How to Cut Employees Pay Without Them Noticing

The reason I bring this up is that I see it happen in my industry, architecture/AEC, on a continual basis. When I bring it up it's often viewed as an opinion when in reality it's econ 101 material, so here goes.

Most people hold a bias known as money illusion. The gist of it is that people tend to focus on the nominal cost (literally the number after the dollar sign) of something as opposed to the real cost (the purchasing power of our earnings). But to understand why not receiving an annual raise is the exact equivalent of getting a pay cut it helps to understand a related phenomenon known as sticky prices/wages.

Sticky prices is the idea is that the price of a good/wage moves easily in one direction but not the other. For example, say you're a gas station owner and you order a tanker of gasoline at a certain price. The next day gasoline prices go up ten cents. You raise the price accordingly since it's now worth more. The next day the price of gas drops twenty cents making it ten cents cheaper than where you bought it at. You most likely won't drop the price you charge below that of what you paid until you sell all your inventory. This is a sticky good.

Workers are much the same way. Raises are readily accepted whereas pay cuts are not. Most workers would either leave their job or prefer that some of their coworkers were fired as opposed to take any significant cut in pay. This is known as downward nominal wage rigidity (if that fascinates you here you go), but I think sticky wages has a better ring to it.

So say you're an employer and in a down economy you can't afford to give your employees raises. What do you do? Nothing. One year goes by. Then two. If you stopped giving employees raises in 2008 how much would their earning power be at the start of 2013?

Roughly $0.92 (source). And that's not too bad. Inflation has been really low in the last few years1. Anyways, that's how you cut employees salaries without them noticing. Inflation and ignorance.

1 - 2008 - 0.1%, 2009 - 2.7%, 2010 - 1.5%, 2011 - 3.0%, 2012 - 1.7%. Source.
2 - The Social Security Administration uses these same numbers.
3 - Krugman has some nice graphs showing how this has happened over recent years in the US.

The Biggest Mistake of Our Generation

I haven't posted much on economics in the last year or so. The news is overwhelmingly depressing and I feel exasperated on the subject. The missteps of our politicians, most of which were entirely preventable, continue to cause enormous suffering on the parts of millions of people - especially young workers looking to start their careers. The cumulative effects of these errors will be felt for decades. People's lives are being destroyed and few seem to consider it a big deal.

The worst part of it all is that many people truly believe that there must be suffering for the situation to improve, but this is how people felt during the Great Depression too. "The weak must be culled!", but there's an aspect of moralization to that argument that I'm uncomfortable with. This is macroeconomics, not metaphysics. The Great Depression can largely be explained as a money supply problem (there wasn't enough money/liquidity in the economy much like the babysitter co-op problem); an answer which makes many uneasy as it's a somewhat simple technical fix. People believe that it must be more complex, but it simply isn't.

This morning the New York Times ran this piece: Defecit Reduction is Seen by Economists as Impeding Recovery. No shit? Every respectable economists knows that reducing government expenditures during an economic downturn is inadvisable and they've been saying so all along. The article goes on to rationalize what happened. This is what's been so frustrating over the last five years, giving credence to ideas that have been proven demonstrably wrong - repeatedly. Few people will step up and say "Yeah, I've focused on the national deficit and reduced government spending but it turns out I was wrong. Let's focus on unemployment." Not going to happen, so they obfuscate with rhetoric and the suffering continues.

In the meantime the American public thinks there's an actual debate going on. There isn't one. Textbook New-Keynesian economics has been validated. We've all been screwed and my generation is fucked. If anything this is an understatement.

The data that's been coming in over the last five years is in line with typical macroeconomics textbooks that any econ 101 student is exposed to. If the following were a test question to me in undergrad:
The current economic indicators are as follows (May 2013): 
Describe the most advantageous course of action which a central government could, through fiscal and monetary policy, increase GDP growth and lower unemployment in both the short and long run.
My answer would be something along the lines of:

Short answer - The government should borrow money and invest in itself because there are many idle workers, slow economic growth, and financing costs are zero or negative (!). Although politically it may be unpopular to borrow money to spend, no other entity is large enough to assume this role, so the federal government must.

