Comments on Fiscal Policy

Back in December, I spoke at a conference at the Federal Reserve Bank of Philadelphia.  My remarks about fiscal policy have now been transcribed.  You can read them here.

Marron on the Fiscal Challenge Ahead

Donald Marron, with whom I worked at the CEA, reflects on the budget shortfall.

Taxes per Person

Some pundits, reflecting on the looming U.S. budget deficits, claim that Americans are vastly undertaxed compared with other major nations.  I was wondering, to what extent is that true?

The most common metric for answering this question is taxes as a percentage of GDP.  However, high tax rates tend to depress GDP.  Looking at taxes as a percentage of GDP may mislead us into thinking we can increase tax revenue more than we actually can.  For some purposes, a better statistic may be taxes per person, which we can compute using this piece of advanced mathematics:

Taxes/GDP x GDP/Person = Taxes/Person

Here are the results for some of the largest developed nations:

France
.461 x 33,744 = 15,556

Germany
.406 x 34,219 = 13,893

UK
.390 x 35,165 = 13,714

US
.282 x 46,443 = 13,097

Canada
.334 x 38,290 = 12,789

Italy
.426 x 29,290 = 12,478

Spain
.373 x 29,527 = 11,014

Japan
.274 x 32,817 = 8,992

The bottom line: The United States is indeed a low-tax country as judged by taxes as a percentage of GDP, but as judged by taxes per person, the United States is in the middle of the pack.

Update: This post has been more controversial than I expected.  I am surprised because I did not say much here.  I merely presented an identity and some data, which illustrated international differences in a novel (and, I thought, interesting) way.  In any event, I thank Scott Sumner for coming to my defense.

Preparing for the Next Financial Crisis

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

David Brooks on the State of Economics

In today's NY Times, David Brooks has an interesting column on the field of economics.

While the column is well worth reading, I think it is more wrong than right.  Journalists are fond of writing articles about how recent events require a fundamental rethinking of economic theory.  It is their job, after all, to identify new things on the horizon.  But when they try to predict trends in academic theorizing from current events, they are usually incorrect.  In particular, I think what we teach in economics courses is more robust than a reader of David's column would think.

David writes, "Economists and financiers spent decades building ever more sophisticated models to anticipate market behavior."  I don't know about financiers, but relatively few academic economists devote their time to forecasting.  The economists you see on TV are often trying to predict the future, but that is hardly a random sample of top economists.  Indeed, one reason I am not fond of TV appearances is that TV hosts frequently ask questions that presume PhD economists can see into the future better than others, whereas actual PhD economists know that very little of our training has anything to do with forecasting.

Oddly, David refers to Reinhart and Rogoff's new book on financial crises as a work of history.  He fails to note that the authors are two prominent and very mainstream economists.  Moreover, this research project began long before the recent crisis.  It would be a mistake to say that economists did not study financial crises.  Their book is in fact evidence that some of the leaders of the field were working on precisely this topic long before it caught the public's attention.  The fields of behavioral economics and behavioral finance have also been active for many years now.

To be sure, in undergraduate economics courses, some specific topics will need more coverage in the future, as I noted in a column a while back.  The role of leverage in financial institutions is one example.  Those people who study financial institutions and their regulation have moved to the forefront of the profession for a while, and that area of work may well get more coverage in the undergraduate curriculum. 

But I doubt there will be a fundamental change in the field of economics.  The old textbooks don't need to be thrown away.  I admit, however, that on this point, I may not be the most objective judge.

Help Wanted

I am looking to hire a Harvard student to work with me as I revise my principles textbook (along with several other less time-consuming tasks). The part-time job requires strong writing/editing skills, the ability to proofread carefully, some facility with data, and an interest in pedagogy.  Work would start soon, and it would continue throughout the summer and into the fall term. Because most of the communication can be via email, there is no need to stay on campus during the summer.

If you are interested, please drop off a brief letter, resume, and transcript with my assistant Lauren La Rosa in Littauer 230.

Update: Applications are no longer being accepted.

A Fiscal Train Wreck

A couple days ago, Bloomberg reported:

The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

The $2.59 trillion of Treasury Department sales since the start of 2009 have created a glut as the budget deficit swelled to a post-World War II-record 10 percent of the economy and raised concerns whether the U.S. deserves its AAA credit rating. The increased borrowing may also undermine the first-quarter rally in Treasuries as the economy improves....

