Richmond Fed Interview

The Richmond Fed published a long interview with me in their Econ Focus, shorter pdf (print) version here and longer web version here. Some of the questions:

• Does the 2010 Dodd-Frank regulatory reform act meaningfully address runs on shadow banking?
• So what do you think is the most promising way to meaningfully end “too big to fail”?
• Do you think there’s any reason to believe recessions following financial crises should necessarily be longer and more severe, as Carmen Reinhart and Kenneth Rogoff have famously suggested?
• Many people have asked whether the finance industry has gotten too big. How should we think about that?
• What are your thoughts on quantitative easing (QE) — the Fed’s massive purchases of Treasuries and other assets to push down long-term interest rates — both on its effectiveness and on the fear that it’s going to lead to hyperinflation?
• Both fiscal and monetary policies have been on extreme courses recently. What are your thoughts on how they might affect each other as they move back to normal levels?
• Switching gears to finance specifically, what do you think are some of the big unanswered questions for research?
• You wrote an op-ed on an “alternative maximum tax.” What’s the idea there?
• Can transfers really help the bottom half of the income distribution?
• Which economists have influenced you the most?

You’ll have to click to the interview for answers!

Thanks to Aaron Steelman, Lisa Kenney and especially  Renee Haltom, who helped a lot with the editing. I’m a lot less coherent in person!

Job market doldrums

Three recent views on the dismal labor market pose an interesting contrast.

Alan Blinder wrote a provocative WSJ piece on 6/11, Fiscal Fixes for the Jobless Recovery. A week prviously, 6/5, Ed Lazear wrote about The Hidden Jobless Disaster. And John Taylor has a good short blog post Job Growth–Barely Keeping Pace with Population

All three authors emphasize that the unemployment rate is a poor measure of the labor market. Unemployment counts people who don’t have a job but are actively looking for one. People who give up and leave the labor force don’t count. Employment is a more interesting number, and the employment-population ratio a better summary statistic than the unemployment rate. After all, if unemployment falls because everyone who is looking for a job gives up, I don’t think we’d see that as a good sign.

Source: Wall Street Journal

Ed Lazear made this interesting chart. As he explains,

Every time the unemployment rate changes, analysts and reporters try to determine whether unemployment changed because more people were actually working or because people simply dropped out of the labor market entirely… The employment rate—that is, the employment-to-population ratio—eliminates this issue by going straight to the bottom line, measuring the proportion of potential workers who are actually working.

While the unemployment rate has fallen over the past 3½ years, the employment-to-population ratio has stayed almost constant at about 58.5%, well below the prerecession peak. Jobs are always being created and destroyed, and the net number of jobs over the last 3½ years has increased. But so too has the size of the working-age population. Job growth has been just slightly better than what it takes to keep the employed proportion of the working-age population constant. That’s why jobs still seem so scarce.

The U.S. is not getting back many of the jobs that were lost during the recession. At the present slow pace of job growth, it will require more than a decade to get back to full employment defined by prerecession standards….

Why have so many workers dropped out of the labor force and stopped actively seeking work? Partly this is due to sluggish economic growth. But research by the University of Chicago’s Casey Mulligan has suggested that because government benefits are lost when income rises, some people forgo poor jobs in lieu of government benefits—unemployment insurance, food stamps and disability benefits among the most obvious. The disability rolls have grown by 13% and the number receiving food stamps by 39% since 2009.
….

John Taylor makes the point nicely with another graph, which contrasts the labor force participation rate to the BLS’ forecast of what should have happened from demographic effects.

The graph comes from a recent paper Chris Erceg and Andrew Levin.

I part company a bit with Lazear on his conclusions

… the various programs of quantitative easing (and other fiscal and monetary policies) have not been particularly effective at stimulating job growth. Consequently, the Fed may want to reconsider its decision to maintain a loose-money policy until the unemployment rate dips to 6.5%.

If low employment is “structural,” resulting from the worker-side disincentives as well as employer-side disincentives – policy uncertainty, regulatory threats, NLRB, Obamacare, Dodd-Frank, EPA, and so on – then the problem isn’t lack of “demand” in the first place. If the problem has nothing to do with the Fed, and if $2 trillion of QE didn’t do anything to help it, why does the solution have anything to do with the Fed?

The greater surprise is to hear so much agreement from Alan Blinder:

The Brookings Institution’s Hamilton Project, with which I am associated, estimates each month what it calls the “jobs gap,” defined as the number of jobs needed to return employment to its prerecession levels and also absorb new entrants to the labor force. The project’s latest jobs-gap estimate is 9.9 million jobs. At a rate of 194,000 a month, it would take almost eight more years to eliminate that gap.

…. policy makers should be running around like their hair is on fire.

Lazear said “a decade."  More suprising agreement on the impotence of monetary policy:

The Federal Reserve has worked overtime to spur job creation, and there is not much more it can do.

As you might imagine, I’m not such a fan of Blinder’s suggested fixes. He starts with traditional simple Keynesian recommendations that  the government should hire people and "spend” more. No need to refight that here. The more interesting recommendations follow as he warms up to his latest clever scheme.

… the basic idea is straightforward: Offer tax breaks to firms that boost their payrolls.

