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Why is the middle a tough place to operate?

For any given product, one can usually find businesses that succeed on either end of the quality spectrum. On the lower end of the quality spectrum, successful firms use scale in order to produce the simplest, cheapest version of a product. On the other end of the spectrum, success depends on producing the best possible product while charging a price that more than offsets a lack of scale. Businesses that attempt to sell a product in the middle of the quality spectrum tend to struggle because it is not possible to offset the advantages of scale without charging a disproportionately higher price. All of this begs the question: could a company successfully produce a mid-tier product simply by applying the advantages of scale to additional features? The answer is no, for two reasons that are related. First, it is difficult to offer new features while taking advantage of scale because scale requires simplicity. Second, the moment a firm successfully incorporates a new feature into their production process without adding significant marginal cost, competitors will simply incorporate that same feature into their own production process and offer the same product at a lower price again. In essence, every time a firm successfully accomplishes this goal, the low end of the quality spectrum shifts up. As a consumer, I must have witnessed this process play itself out with DVD players. At one point, the differentiating feature between the cheapest and most expensive DVD players on the shelf at Target was something called “progressive scan”, which increased the resolution of the image. Eventually, the cheap DVD players all offered progressive scan without charging a higher price. Someone must have figured how to incorporate the progressive scan technology into their manufacturing process without adding much to the marginal cost of each DVD players. The cheap DVD players on Target’s website today list progressive scan among their features while upscale production has shifted to Blu-ray technology and other new-fangled gadgets.

Framed this way, I believe it is relatively clear why it can be hard to produce mid-tier products at a profit. A consumer-based view, on the other hand, can distort the picture and that is why I thought this was worth pointing out. A hypothetical example this time: an entrepreneur notices that 90% headphones sold today are inexpensive and of low quality while 10% are extremely expensive headphones with features such as noise cancelling technology. Within the 90% of consumers purchasing cheap headphones there is actually a wide range in income from people making close to nothing to people earning $100,000 per year. Because both individuals earning $100,000 and those earning very little income are purchasing the same headphones, the entrepreneur concludes that there is demand for a middle quality product. Unfortunately, what the entrepreneur eventually discovers is that while the demand is in fact there, the sale price of the headphones is not high-enough to offset his loss of scale.

I was thinking about all of this today because I have started to notice a pattern in business and economic news where firms in the middle are unable to compete. In one example from last week’s edition of The Economist, both General Motors and Land Rover are performing well at the moment, but mid-size firms such as Peugeot-Citroen are not. In another example, Capitol Grille and Chipotle are succeeding at the same time that casual dining chains such as Red Lobster are floundering. The labor market is not immune to these forces either: how many headlines have there been reaffirming the “hollowing out” of the job market? Talented executives are earning higher pay while jobs are always open for those willing to accept low pay, but there seems to be little in between. The fact is, the middle is not a safe place to operate because profits are built on scale or price and there is no happy medium between the two.


More on government spending under Obama from Kevin Drum and Ezra Klein

Kevin Drum and Ezra Klein do a good job elaborating more on the ideas Yglesias touched on in my last post. It’s important read the post and take a look at the charts, but Kevin Drum sums up his point:

“total government spending didn’t go up much during the Clinton era, and it’s actually declined during under President Obama. In the last two decades, it’s only gone up significantly during the Bush era, the same era in which taxes were cut dramatically.”

Two very important charts from Matthew Yglesias

These were originally posted by Yglesias here and here.

The first chart was mind blowing for me:


Why is that so mind blowing? I’ll let Yglesias himself explain (emphasis mine):

“The data show government health care spending per capita in the United States and Canada. The United States spends more. And that’s not more per person who gets government health insurance, it’s more per resident. And yet Canada covers all its citizens, and we don’t. That should be considered shocking stuff, and yet I rarely hear it mentioned.”

and here is the second, somewhat less surprising, chart:

FRED Graph

Again, Mr. Yglesias:

“People are very interested in partisan politics. Political partisans are very interested in the presidency. The president is an important player in federal budget debates. And thus people are very interested in questions about federal government spending “under Obama.” But the national economy doesn’t care about why money gets spent or which level of government spends it.

