A theory of fiscal policy: Self-sustaining stimulus | The Economist

Expansionary fiscal policy is a tool governments often turn to when the economy is facing high unemployment and sluggish or negative economic growth. Cutting taxes and increasing government spending can contribute to the overall demand in the economy and thereby lead to job creation and economic growth.

One of the oldest arguments against stimulus, however, is that which says when a government borrows money to pay for such a policy, it can lead to a decrease in private investment and a decrease in future demand as the higher level of debt must be paid back in the future. Short-term stimulus, therefore, is counter-productive since any debts incurred must be paid back in the future, leading to lower levels of spending and therefore higher unemployment sometime down the road.

The crowding-out effect of fiscal policy is explained in detail in the following video from The Economics Classroom:

A recent study by two leading American economists provides an argument against this view of the crowding-out effect of fiscal policy:

In a new paper* written with Brad DeLong of the University of California, Berkeley, Mr Summers, now at Harvard after a stint as Barack Obama’s chief economic adviser, says that in the odd circumstances America faces today temporary stimulus “may actually be self-financing”…

Mr DeLong and Mr Summers are careful to say stimulus almost never pays for itself. When the economy is near full employment, deficits crowd out private spending and investment. In a recession the central bank will respond to fiscal stimulus by keeping interest rates higher than they would otherwise be. Both effects mean that in normal times the fiscal “multiplier”—the amount by which output rises for each dollar of government spending or tax cuts—is probably close to zero.

The “multiplier” referred to here is what economist refer to as the Keynesian spending multiplier, which is based on the theory that any increase in spending in an economy (say, through a new government spending package), will lead to further increases in spending (as households feel more confident and firms start to hire workers again), therefore the final change in national income resulting from a fiscal policy will be greater than the initial change in spending itself. This multiplier effect has formed the basis of the argument for expansionary fiscal policy since Keynes articulated it in the 1930’s.

The multiplier effect is explained in detail in the following video lesson:

If the multiplier is ZERO, there is no point in engaging in expansionary fiscal policies since there will be no additional increase in output as a government goes into debt to pay for a tax cut or an increase in spending. In the US today, argue Summers and Delong, the multiplier is probably not zero. Additionally, crowding-out is unlikely to occur.

Such constraints are not present now (meaning in the United States in 2012). Investment and demand are deeply depressed and the central bank, having cut interest rates to zero, is not about to raise them. The multiplier is higher than usual as a result…

Basically, Summers and Delong are trying to argue that the US government should engage in another round of fiscal stimulus, to offer additional support to the economy beyond 2009’s “Obama stimulus” and the current bill being debated in Washington, the American Jobs Act, a $470 billion tax cut and spending bill aimed at keeping unemployment from rising in America.

On one side of this debate are those like Summers and Delong who argue fiscal stimulus can pay for itself since it can leads to a larger increase in GDP than the increase in the government’s budget deficit needed to finance the stimulus. On the other side are those “deficit hawks” who believe that any increase in government debt will lead to a fall in current and future aggregate demand from the private sector, and therefore expansionary fiscal policies will just be crowded out by declining private sector spending.

By understanding the circumstances in which crowding-out is most likely and unlikely to occur, we should be able to make a more informed decision about future fiscal policy decisions. As these two economists argue, and as I have tried to present in this post and in a previous post A Closer Look at the Crowding-out Effect, today’s economy provides policy-makers with the perfect opportunity to stimulate aggregate demand by increasing the deficit and providing the US economy with the boost in demand it needs to get America back to full employment.

Discussion Questions:

1. Why is crowding-out more likely to occur when an economy is already producing at or near its full employment level of output than when an economy is in recession?
2. How are the theories of crowding-out and the multiplier effect used to argue for two different sides in the debate over the use of expansionary fiscal policy?
3. Why might a government deficit, paid for with borrowed money, lead to an expectation of a future increase in taxes?
4. Do you believe the government should take action during periods of economic hardship, or should it just get out of the way and let the economy “correct itself”?

Related posts:

1. The “teenager tax” – why expansionary fiscal policy just ain’t fair!
2. How big is the government spending multiplier in America? Well, it depends on which economist you ask…
3. The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal

The $1.4 Trillion Question – James Fallows – the Atlantic

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

Related posts:

1. Exchange rates and trade: a delicate balancing act, currently out of balance!
2. Exchange rates, currency manipulations, and the balance of trade
3. China’s “silver bullet” – a strong RMB could solve her biggest economic woes…

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

• Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
• This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
• Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
• The really scary thing is the prospect of another Great Depression.
• Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
• With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
• Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
• If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
• We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
• The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
• The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
• Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
• When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

• The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
• There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
• This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
• If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
• This is not a double dip recession, because we never left the first one.
• Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
• If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
• Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
• Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
• Until we get the debt levels down, we cannot get back to robust growth.
• It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
• When it comes down to it, there is just too much debt in the economy!