Longer answer - Monetarily the Fed should reduce rates (done, it's at 0%) and increase the money supply (done) while the Federal government should increase its expenditures (it's done the opposite) and encourage state and local governments to do similarly (they've been the worst). Although it would be advantageous to spend on infrastructure, education, and other areas that produce long term benefits, where the money is spent is somewhat irrelevant (although politically unpopular, Keynes burying money in jars). This spending can be financed by the historically low interest rates (negative rates on a 10-year bond, who wouldn't want to get paid to borrow money?). Further, the federal government should reduce taxes on those who are most likely to spend additional income, the poor, as the multiplier effect is larger  (it's done the opposite). To add to the last point, social safety net programs should be expanded (they were for a while but they're being cut back now) as those with little money are most likely to spend any additional income which would create a larger multiplier effect.

Government Spending: Low and Falling

Just a quick note about an article by Paul Krugman that appeared on his blog today.

Krugman posits that the increase in government spending is mainly due to two factors.

1 - Since the economy has contracted, government spending is going to make up a larger percentage of GDP. Pretty straight forward.

2 - More people are unemployed and are thus collecting from various social safety nets: unemployment, medicaid, food stamps, etc.

The blue line is government (at all levels) spending as a percentage of GDP, so in the last 25 years it was fairly consistently was between 31%-34% of GDP. I'll also note it fell under Clinton and rose during W, although not by too much. Today it's 36%, actually not that high, relatively speaking. The red line is this same measure but as it relates to potential GDP. Basically, what our economy can and should produce. This number is about 34% which is much closer to the trend for the last 25 years.

Source: Paul Krugman's Blog: The Conscience of a Liberal

So there has been some increase in government (again, this is all levels of government, not just federal) spending, but a large portion of it is clearly due to our economy contracting (red line). If one considers #2 from above then it becomes clear that our government, sans safety net programs, has actually contracted in the last several years. This is extremely troubling. 

Politics and our general inability to come together as a nation and implement our hard won knowledge (see Great Depression) has prolonged this recession and harmed many lives in the process. This isn't "oh we just don't have quite as much money..." This is more young people committing suicide, high school students skipping college, older workers not being able to retire when they planned to (even when working class people's life expectancy has stagnated. Source: 1, 2), and increasing rates of depression that are no doubt related to the inability to find a decent paying job. Bad things happening are a fact of life, but watching them happen when they're largely preventable is tragic

Belief That the Poor Are Lazy

I'll keep this brief and mostly anecdotal.

In an article in New York Magazine a patron at a Romney fundraiser had this to say:
Obama wants to take my money and give it to do-nothing animals.
And less to that quote and more to the feeling I get from my friends and peers. If you're poor it's probably your fault - you should work harder. People make some allowances but not many. At some level most people believe this to be true. A meritocracy is a comforting and dare I say, logical, thing to believe in. It takes quite a leap of imagination and distrust in humanity to believe otherwise. But it's just factually not true. Your income has little to do with how hard you work. I could cite statistics and show graphs but facts rarely convince people.

The evidence is overwhelming. The largest single indicator of future earnings potential for an individual is their parents wealth. Full stop. Not education, IQ, hours worked, race, gender, etc. It's your genetics. We have less class mobility than old world Europe.

The reality of the world today is that jobs that used to take dozens or hundreds of people can be done by one person. In the short term this hurts people but in the long run it helps everyone. It's what has made everything from clothing to food less expensive. Every time we destroy jobs in this fashion we free up workers for other jobs which raises worker productivity (money generated per person). In the last several decades these gains have more or less all went to the people at the top. About 90% of people have seen their wages/standard of living stagnate since the 1970's. Did people stop working hard? Of course not.

If you think the poor are any lazier than anyone else then answer me this: why aren't the Amish billionaires and why weren't medieval peasants rolling in the dough? What we want to believe and what is reality are different things.


Keeping It Victorian: Part I

This is part 1 of a series that will take a look at what I percieve as problems with the way housing is dealt with in the US.

It bothers me that the vast majority of people buy large cheaply built homes that are neither beautiful nor thermally efficient. If your house is going to be ugly at least make it energy efficient, and if it's going to be energy intensive then make is beautiful. Yet people choose the third option, big, over all others. Research shows that large houses do not make you happy (source - interesting paper by the way). The purpose of this post is to explain, mostly to myself and in a very mechanistic manner, why houses are a certain size, cost, and quality. I'll be looking at the Midwest since that's where I live.
My argument is this:

1 - Housing is generally the most expensive thing most people ever buy.
2 - Most people are not well informed as to what they are buying.
3 - Banks/financiers have a large influence on what is built.
4 - Our cultural values in the US specify a certain housing type.
5 - Money is the biggest constraint in the housing industry (and probably everything).

