The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:
The AD/AS model, on its surface, is a very simple diagram, showing the total, or aggregate demand for a nation’s output and the total, or aggregatesupply of goods and services produces in a nation. It is very similar to the microeconomics supply and demand diagram, except that instead of comparing the quantity of a particular good to the price in the market, the AD/AS model plots the national output (Y) against the average price level (PL). The model shows an inverse relationship between aggregate and price level, and a direct relationship between aggregate supply and price levels.
What makes this seemingly simple model so interesting, however, is that there are two wildly different opinions among economists on one of the its two primary components. Some economists, whom we shall refer to as Keynesians, believe that the AS curve is horizontal whenever aggregate demand decreases, and vertical whenever AD increases beyond the full employment level of output. On the other side of this debate is whom we shall refer to as the Hayekians who believe that AS is vertical, regardless of the level of demand in the nation. The two views of AS can be illustrated as follows.
Underlying the two models above are very different ideas about a nation’s economy. The Keynesian AS curve implies that anything that leads to a fall in a nation’s aggregate demand (either household consumption, investment by firms, government spending or net exports) will cause a relatively mild fall in prices in the economy but a significant decline in the real GDP (or the total output and employment in the nation). The neo-classical AS curve, on the other hand, being vertical (or perfectly inelastic), implies that no matter what happens to AD, the nation’s output and employment will always remain at the full employment level (Yfe).
Behind these two models of AS are two schools of economic thought, one rooted in Keynesian theories and one rooted in the theories of an intellectual rival and contemporary of John Maynard Keynes’, Friedrich Hayek. Keynes and Hayek were the most pre-eminent economists of their era. Both lived in the first half of the 20th century, and rose to prominence in between the two World Wars. Both economists saw the world fall into the Great Depression, but each of them formulated their own distinct theory on the best way to deal with the Depression. The episode of Planet Money below goes into some detail about the lives and the theories of these to most influential economists.
Keynes believed in what we today call demand-management. The idea that through well planned economic policies, governments and central banks could intervene in a nation’s economy during periods of economic downturn to return the economy to its full-employment level, or the level of output the nation would be producing at if everyone who was willing and able to work was actually working. Keynes believed that aggregate demand was the most vital measure of economic activity in a nation, and that through its use of fiscal and monetary policies (changes in the tax rates, the levels of government spending, and the interest rates in the economy), the government and central bank could provide stimulus to a depressed economy and create demand for the nation’s resources that would help move a depressed economy back towards full employment.
Hayek and his disciples, on the other hand (sometimes referred to today as the supply-siders) had a different interpretation of the macroeconomy. Hayek was what many today refer to as a libertarian. He believed that the government’s best strategy for handling an economic downturn was to get out of the way. Any attempt by the government to influence the allocation of resources through “stimulus projects” would only reduce the private sector’s ability to quickly and efficienty correct itself. The free market, argued Hayek, was always superior to the government when it came to allocating resources towards the production of the goods and services consumers demanded, so why allow government to intervene in the economy at all. All a government should do, argued Hayek, was provide a few basic guidelines to allow the economy to function. A legal system of property rights, for instance. The government need not provide anything else. The free market would take care of health care, education, defense, security, infrastructure, and anything else the market demanded.
During depressions, Hayek believed that government could only make things worse by trying to intervene to restore full employment. At any and all times, government’s best action would be to lower taxes, reduce its spending on goods and services, and thereby encourage private entrepreneurs to provide the nation’s households with the output they demand. Any regulation of the private sector, including minimum wages, environmental regulations, workplace safety laws, government pensions, unemployment benefits, welfare payments, or any other measures by government to redistribute wealth or promote equality or social welfare would reduce incentives for individuals in society to achieve their full productivity and strive to maximize their potential output. By minimizing the government’s role in the economy, argued Hayek, a nation would be likely to recover swiftly from a 1930’s style Depression, and output can be maintained at a level that corresponds with full employment of the nation’s resources.
The graphs below show how the two competing ideologies view the effects of a fall in aggregate demand in the economy.
On the left we see the Keynesian model, which shows output (real GDP) falling with a fall in AD. The fall in output corresponds with a fall in employment, and therefore a recession (or Depression). To return to full employment, aggregate demand must move back to the right (or increase). To facilitate this, Keynes and his contemporaries believed that government should increase its spending, decrease taxes (to encourage households and firms to spend) and lower interest rates (to make saving less appealing). All that is needed, say the Keynesians, is a dose of stimulus to get back to full employment (Yfe).
