The Slippery Side of the Laffer Curve?

The United Kingdom increased its top marginal tax rate to 50% for households earning more than 150,000 pounds ($238,000) to attempt to close its budget deficit. Like the political debate in the United States, liberals argue that increasing taxes on the rich produces a more fair tax system. Very early results indicate that the tax increase has decreased tax revenues (“50p tax rate 'failing to boost revenues’”) implying that the United Kingdom is on the wrong side of the Laffer curve named after Arthur Laffer.

The graph plots a possible Laffer curve that is not based on data. It shows tax revenue increasing until the marginal tax rate reaches 57%. The point of maximum revenue does not indicate the best size of government. Raising the top marginal rate beyond that point would punish the wealthy rather than generate more revenues. The maximum revenue level does not suggest the best size of government. It could easily be smaller but not larger.  

Suppose government officials demonstrate that larger government expenditures would increase social welfare. Those expenditures would require deficit financing which may slightly increase the size of government but would soon give rise to unmanageable levels of debt. 

Have the British reached the slippery side of the Laffer curve? Mathias Trabandt and Harald Uhlig suggest they might have given the increase in the top marginal rate in “How Far Are we From The Slippery Slope? The Laffer Curve Revisited” Using date from 1995 until 2007, they conclude that 
 For benchmark parameters, we have shown that the US can increase tax revenues by 30% by raising labor taxes and by 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. A dynamic scoring analysis shows that 54% of a labor tax cut and 79% of a capital tax cut are self-nancing in the EU-14….

 However, transition effects matter: a permanent surprise increase in capital income taxes always raises tax revenues for the benchmark calibration. Finally, endogenous growth and human capital accumulation locates the US and EU-14 close to the peak of the labor income tax Laffer curve. 

We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts. Transitions matter. 

 Trabandt and Uhlig’s work might provide an explanation as to why countries that tax a larger share of GDP than the United States have less progressive tax structures. The rich earn a larger percentage of their income from capital which is inherently more difficult to tax due to the ability of the wealthy to avoid taxes. The United State and the EU-14 may also be much closer to the peaks of their capital Laffer curves than their labor Laffer curves.
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Summers or Taylor

The effectiveness of fiscal policy is an issue that divides macroeconomists.  “Tinkerers” believe that aggregate demand can be stimulated by federal deficit spending and cutting taxes.  Larry Summers is a well respected economists that supports active fiscal policy to improve economic outcomes.  In an interview with Charlie Rose, he describes the policies he believes that are or would be helpful in today’s economy.  Please keep in mind that Summers was an important policy maker in both the Clinton and Obama administrations and that he has acquired a tendency to blame Republicans for bad outcomes rather than stick strictly to the economics of policy options.  While the tendency is natural and appropriate for a policymaker, it is sometimes a distraction.  Please ignore the politics and stick to the economics.     

Another group of macroeconomists believe in “rules” and doubt the effectiveness of tinkering.  These rules are largely attempt to build stability and predictability and abandon stimulus policies.  John Taylor argues for rules and against discretionary fiscal and monetary policy in an EconTalk interview with Russ Roberts.  Rather than increase deficit spending to stimulate aggregate demand, he argues that cutting deficits would create a more stable governmental fiscal environment allowing market participants to operate with less risk.   
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Your Report Card for President Obama

Voters on the left claim that President Obama is extraordinary, restoring employment while transforming the economy to meet the challenges of the 21st century.  Voters on the left claim that he is among the worst presidents, a reincarnation of President Carter who has ineffectively dealt with the Great Recession and through health care and regulatory reform has placed the dynamic American economy into a comatose state.

To help readers grade President Obama’s performance and the economy’s performance since the beginning of recession, I have included three characteristics that Reinhart and Rogoff (“This Time is Different”) believe that financial crisis share juxtaposed with corresponding U.S. statistics which are bolded.

Asset Markets

First, Asset market collapses are deep and prolonged.  Declines in real housing prices average 35 percent stretched out over six years, whereas equity price collapses average 56 percent over a downturn of about three and a half years. 

Housing prices fell 24.7 percent from the their peak in the third quarter of 2007 and are forecast to fall another 5.5 percent in total (“Fiserv Case-Shiller Home Price Insights: After Five Years of Record Declines, U.S. Home Prices Begin To Stabilize”). The DJIA fell 43% from a high of 14,164.53 on October 9, 2007 to a low of 8,046.42 on November 21, 2008.  The index has recovered to 88 percent of its high value and now stands at 12,468.19 at the opening of trading on May 27, 2011. 

Output and Employment

Second, the aftermath of a banking crisis is associated with profound declines in output and employment.  The unemployment rate rise an average of 7 percentage points during the down phase of the cycle, which lasts on average more than four years.  Output falls (from peak to trough) more than 9 percent on average, although the duration of the downturn, averaging roughly two years, is considerably shorter than that of unemployment. 

The U.S. unemployment rate rose 5.4 percentage points from 4.7 percent in September 2007 to 10.1 percent in October 2009.  Nearly four years later, unemployment stands at 8.8 percent.  Real GDP (2005 dollars) fell 4.1 percent from $13.363 trillion in December 2007 to $12,810 trillion in June 2009.  By first quarter 2011, real GDP had fully recovered to $14,438 trillion. 

Government Debt

Third, as noted earlier, the value of government debt tends to explode; it rose an average 86 percent (in real terms, relative to precrisis debt) in the major post-World War II episodes. 

Nominal debt held by the public has increased from $5,055 trillion on August 29, 2007 and rose 90 percent as of April 2011.  

A few other facts may be useful in grading the president’s success in managing the economy.  The Troubled Asset Relief Program was signed on October 3, 2008 during the Bush administration.  Funds were immediately released.  Senator Obama voted in favor of the bill and retained the services of Tim Geithner and Ben Bernanke both have played significant roles during the Bush and Obama administrations.  These facts will make it difficult to separate the performance of the two presidents.

