Karl Smith on Market Power, the Great Variation, and Choices for Fed Chair

Karl Smith is the director of economic research at the Niskanen Center. Karl joins Macro Musings to discuss his thoughts on increasing market power (the ability of firms to influence prices) in the United States, as he argues that this is at least partially due to what he calls the “Great Variation,” the desire many Americans have had for more individualized consumer goods since the 1960s. Finally, Karl also shares his thoughts on some of President Trump’s choices for Federal Reserve chair.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Karl, welcome to the show.

Karl Smith: Thanks. I'm glad to be here.

Beckworth: It's good to have you on. We actually go way back, back in the good old days of blogging. We still blog occasionally. But we cut our teeth I believe in blogging back during the crisis. But tell us and our listeners, how did you get into economics and tell us your journey to the Niskanen Center.

Smith:   Okay, so I went to North Carolina State. I was born in North Carolina, I was raised in Greensboro. I went to North Carolina State mainly to be a student athlete, but when I took my first sort of economics course service economics 101, I fell in love with it. I took another course and took another course, and in fact, in I think the first three years I was there, I had taken through all the main theory courses of undergrad, and I started on their sort of graduate program. It was an immediate falling in love. I left a little bit to try to make a…

Beckworth: Interesting.

Smith:   I actually... for a brief period I came... for coming here. I think it's called [inaudible]. That company folded and I went to work for Accenture to the large consulting firm and then after just about one was clear that everything was not going to pan out there I just went back to graduate school and I finished my graduate degree. I got my PhD and that was actually NC State, just where I come from. And then I became professor at the University of North Carolina, UNC in their school government. And so I was there, I don't know, maybe about five years, I guess. And during that time I started model behavior. It actually turned out because the school government has a unique mission and has a really strong engagement mission, and it's actually advisor to the North Carolina General Assembly, that they became a little bit uncomfortable with some of the stuff that I was doing on model behavior, they thought I was a little bit too sharp.

Smith:   And after some negotiations, they basically gave me some money to leave. And so I came to DC briefly to try to sell model behavior big time, but I think that was about when blogs as blogs were sort of like.... there where some who were getting eaten up, but I had the idea that maybe I would get eaten up, maybe get eaten up by a box or something else. But that didn't happen and so I started an independent consulting for a while … some consulting for … called Pantheon. And I came to Niskanen. I don't know, that's a long story I don't know if you were able to hear. But yeah.

Beckworth: That was great. As the listeners know I started blogging back in the fall of 2007-

Smith:   It sounds about when I was in... maybe a little bit after that. I mean-

Beckworth: ... Yeah. You... I'm already coming on the scenes, modeled behavior, and what's interesting is, one day I get an email to go to a blogging conference all paid at the Kauffman Center, and at first I thought this must be a joke who pays bloggers to go to conferences? Trip pay but anyways, you were there, a number of other people were there and that's where we first met and kept our conversations going. So it's been new to see you getting to the Niskanen Center and said of course I'm here at the Mercatus Center now. So have a blog will travel, open up doors for us. In addition to the fact we were already academics doing our own our research and stuff along the side, but you've done some interesting work and model behaviors has been great to follow over the years. And some of the work you've been doing recently at Niskanen Center, some of your writings still is with this big hot Topic of market power. We're going to get into that and as well get into some maybe recent Fed Policy, time permitting on the show. But before we do that, tell us about the Niskanen Center because it's relatively new, maybe some listeners would like to know more about it.

Smith:   It's relatively new, our president Jerry Taylor spent... I'm going to probably get the exact details wrong here, but I'm going to say something like 30 years at the Cato Institute, he decided to leave and start his own organization. So he struck out with Niskanen Center, named after Bill Niskanen who was one of the founders of Cato. And the idea behind the Niskanen Center was to stay with generally libertarian policy, although we've moved over to what some people might call liberaltarian after an article that Lindsay wrote who at the time was a scholar at Cato. I've tried to call it neoliberalism, but I don't know. I don't want to get into that I've sort of like hijacked this term and used it for us. But basically, it sort of abandoned some of the, I guess, deep first principles commitment to libertarians that Cato has, and has more of a Chicago School of Economics approach to libertarianism. So it's a practical sort of libertarianism, and we think that moves the margin, make a big difference. And so we're not concerned with the grand scheme to sweep away the state, but how to make the economy more dynamic, how to make it more market focused, how to deal with problems like climate change in the most market friendly way. So that's what we're doing at the Niskanen Center.

Beckworth: Okay. very pragmatic-

Smith: Pragmatic.

Beckworth: ... Push for more free market solutions. All right, let's get into this question of market power. And to motivate this, I want to bring up some of the recent discussions we're hearing about or read about a lot. That includes things such as fear of startups, we hear often, there is a rise in business concentration, declining interest rate, labor, mobility, declining labor share of income, medium real wages have fallen, labor force participation rate for males has declined, I just read an article this morning that the companies are getting older, they're aging, and there is consequence to the less productive, which is productivity growth, is a very depressing kind of collective narrative here, you put together and it's really, man, what's happened to us? So you kind of get this impression, and we're either this old man who's sick type of economy, like we're losing dynamism.