Discussion Question:

1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

Related posts:

1. The U.S. National Debt: How Bad is the Problem?
2. McCain and the Republicans: fiscal conservatives? Think again…
3. Does expansionary fiscal policy “pay for itself”?

BACKGROUND & FRAMING OF THE ISSUES
One of the most widely discussed and often misunderstood areas of the U.S. economy is the current amount of the United States’ national debt, which currently totals $14.1T. Yes, currently the U.S. Government owes a collective $14.1T to both American & foreign households & institutions. This borrowing was necessary since the U.S. government has spent in excess of its tax revenue over the years, which, in economic speak, is called “deficit spending”. In short, the U.S. government must borrow when its spending exceeds its tax revenue. Over the past 10 years especially, government spending has well exceeded tax revenue almost tripling during that period. A combination of two wars, two recessions, and two political parties that have not yet made deficit fighting an urgent priority accounts for this surge in debt over the past 10 years.

The shear magnitude of the U.S. national debt ($14.1T), coupled with alarmist comments by the U.S. Congress and the American press lead most Americans to conclude that our country is in a very precarious position and is perhaps on the verge of bankruptcy. Moreover, many Americans are aware that future Federal payouts for social security and Medicare alone, assuming no benefit changes, will rise at a much faster rate than the current tax revenues for those same social programs further increasing the national debt.

THE IMPORTANCE OF DEBT TO A COUNTRY
Contrary to what many Americans believe to be conventional wisdom, debt is actually a beneficial and recommended pursuit, if used correctly, since it enables a nation or an individual to equalize income and expenditures over time, and improve standards of living earlier than what would otherwise be attainable. It is easier to accept this premise on the personal front as millions of Americans have been able to improve their standard of living currently by pulling their future incomes forward via borrowing to purchase homes, cars, and education. Of course, we all know that debt, like a car, can cause damage if it is not used and managed wisely, and that is where many alarmists focus and even some go so far as saying that all debt is bad and should be avoided. Many nations, with Russia being a prime example, have been criticized by economists for not utilizing enough national debt to improve their economy and their citizens’ standards of living. Thus, hopefully, with a conclusion that debt is actually a “good thing”, if used for productive purposes, one can then proceed to the next section as to what are acceptable levels of national debt.

$14.1T: AN AFFORDABLE LEVEL OF NATIONAL DEBT?
The United States’ current level of national debt is still affordable and consistent with several other nations. The problem, however, is that with the continued rate of growth in the debt experienced over the last 10 years it will not be affordable forever. National accounting statistics show clearly that the U.S.’s 96% national debt/GDP percentage is, in fact, above average compared with most other modern economies, but it is certainly not the highest as economies like Japan and Italy currently have debt/GDP levels at 204% and 130%, respectively. Moreover, the level of U.S. national debt as a percentage of GDP (96%) is relatively close to where it was back in 1950 after having financed World War II. Our nation’s highest level of debt relative to GDP was 121% back in 1945. The key point is that debt must be benchmarked to our nation’s income which is GDP. I find it interesting that if I tell someone that Bill Gates owes someone $10M they quickly can figure out that he’s probably fine, but if I tell the guy at Starbucks that the U.S. owes $14.1T they think the country must be ready to go bankrupt. Big numbers really scare people, so one needs a perspective.

WHO IS THE NATIONAL DEBT OWED TO?
Much has also been made of the fact that $4.3T of the U.S. national debt, or 30%, is owed to foreigners. The fact that a good chunk of the debt is owed to foreigners is not nearly as much of a concern as the growth of the national debt in general. Foreign debt is nothing more than foreigners temporarily saving their U.S. dollars, the same dollars sent to them for their products imported into our country. Some foreigners elect to temporarily save these dollars and earn interest by lending them back to the U.S. Government by purchasing bonds. I don’t consider the fact that debt is “foreign” to be a problem, as these dollars will eventually be paid back to the foreigners with interest and these same dollars will, in turn, be spent back into our U.S. economy. Debt held by foreigners is “dollar savings” just like debt held by American citizens is “dollar savings”, so, in other words, it is really not that important whether the debt is held by foreigners or US citizens since eventually those dollars will be spent back into the U.S. economy since they can’t be spent in another economy!

SO IT MIGHT BE AN AFFORDABLE LEVEL OF U.S. NATIONAL DEBT NOW, BUT WHAT ABOUT THE FUTURE?
Many have argued that the U.S. aging population coupled with the flood of “baby boomers” moving into their retirement years will cause social security and Medicare alone to “shoot through the roof” and cause the U.S. national debt to reach unacceptable and unmanageable levels, potentially, some say, even bankrupting the U.S. Government. Many use extrapolations of future social security and Medicare payments out into varying distant futures based on the number of retiring baby boomers and increasing life spans concluding that there are trillions of unfunded government obligations ($10T, $25T, $80T, etc.) which are insurmountable. The problem with most all of these analyses are that they fail to address how simple and relatively small adjustments make these problems disappear. For example, on social security, an increase in the social security tax rate from its current rate of 12.4% (6.2% for employees matched by employer) to 15.9% is deemed by one source to fully fund social security at today’s benefit structure out into perpetuity (i.e., forever). Similar analyses are out there for other actions such as updating social security retirement ages to be more consistent with longer life spans. Now granted, few would be happy with a 28% increase in their social security taxes paid or later retirement ages, but what will likely happen will be a combination of different types of changes including reduced benefits, higher taxes, later retirement ages, and reallocations of the overall federal budget.