The American Recovery and Reinvestment Act was signed on February 17, 2009.  Very few funds were released prior to the ending of the recession in June 2009.

Rising oil prices may be harming the recovery.  There is little a president can do in the short-run to lower energy prices.
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Jeffrey on Social Welfare Programs

(HT Drudge Report) Terence Jeffrey’s article, “Jeffrey on Socialism's Trajectory: Obama's HHS Is Bigger Than LBJ's Government,” is an interesting blend of the good, the bad and the ugly.  To be sure, the bad and the ugly are small, and the good is big.  His main point is that in the past increased spending on social welfare programs has dramatically increased the size of government and placed us on a socialist path to ruin and that Patient Protection and Affordable Care Act (healthcare reform) pushes us further down that path.

The ugly is the overuse of the word “socialism.”  The Merriam-Webster Dictionary defines socialism as

a system or condition of society in which the means of production are owned and controlled by the state.

None of the programs he mentions, Social Security, Medicare, Medicaid, the prescription drug benefit, and now healthcare reform is a socialist program.  The government exercises control without owning the means of production.  Like socialism, the healthcare programs, as they have been designed and implemented, have weakened markets by limiting the role of prices. Socialism is only one road to serfdom. 

The bad is the exaggeration of the growth of government associated with the introduction of Medicare and Medicaid in 1965 and the prescription drug benefit in 2003.  He introduces his ideas with an interesting fact he discovered while examining the historical tables published with Obama administration’s $3.7 trillion budget.  If the budget is passed as the administration proposes, the Department of Health and Human Services will spend $909.7 billion, more than the entire 1965 inflation adjusted budget of $822.6 billion.  The fact is a good literary tool because it catches the eye, but it also exaggerates the still impressive growth of government.  It exaggerates because America’s population and wealth have grown; we should expect a bigger budget.  Measuring the budget as a percentage of gross domestic product is a more meaningful measure. 

As Jeffrey noted, budget expenditures, which were 17.2% of GDP in 1965, grew to 25.3% of GDP in 2010.   Expenditures by Health and Human Services represented a miniscule .68% of GDP in 1965 to 6.25% in 2010.  The contribution of Health and Human Services expenditures to the total budget is similarly impressive.  Those expenditures were 6.24% of total budget expenditures in 1965 and grew to 24.7% in 2010.

The good was Jeffrey’s brief tour of important events leading to an expansion of the size of government.  In 1937, Roosevelt attempted to pack the Supreme Court with politically like-minded justices.  He failed to pack the Court, but he succeeded in intimidating it.  Social welfare programs deemed unconstitutional prior to the attempted Court packing were found constitutional thereafter. Medicare and Medicaid began in 1965 and government grew.  The prescription drug benefit was signed into law in 2003 and the government grew.  The new programs are at least correlated with an increase in the size of the federal government as a percentage of GDP and because they programs have grown rapidly, they are probably one of the causal factors of government’s growth. 
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The Japanese Fiscal Crisis

My thoughts are the outcrop of reading Megan McArdle’s article “Japan and the Limits of Keynesianism” and following her links.  The post war Japan economy experienced strong economic growth culminating in the 1980’s.  Real estate and stock prices tripled.  Like China today, Americans both marveled and feared its strength but weaknesses of an underdeveloped financial sector unraveled the Japanese mystic.

In late 1989, the Japanese Finance Ministry raised interest rates and asset prices collapsed, beginning Japan’s “Lost Decade.”  The financial weaknesses of many highly indebted, poorly run corporations were exposed but they were sheltered from the winds of creative destruction by a government that deemed them and the backs that loaned to them as too big to fail.    The government responded with Keynesian deficit spending to try to kick start the economy, but with little positive effect.  The private sector financial crisis turned into a government sector fiscal crisis. 

How bad is the Japanese fiscal crisis?  They have the highest debt-to-GDP ratio in the developed world and over half the current budget is debt financed.  Megan quotes views of two other writers, Felix Salmon and Matt Iglesias, and then gives her own.Salmon implicitly assumes that cutting deficits is the proper policy and cannels one of my biggest fears.

The lesson here, I think, is that it’s very, very hard for a government to enact a serious fiscal adjustment unless and until the bond market forces its hand. The Brits are trying, of course — and we’ll see whether or not the coalition government can succeed. But as we saw with George W Bush, the fiscal rectitude of one administration can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on sovereign fiscal issues than ever, the Japanese government can still contrive to raise agricultural subsidies by 40% and send child-care payments soaring, including payments to families who don’t need the money. It’s even getting rid of highway tolls. Oh, and it’s cutting the corporate tax rate.

From a bond-market perspective, this basically just means an ever-greater supply of JGBs: we’re still a very long way from any real credit risk, given the political power of the owners of those bonds. But as a lesson in fiscal political economy, Japan is much more worrisome. Everybody agrees that the budget must be cut and the country put onto a sustainable fiscal course. But no one is capable of doing that, and instead they go in the opposite direction entirely. It’s the see-no-evil easy choice to make. And I suspect that we’ll see continue to see similar choices being made in other highly-indebted countries around the world. Including the US.

Matt Iglesias pushes for increased immigration and printing money.

Normally, though, we expect human beings and the organizations they run to respond to incentives. If people cease wanting to buy Japanese debt, then the Japanese government will find ways to issue less debt. But demand for Japanese debt is high, so why wouldn’t the government keep issuing more?

That’s not to say these endless debts are optimal policy for Japan. What they ought to be doing is trying to have more economic growth. Finance their government with a bit less debt and a bit more printing of yen. That’ll create elevated inflation expectations and spur growth. More immigrants wouldn’t hurt either. I think the real mystery is why unconstrained governments are so reluctant to really put the pedal to the metal.