The median square footage of a home completed in 2010 was 2,200 square feet (SF), in the midwest it was 2,000 SF, and 30 years ago the median for the US was 1,600 SF (source).

Note: the average in 2010 was 2,390 SF but I'm not going to use that. My logic is that housing typically can only get so small, whereas the very wealthy often build huge homes which skews the data. Hence, I'm using the median.

Note 2: how closely correlated is home size to GDP per capita? This is a fun idea for a stats based blog post in the near future. For now though I took GDP in 1980 ($2,778 billion) divided by 1980 population (226.6 million) adjusted for inflation ($12,300 becomes $32,100), then compared to 2010 GDP per capita ($47,100) which is a growth of 46.6% in real terms (actual goods you can purchase). In that same 30 year period (1980-2010) the median home size went from 1,595 SF to 2169 SF, a growth of 36.0%. That's pretty close. If I were running a regression analysis I'd work in a Gini coefficient (change in level of inequality). I have a feeling that'd explain a decent amount of the difference. You would then be able to extrapolate how much larger houses should be if the level of economic equality had remained at 1980 levels. Conversely, you could estimate how much more energy efficient homes could have been with the added money and then translate that into any number of things like possible savings in carbon emmisions, barrels of oil, square miles of coal etc.

The vast majority of people take out a loan when purchasing a home and increasingly that loan tends to be of the 30 year variety, which corresponds roughly to most people's working careers (if you buy a home/loan it makes it harder to leave your job and the region, which decreases your bargaining power over wages, which makes your firm more profitable/competative, which gives local banks more business -- surely they have no vested interest in helping people secure loans for housing right? This is why companies pay you more money initially if you move to their city and buy a home in the area). Typically it is recommended that most people do not take out a loan that is more than 28% of their gross income (why do people rarely live below their means?) or 36% of their total income after other debt obligations. The median income in the Midwest in 2010 was $48,500 (source). Using the 28% figure on a median income of $48,500 we get $13,580/year or $1,130/month. Using an amortization table that comes out to about a $190,000 loan over 30 years at 6.00% interest. Interest rates are currently around 4% but I'm not sure who you have to kill or what god you have to dance to during a full moon to actually get that rate.

I'm going to assume a 20% down payment because it's conservative and you can avoid paying loan insurance at this rate. This comes to $47,500 + $190,000 = $237,500 and we'll round to $240,000. That's what the typical family in the Midwest can afford; a $240K home that is 2,000 SF and who pays a little over $1,100 per month on thier mortgage.

$240,000/2000 SF = $120 a square foot in total cost. That's what people pay, not what it actually costs to construct, but construction profit margins are razor thin so it's probably close to that minus land costs and what not. This is why no one is building right now. Construction costs in Chicago right now will probably run you in the $150/SF range which makes sense given that it's a major metropolitan area and the cost of living is higher. It costs more to build a new building than it does to buy an existing building, hence the current housing situation. This is a fairly fundamental reason why buying housing right now may not be a bad idea. You can not physically build new things cheaper. I think #1 on the list is well established so let's look at #2.

Most people do not know how a building is built, and that's fine, why should they? The problem is that the person selling you the building doesn't know either, and the bank only cares in so much as they have confidence that the building will make them money. They accomplish this by doing the same thing repeatedly. This is why the construction industry is so conservative; construction costs a lot and no one wants to "lose their ass" so to speak. The only person who does truly understand what's happening is the architect and contractor. Most market rate housing doesn't have an architect so now it's down to the contractor. This gets interesting because one doesn't need anything particularly to become a contractor. If you have tools, know how to build things, have financial backing, and sometimes insurance, you can be a contractor. Not to say that there aren't excellent contractors out there. I'm just saying that it varies greatly and these people are not always well versed in things like thermal heat bridges, structural calculations, etc. Their main goal is to stay in business, make money, and not get sued -- much like anyone I suppose. They're not exactly trying to buck the system and do something extraordinary. Let's take a closer look at the banks role, #3 on the list.