CONCLUSION
Today’s $14.1T U.S. national debt, although currently affordable, is rising at too fast a rate. In just 10 years, the U.S. debt level has gone from 58% of GDP in 2000 to 96% today. At current rates of spending and tax revenues, our country will exceed 100% of GDP by the end 2011.

The U.S. economy has some sizable challenges ahead in terms of keeping our increasing national debt in line with increases in our economic growth. Most notably, our demographic trends of fewer births and increased retirees with longer life spans will put additional strains on our country’s debt/income relationship.

Am I optimistic? Very much so! Our Government has shown before that we can pare our debt down. Our nation restored fiscal soundness after World War II when national debt reached an all time high of 121% of GDP and again in the 1990’s as our Government made significant changes in government spending and taxation policies to curb our debt from 67% of GDP to 58% of GDP.

What should be the goal? I say a debt level of 67% of GDP should be the goal, which is a very average and affordable level of debt. It’s OK for debt to grow as long as it does not become too high relative to the size of our economy or GDP.

The next 5 years will be very important years to establish the fiscal discipline to restore our debt to very manageable levels. If not…well….has anybody heard about Greece?

Discussion Questions:

1. How do economists gain a perspective of just how high a country’s national debt is? Can you think of any other ways to gain a perspective on how high a country’s debt levels are?
2. Respond to the comment: “Reponsible governments should balance their budget (spending = tax revenue)”
3. If Japan’s debt to GDP ratio is over twice that of the U.S. can we conclude that the U.S. has a lot of “breathing room” and can continue to carry large annual deficits out into the future?

Related posts:

1. The U.S. National Debt Level: Is The Sky Really Falling?
2. Too much debt or not enough demand? A summary of the debate over America’s fiscal future
3. When Spain’s unemployment problem gets ugly

Should President Obama consider writing a thank you note to Chinese leaders for artificially manipulating the Chinese Yuan in the foreign currency markets?

For many years now, Chinese authorities have artificially intervened in the foreign currency market by buying up U.S. dollars spent on Chinese products and, in turn, investing those same U.S. dollars in U.S. Treasury Securities (ie, bonds and notes). For those that are not familiar with the foreign currency market, Chinese authorities buy the same U.S. Dollars provided by the U.S. to purchase Chinese products and, thus, leave or supply Chinese Yuan to the currency traders resulting in a decrease in the price of the now more plentiful Yuan and an increase in the price of the now more scarce dollar.  The Chinese authorities intervene in the foreign currency market for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive in global markets. It is estimated by many economists, that the Yuan may be overvalued versus the U.S. dollar by approximately 30% due to this foreign currency intervention by China.

So while it is true that this action taken by Chinese authorities clearly depreciates the Yuan and appreciates the Dollar, thus, unfairly harming U.S. exporters; it is also hitting the “sweet spot” by sending those same U.S. dollars back to the U.S. Government to fund the record federal deficit spending expecting to total $1.3T in 2011 and providing American citizens with reduced prices on imports via the stronger dollar! More specifically, this currency intervention by Chinese authorities provides needed loanable funds back to the U.S. Government lowering borrowing costs or interest rates during this important U.S. economic recovery time. It also appears that US leaders are sending mixed messages to China as just last year, Secretary of State Hillary Clinton visited Beijing to encourage Chinese leaders to continue to purchase U.S. Government securities. This seems at odds with US officials cry for China to stop intervening in the foreign currency markets because by doing so needed federal deficit funding would dry up from the Chinese, forcing the US to borrow elsewhere and raise interest rates to entice that lending.

In summary, perhaps in the short term the United States should consider not pressuring China, as Treasury Secretary Tim Geihtner, Obama and the media have done regularly. Perhaps US officials should lay low, at least for awhile, and start pressuring the Chinese again in about three or four years, after the Government’s budget no longer calls for such large spending deficits.

Review Questions

1. What specifically are Chinese leaders doing to keep the Yuan weak against the U.S. dollar?
2. Why are Chinese leaders intervening in the foreign currency market?
3. Which parties, both American and Chinese, are helped and hurt by this intervention?
4. What would happen, other things equal to U.S. interest rates if Chinese authorities immediately stopped intervening in the currency market? Why?
5. What would be the immediate impact on the U.S. poor and working class if the Chinese immediately stopped intervening in the currency market?
6. What policy position would you take as President of the United States on this issue?