Beckworth: Well, there's another story you can tell which I think we'll get into more your take is that maybe there's some structural changes going on. We're just miss reading these signals, they've made it look bad on the surface, but the implications, interpretations might be actually more benign, maybe even positive. Before we get into the nitty gritty of market power, though, I just wanted to kind of step back and ask your take on it, is this more of a sick man story, all of these indicators we've just mentioned? Or is it more of a structural change story?

Decline of Dynamism: The Sick Man Story

Smith:   I think it's some of both. I mean, I think the loss of dynamism in the economy or the story you told is probably central to Niskanen sort of work and our focus and what we want to examine. And so I spent virtually all the time there thinking about it, and even before I came…] where the people spend a lot of time thinking about that. And I mean, what we think is that especially with some of the things of the regulatory state, we think that there are what we sometimes called pebbles in the stream, or things that have sort of slowed us down there are land use regulations, which I think almost everybody is starting to accept as a big deal. We think that things like occupational licensing are big deal. We think that the general sort of predisposition to restrict economic rights, if there is even the sense of a harm or the sense that some will be put out, but those things do seem to be having some negative effect on the economy.

Smith:   I think also that there is probably... well, that is related to a deeper structural change that seems to taken place around 1960, and I think it's a story referring to our talk about that. A lot of what seems to happen is that our drive and sort of pure industrialization in just getting more total atoms under our control, and molecules under our control for each person, more material stuff, ran into diminishing returns in the 60s', because people had almost as much material stuff as they wanted, what they then wanted were things that were more tailored to them, more individualized experience, and so there's something at that hypothesis I talked about, is that coming out 1916 you saw the great variation, where we see instead of just bigger and more bigger cars, more houses, more products, we see more personalized stuff.

Smith:   So someone is like, what kind of home where it like represents me. And this is a different kind of economy that rewards different things. In particular, you're going to need to spend a lot of time developing particular niches in the economy, and that's a sort of capital that's hard to measure, but it's as important to produce in the experience as our traditional sort of, like bricks-and-mortar capital as the machines that we've had in the past. And so some of what we're seeing is just heavy investment in these particular niche experiences, to give people I guess, more what they want now, not just more stuff, but more stuff that sort of tailored to me in my life. Yeah.

Beckworth: So this story that you're telling is a little bit different I think, correct me if I'm wrong, but kind of the smart machines are coming in to take over the world story. The second industrial age. This is a little bit different. You're speaking more towards we all have niches that we want, or maybe the technology has arisen to meet that demand. Are these stories different? Are they complimentary?

Smith:   I think they're somewhat complimentary. I mean, one of the things that like digital technology is allowed and the way that we've used it is to give us more personalized experiences. So I think everyone sort of identifies the big product to come out of your smartphones. Well, smartphones give you your own sort of like on me personal computer personal view into the world. And so that's an example of how one of our fastest growing technological areas has split off into giving people personalized experiences, where we don't then just have our like bigger and bigger and more powerful computers. And we sort of saw that run out in digital technology too, that I mean, at first is just about more memory, more processing speed, how fast can I possibly get my computer, but then it soon turned or not soon, but eventually turned into shrinking it down, having an army all the time, having absolutely exactly this week that I need and not just a bigger, more powerful version of Word, and that's illustrative of the kind of switch once you get to a certain level of base power towards individualization. Towards making it personalized for the individual.

Beckworth: Okay, so there's both structural change, it's coming that.... I believe is coming really big, driverless cars, smart machines, artificial intelligent. All this is happening but at the same time alongside that is this increase product differentiation, this increase niche marketing of people because it's not just about having the quantity, it's the quality of life as well. Alright, so that's kind of the nice story with all these bad signs. I just went through the declining and labor income, the concentration of business, pure startups. That's one possible interpretation, the other one and of course, is that we're the old sick man, the economy, it's stagnating, and you said there's a bit of both going on. Right? So there's some of both. The bad regulations... Tyler Cowen is you know, has a new book The Complacent Class, and I had him on the show and kind of the takeaway I took from that book is that as a whole, our American culture is becoming more risk averse on the margin.

Beckworth: And so we see it manifested in regulations that you mentioned, the protection of income and businesses, but also the way we raise our kids helicopter parenting to little things like that to broad things like we couldn't build the Hoover Dam again if we wanted to just because of so many regulations. So, do you worry that we are becoming more risk averse in the margin? Generally, in our culture, do you buy into this complacent class?

Are We Becoming More Risk Averse?

Smith:   I do to some extent, and I think that these two phenomenons are sort of related too. So when there was sort of like, widespread metallic deprivation, the notion that we could just do more have more, cure diseases, control the rivers was inspiring to everybody. But as I think we sort of shifted out into, our own niches, the great variation or whatever, not messing up my little corner of the world became more important to people. Now, on just the surface of that, I would say, there's a preference, nothing wrong with it, but what you lose, I think, is the spillover effects from dynamism. So one of the things that happens is that as people take risk, as they take chances, they discover new things, and a lot of the benefits of those things don't just accrue to them, but to anybody else in society.

Smith:   So there's a self-reinforcing story of growth that happens when everyone is taking chances. Some people will fail, but the knowledge that they create, even during some of their failures will help out the next person. And the fact that we've lost that, those sort of like dynamic spillovers, I think it's disconcerting. And I think that, that fits with what Tyler's talking about. He's always a little cagey about exactly what the underlying phenomena is, but I think our stories are complimentary. I mean, his take I think he's a little bit more pessimistic, and mine is ego tends towards the optimistic but aware of sort of the challenges that this presents us.