Banks are (or should be) in the business of taking deposits, providing money (liquidity) to those who need it, and managing the risk in between by charging a competative interest rate. In short, they want to be assured they will be paid back. Since the bank is typically providing 70-90% of the money in a project they get a lot of say. As in, if they don't like what you're building they won't give you any money, so unless you have all your own money to build whatever you want you're going to have to build fairly conservatively or be excellent at selling ideas to bankers. This is a large part of the reason why most buildings in the US look pretty much the same. In all fairness this is beneficial as it keeps people from doing unproven things that fail. On the other hand it keeps people from taking risks that advance the industry. None the less, this situation leads us to build homes much in the same way as people did in the Victorian era.

This brings us to #4. Simply stated, bigger is better. If you spend some time researching properties you find that housing in a general area tends to be the same price. Buildings are a lot like cars. There are class sizes, standard features, upgrades, and general price ranges. They're just not that unique for the most part. It also means that some features do not make sense at certain price points. I insist that certain things should be standard on all housing. Good windows, thick insulation, good structure, etc. I think that should be standard, but it doesn't work that way. Cheap housing gets cheap windows, expensive housing gets decent windows, and everyone gets thin insulation. You wouldn't expect wood grain in a Ford so why should the average person expect thick walls... or so goes the logic.

While researching for a project last spring I found that the price for new market rate condos in the South Loop of Chicago tended to be around $199/SF. From building to building this varied very little. We're talking $2-3 tops. Everyone had the same counter tops, same cabinets, same square footage etc. The thing that would set one place apart from another would be something like a really nice appliance or a computer nook. Maybe they spend an extra $1,000 on a big refrigerator and over a 1,000 SF apartment that raises the cost $1 SF, or maybe you get a balcony you rarely use. That's how tight construction budgets are. Buildings differentiate themselves with small perks generally in the 0.5%-2% of total price range. Why would anyone pay 10% more for a well built home? You would price yourself out of the market. The alternative is to build smaller but higher quality... think that's going to happen in America? That's #5.

In summary, people tend to buy the most expensive house they can afford, the construction type is determined by what banks and contractors are comfortable building, since banks and contractors do not have to live in the houses themselves they build cheaply, since buyers are not well educated on construction they tend not to value well built homes, add to this American's inherant preference for size over quality and you get the ubiquitous 2,000 square foot  $240,000 home with 30-year loan. This is how our incentives are aligned and this is the result they produce; huge homes with a corresponding loan for all.

Why is Europe different? They charge more for energy, pass laws and codes regarding energy useage, their code officials tend to be less stringent, they have less land, and tend to prefer well built over size. I would also argue that they have better taste in general but that's probably just my personal bias.

Links for May 13th

First, some background music, Irene by Beach House (hat tip: Chris).

The first several Boeing 787's are going into service. Why is this interesting? There are two main airline manufacturers in the world: Boeing and Airbus. They've both moved to composite materials to reduce weight and increase the range their planes can travel. This changes the routes airlines can fly - it's game changing; new hubs, longer distances, smaller cities being connected, more diffuse growth in general. Where they differ is in size. Airbus went huge with the A380 and Boeing downsized with the 787. In my opinion, one of the lessons of recent history has been to downsize: smaller baseball parks, smaller cars, smaller laptops, smaller homes, smaller cameras. I'm betting on Boeing but to be honest I think the contest will mostly just be awash.

It's no longer illegal to tape record police officers in Illinois. How anyone thought that police officers being immune to public scrutiny in this manner benefited citizens I will never know. In my opinion every police officer should be wearing a camera at all times. Tiny cameras that can fit in sunglasses already exist. Why shouldn't we be allowed to see the activities of those who have been entrusted with such immense power and responsibility?

Apparently being unemployed is bad for people. No shit? Among other negative side effects, people commit suicide more often when unemployed. So yes, in the long run the economy will fix itself, but by sitting idly by we are in fact collectively allowing an entire generation of young (and old) Americans to suffer. Krugman on the matter (sort of).

Oh, and college is expensive. Colleges response: “I didn’t think a lot about costs. I do not think we have given significant thought to the impact of college costs on families.” - the president of Ohio State University






Income Inequality Addendum

The CBO (Congressional Budget Office) just released a report showing growth in incomes and growth in income as a share of overall income.

This first one shows growth in income over the last 30 years among the various quintiles (each 20% of the income spectrum). The gains were as follows:

275% for the top 1 percent of households,
65 % for the rest of the top quintile
< 40% for the second, third, & fourth quintile
18 percent for the lowest quntile



So everyone's income grew, that's good, but here are the gains as a whole (taken from Krugman).


