the consumption tax, people can only benefit from this reduction by spending more now.

If you’re interested in this, I highly recommend Frank’s book Falling Behind. It’s very well-written, no economics background required, and also has lots of interesting data on American consumption trends, rising inequality, and some of the psychological/evolutionary causes of the positional vs. non-positional spectrum.

Spurred by some links from Economist’s View and some conversations with Yang about a highly progressive consumption tax, I have been reading some of economist Robert H. Frank’s editorials. The theme seems to be that government, and policy makers in general, have the imperative to eliminate or mitigate “smart for one, dumb for all” incentives.

Some examples of “smart for one, dumb for all” situations: at a stadium, one can get a better view by standing up, but if everyone stands up, then everyone has the same view as before but without their comfy seats. In athletics, one can gain an edge by taking steroids that may have some small probability of health risk, but if everyone takes the steroids, then everyone has the same relative standing but now all have the health risk.

I find the metaphor of an arms race most compelling.

Capitalism is all about competition (relative gains are rewarded). But there is a hidden assumption that improvements in relative value result in improvements in absolute value. In many cases this is true; companies compete to produce a higher quality product, or the same product for a lower price, resulting in value for the society as a whole.

Frank’s essays focus on situations where this assumption breaks down.

The relevant recent example is the rise and fall of the housing market in the US. There is growing competition between people to buy more expensive houses. Much of the motivation for this is as a display of social status (that is, consumerism in general). In addition, the best public schools are found in richer neighborhoods, and due to the growing importance of eduction, it’s rational for a family to try to live in the most expensive house it can afford.

But what’s good for one family is bad for society as a whole. Bidding wars result in home prices way above their value as shelter (this can be measured as the ratio of home prices to rental prices). One difference between the 1950s (the beginning of America’s recent prosperity) and the early 2000s is that lending rules became laxer (no/low down payments, for example), which allows home buyers to stretch to the very limit of what they can afford.

There is a symmetric story on the side of the lenders, where competition incentivizes fund managers to make riskier and riskier investments. Due to the lifting of regulations, lenders likewise take this to the limit.

The pattern:

A really excellent, very human telling of this story from the perspective of all players can be found in the This American Life episode, The Big Pool of Money.

Will post in the future about how this relates to Frank’s proposal of a highly progressive consumption tax.