In the Hayekian model, no government intervention is needed at all when aggregate demand falls. In fact, in an economy with very limited government, a fall in AD will have little or no effect on output and employment. Without minimum wages or laws making it difficult or expensive for firms to reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees’ wages and reduce the prices of their products to maintain their output. If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering. Wages and prices are perfectly flexible in the Hayekian view, because there is no government interfering, demanding workers for big government projects, competing wages up, enforcing a minimum wage, or paying unemployment benefits to those out of work: all policies that make it difficult for wages to adjust downwards during a recession. Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level.
The two models could not be more different. In one (Keynes’) recessions will occur anytime demand falls below the level needed to maintain full employment. In the other (Hayek’s), recessions are impossible as long as government gets out (and stays out) of the way.
Which models is the right model? For most of the last 100 years, most Western economies have demonstrated more of the characteristics of the Keynesian model. As the last several years show, recessions certainly are possible. Wages and prices have NOT fallen as much as Hayek’s model suggest they should, and economic output has declined in many Western nations and remains below the levels achieved in 2007 in many places. Most economists would argue that this prolonged recession is likely due to a weak level of aggregate demand. And the economic policies of many Western nations have reflected the Keynesian belief that government can “fix the problem” through stimulus plans involving tax cuts, spending increases, and low interest rates.
But two years of Keynesian policies are now being reversed. US President Obama’s latest attempt at a Keynesian-style stimulus (his $447 billion “American Jobs Act”) has been rejected by the US Congress. Across Europe, government spending is being slashed and taxes are being raised, both policies that threaten to further reduce aggregate demand. Deregulation is the battle cry of the Republican Party in the United States one year before the next presidential election. Presidential candidates are promising to “cut taxes, cut spending and cut government”, which sounds like a Hayekian battle cry. Less government will lead to more competition, greater efficiency, more employment and a stronger economy, goes the thinking. Government cannot solve our problems, government is our problem.
This debate is not a new one. It has been going on since the 1930s when two scholars, one an Englishman from Cambridge, the other an Austrian at the London School of Economics, went toe to toe on the role of government in a nation’s economy. The two models of aggregate supply above survive to this day, and 80 years later, in the midst of what may be the second Great Depression, economists and politicians still haven’t figured out which theory is correct. Part of our problem is that in our Western democracies in which economic policies are determined by politicians who are often only in office for two to four years, we have not had the opportunity to truly put either economic theory to the test. Less than three years ago Barack Obama, freshly elected, embarked on the greatest experiment in Keynesianism since Franklin Roosevelt’s “New Deal”, which was widely credited with getting the US out of the Depression. Now, with another election looming, we have politicians promising to bring America back to economic prosperity in a truly Hayekian fashion, by “cutting, cutting and cutting”.
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!
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?
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?
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?
Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
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?
In my last post, I outlined the consequences of a nation running a persistent deficit in its current account. In the post below, I will share some thoughts on how a nations can reduce its trade deficit by promoting increased competitiveness in the global economy through the use of expansionary supply-side policies. Earlier in the chapter from which this post is taken, I outlined other deficit reduction strategies, including the use of protectionism, currency devaluation and contractionary demand-side fiscal and monetary policies. In my opinion, each of these methods creates more harm than good for a nation, resulting in a misallocation of society’s scarce resources (in the case of protectionism) and negative effects on output and employment (in the case of contractionary demand-side policies)
Therefore, the following presents the “supply-side” strategies for reducing a deficit in a nation’s current account.
From Chapter 22 of my upcoming textbook: Pearson Baccalaureate Economics
Contractionary fiscal and monetary policies will surely reduce overall demand in an economy and thereby help reduce a current account deficit. But the costs of such policies most likely outweigh the benefits, as domestic employment, output and economic growth suffer due to reduced spending on the nation’s goods and services. A better option for governments worried about their trade deficit is to pursue supply-side policies that increase the competitiveness of domestic producers in the global economy.
In the long-run, the best way for a nation to reduce a current account deficit is to allocate its scarce resources towards the economic activities in which it can most effectively compete in the global economy. In an environment of increasingly free trade between nations, countries like the United States and those of Western Europe will inevitably continue to confront structural shifts in their economies that at first seem devastating, but upon closer inspection will prove to be inexorable.
The auto industry in the United States has been forever changed due to competition from Japan. The textile industry in Europe has long passed its apex of production experienced decades past, and the UK consumer will never again buy a television or computer monitor made in the British Isles. The reality is, much of the world’s manufactured goods can be and should be made more cheaply and efficiently in Asia and Latin America than they could ever be produced in the US or Europe.
