Slow Growth and Rising Debt

From Carmen Reinhart and Kenneth Rogoff:

As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. Our research on the long history of financial crises suggests that choices are not easy, no matter how much one wants to believe the present illusion of normalcy in markets. Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis.

In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.

We do not anticipate outright defaults in the largest crisis-hit countries, certainly nothing like the dramatic de facto defaults of the 1930s when the US and Britain abandoned the gold standard. Monetary institutions are more stable (assuming the US Congress leaves them that way). Fundamentally, the size of the shock is less. But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

ECONOMICS!!

From my inbox:

Dear Dr. Mankiw,

I've been using your introductory textbook for a couple years. I tell students that in five years if all they remember about economics is the first chapter, then their efforts will not be wasted. To help them remember, I created this acrostic device. It finally occurred to me that it might be useful to others. So if you like it, feel free to use it, in class or in the 6th edition. The acrostic is ECONOMICS!! The attached explains the connection to the ten principles.

BTW, I am a regular reader of your blog, and I appreciate your views and the wide scope of views you moderate on your blog. You have directed me to quite a few places and opened doors I wouldn't have found so easily.

Best regards,

Gordon Boronow
Assistant Professor
Nyack College

Thank you, Gordon, for sharing this.  Here it is:

Ten Key Principles in Economics

Everything has a cost. There is no free lunch. There is always a trade-off.

Cost is what you give up to get something. In particular, opportunity cost is cost of the tradeoff.

One More. Rational people make decisions on the basis of the cost of one more unit (of consumption, of investment, of labor hour, etc.).

iNcentives work. People respond to incentives.

Open for trade. Trade can make all parties better off.

Markets Rock! Usually, markets are the best way to allocate scarce resources between producers and consumers.

Intervention in free markets is sometimes needed. (But watch out for the law of unintended effects!)

Concentrate on productivity. A country’s standard of living depends on how productive its economy is.

Sloshing in money leads to higher prices. Inflation is caused by excessive money supply.

!! Caution: In the short run, falling prices may lead to unemployment, and rising employment may lead to inflation.

How to Help Haiti

Paul Collier and Jean-Louis Warnholz look at the challenges ahead.

Lazear on the Spending Freeze

Eddie opines on fiscal policy.

The Budget Picture

Source: CBO.

Cooley on the Bank Tax

The NYU economist opines.

Hayek vs Keynes Rap

A Note from Inside

One of my many friends working for President Obama sends me this email, along with permission to share it with my blog readers:

My perspective here has given me an unusual window into the looking-glass mirror of how things I see on the inside are interpreted on the outside.

The most vivid case in point is the recent policy announcements about implementing the Volcker ideas about separating investment and commercial banking.

This policy process has been in the works for months, and it came to fruition in the normal course of policy operations after extensive meetings and consultations among Treasury, NEC, the PERAB board, and other parties.

Regardless of how one evaluates the wisdom of the policy (and I fully acknowledge that reasonable people can differ on this), in practice the timing of the announcement (coming after the loss of the Massachusetts Senate seat) is being interpreted as "the Administration has finally decided to cave in to the populist temptation." As a result there is a lot of uncertainty about whether Bernanke will be reappointed and whether the new policy signals that the Administration is going to dump him. Honestly, dumping Bernanke was NOT the point of this announcement.

But it seems like Wall Street is interpreting this as "Summers, Geithner, and Bernanke are on the way out because Obama has finally decided to go populist." Honestly, that is truly not right, though I can see how from the outside it would look like it.

Oddly enough, this is one of those cases where the whole thing could be a self-fulfilling prophecy. The policy announcement had nothing to do with Bernanke, but now the sharks are scenting blood, inTrade is putting Bernanke's odds of confirmation much lower, and a lot of Senators are starting to waver and back off and say they won't vote to confirm him, so now maybe he can't get through. If not for the misinterpretation of the get-tough-on-banks move, though, Bernanke's standing would not have changed.

[name withheld]

PS  I know it's a fool's game to try to explain moves in the stock market, but I have a friend on Wall Street who tells me that the selloff in the last couple of days is more due to uncertainty caused by the sense that Summers and Geithner are losing out to populism than to specifics of the bank plan.

Thanks for helping to get the true story out.

Bad News for Ben (and for the rest of us)

According to Intrade, the probability that Bernanke will be confirmed for a second term is now about 0.7, which down from 0.95 a few days ago.  This uncertainty cannot be good for financial markets.

The Height Tax gets some publicity

Asher Meir writing in the Jesusalem Post does a good job describing my paper with Matthew Weinzierl.

Bob Solow on John Cassidy

A book review.

Diamond and Kashyap on the Bank Tax

Two Chicago economists offer a proposal.

Feldstein on Obamanomics

Marty evaluates the President's first year.