While Treasuries backed by the full faith and credit of the government typically yield less than corporate debt, the relationship has flipped as Moody’s Investors Service predicts the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.

In my view, a default on U.S. government debt is less likely than another scenario, suggested by Paul Krugman:

How will the train wreck play itself out?...my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar. It won't happen right away....But unless we slide into Japanese-style deflation, there are much higher interest rates in our future.

I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that "a fiscal crisis threatens our future standard of living" — investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions.

Actually, Paul wrote that in 2003, and we know now that his prediction of higher inflation did not come to pass. But budget deficits are much larger today, so maybe his logic will apply this time around.  If it does, the inflation would adversely affect the real return on both government and private bonds (and thus cannot explain the inverted spread described in the Bloomberg article).

My own guess is that the United States will likely raise taxes substantially, and taxes as a percent of GDP will reach levels never seen in U.S. history (although common in Europe).  The politics of that will be fascinating to watch.  If the political process is stymied as our leaders debate the relative merits of tax hikes versus spending cuts, bond investors may get nervous, and we could witness either the Krugman inflation scenario or the much less likely default scenario.

An Inflation Debate

An interesting debate between Michael Kinsley and Paul Krugman.  Read in this order:

1. Kinsley's orginal article
2. Krugman's critique
3. Kinsley's response
4. Krugman again
5. Kinsley again

Healthcare, Tradeoffs, and the Road Ahead

Well, it appears certain that the healthcare reform bill will become law. One thing I have been struck by in watching this debate is how strident it has been, among both proponents and opponents of the legislation. As a weak-willed eclectic, I can see arguments on both sides. Life is full of tradeoffs, and so most issues strike me as involving shades of grey rather than being black and white. As a result, I find it hard to envision the people I disagree with as demons.

Arthur Okun said the big tradeoff in economics is between equality and efficiency. The health reform bill offers more equality (expanded insurance, more redistribution) and less efficiency (higher marginal tax rates). Whether you think this is a good or bad choice to make, it should not be hard to see the other point of view.

I like to think of the big tradeoff as being between community and liberty. From this perspective, the health reform bill offers more community (all Americans get health insurance, regulated by a centralized authority) and less liberty (insurance mandates, higher taxes). Once again, regardless of whether you are more communitarian or libertarian, a reasonable person should be able to understand the opposite vantagepoint.

In the end, while I understood the arguments in favor of the bill, I could not support it. In part, that is because I am generally more of a libertarian than a communitarian. In addition, I could not help but fear that the legislation will add to the fiscal burden we are leaving to future generations. Some economists (such as my Harvard colleague David Cutler) think there are great cost savings in the bill. I hope he is right, but I am skeptical. Some people say the Congressional Budget Office gave the legislation a clean bill of health regarding its fiscal impact. I believe that is completely wrong, for several reasons (click here, here, and here). My judgment is that this health bill adds significantly to our long-term fiscal problems.

The Obama administration's political philosophy is more egalitarian and more communitarian than mine. Their spending programs require much higher taxes than we have now and, indeed, much higher taxes than they have had the temerity to propose. Here is the question I have been wondering about: How long can the President wait before he comes clean with the American people and explains how high taxes needs to rise to pay for his vision of government?

Caveats from CBO

In a letter from the Congressional Budget Office to Nancy Pelosi, released yesterday, the CBO offers the following caveats about its own numbers concerning the healthcare bill:

The reconciliation proposal and H.R. 3590 would maintain and put into effect a number of policies that might be difficult to sustain over a long period of time. Under current law, payment rates for physicians’ services in Medicare would be reduced by about 21 percent in 2010 and then decline further in subsequent years; the proposal makes no changes to those provisions. At the same time, the legislation includes a number of provisions that would constrain payment rates for other providers of Medicare services. In particular, increases in payment rates for many providers would be held below the rate of inflation (in expectation of ongoing productivity improvements in the delivery of health care). The projected longer-term savings for the legislation also reflect an assumption that the Independent Payment Advisory Board established by H.R. 3590 would be fairly effective in reducing costs beyond the reductions that would be achieved by other aspects of the legislation.

