Fiscal Policy in the Long and Short Runs

The Times' Edmund Andrews has a useful look (with nice charts) at the fiscal policy challenges that will confront the next administration. One major issue is that the tax cuts passed in 2001 and 2003 are scheduled to expire:

Extending them would reduce revenues by about $3 trillion over the next 10 years, according to the Congressional Budget Office. Those reductions would coincide with sharply rising costs for Social Security and Medicare as millions of baby boomers enter retirement.

Senator John McCain of Arizona, the front-runner for the Republican nomination for president, has flip-flopped on the issue. In 2001 and 2003, he alienated many Republicans by voting against the tax cuts, arguing that they were too heavily tilted toward the rich. But as a presidential candidate, Mr. McCain competed fiercely with his Republican rivals in vowing to not only make the tax cuts permanent but also to cut the corporate tax rate....

The Democratic contenders, Senator Barack Obama and Senator Hillary Rodham Clinton, would extend the tax cuts for most people but revoke them for families earning more than $250,000 a year. “I am not bashful about that,” Mr. Obama said at the Democratic candidates’ debate on Jan. 31. “What we have right now is a situation where we cut taxes for people who don’t need them.”

Clinton and Obama plan to use the additional revenue to finance their health care plans. Obama has also expressed a willingness to consider raising the social security payroll tax on earnings over the current cap of about $90,000 (see earlier post).

The steps discussed so far on the campaign trail are unlikely to close the gap between revenue and spending (and McCain, if he doesn't change his mind again, would widen it). None of the candidates (except Huckabee) has offered plans for fundamental changes to the tax system. Andrews puts it in context nicely:

Historically, federal taxes have averaged about 18.5 percent of the gross domestic product.

That percentage sank to 16.3 percent of the G.D.P. in 2004, largely because of Mr. Bush’s tax cuts, but it edged up to 18.8 percent last year as a result of booming corporate profits and investment income.

But government spending remains above 20 percent of G.D.P., and the gap between taxes and spending is likely to widen sharply as a result of the economic slowdown this year.

President Bush’s budget plan for 2009, which includes money for an economic stimulus package, calls for the federal deficit to more than double, to $410 billion, this year.

That is, in addition to the gap between revenue and spending expected over the long run, we can expect the deficit to increase in the short run, and that's not entirely a bad thing. The expected increase in the deficit this year is partly a reflection of the "automatic stabilizer" role of the federal budget - since most taxes are proportional to income, revenues automatically fall when incomes decrease, and spending on some government transfer programs like unemployment insurance rises in a downturn. On top of that, we are indeed going to get a "fiscal stimulus" - a one-off tax rebate intended to increase aggregate demand this year. The efficacy of this has been much-debated; I think Jared Bernstein has it about right:

It's both good news and a missed opportunity to craft a much more effective package.

On the plus side, those who said the political system was too clogged with partisanship to get this out the door quickly are proved wrong. The package is also much improved from the White House's first pass, which excluded low-income families and about 20 million elderly persons.

On the negative side, they could have crafted a package that would have had a lot more bang-for-the-buck....

By leaving out extended unemployment benefits and other more directly stimulative measures, like helping revenue-strapped states invest in infrastructure (roads, school repairs), the Congress and the White House missed the chance to get a significantly bigger return on our investment...

That said, and I know there's a fair bit of skepticism on this point, this package will surely help. It won't stave off recession, but it will mitigate the pain for many.

Speaking (Bob) Frankly

Economists' proofs that markets lead to "efficient" outcomes hold only under a specific set of assumptions, including perfect competition, perfect information, and the absence of externalities. These assumptions, of course, never completely hold - the world we live in is one of "market failure." The benefits of markets are often hard to see and appreciate; understanding them is an important contribution of economics, but it is also important to understand market failures. One of the most acute observers of market failure is Cornell's Bob Frank, who Steven Pearlstein writes about in his Washington Post column:

Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The latest example of Frank at work is his piece in today's New York Times. He looks at the puzzle of why people contribute to political campaigns, which seems to go against our assumption that people behave in a narrowly self-interested manner:

The problem, as described by Mancur Olson in his classic book, “The Logic of Collective Action,” is that even those who share a presidential candidate’s policy goals will reap no significant material advantage by donating their time or money. After all, with cash donations legally capped at $2,300, even donors who give the maximum have no realistic hope of influencing an election’s outcome. Nor can any individual volunteer — even one whose efforts resulted in hundreds of additional votes for his candidate — realistically hope to tip an election.