Baumol's Cost Disease

A nice discussion in today's Times.

The Inflation Monster

Click here to read my column in tomorrow's NY Times.

Healthcare Reform Debate

A symposium at Harvard Medical School.  The video takes about two hours.

The Bank Tax

President Obama has proposed a special tax levied on large financial institutions.  In general, I am skeptical of narrow-based taxes, as they feed a particularly nasty kind of politics, where the majority gangs up on a minority.  And I am turned off by the populist rhetoric coming from the administration, which suggests the issue pits Wall Street fat cats against ordinary Americans.  Nonetheless, on the economic merits, there may be a case for the bank tax.

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail.  The bailouts of the past will surely lead people to expect bailouts in the future.  Bailouts are a specific type of subsidy--a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency.  In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.

You may recall that I made precisely this argument regarding Fannie Mae and Freddie Mac some years ago when I was CEA Chair.  (No, I was not a prescient genius.  The potential problem was apparent to anyone who cared to look.)  But now the problem of implicit subsidies is far more widespread.  We have in effect turned much of the financial system into government-sponsored enterprises.

What to do?  We could promise never to bail out financial institutions again.  Yet nobody would ever believe us.  And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax.  If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

Will the tax law in fact be so well written?   It certainly won't be perfect.  But it is possible that it will be better than doing nothing at all, watching the finance industry expand excessively, and waiting for the next financial crisis and taxpayer bailout.

The Rise of European Leisure

There has been some recent discussion in the blogosphere about comparing the United States and Europe.  With the pending passage of the healthcare bill and the more general expansion in the size of government, the United States of the future will in some ways start looking more like Western Europe today.  So I thought my blog readers might enjoy this excerpt from my favorite intermediate macroeconomics textbook:

Higher unemployment rates in Europe are part of the larger phenomenon that Europeans typically work fewer hours than do their American counterparts. Figure 6-5 presents some data on how many hours a typical person works in the United States, France, and Germany. In the 1960s, the number of hours worked was about the same in each of these countries. But since then, the number of hours has stayed level in the United States, while it has declined substantially in Europe. Today, the typical American works many more hours than the typical resident of these two western European countries.

The difference in hours worked reflects two facts. First, the average employed person in the United States works more hours per year than the average employed person in Europe. Europeans typically enjoy shorter workweeks and more frequent holidays. Second, more potential workers are employed in the United States. That is, the employment-to-population ratio is higher in the United States than it is in Europe. Higher unemployment is one reason for the lower employment-to-population ratio in Europe. Another reason is earlier retirement in Europe and thus lower labor-force participation among older workers.

What is the underlying cause of these differences in work patterns? Economists have proposed several hypotheses.

Edward Prescott, the 2004 winner of the Nobel Prize in economics, has concluded that “virtually all of the large differences between U.S. labor supply and those of Germany and France are due to differences in tax systems.” This hypothesis is consistent with two facts: (1) Europeans face higher tax rates than Americans, and (2) European tax rates have risen significantly over the past several decades. Some economists take these facts as powerful evidence for the impact of taxes on work effort. Yet others are skeptical, arguing that to explain the difference in hours worked by tax rates alone requires an implausibly large elasticity of labor supply.

A related hypothesis is that the difference in observed work effort may be attributable to the underground economy. When tax rates are high, people have a greater incentive to work “off the books” to evade taxes. For obvious reasons, data on the underground economy are hard to come by. But economists who study the subject believe the underground economy is larger in Europe than it is in the United States. This fact suggests that the difference in actual hours worked, including work in the underground economy, may be smaller than the difference in measured hours worked.

Another hypothesis stresses the role of unions. As we have seen, collective bargaining is more important in European than in U.S. labor markets. Unions often push for shorter workweeks in contract negotiations, and they lobby the government for a variety of labor-market regulations, such as official holidays. Economists Alberto Alesina, Edward Glaeser, and Bruce Sacerdote conclude that “mandated holidays can explain 80 percent of the difference in weeks worked between the U.S. and Europe and 30 percent of the difference in total labor supply between the two regions.” They suggest that Prescott may overstate the role of taxes because, looking across countries, tax rates and unionization rates are positively correlated; as a result, the effects of high taxes and the effects of widespread unionization are hard to disentangle.

A final hypothesis emphasizes the possibility of different preferences. As technological advance and economic growth have made all advanced countries richer, people around the world must decide whether to take the greater prosperity in the form of increased consumption of goods and services or increased leisure. According to economist Olivier Blanchard, “the main difference [between the continents] is that Europe has used some of the increase in productivity to increase leisure rather than income, while the U.S. has done the opposite.” Blanchard believes that Europeans simply have more taste for leisure than do Americans. (As a French economist working in the United States, he may have special insight into this phenomenon.) If Blanchard is right, this raises the even harder question of why tastes vary by geography.

