Deconstruction

This has never happened to me before. Honest.

I know for some people, it’s normal. And I understood it from an intellectual level. But never like this. I’ve never experienced it myself.

I never knew how embarrassing and frightening it would be.

I’ve never gone into an election as an undecided voter.

My issues

Part of the problem is that the parties don’t give a damn about the two issues I care about most.

My top economic issue is the housing bubble. I think this is the biggest issue of Generation X and the Millenials. Not because houses are too expensive for these cohorts to buy, but rather because they’re too expensive to buy, yet they’re buying them anyway. In essence, they’re being sucked into an economic trap that they will struggle a lifetime to escape, taking on far too much debt for an asset that’s likely to fall dramatically. In the end, the policies in place will likely bankrupt a generation.

Every party seems to have the same response to this concern: inflate the housing bubble more!

So that doesn’t help me at all in deciding who to vote for.

My second key issue is the environment. Global warming is a huge risk for humanity that can be eliminated at a relatively low cost, so it seems like a no-brainer to deal with it now. While the major parties wave their hands about the environment, they don’t actually seem to have a concrete plan. Only the Green Party is willing to say that they’ll do something.

So that doesn’t help me much either.

If I can’t look at it from an “election issue” standpoint, how about looking at the individual parties?

Liberals

I look at the liberal platform, and there’s some stuff I like in there. But a couple things really bug me.

First, they want to roll back the TFSA increase. In other words, they want to make it more difficult for people to save for their retirement. They say that anything over $5,000 is only for rich people, but if you run the numbers, if you max out a $10,000 TFSA every year, and get a 7% return on it, after 40 years, you’re only at about $2 million.

This might seem like a lot, but that’s before you factor in 40 years of inflation. According to my rough calculations, $2 million in forty years is roughly equivalent to having $30-40K a year (in today’s dollars) to spend in retirement. In other words, it’s enough to make you secure, but far from wealthy. So really, a $10,000 TFSA isn’t for rich people. It’s for prudent people.

The other thing the Liberals are doing is discouraging stay at home parents. Personally, I think if a parent wants to stay at home and raise their kids, that provides a huge value to society. Instead, by eliminating income splitting, the Liberals would encourage people to value a second income over their family’s well being. That’s uncool.

Finally, the Liberals plan to take on a lot of new debt. I think this is a bad idea too. It really bugs me when politicians say, “your kids can’t vote, so we’ll take on a bunch of debt to buy toys for you now, and your children will have to pay for later.” If you want to give me toys, fine. But I should be the one paying for those toys, not my kids. Raise my taxes and let me decide if I want those toys enough to actually pay for them.

NDP

I like that the NDP is thinking about childcare. Though I suspect they only care about the short term votes it will get them, if you can properly execute a good childcare plan, it can have huge returns over the long term.

The problem is that the NDP struggles with math and concrete ideas. They say things like they’ll “secure your retirement”, without actually saying what that means. And to me, that implies that either they don’t have a clue, or they’re just lying. Thus, their “balanced budget” claim seems implausible.

Like the Liberals, they’ll also cut back on TFSAs and eliminate income splitting. But in addition, they’d also get rid of the stock option tax credit. In effect, this would be a huge hit to technology workers, who make reasonable amounts of money from this tax credit. As a tech guy, I’ve benefited substantially from it in the past.

I don’t think it will impact the really wealthy much–it’s easy for those guys to come up with tax-efficient ways of paying themselves a lot. However, if the goal is to hurt upper middle class tech workers, increasing the tax on stock options will do it. I imagine it would further encourage Canadians with technology skills to migrate to the Silicon Valley and the Seattle area.

I’m also paranoid that the NDP will introduce a wealth tax or increase the capital gains tax, both of which would be a disaster for me and anyone else who believe in saving money for the future.

Conservatives

Financially, the Conservatives would benefit me the most. But I have two main problems with them. First, the Conservatives don’t care about the long-term future of Canada, wealth inequality, or environment. They took office with a balanced budget and accumulated huge deficit every year. So, they’re not fiscally responsible, and don’t really care about the issues I care about.

The second problem is that they’re loathsome. They used tricks to subvert the democratic majority in parliament, proroguing it when it looked like they were about to lose power. They discouraged science. They attacked human rights and privacy, spying on Canadians in the name of security. They quelled disagreement and discussion, ruling by ideology rather than evidence.

And frankly, Stephen Harper seems like a total jerk.

Green

The Green party is perhaps the best option. They care about the environment and boosting education. What’s more, they’ve been talking about the guaranteed minimum income, which is an interesting idea to examine, at least. What’s more, Elizabeth May seems like the brightest of all the party leaders, by far.

However, the Green party is also against the TFSA limit increase. In other countries, they’ve also supported wealth taxes and “polices that restrict the accumulation of excessive individual wealth”.

During my lifetime, I’ve started four or five businesses, risking a large chunk of my net worth every time. In doing so, I’ve created somewhere between fifty and a hundred jobs. I wouldn’t have started any of those businesses if I didn’t think there was some chance that I could accumulate excessive individual wealth. Why take the risk if there was no potential payoff? I’d rather work for someone else in that case. (Though perhaps there wouldn’t be anyone else, since most people wouldn’t be stupid enough to take the risk either.)

As far as I know, Canada’s Green Party hasn’t said they’ll destroy my ability to get rich, but the fact that the Green Party has such policies elsewhere makes me wary.

The bottom line

At this point, I’m still not sure who I’ll vote for. I’m in a swing riding–it’s unclear who is leading now and the top three candidates are likely to be within 10 percentage points of each other in the end. I’ll certainly vote. I just don’t know for whom….

The biggest challenge with early retirement is knowing that you have enough money, because life is sometimes capricious and work skills atrophy. It would be horrible to retire in your fifties from a high-paying job only to run of money when you’re 80 and can only be employed as a Walmart greeter.