For example, companies might be offered a tax credit equal to 10% of the increase in their wage bills over the previous year. …

Another sort of business tax cut may hold more political promise….Suppose Congress enacted a partial tax holiday that allowed companies to repatriate profits held abroad at some bargain-basement tax rate like 10%. The catch: The maximum amount each company could bring home at that low tax rate would equal the increase in its wage payments as measured by Social Security records.

For example, if XYZ Corporation paid wages covered by Social Security of $1 billion in 2012 and $1.1 billion in 2013, it would be allowed to repatriate $100 million at the superlow tax rate. The reward for boosting its payroll by $100 million would thus be a $25 million tax saving. That looks like a powerful incentive.

…companies could claim the tax benefit only for individual earnings below the Social Security maximum ($113,700 in 2013). No subsidies for raising executive pay.

I find this most interesting at the level of basic philosophy; how we think about economic policy.

There are huge, longstanding, tax and regulatory disincentives to hiring people. Income tax, payroll taxes, health care and other mandates, and NLRB, OSHA, and so on. There are the high marginal taxes to labor implied by social insurance programs, as Mulligan points out.  If we want to increase the incentive for companies to hire people and people to take the jobs, why add another tax break to an obscenely complex tax code, rather than fix some of the existing disincentives? 

Is this really the right way to run a country? When “policy makers” want more employment, they slap on a complex, tax break on top of a mountain of disncentives. Presumably they then will remove this tax break, and pages 536,721 to 621,843 of the tax code describing it, despite the lobbying by large corporations who have figured out how to exploit it for billions of dollars, once the Brookings Institution decides that there is “enough” employment (!), and “policy-makers” no longer need to encourage it? 

How are the existing hundreds of bits of social engineering in the tax code working out? Do we really need more of this?  Isn’t it time to return to a tax code that raises money for the government at minimal distortion?

The contrast between the benevolent “policy-maker” (no dictator ever had such power) and the reality of how the tax code in this country is actually enacted is pretty striking.

I have to say, I’m a bit disappointed in the end by both. They agree that the US economy is about 10 million jobs short. Something big is in the way. Lazear at least mentions some candidates, though many are long-standing. But the stirring conclusion from Lazear is only to continue a loose monetary policy that he says has been ineffective so far, and the conclusion from Blinder is the sort of clever scheme that economists cook up in late-night cocktail parties piling one more quickly-exploitable bit of social engineering on top of a tax code rife with them. Neither recommendation comes close to 10 million jobs, or addressing any sort of clear story why those jobs have vanished.

Debt and growth in 10 minutes

This is a short video from last year. I only just found out it exists. It still seems pretty topical, and (for once) condensed because Lars Hansen really forced me to obey the 10 minute time limit!

There is a better link here from the BFI page here that covers the whole event, but I couldn’t figure out how to embed those.

Fun debt graphs

I was having a bit of fun making graphs for a talk. Are we all fine and debt is no longer a problem? I went back for a closer look at the CBO’s long term budget outlook and The budget and economic outlook 2013 to 2023. All numbers from these sources.

 Above, I plot the CBO’s long term outlook, in the alternative fiscal scenario (i.e. the one that is even faintly plausible).  As you can see, though they think the deficit gets better for a bit, then the entitlements disaster is still with us.

Of course, this will not happen, the only question is what adjusts.  If bond markets get a whiff that we actually will try these paths, we have a crisis on our hands.

So what can adjust? Revenue is historically about 20% of GDP no matter what tax rates are.  Doubling Federal revenue, while of course states, cities and counties keep taxing us, seems like an unlikely prospect. I’m all for cutting spending, but really, cutting spending in half, and by more than 20 percentage points of GDP? Well, it’s in the Ryan budget, but it’s a lot. So, what else can we do?

Answer: Growth. Tax revenue equals tax rate times income, and income equals todays income times growth. Greater growth makes all the difference.

To illustrate this point, I made a simple calculation. Suppose growth is 1% and then 2% greater than the CBO projects. What effect does that have? To keep it very simple, I assume that spending stays the same, and revenue stays the same fraction of GDP. Thus, I just divide spending/GDP by a 1% and then 2% growth rate (e^(0.01 t)) and we have the new spending as a fraction of the larger GDP.

This is pretty amazing, no? If we just had two percentage points GDP growth greater than the CBO’s forecast (which is a bit above 2% in the out years) the whole budget would be solved without fixing anything.

This thought sent me back to look at the CBO’s economic assumptions,

Uh-oh. The CBO thinks we are going to quickly enter a period of 4% growth, go back to trend, and then start growing smartly. Tax revenue = tax rate x income, that’s a lot of revenue.  The CBO, the Fed, and everyone else (me too for a few years) has been forecasting this bounce back growth just around the corner for a while now. What if it doesn’t happen, and 1.5% growth without catching up to trend is the new normal?

To keep it simple, I redid the above chart now just assuming 1% and 2% less growth than the CBO.

Is that Greece, or Cyprus?

So, the real budget news that could matter has little to do with tax rates or spending. What matters most of all is whether we break out of this sclerotic growth trap.

I found this graph pretty chilling as well: 

Really, what chance do you think there is that defense, nondefense discretionary and other mandatory spending will decrease form 4% of GDP to 2.5-3% of GDP in 10 years?

The net interest line is interesting. That’s a huge rise. Why? Here are the other economic assumptions

You see the strong GDP growth, 4% for several years, in the top left panel. Inflation, bottom left, apparently has nothing to do with deficits, the Phillips Curve is alive and well.