Not so pretty. Also, that top 1% could be broken down further. I like to think of this as market share. Basically there's a pool of something - customers, income to be had, etc. - and there are entities vying for control of that pool. Well, the 99% is losing out.

Occupy is Right, Stop the Skepticism and Apathy

I've been unexpectedly alone among my friends in my support for the OWS movement and it's bothering me quite a bit. I'm convinced that most people are completely unaware of just how one sided our society is. Further, all the critiques I've heard of OWS is the same utter crap that the news media (see: owned by rich white conservative men) spouts. Here are the three main gripes I hear about the Occupy Movement:

1- "They don't have a clear message."

Yes they do. OWS is fighting against economic and political inequality. They want everyone to pay their fair share. And they're right. The system is broken and unfair.

2- "There's a bunch of weirdos at their protests."

There always is. In the 1960's there were a lot of LSD dropping and free-sex having protestors, but out of it came the civil rights movement, women's rights, and anti-war protests. Does that invalidate them?

3- "They're just bitching. They/we don't have it that bad. Plus, nothing is going to change."

That's utter apathy and it misses the point. Sure, a lot of us live quite well in the bottom 99%, but even as our country has grown richer in the last 30 plus years our share has not increased. Study after study shows that wealth inequality is bad for just about everything in a society from crime rates to levels of happiness. Even the richest are better off in a more fair society.

Evidence:

First, here's the past 100 years or so of income distribution in the US as given by the New York Times:


Currently the top tax rate is 35% for any income made over $379,150 and that doesn't include capital gains (money made on stocks, interest, etc.) which is currently taxed at 15% (really low). It is common to hear people saying that high taxes are bad for an economy. Yet, during America's greatest economic growth, post WWII to somewhere in the 1980's, the top marginal income tax rate was between 70-94% and included capital gains. So no, high taxes are not bad for an economy (see: Northern Europe).

It has come to my attention that the chart that was once here contained some incorrect information. I will repost this when they release the new data (hat tip: Joe). The chart showed varying effective tax rates among similar income earning groups compared with various levels of income earners. The point was that a percentage of the very wealthy pay a very small effective tax rate.

Income Inequality is bad for EVERYONE.



The more a country taxes the rich the happier its people. It's really just a small part of that video from above.

Also, the top 1% is misleading. It's more like top 0.1% (both of these graphs are taken from Krugman's analysis of CBO data):


The top 20% of income earners haven't gained any income share since the late 1970's while the top 1%'s share has grown from about 8% to about 17% - or more than doubled.


The top 1% minus the top 0.1% share of income has grown from about 5% to 8% - a 60% increase - not bad, but the top 0.1% of earners went from 2.6% to about 8% - about a 300% increase. It truly is the super wealthy who are making all the income gains.

Solutions:

There was a study done a little over a year ago that I wrote about before where people of all ages and political affiliations were asked who had the wealth in America.


Of course, everyone was totally wrong. Reality was far more unfair than they had realized. In fact, when asked what the division of wealth should be, people overwhelmingly responded that it should be more fair than what they thought it was - which was to generous to begin with.

So how do we fix our system?

Simple, see that bottom line in the graph? That's what people want. That's the society Americans say they want to live in. To accomplish this first we have to elect people who will represent our interests - fairness. Now the fun part, Congress will set goals as to what percentage of the total national income any group is allowed to keep as income. Say the top 0.1% gets 5% of earnings, top 1% gets 5%, etc. Whatever we choose. Next, the IRS and CBO changes the marginal rates (which now include capital gains taxes) of those income tax brackets every year to bring the targeted goals to within range. It'll take a few years to settle out, but eventually the tax brackets will stabilize. If you think that's too socialist or whatever then simple... just lower your targets and let the rich get richer. This is already what we do, we just don't set goals. We just set arbitrary numbers that mean nothing.

My guess is that the vast majority of people would pay less in taxes, more income brackets would be created near the top end, and those really high end brackets rates would be close to 70 plus percent.

Parting Thoughts:

The top 400 wealthiest people in America have more than the bottom 50% (about 155 million people). That means one person has as much as 390,000 people. That's like getting rid of Chicago and replacing it with 7 people.

"No country, however rich, can afford the waste of its human resources.  Demoralization caused by vast unemployment is our greatest extravagance. Morally, it is the greatest menace to our social order." -FDR