Beckworth: Okay, so we've got the two narratives, the sick man story, or the structural change story, which is much more positive, there may be a bit of both of those of actually what's going on. But going back to the phenomenon and the people trying to explain, one of them is the decline in labor share of income, so a lot of on the surface bad developments, that seems to be one of the troubling ones, and there's been different stories again, we can point to these two broad explanations, but some of the explanations would fit into those two camps. One would be automation is driving some of that decline labor income. Another one is globalization.

Beckworth: And then I want to mention an article here by David Otter, David Dorn, Lawrence [inaudible], Sheena Patterson, John Van Renan 2017 AEA preceding article, but the articles concentrated on the fall labor of share, and they basically tell the superstar winner take all argument driven actually by good firms who are better with technology, more productive firms are increasing concentration, so in a way there's increasing concentration they show but it's because these firms are better than other firms and you're more productive, higher productivity, you don't need as much labor you don't need, as many labor inputs because you can do more with the same amount of labor. And they should be... that is one of the explanations. Do you think that's a reasonable story, the superstar?

The Winner Take All Story of Market Power: The Superstar Effect

Smith:   I think it is. I think there's some chance that it's part of it. I'm sure going to get to it later, but that contrasts a little bit with some of the locker stuff in that like, where we see seemingly the largest sort of markups over labor costs are not actually in the biggest firms. So there' some obvious examples of super big firms where you see… Apple would be the big exam of them, but Amazon is a zero profit firm, they're pretty large. I think the margins for Walmart are not particularly large, and so there are lots of very large firms that clearly use information technology to become dominant in their field and to do things better than everybody else, but they're not necessarily getting a lot of markup over labor costs. And so I'm not sure that's where the declining share is coming from. Yeah.. but-

Beckworth: Okay. Yeah, so it's got to be more than you just said, that's their argument, simply more. I guess maybe we should define what is this winner take all kind of argument anyways. How would you explain it to the average person?

Smith:   So what I would say is that what you have, there are a couple of ways that it works but through a variety of things. I think the argument I like the most is mastery of information technology. And so even a firm that seems pretty bricks-and-mortar like Walmart, what they developed in the early 90s' was a really strong inventory control. And they had the little hand scanners everywhere and the central office knew exactly how much inventory they needed and they could set up the trucks to be really efficient. They had the warehouse they had these legendary warehouses where they're like, trucks backup at one end and backup on the other end, they just crossed one box from an incoming truck, and an outcoming truck, and they're able to manage all this stuff seamlessly because they had such a strong proprietary IT system.

Smith:   And it costs a lot to build that system. You pay a lot of money to build it. But once you build it, you can scale it up really easily. And because you can scale it up really easily, then you can... if your IT system is the best you can sort of dominate most of the market. No one will be able to compete with you on price, and that's largely what we saw from Walmart. Because like you have this this special advantage. So even if Kmart someone is trying to offer the lowest prices, is trying to put pressure on suppliers, they can't quite match exactly what you're doing because you have this IT advantage that you've invested in, and now you can spread it out to all of your stores everywhere across the country.

Beckworth: Yeah, I mean, think if Amazon is the … I mean when they first came out in the late 90s', late 90s' or mid 90s'.

Beckworth: And that's all I got was the book. All those books, but now they sell everything, right? And they're getting into groceries, and they have this advantage, right? This innovation and advantage due to technology. Okay, and this also applies... I mean, we've heard the superstar effect in terms of people, right? So if you're a musician where you used to have maybe one national market, you've got the global market now and it's yours for the taking if you're the one who gets there first so you can get super rich super, super big market share gains, fast…

Smith: The billionaire authors, right?

Beckworth: Yeah, right.

Smith: Yeah. Think of the JK Rowling's and others like that.

Beckworth: Alright, so there's the superstars one argument, superstar effect for firms one argument for the client labor share of income. Another one, I mentioned another our author here I'm sure you've heard of... I hope I pronounce his name correctly, [inaudible], he's the one... he had a paper that came out, he was a University Chicago grad student, I think he's in University in London now, but he argued that the decline in labor share was not offset by rising capital share of income but a rise and profit share, which is kind of an interesting argument. But he goes on and he says the reason this has happened is because markups have gone up and it's not an efficient outcome, which is a nice kind of segue into drum roll the paper of the hour, and that is the [inaudible] Eckhardt paper, which has really made a lot of headlines and... tell us about that, because they're making the same point about markups being inefficient being... And what's striking about this paper, I'll let you summarize, but one thing I want to put in, it tries to explain all these developments, all these phenomenal we just described. So give us a summary of it and tear it apart for us.

The Markup Inefficiency Argument

Smith:   Okay, so what they... so I don't know how much you want to go into the methodology, but essentially their argument is this. Is if we look at what firms cost of production is and they have a slick way of sort of estimating this, and then we look at the prices they charge, we can identify a markup there. And then over time, this markup has gotten larger and larger and larger. And from a basic economic standpoint, that is a sign of some type of monopoly power. Now, if you think of it as just traditional monopoly power, like when any kind of one to one, there's perfect competition on the one hand, and monopoly on the other, if you think this represents traditional monopoly, then what you're seeing is that the reason firms are able to make this markup is because they're actually restricting production. They're actually producing less than the market would take at the cost, right? So they raise their costs, they sell a little bit less, or whatever, and we're missing an efficient allocation, because there's somebody who would want to buy it for the cost of production, but they've raised the price.