The question Europe and the United States should be asking, therefore, is not “how can we get back what we have lost and restore balance in our current account”, but, “what can we provide the world with that no one else can?” By focusing their resources towards providing the goods and services that no Asian or Latin American competitor is capable of providing, the deficit countries of the world should be able to reduce their current account deficits and at the same time stimulate aggregate demand at home, while increasing the productivity of the nation’s resources and promoting long-run economic growth.
Sure, you say, that all sounds great, but how can they achieve this? This is where supply-side policies come in. Smart supply-side policies mean more than tax cuts for corporations and subsidies to domestic producers. Smart supply-side policies that will promote more balanced global trade and long-run economic growth include:
Investments in education and health care: Nothing makes a nation more competitive in the global economy than a highly educated and healthy work force. Exports from Europe and the US will lie ever increasingly in the high skilled service sector and less and less in the manufacturing sector; therefore, highly educated and skilled workers are needed for future economic growth and global competitiveness, particularly in scientific fields such as engineering, medicine, finance, economics and business.
Public funding for scientific research and development: Exports from the US and Europe have increasingly depended on scientific innovation new technologies. Copyright and patent protection assure that scientific breakthroughs achieved in one country will allow for a period of time over which only that country will enjoy the sales of exports in the new field. Green energy, nano-technology, bio-medical research; these are the field that require sustained commitments from the government sector for dependable funding.
Investments in modern transportation and communication infrastructure: To remain competitive in the global economy, the countries of Europe and North America must assure that domestic firms have at their disposal the most modern and efficient transportation and communication infrastructure available. High speed rail, well-maintained inter-state or international highways, modern port facilities, high-speed internet and telecommunications; these investments allow for lower costs of production and more productive capital and labor, making countries goods more competitive in the global marketplace.
Reducing a current account deficit will have many benefits for a nation like the United States, Spain, the UK or Australia. A stronger currency will assure price stability, low interest rates will allow for economic growth, and perhaps most importantly, less taxpayer money will have to be paid in interest to foreign creditors. Governments and central banks may go about reducing a current account deficit in many ways: exchange rate controls, protectionism, contractionary monetary and fiscal policies, or supply-side policies may all be implemented to restore balance in the current account. Only one of these options will promote long-run economic growth and increase the efficiency with which a nation employs its scarce factors of production.
Supply-side policies are clearly the most efficient and economically justifiable method for correcting a current account deficit. Unfortunately, they are also the least politically popular, since the benefits of such policies are not realized in the short-run, but take years, maybe decades, to accrue. For this reason, we see time and time again governments turning to protectionism in response to rising trade deficits.
The following is an excerpt from Chapter 22 – “Balance of Payments” of my soon to be published textbook “Pearson Baccalaureate Economics”
If the total spending by a nation’s residents on goods and services imported from the rest of the world exceeds the revenues earned by the nation’s producers from the sale of exports to the rest of the world, the nation is likely experiencing a current account deficit. The situation is not at all uncommon among many of the world’s trading nations. The map belowmap represents nations by their cumulative current account balances over the years 1980-2008. The red countries all accumulated current account deficits over the three decades, with the largest by far being the United States with a cumulative deficit of $7.3 trillion. The green countries are ones which have had a cumulative surplus in their current accounts, the largest surplus belonging to Japan at $2.7 trillion, followed by China at $1.5 trillion.
The top ten current account deficit nations are represented below. It is obvious from this chart that the United States alone accounts for a larger current account deficit then the next nine countries combined. At $7.3 trillion dollars in deficits over 28 years, the US deficit surpasses Spain’s (at number 2) by 1,000 percent.
The consequences of a nation having a current account deficit are not immediately clear. It should be pointed out that it is debatable whether a trade deficit is necessarily a bad thing, in fact. Below we will examine some of the facts about current account deficits, and we will conclude by evaluating the pros and cons for countries that run deficits in the short-run and in the long-run.
Implications of persistent current account deficits: When a country like like those above experience deficits in the current account for year after year, there are some predictable consequences that may have adverse effects on the nation’s macroeconomy. These include currency depreciation, foreign ownership of domestic assets, higher interest rates and foreign indebtedness.
The effect of a current account deficit on the exchange rate: In the previous chapter you learned about the determinants of the exchange rate of a nation’s currency relative to another currency. One of the primary determinants of a currency’s exchange rate is the demand for the nation’s exports relative to the demand for imports from other countries. With this in mind, we can examine the likely effects of a current account deficit on a nation’s currency’s exchange rate. Additionally, we will see that under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.
When households and firms in one nation demand more of other countries’ output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners’ currencies and downward pressure on the importing nation’s currency. In this way, a movement towards a current account deficit should cause the deficit country’s currency to weaken.