Although the logic of the free-rider problem may seem compelling, people’s behavior strikingly contradicts many of its predictions. Last month alone, for example, the presidential campaign of Senator Barack Obama raised over $32 million from more than 250,000 individual donors and sent huge numbers of volunteers into the field. (Disclosure: I’m an Obama contributor myself.) Other campaigns have benefited in similar, if less spectacular, ways from their supporters’ willingness to set narrow self-interest to one side.

Frank goes on to describe a theory from Albert O. Hirschman that posits alternating periods dominated by collective action and by selfishness. So, while Obama was criticized for saying positive things about Ronald Reagan, his "movement" may be a sign that the Reagan era is over...

One crucial thing sometimes students (and professors) misunderstand about the free rider problem - and the assumptions we make about behavior in general - is that economics does not exist to tell people how to act. Economists are social scientists, and our task is to explain human behavior. In Frank's example, what is problematic is not the behavior of the donors, but the fact that economic theory has a hard time explaining it.

Panda Bearishness

Double-digit annual GDP growth has become almost routine for China, but in the Financial Times, Kenneth Rogoff argues a slowdown may be in the offing:

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.

The bar is pretty high when 6% growth counts as a "growth recession" (a period of below average growth, but not a full-blown recession where output actually falls). In the "Economists' Forum" comments, Rogoff's former professor Jagdish Bhagwati reminds us of some institutional issues that could yet derail the China growth story:

I think that Rogoff's analysis needs to be supplemented by a fuller recognition of the problems that Chinese authoritarianism poses. Unless you have the institutions of a liberal democracy - a free press, NGOs, opposition parties and an independent judiciary - you run the danger of "social disruptions" that China has and you are unable to channel dissent and distress into creative political channels. This is why a big question mark hangs over China's future.

And William Easterly expects "regression to the mean":

Growth forecasters are curiously oblivious of the overwhelming evidence for regression to the mean. Of course, a small number of countries can defy gravity for a while, as China has already done with the length of its current rapid growth episode. Until recently, the East Asian tigers (Hong Kong, Korea, Singapore, Taiwan) also defied gravity for an unusually long period, but in the last ten years gravity reasserted itself - their growth has decelerated back down towards world average growth.

Or, to put it on a more solid theoretical footing - neoclassical growth models (e.g. the Solow model) imply that the rate of growth will slow as an economy gets closer to its steady state.

More Sino-pessimism is available from Michael Pettis, who considers the possibility of Chinese stagflation on his China financial markets blog.

Update (2/10): The Cleveland Fed's "Economic Trends" has a good explanation of the relationship between inflation and China's exchange rate policy.

Aim Slightly Higher

The unusually aggressive reductions in the fed funds rate target in the last two weeks have been criticized for increasing the potential for future inflation. One defense of the Fed is that the risks it faces are asymmetric. In particular, the Fed wants to make sure to avoid falling into deflation and a "liquidity trap" where monetary policy becomes ineffective - when the price level is falling, even if nominal interest rates go to zero, real interest rates can still be high. This is the point made in the FT's Economists' Forum by Johns Hopkins' Christopher Carroll:

[T]he Fed's gamble seems well judged, not because the concerns of the inflation hawks are unwarranted but because they are balanced by a more dangerous possibility on the opposite side. Put it this way: if I'm hiking a narrow cliff-hugging mountain trail, I don't want to stroll right down the middle of the path. Instead I will edge to the to the side of the trail away from the precipice, even if this means an occasional scraped ankle or a bit of extra scrambling. This is the "precautionary principle" in mountain-climbing.

The cliff, for monetary policy, is the possibility of deflation, whose dangers were calamitously illustrated by the Japanese government during the 1990s. And the precautionary principle would say that it is worth risking a spell of extra inflation to avoid even a small risk of a deadly dose of deflation.

The uptick in long-term interest rates (noted previously) might suggest that the Fed's actions are denting its inflation-fighting credibility and that inflation expectations are rising. One way to enhance credibility and keep inflation expectations anchored would be for the Fed to adopt inflation targeting (i.e. announcing a goal for inflation and committing to adjusting monetary policy to meet it). As an academic, in addition to being a student of the depression, Ben Bernanke was an advocate of inflation targeting.

Most of the countries that have adopted inflation targeting (e.g. Britain) have set targets of 2% (or ranges centered on 2%). If the Fed is indeed strongly deflation-averse (as it should be), perhaps 2% would be cutting it too close. Setting a slightly higher target - say 3% - would give the benefits of inflation targeting without requiring it to walk so close to the edge of the cliff. For example, if we start from an equilibrium at an assumed "neutral" level of the real fed funds rate of 2.5% and an inflation target of 3%, the fed funds rate would be 5.5%, giving the Fed 550 basis points to work with in a downturn (as opposed to 450 bps with a 2% target).

