Nationalism, the U.S. debt, and the "party of business"

I've been avoiding writing anything about the whole debt ceiling situation, because it just depresses me too much...not just because a U.S. default/downgrade will have a seriously negative impact on my upcoming job search, but because it represents the final nail in the coffin of American exceptionalism, and I am a very strong nationalist.

At this point, it matters a bit, but only a bit, whether a deal is cobbled together, whether Obama uses the constitutional option, or whether we mint a bunch of huge platinum coins. Much of the real damage has, it seems to me, already been done. The interest rates at which a nation can borrow are an inverse function of the strength of bond investors' belief that the nation will pay the money back. And the events of this debt ceiling crisis have brought new information to light that will deeply shake investors' belief in the creditworthiness of the U.S. government.

In particular, one piece of information is crucial above all others. This is the fact that the Republican Party is willing to seriously entertain the option of a sovereign default.

Before this crisis, it seems to me that most people believed the Republican Party to be the "party of business" - that is, that corporations and businesspeople held ultimate sway over the party's decisions. Whatever happens with the debt ceiling, it is now clear, as Brad DeLong points out, that the GOP is not the "party of business." They are the party of Someone Else (more on this later).

This fact is not precisely "new information." There were many, many warning signs. Most recently, there was the rebellion of the House Republicans against the TARP bailout. Before that, there were the massive deficits run up by the Bush 2 and Reagan administrations - deficits that the Nixon or Eisenhower (or Coolidge, or Harding, or Hoover) administrations would never have contemplated. Yet despite these troubling signs, a bedrock belief in the "party of business" label persisted. Conservatives and liberals alike believed that Republican tax cuts were rewarding today's rich people rather than penalizing tomorrow's rich people.

Now that people are finally starting to question the political priorities of the Republican Party, the U.S. Treasury market, and a bunch of other markets that use the Treasury as the risk-free benchmark, are going to be disrupted, platinum coins or no platinum coins. Whether we default this week or in five or ten years, the bond markets now know that it will be the GOP that pulls the trigger.

Without patting myself on the back, I have to say that I always strongly suspected that the Republicans were not the "party of business." This is not because of any knowledge of political theory on my part, but because I grew up in College Station, Texas, one of America's most conservative towns (and the home of Texas A&M, which is sort of a feeder school for the Republican Party). College Station has a few businesspeople, but they tend to be pretty moderate. The real movers and shakers in local politics are "social conservatives."

This has national-level implications. Social conservatives dominate the South, and the South dominates the GOP. Since 1992, the Republicans have won 21 percent of the electoral votes outside of the South. You heard that right: one fifth. The GOP lives and dies not by the campaign contributions of CEOs and investment bankers, but by the votes of Southern white middle- and working-class social conservatives. This is a fact that the world, and bond markets, are just now beginning to understand.

I haven't looked at the names of the House Republican rebels who are blocking John Boehner's attempts to cut a deal on the debt ceiling, but I:m willing to bet dinner that they are even more Southern than the GOP as a whole. I have some evidence to this effect, so you probably shouldn't take the bet.

And this is why we have a debt crisis.

Which leaves one big question: Why are Southern white middle- and working-class social conservatives so eager to embrace a debt default? The effects on the real economy of a U.S. debt downgrade would hit every Southerner in the pocketbook. I suppose this is generally the case in debt default situations - the same working-class populists who think a default represents "free money" end up being the people who lose their jobs. But usually this only happens in poor countries with sclerotic political systems - Latin America, etc.

It seems to me - and this part is a guess and a supposition - that white Southern conservatives just don't have a lot of nationalism - at least, not for the nation they currently inhabit. They seem to feel, instinctively, that the United States of America is only "their country" when one of their own is in power. As soon as a liberal takes office, off come the U.S. flag bumper stickers, and on go the Confederate flag bumper stickers. When Southern white conservatives talk about the "real America," or cry "I want my America back!", my instinct says that they are talking about an America that the United States has never been - a white racial nation. That America did exist, briefly, before it got stomped by the United States. But its flag still flies, and now it is getting its revenge.

