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The New Bezzle

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John Kenneth Galbraith gave us the term “the bezzle” in his 1955 book The Great Crash, 1929. Galbraith saw that there was often a long time between a financial crime and its discovery. In the interim holders of the financial asset involved in the crime experiences “psychic wealth”, because they are unaware of the actual losses. Eventually, something changes, and they find out. The Bernie Madoff case is a good example. Until he was exposed after the Great Crash, his loser investors thought they had $57 billion in their accounts. Turns out they had net recoveries of about $10 billion on the $17 billion they invested. That puts the bezzle at $47 billion.

Here’s another example. In the Antebellum South, there were nearly 4 million slaves with a value estimated at between $3.1 and $3.6 billion. After the war, that value went to zero. What was the net worth of the slavers in the late 1850s? They thought they were rich enough to battle the Union on equal terms, but the value of slaves wasn’t nearly equal to the value of the steel mills and industry of the northern states.

The problem of identifying the value of capital interests is very difficult. In Capital in the Twenty-First Century Piketty acknowledges the problem, and selects a solution appropriate to his purposes: the market valuations of the many forms capital can take. Here’s an excellent essay discussing this choice and its critics. By using this definition, Piketty simply ignores the problem of the bezzle, which makes sense in the terms of his project. Using Galbraith’s definition I suspect it wouldn’t make make a difference.

But I think the term leads us to a broader definition. The Great Crash provides a good example of what that new definition should be. The current estimate is that the Great Crash resulted in the loss of nearly 30% of household net worth between 2007 and 2010. The average household lost nearly $50 thousand in net worth between 2007 and 2010 according to the GAO report. Page 27 in the .pdf. By 2013, when markets were functioning — let’s say normally — the GAO estimated total household paper wealth losses at $9.1 trillion. Report here.

A large part of this paper loss was the decline in financial assets which affected people directly and through their pensions and retirement plans. Another large part was the result of lower house prices, which left many people with mortgage debt higher than the new prices. Here’s a priceless sentence from the report:

Economists we spoke with noted that precrisis asset prices may have reflected unsustainably high (or “bubble”) valuations and it may not be appropriate to consider the full amount of the overall decline in net worth as a loss associated with the crisis.

I bet the millions of people who lost that money don’t really care what economists think now, because none of the economists who could have made this stick before the Great Crash said this when it would have mattered. Far from it: the economics tribe insisted that markets were all-knowing and perfect in their understanding, and spent their days explaining why this time was different.

This superficial description shows that these households are in the same position as Madoff investors and Southern slavers: they thought they had something they didn’t, and they changed their behavior based on it.

I can just hear Paul Krugman explaining that bubbles and bezzles are really hard to model, and that’s why no one studies them. That’s probably true. Also, so what? Here’s my clever idea: look for data and see what it tells us. It worked for Piketty, who found that the historical record showed that inequality increases when r > g. Piketty and Saez, and Gabriel Zucman who did the estimate on tax shelters, didn’t have a model. They did have dusty records and big computer skills, just like all their contemporaries.

I hope that somewhere in academia there are young economists who look at Piketty, Saez and Zucman and their colleagues and say “I could do that”. And it’s just not that hard. Here are some hints.

1. There’s a big pile of student loan debt that isn’t going to be repaid. How much of that is on the books of the US Treasury, and how much is private sector? How much in the latter category is delinquent? Who holds it and in what form? If it’s in trusts, there isn’t going to be any enforcement, and the losses will fall on the owners of the securities. If it’s in the hands of originators, what happens to their balance sheets as this stuff cascades into default?

2. Every month we see another big business crash and burn. Often they fail because they are held by private equity investment firms. The crashes mean that a lot of debt isn’t going to be repaid. How big is that likely to be, and who’s going to eat that loss?

3. For the past 8 years or so, investors have been chasing yield. There’s some Galbraith bezzle in this stuff. How much dreck is sitting in their portfolios?

4. What does the rest of the mortgage overhang and related RMBS look like?

5. How much money is there in organized crime? A big part of the profits filters into the economy in the form of some kind of investment. How much of it is in the stock market? What happens when or if that ever gets traced and seized?

6. In the same way, how much have oligarchs and politicians stolen from other nations and moved into world financial markets? What happens if we got serious about that?

7. Another form of points 5 and 6: Rich people have stashed as much as $32 trillion in overseas tax shelters. If people got serious about this, their governments could seize this money and/or impose huge taxes on it. Say half of it, $16 trillion, got sucked up by taxation and seizure, and was removed from the financial markets and banks where it sits. What would happen then?

So, economists, just how big is the bezzle?

Testing The Limits on Wealth Inequality

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In this post, I pointed out that we are going to see an empirical test of Piketty’s theory of rising wealth inequality. The theory itself is not well understood, and Piketty has revisited it since the publication of Capital in the Twenty-First Century, and published an economist’s dream of a paper in full mathematical glory here. The American Economics Association devoted space in its journal to arguments about the theory, giving Piketty an opportunity to discuss his theory in what I think is a very readable paper, and one worth the time.