But, the CBO is projecting interest rates to rise sharply in 2016, back to a low-normal 4% 3 month and 5% 5 year rate. This causes the $850 billion a year in interest costs highlighted in the previous graph, about the same numbers I was bandying about in “Monetary Policy with Large Debts” when worrying whether the Fed could actually do that to deficits.

From the deficit view, a Japanese lost decade of low interest rates would keep this from happening (or postpone it). Of course any financial event leading to higher interest rates would increase these interest payments a lot.

Growth in the UK?

I thought European “austerity,” meaning mostly large increases in marginal tax rates on anyone daring  to work, save, invest, start a company or hire people, while spending stays north of 50% of GDP, was a pretty bad idea.

So I was glad to read the tiltle, when a friend sent me a link to the Telegraph, announcing Osborne to unleash raft of policies to kick-start growth. Great, I thought, after trying everything else, the British will finally try the one thing that will work.


The byline was only a bit disappointing

The Government is to reveal a series of major new measures to boost national and regional growth ahead of the Budget to show its “pro-business” strategy is working

Pro-business is usually a code word for protection and subsidy. But there are plenty of worse code words.

And then it all falls apart

The measures will include:

• Billions of pounds of central government funding directed at boosting regional growth and a backing for Michael Heseltine’s plans for new local spending powers;

• The planning go-ahead for the Hinkley Point C nuclear power station;

• Support for housebuilders and for first-time buyers trying to get mortgages;

• A push on major infrastructure projects, including the Merseyside Gateway and the “super-sewer” in London, and more government guarantees for such projects;

… The Bank of England could also be given a broader mandate to support growth.

…billions of pounds of central government funds should be made directly available to the regions and cities such as Birmingham…

Lord Heseltine’s report made far-reaching recommendations for stimulating economic growth. The Government will unveil plans enabling Local Enterprise Partnerships and businesses to bid regionally for money that is now allocated centrally.

It’s not all bad. Allowing a nuclear power plant to operate is nice, and some plans to lower corporate taxes a bit. But the blossoming of free enterprise in the land of Adam Smith, alas, this is not. Keynes still rules.  

GMO Salmon

Source: http://www.aquabounty.com

This weekend’s New York Times brought the interesting story of AquaBounty’s genetically modified salmon, which are genetically engineered to grow twice as fast as normal Salmon. A few choice bits:

“In 1993, the company approached the Food and Drug Administration about selling a genetically modified salmon that grew faster than normal fish. In 1995, AquaBounty formally applied for approval. Last month, more than 17 years later, the public comment period…was finally supposed to conclude. But the F.D.A. has extended the deadline…

Appropriately, it has been subjected to rigorous reviews… scientists, including the F.D.A.’s experts, have concluded that the fish is just as safe to eat as conventional salmon and that, raised in isolated tanks, it poses little risk to wild populations.

Why the delay?

… some suspect that political considerations have played a role in drawing the approval process out to tortuous lengths. Many of the members of Congress who oppose the modified fish represent states with strong salmon industries. And some nonprofit groups seem to be opposing the modified salmon reflexively, as part of an agenda to oppose all animal biotechnology, regardless of its safety or potential benefits.

Even the White House might be playing politics with the salmon. “The delay, sources within the government say, came after meetings with the White House, which was debating the political implications of approving the GM salmon, a move likely to infuriate a portion of its base.”

namely,

anti-biotech groups, which traffic in scare tactics rather than science…

This story brings three thoughts to mind.

1. So who is "anti-science?” I can’t resist. There were a lot of potshots at Republicans for being anti-science, some well-deserved. But “science” is abundantly clear here. “Science” is indeed wrong at times, but if we want policy based on “science,” the safety of GMO foods is about as good as it gets. There’s plenty of magical thinking on both left and right, it turns out.

2.  $10,000 dollars invested in the stock market in 1993 is worth $50,000 today ($31,477 after inflation)  yes, even after the crash. It was already worth $37,600 ($32,700 after inflation) in 1999.  Remember, AcquaBounty hasn’t sold a single fish. The cost of 20 years delay is enormous, amounting to a huge tax disincentive.

3. We need growth. Where does growth come from? Modern growth theory is abundantly clear. New ideas, new processes, new businesses that raise productivity. Like a new idea that lets us double the growth rate of farmed salmon. And, yes, lower profits of current salmon fishermen, much to the relief of wild salmon.

GMO foods are, potentially, a huge game changer. Once every 50 years or so, we bump up against a Malthusian limit, and a new idea frees us again. Fixing airborne nitrogen. Green revolution. Now, GMO foods. GMO plants are being bred to use less fertilizer and insecticide, i.e. to be better for the environment, as well as to cure vitamin A deficiency, produce less waste, and so on. No, dear Greenpeace, organic farming is not the answer, unless we use a lot more land for agriculture, starve out half the people, or believe in magic.  (It’s too bad organizations like this suffer such mission creep. I would happily support their efforts on behalf of endangered species.)

Or maybe not. The lesson of industrial policy is that academic bloggers are just as bad as government bureaucrats in finding the next game changer. But there are hundreds of similar game-changers underway. Read any popular science magazine. Will we let the winners bear fruit?

Why do countries and civilizations fail? When interests vested in the status quo or magical thinking stop that process.  A long decay precedes the crises. I am reminded of the famous failures, such as the Chinese Emperor’s ban on long-range shipping, at a time when Chinese ships were way better than Portugese.