And taken as a whole, consolidated government spending—federal, state, and local—simply hasn’t surged. You can take the beginning of the recession or the beginning of the Obama administration or whatever you like as your starting point and it still hasn’t happened. Spending continued on essentially the previous trend throughout the official NBER business cycle dates, and then flattened out in a nearly unprecedented way once the economy began. “

It’s true there are record deficits under the president (see next chart), but that has to do with falling tax revenue during the recession, automatic spending increases as a result of hard times (think of unemployment insurance, food stamps, etc) and yes, the largest stimulus package in history. It still should put things into perspective that even with an $800 billion stimulus package (which I fully support, by the way) spending really only increased along with the trend and then it completely flattened out, which is unprecedented.

FRED Graph

A reminder not to forget about revenue or growth

In my post yesterday discussing the growth in government spending I failed to mention the revenue side of the equation, but a piece by Eduardo Porter in The New York Times reminded not to forget about taxes. Porter’s op-ed echoes a blog post by M.S. at The Economist from a couple of weeks ago that also contributed to my thoughts here.

Maintaining a minimum tax burden on society is an important goal, but it is a means to an end; the end being a more prosperous society. If it turns out that the best thing for society is a higher overall tax burden we should not fight it. Spending on the social safety net is going to continue increasing, and while we can buy ourselves a little breathing room via cuts to the defense budget, total government spending going forward will make up a larger share of GDP than it does today. Couple that with the fact that we are currently running a trillion dollar deficit and that might sound disconcerting. The picture looks a bit better though when you consider this other fact: According to the OECD, in 2011 total tax revenue in the United States was 25.1% of GDP while the OECD average take was 34.5% of GDP. The tone of the fiscal debate in Washington might make it sound like we are already close to some maximum level of taxation, but in 2011 Canada’s tax burden was 31% of GDP, Germany’s 37%, and Sweden’s 44.5%. I’d say it is fair to conclude the United States has a little breathing room to increase taxes if necessary to protect spending on the safety net programs that we are so reluctant to give up.

Many would argue, and I would agree, that culture in the United States is different and that we are not willing to build and pay for the generous social safety nets that can bee seen in Western Europe and Canada. Nevertheless, we did in fact create Social Security, Medicare, Medicaid, the American Care Act, and more, so it’s not fair to paint the United States as some kind of every-man-for-himself frontier society. Further, I believe our attachment to these programs has been proven to be very strong given how hard it is to reform them, and is probably so strong that we are willing to pay more for them rather then drastically reduce the benefits provided.

Raising enough tax revenue will mean increasing taxes on everybody. Democrats will probably continue banging on about getting the wealthy to pay more and going after corporations, but at the end of the day middle and even low-income individuals will need to pay more as well. Fortunately, there are relatively healthy ways for the United States to do this: tax reform (in other words, the elimination of deductions) the creation of a value added tax, and increased taxes on things that currently are tax inadequately (carbon emissions in particular).

Facts on government spending from Nate Silver

Silver has written an excellent primer on the growth in total government spending in the United States. I plan to keep this post in my back pocket and refer back to it now and then to keep the fiscal debate in perspective.

Silver does not really have an agenda with the post other than to remind his readers that the growth in government spending is very real and that it is driven by safety net spending, as shown in this chart (one of many simple visuals sprinkled throughout the post):

This does put my desire to eventually address the budget deficit partially through defense spending in perspective. Sure, defense spending does make up 24 percent of the federal budget, and significantly reducing military spending will not put American citizens in danger, but defense spending is not driving the trend in increased federal spending. I still support reduced defense spending, but we are still going to need to address the increasing cost of the social safety net either way.

To me, this is an important reminder that as long as spending on Medicare, Medicaid, and Social Security needs to be addressed then it might as well be people who believe in these programs that take the lead in reforming them. At some point someone is going to cut spending on these programs (or at least cap the growth in spending) because the math necessitates it and if those who support these programs do not take the lead themselves then they may not like the outcome.