Like I said...just a hunch. But do you have a better explanation why 60 house Republicans are dead-set on ending America's status as the center of the global economy?

Special Limits in Your Homeowner Policy

Your homeowners insurance policy places limits on certain types of property. In your policy there is a section titled “Special Limits on Certain Property.” This section will list various items and place a dollar limit on each type of property- such as jewelry, fine arts, guns or money.

Why do insurance policies contain such provisions? The homeowners insurance policy is written to provide coverage for the average policy holder. Most of us do not own collections or keep large amounts of cash at our homes. While the policy provides some limited coverage for special types of property, it in no way serves the needs of the unique collector.

There is, however, a solution for the collector or owner of unusual property items. It is possible to amend your homeowners policy, by endorsement, to provide special coverage for unique collection items such as coins or stamps. By asking your agent to include a schedule property floater in your coverage, you can specifically insure items of special interest. The personal property floater also expands coverage for perils not included in the homeowner policy.

Our 100th Blog Post!

We have now reached 100 posts on the Fey Insurance Services blog. Over the past few years we have posted about a variety of insurance and risk management topics. We have helped to educate businesses and individuals on how to best protect their hard earned assets such as their home, cars, and businesses. We have also give tips on how to stay safe in an ever changing world including tips on online identity safety and how to best prepare your home for the winter months.

Our hope is that you have enjoyed the 99 other posts and found some information that was helpful in each one. For the years to come we will continue to add helpful content so that our clients and readers can enjoy a safe and protected life.

Why Japanese government bond yields are so low

 

 Paul Krugman poses a puzzle:

A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.

I ask this because in a number of ways the two countries look similar. Both have high debt levels, although Japan’s is higher. Both have awful demography. In other respects, the numbers if anything favor Italy, which has a much smaller current deficit as a percentage of GDP.

I don't really know anything about Italy, but I do know a bit about Japan, and today I asked several Japanese economists why Japanese government bond yields are so low when Japanese government debt is so high. Their answers were pretty much in agreement.

It comes down to three things: 1) financial repression, 2) home bias, and 3) dysfunctional equity markets.

Although many of Japan's legendary bureaucratic ministries have dramatically weakened in power and prestige since the 1980s, the Ministry of Finance (MOF) is still extremely powerful. Japan's financial system, like many financial systems in Asia, is dominated by large banks. In order to finance the government's huge deficits, the MOF puts pressure on the big banks to buy lots and lots and lots of Japanese government bonds (JGBs). 

This holds JGB interest rates down to very low levels. It also reduces deposit rates on Japanese households' savings accounts to zero, since the big banks need to maintain their spreads. So households see JGBs as fairly attractive investments compared to savings accounts. This is less of a factor these days, since Japanese net household saving is actually quite low now, but one professor I spoke with told me that households have apparently been shifting money from savings accounts to bonds.  

This is the same kind of financial repression that Michael Pettis has talked about with regards to China. Ultra-low interest rates on household savings act as a stealth tax on households. In China this stealth tax has apparently been used to pay off non-performing loans at big banks; in Japan, it is going to fund government spending. 

Of course, in China, the government can dictate the return on household savings because China has capital controls. Japan does not. So why don't Japanese households (and pension funds, another big purchaser of JGBs) simply defect and purchase foreign assets? Apparently, home bias is a big part of it. Japanese investors are scared of exchange rate risk; only recently have companies began offering households global index funds matched with currency swaps in order to limit this risk. Also, xenophobia appears to play a role as well; Japanese investors still tend to see foreign assets as inherently risky, ignoring the fact that diversification can dramatically lower that risk.