But we live in a world where stock market crashes happen and inflation rises and falls. How the heck can you know how much a loaf of bread will cost in 30 years? Or 50 years?

Forecasting the future

There’s no way to be completely certain. It’s possible that the politicians and bankers will mess up the country so badly that hyperinflation will destroy the savings of everyone, and it’s hard to guard against that without going to extremes that are completely horrible in any scenario except a complete failure of the country’s financial system. International diversification can help you a bit, but only a bit.

Thus, you have to accept that early retirement does come with some small chance of a terrible outcome– say 1%–that you cannot avoid.

But it’s a bad strategy to optimize your life for extremely low probability outcomes. Instead, you want to optimize for the most likely outcomes in a way that is reasonably robust against extreme outcomes.

The basic idea

Applying this strategy to retirement, we want to determine how much money we need now to live for the rest of our lives without working, with a reasonable margin of safety for extreme events. The easiest way to figure this out is by inverting the question. Instead ask, what percentage of my portfolio can I withdraw each year (adjusted upwards for inflation), without worrying too much about running out of money?

One way to start answering this question is by taking a reasonably diversified portfolio, and seeing how it would have performed during various time periods and various withdrawal rates. For instance, how would the portfolio have done if you retired in 1970? 1952? 1929? (Gulp!) How long would it have lasted if I took out 3% every year? How about 5%?

If you do this a bit, you’ll figure out quickly that the order of the good years and bad years matters. If you lose 30% in the first year, you have a much worse outcome than if you lose 30% in the 15th year. This means that simple models like “a portfolio averaging 7% per year” don’t represent reality well at all.

When you start running the numbers, you find that historically, if you withdrew 4% a year (adjusted for inflation) from a 75% stock/25% bond portfolio, you would never have run out of money after 30 years, regardless of when in the last century you retired. What’s more, you’ll find that 30 years is almost the same as infinite–if the portfolio still has money left after 30 years, it is almost equally likely to have money left at 50 years.

Increasing robustness

So that takes care of the most likely outcomes. But I’d also like it to be robust against many extreme outcomes. Perhaps in the future there will be something that rarely has happened in the past, like stocks and bonds both falling dramatically at the same time for a decade. To take care of this sort of scenario, I’d like to add an extra margin of safety by using 2.5-3.5% withdrawal rates instead.

The most likely outcome of using these lower withdrawal rates is that I get rich, generating far more cash than I’ll ever spend. In some sense, this is a loss. If you equate spending with happiness (which I wouldn’t recommend), it means that I will be less happy in my early retirement than I could have been. On the other hand, it also means that in later retirement, I will be able to increase my spending without running into problems and still leave a healthy inheritance.

What’s the number?

Suppose you decide to be very conservative, and only spend 2.5% each year. Then, if you know your spending, you now know exactly how much money you need to save for early retirement. Want to spend $40,000 a year? Well, you’ll need 40 times that–$1.6 million.

And this is where it gets interesting, because the less you spend a year, the less money you need before you can retire. But it’s also true that the less you spend a year, the more you can save.

Suppose you net $50,000 a year and are saving $10,000 a year, and want to live off $40,000 per year. If, while you’re working, you’re making 7% off your investments, then it will take approximately 37 years to save $1.6 million for retirement.

But suppose instead, you can live off $20,000 a year, and are happy to continue doing that in retirement. Well, then you only need $800,000 retire, and can do that in 16 years, saving $30,000 a year. In a way, by reducing your expenses, you get a double hit–you save more each month and need less money in the end.

The bottom line

What this means is if you really care about early retirement, the way to do it is to cut your expenses and be happy with less. That might seem ridiculous, but there are some people with high-paying jobs who take this to the extreme, and are able to retire in under a decade. Like, in their early thirties. And the math all works.

This isn’t for everyone. But it might be for you. It’s a question of what you value the most. Would you rather have a Starbucks coffee every day, a nice car, and designer clothes for the next 30 years? Or would you rather pick up 50 extra hours of free time every week for 20 years, to use as you wish?

The big economic news this month is what the Federal Reserve will do to short-term interest rates, the rate at which banks loan each other money overnight. Currently, the rate is close to zero, and has been since the height of the banking crisis in 2009.

The Federal Reserve manages short-term interest rates to regulate the economy and inflation. In a recession, when the employment rate falls, they’ll lower rates so that people will borrow and spend more. This will increase demand and stimulate the economy. If inflation gets too high (i.e. prices are increasing rapidly), they’ll raise rates, so that people borrow less. As a result, there will be less money to buy goods, reducing inflation and slowing the economy.

The Fed’s been at this for a while, and it’s mostly worked–inflation has been under control for decades and we were able to come out of the Great Recession and banking crisis. However, I think there are some big problems with this strategy.

The horrible incentives

Everybody loves it when the economy is roaring. Everyone has a job. Businesses are making piles of money and hiring more workers every day. Salaries are increasing. Politicians claim credit for the economy and get re-elected. Life is good for pretty well everyone.

And in a slowdown, life becomes pretty bad. People lose their jobs and their houses. Businesses profits decline as demand falls and corporations start to compete for what little demand remains, driving down prices. Politicians lose their jobs.

So, if you’re in charge of the interest rates, people will hate you when you raise rates and love you when you lower them. Now, Federal Reserve Bank Presidents, in theory, are supposed to be blind to these forces, and just act in the long-term good. But I think Federal Reserve Bank Presidents actually have a higher motivation: not to look like a nincompoop.

If you’re in charge of interest rates and the economy gets overheated, people won’t care too much. Everyone will be making more money! What’s not to love? On the other hand, if you raise rates too quickly, or set them too high, you can put the economy into a tailspin, creating your very own recession or depression. And, more importantly, you’ll look like a nincompoop.