More thoughts on fiscal policy

First, Larry Summers has written an op-ed I spotted in the Financial Times and the Washington Post today. Summers appears to broadly agree with my take that some people are overly focused on shrinking the budget deficit right now. He makes some of the same arguments that plenty of Keynes’ disciples tend to make: fiscal policy should run deficits when the economy is weak, there are important investments we could make as long as output remains below trend and interest rates low, long-term unemployment hurts the country’s economic potential in the future, etc. None of the points Summers makes or policies that he advocates are new, but what is new the way he phrases the debate. Summers points out that we are often obsessing over the fiscal deficit because a deficit is, almost by definition, something bad and should be eliminated. The problem is too much focus on the fiscal deficit could lead us to focus on this one issue at the expense of other important issues. If it helps then, Summers suggests thinking of other problems in terms of deficits as well:

“As important as avoiding the repression of budget deficits is ensuring that the focus on the budget deficit does not come at the expense of other equally real deficits. Interest rates in the United States and much of the industrialized world are remarkably low. In real terms, governments’ cost of borrowing recently has been negative for horizons as long as 20 years. No one who travels abroad from the United States can doubt that this country has an enormous infrastructure deficit. Surely even leaving aside any possible stimulus benefits, current economic conditions make this the ideal time for renewing the nation’s infrastructure. Such investments, borrowed at near-zero interest rates, need not increase debt ratios if their contribution to economic growth raises tax collections.

Infrastructure represents only the most salient of the deficits facing the United States. Nearly six years after the onset of financial crisis, we clearly are living with substantial deficits in jobs and growth. Consider that if an increase of just 0.15 percent in the economy’s growth rate were maintained over the next 10 years, the debt-to-GDP-ratio in 2023 would be reduced by about 2.5 percentage points. That’s an amount equal to the much debated year-end fiscal compromise that raised taxes. Increasing growth also creates jobs and raises incomes.”

I like what he did there: if deficits have such a strong impact on people then try to demonstrate that the gap between the current unemployment rate of 7.8% and what the unemployment rate would be at “full” employment, say, 5.0%?, is also  a deficit of roughly 2.8%.  Does it make sense that we should focus on the fiscal deficit exclusively and ignore this or other deficits, even if they are harder to define?

Next, Tyler Cowen makes some good points when he argues that even if now is not the ideal time to adopt a tight fiscal policy, there are still good reasons to focus on the deficit. It is true that safety net spending is expected to grow at a very high rate in the coming decades as the population ages and the cost of healthcare increases. It would be irresponsible of us not to pay attention to these painfully obvious trends and take some action to avoid future problems. We can enact policies that will curtail future spending in debates that we are having today without tightening fiscal policy right now. This actually could be a positive outcome of the sequester and budget negotiations taking place in Washington right now.

Reality check

In my first post on this blog I attempted to build a comprehensive case that one can of course have a rational view of the US economy and fiscal policy and simultaneously not endorse many of the main ideas espoused by Republican leaders. In that post I pointed out that Republicans who claim to be focused on the deficit are actually primarily concerned with low taxes and high defense spending. R.M. at The Economist agrees with that sentiment and first shares this great quote from a Matthew Yglesias column, which was actually referring to the group Fix the Debt, but is still applicable to Republican leaders:

“[I]f you saw a bunch of Quakers running around in a panic about the national debt pushing a plan to reduce the debt by cutting military spending, and then loudly objecting to all debt-reduction plans that don’t slash military spending you’d rapidly reach the conclusion that the Quakers don’t actually care about the national debt. They’re just pacifists”

and then R.M. further goes on to clarify why fixing the debt is rarely ever actually priority number one, and I broadly agree with this sentiment:

“Something similar is true of most members of Congress. They may like to think of themselves as deficit hawks and others as deficit doves; in fact, they are a motley crew of tax cutters, defence spenders, entitlement protectors and so on. That’s because tax cuts have a constituency (those who will benefit), entitlements have a constituency (those receiving them) and defence spending has a constituency (defence contractors and their rah-rah chorus). Fixing the deficit doesn’t really have a constituency, as nobody benefits directly. Even those voters who claim to be most concerned about the deficit are likely viewing it as a proxy for taxes, jobs or entitlements. Republicans, who tend to express more concern about deficits, often equate it to big government. But big governments have been run with small or no deficits, and small governments have been run with big deficits.”

I never actually believed that the crux of today’s fiscal debate is some kind misunderstanding as my first post seems to imply. Instead, I felt compelled to address the discussion with a certain naive tone because i believe it’s necessary to first tackle an idea on its merits before moving on to an ad hominem assault.