Fantasy Island Economics

“There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately….”
Milton Friedman 1998

It took the Bank of Japan 15 years to take Friedman’s advice and now their great experiment is on. Our Federal Reserve Board responded almost immediately to the current crisis and quantitative easing has been the order of the day since interest rates hit an effective lower bound. Currently the Fed is purchasing assets at the rate of about ½ of one percent of GDP per month and they have pledged to continue until a strong recovery is in evidence. The Bank of Japan’s purchase rate is double the Feds, but they have had 15+ years of deflationary pressure and economic stagnation to overcome.

The current economic reality is not incipient inflation, but potential re-recession in the U.S. and stagnation in Europe. The low interest rates for U.S. securities and declining gold prices are evidence that the market expectations are not for economic expansion and inflationary pressures but quite the opposite. Even the gold bugs are getting a whiff of reality.

There are many who deny the wisdom of the Federal Reserve’s response to the financial crisis, even though the response has been well within the framework proposed by Milton Friedman, an economist they revere in another context. What accounts for this philosophical schizophrenia?

The truly antediluvian conservatives have never accepted macroeconomics as a legitimate discipline. Therefore they have ignored Friedman’s monetary research and theoretical arguments for monetary policy. These conservatives believe in what is known as “The Treasury View.” This was the view of British Treasury (the Exchequer) post WW1.

 Simply put, this view regarded monetary and fiscal stimulus as unable to increase real output and employment, but only crowd out private spending. This view only makes sense if the economy’s resources are fully employed. The policies generated by this view resulted in persistent deflation and high levels of unemployment. Great Britain suffered through the 1920’s in a continual recession. We now call that “austerity”.

Since the resurrection of the Treasury View during the current crisis cannot be based on theory or evidence, it must be the result of ideological fantasy. Unfortunately the real world is not Fantasy Island and real people are unemployed and real output is being lost, not just delayed
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There are two salient observations from the Great Depression. First, there is a direct correlation between countries leaving the gold standard and the beginning of their recovery. Second, there is a direct correlation between the aggressiveness of their monetary and fiscal policies (as measured by share of GDP) and their rate of recovery. Sweden had fully recovered by 1934. The US and France were the slowest to recover and had the most conservative economic policies.

The same general observations hold true today. Western Europe’s relatively conservative approach to economic recovery has stalled their growth prospects. The US economic recovery, buttressed by a Federal Reserve’s comparative aggressiveness and modest fiscal stimulus, has the US on a slow growth path, but it is a growth path.

 The current legislative impasse in the other Washington will remain an effective impediment to economic growth. They are not at fault; after all we elected them.

            “It Ain’t Necessarily So” George and Ira Gershwin, Porgy and Bess (1935) 

It is an article of faith among conservatives that government deficits automatically carry the threat of inflation. Milton Friedman once noted that inflation is everywhere and always a monetary phenomenon. The relationship between deficits and money creation is not absolute and the short-run relationship between money creation and inflation is also not absolute.

  Inflation is a sustained increase in the price level, not an increase in any specific price or a singular increase in the price level that does not continue. These distinctions are important because inflation requires money creation to continue. When the economy is operating at less than full employment levels, neither money creation nor deficits necessarily carry the threat of inflation.

 Recent published research (The Journal of Economic Perspectives, 3rd Quarter 2010) examined the relationship between large deficits and inflation in industrial economies since 1970. Let me quote from their conclusion: “We find that large deficits are not associated with higher inflation contemporaneously, nor are they associated with the emergence of higher inflation in subsequent years.”

Conservatives have been warning of the inflationary wolf since 2009. The pressing problem is unemployed resources not hypothetical inflation.

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. It is even possible that the government expenditures totally displace private expenditures in the affected region.

  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. This phenomenon is known as “crowding out”. Evidence of crowding out through government borrowing would be a rise in real interest rates. Ten year rates are now less than 2% (virtually zero in real, inflation adjusted terms). There is no indication that private borrowers are being discouraged by higher interest rates. 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 potential.

Let’s return to the notion of “crowding out”. This is another way of illustrating the concept of opportunity costs or the foregone uses of resources when they are reallocated to a specific use. At the macro level this cost is only apparent when resources are alread fully employed and a new expenditure pattern develops.

At full employment, increased government expenditure would require a transfer of resources from one set off private uses to another set of uses. This could be accomplished by raising taxes, thereby reducing private consumption and investment and freeing resources from current uses. Increased government expenditures would just result in a transfer of real resources with no increase in real output.

Now let’s assume the expenditure is financed by borrowing from the public (domestic or foreign).Once again, the previous level of domestic investment was consistent with full employment and nothing real has changed other than the composition of output. Under full-employment conditions nothing real changes with changes in government expenditures and revenues. The GDP is unchanged. All effects are compositional, more scientists and fewer pole dancers.

If the economy is operating at less than full employment there are unused reserves of labor and other resources available. Increased government expenditures can lead to increased real output as government expenditures mop up unused or underutilized resources.

 Under this condition it makes no sense to raise taxes to finance the increased activity because increased taxes will reduce expenditures and total expenditures are already insufficient to generate full employment. The efficient option is to borrow the funds from savers. The private loans to the government will come out of excess reserves of the banking system and not crowd out private lending. Therefore increased public spending will increase total spending and employment QED.


There is one potential fly in this expansionary ointment. Economists of The Rational Expectations School argue that the government can’t expand output regardless of the level of employment or the means of financing. They adhere to a version of something called Ricardo Equivalence (Let it be stated that Ricardo did not hold to a strict interpretation of this concept. Like most true believers, the modern supporters of the view have gone well beyond the master’s views.). According to the equivalence principle the current generation recognizes the future tax burdens associated with deficit spending and adjust their current level of saving upward so as to meet the future tax burden. Therefore the drop in current consumption expenditures offsets the increase in government expenditures and there is no stimulative effect to increased government expenditures.

  Obviously raising taxes to pay for government expenditures is offset by decreased private expenditures. You can’t win! Fortunately for fiscal policy, the empirical evidence for this effect is wanting. During the 1981 to 1984 period when deficits increased dramatically there was not a compensating savings offset. So the deficits were expansionary and helped speed the recovery from a severe recession. Reagan’s results were Keynesian in principle.(Herbert Stein noted this at the time with the proper sense of irony). When the Federal Budget went from surplus to deficit under Bush there was no corresponding uptick in saving. In fact the savings rate fell.

As an aside, Alan Greenspan estimated, at the time, that about 20% of the Reagan tax cuts would be recouped through revenue gains. He was too pessimistic. Later estimates placed the figure closer to 30%. Thus a $100 billion tax cut would only increase the deficit by $70 billion. So much for the supply-side arguments, they should rest in peace.

“A regulatory climate that does not appreciate that the financial developments over an extended period of good times will tend to breed the financial environ- ment that leads to the likelihood of crisis and hard times, will not serve this economy well.
                               ” Hyman Minsky (1975)

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.