Federal Spending and Employment

Over the last few months much ink has been spilled over the effectiveness of federal government spending in stimulating job growth and employment. I propose to spill more ink. No sentient resident of Washington State can deny the influence of federal spending on job creation.

The development of hydropower on the Columbia River, naval bases (Bangor, Whidbey Island) and ports (Bremerton, Everett) and the role of defense contracts in the growth of Boeing all attest to the regional employment effects of federal government spending. Government spending creates jobs.

But regional job creation is not the same thing as national growth in employment. It is possible that more economic activity here leads to less activity elsewhere, so the net effect is zero. Possible but not likely under our current economy.

If the economy is operating at full employment, increased federal government spending financed by borrowing or taxes just transfers spending and resources from one use to another and there is no overall increase in employment or output. However, if there is excess capacity and unemployed resources, increased government spending financed by borrowing (deficit spending) utilizes these resources and increases total output. Current data indicates the economy is operating at less than its potent

Taxing Evidence 

President Nixon once noted that, although honesty isn’t always the best policy, it should be tried now and then. When it comes to taxes, politicians fall back on ideological/philosophical bromides and seldom refer to the data. Now and then it is worthwhile to look at the data. In particular, what actual evidence supports a relationship between capital gains tax rates and economic growth? I’ve selected the capital gains tax because it has it has the most quasi-religious ideology attached to it. Since the political ascendency of supply-side economics (mid 1970s), politicians have focused on marginal tax rates for ordinary and capital gains income. They have asserted that economic behavior is highly sensitive to minor changes to the tax rates. Much of this discussion has been economics by assertion (hysterical evidence) rather than to actual data (historical evidence).

Academic economists have remained largely immune to the more extreme supply side arguments, i.e. any assertion by Arthur Laffer. Why? The reason is simple: the data do not support the assertions. One would expect the data to reveal a strong negative relationship between the capital gains tax rate and economic growth. As rates go down, the “job creators” would engage in a feeding frenzy of new investments and economic growth would soar. Conversely, increases in the rate would dramatically reduce investment and economic growth would slow to a crawl. Statistical investigations of the macroeconomic data for the last 50 years do not reveal this asserted behavior.

There are, at least, two explanations for these results. First, other economic factors overwhelm the tax rate affect. The tax rate affect may exist but is not strong; the noise drowns out the signal. A second reason may be that capital gains taxes are poorly targeted and reward behavior that isn’t related to real investment and growth. Growth requires investment in plants, equipment and people; not the financial churning that characterizes much of the activity in stock and bond markets, let alone real estate. Many financial transactions have little to do with risk taking investment in productive assets, but are eligible for the capital gains tax rate. For example, I can go to my broker and purchase $1000 worth of stock from a seller and, if I hold it long enough and the value of the stock increases, I can sell it and be taxed at the capital gains rate rather than the income tax rate. I’ve been rewarded for taking financial risk but the risk is not directly related to the creation of real productive assets. Lucky me! Only if the stock is an initial public offering (IPO) or is newly minted by an existing firm to raise capital, is a stock transaction related to real investment.

Finally, even though the real economic benefits of the capital gains tax are ambiguous at best, it does have one clear effect: it widens the income and wealth gaps between the rich and poor. Over a 20 year period from 1991 until 2011, 80% of capital gains income went to 5% of the population. Actually the result is even more skewed. The top 0.1% of income earners garnered 50% of the total capital gains income. So the tax slices the pie without encouraging its growth.

I am not writing this piece as a partisan ideologue. I am not a member of either major party. I do believe, as did President Nixon, that honesty should be tried now and then. This means that assertions should be buttressed by actual facts. Ideology should not triumph evidence.

Entitlement Blues

The late economist Herbert Stein (Chairman of the Council of Economic Advisors under Nixon,  a founder of the American Enterprise Institute and an avowed Rockefeller Republican) once noted that something that is unsustainable cannot continue. It is asserted by those in the know of both right and left political persuasions that the current federal budget path is unsustainable and entitlements are the problem.