The downside of that, of course, is higher inflation. But many of the problems with inflation come more from uncertainty and volatility rather than the rate itself. Its not clear that an economy with consistent, anticipated inflation of 3% is much worse than one with consistent, anticipated 2% inflation. Moreover, if nominal wages are sticky downwards, a little bit of inflation makes it easier to adjust real wages (as Akerlof, Dickens and Perry explained).

The Mandate Debate

Part of the discussion in last week's Democratic debate was over an "individual mandate" for health insurance. Clinton is for it - her health care proposal would require all people to get insurance (like most states require all drivers to be insured) - and Obama is opposed, which is why Clinton can say he wouldn't provide "universal coverage" since some people would choose to go without insurance.

For more, Jonathan Cohn of The New Republic has an even-handed assessment of the issue (and Krugman continues to take Obama to task, as does Ezra Klein). The plan instituted by Governor Romney in Massachusetts also includes an individual mandate.

For a broader look at the candidates' economic policy views, see the series by NY Times' David Leonhardt. Here's his article about Obama, Hillary Clinton and John McCain.

Obamamania

Part of Barack Obama's appeal comes from the notion that he can bring people together. Last week he collected the endorsements of Hulk Hogan and former Federal Reserve chairman Paul Volcker. Both are known for laying down some smack in the 80's - Hogan on the Iron Sheik and Andre the Giant, and Volcker on inflation. The victory over inflation was not without its cost - Volcker's tight, quasi-monetarist policies led to the 1981-82 recession, the deepest US recession since the great depression.

Obama talks of working as a community organizer in the 1980's in south Chicago neighborhoods devastated by factory closings. The unemployment he saw is at least partly attributable to the Volcker Fed's actions.

The red line is the Fed Funds rate, the blue line is inflation (CPI) and the unemployment rate is in green.
It should be noted that the Fed's policies were a response to the inflation that had developed over the 1970's, and some economic "pain" was arguably necessary in those circumstances.

The Business End of the Stimulus Package

Most of the discussion (including mine) of the proposed fiscal stimulus package has focused on the tax rebates for individual households. I wasn't sure how to assess the roughly $50 billion in corporate tax breaks, but according to Howard Gleckman of the Tax Policy Center, the news isn't good. At Tax Vox (the TPC blog), he writes:

The bills moving through Congress would permit businesses to accelerate their tax write-offs for the purchase of equipment. This "bonus depreciation" was a favorite of Congress in 2002 and 2003 as well. The Senate Finance Committee version would also allow companies to use current losses to reduce their tax liability from as long as five years ago.

But this morning, at a TPC Forum on the stimulus effort, tax experts generally agreed that neither idea would do very much to accelerate investment.

Doug Elmendorf, a fellow at TPC and Brookings, says that he and former colleagues at the Fed struggled to find evidence that bonus depreciation enacted in response to the 2001 recession boosted capital spending. The Joint Committee on Taxation concludes that only 10% of businesses changed either the timing or amount of their investments as a result of the 2002-2004 tax breaks.

Plenty of other companies took the extra depreciation, all right, but they got it for investments they would have made anyway. Some call this "leakage," which is a polite way to say "boondoggle."

This time, we are creating the worst of all worlds. On one hand, the business breaks will increase the deficit by nearly $50 billion over the next two years. At the same time, they are too small to matter much to the real economy. If the 2002–04 changes, which were more than twice as generous as those on the table today, didn't do much, it is hard to see how the 2008 version will encourage investment. Besides, the Fed's huge cuts in interest rates will be far more important to a business' decision to invest than these tiny tax changes.

The stimulus, naturally, is cooling in that saucer of democracy known as the US Senate.

The News Today, Oh Boy

A big day for macroeconomic news:

The BEA released its advance estimate of US output for 2007, reporting that real GDP grew by 2.2%, which is slower than the postwar average of 3.3%. The effect of the housing market implosion is evident in the 16.9% decrease in "residential fixed investment" which contributed -0.97% to overall GDP growth. With the aid of a declining dollar, exports increased by 7.9%, contributing 0.89% to the total (imports also rose, by a smaller amount, making for a total contribution of 0.55% from net exports).

The last quarter of the year was sluggish indeed, with an 0.6% annual growth rate. At that pace, growth is too slow to keep unemployment from rising, but as long as output growth is positive, we're not - technically - in a recession.