Under the legislation, CBO expects that Medicare spending would increase significantly more slowly during the next two decades than it has increased during the past two decades (per beneficiary, after adjusting for inflation). It is unclear whether such a reduction in the growth rate of spending could be achieved, and if so, whether it would be accomplished through greater efficiencies in the delivery of health care or through reductions in access to care or the quality of care. The long-term budgetary impact could be quite different if key provisions of the legislation were ultimately changed or not fully implemented.

A Warning about CBO Scoring

There has been a lot of talk lately about the CBO scoring of the health bill.  Here is one thing people should understand about their numbers: When they estimate the budget impact of a bill like this, they assume the path of GDP is unchanged.

Recall that the bill raises taxes substantially.  Some of these tax hikes are the explicit tax increases on capital income to pay for the insurance subsidies.  Some of these tax hikes are the implicit marginal rate increases from the phase-out of the insurance subsidies as a person's income rises.  Both of these would be expected to reduce GDP growth.

Indeed, to be very wonkish about it, these tax changes could have especially large GDP effects.  Some people like to argue that taxes have small GDP effects because income and substitution effects offset each other.  But if you give someone a subsidy and then phase it out, both the income and substitution effects work in the direction of reducing work effort.

Why does CBO assume no change in GDP?  It is not because the CBO staffers necessarily believe that result.  Rather, it is just one of the conventions of budget scoring.  Their estimates should come with a warning label:

Comments on Alan Greenspan's "The Crisis"

I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan's new paper on "The Crisis," which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper.  Here they are:

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.

To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.

Next, Alan points out that our political process, rather than reducing the risks associated with the bubble, helped contribute to them. In a footnote, Alan points out that in October 2000, in the waning days of the Clinton administration, the U.S. Department of Housing and Urban Development finalized rules that expanded the affordable housing goals of the government-sponsored enterprises (Fannie Mae and Freddie Mac). As a result, the GSEs expanded substantially their holdings of subprime mortgages. While neither Alan nor I would suggest that the current crisis is primarily the result of misguided housing policies, we both believe that these policies served to make a bad situation worse. This fact is important to keep in mind not to assess blame; there is more than enough of that to go around. Rather, in judging how much policy can accomplish going forward, we should be mindful of how imperfect the political process is.

When considering what future regulations can do to reduce the likelihood of future crises, Alan emphasizes that whatever rules we promulgate cannot be premised on our ability to anticipate an uncertain future. In my view, this is particularly wise. There are some people who think that the main cause of the recent crisis is that policymakers failed to anticipate the bursting of the housing bubble. If only we had central bankers with greater prescience, the argument goes, all this could have been avoided. In my view, and I believe Alan’s as well, this is wishful thinking in the extreme. It indeed would be nice if somehow those individuals guiding our national economy had superhuman powers to see into the future. (Nouriel Roubini, for example.) In reality, however, our national economic leaders are likely to be mortals and share the same biases and flaws in perception as market participants.

So what then can we do to make the financial system more crash-proof? Alan offers several good suggestions.

First, and most obviously, we should have higher capital requirements. This is truer now than it has ever been. By bailing out almost every major financial institution that needed it, as well as a few that didn’t, the U.S. federal government has raised the expectations of future bailouts, thereby turning the entire U.S. financial system into, in effect, a group of government-sponsored enterprises. Going forward, creditors to these institutions will view them as too safe, and so they will lend to them too freely. The financial institutions, in turn, will be tempted to respond to their low cost of debt by leveraging to excess. Higher capital requirements are needed to counteract this newly expanded moral hazard.

Second, I like Alan’s idea of “living wills” in which financial intermediaries are required to offer their own plans to wind down in the event that they fail. The advantage to this idea is that when future failures occur, as they surely will, policymakers will have a game plan in hand. How well that will work, however, is hard to say. Like real wills, these financial wills may well be contested by next-of-kin when they are about to be applied. For this plan to work, the living wills had better be widely publicized—say, by putting them on a centralized webpage—to discourage counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do.

Third, and perhaps most important, I like the idea of requiring contingent debt that will turn into equity when some regulator deems that a firm has insufficient capital. Essentially, this debt would become a form of preplanned recapitalization in the event of a future financial crisis. But most importantly, the recapitalization would be done with private rather than public money. Because the financial firm would pay for the cost of these funds, rather than enjoying taxpayer subsidies, it would be incentivized to make itself less risky, for instance, by reducing leverage. The less risky the firm, the less likely the contingency would be triggered, and the lower the interest rate the firm would need to pay on this contingent debt.