In particular the Medicare and Medicaid programs are on a long-run path to swallowing the whole budget. (Social Security also has a problem but it is modest by comparison.) The medical expenditures are driven by the nation’s demography and the medical sector’s increasing treatment costs. Both of these elements are outside of the formal budgeting process. Our population will continue to age. No one has made a convincing argument yet as to how to slow down the rate of medical inflation.

The Ryan/Republican approach is to shift the costs off budget by increasing the share of the costs paid for by the beneficiaries. The Obama Administration and the Democrats hope to shift some of the costs to the supply side of the medical market place. Neither approach directly deals with the demographic and cost inflation. The burdens are just redistributed. A real solution remains politically elusive.

This Ryan Won’t Fly-Part 1

Back in the days when economists had a sense of humor and irony Herbert Stein noted that something that is unsustainable will not continue. This unalterable fact is true of federal finances as currently constructed. The budget has a structural deficit of about 4%+ of GDP and this structural component will grow if the spending/taxing relationship is not changed. The Debt/GDP ratio will have to be reduced and stabilized. Empirical research indicates a ratio of around 60% is necessary for long-run economic stability. We are currently at 80% and moving towards a three digit level within the next few years. The recession is only partially responsible (about 60% of the current deficit can be attributed to the slow economy).

Currently there are three fully formed budgetary proposals designed to put federal finances on a sustainable path and reduce deficits and federal debt. They are : The Bowles-Simpson plan put forward by the President’s Commission on Fiscal Responsibility and Reform, the Rivlin-Domenici deficit reduction plan proposed by the Bipartisan Policy Center and the “Path to Prosperity” fiscal plan proposed by Congressman Ryan. And recently the Obama Late Entry Plan. I take it as a political truth that only bipartisan support will generate a plan that has any chance of legislative enactment, and bipartisan support indicates the public has the stomach for the plan’s distribution of pains and benefits.

This eliminates two extremes: A plan that claims to attack  the fiscal crisis by only cutting spending (The Ryan Plan )or a plan that solves the problem by only raising revenues (I’m speaking of both of these as a share of GDP). The current fiscal gap is roughly 10% of GDP.Under the current structure of taxes and expenditures. This gap would close to around 5% if the economy were operating at a full employment level of output. Any plan must reduce this structural gap to claim it will achieve fiscal sustainability.

The trick is to move toward a sustainable fiscal balance without jeopardizing the recovery. The adoption of a plan will not in itself immediately stimulate the recovery. It will improve the nation’s balance sheet overtime and provide a foundation for more economic stability. It accomplishes this by stabilizing and gradually reducing the Debt/GDP ratio at the 60% range, and reduces the potential “crowding out” effect of increasing federal debt held by the public. This does not assure balancing of the budget, at least not, annually. The ideal solution (I think) involves cyclical balancing of the budget with a virtual balance at around 5% unemployment and surpluses at output levels that generate unemployment a lower levels.

In the real world a politically acceptable solution will involve increased taxes, and program cuts (this will involve actual reductions in the growth rate of entitlement spending, actual reductions in Medicare and Medicaid. Pain for all is the politically acceptable solution.

A balanced plan also implies some growth in the federal share of the GDP. Demographic trends augur for an aging population and this means increased medical care per capita. Demography is destiny.There is no extant evidence that medical costs for the elderly will decline in absolute terms, or for that matter in relative terms. This means that the current and future generations will have to save more (either through increased personal savings or increased taxes) to cover growing medical expenses. Geriatric care is the elephant in the closet, and the elephant is growing. We can offset some of this burden through economic growth but growth is unlikely to offset all of it. We can try and offset the growth in medical federal medical liabilities trend by reducing government expenditures on other programs. That will buy some time but unless you can envision defense spending and non-defense discretionary spending trending to zero, the budget will increase. The interest on the debt is the other item that seems primed for inexorable growth absent serious fiscal discipline.

The Ryan approach throws all the burden of hunting elephants to the expenditure side of the budget. Over time discretionary spending declines by 91% as a share of the budget and Medicare and Medicaid spending are significantly reduced The burden of all these cuts falls on the majority of the population.