Update: A very nice article by Henry Miller on GM foods, titled “Anti-Genetic Engineering Activism: Why the Bastards Never Quit.” Henry is obviously much more knowledgeable than I am.

What's holding back the US economy?

This is a video I did with Steve Davis and Amir Sufi, moderated by Hal Weitzman, part of the new Chicago Booth “The Big Question” series. Youtube link here. I’m actually a lot calmer through most of it than I appear in the cover shot.

The Times on Taxes

The New York Times’ Sunday lead editorial (12/30) is simply breathtaking. The title is “Why the economy needs tax reform.” It starts well,

Over the next four years, tax reform, done right, could be a cure for much of what ails the economy…

OK, say I, the sun is out, the birds are chirping, my coffee is hot, and for once I’m going to read a sensible editorial from the Times, pointing out what we all agree on, that our tax system is horrendously chaotic, corrupt, and badly in need of reform. Let’s go – lower marginal rates, broaden the base, simplify the code.

That mood lasts all of one sentence.

Higher taxes,…

Words matter. “Reform” twice, followed by paragraphs of “higher taxes,” with no actual “reform” in sight. The Times is embarking on an Orwellian mission to appropriate the word “reform” to mean “higher taxes” not “fix the system.”

Let’s be specific. What is the Times’ idea of tax “reform?”

tax capital gains at the same rates as ordinary income…. a restoration of the estate tax, higher tax rates or surcharges on multimillion-dollar incomes, and higher corporate taxes..

That’s just to get started. Since, as the Times refreshingly admits,

..the new revenue would only slow the growth of the debt in the near term..

before the health care entitlement deluge hits,

… Mr. Obama would be wise to instruct the Treasury Department to start work on tax reform now, exploring carbon taxes, both to raise revenue and to protect the environment; a value-added tax,… and a financial transactions tax…

That’s “reform?”

What will all those taxes do? The Times has a little bit of deficit reduction on its mind,

 More revenue would also reduce budget deficits, helping to put the nation’s finances on a stable path.

But with “reduce,” “help,” and “stable path,” you can tell that eliminating deficits and paying off the debt are not a real high priority here. The Times has bigger fish to fry, starting with a red herring and ending with a red whale.

Higher taxes, raised progressively, could encourage growth by helping to pay for long-neglected public investment in education, infrastructure and basic research…

We’ve been spending more and more on education for years. While performance steadily declines. The trouble with schools is not lack of money.

Yes, infrastructure is crumbling, as a few New Yorkers may have figured out when their power went off, while their politicians – and the Times – instead of talking about burying electric lines and putting in a modern grid, wished instead to stem the rise of oceans and sugar in their soft drinks. But infrastructure spending is a tiny component of the Federal budget; we could support anyone’s wish list without a Federal income tax.  Basic research spending could be doubled on about 10 minutes worth of Federal spending. Red herring.

The whale comes last:

Greater progressivity would reduce rising income inequality, and with it, inequality of opportunity that is both an economic and social scourge. 

The Times is arguing forthrightly for confiscatory taxation of income and wealth, in order simply to  reduce post-tax incomes. This isn’t “redistribution,” it’s “off with their heads!”

Inequality of opportunity? No, President Obama’s kids should not go to Sidwell Friends, they should go to DC public schools like everyone else?  Mayor Rahm Emanuel’s kids shouldn’t go to the University of Chicago Lab school (mine go there too, but I don’t preach this stuff), they should have to go to Chicago public schools like everyone else? These are “economic and social advantages” arising from unequal income. Big ones, that motivate a lot of parents to work hard so they can afford the tuition.  French President Francois Hollande has a better idea: ban homework, so kids with smart parents can’t get an advantage because they get help on homework. Too bad you can’t ban homework in China and India. No concierge medicine either. Stand in line for medicaid like the rest of us.

And to accomplish this leveling, we’ll just take money from “the rich” until all are equally impoverished.

Am I being alarmist? No. Read the sentence again, carefully. Words matter. What else can it possibly mean?

It’s just astounding. When has a society ever grown, become prosperous, and raised opportunities for its citizens–of any background–by confiscatory taxation, transferring wealth to the State, with the deliberate aim of reducing the opportunities of a segment of its population? The examples I can think of – French and Russian revolutions, the whole communist world – ended rather badly.  Even more modest attempts, say postwar Britain, do not augur well. The evidence of Europe’s current high-tax “austerity” (another word Orwellianly appropriated to mean “high taxes”) and the weight of academic research (most recently from the IMF and Alberto Alesina) stand before us: Fiscal retrenchment led by higher marginal tax rates simply does not work.

Moving from outcome to opportunity, as the Times does, when has a society ever accomplished equal and plentiful opportunities by confiscatory taxation and heavy regulation? I can think of lots of societies that by these means became much less equal, with opportunity dependent on political and family connections, and thus out of reach of even the most talented and industrious people without connections. 

What of us naysayers? On taxing “capital gains at the same rate as ordinary income,”  

That is an indefensible giveaway to the richest Americans. Research shows that the tax breaks do not add to economic growth but do contribute to inequality. Currently, the top 1 percent of taxpayers receive more than 70 percent of all capital gains, while the bottom 80 percent receive only 6 percent.

Three more fish and a whopper.