What about the Japanese domestic stock market? The experience since the bubble and crash in the 80s have convinced many Japanese investors that stocks go down in the long run, not up (as Americans tend to believe). And though no one I talked to mentioned this, I suspect that continued prevalence of cross-shareholdings and all-insider boards of directors have convinced investors that Japanese stock markets are institutionally dysfunctional, and hence a bad bet. I can't say I really disagree.

So I think that solves the Japan part of the puzzle. Bureaucratic power over a bank-centric financial system, enabled by home bias, allows the government to hold down its borrowing costs at the expense of households. As for Italy, though I don't know anything about it, I suspect that it has a far more "normal" financial system.

As a final note, it seems to me that the Japanese government's success in holding down its borrowing costs has probably had big negative effects on the economy. Banks that are forced to buy JGBs can't lend as much to firms, which seems like it would depresses economic activity, holds down growth, and probably contribute to deflation via suppressed wages. Households have been squeezed and squeezed by falling incomes until their savings rates have gone negative, yet they are still earning nothing on their savings. As a result, households are dead set against tax hikes to close the budget deficit, but politically powerful farmers and construction companies won't allow spending to fall either. It's hard to see how this vicious cycle will be broken, until Japan is forced to default from the sheer weight of interest payments. That would be the biggest and most catastrophic sovereign default in world history, unless of course the U.S. manages to pull one off first.

Update: A friend at the Ministry of Finance points out that much of the pressure on banks to buy JGBs is regulatory rather than informal. Banks are required by law to keep a certain amount of their capital in "safe assets," which in practice means JGBs only. Foreign-country bonds do not count, even if exchange rate risk is hedged via currency swaps. He also told me that much of the demand for JGBs is expected to come from small and regional banks in the near future, while big banks are hedging their bets by shifting into shorter-term JGBs.

Business Income

Calculating the appropriate business income limit does not have to be a mind-numbing process. To understand business income coverage limits, you must simply understand that the coverage is almost entirely based on time. The amount of coverage and the correct coinsurance amount can be calculated once a reasonable estimation of the time necessary to return to full operational capability is determined.

Four Key Objectives must be accomplished as quickly as reasonably possible:

1) Rebuild the building, or find a move to an alternate permanent location.
2) Find, purchase, and have operational, replacement machinery and equipment.
3) Replace and/or replenish stock (raw materials for manufacturing operations).
4) Return operations to the same level existing just prior to the loss.

Business Income’s Necessity

According to the Federal Emergency Management Agency (FEMA), there is a structure fire ever 4.5 minutes. Approximately 25 percent of businesses never reopen after a shutdown of just 30 or more days, according to the insurance industry. When you include the number of business failures within five years that are directly traceable to the same kind of claim, the number could approach 40 percent.

Business closings as a result of natural disasters also reach 25percent. The U.S. Small Business Administration reports that more than 90 percent of small businesses fail within two years after being struck by a disaster. Combining these two pieces of statistical data, losses can lead to the closure of thousands of business in any given year due to an interruption in operations.

The Calculation

Once total revenues and the total amount of non-continuing expenses (production-related expenses that do not continue during the interruption) is known and applied to an honest worst-case scenario estimate of the time necessary to resume operations, the correct coinsurance percentage can be calculated. Coinsurance percentages, in 10 percent increments, can be from 50 percent to 100 percent- each representing a proportion of one year (50 percent equals six months; 60 percent equals 7.2 months; 100 percent equals 12 months). It is also sometimes possible to obtain a 15-month business-interruption period at a corresponding coinsurance limit of 125 percent.

The Reality

Most businesses that close and never reopen after a catastrophic closure (30 days or more), don’t close because of the lack of building and business personal property coverage. They close because there is no money coming in the door. Few businesses can remain viable without a source of income. Many business expenses continue even during the period of temporary closing.

Obviously, the optimal goal is to have the building, contents and business income all properly insured. Ultimately, only the business can provide these figures, but this simple approach can make this exercise much easier. Once you accept the reality that loss of income is as important to the insure as insuring your property, we can help guide you to the proper coverage to further protect your business.