Related posts:

1. Is An Obama “Thank You Note” Owed to the Chinese?
2. Excuse me, China… could you lend us another billion? Understanding the imbalance of trade between China and the United States
3. China’s “silver bullet” – a strong RMB could solve her biggest economic woes…

Mr. Welker’s note: The following post was submitted by a former student of mine at Shanghai American School. Marco graduated in 2008, completing the higher level IB Economics program. He now studies Economics and Political Science at McGill University in Canada. The following was written as an assignment for a McGill course, Econ 302: Money, Banking and Government Policy.

When Mr. Welker supervised my Extended Essay in 2008, the US Congress had already started putting pressure on the Chinese to allow their currency to appreciate. The economics of the US trade deficit seemed quite simple: the US bought more Chinese goods than the other way around, resulting in a current account deficit and causing the Yuan to appreciate. In return, the Chinese were in the habit of buying US government bonds, resulting in an American capital account surplus and depreciating the Yuan in relation to the Dollar. In other words, America has a Chinese credit card and the bill is quite large.

For obvious reasons, Congress is not thrilled with the debt. They have long claimed that the Chinese purposefully buy all this debt in order to boost their exports, but that it unfairly drags the US into further debt. The old protectionist tendencies flared and Congress tossed around accusations that Chinese companies maintain sub-American product quality, evidenced by the lead that was found in some toys, among other things. The threat of lead poisoning was a nifty pretense under which more stringent safety regulations could have rid the US market of Chinese goods without explicitly saying that they were doing so. In the end, Congress stuck to labeling China a ‘currency manipulator,’ which Chairman of the Fed Ben Bernanke upheld just a few days ago.

The game changer was the financial crisis. It turned out that the US wasn’t just indebted to China but also to themselves. For example, the price of housing in America had divorced itself from reality and people were purchasing houses that they couldn’t afford, on the assumption that they could sell it later at a higher price. When the housing bubble popped, the bookies came to collect the debt and people had a problem.

The US Federal Reserve responded to the crisis by pumping US$800 billion into the American economy. It has followed up by announcing second cash injection of US$600 billion just a few weeks ago. This is part of a policy called Quantitative Easing (QE), in which the central bank maintains a low interest rate and purchases bonds from the government, financial institutions, insurance companies and pension funds with the objective of creating more credit in the economy.

This is where politics and economics really start to interact. Bernanke has showed the Chinese that is not afraid to create more money. That is, he is not afraid to create more US Dollars. China owns a substantial amount of US Dollars. If the value of the US Dollar falls, then the value of Chinese assets fall, since nearly $2 trillion US dollars and dollar denominated assets are held by the Chinese central bank. The Fed’s increase in the money supply could ultimately cause inflation and a depreciation of the dollar, eroding the value of China’s US$ assets. The Chinese will surely not allow Bernanke to simply inflate away the value of Chinese owned American debt.

In response, the Chinese have been slowly moving out of US Dollars, which is smart. Chinese companies and the government (the distinction is blurred) are showing strong demand for raw materials and commodities. China is buying big in copper, buying big in Africa, buying lots of aluminum, tin, zinc, canola and soybeans, as well. According to J.P. Morgan, China’s iron ore imports were 33 percent higher in April than a year earlier. Crude oil imports were up nearly 14 percent, aluminum oxide imports climbed 16 percent and refined copper imports jumped 148 percent.

The future looks very bright for China, indeed. By recycling its US debt into commodity ownership, China is creating a very nice situation for itself. Commodities are goods of real value and only likely rise in value over time, whereas US debt exists on paper and is subject entirely to the value of the US Dollar. Purchasing abroad reduces the current account surplus, stops the yuan from rising and keeps China’s exports competitive. But, most importantly, having large commodity reserves will safeguard its industrial policy in the future, when the West may find itself in a supply crisis. China may have internal discontents, but it is exceptionally well placed in the international economy.

Related posts:

1. China: formerly the world’s factory, now a nation of consumers…
2. Excuse me, China… could you lend us another billion? Understanding the imbalance of trade between China and the United States
3. China makes, the world takes

With more than four million Spanish people out of work this week, the eighth largest economy in the world finds itself once more in a perilous position. In the last twelve months the number of unemployed people in Spain has doubled. Spain now has as many unemployed people as France and Italy combined, and the unemployment rate is nearing the historic highs of 1993.

Click here to view the embedded video.

The type of unemployment in an economy can be classified in different ways. The main types are cyclical or demand deficient unemployment but other forms exist such as real-wage unemployment and equilibrium unemployment. Some economists also refer to unemployed people as structural, frictional, seasonally or cyclically unemployed.

From the graph below we can see that unemployment in Spain has been high for at least the last 20 years, compared to other countries within the European Union.

Source: OECD Factbook 2009: Economic, Environmental and Social Statistics

The cause of growing Spanish unemployment in 2008 to 2010 is related to the collapse of the domestic building boom and the wider global recession. In 2006, Spain enjoyed low interest rates and therefore cheap loans, this allowed developers to build new apartment blocks, houses and commercial buildings with a relatively low cost of borrowing. Spanish people could afford mortgages at low interest rates and therefore purchased houses contributing to the building boom. However, when the flow of “cheap money” ran out in mid 2008 the building stopped and the flow on effects of spending dried up. Falling tourism receipts and less foreign investment have also exacerbated the issue leading to unemployment doubling between 2008 – 2010.