We might start with the interesting assertion that any tax rate is a “giveaway.” Who gives what to whom, dear Times?

“Research shows” is another fascinating choice of words.  “Research shows” means “all research shows,” or “the consensus of research shows,” without actually saying it. The facts are “some research shows,” or in this case, really, “two unpublished papers we found on the web claim.”

The links point to a report by the Congressional Research service and a one-page screed from the Urban Institute.  Both pieces of “research” simply plot the usual pointless correlations ignoring the hundreds of other causes, effects, and things not held constant. Aspirin causes colds you know: Look, there is a strong correlation between asprin-taking and colds. Neither one is even submitted let alone published in a refereed journal, which is no guarantee of anything but at least it’s the minimum standard for “research.” If this were indeed what constitutes “research,"  and "science,"  vast new funding for fundamental research in economics might well be warranted.

Fortunately, that is not the case.  What real research concludes, as much as anything in economics concludes, is that capital gains taxes are about the easiest to avoid (see Buffett, Warren).  Real research shows that when capital gains rates were reduced in the 1980s, revenue increased. Real public finance, the rest of the world’s tax systems, and the broad conclusion of just about everybody until the world lost its head in 2008, was that capital gains taxation is a bad idea.

And the whale: "Receive” capital gains? Dear Times, capital gains are not a check sent by great-grandma’s trust fund. Let me educate you on where capital gains come from: People work, and earn money, and pay taxes on that money.  Rather than blow it all stimulating consumption demand, they save some of it, invest in stocks, or start businesses. When those investments pay off, they sell, and receive capital gains. A vast swath of retirees lives off capital gains, especially from their houses.Small business owners are “high income” in the one year they sell their businesses.

Words matter, again. “Receive” paints capital gains as passive receipts form a mysterious ill-gotten mountain of gold, ripe for plucking with neither tax avoidance, behavioral change, or economic consequence. That’s just not how our world works, but very revealing of the Times’ zero-sum, class-warfare worldview.

What about 

…higher corporate taxes..

Once again, one of the few things real “research shows,” and  economists agree on pretty heartily, is that corporate taxation – already higher in the US than the rest of the world – is a silly idea. All corporate taxes are passed on to people, through higher prices, lower wages, or lower returns to investors, primarily the former two. Tax people when they get the money. And corporations are much better at evasion, lobbying, moving abroad, and structuring operation in silly ways to avoid taxes.

The value added tax – the economist’s favorite, if coupled with elimination of other taxes – is famously “regressive,” the modern term (here are those important little words again) for “everybody pays the same rate."  Value added is, in Europe (along with 30-40% payroll taxes) the middle class tax that pays for middle class benefits. What about that, dear Times?

a value-added tax, coupled with provisions to protect lower-income taxpayers from higher prices, to tax consumption and encourage saving;

This is just incoherent. If you’re "protected from higher prices,” you’re not paying the tax. If we couple the VAT with a vast new income transfer program, adieu revenues.

At least we close with some humor. The VAT is there to encourage saving, while heavy taxation of interest, dividends, capital gains and estates, says just the opposite.

What about spending?

The big obstacle to comprehensive tax reform is the persistent Republican myth that spending cuts alone can achieve economic and budget goals. That notion was sounded rejected by voters during the election. Yet it still has adherents among many Republicans, which will make it that much harder for Congress to grapple with the bigger and more complex issue at the heart of tax reform: how to pay for government in the 21st century.

….All that [long list of taxes] would only be a start, because the new revenue would only slow the growth of the debt in the near term. After 10 years, the pressures of an aging population and health care costs would cause the debt to accelerate again.

Oh those evil Republicans, standing against “reform,” and reusing to grapple with “how to pay for government.” The size and scope of which is not under discussion. No, dear Times, it’s not “the pressures of  an aging population and health care costs.” It is the Federal Government’s promises to pay for it all. Which are, apparently, fixed stars.

Technical regress in any area is sad. Once upon a time, when we talked about taxes, there was a modicum of economics involved. When we thought about raising or lowering a rate, we thought seriously about the inevitable avoidance and distortions.  The first question was, “if we pass this law, will x actually pay more money, or will he simply change behavior to avoid the tax?” The second question was, “will his change in behavior hurt the economy?” Before we talk about what’s “fair” we talked about “what works.”

And we knew the sign of the answer: distorting taxation raises less revenue than you think, and reduces economic prosperity. The only question is how much. We did not indulge in magical thinking that appropriating anyone’s income would actually improve the economy, all on its own. We understood the damage, and tried to carefully balance the benefits of spending against that damage. This is how we got, for a while, to low marginal rates with a broad base (the latter since loopholed away), low capital gains, estate, and corporate taxes, and were headed messily towards a system that taxed consumption more than rates of return. 

As one glorious counterexample of all the Times’ monstrous confusions:

a financial transactions tax, to ensure that the financial sector, whose profits have substantially outpaced those of nonfinancial corporations, pay a fair share

A transactions tax is the easiest thing in the world to avoid with financial engineering.  How do you begin to figure out the “fair share” that financial vs nonfinancial corporations should pay? How about mutual funds whose beneficiaries are impoverished union schoolteachers? 

Orwellian language, blatant mistruths, and magical thinking aside, however, I want to applaud this editorial. No, I’m not kidding.