Smith:   Now, it's actually not just the raising of the price, but the pulling back on production, which allows them to explain all these phenomena. So that makes everything in the economy, especially labor less productive than it otherwise could be because you always are going to be having some form of idle resources. You're not going to do as much capital investment as you could, because you're not trying to expand product out to the point where costs are exactly equal to price. And so they go through, and once you've got that, they go through and show that then labor share is going to go down because some of this is going to these extra profits, productivity is going to go down because you're not investing as much. Once you get productivity going down, then I think you're going to be able to explain what's happened to wages, what's happened to median income, what's happened to lots of the phenomena that people are worried about throughout the economy. And so their grand explanation is that like what we're seeing here is classic monopoly power. And that monopoly power is having these inefficient effects that have spread across the economy and produce misery for everybody.

Smith:   What makes me scapula this is a number of things. One is the fact that even when you look at their own date, and they try to talk about this a little bit, it's not actually the largest firms that have the biggest markup. They split their analysis at one point between very large firm and sort of smaller firms, and the very large firm seem to have almost a constant markup across from the 60s' where we think that the economy is working, and it's like classical, strong productivity push mode, all the way to 2015, one of their last data… it's pretty constant. All we see is there're smaller firms, which have had a much larger markup. So that's one clue about what's going on. The other is that they're not telling or there's nothing in there that talks about contestability. And I think for economists, like I talked about how I think about it, this is the big test of Monopoly. It's not how large you are, it's not even how higher profits are, but it is whether or not you're afraid of other entrants into the market, whether other people can come in and try to compete away the monopoly profits that you have.

Smith:   Because if they can't, then we're in a world that something more like monopolistic competition, which is a model some people want to in the middle. And the thing about monopolistic competition is you still have markups you still have price above minimum average costs, but what that's rewarding, what that's paying for is the specialization that the firm had to do to get its particular niche market. And as long as the profits are higher than what it costs to build your brand, or to build your special product then you're going to see competitors come in and offer rival brands. And I mean, that looks like a lot of what we see in the modern world, so if you have like Apple doing really well, Samsung comes in and tries to offer, an alternative.

Smith:   In fact, and this sort of falls into this story, is early on in the smartphone revolution, you had a huge number of competitors, right? There are all kinds of phones operating on Android System, there are some phones operating on Windows System, there's some phone operating nothing like Symbian System, I think blackberry tried to come up with a system, I think Palm was trying to hang in there, and most of them couldn't do it. And I think the reason why they couldn't do it is because they weren't producing, their product, despite their enormous amount of investment in information technology and attempting to offer the best product. They just couldn't get... they lost out to Apple, they lost out to Samsung. And for a while there, I think like Samsung and Apple has something like 115% of all the profits in the phone market, because everyone else combined was making losses.

Smith:   So what that sort of tells us is that they were investing heavily in order to sort of chase these profits, investing so heavily that the number of phones they sold couldn't make it up make up for it. And so what we have coming out with this sort of seemingly market split between Samsung and Apple is the result of a fiercely competitive process that's driven forward with the technology, that's exactly the opposite of what we think of in classical monopoly. We think of a classical monopolist as sitting on their hands, as not investing, as not looking towards the future, as just sort of soaking up the privilege of being the only player in town.

Beckworth: So there's a benign form of market power, or monopoly power. And just to keep it real simple for people out there who may not have all the economic training that we do, market power basically, is the ability to change your price without losing all your customers, right? So, a monopolist is the extreme example, that they can increase their price and there's no one else who competes with them, and maybe even they try to keep up with competitors, the evil standard... I mean, that example in the textbook evil Standard Oil, which even that's not a clear cut case. But that's kind of like you think of this evil monopoly villain who keeps out competition jacks up price and you have no choice but to go to them. But what your argument is there's something less than that where people are willing to pay more, willing to allow these firms to have market power because they value something unique, something different. And you used a term monopolistic competition, which defines maybe a large part of what we're talking about here. So can you give an example of monopolistically competitive firm? And what is it that we value about these firms?

Monopolistic Competition

Smith:   Okay, so I think one of my favorite examples because it shows how you can make a lot of profit, how you can grow really big, but how you have to stay in your game, it's Chipotle. So they're not in the tech space, and it's hard to see whether an information technology and stuff was a big player in them, but they created sort of a unique product experience that people loved, they expanded rapidly, their stock price went up, they made enormous amounts of profit. But they had an Ecoli incident, they lost a bunch of customers, and they've never recovered since. And that's important because what you see is that you have this innovation that provides people with a much different experience that they want, but unless the company continually reinvest in making sure everything about their customer experience, and I think that's really what monopolistic competition is about, is the customer experience, when their customer experience is good, they're going to lose that very market power, they're going to lose what we might think of as brand power, the desire of people to say, "Here, I get this special experience at Chipotle.