So, I think that the Federal Reserve almost certainly has a “lower interest rate” bias. I think they’ll interpret the data in such a way to keep interest rates lower than they should be.

GDP not going up fast enough? Decrease interest rates.

Employment plateauing? Decrease interest rates.

House prices skyrocketing? Asset price inflation doesn’t count as inflation, so keep interest rates flat.

Escalating debt

But is that really a problem? Everyone loves a party, right?

The problem with keeping interest rates low for extended periods of time is escalating debt and the creation of asset bubbles. When rates are low, people borrow more. This fuels the economy and also bloats the prices of assets that can be purchased with debt. That’s one of the reasons why there was a housing bubble in the USA and currently is a housing bubble in Canada.

What’s more, when people see the Federal Reserve managing interest rates to bail out the economy, they begin to plan for this to happen. They think the economy is far less volatile than it is. They take on more risk believing that the Fed will “save them” by dropping rates dramatically if something goes wrong. And they’d largely be right.

The reckoning

But then what happens when rates go up? There’s two options.

The first option is that the asset prices collapse. A bunch of people default on their debt because they can’t afford to pay the debt at higher interest rates and the assets are no longer worth what they paid. So the economy is destroyed.

The second option is that the Fed sees the economy getting demolished by higher interest rates, so lowers interest rates even more to avoid a collapse. This does boost the economy, but it also leads to more debt, making it even harder to raise rates later.

So, by managing interest rates, you’re able to avoid a recession, but only by creating an economy that’s even more dependent on perpetually decreasing interest rates and the ratcheting up of debt levels.

The problem with that strategy though, is that you can’t decrease interest rates forever and can’t increase debt levels forever. After a certain point, people can’t take on more debt and lenders won’t lend to people who won’t pay them back (e.g. see Greece). And then you have an explosion.

Increasing fragility

So, by managing interest rates to avoid the short term pain of recession, you get to the point where a much larger blow-up is inevitable. In essence, managing interest rates decreases the medium-term volatility of the economy, but greatly increases its long-term fragility. The result is piles of debt, inflated asset prices, and an economy dependent on debt to achieve any growth.

Is there a better way to do things? I suspect there is, but I’m not sure what it is yet. And I’m confident that we won’t change the way of doing things until there is a massive blow-up. The problem is obvious now, but politically people won’t be willing to do anything about it (those incentives again), until there’s been at least one big blow up.

In my last blog post, I discussed some of the problems with the labor market, focusing on the overpaid. I this post, I’ll discuss the group that is most underpaid in society: teachers.

Are teachers really underpaid? Really? You know they have summers off, right?

Many CEOs are overpaid because the market for CEOs has been distorted by the crony capitalisms of boards and nonsensical pay policies. If that’s the case, what’s distorting the market for teacher’s pay?

Nothing. I think teachers are paid market or above-market rates. There is a fair amount of education required to become a teacher–often an undergraduate degree and a teaching certificate. Nevertheless, enough people want to be teachers that there’s not really a shortage of teachers. There is a constant demand, but also a large supply.

What’s more, the correlation between teachers and making money is hard to determine and indirect. It’s harder to measure than, say, the correlation between sports stars and sporting ticket revenue. Most of the time, you can’t say “Billy had Mr. Abecendari as a teacher, and because of that, he’s making twice the salary he would otherwise.”

So if that’s the case, why are teachers underpaid?

I don’t think they’re overpaid according to the rules of economics. Instead, I think they’re underpaid in the sense that society would benefit greatly out of proportion to the salary increase if they were paid more.

The power of leverage

Teachers are among the jobs with the most leverage in the entire economy because of the massive impact they can potentially have on children. A teacher can make a huge difference in life outcomes, raising a child out of poverty into the middle or upper class. They can turn someone with just potential into someone who wins Nobel prizes or builds companies that change the world, improving the standard of living for everyone.

If each teacher has a class of 40 students, over a 30-year career, they’ll have the ability to significantly influence 1,200 lives. If they simply increase the standard of living of each of those students by 10%, then the return is huge. Ignoring the effects of inflation, we’re talking $5,000 per student, about $6 million per year, or $180 million over the course of their thirty-year careers.

The average teacher salary in the USA is about $55,000. If you were to double it, that’s about $1,600,000 in extra expense over the course of a 30-year career, a significant portion of which come back in income taxes right away. So, you’re making $180M for a 1.6M in investment, over a 100 times return, and that’s just on incomes. When you add in other things that correlate with education and wealth, like less crime, lower incarceration rates, reduced healthcare spending, and increased life expectancies, the leverage you potentially get from excellent teachers is clearly huge.

So, if you really believe that teachers can potentially have this sort of leverage over children’s life outcomes, economically, it’s a no-brainer.

How do you do it?

The strategy, I think, is to start to treat teachers like professionals–doctors, lawyers, etc. Make the job prestigious and well-paid. However, also increase the requirements for becoming a teacher. Ensure that the teachers are truly experts. Take away the union-derived security that teachers have so that, like most other employees, they can be laid off simply for not being great at their job. Pile more money into teacher training and make it competitive, like med school. Measure the short term and long term outcomes of students.

We want to ensure that the teachers we have are among the best in society we have at teaching, rather than ones who want to teach, but are not necessarily that good at it. We want that great teacher who could be making $200K in the private sector instead decide to teach because the position pays enough and is prestigious enough to make it worth it to them. The most valuable teachers aren’t the ones who have done the job for the longest time, but rather those have the best outcomes.

Why aren’t we doing this already?                                                                                                    

The problem with doing something like this is that the benefits derived from education appear long after the education itself. The students that we educate today will be at peak earning levels thirty years down the road. Thus, right now, teachers are viewed as an expense, rather than an investment.