A real Laffer

One more short note on John Cochrane's paper. In my last post I talked a bit about "dynamic Laffer effects," and claimed that they didn't make sense in a historical context. But I wanted to point out that they make even less sense in a theoretical context.

A "dynamic Laffer effect" is a permanent effect of tax rates on growth rates. John Cochrane illustrates the idea with this equation:

PV is tax revenues, Y is GDP, g is the long-term growth rate of GDP, t is the tax rate, and r is the interest rate.

The third term on the right hand side represents the permanent effect on growth rates of a change in tax rates. Cochrane asserts that this term is negative, and suggests a value of "only" -0.02 for the derivative dg/dlog(t).

Sounds small and insignificant, right? It makes sense that taxes have some negative effect, however small, on the rate of growth, right?

Except it doesn't make sense. If taxes change the long-term growth rate, then tiny differences in tax rates between countries will, over a long enough time scale, cause countries' incomes to diverge. A country with a 10.01% tax rate will eventually become infinitely richer than a country with a 10% tax rate.

But you don't need to invoke infinity to see how silly this is. Here's a numerical example. The United States takes in about 27% of our GDP in tax revenue. Using Cochrane's numbers, a country that took in only 6% of its GDP in tax revenue would - all else being equal - grow about 3% per year faster than us, year after year. In a mere 24 years, that country would be twice as rich as us. After a century, they would be 19 times as rich as us. That's about the same as the current disparity between us and sub-Saharan Africa.

In other words, dynamic Laffer effects can't exist, because, as a physics prof of mine liked to say, "then the Universe would explode." Tiny differences in tax rates among rich nations would eventually add up to massive differences in wealth, and we'd see exponential divergence instead of the convergence that we see in the real world. The nonexistence of dynamic Laffer effects is a stability condition of growth theory.

And yet the existence of these Universe-exploding effects is absolutely central and crucial to conservative policy ideas.

The sum of all right-wing assumptions

 

Dang you, Matt Yglesias! If I don’t get my dissertation done on time, it’s all your fault!

I am referring to this post, in which Matt points out a paper by John Cochrane of the University of Chicago:

Cochrane argues that...not only is it plausible to think that runaway inflation is right around the corner even though there’s no evidence of elevated inflation expectations, he argues that runaway inflation is likely to be sparked by tax increases and can best be combatted by gutting Social Security and Medicare. 

Here’s a slice from the conclusion of his piece:

Will we get inflation? The scenario leading to inflation starts with poor growth, possibly reinforced by larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative influence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovereign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deficits will not help.

When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reflecting expected inflation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inflationary decline in demand for U.S. debt. A substantial inflation will follow—and likely a “stagflation” not inflation associated with a boom. The interest rate rise and inflation can come long before the worst of the deficits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. (emphasis Yglesias')

Basically, if Cochrane is right, then tax cuts actually represent fiscal austerity, and conservatives don’t have to worry about all those silly economists who say that you can’t cut the deficit without tax hikes. Matt drily notes that it’s pretty convenient that this…um…counteruintuitive conclusion just happens to dovetail perfectly with the policy proposals of Cochrane’s drinking buddy Paul Ryan. But Matt stops short of critiquing the paper’s methodology, basically daring me to do it:

 I obviously don’t have the technical chops to wrangle with Cochrane’s model in detail.

Hence, Matt is entirely responsible for my failure to complete my dissertation.

Anyway, on to the paper… 


Overview

Cochrane analyzes the effects of fiscal and monetary policy using a system of two equations. The first equates the total real government debt + the money stock with the expected present discounted value of future government surpluses:

This is just the statement that the value of government debt is equal to the government’s ability to pay back the debt by taxing people. The second equation is the “quantity theory of money”:

The first of these equations is pretty uncontroversial. For a critique of the quantity equation, see Matt Rognlie, Matt Rognlie, and Matt Rognlie, but having some kind of relation between money, output, and prices is pretty unavoidable in a macro model.