We can classify the form of unemployment, illustrated in the Spanish example as demand-deficient unemployment. It is related to a downturn in the economic cycle. This concept is explained below.

#2aEffects and Solutions

The social and economic impacts of 20.7% unemployment are obvious, but the solutions are less so. Climbing unemployment creates two evils; falling tax revenue as workers no longer earn wages and the increased burden of paying benefits to the four million unemployed citizens. In addition, a series of social problems are often intertwined with high unemployment, these include depression; lose of skills, poverty and higher crime rates. Spain therefore has a few problems to solve this summer. Whilst Spanish people may enjoy a summer by the beach, and a glass of sangria, the government will be hitting the books to find a solution to the problem. Here are a few suggests to get the politicians thinking.

• Use fiscal stimulus to boost consumer and government spending, thereby increasing the demand for jobs. Spain could plan for a budget deficit (expansionary fiscal policy) and fund spending increases though increased government borrowing. Spain’s current level of public debt is 67% of GDP, which is well below stricken Greece at 124%. However, Spain now has to borrow money from international bond markets, which are skeptical about Spain’s ability to pay back this debt. This is despite assurances and favourable rates offered from the European Union this week. Increasing government debt in a period of European financial crisis is a risky option.

• Use loose monetary policy (lowering central bank interest rates) to encourage Spanish people to increase their consumer spending through increased borrowing. If you understand the complexities of the European Union, you understand that all 21-member countries use the same currency and follow the lead of one central bank. Despite one country wishing to lower interest rates, other countries may think differently. Europe can be compared to a train rolling along on a set of rails, with 21 separate carriages. Each European country must follow behind the big engine, there is no room to deviate from the central banks interest rates and all of the countries must move together. Many people have wondered how long the European train would run, before one of the carriages derailed.

• Force Spanish firms to employ more people. Firms have no requirement to hire more people. They may choose to employ more people but will logically offer everyone lower wages to maintain profitability.

• Use supply side policies to bring greater efficiencies to firms though increased on the job training and worker education. This is a long-term solution, which will require large structural adjustments, how Spain produces goods and services and exactly what is does produce. A startling statistic is that the average Spanish university graduate will find their first job at the age of 27, long after they have graduated.

Discussion Questions:

1. How do economists measure unemployment?
2. Explain the causes of increased unemployment in Spain?
3. Explain in a few sentences how expansionary fiscal policy could reduce the rate of unemployment?
4. How could supply side policies be used to reduce the level of unemployment in Spain?

Related posts:

1. The business cycle rears its ugly head!
2. Unemployment and inflation: understanding the Fed’s balancing act
3. The U.S. National Debt: How Bad is the Problem?

Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.

Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:

One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“

There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.

Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.

Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.

But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.

Fareed Zakaria asks Ferguson:

“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”

Ferguson’s reply:

The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.

Finally Fareed asks the question everyone wants to know:”What the hell do we do?”

Ferguson:

One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.

Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.

The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.

Discussion Questions:

1. Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
2. How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
3. Do you think investors will ever totally lose faith in US government bonds? Why or why not?
4. In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?

To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:

Related posts:

1. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
2. Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program
3. To continue stimulus or to pursue austerity, that is the question

Should President Obama consider writing a thank you note to Chinese leaders for artificially manipulating the Chinese Yuan in the foreign currency markets?

For many years now, Chinese authorities have artificially intervened in the foreign currency market by buying up U.S. dollars spent on Chinese products and, in turn, investing those same U.S. dollars in U.S. treasury securities. For those that are students of the foreign currency market, Chinese authorities buy U.S. Dollars and supply Chinese Yuan to the foreign currency markets for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive.

So while it is true that this action taken by Chinese authorities depreciates the Yuan and appreciates the Dollar, thus, unfairly harming U.S. exporters; it is also hitting the “sweet spot” by sending those same U.S. dollars back to the U.S. federal government to fund the record federal deficit spending. This action by Chinese authorities helps keep U.S. interest rates lower than possible during this important U.S. economic recovery time and provides a great source of lending for U.S. government’s $800 Billion stimulus bill and the expensive Federal budget.

In summary, it seems to me that in the short term the United States should consider not complaining, as Treasury Secretary Tim Gheitner has done on several public occasions. Perhaps Gheitner should keep quiet for now and should start complaining again to the Chinese in about three or four years, after the proposed Obama budget no longer calls for such large deficits.

What do you think?

Related posts:

1. Should Obama Send A Thank You Note To The Chinese?
2. China’s Vice Premier talks basic economics
3. The Great Wealth of China: Shaping the World Economy

Colbertnation | The Colbert Report Official Site | Comedy Central

Newsweek international edition editor Fareed Zakaria explains in clear terms the root causes of the United State’s economic hardships. Simply put, Americans have lived beyond their means for far too long.