The Times is saying, out loud, that if we are to have the regulatory and welfare state we have enacted, it must be paid for with huge middle class taxes, as well as confiscatory taxes on anyone who dares to save, invest, or start a business. This is refreshing honesty. Up until about November 3, all we heard from them is that reversing the Bush tax cuts on the rich would pay for it all. At least a few of its readers may wake up and say, “wait, we voted for this?”

Really, my main complaint is that they left out the “if,” and its logical consequence, and any doubts that raising tax rates so massively might not produce the needed long-run revenue growth they hope for.

It is a mistake to dismiss this clear editorial. This isn’t the Village voice, or the Berkeley Free Press. This is the New York Times. This is how a wide swath of our fellow citizens, and majority of our fellow voters, see the world.   This is the agenda. They could not have been clearer if they had said “first we annex Austria and move against Czechoslovakia. Then we invade Poland and swing North and West.” Heed them.

Two views of debt and stagnation

Two new papers on economic stagnation in periods of high government debt (i.e. now) are making a splash: 

Public Debt Overhangs by Carmen  Reinhart,Vincent Reinhart and Ken Rogoff
The Output Effect of Fiscal Consolidations by Alberto Alesina, Carlo Favero and Francesco Giavazzi

This review is mostly about the former, with a little mention of the latter (maybe I’ll get back to that later)

The Reinharts and Rogoff look at episodes in which government debt crossed 90% of GDP. They have two big conclusions: the episodes lasted  a long time, “…among the 26 episodes we identify, 20 lasted more than a decade,” and those episodes are associated with slow growth: “the vast majority of high debt episodes—23 of the 26— coincide with substantially slower growth.”

They want very much to conclude that high debt causes the slow growth, referring to “growth-reducing effects of high public debt.” But as always in economics, correlation is not causation, which they recognize:

But obvious concerns arise here about cause and effect. Is the public debt overhang causing the slower growth? Or is an exogenous shock that causes slower growth either helping to generate the public debt overhang or else prolonging the escape from that debt overhang?

Evidence? Well, the debt episodes last a long time

The long length of typical public debt overhang episodes suggests that even if such episodes are originally caused by a traumatic event such as a war or financial crisis, they can take on a self-propelling character…

 The long duration belies the view that the correlation [high debt with low growth] is caused mainly by debt buildups during business cycle recessions. …

No, alas. This makes a pretty good first-year exam question: write down a model in which income is completely exogenous (unrelated to debt levels) yet once a country crosses 90% debt/GDP it takes decades to repay, and growth is slower conditional on high debt. (Hint: Use the permanent income model. Countries get in debt when they have bad income shocks. Debt has a unit root in that model, so debt excursions are never expected to revert.  It does take “growth fluctuations” that are beyond “cyclical,” but those do exist, even without high debt.)

Ok, well,

This endogeneity conundrum has not been fully resolved. However, a number of recent studies have tackled the problem. …. [they] have concluded that the relationship cannot be entirely from low growth to high debt, and that very high debt likely does weigh on growth.

Oh, great. “Studies.” Yet, as I read the review of the “studies,” they are the usual sort of growth regressions or instruments, hardly decisive of causality.

I shouldn’t be too hard, because I agree with the conclusion (high debt is likely to cause low growth). I’m just picky about the logic. But for a reason.

What’s missing? A mechanism. To discuss cause and effect sensibly we have think about the plausible mechanism is. Regressions can too easily conclude that since rich guys drive BMWs, all you need to do is drive a BMW and you’ll get rich.

And clearly, debt by itself doesn’t matter – it’s how debt leads to other economic events that matters.

This is to me a frustrating feature of Reinhart and Rogoff’s earlier work. Recessions after financial crises are typically longer (usually misquoted as “always.”) Ok, but why? Because governments follow policies after financial crises that screw up economies for a long time (distorting taxes, wealth transfers, propping up zombie financial institutions)? Because of “private debt overhang” that would be cured by a massive transfer from savers to borrowers? (Not my favorite theory, but popular around the lunchroom so I’ll mention it.)  Because the destruction of property rights in bailouts freezes new investment?  Their work is quoted as a mysterious fact of nature about which nothing can be done.

Here, Reinharts and Rogoff do mention some mechanisms

The first channel operates through a quantity effect on private sector investment and savings. When public debt is very high, it will tend to soak up the available investment funds and thus to crowd out private investment. If the government at the same time is imposing policies that attempt to reduce its debt burden with higher taxes, a burst of unexpected inflation, or various types of financial repression, then investment may well be discouraged further.

The first mechanism seems to me to confuse debt with deficits. The second one rings true: high debts correspond to high taxes (really high tax rates), wealth expropriation, and other big drags on investment. Financial repression is an under-reported issue:

In addition, governments in the second half of the twentieth century often used policies of “financial repression” to reduce the cost of the public debt, by limiting capital flows and regulating financial institutions in such a way that alternative investments were blocked and financing for government debt would flow more cheaply.

See Banks, comma, European. And given the detailed control that Dodd-Frank gives to US regulators, I can see “gee, we didn’t see you at the Treasury Auction. Should we send some inspectors down to look at the books?” coming to a bank near you soon.

The second channel involves a rising risk premium on the interest rates for government debt. Sufficiently high levels of public debt call into question whether the debt will be repaid in full, and can thus lead to a higher risk premia and its associated higher long-term real interest rates, which in turn has negative implications for investment as well as for consumption of durables and other interest-sensitive sectors, such as housing. 

