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:

• Price level stability
• Full employment, and
• Economic growth

source: http://www.beaumontenterprise.com/

 

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?

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.

source: http://en.wikipedia.org/wiki/File:Cumulative_Current_Account_Balance.png

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.

Discussion Questions:

1. 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?
2. 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?
3. Would a nation with a large trade deficit be better off without trade at all? Why or why not?
4. 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?

Also posted at economic and eLearning – digging a little deeper

The Danish people are a notably generous and happy group of people and for many years they have had the most extensive welfare system in the world. Danish citizens pay nearly 50% income tax, which allows its citizens to enjoy a high quality of life, free education, healthcare and lavish unemployment benefits.

Since the Global Financial Crisis in late 2008 unemployment in Denmark has more than doubled from 1.7% to 4.2% now. This is still far below levels in other parts of Europe, such as Spain with 19% unemployment. The Danish government is however evaluating the level the unemployment benefits, as the government budget tightens. An unemployed worker in Denmark is entitled to an unemployment benefit which is between 70-90% of their prior salary. Currently they can receive this compensation for up to four years.

High unemployment puts two specific strains on the governments budget during a recession. There are decreased tax receipts as workers are forced out of work, but at the same time expenditure on transfer payments to the unemployed workers will simultaneously increase. Therefore a swift rise in unemployment in the recent recession, lead to some governments such as the United Kingdom falling into a deep budget deficit very quickly. The opposite effect occurs in an economic boom where transfer payments fall and tax revenue increase, leading to a swelling of the budget surplus.

Policy makers in Denmark are therefore planning to trim the generous safety net provided to its workers,

Having found that recipients either get work right away or take any job as their checks run out, officials are also redoubling longstanding efforts to move Danes more quickly out of the safety net.

“The cold fact is that the longer you are out of a job, the more difficult it is to get a job,” Claus Hjort Frederiksen, the Danish finance minister, said during an interview. “Four years of unemployment is a luxury we can no longer allow ourselves.”

New York Times – Liz Alderman – 16th August 2010

Statistics from Denmark show that in the Global Financial Crisis of late 2008, 100,000 Danish people were registered as unemployed. Approximately 62% of these people found another job within two months, and only 6% of these people had been unemployed for longer than two years. This highlights the fact that Denmark has a very flexible labour market. Meaning in simple terms, that workers can freely move between jobs, and can be hired and fired more easily than in comparable European nations such as Germany or Sweden. The flexibility and security of the Danish system is nicknamed “flexicurity”. The following comments highlight the elements of the flexicurity culture.

“It’s no surprise the government is saying that programs that are highly expensive and give a Rolls-Royce treatment to citizens have to be trimmed,” said Iain Begg, a professor at the London School of Economics. “So the search will now be on for labor market policies that deliver more people in work with less money, which has an inevitable air of the holy grail about it.”

In Denmark, employers have carte blanche to hire and fire, and in most cases laid-off people are guaranteed about 80 percent of their wages in benefits, a figure capped for high earners. In turn, they must participate in retraining and job placement programs tailored to get them back to work, which the government has intensified.

Each year, a remarkable 30 percent of Danes change jobs, knowing the system will allow them to pay rent and buy food so they can focus on landing a new position. About 80 percent belong to unions, which manage the workplace, help run the unemployment insurance program and press the laid-off into retraining.

New York Times – Liz Alderman – 16th August 2010

If 30% of workers are willing to change jobs each year, this would have a positive effect on the economy. This proportion is high because workers are not scared into becoming unemployed and poor. Some like myself, would consider the opportunity cost of receiving 80% of my previous wage and an unemployed holiday a great trade off. Of course, workers also consider issues such as social dislocation, loss of skills in the decision making process and are therefore keen to get back into work as quickly as possible.

Within Denmark and the flexicurity system; it would suggest that workers are prepared to accept new challenges and develop skills that are required in new jobs. This also opens up jobs to younger graduates each year. During a recession the same system allows firms to reduce thier demand for labour quickly and to restructure the business to the new economic climate. The supporting welfare structures in Denmark which help unemployed people with training and job applications is an important spoke in the system. These elements are considered labour market supply side policies.

Discussion Questions:

1. Describe the concept of “social safety nets”
2. If the Danish government continued to allow up to four years unemployment benefit, what could be the potential impacts on the Supply of Labour within Denmark?
3. Describe why Denmark has the one of the lowest Gini Coefficient scores in the world (0.29, CIA Factbook 2007)
4. How does labour flexibility or the Danish system of flexicurity, improve economic growth?
5. Evaluate the relative merits of Denmark having one of the highest income tax rates in the world.

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.

In a separate piece on the Economist’s blog, the relationship between tax rates and long-run economic growth is further analyzed.  The blog presents the main point of the supply-side argument:

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:

Discussion questions:

1. Under what circumstances would a tax increase harm not only workers and firms, but reduce government tax revenue as well?
2. 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?
3. How does achieving a more balanced budget now assure that Americans will have to pay less in taxes in the future?
4. 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?

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

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.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

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.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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Over a year has gone by since the 2009 American Recovery and Reinvestment Act (ARRA) was passed and put into action by the Obama Administration. Supporters of the program say that it has been successful, arguing that the economy would be in much worse shape if no stimulus had been introduced at all. In fact, some are arguing that government spending has not been sufficient for a full economic recovery and that more direct government spending is necessary. Economists on the other side argue that the stimulus package has done little for the economy except to delay the inevitable, self correcting forces of the economy needed to pave the road back to recovery. Some actually say that we are in a worse situation now due to the massive increase in government debt which will eventually have to be paid back.