Smith:   And so they got a little bit ahead of themselves, in the details of it, but they` fell to the wayside. And so we see this spinning or stability of churn to happen for new competitors to come in and for old competitors to be pushed out. I think I want to kind of make a point of the it is like I'm not I'm not purely sort of like a [inaudible] about like, What's going on, my main thing is that it's complicated. And then we have to think about it. So here, there's certainly lots of monopolistic competition going on. Some of that seems to be about innovating special customer experiences, but some of it may be maybe more harmful. And this is the kind of example I think of. So like the urban restaurant market is really popular now. People like their Ethiopian restaurants, they like lots of variation. And so they're get higher prices for urban restaurants, but where much of this becomes capitalized, is not in investing in new forms of food stuff, but as in rental prices for the restaurant, the rents in the areas where you have this dense concentration of restaurants goes higher and higher and higher.

Smith:   And part of the reason it goes higher is because there're land use restrictions that won't allow the commercial area, the area in which we're selling restaurants to expand. And that is a more costly form of restriction. And we still would see the same sort of markup and we still would see the same increase of price, but instead of us having like the extra money going to investing in innovation, it's just going to rent for landlords. And so even if even if all of this is inspired by an attempt to provide specialty experiences, how those experiences are produced, and whether or not they're contestable is this thing that we have to look at. Are new entrance, able to get into the market and provide alternatives, innovative things? Do the current influence have to keep spending their profits on innovation or not? And that rather than simply looking at size, or even profitability is sort of the metric that I want to focus on.

Beckworth: All right. I like that you put the example, one I love eating there, two, I think it's a good example, in a sense that people are willing to pay a little bit more to go to Chipotle over Taco Bell, right, because you're an experienced, the food, the ambience, the environment, that they're willing to pay this extra amount for and that's going to be the markup, is that that added profit they get because I'm willing to pay for that experience. And what you're showing, I think it's a great example is I had a bad Chipotle experience, and suddenly, I'm going back to Taco Bell and maybe some other comparable-

Beckworth: ... above Taco Bell level, but the thing is they had to be careful, right? That margin, that profit margin is not guaranteed, where we think of a true monopoly, it's a little more... it's not guaranteed, but it's a little safer, but Chipotle they will lose it. They will lose a big part of the market share if they're not careful. Now, I guess my question is so what i think I'm hearing you say is that there's been a big rise in monopolistic competition since-

Smith:   I think so.

Beckworth: ... Okay, so why did it start when it did? And then what enabled it?

Smith:   And so I would go back to my story about industrialization that up to... I think this is the baseline cause of it, is in the generation that came through after the 1950s into the 1960s was one of the first ones we would think of as pure material deprivation was unknown to a significant portion of the middle class. Where people basically you would definitely going to have enough to eat, you're definitely going to have a house, you going to definitely have enough clothes, so that what we think of as material deprivation wasn't there. And it was in this moment in history that we also saw this big push towards counterculture, this big push away from materialism. And since these people are at exhausted that journey and they were looking for something else, looking for something specialized, one of the stories I like to joke about just to give people a sense of how pervasive this pattern was, is, I think, by some scientific measures say like a lollipop. So would be like the catchiest song possible by using mathematical algorithms. In fact music in the late 50s', they had scientists come in and they had people test these and do focus groups and all sort of stuff to see what's the catch... So you do that.

Smith:   But then people went into the thing of we want something more authentic. That's not really me. I mean, it's catchy, and sure, everybody loves it, but it wasn't me. And so you have a push away from that to folk music or different types of rock or things that are much more individualized and pushing back against the larger culture. And so this is sort of expanded out, like this originally counterculture, but then counterculture became the dominant culture. So then it's sort of like, just what we think of as a fluent near fluent Americans desire to have specialty experiences, and it's bleeding further and further down the chain. I mean, you can see even now, so we stay within restaurants, that McDonald's is like is our classic sort of 1940s, build more restaurants build faster, cheaper restaurants is in financial trouble and is trying to find any way they can to offer you these Deluxe, Sriracha whatever kind of experience they can to keep customers, even customers that will go down the income scale there as opposed to searching for another sort of specialized experience. Just the fact that that can give you a cheeseburger is not enough anymore. And it's not enough for a larger and larger portion of the population. And so that's why we see this sort of like total switch to monopolistic competition, because we've sort of exhausted just getting over material deprivation.

Beckworth: Okay, so you're telling a story, which is benign, even as [inaudible] good we get more product variety as consumers which we value. People like Noah Smith have pushed back against this. He has said monopolistic competition there's a level of inefficiency, because there are some idle resources, and there is that profit margin, there's... it's not doing as much as one could, but your pushback, I think is but what that ultimately gives us is all this variety, Right? And he tends to overlook that point.

Smith:   I think so. And I mean, so in the strictest sense, a monopolistic competition, doesn't push firms to produce at minimum total costs, right? Minimum average total cost. They're not as purely cost cutting, you would think of that, as is a perfectly competitive firm. And so in a very technical way, they're not as efficient. But what that extra cost is paying for, what the price over cost is paying for, is the development of this particular brand. I mean, that's exactly what comes out of the model. And so If you were to think about just pushing the entire economy to perfect competition, then you would just get like lots of all the same, widgets, but they would be really, really cheap.