This makes less sense by itself. Why should a risk premium on government debt matter to private investment?  Well, because we can all see that an indebted government is going to tax away private businesses… but we already talked about that.

A mechanism could let us sort out cause and effect. We can see distorting taxation, financial repression, property rights destruction in defaults, inflation, and see which paths following high debt make growth better or worse.  (Many PhD theses here!)

And, more importantly, the correlation is really pretty useless until we figure out which mechanism is at work.

RRR’s Conclusions:

This paper should not be interpreted as a manifesto for rapid public debt deleveraging
exclusively via fiscal austerity in an environment of high unemployment.

OK, but I find this annoyingly misleading. Why sign on to the deliberately obfuscation induced by current political use of the word “austerity”? Cutting spending is a lot different from raising marginal tax rates. “Unemployment” sounds like an endorsement of short-term Keynesian stimulus, which must be the one thing that clearly doesn’t work in their data once debt gets to 90% of GDP.

Alesina and company make this clear:

Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions. 

Here we have in a nutshell my frustration with the Reinhart-Rogoff paper. There is a causal mechanism staring us in the face – high taxes, prospective wealth confiscation (and financial repression) kill growth. Yet, they want to make “debt” the culprit, not really looking at the causal mechanisms in any detail. Why are they not just a big data set for Alesina and co’s conclusions?  Back to RRR:

Our review of historical experience also highlights that, apart from outcomes of full or selective default on public debt, there are other strategies to address public debt overhang including debt restructuring and a plethora of debt conversions (voluntary and otherwise). 

Now you get the agenda and weak discussion of causal mechanisms. If “debt” is the problem, the answer is obvious: default or inflate it away. “Restructuring” and “conversions” are nice words for default.

But the case for default is not, in fact, made anywhere in the “review of historical experience” in this paper. Serial defaulters in their data do not have higher growth rates. Paying it back worked out OK for Alexander Hamilton. The Soviet Union was inaugurated the opposite way with a big default. If washing your hands of debts is such a good idea, it’s interesting that so many governments go to such lengths to avoid it.

Where is the option, liberalize your economy, and grow out of it? They dismiss the one great data point that goes against the trend, the UK paying off Napoleonic war debt, thus,

there were substantial transfers from the colonies to finance debts and facilitate debt reduction…With the exception of the United Kingdom at the height of its colonial powers in the nineteenth century,

So forget  free markets, industrial revolution, railroads and all that – England just taxed colonies like ancient Rome?

Speaking of the 19th century

In those days before fiat currency, inflation was not as prevalent as it would later become. Thus, the “liquidation” of government debt via a steady stream of negative real interest rates was not as easily accomplished in the days of the gold standard and relatively free international capital mobility as in the decades after World War II.

This sounds like a bad thing!

Yeah, default sounds great ex-post. But it is the precommitment against default ex-post that lets you borrow ex-ante. To say nothing of the chaos a large-scale sovereign default or inflation in the US and Europe would cause. Not so easy.

I don’t mean to sound one-sided on this. I’ve been advocating Greek default for a while, at least while the original bond holders still held some of the debt. (Too late now). I’d still rather see us all  liberalize, grow, and pay it off. I’d rather see governments cut spending, as I see that paying it off by confiscatory wealth taxes will lead to a big no growth data point. Default is only a little better than that option. But let’s face up to the costs of default, not just how nice it will be to wipe out the debt.

However, the evidence, as we read it, casts doubt on the view that soaring government debt does not matter when markets (and official players, notably central banks) seem willing to absorb it at low interest rates—as is the case for now.

I’m glad to end on a note of total agreement. “As is the case for now” only applies to some countries – ask a Greek friend!

Gordon on Growth

Bob Gordon is making a big splash with a new paper, Is US Growth Over?

Gordon’s paper is about the biggest and most important economic question of all: Long-run growth. It’s easy to forget that per-capita income, the overall standard of living, only started to increase steadily in about 1750. The Roman empire lasted centuries, but the average person at the end of it did not live better than at the beginning.

Gordon’s Figure 1, reproduced here shows how growth picked up in the mid 1700s, reached 2.5% per year – which made us dramatically better off than our great-grandparents – and now seems to be tailing off.

As Bob reminds us with colorful vignettes of 18th and 19th century living, nothing, but nothing, is more important to economic well being than long-run growth.

And modern growth economics is pretty clear on where the goose is that lays this golden egg: Innovation. New ideas, embodied in new products, processes and businesses. For example, see Bob Lucas’ “Ideas and Growth” which starts

What is it about modern capitalist economies that allows them, in contrast to all earlier societies, to generate sustained growth in productivity and living standards? It is widely agreed that the productivity growth of the industrialized economies is mainly an ongoing intellectual achievement, a sustained flow of new ideas

Growth theory neatly divides economics into “growth effects,” which is really how fast new ideas are born and implemented, versus “level effects.” Many economic distortions screw up the level, making an area or a country less well off than its neighbors. But so long as the frontier keeps growing, even level effects only retard a country a few decades.

Here’s a picture. The red line represents 2% growth (real, per capita), starting at $100,000 income. By 2100 your great grandchildren are earning $738,000. The blue line shows a “level effect.” Suppose some set of harebraned policies is so awful that it reduces the level of GDP by 20% – but does not interfere with the growth mechanism. It’s pretty bad. But the blue line is really just shifted to the right, lagging a decade or so behind but still participating in the eventual miracle.