I agree that pushing immigration could help Japan’s aging population with the infusion of a little young blood.  The population is declining and the median woman is 46 years old.  I hope that he is correct in assuming that the government will solve the budget puzzle when Japanese stop buying debt and don’t agree with his “helicopter drop” plan to print money.  Having spent a couple years in Argentina during an inflationary binge, I have little confidence that inflation will produce growth, even in a deep recession.  It will lower long run growth.  I do believe that Japan pushed the pedal to the metal, but instead of unleashing 400 horse power of policy muscle, found instead 120 horses pulling an economy with four flat tires. 

McArdle focused on the limits of Keynesian fiscal policy.

Japan has simply reached the limits of Keynesian policy in an economy which has never managed to jolt itself back up to a healthy rate of growth.  Demographics is obviously a big contributor to that slow growth, and there are a whole host of secondary factors one could nominate, but whatever the reason, they have now had two decades of anemic growth, which they have fitfully attempted to address with stimulus.  Maybe not enough stimulus, maybe badly designed, but they've certainly tried to follow the basic Keynesian playbook:  borrow money and spend it when times are bad, in the hopes that you can bring back growth.

But for Japan, at least, the growth has not materialized.  Few economists would advise undertaking a fiscal adjustment, on the scale that Japan requires, in the face of the current crisis.  The problem is, there hasn't been a good time for retrenchment in 20 years.  I can't blame the politicians for trying to restore some semblance of normal growth in the run-up to elections.  But at some point, they're going to have to cut back, whether or not it's a good time. 

All the authors offered insights into policy that our policymakers should consider to avoid a lost decade.
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Cogan, Taylor and Wieland on the Stimulus

Economists have been busy measuring the impact of fiscal stimulus on the economy.  In September, John Cogan, John Taylor, and Volker Wieland summarize empirical research in a Wall Street Journal article “The Stimulus Didn't Work.”  They examine two aspects of the American Recovery and Reinvestment Act of 2009, transfer payments and tax cuts, and government spending; they find that neither provided much stimulus. 

The transfer payments and tax cuts fail to cause a sustained increase in consumption.  They write

This is exactly what one would expect from "permanent income" or "life-cycle" theories of consumption, which argue that temporary changes in income have little effect on consumption. These theories were developed by Milton Friedman and Franco Modigliani 50 years ago, and have been empirically tested many times. They are much more accurate than simple Keynesian theories of consumption, so the lack of an impact should not be surprising.

The authors also observe that the Bush administration’s Economic Stimulus Act of 2008 failed for the same reason.

Indeed, one need not have looked any further than the Bush administration's Economic Stimulus Act of 2008 to find plenty of evidence that temporary payments of this kind would not jump-start consumption. That package made one-time payments and rebates to people in the spring of 2008, but, as the chart shows, failed to stimulate consumption as had been hoped. Some argued that other factors such as high oil and gasoline prices caused consumption to fall during this period and that consumption would have been even lower without the stimulus, but no significant impact of these rebates is found even after controlling for oil prices.

They say less about government expenditures because, at the time they wrote, those expenditures were small.

Direct evidence of an impact by government spending can be found in 1.8 of the 5.4 percentage-point improvement from the first to second quarter of this year. However, more than half of this contribution was due to defense spending that was not part of the stimulus package. Of the entire $787 billion stimulus package, only $4.5 billion went to federal purchases and $17.7 billion to state and local purchases in the second quarter. The growth improvement in the second quarter must have been largely due to factors other than the stimulus package.

In a second article by Cogan and Taylor, “The Obama Stimulus Impact? Zero,” also published in the Wall Street Journal but with fifteen months more data, examines federal spending and transfers to state and local governments.  They conclude that government expenditures have done little to stimulate economic activity.  They provide an explanation for the program’s lack of efficacy.

Recently released Commerce Department data show that of the $862 billion stimulus package, the change in government purchases at the federal level has, thus far, been extremely small. From the first quarter of 2009 through the third quarter of 2010, government purchases have increased by only 3% of the $862 billion ($24 billion). Infrastructure spending increased by an even smaller amount: $4 billion. In a $14 trillion economy, these amounts are immaterial.

Of the effectiveness of transfers to states and local governments they write

The bottom-line is the federal government borrowed funds from the public, transferred these funds to state and local governments, who then used the funds mainly to reduce borrowing from the public. The net impact on aggregate economic activity is zero, regardless of the magnitude of the government purchases multiplier.

This behavior is a replay of the failed stimulus attempts of the 1970s. As Gramlich found in his work on the antirecession grants to state and local governments: "A large share of the [grant] money seems likely to pad the surpluses of state and local governments, in which case there are no obvious macrostabilization benefits."

The implication of our empirical research and Gramlich's is not that the stimulus of 2009 was too small, but rather that such countercyclical programs are inherently limited. The lesson is to beware of politicians proposing public works and other government purchases as a means to stimulate the economy. They did not work then and they are not working now.

Those economists supporting the stimulus will find evidence of its success, but I do not believe that it will counterbalance evidence showing its limitations.  The bulk of economic research long ago concluded that fiscal stimulus was ineffective in recessions of average length and depth.  It looks as if new research will find that fiscal stimulus is also ineffective in longer deeper recessions, but the price is real.  The deficit is wider and more difficult to close and the debt is mounting. 
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Miron’s Alternative Stimulus

Jeffrey Miron, and Harvard professor and the author of “Libertarianism from A to Z” suggests a counterfactual stimulus that would have earned Republican support, improved prospects of long-run economic growth, and perhaps added immediate stimulus to the economy in “The Case Against the Fiscal Stimulus.”  Miron accepts basic assumptions of the Keynesian model along with standard criticisms of that model to describe weaknesses of the stimulus package and to craft a Keynesian stimulus that would have been appealing to Republicans.  The article is an easy read and is well annotated.  Miron concludes,

The Administration should have endorsed a stimulus package based on a repeal of the corporate income tax and reductions in employment taxes. This policy would have accomplished its stated goals, and the budgetary implications would have been less negative than those of the package ultimately adopted because this alternative plan would have enhanced rather than detracted from economic efficiency. This approach would also have been difficult for Republicans to oppose.