Smith:   So everybody has the same [inaudible], has as the same this, all the cars look the same, which was a period in the US as to where it seems to be going in that direction. But I don't think that's the future that most people envision, or think as best. There's more to life than just the total mass of consumption that you can have, the variety or the quality of it makes a big difference. And I think now overlooks that [inaudible], I think part of it is because it's kind of like you're upset about [inaudible] starting out. Like you're upset about what the possibility of market power and so is we're sensitive to any sort of possibility of inefficiency.

Beckworth: Yeah. So I want to get into this back up to the macro level. This is Macro Musings after all, but what we've been talking about here this past few minutes has been an explanation for the rise in the market price above the marginal cost of production. So this this is a benign explanation for that phenomenon. There's still a host of other things going on that there are maybe more troubling or maybe not, business concentration, income inequality, stagnant real median wages, but are those separate issues by displayed by other developments or are they related to this monopolistic competition story that you're telling?

Effects of Monopolistic Competition at the Macro Level

Smith:   I think they may be related. So one of the things that you're going to see in the monopolistic competition story is that returns are going to come not just from even just like providing labor, but providing labor that is able to produce these types of experiences. So through base industrialization, we have a classic story of moving from farm to city, from agricultural to the factory, and really, you just need to be person on the floor, who can follow the basic routine and instructions to do it. And there's an enormous demand for that labor, is way more productive than it was in the agricultural sector, and so you see both productivity and wages rising together. As you get out to a more monopolistically competitive story, as you get out to store that's about varieties, then where the bang for the buck comes from, is are you able to use using creativity or using skills or specialized skills, to produce some of this produce one of these particular experiences?

Smith:   And so all throughout the entire labor market, what we're seeing are like increasing returns of skill, and we're seeing evermore increasing returns to people who can develop something new. And so like exactly what you're talking about. It's not just superstar firms, but superstar individual, superstar workers, who can add something to the value of their firm. So I think this even goes to intact. There was an economist, I think… Google said that their best engineers are 300 times more valuable to them than the average engineer. And if you see that, if you have someone who for whatever reason, is super sharp, able to write these programs, that produces enormous amount more value. You're also going to see that to someone who's even able just to create a more specialized retail experience. Someone who is setting the right like …is setting the right mood. So even those types of skills are going to be more valued than just sort of like force showing up to work and lifting boxes sort of skills.

Beckworth: Okay. What does that imply then about someone's education, their career, what would you recommend then in this type of environment? Do you want to be that superstar, or at least working your way toward that? How would you encourage a young person today moving forward?

Smith:   I don't know if my advice is that different than the mainstream, but what I would say is that, there's every indication that this preference for specialized skills is going to continue. And so going into a field that allows you to develop that allows you to maximize that is going to have a lot more return. And the more specialized education you can have, the higher your return is going to be. I think that's the baseline based on explanation. And I mean, I think we do see this, like, there are particular things that you can study, that allow you to create things. And so like, the most obvious example of this is like computer science. So computer science empowers a single individual to actually create this program, to build this program, and we do see enormous returns there. We still see very large returns in engineering. Engineering salvage is still around going up. And there, you're talking about building things. If you have specialized marketing skills, so like statistics is big now, statistics is sort of about finding the patterns, the particular patterns, uncovering things that other people might have missed. So all that is about specialization, creativity, being able to do things that are new and different, instead of just replicating, what's already been done on a larger scale.

Beckworth: So this development values creativity?

Smith: Yeah.

Beckworth: I mean, pattern recognition, but also taking that data and turn it into something new I mean, being entrepreneurial…

Smith: Being entrepreneurial.

Beckworth: In your own way in your own field. All right, well, and this is a very fascinating discussion, and I could go on for a long time with this, but I do want to move into another area. We're going to switch gears here, talk about something else that you write about and that is monetary policy, Fed policy, which is my real wheelhouse, but I'm always glad to learn from you about markups, and the market power. So one of the big issues before us now is going to be who will President Trump appoint to the Board of Governors? Who will he appoint the Fed Chair? And by the time this comes out, maybe this will have been made clear. But there are a number of open seats and in the Fed position is open just today. There's a Bloomberg article that came out that says Trump [inaudible] deliver him a shortlist of Fed candidates… I think these things have been polluted already. But Kevin Warsh, Janet Yellen, Jerome Powell, Gary Cohn, John Taylor, are the ones on that shortlist. What are your thoughts about that shortlist and who would you like to see as Fed chair moving forward?

Fed Chair Possibilities

Smith:   On the shortlist I think that I'm okay with Janet Yellen. I think that, that'll probably be my pick off of that list. I had like a dream sort of draft, Greg [inaudible] at a time, but he was a never a Trump person, so I don't think that he's ever going to make it in his list. What has sort of concerned me is the ascendancy of Kevin Walsh. And so, Kevin Warsh there are a couple things, he was a lawyer by training and an employee of Morgan Stanley, an executive of Morgan Stanley by experience, and inherently there's nothing, there's nothing wrong with I don't think that, I don't think that everybody on the Fed necessarily has to be an academic, but all his previous tenure in the Fed, he showed at least, from my perspective, a lack of sort of appreciation or understanding of monetary policy, and instead has been keen to sort of invoke some of the explanations that you hear on CNBC, or sometimes out of Wall Street people that the economy only suffers from structural problems or the Fed getting into the economy, always screwed up with relative prices.