He starts by saying that the relation between r, the rate of return to capital, and g, the rate of growth in the overall economy, are not predictive. They cannot be used to forecast the future, and are not even the most important factor in rising wealth inequality. The crucial factors are institutional changes and political shocks. Neither can the relation tell us anything about the decrease in the labor share of national income. He points to supply and demand for skills and education in this paper, as he does in his book, but this is a at best an incomplete explanation, owing more to the neoliberal view that the problems of workers are their fault than to a clear understanding of social processes in the US. A better explanation lies in tax law changes, changes in labor law and enforcement of labor law, rancid decisions from the Supreme Court, failure to update minimum wage and related laws, and government support for outsourcing and globalization.

What the theory does say is the subject of Part II.

I now clarify the role played by r > g in my analysis of the long-run level of wealth inequality. Specifically, a higher r − g gap will tend to greatly amplify the steady-state inequality of a wealth distribution that arises out of a given mixture of shocks (including labor income shocks).

In other words, as the raw number r – g increases, wealth inequality reaches a limit at a higher level, and income and wealth mobility become lower.

The important point is that in this class of models, relatively small changes in r − g can generate large changes in steady-state wealth inequality. For example, simple simulations of the model with binomial taste shocks show that going from r − g = 2% to r − g = 3% is sufficient to move the inverted Pareto coefficient from b = 2.28 to b = 3.25. Taken literally, this corresponds to a shift from an economy with moderate wealth inequality — say, with a top 1 percent wealth share around 20–30 percent, such as present-day Europe or the United States — to an economy with very high wealth inequality with a top 1 percent wealth share around 50–60 percent, such as pre-World War I Europe.

The inverted Pareto coefficient β is a measure of inequality used by Piketty and his colleagues. Here’s how he explains it in this paper:

That is, if β = 2, the average income of individuals with income above $100,000 is $200,000 and the average income of individuals with income above $1 million is $2 million. Intuitively, a higher β means a fatter upper tail of the distribution. From now on, we refer to β as the inverted Pareto coefficient.

The theoretical basis for this result can be found here, where Piketty and his colleague Gabriel Zucman provide a typical economists mathematical explanation. I’ve read some of this paper, but it is tough going.

The returns to capital, especially business capital, are quite a lot higher than the levels given in Piketty’s example. Here’s the chart:

real returns on capital
The returns to all capital after tax are about 7%. Paul Krugman put up a blog post saying that a realistic growth rate is about 2.2% at best for the next few years. This gives a difference r – g = 4.8%. Then using the equations on page 1356, we get an estimate that the inverted Pareto coefficient would be in the range of 11, which is a lot higher than the levels Piketty uses in the quoted material. By way of comparison, with that number, the average wealth of people with more than $10 million net worth would be $110 million. In the example Piketty gives for the top .1% with β =3.25, the figure would be $32.5 million.

Piketty notes that these coefficients are a rapidly rising function of r – g, which is apparently the case. In a recent paper, Emmanuel Saez and Gabriel Zucman estimate that the top .1% has a wealth share of 22% as of 2012, and there is every reason to think that has risen.

With Piketty’s general rule standing alone, there is no obvious limit to the level of wealth inequality, but in practice there are many practical reasons that it will level off. Some people will have more children, so the fortunes are divided into smaller shares. Some are lucky in investments and others aren’t. There are external shocks, wars and depressions. There are divorces, which split fortunes. Some people are able to earn high levels of labor income on top of capital income, increasing their wealth. Some die early, so their offspring are forced to spend more of their capital income to preserve their existing level of consumption. Others have expensive tastes and spend too much. These external forces eventually bring about a more or less static level of wealth inequality. Overall, this static level is higher when the fraction g/r is lower.

The time periods in the theoretical models used by Piketty and his colleagues are generational, they run 30 years. The big changes in wealth inequality began in the 70s, I’d guess, but became prominent enough that they were noticed in the late 80s and early 90s as the Reagan/Bush era tax cuts took hold, and regulatory structures were dismantled. By 2000, the final touches of formal deregulation were complete, and the Bush administration stopped enforcing most remaining laws leaving capital accumulation without restraint from legal pressure. It’s been about 15 years with little change, about half a cycle. The results follow the line Piketty and his colleagues predicted, and every year the new data supports their theories.

From this we can see that the coming empirical test is the maximum level of wealth inequality, or to put it another way, it’s a test of the downward pressures on the limits of wealth accumulation.

As a nation we have only taken the smallest possible steps to stem that tide, such as slow increases in the minimum wage, and tiny increases in taxes on the wealthiest to the extent they choose not to evade taxation in all sorts of allegedly legal ways. Neither of the presumptive candidates has any intention of making the kinds of changes necessary to change the outcome.

That brings us to the second empirical test: the level of wealth inequality that a civilized nation will accept before demanding change.

Or maybe the test is whether we are so cowed we won’t ever make any demands on our new lords and masters.

Update: for more on the uselessness of tweaks to the current system, see this interview by the excellent Lynn Parramore with Lance Taylor.