Yet the Administration did not take this approach, presumably because its true goals were not just economic stimulus.  Instead, the Administration wanted to reward its constituencies (unions, environmentalists, public education) and increase the size and scope of government. This tactic is consistent with the Administration’s policies in general. Across the board, it has taken a big government, redistributionist approach, whether regarding housing, unions, health, the auto industry, trade, antitrust, or financial regulation. The Administration’s view appears to be that government is better than individuals at deciding how taxpayers get to spend their money and that government should engineer large transfers from richer to poorer.

Whether the Administration’s stimulus package will be successful is still to be determined. If the extra spending ends up being productive, then the impact of the stimulus might be positive on net. My own prediction, however, is that the programs adopted will generate large distortions and substantial waste, with minor stimulus impact. This is a pity because much better alternatives were available.

I agree with Miron’s economic assessment.  I would not have attributed the administration’s policies as a desire to “reward its constituencies” but rather to enhance “fairness” in the American economy.  It just happens that his constituencies benefited from that enhancement.  Quickly restoring full employment may be beyond the reach of any policy making alternative policies that attempt to achieve other objections, like increasing fairness, logical and while selling these policies as pro-growth may be a little disingenuous, such misdirection is the political norm.
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Hassett and Viard on Extension of the Bush Tax Cuts

After the November elections, Congress will consider the extension of the 2003 Bush tax cuts.  A growing number of Congressmen support some sort of extension.  The Obama administration favors permanent extension for single taxpayers earning less than $200,000 and married couples with incomes below $250,000.  

Some elected officials who support phasing out tax cuts on the wealthiest Americans assert that only 98% of American families and 97% of small businesses would pay more taxes.  The implication is that the percentage of small businesses that would face the tax is so low, that the negative impact on future growth would be small as well.  Kevin Hassett and Alan Viard of the American Enterprise Institute take issue with the statistic and its implication in “The Small Business Tax Hike and the 97% Fallacy.” 

The 3% figure, which is computed from IRS data, is based on simply counting the number of returns with any pass-through business income. So, if somebody makes a little money selling products on eBay and reports that income on Schedule C of their tax return, they are counted as a small business. The fact that there are millions of people in the lower tax brackets with small amounts of business income may be interesting for some purposes, but it is irrelevant for the assessment of the economic impact of the tax hikes.

The numbers are clear. According to IRS data, fully 48% of the net income of sole proprietorships, partnerships, and S corporations reported on tax returns went to households with incomes above $200,000 in 2007. That's the number to look at, not the 3%. Would Mrs. Pelosi and Mr. Biden deny that the more successful firms owned by individuals in the top income-tax bracket are disproportionately responsible for investment and job creation?

It appears that 3% of households earn 48% of net income of small businesses.  They also cite economic literature that finds that increasing taxes on small businesses would reduce gross receipts of small businesses subject to the tax by 7%, impede long-run economic growth, and discourage entrepreneurs for starting new businesses. 

Which statistic is appropriate?  Normatively speaking, is the increased equality of after tax income worth the decreased economic activity?
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Samuelson on Population Growth and Deficits

Throughout most of my life, many social scientists have warned of a Malthusian population bomb that threatens our planet's limited resources. Thomas Malthus (1776-1834), an influential economist, observed that population tends to grow geometrically and food production, arithmetically. But here the similarity between many of today's demographers and Malthus ends. He concluded that mankind was not starving so other economic forces must be at work to extend life and that it was the role of the economists to study these forces.

With the aging of Western countries, economists are revising theories of population growth and finding that there is much to recommend at least stable populations. Robert Samuelson explores the impact of population growth on the U.S. economy and discusses tax policies to encourage birth in "Taxes, Fertility and Economic Growth."

...a budget is not just a catalogue of programs and taxes. It reflects a society's priorities and values. Our society does not -- despite rhetoric to the contrary -- put much value on raising children. Present budget policies punish parents, who are taxed heavily to support the elderly. Meanwhile, tax breaks for children are modest. If deficit reduction aggravates these biases, more Americans may choose not to have children or to have fewer children. Down that path lies economic decline.

Societies that cannot replace their populations discourage investment and innovation. They have stagnant or shrinking markets for goods and services. With older populations, they resist change. For a country to stabilize its population -- discounting immigration -- women must have an average of about two children. That's a "fertility rate" of two. Many countries with struggling economies are well below that. Japan's fertility rate is 1.2. Italy's is 1.3, as is Spain's...

The U.S. fertility rate isn't yet close to these dismal levels. In 2007, it was at the replacement rate of 2.1 children per woman, reports the National Center for Health Statistics...

While having a child is a deeply personal decision, it's also shaped by culture, religion, economics and government policy...

We need to avoid Western Europe's mix of high taxes, low birth rates and feeble economic growth. Young Americans already face a bleak labor market that cannot instill confidence about having children. Piling on higher taxes won't help. "If higher taxes make it more expensive to raise children," says demographer Nicholas Eberstadt of the American Enterprise Institute, "people will think more about having another child." That seems common sense, despite the multiple influences on becoming parents.

How to reconcile this with deficit reduction is unclear. From 2011 to 2020, the Obama administration projects budget deficits of $8.5 trillion. Other estimates are higher. Even if spending and benefits for the elderly are cut -- as they should be -- higher taxes will still almost certainly be needed. Parents ought to be shielded from the steepest increases.