Inflation, as measured by the GDP deflator, came in at 2.7%, and the currently fashionable deflator for personal consumption expenditures excluding food and energy (i.e. "core PCE") increased 2.1% (and at a 2.7% pace in the 4th quarter.... is that a whiff of stagflation in the air?).

An important caveat - today's release was the "advance estimate," which will be followed by the "preliminary estimate" at the end of February and the final figure a month after that. (See also Krugman's observations, and James Hamilton's).

Later the same day...

The Federal Reserve announced announced a 50 bps (0.5%) cut in the target for the Federal Funds Rate, to 3.0%. This is only eight days after the surprise 0.75% cut last Tuesday (today was the regularly scheduled meeting for the FOMC). The Fed said:

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

The Fed's short term concern is growth and employment, but it also has a mandate to keep inflation low (and, as ever, tension between those two goals). Even as the Fed pushes short-term rates down, the yield on 30-year US Treasury bonds has risen from 4.28% on Jan. 18 (before the 0.75% cut) to 4.44% today. Many things can influence rates, but this increase in the term component may be a sign that the Fed's apparent eagerness to keep growth growing with loose monetary policy has caused inflation expectations to tick upwards. Willem Buiter is not pleased:

By now, the neglect by the Fed of the price stability leg of its mandate no longer comes as a surprise. But even fully anticipated mistakes hurt. The US and the world economy will pay the price when, in due course, the Fed has to clean up the mess it is creating by its reckless pursuit of the maximum employment objective.

Also, Dean Baker makes an interesting point about the steepening of the yield curve.

Update (2/2): The Journal's Real Time Economics reports on the rise in inflation expectations, as measured by the yield on TIPS (Treasury Inflation Protected Securities) which are Treasury bonds whose value is indexed to inflation (see also Mankiw's comment).

Economist Smackdown

In Sunday's Washington Post, economist Steven Landsburg explained "Why the Stimulus Shouldn't Stimulate You" -

As a general rule, economic policies command bipartisan support only when they're incoherent. Take, for example, the fiscal stimulus package now bulldozing its way through the legislative process. It's poorly conceived, it's unlikely to work, and it's sure to do a lot of collateral damage.

The idea, we're told, is to stave off an all-out recession by stimulating both investment (through tax cuts for businesses) and consumption (through tax rebates to individuals). But hold it right there.

Investment and consumption are natural rivals.

Investment means converting resources into machines and factories; consumption means converting those same resources into TV sets and motorboats. In anything but the very short run, more of one means less of the other.

Ah, say the package's more honest proponents, that's exactly what we care about -- the very short run. And in the very short run, we can have more of everything if only we put more people to work.

Fine, but what makes you think that this package will put anyone to work? The idea behind the stimulus deal is to give people tax cuts so they'll feel richer and spend more. But government can't make people richer on average; all it can do is shuffle wealth around. To pay Peter, you must tax Paul (or at least promise to tax Paul in the future, when your debts come due). Peter spends more, but Paul spends less.

Landsburg's argument seems to be based on classical economic theory, which holds that changes in aggregate demand do not affect the level of output. That was prevailing economic wisdom 80 years ago, but we've figured some things out since then, as Paul Krugman explains:

The understanding that Say’s Law doesn’t work in the short run — that a fall in consumption doesn’t automatically translate into a rise in investment, but can lead to a fall in output and employment instead — is the central insight of Keynes’s General Theory. (My introduction to the new edition is here.) And we’re having a serious debate about economic policy that hinges on that insight.

Yet here we have an opinion piece published in a major newspaper 70 years after that profound insight, supposedly informing readers about economics, by someone who obviously just doesn’t get it.

Brad DeLong thinks its the "stupidest thing published by the Washington Post so far this year," and Mark Thoma is also critical.

Landsburg and Jason Furman are debating the stimulus in the LA Times (Hat tip: Greg Mankiw).

Migration and Global Poverty

Reason Magazine has a thought-provoking interview with Harvard Economist Lant Pritchett who argues the best way to improve the lives of the world's poor is to make it easier for them to move to rich countries. Pritchett says:

Being against migration to the United States is wrong for two reasons. One, I don’t think it gets the scale of the poverty in the United States vs. poverty in the rest of the world right. Second, if you are really concerned about inequality in the United States, there are many things you can do that would be better than blocking other people from coming to our country. I don’t want to say that people who are concerned about inequality in the U.S. aren’t right to be concerned about inequality in the U.S. But I think taking that concern and using it to keep people from coming to the United States is victimizing the world’s true victims in favor of people who happen to live closer to you.

An interesting argument, though clearly a political non-starter these days... Pritchett was also featured last year in the NY Times magazine. Hat tip to Free Exchange.