Smith:   And in this sense, I mean, one of the arguments that he made at one time was that the Fed shouldn't do everything it can to bring down unemployment, because that just takes the fiscal governor, the fiscal side off the hook. I mean, and that's a perspective that is just radically different, that I think what we've learned in Monetary Policy, over the last... since really the Great Depression, that the Fed is the line of first defense, that its ability to stabilize the economy is extremely powerful if it's motivated, and that rather than fiscal authorities mastering the economy worrying about particular structural issues, they're providing a baseline of steady growth. I like NGDP but steady growth in nominal demand really helps to smooth out these frictions and gives a playing field that market participants can respond to make optimal decisions.

Beckworth: Yeah. What's interesting to me is to look back at the past two Fed Chairs, Ben Bernanke, Janet Yellen, in some ways they were textbook folks to take that position. Right? Ben Bernanke the great scholar, the great academic. He wrote on the Great Depression, so as well time to came in for the Great Recession. He also wrote on Japan with economy. Janet Yellen had been on the Board of Governors, she'd been president in San Francisco Fed, and Ben Reagan came in and like, who better of a person to ask and the Fed did prevent us you could argue from going into a Great Depression. Again, there's also a lot of critique from Ben Bernanke he did. Ben Bernanke the central banker is a little bit different than Ben Bernanke the academic, right? So we had these great hopes and you could say things could have been worse, but things could have been a whole lot better too. I remember a similar event with Janet Yellen, Janet Yellen came on and of all things I had gotten this Twitter exchange with Justin Wolfers once I was just randomly walking in Walmart and rural Kentucky and I got this big exchange with... he was super stoked about Janet Yellen.

Beckworth: Like, she's the best thing since sliced bread because she's got all the qualities, all the qualifications, and she's done a decent job, but you can also point to the fact that inflation has persistently undershot its target, and it remains a mystery, a puzzle. And it shouldn't be the central bankers. I mean, if the Fed can't figure out inflation which is one of his core jobs, then it makes you wonder. So all I'm saying in this is that even the best people you can put out there oftentimes aren't perfect, right? And sometimes maybe they adapt to the institution themselves. So I wonder even if Kevin Warsh were appointed, how long would those Wall Street views last? Would he conform to the... Paul Krugman, called the Fed the ball of collective. You come in and you're assimilated, right? So I'm wondering, to what extent would he be assimilated? Or do you think those views would be persistent enough, also, given the fact that the FOMC is so wide open in terms of static could vastly change the nature of the Fed?

The Future of Fed Assimilation

Smith:   So I'll say something in a couple different ways. So if I just had to do a detached analysis of it, I would bet that the staff at the Fed would make a concerted effort to assimilate him, and that effort would be at least somewhat successful. Now, the fear is that, we're in a time where we have very low interest rates around the world where we need unconventional Monetary Policy, and what we've seen with Ben Bernanke and Janet Yellen, is that they had a deep understanding, they had an appreciation for the fact that rather radical measures based on a not traditional monetary practice, but a fundamental understanding of the way monetary policy works might be necessary. But they were constrained by the bureaucracy in the Fed. The bureaucracy of the Fed seems to be very risk averse, seems to be very concerned about doing anything unusual, something that they can be criticized for, from Congress, from members of the financial community, and that almost exacerbates the Kevin Walsh problem, because he's one of the people who has been the most critical outside voices for doing nonstandard things that go along with our understanding of monetary theory to deal with the particular circumstances of this crisis.

Smith:   And so for example, when the Fed had to engage in QE a lot of people on Wall Street had like conniptions about this and predicted that there was going to be massive inflation Kelvin Warsh, I think even came at a time when inflation was 1%, Unemployment was I think nine or 10%, and sort of sided with the Wall Street people that this was too much, this was too interventionists, we shouldn't be pushing the economy as fast, because we're just going to have runaway inflation. And the way that the economy or the way that QE was going to work seem to be completely escape his analysis. And so I worry that that mentality is going to be like, combined with sort of the natural conservatism of the Fed to prevent anything unusual from happening.

Smith:   And that's very dangerous when we get into another crisis, right? So I mean, if we have another large shock to the economy, we have almost no room to move on interest rates, we are probably going to require something unconventional. I think both you and I for a long time have been looking towards more, deeper structural changes, some move to like NGDP targeting system or something like that. That's the seems like the farthest thing from somebody like Kevin Warsh's mind, and given his previous statements and sort of like the confidence and you know, I don't want to say it but I guess I will say arrogance with it, I am worried about a Fed that just continues to blame everyone else in the economy and says that they're doing all they can when they're really not exploring the possibilities that we've already laid out as a result of the Great Recession.

Beckworth: So sounds like you're worried that we might get an ECB … at the Fed.

Smith:   Exactly you might get an ECB …

Beckworth: Warsh would be the new Trichet

Smith:   Exactly. And the experience of the European economy in the wake of the Great Recession will significantly worse ours. Right? So I think there was a time I don't know if I'm going to get my dates exactly right, around maybe 2009 or 2010. When both of our economies, we're in the nine or 10% unemployment range, but the Fed took much more immediate and drastic steps and unemployment …much down to about 4%. It kept climbing in Europe to about 12% and didn't come down. I don't know exactly when they started their extraordinary measures, but it might have been 12 or 13. It was a number of years later and the experience of the worst countries in Europe was horrific throughout that. So the monetary shock was called the periphery countries like Greece, Italy to a little bit lesser extent but nonetheless in southern Italy was worse in some cases than what they experienced during the Great Depression.