Any tax system rewards some activities and punishes others. A case in point is the mortgage interest rate deduction that rewards people for buying larger homes with more debt. We might reduce this dubious subsidy and shift some savings toward children. Stein advocates combining pro-child tax breaks (the personal exemption, the child tax credit, the child-care credit and the adoption credit) into one generous credit. Whatever the details, policies should have a pro-family bias because parenting is, as he writes, "one of the most important services any American can perform."

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Rogoff Compares Japanese, U.S., and European Financial Crises

Kenneth Rogoff is one of the nation's foremost scholars on financial crisis. With Carmen Reinhart, he coauthored the popular and widely cited book "This Time is Different: Eight Centuries of Financial Folly." Rogoff has the talent of engaging in politically charged economic debate without partisan rancor.  Rogoff compares the ongoing financial crises in the United States and Europe to the crisis in Japan that evolved into the "lost decade" in "An Age of Diminished Expectations?"  The article is short and well worth the time to read highlighting similarities and many differences between the economies as they entered their financial crises.  I have focused on paragraphs that describe policies that might help the United States exit the Great Recession and resume more robust growth. 

As the United States and European economies continue to struggle, there is rising concern that they face a Japanese-style “lost decade.” Unfortunately, far too much discussion has centered on what governments can do to stimulate demand through budget deficits and monetary policy. These are key issues in the short term, but, as every economist knows, long-run economic growth is determined mainly by improving productivity...

In the short term, it is important that monetary policy in the US and Europe vigilantly fight Japanese-style deflation, which would only exacerbate debt problems by lowering incomes relative to debts. In fact, as I argued at the outset of the crisis, it would be far better to have two or three years of mildly elevated inflation, deflating debts across the board, especially if the political, legal, and regulatory systems remain somewhat paralyzed in achieving the necessary write-downs.

With credit markets impaired, further quantitative easing may still be needed. As for fiscal policy, it is already in high gear and needs gradual tightening over several years, lest already troubling government-debt levels deteriorate even faster. Those who believe – often with quasi-religious conviction – that we need even more Keynesian fiscal stimulus, and should ignore government debt, seem to me to be panicking.

Last but not least, however, it is important to try to preserve dynamism in the US and European economies through productivity-enhancing measures – for example, by being vigilant about anti-trust policy, and by streamlining and simplifying tax systems.

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A Manifesto for Stimulus Spending

My training is primarily in microeconomics.  I know enough about macroeconomics to discuss it but not enough to lose my humility.  As I explain below, I do not support additional stimulus spending but many do including forty economists and historians including three Nobel Laureates (Stiglitz, Maskin, and McFadden) who signed a manifesto in the Daily Beast.  The manifesto reads ("Get America Back to Work"),

Fourteen million unemployed represents a gigantic waste of human capital, an irrecoverable loss of wealth and spending power, and an affront to the ideals of America. Some 6.8 million have been out of work for 27 weeks or more. Members of Congress went home to celebrate July 4 having failed to extend unemployment benefits.

We recognize the necessity of a program to cut the mid- and long-term federal deficit but the imperative requirement now, and the surest course to balance the budget over time, is to restore a full measure of economic activity. As in the 1930s, the economy is suffering a sharp decline in aggregate demand and loss of business confidence. Long experience shows that monetary policy may not be enough, particularly in deep slumps, as Keynes noted.

The urgent need is for government to replace the lost purchasing power of the unemployed and their families and to employ other tax-cut and spending programs to boost demand. Making deficit reduction the first target, without addressing the chronic underlying deficiency of demand, is exactly the error of the 1930s. It will prolong the great recession, harm the social cohesion of the country, and continue inflicting unnecessary hardship on millions of Americans.

I believe that the manifesto oversells government's ability to "fine tune" the economy in the first sentence of the second paragraph.  Nearly all economists recognize the need for deficit and debt reduction, but waiting until the mid- and long-term is probably politically not feasible.  Students of economics know that an economist's definitions of mid- and long-term is not precise, nor are the men and women who signed the manifesto clear about when deficits need to be reduced, presumably after more robust employment has been achieved.  Given that much of the future deficits will be caused by underfunded entitlement programs such as Social Security and Medicare, the reluctance of the electorate to support entitlement cuts or tax increases, and the reluctance of politicians to buck the will of the electorate, I have doubts that our collective institutions can reduce the structural deficits.

The third paragraph is a Keynesian plea for funding an extension of unemployment benefits through deficit spending.  I believe that a good humanitarian case can be made for extending the benefits but not through deficit spending.  The manifesto claims that "Making deficit reduction the first target, without addressing the chronic underlying deficiency of demand, is exactly the error of the 1930s."  There have been two global financial recessions.  We did not use stimulus spending to lift us out of the first, the Great Depression, and over two trillion in stimulus spending has failed to lift us out of the second, the Great Recession.  There is a literature that supports stimulus spending, but it is disputed because many of the models used assume that stimulus spending works and automatically produce big multipliers.  I do not support continued stimulus spending, a strategy that might work, when impending deficits and debt crises, problems that will be made marginally greater through stimulus spending, will lower economic growth and employment for decades if they are not successfully resolved. 
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Vernon Smith on Continued Stimulus Spending

The Great Recession was caused by the bursting of a housing bubble inflated in part by government policy that encouraged home lenders to lower credit standards.  Good politics require a government response to counter the recession even if policy has limited value.  Vernon Smith, the 2002 Nobel Laureate in Economics, adds his voice to the debate about the effectiveness of stimulus spending in the the Daily Beast ("Please, No More Government Spending!"). 

