krebscycle

Conventional economics used by everyone from Paul Krugman to the wacknuts at the Chicago school is based on the assumption that people who participate in the market all act to maximize their income. There are a lot of problems with this assumption, but it’s fundamental to conventional economics and it’s just as fundamental that conventional economists sneakily drop the assumption when it would lead to conclusions they don’t like. The obvious example is that it’s easy to show that high personal “marginal” tax rates would prevent the kind of crazy risk taking that caused the current financial crisis. Since high marginal tax rates are “socialism” (as practiced by Dwight Eisenhower), our brilliant economists use a sleight of hand so open that would embarrass a synthetic CDO trader on Wall Street. They pretend that corporate managers care about maximizing profit for the collective (the corporation) and not for themselves.

Let’s do one of the dumb probable value calculations so beloved of financial analysts. Suppose a medium size firm has say five possible results in a year ranging from losing $500M (fail) to making $500M (jackpot). Let’s suppose a manager has to decide between two strategies. The safe strategy gives up the possibility of a jackpot to avoid the possibility of big losses. The casino strategy is the opposite. Filling in some numbers we can get a probable value of a profit of $32M for the safe strategy and a loss of  $228M for the casino strategy. Obviously, the firm is better with the safe strategy. I’ll give you the exact numbers at the bottom of this note.

But suppose the manager is paid a 3% bonus on profits and let’s do a simplified tax model of %10 taxes on profits over $250,000 and no taxes for under $250,000. The same calculation reveals the manager will nearly quadruple his or her expected take home bonus from $400K with the safe strategy to about $1.5M on the casino strategy. And that’s just probable return – if he or she lucks out, there is $13M+ in the bonus pool. So it’s a no brainer! Probable outcome $1.5M and best of $13M is a lot better than probable $400K and best option $565K (since the safe option makes jackpot case impossible).

On the other hand, if the marginal tax rate is bumped up to 90% – the Eisenhower rate, the expected result is just about the same for both strategies. With nothing to win, the manager will have no motive to pick the casino option.

Multiply by 10 or more and you get wall street type numbers. Of course, this type of expected value analysis misuses probability theory in the most atrocious way, but people use them anyways.  And it’s possible that people will still want to take on wild risk in hopes of wild returns. Nothing inherently wrong with that. But one of the features of our financial crisis is that pension fund managers and bank managers who were both specifically required to find safe business plans and to stay away from casinos managed to convince themselves that things like synthetic CDOs were safe. The quick analysis done here shows why high marginal tax rates are essential then in any economy that, like ours, has financial managers in custodial roles. But you won’t find such analysis from many conventional economists because they smoothly drop the card that says “interests of the firm” from their sleeves while palming the card  marked “interests of the person”. As a result, they are gobsmacked, surprised, and positively shocked that there is gambling in this establishment. But at least they do not have to embrace the grim Stalinist economics of Dwight Eisenhower and his even more communist Vice-President! Golly, that would be unthinkable.

Here are my assumptions
5 outcomes: (500,000,000)     Even      20,000,000      100,000,000      500,000,000

Safe strategy probabilities
0    0.2    0.6    0.2    0
Note we’re living with 60% chance of minimal profits.

Casino strategy probabilities
0.6    0.1    0.1    0.1    0.1
Note we’re living with 60% chance of catastrophe in order to get that 10% chance of jackpot.

Final note:
In defense of Paul Krugman, in my opinion as he works as a political analyst, he’s become in practice more skeptical of the counter-factual traditions of his discipline.