As an illustration, say that New Zealand’s imports from Japan begin to rise due to rising incomes in New Zealand and the corresponding increase in demand for imports. Assuming Japan’s demand for New Zealand’s output does not change, New Zealand will move towards a deficit in its current account and Japan towards a surplus. In the foreign exchange market, demand for Japanese yen will rise while the supply of NZ$ in Japan increases, as seen above, depreciating the NZ$.
The downward pressure on exchange rates resulting from an increase in a nation’s current account deficit should have a self-correcting effect on the trade imbalance. As the NZ$ weakens relative to its trading partners’ currencies, consumers in New Zealand will start to find imports more and more expensive, while consumers abroad will, over time, begin to find products from New Zealand cheaper. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account. The persistence of global trade imbalances illustrated in the map above is evidence that in reality, the ability of flexible exchange rates to maintain balance in nations’ current accounts is quite limited.
Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad ends up in the does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations’ central banks.
Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation’s currency.
The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained above, a current account deficit can put downward pressure on a nation’s exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country’s central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country’s government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.
Side note: While the interest rate effect of a large current account deficit should be negative (i.e. causing interest rates to rise in the deficit country), in recent years the country with the largest trade deficit, the United States, has actually experienced record low interest rates even while maintaining persistent current account deficits. This can be understood by examining by the macroeconomic conditions of the US and global economies, in which deflation posed a greater threat than inflation over the years 2008-2010. The fear of deflation combined with low confidence in the private sector among international investors has kept demand for US government bonds high even as the US trade deficit has grown, allowing the US government and central bank to keep interest rates low and continue to attract foreign investors.
Whereas under “normal” macroeconomic conditions a build up of US dollars among America’s trading partners would require the US to raise interest rates to create an incentive for foreign investors to re-invest that money into the US economy, in the environment of uncertainty and low confidence in the private sector that has prevailed over the last several years, America’s trading partners have been willing to finance its current account deficit at record low interest rates.
The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. For instance, as of August 2010, the Chinese central bank held $868 billion of United States Treasury Securities (government bonds) on its balance sheet. In total, the amount of US debt owned by foreign nations in 2010 was $4.2 trillion, or around 50% of the country’s total national debt and 30% of its GDP.source: http://www.ustreas.gov/tic/mfh.txt
On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country’s government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.
The opportunity cost of foreign owned national debt is the public goods and services that could have been provided with the money that instead is owed in interest to foreign creditors. If the US current account were more balanced, foreign countries like China would not have the massive reserves of US dollars to invest in government debt in the first place, and the taxpayer money going to pay interest on this debt could instead be invested in the domestic economy to promote economic growth and development.
Why would a large current account deficit cause a nation’s currency to depreciate? How could a weaker currency automatically reduce a nation’s current account deficit?
Why should governments be concerned about a large trade deficit? What is one policy a government could implement to reduce a deficit in the current account?
Would a nation with a large trade deficit be better off without trade at all? Why or why not?
Discuss the validity of the following claim: “Americans buy tons of Chinese imports, but the Chinese don’t buy anything from America, this is why the US has such a huge trade deficit with China”. To what extent is this claim true or false?
As the United States enters its mid-term election period, one of the major issues being discussed in Washington D.C. is whether or not the “Bush Tax Cuts” of 2001 and 2003 should be extended. In essence, the tax cuts under the previous president lowered America’s marginal tax rates at all income brackets. From the Wikipedia article on the “Bush tax cuts”:
a new 10% bracket was created for single filers with taxable income up to $6,000, joint filers up to $12,000, and heads of households up to $10,000.
the 15% bracket’s lower threshold was indexed to the new 10% bracket
the 28% bracket would be lowered to 25% by 2006.
the 31% bracket would be lowered to 28% by 2006
the 36% bracket would be lowered to 33% by 2006
the 39.6% bracket would be lowered to 35% by 2006
To be clear, the White House and president Obama do not want to repeal all of the tax cuts above, only those enjoyed by those in the highest income bracket. The 35% marginal tax rate only applies to households earning above $250,000 in the United States. This bracket includes less than 2% of American households. So what Obama wants to do is raise the marginal tax rate by 4% on income earned above and beyond $250,000. Only a couple of million Americans will be affected by this tax increase, while more than 98% of American households will experience no increase in income taxes.
The backlash against Obama has been fierce. The main argument against raising taxes on the richest Americans comes from the Republican party, who argue that higher taxes on the rich will decrease the incentive for workers to produce more output and increase productivity to earn higher incomes. In addition, say the Republicans, it is the rich who are the investors, the capitalists, the firm owners in an economy. Increasing income taxes on the rich will decrease their incentive to invest and thus decrease the overall demand for labor in the nation, leading to lower overall levels of employment and national output. This supply-side argument claims that higher taxes may in fact lead to less taxable income, thus lower tax revenues for the government.