So what has been the government’s response in the current crisis? Besides spending stimulus, it was tax incentives for new home buyers and cash for clunkers if you bought a new car. All three are programs for borrowing output, homes and cars from future production and sales. Using subsidies to pump up home sales beyond what people could afford was the problem that led to the crisis. Now the problem is touted as the solution.

We are in times not seen since the Depression, when at its depth in 1934 my parents lost their Kansas farm to the bank. Such memories and the intensity of the current crisis led me and my colleague, Steven Gjerstad, to examine the last 14 recessions including the Depression. We have been surprised and dismayed to learn that in 11 of these 14 recessions the percentage decline in new house expenditure preceded and exceeded percentage declines in every other major component of GDP. Hence the sources of the current debacle are hardly new! Moreover, past recoveries in the housing market have been closely associated with recovery from recession. The latest data continue to tell us that the turnaround in housing, consumer durables, and business investment are all anemic.

Our past housing and government spending mistakes leave us with no good choices. But please no more government spending! The deficit must now be faced. Avoid any new taxes; they are unlikely to reduce the deficit without discouraging recovery.

Our best shot at increasing employment and output is to reduce business taxes and the cost of creating new start-up companies. Don’t subsidize them; just reduce their taxes even as they become larger; also reduce any unnecessary impediments to their formation. This is strongly indicated by the business dynamics program of the Bureau of Census and the Kauffman Foundation which has tracked new startup firms in the period 1980-2005. The entry of new firms net of departing firms in this period account for a remarkable two-thirds more employment growth (3 percent per year) than the average of all firms in the US (1.8 percent per year). The invigorating turmoil created by new technologies, with accompanying growth in output, productivity, and employment lead to new business formation as old firms inevitably fail. Reducing barriers to that growth encourage a recovery path which does not mortgage future output.

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The IMF, Chinn and Continued Stimulus

The headline screams, "IMF presses US to cut debt," but the story itself is a tacit endorsement of Obama administration policy to continue stimulus spending until growth is on a more secure footing.  Beatty writes,

"The central challenge is to develop a credible fiscal strategy to ensure that public debt is put -- and is seen to be put -- on a sustainable path without putting the recovery in jeopardy," an IMF report said.

The balance between spending to stimulate the economy and putting budgets in order has vexed countries around the world as the recovery has looked more and more precarious...

The IMF praised US efforts to cut the long-term deficit through health system reform, but said more needed to be done now.

Menzie Chinn at Econbrowser gives a spirited defense of deficit spending given current economic conditions in "A Specter is Haunting America."  While I am more of a deficit hawk and would like to see more immediate reductions in spending, I find reading Chinn profitable because he makes well reasoned arguments using established economic methods.  He also makes good use of empirical studies.  The linked post is a little technical for principles students but well worth the investment.  Replace this text with...
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Germany's Austerity Program

Yesterday, I referenced an article on the influence of Alberto Alesina on fiscal policy in Europe and criticism by Paul Krugman and Brad DeLong.  Today, the Financial Times reports more on the shape of Germany's austerity programs ("Germany focuses on cutting spending").

Germany’s cabinet is poised this week to approve a 2011 budget as part of a four-year programme of public spending cuts meant to serve as an example to other European governments without jeopardising the country’s increasingly robust economic recovery.

Briefing papers for Wednesday’s cabinet meeting, released by Berlin on Sunday, argue that by curbing spending – rather than increasing taxes – the €80bn ($100.3bn, £66bn) savings programme would differ “fundamentally” from previous fiscal squeezes and offer “noticeable, better growth possibilities”.

The comments appeared aimed at heading off international criticism that German fiscal austerity would hit Europe’s growth prospects.

Germany’s economy is enjoying an industry-led growth spurt, with engineers rehiring workers and returning production almost to pre-crisis levels.

The stronger-than-expected growth and falls in unemployment were making it significantly easier for Germany to reduce its public sector deficit.

I continue to believe that cutting spending is a good method of encouraging long-run economic growth.  I am not convinced that there is any policy that effectively encourages short-run growth in the face of a severe financial crisis. Replace this text with...
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Austerity or Stimulus?

Alberto Alesina, a Harvard economist, advises cutting deficits to revive growth in countries wishing to escape the Great Recession (Peter Coy, Businessweek, "Keynes vs. Alesina. Alesina Who?"). 

Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes. The Madrid paper, a summary of his views, was influential enough to be cited in the official communiqué of the EU finance ministers' meeting...

Alesina's own research shows mixed results from deficit-cutting. He identified 26 examples since 1980 of deficit reductions that triggered growth of gross domestic product and 21 that lowered government debt substantially. He found only nine double victories in which government policymakers managed both to expand their economies and reduce debt. (Among them: Ireland in 2000, and the Netherlands and Norway in 2006).

Paul Krugman, a Princeton economist and a Nobel laureate who supports additional stimulus spending, argues condescendingly against supporters of austerity (New York Times, "Myths of Austerity").

This conventional wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination — specifically, on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy.

Bond vigilantes are investors who pull the plug on governments they perceive as unable or unwilling to pay their debts. Now there’s no question that countries can suffer crises of confidence (see Greece, debt of). But what the advocates of austerity claim is that (a) the bond vigilantes are about to attack America, and (b) spending anything more on stimulus will set them off.

Brad DeLong, a Berkeley economists, worries that leaders in Washington are not concerned about ten percent unemployment because they will not pass additional stimulus spending (The Week, "Does Washington care about unemployment?").

Still, where is the panic, the sense of urgency? The Obama administration and the Democratic majority in Congress passed a fiscal stimulus plan half the size recommended by Democratic economists fifteen months ago. Since then, they have been unable to assemble a political majority to finish the second half of the job. There seems to be no appetite for addressing ten percent unemployment.