If you’re a politician, you can’t get away with playing the long game. Sure, the decision you make today to increase funding for education could pay off in a big way, but the electorate doesn’t understand that. Instead, they’ll whine about “inefficient, big government” and send you home in the next election cycle. So if you’re a politician, you can’t really care about putting your country in the best position for the future. You have to get elected today.

And what’s more, while you’ll get huge support from the teachers for higher salaries, you’ll have massive opposition to accountability measures. This is understandable, since a large percentage of teachers may not make the cut.

So, you have a situation where the people with the ability to change things will likely get punished for making those change, and the people who care most about education would hate many of the changes. Thus, it no surprise that something like this won’t get done. That sort of thing happens with many interesting ideas.

The bottom line

So, the outcome will be muddling along as we are, with minor incremental changes. We won’t take full advantage of the huge leverage teachers have to make the world a better place. But at least we won’t know how big a mistake that is, because we’ll never see how great the world would 30 years from now if we piled resources behind maximizing our children’s potential.

In our society, people are mostly paid according to supply and demand. If you have a job that a lot of people can and want to do, you generally won’t have a high salary. On the other hand, if you have a high-demand job that few people can do, then you’ll be paid much more. In essence, the market for labor is, in many respects, similar to other markets.

Mostly, this works pretty well. Dentists and doctors should get paid more than low-skilled construction workers. But leaving it there is boring. Instead, it’s fun to look at the areas where this market design fails. And when it comes to salaries, people seem to complain the most about highly-paid sports stars, actors, and musicians.

“He’s paid millions just to play a game!”

It’s obviously true that the ability to put a ball or puck into a net isn’t worth a lot intrinsically. Athletes don’t provide food to millions or greatly improve the standard of living for thousands. You can go for an entire year without watching TV or listening to music, and you won’t die.

Nevertheless, I think athletes, movies stars, and musicians are worth the amounts they are paid. These people are in the business of entertainment, which can be highly lucrative in an economy with the mass media. Today, millions of people can observe a single performance. If you charge $10 for each person, then you have huge amounts of revenue.

What’s more, these sports stars, actors, and musicians aren’t interchangeable. They have their own distinctive abilities and brands. People really want to see LeBron James play basketball or Tom Cruise tear a mask off his face. They don’t want to see me do the same thing, for good reason.

So in an economy with mass media, these celebrities are going to bring in piles of revenue. A significant portion of that revenue wouldn’t exist without the star, so it’s reasonable that they get large paychecks. In fact, I think athletes are often worth more than they’re paid, since the owners of sports teams have collaborated to pay them far less than the natural market wage (using strategies such as capping the amount that a new player or the entire team can be paid).

And if you still believe that these celebrities are making too much, who do you think does deserve the extraordinary revenue these stars bring in? Their sports team? Their recording label? The film studio?

The ones who are overpaid

On the other hand, there is a group that I believe is often overpaid, CEOs of large, successful companies. Much of the time, they’re not providing significant value in excess of what many others could provide in running the company. In many cases, I think you could roughly the same outcome with someone much cheaper.

The crux of the problem is that most large companies are successful because they have competitive advantages. For instance, Pfizer has both patents and trademarks that stop other companies from selling Viagra and the institutional knowledge of how to get drugs through the FDA. Coke has brand recognition and distribution networks. eBay has networking effects (i.e. buyers purchase from the website with the most sellers so they can get the biggest selection at the lowest price).

These businesses have become successful because of these competitive advantages and remain successful because of them. If you’re a retailer, are you more likely to stock a new soda from Coke on your shelves or a new soda from Joe Shlubadub? Clearly Coke. It has the better brand,resources, and organization to launch a new drink.

As the CEO of Coke, you don’t have to be all that smart. It’s quite difficult to mess up badly, because the business has such large competitive advantages. Warren Buffett summarizes the situation for these sorts of businesses nicely: “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Nevertheless, the CEOs of these businesses are paid extraordinarily large sums. Often, they’ll get stock or options that will pay them hundreds of millions of dollars even if they underperform the market.

Why does this happen?

This problem arises because the market for CEOs is designed in a way to constantly inflate salaries. It doesn’t obey the “supply/demand” dynamic.

The start of the problem is that for these supersize companies, twenty-five million dollars isn’t that big a deal, often far less than 1% of revenue. So, they have the ability to pay out extraordinary salaries.

Second, the people who determine the salaries are the board members. Typically, board members are also leaders of their own successful companies and friends with the CEO whose compensation package they are deciding.

Thus, as CEOs, they likely often start from the position that CEOs ought to be paid a lot of money because they believe that they themselves should be paid a lot of money. They probably also believe that the CEO is responsible for a huge portion of the success of the company, rather than just being one of hundreds of thousands who could run a business from a strong competitive position. (And really, if Fred’s your friend and the company can afford it, why not pay him lots of money? Fred’s a good guy.)

They’ll generally claim this approach is reasonable because a market research firm agrees with them. A market research firm hired and paid by the highly-paid board, a market research firm that has a choice between saying, “You guys are insane. You’re grossly overpaying your CEO, and are probably overpaid yourselves”, or saying, “Yeah, that’s the right number. You guys are brilliant.” I imagine the market research firm invited back the next year is rarely the one that delivers the former message.

As if this wasn’t enough, many companies have a strategy to pay at the 80th percentile (i.e. pay more than 80% of comparable companies) to their top people. This is justified, of course, by saying that it’s worth making that sort of commitment to ensure that you have the best CEO. But when everyone uses this strategy, it causes huge wage inflation as it’s impossible for more than 20% of companies to be 80th percentile. Price wars develop as 100% of the market struggles to be in the top 20%.

The bottom line

This isn’t to say that all CEOs are overpaid. There are CEOs who, like celebrities, add enough value to their businesses to be worth their huge salaries. But they aren’t the CEOs of Coke or Proctor & Gamble. Rather it’s the guys like Bill Gates, Elon Musk, Mark Zuckerberg, Jeff Bezos, and Warren Buffett–often founders, but not always. These are the people who are able to do extraordinary things that nobody else could do, and in doing so, provide significant value to their businesses.