Nothing real has changed. The elephant is still growing demography and medical cost trends guarantee this result. The cost is shifted to the consumers of medical services. (Additionally, The Affordable Care Act is also repealed) Let me suggest that all of this is politically impossible, but the fight will slow down the search for real alternatives.

The federal budget deficit is not the real focus of the Ryan Plan. He wants to reduce the share of Federal spending to GDP to its post WW2 average of around 18% and just cuts spending growth to get there. The deficit is not eliminated until 2030 under his favorable economic growth assumptions. A discussion of these assumptions will follow in the next installment of the Ryan flight plan.

These spending cuts and medical cost redistributions will be combined with higher income earners sacrificing pre-Bush tax rates. This is the most regressive fiscal revision in US history.

Cliff Notes

The length of a recession is officially measured by the National Bureau of Economic Research (NBER) as the time from the previous peak in economic activity to the nadir (trough). This recession, known as The Great Recession, lasted 18 months according to the NBER, from December 2007 until June of 2009. Seems like forever. The recovery has been phlegmatic compared to typical post war recessions.  The cause(s) of this recession were not typical and were characterized by a severe financial crisis. Academic research indicates that the private deleveraging process required to recover from a crisis of this type typically takes several years (See Rienhart and Rogoff “This Time is Different: Eight Centuries of Financial Folly” 2009). We are doomed to a typical recovery. Our potential recovery is complicated by perceptions of the risks associated with our high level of public debt, particularly federal debt.

 It is obviously naïve to expect politicians to clarify issues surrounding the present state of the economy They have not disappointed.. The role of political philosophy colors the debate. Ideology prevents reasonable discussion and the weighing of evidence. The mavens of the left overstate the benefits of intervention and those of the right deny the possibility of benefits and see only negative consequences. How about a discussion based on logic and/or evidence rather than quasi-religious beliefs?

Simply put the “fiscal cliff” is a combination of tax increases and expenditure cuts designed to reduce the deficit by about 50% immediately. If this combination sounds like the European approach to their fiscal crisis, that’s because it is. We can observe how well it’s doing there. Why should we be different? There is no reason why. The Congressional Budget Office (CBO) estimates the effect of making the leap as a one-half percentage point reduction in the growth rate( or about $80 billion a year in GDP loss) with a high probability of a recession in 2013. So the price is lost output and increased unemployment. The economy returns normal growth (from a lower base) by 2015 according to projections. The gain is a lower cumulative deficit in the ensuing years. But the accumulated output loss adds insult to injury and insures that this accumulation will take years to overcome. The price is too damn high.

Larry Summers and Christina Romer have argued convincingly (April 2012) that more stimulus now with a real long-term plan for fiscal rectitude will achieve greater growth at less short-term cost. Makes sense to me. Sometime you have to strengthen the patient before performing the surgery.

More fiscal stimulus at this time with continued Quantitative Easing by the Federal Reserve has the possibility of giving the economy the jolt it needs to continue its revival even though global growth is slowing down. This prescription is the only game in town. Krugman and some other lefties have argued for a more aggressive monetary policy by the Fed. They would like the Fed to raise the target rate of inflation (currently 2% per year to 3 or 4%). They argue that raising the explicit target would encourage more consumer and business spending as there would be an expectation of more inflation, hence a fear of depreciating currency. I sympathize with this argument but it is not without risk. Once in place, inflationary expectations are hard to reverse, and there is a danger of overshooting the target. Let me just note at this time that the tighter monetary policy necessary to reduce inflation is not without significant costs.

Robert’s Rules of Order

The Supreme Court has spoken and the political din is in full campaign mode. Dickens was half right. This is the worst of times for the democratic process. Partisanship has removed all rationality from the discussion of America’s health care system and the Affordable Care Act in particular.

Let’s be clear about the basic parameters of the system. Everybody has access to medical care. About 15% of the population is uninsured and have inadequate access to regular care but can receive care at emergency rooms. This is very expensive and the cost is shifted to those covered by insurance. The result is higher cost for those insured and greater morbidity for the uninsured. A Dickensian result. Everybody is worse off.