How can they give such contradictory advise?  The empirical evidence does not overwhelmingly support either austerity or stimulus.  Multipliers, the fulcrum that magnifies the stimulus, are generally found to be small and to vary greatly depending on economic conditions including the state of the economy, a government's debt as a percentage of GDP, and the type of fiscal stimulus such as a tax cut or spending increase all affect the multiplier.  With so many variables, and so few observations, it is not surprising that empirical investigations produce mixed results. 
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Positive and Normative Differences

(HT Drudge Report) Using funds from the American Recovery and Reinvestment Act, the Obama administration is increasing spending on paths for cyclists and walkers by $600.  I believe that the projects will be viewed very differently based on people's normative and positive positions (Telegraph, "Obama administration spends $1.2 billion on cycling and walking initiatives").

If you find positive evidence supporting fiscal stimulus through expanded deficits convincing, the cycling and walking projects seem a good fit.  They will be less costly in terms of spending and time than roads for automobiles so many projects can be funded and completed in a timely fashion, and their funding can be cut dramatically once the economic recovery is better established.  If you normatively believe in a paternalistic government, the project has advantages as well.  The government should wean Americans from the gas guzzling automobile and the exercise will be great for our expanding waistlines.   

If you find the positive evidence supporting fiscal stimulus weak due to expanding national debt or small multipliers, the project is like pouring gasoline on a fire.  Funding for projects, even those with set termination dates, seems to roll on forever.  If you are normatively concerned about the paternalistic influence of government, then you believe federal government has no interest in the driving habits or weight of Americans and their efforts are meddling. Permanent Link
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Blinder on Government and the Economic Recovery

Alan Blinder was a member of the Council of Economic Advisors to President Clinton, a Vice Chairman of the Board of Governors of the Federal Reserve and is a professor of economics at Princeton.  Few economists can match his academic and practical experience.  In "Government to the Economic Rescue," published in the Wall Street Journal, he argues that three policies spanning two administrations are responsible for the economic turnaround.  The policies are the Troubled Asset Relief Program (TARP), otherwise known as the bailout, the stimulus, formally known as the American Recovery and Reinvestment Act, and the "stress tests" of major banks.  While I tend to believe that TARP continued to feed the too-big-to-fail moral hazard, that fiscal multipliers are small, possibly less than one, and that the cost of expanding debt are yet to be felt, his arguments are well reasoned and represent an empirically supportable position.  I picked a few key paragraphs but recommend that students and others interested in the impact of fiscal policy read the entire article.

Let's start with two indisputable facts. First, both the financial system and the economy are in far better shape today than they were in the dark days of January or February 2009. For example, even though unemployment is higher now, it is receding rather than soaring, dropping to 9.7% in May from 9.9% in April. Second, the growth of the U.S. economy over, say, the last 12-18 months beat virtually every forecast made back then. I know, because I stuck my neck out on this page with a forecast viewed as too optimistic in July 2009, and the U.S. economy did better than I predicted.

He argues that government policy was causal in the turnaround.

The first was the much-maligned Troubled Asset Relief Program (TARP), which Fed Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson persuaded Congress to pass on Oct. 3, 2008. TARP must be among the most reviled and misunderstood programs in the history of the republic. Voters are clearly appalled by the idea that their government spent $700 billion bailing out banks.

The only problem is: It didn't. Even if we count insurance giant AIG as a bank, no more than $300 billion ever went to banks. TARP's total disbursements, including the auto bailout, never reached the $400 billion mark. The money went for loans and to purchase preferred stock; it was not "spent." In fact, most of it has already been paid back—with interest and capital gains. When TARP's books are eventually closed, the net cost to the taxpayer will probably be under $100 billion—far under if General Motors ever repays.

Spending perhaps $50 billion of taxpayer money to forestall a financial cataclysm seems like a bargain. Yes, I know it's maddening to hand over even a nickel to bankers who don't deserve it. But doing so was a necessary evil to save the economy. Think of it as collateral damage in a successful war against financial armageddon.

The second landmark was the fiscal stimulus package that President Obama signed into law about four weeks into his presidency. Originally priced at $787 billion, it was later re-estimated by the Congressional Budget Office (CBO) to cost $862 billion. A huge waste of money, say the critics—even though most independent appraisals, including that of the CBO, credit the stimulus with saving or creating two million to three million new jobs...

I come, finally, to the third major landmark: the "stress tests" of 19 big financial institutions (not all of which were banks) conducted by the Federal Reserve and other banking agencies in the spring of 2009. This unheralded but ingenious policy initiative was a riverboat gamble that paid off big.

When the stress tests were announced in February 2009, hardly anyone in the financial markets trusted anyone else—least of all the banks. The nervous markets might have panicked if the Fed had declared the need for bank capital to be either too large ("My God! It's hopeless!") or too small ("My God! It's a government whitewash!"). Instead, the Fed's careful and credible estimates found capital needs that were both realistic and manageable.

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Laffer Forecasts Economic Collapse

Arthus Laffer, for whom the Laffer curve is named, offered a gloomy forecast for the economy in "Tax Hikes and the 2011 Economic Collapse" written for the Wall Street Journal.  He notes that people respond to tax incentives. 

People can change the volume, the location and the composition of their income, and they can do so in response to changes in government policies.

He provides examples of people responding to tax incentives.

According to a 2004 U.S. Treasury report, "high income taxpayers accelerated the receipt of wages and year-end bonuses from 1993 to 1992—over $15 billion—in order to avoid the effects of the anticipated increase in the top rate from 31% to 39.6%. At the end of 1993, taxpayers shifted wages and bonuses yet again to avoid the increase in Medicare taxes that went into effect beginning 1994."

Just remember what happened to auto sales when the cash for clunkers program ended. Or how about new housing sales when the $8,000 tax credit ended? It isn't rocket surgery, as the Ivy League professor said...