For me, the key to differentiating them is whether they’re making decisions that a monkey could make or if they’re constantly surprising you in a good way.

An Allowance Strategy for Children

One of the best things that you can do to help your children out in life is to teach them money management skills. Many problems in life are caused directly or indirectly by money (or lack thereof), so if you can teach them to handle their money sensibly, then you can eliminate many problems before they even arise.

There are many aspects to handling money well, but one of the earliest ways to start is by instituting an allowance. In this blog post, I will discuss the allowance strategy we are using with our children.

Entitled brats

In the adult world, you typically don’t get money handed to you without doing anything. So, even the concept of the allowance is a bit unnatural and one can reasonably argue that by providing an allowance, you’re teaching their child that the world owes them something. Such an entitlement mentality seems like a bad thing–a child with such an attitude is likely to act like a jerk and suffer lots of pain until living in the real world disabuses them of the notion.

Nevertheless, I think an allowance, properly implemented, is unlikely to result in this entitlement mentality. First, a reasonable sized allowance will only be enough to buy a small fraction of what the child will want to acquire. Thus, they are unlikely to feel entitled to anything when they see their money sharply limiting what they can purchase themselves.

In fact, when I was a teenager, one of my brighter friends didn’t want an allowance. His reasoning was that he would actually be able to get more stuff just by begging his parents, since they wouldn’t be able to fall back on the “buy it yourself with your allowance” argument. This strategy worked out quite well for him (in terms of accumulating more stuff, anyway….)

So, I think the entitlement argument mostly a red-herring, unless you give your child enough money to buy whatever they want or don’t force them to live within their budget (i.e. give them an allowance, but still buy them whatever they want when they run out of money). Thus, allowances might not be representative of the real world, but in moderation, they shouldn’t be too destructive either.

The goals

So entitlement isn’t a problem, but neither is it a good reason to provide an allowance. So, before implementing an allowance, it’s important to think about why you would do so. For me, the answer lies in providing a basic education about money. There are several things I want my children to learn.

How to handle money: In this category is the physical act of purchasing goods. They will understand how to go to the cash register at the toy store, hear the cashier tell them how much they own, take the money out of their pocket and give it to the cashier, and get change in return. They’ll learn about sales tax. They’ll learn basic money math (if I buy a Barbie for $12.99, and I have $20, I will get back about $6 in change after tax.) When they get a bit older, they’ll even learn about tipping.

The value of money: If children get whatever they want just by asking their parents, there’s no reason not to ask for anything they want. But if they have an allowance, they have to start making value decisions. Do they want to purchase that video game or a new set of Magic cards? There isn’t enough money to buy both, so they have to decide which one is worth more to them.

Just as importantly, they’ll go through purchase regret, where they buy something shiny, and realize within an hour that it was a really stupid purchase. There will be much wailing and gnashing of teeth, but the child will learn to think carefully before spending their precious money. These are great lessons to learn as a child when the purchase is a $60 bicycle for a doll, rather than as an adult when the purchase is a $300,000 Ferrari.

The power of savings: Just as important as learning the value of spending money is learning the value of savings. It’s important to learn that money spent today cannot be spent tomorrow. They’ll realize that if they hadn’t bought that video game last month, they would have been able to purchase a video game system this month.

The value in giving back: A risk of this focus on money is fostering an obsession with money. Ideally, we don’t want our children to turn into Scrooge. Thus, an allowance also offers an opportunity to teach the value of charity, allowing the child to experience giving away a portion of their own money to a cause they care about.

Advanced financial lessons: Finally, an allowance will enable more advanced financial lessons ranging from the power of compounding, the wealth-draining properties of consumer debt, and the value in investing. If the children don’t have any assets of their own to manage, it’s all theory. Once they are seeing their own assets grow, these lessons become far more real and compelling.

The implementation

In order to try to bootstrap some of these lessons, rather than just throwing money at our kids to spend as they will, we are adopting a three bucket approach. Their standard allowance–which increases at an approximately 10% rate each year–is allocated into three categories.

The first category, making up 60% of the money, goes into the spending category. It can be spent on anything–candy, comics, video games, dolls, books, whatever. The second category, comprising a 30% weighting, goes into savings. This money can still be spent, but only on bigger ticket items that actually require saving up to purchase. Or, it can simply be saved in perpetuity. The final category, at 10%, is for charity.

The hope with this sort of a breakdown is that the children will learn that items that seem prohibitively expensive are actually reachable in reasonable amounts of time simply by saving, while still allowing the children to make impulse purchases if they choose to do so. Ideally, they will also realize that taking care of others is a good thing, and that it’s reasonable to allocate a certain percentage of your budget to giving to others.

Has it worked?

We’ve been offering the allowance for several years. It’s a bit early to know if the lessons the children learn from this will permanently stick, but the basic handling of money seems to be there already. I’ve also seen my eldest decide not to buy something because they thought they’d rather save their money for something better that might come up in the future. So, there are some positive signs that lessons are being learned, but we’re still very early.

When I was ten, I visited some friends in Australia. Now, Australia has some cool things–bizarre animals, gorgeous beaches, and strange politicians. But the thing that struck me the most was that our friends had fruit trees in their back yard. Whenever they wanted, they could go out back, pick a guava, and eat it.

As a ten-year-old, this struck me as the best thing ever. Food that just magically appears on the trees outside, more than you can even eat yourself. So much that you have to share it with your neighbors.

So when I returned to my home in Prince George, Canada, I stuffed an old orange juice container with soil from our vegetable garden. Then I buried a seed from an apple I bought at the grocery store into it, and waited.

Eventually the seed sprouted. I was delighted. I’d soon have my apples.