Economists continue to debate the merits of these alternative hypotheses. In the end, there may be some truth to all of them.

Renting is cheaper than Buying

The title of this blog post might lead you to think I am talking about real estate. But no. What I have on my mind is something far more important: Textbooks!

Check it out here.  Students can now rent my favorite textbook for about half the price of buying it.

Learning from Europe

Here is GDP per capita, adjusted for differences in price levels (PPP), from the IMF, for the United States and the five most populous countries in Western Europe:

United States 47,440
United Kingdom 36,358
Germany 35,539
France 34,205
Italy 30,631
Spain 30,589

Readers of today's column by Paul Krugman might find these figures useful to keep in mind.

Update: See Mark Perry and Tino Sanandaji and Clive Crook.

Unemployment Update

Click on the graph to enlarge. Click here for my interpretation.

Wealth-dependent Fines

Tyler Cowen alerts us to an intriguing story:

A Swiss court has slapped a wealthy speeder with a chalet-sized fine — a full $290,000.

Judges at the cantonal court in St. Gallen, in eastern Switzerland, based the record-breaking fine on the speeder's estimated wealth of over $20 million.

A statement on the court's Web site says the driver — a repeat offender — drove up to 35 miles an hour (57 kilometers an hour) faster than the 50-mile-an-hour (80-kilometer-an-hour) limit.

Is it optimal to base fines on wealth? 

My first thought is no.  We fine activities that have negative externalities, such as putting others at risk.  If X is the size of the externality, and p is the probability of being caught, then the optimal fine is X/p.  That will give people the right incentive to produce the optimal quantity of the externality.  Under this policy, the rich may choose to speed more, but that is optimal.  If we have an optimal carbon tax, the rich will produce more carbon too.  Optimal pigovian taxes do not eliminate income effects.

On further reflection, however, I think a case can be made, at least theoretically, to support the judges' ruling.  First, assume that the negative externalities are very great, so the optimal quantity of the externality is about zero.  By itself, that argues for a large fine, not a wealth-dependent one.  But then add another assumption: Suppose there is some small probability that an innocent person will be found guilty because of a rogue, or simply a mistaken, policeman.  This possibility, together with risk aversion, would induce us to temper how large the fine is.  And this tempering of the large fine would seem to be less for richer taxpayers: Because the mistaken ticket is a proportionately smaller fraction of their wealth, we need to worry less about the uncertainty large fines impose.  The result is larger fines for richer offenders.

Blogometrics

A new ranking of economics blogs based on the scholarly impact of the bloggers.

How well is Team Obama working?

Al Hunt says the economic team is not working well, leading Mickey Kaus to wonder whether Larry Summers will be pushed out.

I would be very surprised if that happened.  President Obama seems astute enough to recognize that Larry as an economic policy adviser is nonpareil.  Larry is simply too good to give up.

On the other hand, the job Larry has--NEC Director--traditionally has the responsibility of coordinatiing the policy process, which requires more people skills than deep insights into economic policy.  Maybe what the White House needs is a reorganization.  Put a hard-working but easy-going person like Jason Furman or Doug Elmendorf in charge of organizing the economic policy process and then give Larry a position such as "senior adviser" from which he can kibitz on a wide range of policy topics.  There is really no one better at asking the hard questions that need to be asked.

Why is the recovery so tepid?

The answer from Gary Becker, Steve Davis, and Kevin Murphy.

Dave Barry's 2009 Year in Review

It was a year of Hope -- at first in the sense of "I feel hopeful!" and later in the sense of "I hope this year ends soon!"

It was also a year of Change, especially in Washington, where the tired old hacks of yesteryear finally yielded the reins of power to a group of fresh, young, idealistic, new-idea outsiders such as Nancy Pelosi. As a result, Washington, rejecting "business as usual," finally stopped trying to solve every problem by throwing billions of taxpayer dollars at it, and instead started trying to solve every problem by throwing trillions of taxpayer dollars at it.

Continue reading here.

Goodbye, Estate Tax (for now)

The estate tax is now gone, one of the goals of President Bush.  But under current law, it will come back next year.

As I recall, the reason for this peculiar state of affairs was not, as Paul Krugman suggests, an attempt to hold down the official cost of the Bush tax cuts.  Indeed, back in 2001, what would happen in 2011 was outside the 10-year budget window, so rigging the official cost could not have been the motive for the return of the estate tax next year.  Rather, some legislative rule made it harder to pass changes in tax law that applied outside the 10-year window.

What should policy be toward the taxation of estates?  The economics profession is far from unanimous on this question.  Paul favors the estate tax.  I favor its repeal, for reasons I explained here.  I am not alone among economists: see also Ed Prescott, Martin Feldstein, Gary Becker, and Jeff Miron.  It is clear that our position will not persuade the current majority in Congress.