This brings me to one part of Alan’s paper where I disagree with his conclusion—or, at least, I was not sufficiently persuaded by his arguments. The issue concerns the importance of leverage to the viability of a financial intermediary.

Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.

When I read this part of the paper, my first thought was: What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.

I have a hunch as to where, from the Modigliani-Miller perspective, Alan’s calculations go awry. Alan assumes that the rate of return on equity must be at least 5 percent. But this number should be endogenous to the degree of leverage. If a bank is less levered, its equity will be safer. (It will be like a combination of today’s equity and bonds.) As a result, the required rate of return should fall.

Indeed, I think it is possible to imagine a bank with almost no leverage at all. Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.

One thing such a system would do is forgo the “maturity transformation” function of the current financial system. That is, many banks and other intermediaries now borrow short and lend long. The issue I am wrestling with is whether this maturity transformation is a crucial feature of a successful financial system. The resulting maturity mismatch seems to be a central element of banking panics and financial crises. The open question in my mind is what value it has and whether the benefits of our current highly leveraged financial system exceed the all-too-obvious costs.

To put the point most broadly: The Modigliani-Miller theorem says leverage and capital structure are irrelevant, while undoubtedly many bankers would claim they are central to the process of financial intermediation. A compelling question on the research agenda is to figure out who is right, and why.

Suggested Readings from Harvard Profs

Via The Harvard Crimson.

An Ec 10 Success Story

Here.

The Chinese Currency Question

Several readers have asked me my views about Paul Krugman's latest column concerning China's currency.  I addressed this topic in a column about a year ago.  My views have not changed.

Shiller's Prognosis

Yale economist Bob Shiller says, correctly, that macroeconomists should be humble.

Happy Pi Day!

Fun fact of the day: MIT releases its undergraduate admission decisions at 1:59 pm today.  (That is, at 3.14159).

Choosing a Graduate Program

Now is the time of year when prospective PhD students in economics are deciding which graduate program to attend.  The decision is often hard.  If you are in that position, here are a few recommendations about things to think about:

1. Start with the rankings.  For some recent rankings of economics departments, click here and here and here.  All ranking systems are imperfect, but other things equal, higher is probably better.

2. Talk with the graduate students who are now in the programs you are considering.  Are they happy?

3. Don't make a decision based on a single faculty member.  He or she may leave or turn out to be not quite as wonderful as you now presume.  Look for a department that is strong overall.

4. Don't presume you know your specific research interests and focus just on faculty in that narrow area.  Many students change their mind over their first few years of grad school.

5. Is the location of the school a fun place to live?  Grad school is a long haul, typically 4 to 6 years, which is a significant fraction of your life.  Being a PhD student is hard work, but it should not be a miserable existence.

6. Is the university overall a good place?  It is always more fun being part of a great institution.  Even if the economics department is perfect, if it is an island in a sea of mediocrity, being there will be less satisfying.

7. Are the undergraduates there good students?  At some point as a graduate student, you will (and should) do some teaching, perhaps as a teaching assistant in an undergraduate course.  If the undergraduates are an academically strong group, they will be more intellectually engaged and more rewarding to teach.

8. Don't be distressed if you did not get into your top choice.  What you do in graduate school (or college) is far more important than where you go.  Your personal drive matters more than the ranking of the school you attend.

Update: Readers suggest an additional criterion:

9. Look at the record of recent PhD students.  What fraction who start the program complete a PhD?  What kinds of jobs do they get upon completion?  Are they the kinds of jobs you aspire to?  The placement record will give you an indication of the caliber of students who enter the program, the value-added of the program itself, and how well the department sells its students on the job market.

NPR disses the Pigou Club

It is a rare opportunity when I find myself to the left of National Public Radio.  But sometimes it happens.

A blog reader alerts me to this NPR story, which says:

economists frown on what they call "Pigovian taxes," which are designed not only to raise revenue but put to governments in the position of trying to influence how people shop or behave.

I don't think economists are unanimous about this issue, but I believe most economists favor Pigovian taxes.

Moreover, the NPR story confuses Pigovian taxes with sin taxes.  Pigovian taxes try to correct for negative externalities--that is, the adverse effects of certain behavior on bystanders.  Sin taxes try to correct for behavior that some social planner deems as not sufficiently virtuous.