One component of the ACA proposed to extend Medicaid coverage (administered by the states and aimed at the poorest segments of the population) and offered, as a sweetener, to cover all of the costs for the first three years  The level of support would decline to 90% by 2020 and remain at that level. This provision was invalidated by the Court due to the penalty provision, so the states have the option of not extending coverage. Some governors have expressed an unwillingness to extend coverage under the rubric of avoiding future costs.

The states may avoid the costs but society won’t. It is an unforgiving law of economics that all bills get paid. It is just a matter of who pays, when and how? Medicaid expenditures explicitly recognize and cover these costs. Those states refusing the extended coverage aren’t reducing these costs; they are just shifting these costs to those covered by insurance. It means higher premiums for the insured. These costs are “hidden,” but no less real.

All of this roiling is another sorry example of the political system’s unwillingness to recognize that all balance sheets have two sides and hiding costs do not eliminate them.

Bad Conventional Wisdom, Then and Now

“By 1960, progressive income taxation on the one hand

and income support measures for the poor on the other

hand were accepted by all but the most unreconstructed

conservatives.”

Herbert Stein, Presidential Economics. Third Revised Edition 1993

(Chairman, Council of Economic Advisors under Nixon)

 Since 1980 a whole lot of deconstruction has been going on, particularly in the Republican Party. Mr. Stein, who was chairman of the Council of Economic Advisors (CEA) in the Nixon Administration and a founder of the American Enterprise Institute, considered himself a Rockefeller Republican. This brand of fiscally moderate, internationalist Republicanism is all but extinct. There may be a member or two of the species still alive in Maine but it’s not clear a breeding pair has survived.

Since 1980 a strident quasi-religious brand of conservatism has fully captured the Republican Party. They’ve rediscovered all the bad advice that Andrew Mellon gave Hoover and made it part of their dogma. The empirically based conservatism of Milton Friedman is no longer part of the received wisdom.

They claim that we are heading down the Grecian path to fiscal ruin while extolling the austerity policies that guarantee decline. There is not a shard of evidence demonstrating that austerity is an effective way out of the current economic problems facing the Greeks or the rest of west. Iceland has the one crisis  economy that is actually generating some heat and their policy is determinedly anti-austerity.

It’s been over four years (Dec ember 2007) since the recession officially began and three years (June 2009) since the recovery officially started. It is the first major financial crisis since the Great Depression and involves all of the major western economies. Even the German banking system is fragile.

The US is recovering very slowly and Europe is stagnant. At the current pace of recovery it will be years before we regain a semblance of a fully employed economy. How did we get here?

Our sustained prosperity of the 1990s was framed by monetary and fiscal policies antithetical to the current conservative cant. Taxes were raised early in the recovery process and monetary policy accommodated the real expansion. The result was an unequaled experience with 108 months of uninterrupted expansion, falling unemployment rates, stable prices and falling federal deficits.

Clearly the monetary and fiscal policies of the period were consistent with uninterrupted prosperity. At the very least policy didn’t get in the way. At the same time structural changes were occurring. Manufacturing was continuing its relative decline, internet industries were enjoying birth and growth, and the financial sector was undergoing growth and deregulation.

Until the current serious financial crises, post WWII history of business cycles indicated that monetary and fiscal policies in the western economies has been consistent with shorter, less extreme business cycles than pre-WWII experience. This is a modest claim, but indicates monetary and fiscal policy as practiced in the US has been more beneficial than its conservative critics claim.

These critics have now left the reservation and are preaching a version of fiscal and monetary austerity that is theoretically and empirically bankrupt given the current circumstances. This bizarre advice has been followed by the Euro Zone countries and the results are apparent. The southern tier of countries has gone from recession to depression. The Irish and British economies are returning to recession and their debt loads are increasing. The German economy is heading towards a stall speed. It’s all pain and no gain. At some time common sense will triumph ideology. In the meantime unemployment will increase and debt will increase. This state of affairs can only be characterized as economic sadism.