The Economist’s Free Exchange Blog wrote a piece last year on supply-side economics and the Laffer Curve, a popular graphic used by the supply-side to argue against increases in taxes.
“The basic reasoning behind the so-called “Laffer curve” is plain, uncontroversial, and by no means was discovered by Arthur Laffer. There is nothing to tax if no one produces anything. But taxes affect the return and therefore the motive to supply labour to economic production. An increase in the tax rate can reduce the pool of wealth to tax — the tax base — by reducing the supply of labour. No taxes, no revenue. Also, 100 percent tax rates, no revenue. Somewhere in between — exactly where depends on, among other things, the responsiveness of labour supply to after-tax wages — there will be a point at which an increase in rates delivers a decrease in revenue. If the tax rate is already past that point, a tax cut delivers more revenue.
…labour supply is just one of many ways in which an increase in tax rates may reduce the effective tax base. In addition to working less, individuals may alter their savings and investment patterns, bargain to shift more of their labour compensation to untaxable perks and benefits, move to a different tax jurisdiction, consume more tax-deductible goods, or simply hide income from the tax authorities.”
As Laffer’s model shows, at certain tax rates, a tax cut will lead to an increase in tax revenue. So how can policy makers be sure whether the United States is currently at a point on its Laffer curve that an increase in taxes won’t result in a decrease in tax revenue?
“Supply-siders” who oppose Obama’s plan to repeal the tax cut, and even argue further tax cuts would benefit the US economy, need to look more carefully at where America is on the Laffer curve.
Republican politicians of late have exhibited a dismaying lack of respect for basic science, and it is not much of a surprise that many are also cavalier about fiscal economics. At current tax rates, new cuts will not “pay for themselves” in the short run. Emphasizing this point, however, does not begin to imply that raising tax rates is smart or harmless.
Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.
On the other hand…
…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.
So do tax cuts “pay for themselves” as some politicians in the United States have argued in opposition to Obama’s desire to let Bush’s tax cuts expire?
Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.
So it’s possible that keeping taxes lower may indeed lead to higher growth and more taxable income down the road in the United States. But all the above analysis neglects to take into account one other VERY important consideration that the US government must consider at this point in time. In a year in which several European nations, most notably Greece, have encountered debt crises, the need to generate tax revenues to finance government spending is as important as ever.
Ironically, some of the same people who oppose ending the Bush tax cuts on the rich also oppose deficit financed fiscal stimulus. People like Niall Ferguson argue that continued deficits threaten to “bring down the US bond market” as foreign and domestic investors lose faith in the US government’s ability to pay off its ever growing national debt. These “deficit hawks” argue that the US should take drastic steps to balance its federal budget, much as several European governments have begun to do, to reduce the likelihood that investors will begin demand higher interest rates for investing in government bonds, which in turn could drive up interest rates for the private sector, crowding out private investment and plunging the US economy into another recession.
The tradeoff may come down to this. Higher taxes now, or higher interest rates AND higher taxes in the future. Raising taxes on the rich now will allow the US to achieve a more balanced budget in the future. This means less government borrowing, less government debt, and lower interest rates on government bonds and in the private sector. It also means that there will be less debt to pay interest on, which makes debt repayment (currently almost 10% of the government’s non-discretionary budget), less of a burden in the future. A more balanced budget now (achievable if we repeal the tax cuts for the riches Americans) means less debt in the future, lower taxes in the future, and lower interest rates in the future.
I’ve always said that humans are short-run creatures living in a long-run world. I think Americans epitomize this reality. American voters can always be convinced to vote against new taxes, or vote for the guy who promises to lower their taxes. But in this case, over 98% of Americans will not even be affected in the short-run, however in the long-run the majority stands to gain from tax increases on the rich in the form of less debt to be repaid and more private investment as government borrowing and the resulting crowding-out of interest sensitive spending by the private sector is reduced.
By the way, one of the most prominent supply-side economists of the last half century agrees with me on this one. Here’s former Chairman of the Federal Reserve Alan Greenspan arguing for a repeal of the Bush tax cuts:
Under what circumstances would a tax increase harm not only workers and firms, but reduce government tax revenue as well?
What would a Keynesian say about the wisdom of raising taxes at a time when unemployment is as high as it is in the United States right now?
How does achieving a more balanced budget now assure that Americans will have to pay less in taxes in the future?
Do you believe that asking the riches Americans to pay 4% more in marginal taxes now will lead to more unemployment in America? Why or why not?