When a household, a firm, or a national government spend more than it earns (in income or tax revenues), it must borrow to do so. The only problem with this type of deficit financed spending is that at some point “the only way people will keep lending you money is that you have to pay higher and higher interest rates…” This, according to Zakaria, is why the US economy has begun to slow down. Higher interest rates make borrowing and spending less and less attractive, while making savings more attractive.

Savings rates have started to rise in America as our debts have come due. Higher savings means less spending, less spending means weak Aggregate Demand, which means slower growth and rising unemployment. There you have it, the root cause of our economic meltdown. Americans have spent beyond their means for far too long; the question is, have we learned our lesson? Will our current hardships teach us to spend more responsibly in the future?

Related posts:

1. Those who foresaw the meltdown…
2. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Who’s specifically to blame for the economic situation we find ourselves in leading up to the $700B Federal bailout bill that is just about to be signed into law?

Assuming you have read my previous post (“U.S. Financial Crisis! What Is Really Happening?”) on this topic posted last week on this blog site, a related and logical question might be who is most to blame for the unfortunate economic situation we find ourselves in?

As you can imagine, there is plenty of blame to go around! Republicans are blaming Democrats and Democrats are blaming Republicans. Many are blaming household decision makers, greedy executives, and bank regulators “asleep at the switch”. In short, everyone is blaming everyone except for themselves. I have yet to see one person blame themselves, their agency, or their companies!

I see the answers to the “who is to blame” question as a 6-point answer. Keep in mind that these 6 reasons are strictly my opinions and many would either disagree or add to the list:

1. Imprecise regulatory law allowed the financial institutions to carry too high a ratio of mortgage-backed securities to collateralized debt.
2. Banking regulators (Banking Committee, FED, Regulators, etc.) should have screamed louder earlier! Although there are many documented attempts from specific people that did warn of this problem it was more a whisper than a scream.
3. Private lenders (and their CEOs) got greedy either lowering or violating their own lending standards in hopes of making more interest income by loaning to people who were very risk bets.
4. New law had been passed several years ago, urging that Fannie Mae and Freddie Mac make more loans to lower income households that carried much more risk.
5. Households borrowed more than they could afford. Citizens that borrowed need to share the blame with lenders, although I place lenders at a higher standard than borrowers.
6. New accounting regulations under Sarbanes Oxley (regulation passed after Enron) are too conservative causing assets like mortgage-related securities to be valued less than their economic value (true worth), which caused the bank debtor run on the bank.

Yes, there is a lot of blame to go around on this one! If there is any good news it is the hope that new regulation and oversight will occur in our “mixed” economy to help prevent this from ever happening again. Of course, there will be many other “next problems” but, hopefully, we will learn from our mistakes!

Discussion questions:

1. Who do you believe is most to blame for the circumstances leading up to this bailout?
2. Have you remained unbiased in learning that this issue is neither solely a Republican nor a Democratic issue?
3. Which presidential candidate gave you the most comfort as to how he explained his views on the bailout?

Related posts:

1. The Costs of the Bailout, More Government Debt
2. Robert Reich – the financial bailout represents “the worst type of trickle-down economics”
3. Deflation: why lower prices spell doom for any economy!

Thanks to my friend Jerry from Shanghai for posting this cartoon to his Facebook profile!

How timely, just as my year 2 IB Economics class is studying the pitfalls of expansionary fiscal policy in times of economic slowdowns. Now, many critics would say that Clinton was the luckiest president of recent decades as he happened to ride a wave of technological innovation fueled by the internet that led to unprecedented grown in income and tax revenue during the 1990s. Sustained 5% growth combined with a period of relative peace on the foreign fronts in between the two Gulf Wars allowed Clinton to balance the budget and begin putting a dent in the country’s $3 trillion deficit during his final years in office.

Along come the “fiscally conservative” Republicans and their faithful leader GWB, just in time to evaporate our budget surplus and add $6 trillion to our national debt over the next eight years. Today, after a long period of “fiscal conservatism” the debt stands at $9.3 trillion, and last year’s budget deficit of $400+ billion broke a record for the largest gap between tax revenue and government spending in US history.

Yeah, you can blame it one the times: a War on Terror costing the US roughly a billion bucks a day, a slowdown in new technology creation, diminishing returns on internet investments, out-sourcing of American industry and jobs, yada yada… but the cartoon does hold some truth. The Democratic Party, long labeled as the “tax and spend liberals”, managed to do what few other administrations have done since the ’60s in balancing the budget, proving that the old stereotype is simply wrong.

Some now consider the Democrats the fiscally conservative party, based only on the simple observation that they tend to spend closer to what they collect in taxes. The Republicans, on the other hand, have had no qualms about spending what they DON’T collect in taxes, in other words, running up huge budget deficits through borrowing from the public and abroad. Are the Republicans the an even worse incarnation of the “tax and spend liberals”? Are they the “DON’T tax and STILL spend Conservatives”?