Click here for previous blog post on sin taxes.

My Visit to Oberlin

I will be talking at Oberlin College tomorrow evening.

The Problem with Deficit Neutrality

Imagine you have a friend who has a budget problem.  Every month he spends more than he earns.  His credit card bills are piling up.  He is clearly on an unsustainable path.  Then one day he comes to you with an idea.

Friend: I am going to take off a few days from work and fly down to Bermuda for a quick vacation.

You: But isn't that expensive?  Won't that just add to your growing debts?

Friend: Yes, it is expensive.  But my plan is deficit-neutral.  I have decided to give up that half-caf, extra-shot caramel macchiato I order at Starbucks twice every day.  I really don't need that expensive drink.  And if I give it up for the next three years, it will pay for my Bermuda trip.

You: Well, then, how are you going to solve the problem of your growing debts?

Friend: I am going to figure that out as soon as I return from Bermuda.

You: But in light of your budget problem, maybe you should give up Starbucks and skip the Bermuda vacation.  Giving up Starbucks could be the easiest way to start balancing your budget.

Friend: You really aren't any fun, are you?

This conversation is meant to illustrate why claims of deficit-neutrality in the healthcare reform bill should not give much comfort to those worried about the U.S. fiscal situation.  Even if you believe that the spending cuts and tax increases in the bill make it deficit-neutral, the legislation will still make solving the problem of the fiscal imbalance harder, because it will use up some of the easier ways to close the shortfall.  The remaining options will be less attractive, making the eventual fiscal adjustment more painful.

A Life in Finance

The great financial economist Eugene Fama offers a retrospective.

CBO on the President's Budget

In my most recent Times column about the President's budget, I wrote,

Making matters worse, these bleak budget projections are based on relatively optimistic economic assumptions. The administration forecasts economic growth of 3.0 percent from the fourth quarter of 2009 to the fourth quarter of 2010, followed by 4.3 percent the next year. By contrast, the Congressional Budget Office predicts growth of 2.1 percent and 2.4 percent for these two years. Lower growth would mean less tax revenue, larger budget deficits and a more rapidly increasing debt-to-G.D.P. ratio.

The CBO has now reestimated the budget effects of the President's proposed policies, and indeed the CBO forecasts larger budget deficits. The CBO's total deficit projected over the decade-long budget window is $1.2 trillion larger than the administration's estimate.

The administration projects that the federal government debt held by the public would rise to 77 percent of GDP in 2020 (from 53 percent in 2009).  The CBO forecasts a debt-GDP ratio in 2020 of 90 percent.

Economics in One Picture

Source.  Thanks to Joshua Gans for the pointer.

Rogoff on Japan

Ken says it is not a pretty picture.

Gorton on the Financial Crisis

Yale economist Gary Gorton offers a very readable Q&A explaining his view of recent events.

Life Expectancy at Retirement

Source: The Economist.  Click on graphic to enlarge.

Americans, as well as citizens of many other advanced nations, now spend about twice as many years in retirement as they did a generation or two ago.  During that time, they expect the government to provide them with income support and healthcare.  Is it any wonder that we face serious fiscal problems?

I hope the president's fiscal commission makes raising the age of eligibility for these programs one of its main recommendations.

Just a Spelling Lesson

Quite a few readers have emailed me comments on my new paper Spreading the Wealth Around: Reflections Inspired by Joe the Plumber.  I appreciate the input.

The most frequent comment is to point out an alleged error: "just deserts" should be "just desserts," I am told.

So here I am with a spelling lesson: In the expression just deserts, the word deserts means that which one deserves.  It may be pronounced like the sweet things you eat after a meal, but it is spelled like the spans of dry land.

For example, consider this dialogue:

Father: If you eat all your vegetables, Bobby, you can have a cookie and ice cream after dinner.

Bobby: Will you also pay me a dollar, Daddy?

Father: No, Bobby.  If you eat all your vegetables, your just deserts are just desserts.

By the way, another reader points out that yesterday's Doonesbury is related to the topic of Just Deserts Theory.

A New Member of the Pigou Club

Thomas Friedman reports:

[Senator Lindsey Graham, the South Carolina Republican,] proposes “putting a price on carbon,” starting with a very focused carbon tax, as opposed to an economywide cap-and-trade system, so as to spur both consumers and industries to invest in and buy new clean energy products.