The faltering dream

It didn’t grow quickly, but after about six months, the seedling was six or eight inches tall. At that point, I decided that it had grown too big for the orange juice container, so I transplanted it outside to the middle of our front yard.

After that, the tree didn’t make much progress. You see, Prince George is in the center of British Columbia. It’s pretty cold up there. In those days, you could expect to see a week or two of sub -30 C (-25 F) weather each winter. What’s more, there wasn’t a lot of sunlight. We lived in the middle of a forest, and the taller trees blocked much of the light.

So my apple tree never really amounted to much. It grew to a foot and a half and just stopped. It never sprouted many leaves or branches, let alone apples. It just wasn’t a great environment for a fruit tree.

By the time I left the city when I was 18, I knew what a naïve dreamer I had been. There was a reason why you never saw apple trees in Prince George. And even if one could survive, it wouldn’t mature fast enough for me to enjoy its fruit.

Recognizing reality                

I realized then that I was a child with a dream when I planted that seed. But at 18, I was close to being an adult. I needed to see the world as it was, not how I wanted it to be. I left and never thought about that seed again.

Now I’m married with two kids, living five hundred miles away in Vancouver. As part of our summer vacation, we decided to drive up north to visit my brother and his family in Fort St. John. Along the way, we passed through Prince George. I hadn’t been there since 1991.

On a whim, we drove up the long winding road to see my old home.

It looked mostly the same. The house had been repainted. The garden was gone. The driveway was refinished.

And there, in the center of the lawn, was a large apple tree, its branches sagging under the weight of hundreds of apples.

In the last few blog entries, I’ve been talking about Guaranteed Minimum Income. A reader asked the very reasonable question of what evidence was there that the GMI would actually “work”. So far, within North America, there have been several experiments to determine the impact of a GMI

These studies generally focused on similar dimensions, trying to understand both the positive and negative impacts of the GMI. In particular, they seem to focus on the labor market, health outcomes, and social outcomes. In this blog post, I’ll talk about the results.

Made in America

In the late 1960s and early 1970s, the US government carried out several experiments with a guaranteed minimum income. Oddly enough, this research was carried out under the direction of Donald Rumsfeld and his assistant Dick Cheney (providing more evidence that, regardless of what you think of Rumsfeld’s politics, he’s probably an interesting fellow to sit beside at a dinner party.)

That they were involved is not as mad as it seems. Milton Friedman, the patron saint of free markets and modern Republicans, suggested the GMI. Though Republicans today would be outraged at the idea of GMI, that outrage would typically stem more from ideology, polarized politics, and fervor incited by the mass media than from actual evidence or reasoning.

These experiments were carried out in New Jersey, Pennsylvania, North Carolina, Iowa, Seattle, and Denver. In all cases, they use a reasonable experimental framework, comparing a randomly selected experimental population to a similar control group.

The evidence indicated that the GMI resulted in reduction in work effort of 13%, the majority of which was secondary and tertiary earners. What’s more, part of the loss seems to have been attributed to adolescent males entering the workforce later, possibly spending more time at school. This hypothesis was supported by higher test scores in children in the experimental group, reduced dropout rates, and increases in adult continuing education. Little health data was analysed, though one study did show improved birth-weights in the most at-risk individuals.

Other than the small work effort reduction, the main negative was an increase in divorce rates of experimental families in one of the studies, though a subsequent analysis concluded that this discovery was a statistical error. To me, this result, even if it were true, isn’t actually all that negative. Is it better for society for a couple to be forced to stay together for economic reasons, or for an unhappy couple to be able to break up because they can afford to be apart? I tend to think the latter is preferable. Individual happiness seems more important than any moral imperative to maintain unhappy marriages.

In the cold, snowy north

A similar experiment was conducted in Manitoba, Canada, both in an urban Winnipeg location and a rural Dauphin location. The Winnipeg location had experimental and control groups, while the Dauphin location offered the program to everyone. The latter has the obvious disadvantage of no control group, while gaining the advantage of showing what would happen with a universal program, rather than a small sub-segment of a bigger community.

In Winnipeg, they only analysed the impact on the labor market. The results there were similar to the US studies–a relatively minor impact on the labor market, clustered in secondary and tertiary earners. This is an interesting result, but I think it’s frustratingly limited, since it can only be used to refute an argument for not providing a GMI, rather than actually supporting a GMI.

Dauphin, on the other hand, had broader data allowing a more detail analysis of other dimensions. Like the American study, the GMI led to fewer teenagers dropping out of school in Dauphin. Hospital use and mental health hospital use of Dauphin residents relative to non-Dauphin residents declined. There were no statistical differences between the incidents of low birth weights, the newborn death rates, or marriage dissolutions.

One other interesting hypothesis proposed by Evelyn Forget in her Dauphin analysis was that GMI may have a social multiplier. If GMI results in one individual deciding to stay in school longer, their friends may be more likely to stay in school as well. I imagine this effect could be both positive and negative–if someone decides to quit their job and just live off the minimum income, their friends might decide to do the same thing as well.

What I make of all this

This social multiplier hypothesis shows one of the problems with these sorts of studies. If this multiplier really exists, it could be highly problematic. It might not be visible in the standard limited-population studies where there is both an experimental group and a control group, but only in saturated studies, studies where every individual participates.

Of course, the saturated studies are closer to a real-world implementation. But in saturation studies, it’s much more difficult to form solid conclusions because it’s much harder to find a control group.

Nevertheless, these studies seem pretty useful to me, because I believe that we largely know already from other, non-GMI studies that higher incomes increase happiness and improve outcomes. And we know that we get the most leverage by helping the poorest. If you give a millionaire $10,000, they probably don’t care too much, but if you give it someone living at the poverty line, it matters a lot.

So to me, the primary argument against GMI is based on labor productivity, and I think the results here show that there is a relatively minor impact on the primary earners. If a bunch of parents stay home to take care of their kids and a bunch of teenagers complete school instead of working, that seems like it could be a good thing.