Discussion questions:

1. How did the Bush administration’s $160 billion “fiscal stimulus package” that sent $600 checks to every American worker demonstrate the Republican party’s willingness to deficit spend.
2. What effect will deficit spending by the government have on interest rates and private investment in the economy? What is this effect known as?
3. In times of weak aggregate demand, as in the US earlier this year, what sort of approach would a “supply-sider” recommend as an alternative to Bush’s deficit-financed expansionary fiscal policy?

Related posts:

1. Too much debt or not enough demand? A summary of the debate over America’s fiscal future
2. The “teenager tax” – why expansionary fiscal policy just ain’t fair!
3. Does expansionary fiscal policy “pay for itself”?

The Sky is Falling! Or is it?
I believe one of the most misunderstood areas of the U.S. economy today is the disdain shown by the average American citizen over the current level of the United States’ national debt which now totals $9.4T. Yes, currently the U.S. Government owes a collective $9.4T to American households, American institutions, and foreigners since the U.S. government has spent in excess of its tax revenue during most years, which, in economic speak is called “deficit spending”.

The shear magnitude of the U.S. national debt ($9.4T), coupled with alarmist comments by the U.S. Congress and the American press lead most Americans to conclude that our country is in a very precarious position and has perhaps grossly mismanaged its financial affairs. Moreover, more Americans are becoming aware that future Federal payouts for social security and Medicare alone, assuming current benefit levels, will rise at a much faster rate than the current tax revenues for those same social programs.

Well, guess what, I am here to tell you the concern is vastly overstated!

THE IMPORTANCE OF DEBT TO A COUNTRY (OR AN INDIVIDUAL)
Contrary to what many Americans believe to be conventional wisdom, debt is actually a beneficial and recommended pursuit, if used correctly, since it enables a nation or an individual to equalize income and expenditures over time, and improve standards of living earlier than what would otherwise be attainable. It is easier to accept this premise on the personal front as millions of Americans have been able to improve their standard of living currently by pulling their future incomes forward via borrowing to purchase homes, cars, and education. Of course, we all know that debt, like a car, can cause damage if it is not used and managed wisely, and that is where many alarmists focus, and even some go so far to say that all debt is bad and should be avoided. Many nations, with Russia being a prime example, have been criticized by noted economists for not utilizing enough national debt to improve their economy and their citizens’ standards of living. Thus, hopefully, with a conclusion that debt can actually be a ”good thing”, if used for productive purposes, one can then proceed to the next section as to what are acceptable levels of national debt.

$9.4T: AN ACCEPTABLE LEVEL OF NATIONAL DEBT?
The United States’ current level of national debt is both affordable and consistent with most all other nations. National accounting statistics show clearly that the U.S.’s 67% national debt/GDP percentage is roughly average compared with other modern economies, about right smack in the middle. Moreover, the level of U.S. national debt as a percentage of GDP (67%) is at the same ratio as it was back in 1997 and 1992, and is much less than it was in 1950! The ‘”trick” is that debt must be benchmarked to the size of a nation’s economy or income. I find it interesting that if I tell someone that Bill Gates owes someone $10M they quickly deduce that he’s probably fine, but if I tell the guy at Starbucks that the U.S. owes $9.4T they think the country is screwed up!

 One additional benchmark is to compare the annual interest paid on the U.S. national debt ($0.4T) relative to current U.S. federal tax revenue ($2.8T) to the percentage of household interest paid as a percentage of household disposable income. Both benchmarks are currently at a 14% ratio indicating that Uncle Sam’s (U.S.) debt load is actually very consistent with Uncle John’s (households).

Much has also been made of the fact that $2.4T of the U.S. national debt, or 26%, is owed to foreigners. Big deal! It sounds scary on the surface, but once you understand it is pretty harmless. Let me explain. Foreign debt is nothing more than saved U.S. dollars which will eventually be spent back into our economy. Foreigners have temporarily not purchased our products (foreigners have U.S. dollars because we bought their products!) and have temporarily lent their dollars to the U.S. Government to finance the U.S. Government’s deficit spending. Debt held by foreigners is “dollar savings” just like debt held by American citizens is “dollar savings”, so, in other words, it is really not that important whether the debt is held by foreigners or US citizens since eventually those dollars will be spent back into the U.S. economy since they can’t be spent in another economy! By the way, the U.S. national debt owed to China is only 5% of the total debt but the newspapers make it seem like 50%.  