In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn't take effect until Jan. 1, 1983. Reagan's delayed tax cuts were the mirror image of President Barack Obama's delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.

But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984.

Laffer describes the incentive, a broad range of increasing taxes.

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush's tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.

Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And there's always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere.

And he predicts the impact of the response to increasing taxes.

Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011, preceded most likely by the stock market.

In 2010, without any prepayment penalties, people can cash in their Individual Retirement Accounts (IRAs), Keough deferred income accounts and 401(k) deferred income accounts. After paying their taxes, these deferred income accounts can be rolled into Roth IRAs that provide after-tax income to their owners into the future. Given what's going to happen to tax rates, this conversion seems like a no-brainer.

The result will be a crash in tax receipts once the surge is past. If you thought deficits and unemployment have been bad lately, you ain't seen nothing yet.

If you tax something you will get less of it. In this case, government at different levels will be taxing economic activity. I wonder how much of the response will be timing of cash flows and how much will be reduced economic activity.
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Parallels Between the Great Depression and Great Recession

Growth in the U.S. gross domestic product was revised downward to 3.0% from 3.2% for the first quarter of 2010.  Initial claims for unemployment remain stubbornly high, falling 15, 000 to 460,000, but the 4-week moving average of initial claims climbed 2,250 to 454,250 (Jeannine Aversa, "Slow-motion recovery keeps unemployment high").  British and European monetarist have a possible explanation, the money supply as measured by M3 is falling at rates not seen since the Great Depression.  Ambrose Evans-Pritchard summarizes monetarist research in "US money supply plunges at 1930s pace as Obama eyes fresh stimulus" noting that M3 fell from $14.2 trillion to $13.9 trillion or 9.6% in the first quarter and the assets of institutional money market funds fell by 37%, the biggest decline ever.  As money assets contract, government debt swells.  Gross public debt will reach 97% of GDP in 2011.

The economy could slip back from weak recovery into recession with another negative shock.  The administration is pushing a $200 billion stimulus to sustain the growth that they believe that the original stimulus created.  Evans-Pritchard quoted Larry Summers, whose words acknowledge the dangers of the expanding deficit, as stating that Congress must "grit its teeth" to pass the stimulus and that it would be "pennywise and pound foolish" to fail to pass it.

In "Crisis and Leviathan," Robert Higgs proposed the crisis hypothesis which states that national crisis increase both the demand for and supply of government regulation of the economy.  Evans-Pritchard also interviewed Tim Congdon who believes that regulation comes at a cost...

"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.

Steven Gjerstad and Vernon Smith see other parallels between the Great Depression and the Great Recession ("Monetary Policy, Credit Extension, and Housing Bubbles: 2008 and 1929," Critical Review, 21(2-3), 269-300).  They document how housing bubbles formed in both 1929 and 2008 based on expansion of housing and mortgage financing for the least qualified borrowers.  They describe the boom and bust cycle.

The massive bubble in housing prices(driven by self-reinforcing price expectations) and the supporting expansion of credit, undisciplined by traditional equity requirements, as well as tiered internal structure of the housing market, had all depended on further unsustainable housing-price growth, premised on unfathomable easy mortgage credit--fueled by easy money.  Once that momentum turned negative, buyers of homes, mortgages, and bank obligations reined in their activity, the stock market plummeted, and monetary policy was impotent to stem the collapse.  Monetary policy was "pushing on a string" that only absent buyers could have pulled.

Traditional policy tools, fiscal policy, monetary policy and regulation seem limited and ineffectual at best and counterproductive at worst.  It is the actions of economic agents working through markets that will end the recession. 
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Trends in Personal Income

(HT Dredge Report) Dennis Cauchon of USA Today wrote a very good article describing changes in the composition of personal income in the first quarter of 2010 and the causes of the changes ("Private pay shrinks to historic lows").

Paychecks from private business shrank to their smallest share of personal income in U.S. history during the first quarter of this year, a USA TODAY analysis of government data finds.

At the same time, government-provided benefits — from Social Security, unemployment insurance, food stamps and other programs — rose to a record high during the first three months of 2010.

Those records reflect a long-term trend accelerated by the recession and the federal stimulus program to counteract the downturn. The result is a major shift in the source of personal income from private wages to government programs.

The article explains that the long-term trend is in part due an aging America where a larger portion of people are retiring, which reduces wages, and collecting social security and medicare benefits, which increases government-provided benefits. The recession, the government response to it, and the Obama administration's expansion of healthcare benefits accelerated the trend. Cauchon provides comments from four economists on the trend. I provide the comments is a different order than Cauchon to distinguish between short-run and long-run affects. The first, Paul Van de Water, believes that the acceleration of the trend is the result of an effective stimulus.

The shift in income shows that the federal government's stimulus efforts have been effective, says Paul Van de Water, an economist at the liberal Center on Budget and Policy Priorities.

"It's the system working as it should," Van de Water says. Government is stimulating growth and helping people in need, he says. As the economy recovers, private wages will rebound, he says.

The wild-eyed libertarian economist in me feels constrained to point out that an ineffective stimulus would have the same short-run impact of increasing government benefits relative to private wages and that the economy would recover with or without government intervention. The remaining three economists focus on the long-run problems caused by the trend.

The trend is not sustainable, says University of Michigan economist Donald Grimes. Reason: The federal government depends on private wages to generate income taxes to pay for its ever-more-expensive programs. Government-generated income is taxed at lower rates or not at all, he says. "This is really important," Grimes says...

Economist Veronique de Rugy of the free-market Mercatus Center at George Mason University says the riots in Greece over cutting benefits to close a huge budget deficit are a warning about unsustainable income programs.

Economist David Henderson of the conservative Hoover Institution says a shift from private wages to government benefits saps the economy of dynamism. "People are paid for being rather than for producing," he says

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