Beckworth: So your concern is having something like that happen with Warsh?

Smith:   Yeah.

Beckworth: So fair enough. Let's go then to the inflation puzzle, right? So inflation has been below the Feds explicit target of 2%. I always remind my listeners that the Fed was implicitly targeting 2% before ,there's number of studies have shown this. So if you Keep that in mind, then it's been really since... and if you discount the Great Recession period itself because a lot of things were going crazy that time. If you start from the recovery mid-2009 to the present, the Feds core PCE deflectors preferred measure of inflation is averaged 1.5%. So full 50 basis points below its target. I mean that's a long haul. That's persistent and systematic. And I get of tired of hearing these one off stories, right? This one off... So Janet Yellen gave a recent speech where she tried to explain why they've been below target for so long, at least since 2012, and she has a model she puts in the paper and a nice chart that explains it and she shows there's three things there's slack, which maybe they've underestimated on the slack.

Beckworth: Also, there she explains a lot of this miss to energy prices, and then also import prices. All right? But the thing is this latitude thing I would argue are also indirectly affected by what the Fed does in particular, we know commodity prices, oil, in particular fell dramatically about mid-2014. And what's interesting Ben Bernanke, he has a post on this and James Hamilton has a post on this, they do a little model and they estimate that about half of that was due to weak aggregate demand, not just excess... there was excess supply, and you can tie that back into what the Fed by the time was talking up to [inaudible] talking up rate hikes, the dollar got stronger… this decline in commodity prices.

Beckworth: So the Fed itself has some indirect influence on at least part of the collapse and commodity price inflation. The second thing is import prices, what affects import prices is the strength of the dollar. And they talked up rate hikes, we see the dollar going up. So my point is this, is if you step back, many of the one off things or the external things like oh, it's a strong dollar or its energy prices are in fact indirect consequences of Fed policy itself. So maybe I'm on a soapbox you're preaching but I guess my question is how do you evaluate this persistent miss and why does the Fed seem to keep looking for answers at other places then it's at itself?

How to Evaluate Inflation Misses

Smith:   So the basic model I have in my head about why this is happening is that even though 2% is that their target their sort of response to miss is that target seemed to be non-symmetric, at least everyone perceives it to be non-symmetric. They talk about it like it's non symmetric, they create expectations that it's non symmetric, even though their official line is that it is. Just as you said, when there's any indication that we may overshoot 2%, the Fed is very concerned about getting ahead of it, getting ahead of the inflation that talks about the dollar, talks about the things. Well naturally if you think that you're okay with missing to the downside, but you're not okay with missing to the upside, then when random shocks come through, right? The ones that puts you to the downside are going to play out. But the ones that put you to the upside or not because market participants are going to expect you to respond to those things. And so the dollar will change and other factors in the economy will change. And you're going to end up consistently slightly below, whatever your target is. Simply because you've eliminated variation on the top, but you haven't eliminated variation on the bottom.

Smith:   So you're going to wiggle along the bottom. That's my basic model. I mean, I'm open to talking about other things, but that's very simple. And it matches the data, matches what's happening. It also matches what seems to be the disposition of the Fed staff, which is to be conservative, right? So here is this inflation target, high inflation is what people think of as being negative, is what members of congress think of as being negative. And so they're much more concerned about going over the 2% limit, or 2% target, and then facing that scrutiny facing the accusation that they're not holding prices steady, then they aren't concerned about going under the target. And they aren't concerned about this sort of persistent missing to the bottom, because that's something that, like members of Congress can more easily get on them about.

Smith:   So I think that's really what's going on there. And I don't mean to think that they're just so like… they are just cowering before Congress, but a sort of institutional mentality can get set in when you have this threat on one side, and then everybody just sort of kind of has an understanding that "Well, well, well, that's that that's bad." And without even setting an official new policy, you set an unofficial policy because of your different level of concern about going over versus going under…

Beckworth: Okay. Yeah, well, that seems reasonable. I mean, at the end of the day, the Fed is a political institution created by an Act of Congress, and it has to be mindful of the political environment in which it operates.

Smith:   I don't know if we were at a time, but I would just say that that is actually one of the advantages of a level target. And especially a level targeting something that is a little bit more neutral. Like I know we've always talked about NGDP, is it like then you have the perceived responsibility for making up for misses on both sides and consistent misses that's going to put you further and further away and you have a target, which seems negative to miss both to the bottom and the top, unlike inflation nobody wants nominal GDP to be low. That sounds bad. And so I think that it'd be more likely that we wouldn't be stuck in this regime.

Beckworth: So is the Niskanen Center official position that they endorse nominal GDP level targeting? Or is that the Karl Smith official position?

Smith:   So I mean, it's hard to say I mean, I'm the economic director there so it kind of gets me there. We haven't come out with that. But I mean, I think we're leaning towards that. And I mean, it might be.

Beckworth: …and Niskanen himself was an executive it-

Smith:   Exactly.

Beckworth: ... so he in fact was one of the early people at the Cato Institute that promoted it so... All right, I think with that our time is up. Our guest today has been Karl Smith. Karl, thank you so much for coming on the show.

Smith:   Thank you.