So the question is, are we better off as an economy a year after the stimulus package was introduced? With growth still sluggish and unemployment at 9.5%, many people have begun to question the success of the ARRA. Again, some say the $784 billion was insufficient while others say less regulation and more tax cuts should have been utilized.

In a recent Washington Post article, Neil Irwin argues that the obstacles towards economic growth may not be solved by more stimulus, lower interest rates or tax cuts for corporations. The problem, he claims, is not a lack of funds for investment, but in the uncertainty businesses have in future conditions. He writes:

Corporate profits are soaring. Companies are sitting on billions of dollars of cash. And still, they’ve yet to amp up hiring or make major investments — the missing ingredients for a strong economic recovery. Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side’s assessment fits.

They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of almost unbroken prosperity of the quarter-century that preceded the financial crisis.

With consumers choosing to save or pay off their debts now rather than spend, many businesses find it in their interest to hold off on investments into new capital until consumers begin spending again. With no planned investment and no incentive to hire workers, unemployment stays high and economic growth remains stagnant. With inflation rates low and economists predicting deflation, it makes more sense to hold onto money as it is not losing its value.

So is there a solution? In this situation, expansionary monetary policy through lower interest rates will not have the desired effect as demand for loanable funds is low. As stated in the article:

For large companies such as Illinois Tool Works, the price of borrowed money isn’t the problem. The company had $1.3 billion in cash on its balance sheet at the end of June, up from $743 million at the end of 2008. Lower interest rates wouldn’t make much of a difference, either.

“I could borrow $2 billion tomorrow for 3 1/2 percent,” said Speer. “But what am I going to do with it?””

Other executives claim that an increase in government spending would only provide a temporary fix but have no effect on long term consumer spending.

David Speer is chief executive of the company, which has 60,000 employees worldwide in more than 800 business units and $14 billion in sales. He said an additional burst of fiscal stimulus from Washington might help boost economic growth for a period of months. But that is unlikely to affect his decisions about hiring and expansion, which Speer said are based on expectations for sales over years to come, not just the immediate future. As long as U.S. consumers remain deeply strained, he is unlikely to undertake aggressive expansion.

More fiscal stimulus “might help make things a little better for a couple of quarters, but I’m not sure it would get at the underlying economic issue,” Speer said. “The core question is: How do you get consumers back on their feet. We need growth in a sustainable way, not another Band-Aid.”

Another solution would be for the government to implement supply side measures such as less market regulation and lower corporate taxes. Again, without the much needed consumer spending and confidence, its difficult to say whether or not this will materialize into increased investment and employment.

The rest of the Washington Post article can be read here. Once you’ve read the article, answer discuss the questions below and share your thoughts in a comment on this post.

Discussion Questions:

Dear year 2 IB Economics students,

Welcome back and I hope you enjoyed your time off. Before breaking for summer we were in the midst of our unit on Macroeconomics, just beginning our debate on whether or not government intervention in the economy in order to kick start activity during a deep recession was a good or bad idea. In other words, would the economy correct itself or would government stimulus be necessary to get our economy moving again.

As you all know, exactly a year and a half ago, the US government decided that in order to a avoid a recession as potentially devastating as the Great Depression of the 1930’s, government interaction into the economy was necessary. 787 billion dollars was put aside for government sponsored projects, transfer payments and decreases in taxes. The hope was that this spending would not only help people maintain their current jobs but also create jobs for those who had recently become unemployed. A year and a half later, proponents of the stimulus package, Keynsians if you will, believe that this great experiment has been a success and that if nothing had been done the economy would be in much worse shape. Opponents of the spending believe that the bill has simply postponed the self correcting forces in the economy and has instead created what economists call a double dip recession where the increase in government spending only creates a temporary, unsustainable increase in economic activity. In fact many of these opponents say that we are worse off now as the government is now further in debt due to the spending.

Has the great experiment thought up by John Maynard Keynes over half a century ago been a success or was it a solution that has caused more harm than good, potentially making the recession worse than it would have been? The radio show Plant Money recently dedicated a show to addressing this very issue. In order to get a balanced look, they interviewed two prominent economists, Tyler Cowen, a Professor of Economics at George Mason University and Mark Zandi, Chief Economist at Moody’s Analytics. Cowen, a skeptic of Keynesian spending, believes that we would now be better off if the government had not intervened in the economy. Zandi, on the other hand, is adamant that the US economy would be much worse off if the government had done nothing. Two economists analyzing similar data and coming up with very different conclusions. This is where economics becomes both complex and fascinating.

Click play on the podcast player below, listen to the whole podcast, and then answer the following questions.

The Great Stimulus Experiment - NPR Planet Money [ 0:01 ] Play Now | Play in Popup | Download (9)

Discussion Questions:

1. How does an economy “self correct” itself once it has entered a recession?
2. What are the arguments put forth by Tyler Cowen and Mark Zandy about the effectiveness of government stimulus? Is one more convincing than the other? Why?
3. What are automatic stabilizers and why does Tyler Cowen believe they are better solutions than the government creating new jobs?
4. According to Tyler Cowen, why is it dangerous for economists to become “wed to only one theory”?
5. What does this podcast teach you about the importance of being able to evaluate economic theory and its effectiveness? Can we ever have an economic theory that is true under any circumstances? Why or why not?