The bottom line

All that said, I still don’t think there’s great evidence either way, and I also think it’s basically impossible to get great evidence. But I believe the mediocre evidence largely supports the idea of a Guaranteed Minimum Income. At this point, we don’t have enough evidence to do it for an entire country. But perhaps we know enough to try it at a state or a province.

A commenter on my last post about a Guaranteed Minimum Income raised some interesting questions. Do we have any evidence that a GMI would actually work?  And if not, how would we get such evidence?

This is certainly a worthwhile question.  After all, if we’re going to totally change the distribution of production for the entire country, it would be nice to know that we’re not going to ruin everything. Remember, we’re dealing with economic incentives, and when you mess with incentives, there are often unforeseen consequences.

I think that we don’t know whether GMI would work, and we’ve unlikely to have conclusive evidence of whether it will work or not without actually trying it. The economy is too complicated to predict and Guaranteed Minimum Incomes would be a huge change.

But that’s a boring, unpalatable answer. So, instead of stopping there, how about we start to look for ways that we might get closer to an answer.

What is success?

The most important question to start with is to decide what “actually work” means.  For this exercise, what is success? Reasonable people could have one of any number of answers, including:

• Maximize GDP per capita
• Maximize GDP growth
• Maximize median income
• Reduce income inequality
• Maximize average happiness
• Reduce happiness inequality
• Reduce the percentage of people below the poverty line
• Reduce catastrophic economic outcomes
• Improve social cohesion
• Create a stable and self-sustaining program

Theoretically, as a scientist, you’d typically figure out which of these areas you care the most about, and examine those through experimentation. As a politician in 2015, on the other hand, you’d decide whether your ideology supports GMI and select whatever dimensions support that ideological view from whatever studies are already out there.

I’m not sure what the right criteria for success are, but I think I think pretty important ones are sustainability and average happiness. In fact, I’d say sustainability is a requirement–without that, none of it is real. And if we’re not doing this to make people happy, then why bother?

On the other hand, if we regressed to become a bunch Neanderthals sitting around banging rocks in a cave, but were really happy doing it, I wouldn’t consider that a success either.  So it feels like success needs to have some element of maintaining economic progress as well.

Becoming a mad scientist

So if we vaguely know what success looks like, then how to we create an experiment to test GMI?

The problem with the social sciences, including economics, is that often, you have to be completely deranged to run real experiments. For instance, suppose you wanted to find out if being a victim of domestic violence as a child leads to perpetrating domestic violence as an adult. Despite the clear value in knowing the answer to this question, many would consider it wrong to divide up a classroom of children into two groups, and beat all the children in group A every day (while giving group B only the number of beatings that a child living in our society would normally expect).

Thus, social scientists are limited in the types of experiments they can run. They typically try to avoid things that hurt people. But even if they can create an ethical experiment, the fact that they are running an experiment can influence the outcomes.

For instance, one natural way to test this theory would be to take a large subset of a population, divide it up into two groups, and give one subset a GMI, and nothing to the other for a long period of time. But would the non-GMI group even care about the study if they weren’t receiving money? Would the GMI group feel like they had to work less to “take advantage” of their good fortune to be in the GMI group? If you add progressive taxes for the GMI group to pay for the program, would it make the wealthy in the GMI group resentful of the wealthy in the non-GMI group, and want to drop out of the study?

Freeloading Canadians

Then there’s the fact that the GMI group benefits from the value provided by the non-GMI group. The pharmaceutical industry is a good example of this today. Drug companies spend billions discovering new drugs because they know that when they find one, they can recoup their costs by charging Americans $10 for a pill that costs $0.03 to manufacture.

But the price for drugs in Canada is far less than those in the USA. Because Americans pay high drug prices, the pharmaceutical companies will create medications that they never would have created if drug prices were as low as in Canada. Yet Canada still gets the benefit of those drug discoveries. In effect, Canada is a freeloader on US pharmaceutical research.

A similar problem would exist with small-scale GMI studies. Suppose some non-GMI participant, incented by lower taxes and the chance to become rich, creates a next whizz-bang gadget. The people in the GMI group will still benefit from the gadget, but you won’t know whether that gadget would have even been created if everyone were in the GMI group.

So what’s the poor social scientist to do?

Social scientists have solved these sorts of issues in several ways.

Data Mining: One way is to become data miners.  Basically, instead of doing experiments, do statistical analysis on data that has already been gathered by surveys and other means.  If you have the number of welfare recipients in a bunch of counties and you know the average GDP in those counties, perhaps you can do correlation analysis and find out something interesting.

There are huge problems here, of course. We’re looking for causation, but correlation doesn’t imply anything about causation. If A is correlated with B, perhaps A causes B. Or maybe B causes A.  Or maybe C causes both A and B.  Or maybe it’s D….

Even worse, the chance that the data contains the exact information that you’re looking for is low.

Natural Experiments: A natural experiment is one where, independent of any experiment, individuals happen to have been assigned randomly into one of two groups, only one of which ends up being exposed to experimental conditions. Thus, in such cases, you end up with an experimental group and a control group with randomly assigned members.

An example of such a natural experiment was the Georgia land lotteries in the early 19th century. Lots of land, formerly owned by the Cherokee Indians, were given away to thousands of Georgians in a random lottery. By comparing the outcomes of those who won the lottery to those who entered but lost, you can determine the long-term impact of an influx of a moderate amount of wealth on Georgians.

The problem, of course, is you have to get lucky to have a random experiment that sheds light on the exact question you want answered.

Say, “Screw It”: The third option is to try to set up an experiment that isn’t really all that much like the question that you want answered, but at least is ethical. State openly the problems with the experiment and how the huge flaws in the experiment’s design are likely to invalidate the conclusions of the experiment.  Then, get picked up by the media, who expand the rather weak conclusions of the experiment into an all-encompassing definitive statement while completely ignoring the massive issues with the experimental design.