By contrast, the black line says, what if there is a policy or change in the environment that has no effect on the level of GDP, but lowers the long-run growth rate to 1%. 2%, 1%, what’s the difference? Cumulate that over a century, and your great grandchildren make $300,000, not $738,000.

OK, so, to Bob’s first thesis: Long-run growth is slowing down. The big ideas of the first two industrial revolutions, roughly the harnessing of energy, urbanization, clean water, have been used as far as they can. The computer revolution, to Bob, seems to running out of its ability to raise productivity. 20-somethings updating their facebook profiles instead of paying attention class are not the jet-packs and rocket ships we thought we were going to have by 2001.

I think Bob has the right question here. And his warning is well-taken. Just because growth has been steady does not mean it’s assured. The “trend” does not come for free. Each improvement in productivity takes hard work, and disruptive new companies putting established incumbents out to pasture.

But I think  – or at least I hope – he has the wrong answer (and he freely admits this is speculative).

My pet theory is that the real defining innovation of growth was Gutenberg. Science gives us real knowledge, at last, by controlled experimentation. But controlled experimentation is extraordinarily expensive.  A farmer can’t afford to test which crops grow best, a country doctor can’t do clinical trials. For society to gain knowledge by scientific method, we need communication. One doctor’s clinical trials inform another doctor’s practice a thousand miles away. Gutenberg made that possible.

More generally, the process of growth, of incorporating new ideas into the economy, almost always represents standing on the shoulders of giants, appropriating, slightly improving, and implementing someone else’s ideas. That, for example, is why we see clusters of innovation such as Silicon Valley.

Well, if Gutenberg (and subsequent innovations that used his ideas, the newspaper, the scientific journal, and the public library) lowered the costs of communicating ideas and widened the community of people that a given idea could reach, the internet just did that tenfold. As I look at the cool stuff – nanotechnology, genetic engineering etc. – underway and the instant worldwide communication of ideas, I have hope we’ll see that 2.5 percent again. If we let the process run.

For example, think how Bob’s idea got to your desk. When I was a young economist, before the internet, he would have mailed a paper to the NBER, a month or two later the working paper would have been distributed. The internet buzz I saw that got me to go look at it would have taken a few more months to percolate to me by older information networks, then I’d have to go read it in the library. Finally, who knows how I would have gotten to you. That all happened in a week. The diffusion of ideas is on steroids.

Well, maybe my pet theory is wrong. Still, long-run growth is the issue,  it is not guaranteed but hard-won,  we didn’t always have it and we could lose it, and that would be a catastrophe.  

Bob prognosticates not only that we seem to have run out of productivity-increasing ideas, but that “six headwinds” stand in the way. His headwinds are 1) Demographics: aging and reduced labor-force participation 2) Plateau in US educational attainment 3) “The most important quantitatively in holding down the growth of our future income is rising inequality.” 4) Globalization and outsourcing 5) Energy and enviroment 6)  Household and government debt.

Here I think Bob is mostly confusing “level” effects with “growth” effects.  He is also mixing constraints – run out of ideas – with self-inflicted wounds – dysfunctional public education, refusing to let in immigrants, refusing to use nuclear power or GM foods.  And, I don’t see how he can focus on the US. Suppose we cede the frontier to, say, China, as the UK ceded the frontier to us in Bob’s graph. But as long as we still use China’s ideas and technology, and they grow at 2.5 percent, so do we.

The optimistic lesson of growth theory is that, no matter how badly you screw up level effects, growth will bail you out eventually. So, any “headwinds” need to be clearly linked to the possibility that economic distortions lower the rate of finding new ideas and incorporating them. The whole point of growth theory is that, in the long run, that’s all that matters.

Do they? My impression of modern growth theory is that the economics of innovation production and adoption are not well understood. Do the distortions of a high-tax,  regulated, crony-capitalist, welfare state,  just screw up levels? Or do they  reduce the spread of ideas behind long-run growth? My fear is “yes.”

In any case, just posing the question this way argues that the dangerous “headwinds” are entirely different from the ones that Bob highlights. The returns from innovation, starting new companies, introducing new products and processes – and in that process making established incumbents very unhappy – are the most likely targets.

But it’s also clear that ideas are public goods, or high fixed cost zero marginal cost goods. Their production and diffusion depends a lot on non-market structures, like, say, universities. (Don’t jump from that observation to “they need to be subsidized,” as it it’s all to easy to subsidize bad ideas too.) That’s another lesson of Bob Lucas’ paper, which is remarkably free of economic incentives.

Finally, a warning about statistics. Here is my last picture, blown up.

As you can see, if you’re just looking at GDP trends, it’s hard to tell a “level” effect from a “growth” effect for several decades.

Much discussion of our current slump presumes it’s a temporary “level” shock; the blue line will go back up quickly to the red line. The “stagnation” hypothesis is that we’re on the blue line – we lost about 5% of GDP in the recession, and now we’re on the growth path with a lower level. That’s disastrous enough. Bob warns us that we might be on the worst of the blue and black lines. That would be a huge disaster.

All said before.  The graph reminds us is that it takes a long time to figure out which it is based on just eyeballing the GDP or productivity data. We have to think. Which Bob is prodding us to do.