SO IT MIGHT BE AN ACCEPTABLE LEVEL OF U.S. NATIONAL DEBT NOW, BUT WHAT ABOUT THE FUTURE?
Many have argued that the U.S. aging population coupled with the flood of “baby boomers” moving into their retirement years will cause social security and Medicare alone to “shoot through the roof” and cause the U.S. national debt to reach unacceptable and unmanageable levels, potentially, some say, even bankrupting the U.S. Government. Many use extrapolations of future social security and Medicare payments out into varying distant futures based on the number of retiring baby boomers and increasing life spans concluding that there are trillions of unfunded government obligations ($10T, $25T, $80T, etc.) which are insurmountable. The problem with most all of these analyses are that they fail to address how simple and relatively small adjustments make these problems disappear. For example, on social security, an increase in the social security tax rate from its current rate of 12.4% (6.2% for employees matched by employer) to 15.9% is deemed by one source to fully fund social security at today’s benefit structure out into perpetuity (i.e., forever). Similar analyses are out there for other actions such as updating social security retirement ages to be more consistent with longer life spans. Now granted, few would be happy with a 28% increase in their social security taxes paid or later retirement ages, but what will likely happen will be a combination of different types of changes including reduced benefits, higher taxes, later retirement ages, and reallocations of the overall federal budget.

CONCLUSION
Today’s current level of U.S. national debt is within our government’s means, is an “average” level of national debt compared to other modern economies, and has been an instrumental and, thus far, a necessary part of our country’s economic success. One should never be concerned with the increase in the nominal or absolute amount of the national debt, but rather it should be measured in relation to the corresponding growth in our nation’s economy, usually nominal GDP.

The U.S. economy has some sizable challenges ahead in terms of keeping our increasing national debt in line with increases in our economic growth. Most notably, our demographic trends of fewer births and increased retirees with longer life spans will put additional strains on our country’s debt/income relationship.

One needs to be aware of the increasing number of doomsayers and alarmists who quote projections that are too one-sided and do not paint a fair picture of our challenges ahead. Within the next several years, relatively small changes involving increasing tax rates, lowering government spending, redefining retirement & health benefits, and delaying eligibility of benefits to coincide better with increasing life spans will be necessary to position America into the future.

Related posts:

1. The U.S. National Debt: How Bad is the Problem?
2. Too much debt or not enough demand? A summary of the debate over America’s fiscal future

FT.com / Weekend columnists / Tim Harford – Why a tax cut just isn’t fair on teenagers

Tim Harford, aka The Undercover Economist, loves to expose the overlooked effects of governments’ economic policies. For example, both the United States and the UK have recently announced tax cut and rebate plans aimed at putting hundreds of dollars back into the hands of taxpayers, with the hope that households will spend their “free money” from the government, giving the national economies a much needed boost in a time of economic slowdown.

Expansionary fiscal policy, as such a tax cut is known, is a popular tool in times of macroeconomic slowdowns. The hope, of course, is that taxpayers who experience sudden fiscal relief will rejoice upon their newfound disposable income, spending it on goods and services, creating new income for various sectors of the economy, which in turn will be spent on more goods and services. In economics, we call this the “multiplier effect”, the idea being that a certain tax cut (say $150 billion), will ultimately create some multiple of that amount in new spending and income throughout the economy as a whole.

In reality, however, house holds do not spend 100% of a tax rebate or tax cut like those recently passed in the US and the UK. When disposable income increases, household will spend a certain proportion and save or pay off past debts with the rest. The proportion of new income spent is determined by an individual’s marginal propensity to consume, and the proportion saved is based on his or her marginal propensity to save. The greater proportion of additional income that is spent, the larger the multiplier effect in the economy as a whole, and the greater impact expansionary fiscal policy will have towards achieving growth in the economy.

Policy makers, therefore, prefer households spend, rather than save, new income from a tax cut or rebate. According to the Undercover Economist, however, saving a tax rebate is precisely what smart households will do. Why? Because of the basic economic truth learned in the first week of most principles of economics courses: There’s no such thing as a free lunch! Tim Harford explains:

…since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

A tax rebate financed through government borrowing does not make American or British households any better off. Imagine a scenario where your buddy is experiencing some financial difficulties (maybe he’s lost his job, maybe he’s experienced an expensive injury and has no health insurance…), so you decide you’ll help him out by throwing some cash his way. The catch is, you’re already in debt and have spent more in the last couple of years than your actual income should have allowed. So, in order to help your buddy out, you actually need to borrow money from him. So you give him an IOU, he scrounges up the little cash he can find, gives it to you for the IOU, and you turn around and give it back to him to “help him out.” You can imagine, your buddy is not very thankful and certainly doesn’t feel any richer.

On the macro level, the cash mailed out to American households as part of the recent stimulus package came from new borrowing by the government from American households. All those IOUs issued to finance the stimulus must be paid back, and must be done so through future tax increases. The government has chosen to forgo future spending in order to stimulate current spending. Not everyone should dismay, however, as a certain lucky group will clearly benefit from today’s debt-financed fiscal stimulus packages:

…some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

A tax cut today almost certainly implies a tax increase tomorrow. Since teenagers enjoy almost none of the tax cuts today, but will bear the future increases required to pay back new debt, it is you, my students, who should be most opposed to the shortsighted policies being undertaken by US and UK policy-makers.

Related posts:

1. Does expansionary fiscal policy “pay for itself”?
2. Fiscal policy and the “vicious” business cycle
3. Hunger, poverty and fiscal policy in the United States