The bottom line

Determining whether GMI would work is hard (impossible). Because it’s a social science, you can’t run the experiments that would give you the evidence you’d need to be confident in your conclusions. Nevertheless, keeping in mind the difficulties inherent in these sorts of experiments, there have been several studies that begin to examine these issues.  I’ll talk about some of those in my next blog.

In my last blog post, I discussed the rise of automation. The basic problem is that, as artificial intelligence systems and robots become more advanced, the value of human labor falls. Unskilled labor–particularly manual labor–may eventually become almost worthless. It’s easy to say that the invisible hand will magically create jobs for the newly unemployed, but to me, this argument seems to be less based on reason, and more based on a religious faith in capitalism. Thus, we need to examine other solutions to the inequalities created by automation.

The problem

We’ve known for decades that there is a correlation between employment and IQ. For instance, one 1994 study found 14% of people with an IQ less than 74 had been unemployed for at least a month in the preceding year, versus only 4% of those with an IQ greater than 126. It seems likely to me, by eliminating unskilled jobs, automation should exacerbate this relationship because many people who lose their job to automation will be incapable of retraining to do more skilled jobs.

Even if you are skilled enough to keep your job, this trend is a big problem. The more income disparity increases, the greater the instability in society. If we end up with, say, a third of the population without any reasonable prospects for employment and the rest of the population with the highest standards of living of all time, then it’s likely to result in conflict.

It’s ironic that, while a significant portion of the population will be struggling to achieve subsistence standard of living, they will be doing so at a time when human productivity will be at an all-time high, when a small fraction of the population can produce enough to address the needs of all.

And that suggests one possible solution, the guaranteed minimum income (GMI).

Will there also be chicks for free?

The guaranteed minimum income is exactly what it sounds like–money for nothing. Every month, every adult, regardless of whether or not they are working, gets a cheque from the government. Those who make more than the monthly minimum income would have some of the amount taxed back.

The government would levy income or consumption-based sales taxes  to pay for guaranteed income. In effect, in a world where people aren’t required to produce a multitude of goods, the government will be ensuring that the goods are more widely distributed than they otherwise would be.

Isn’t that communism?

The GMI model is significantly more free market-based than communism.  Communism typically has a centrally-planned economy–the government deciding which goods get produced in what quantities. In this model, consumer demand will still determine what gets produced, since consumers will decide what they want to purchase with their income.

Second, communism, by definition, has communal ownership of wealth. In this model, there is still private ownership of wealth, but there would be fairly high taxes required to support the guaranteed minimum income, redistributing a significant portion of the wealth.  So, GMI isn’t communism, but is certainly more socialist than what we have today.

One of the problems with communism is that, because individuals don’t own the product of their labor, there is little incentive to work hard. Why work if you don’t get anything as a result of your effort?  And that is also a potential problem with the guaranteed minimum income. If people don’t have to work to survive, will they?

Possible solutions

One possible solution to this problem is to be smart about the tax rate on incremental income above the guaranteed income. If the income tax rate ramps up slowly, then the incentive to work is still relatively high. For instance, perhaps there is no income tax on any income up to $10,000 above the guaranteed minimum income, and the tax rate on the next $10,000 is only 5%.

This strategy will result in a highly progressive tax system, where the top earners will pay a huge percentage of the taxes, but that’s already happening today anyway. There is often discussion about how this will cause the huge earners to not bother trying to become a huge earner. But I believe most people making stupidly large amounts of money are working mostly for reasons other than money (e.g. power, social validation, curiosity, fun, desire to make the world a better place, community). So, while high income earners will whine, it seems unlikely to me that most of them would slack off because of taxes.

Another option is to make the tax system to support the GMI mostly through taxes on consumption so that there are no income tax-based reasons to stop trying. However, this method is perhaps sub-optimal as it would be highly regressive, increasing inequality, the opposite of the goal of GMI.

Would these methods be sufficient to ensure that everyone wants to work?  It’s doubtful, but in this highly-automated economy, you don’t need everyone to work. You just need enough to keep the economy chugging.

And now for a contradiction

Another interesting way to implement the GMI might be to make payouts revenue-based.  In other words, the government will provide a guaranteed minimum income, but the minimum will vary on a monthly basis depending on the tax revenue and the number of people being supported.  You could do this by putting all the GMI tax revenue into a bucket that is divided evenly among all eligible adults. This approach might address the incentive problem–when production falls, the payouts fall as well, and the incentive to work increases.

For instance, suppose that you have a population of 10 people. Eight of them are making $20,000 and have their income taxed at 50%, while two do nothing. Then the tax revenue bucket would be $80,000, divided among 10 people, or $8,000 per person. So the workers make $10,000 from their jobs, and $8,000 from the GMI, or $18,000. The non-workers make just $8,000, just under half of what workers make.

But then suppose three of the workers decide they’d rather not work and just live off GMI. Then, since we only have five workers, the amount of money in the bucket falls to $50,000. The GMI payments are still divided among 10 people, so fall to $5,000. That increases the incentive for the non-workers to start working, since their income is now much lower, $5000–only a third of workers’ $15,000 income. What’s more, with the reduced supply of labor (only five workers rather than eight), those five workers will be more in demand, and their salaries might increase as a result, further increasing the incentive to work.

Conclusion

I have no idea if this bucket approach is actually practical. But GMI is an interesting solution to problem of excess unemployment as a result of automation and should be seriously considered. It’s not something to rush into, since it seriously messes with incentives in the marketplace and therefore has the risk of unforeseen side-effects. But, with some more thought and exploration, we might be able to discover ways–such as the bucket approach–to reduce the disincentive impact of the GMI while still lowering inequalities. And that would be the best of both worlds.