An analysis of the entire paper is, well, beyond the scope of this blog post. I think I’ll stick to analyzing the claim that Matt Yglesias talks about, i.e. the story that higher taxes can cause stagflation. But first a point. The fact that Cochrane reduces the macroeconomy to two more-or-less uncontroversial equations causes me to invoke Noah's Third Law of Article Reading:

If your model is a subset of the intersection of most existing models, either you didn't get any new results, or you need to check your assumptions.

In other words, don't expect to get Exciting New Results using only the Same Old Stuff. Is John Cochrane really going to show that higher taxes cause inflation using nothing but an intertemporal budget constraint and hoary old MV=PY?

Simplifying your model past the point of full determinacy doesn’t remove the need to make additional assumptions about economic relationships; it just makes those assumptions implicit rather than explicit. If you say that only these two equations matter, you’re saying that other things, like imperfect competition and price stickiness, don’t.

Cochrane acknowledges this at the beginning of the paper:

[These two equations] are the beginning, not the end of analysis, and I do not mean to imply otherwise. In particular, monetary models also include a description of dynamics, and price-stickiness or [an]other mechanism that…translates inflation into real output…Additional frictions [that generate] stimulative effects of tax or real debt-financed government spending, and additional financial frictions can easily be added to this style of analysis. 

And again later on:

I am abstracting here from [frictions that] potentially have important effects on the analysis of fiscal stimulus…My goal is…not to deny other channels or try to have a last word on an 80 year old debate. 

So Cochrane is being intellectually honest here. He’s admitting that he just left out all of the things that monetarists and Keynesians believe makes stimulus and quantitative easing effective. They “can easily be added,” but he doesn’t add them. So the conclusion that countercyclical policy doesn’t work is going to follow pretty naturally from the assumption that countercyclical policy doesn’t work.


The Sum of All Right-Wing Fears

Now let’s talk about the scenario that Matt Yglesias picked out. In this scenario, higher taxes – which we normally think of as deflationary – actually create inflation, while still stifling output. To reiterate, the scenario is:

Higher taxes ---> slower growth ---> higher structural deficits ---> higher inflation, capital flight ---> stagflation

As it turns out, this particular sequence of events relies on three assumptions:

Assumption 1: Higher taxes would actually increase deficits, i.e. we’re to the right of the Laffer peak.

Assumption 2: Increased deficits are structural and cannot be reversed.

Assumption 3: Bond investors will not believe that the U.S. will be able to reduce spending in the future, and will thus abandon U.S. Treasury bonds.

Normally, we think tax increases should raise revenue and help close deficits. Not so, say supply-siders; we’re to the right of the peak of the Laffer curve, and thus higher taxes will decrease revenue and increase deficits. Of course, static analyses all agree that the U.S. is well to the left of the Laffer peak, so we’re in no danger of this happening. Supply-siders are forced to assume that the dynamic effects of taxes on future growth are large. Cochrane does in fact assume this:

The top of the Laffer curve is where the elasticity is equal to zero, so higher tax rates raise no revenue. Many economists think the U.S. is comfortably below that point…Trabandt and Uhlig (2009) offer a detailed Laffer calculation with fixed productivity growth and no migration, yielding the result that the U.S. is substantially below the Laffer limit….

The present value of future tax revenues is what matters for the fiscal valuation equation, however...[so] small growth effects can have a big impact on the fiscal limit. Thus, if a rise in [taxes] from 30% to 35% only implies a 0.02 x 0.15 = 0.3% reduction in long-term growth, then we are at the fiscal limit already. 

Note that this is a huge supply-side effect. It implies that the Bush tax cuts raised our trend per-capita growth by 0.36%, or more than one-sixth. It also implies that the Johnson and Reagan tax cuts raised our trend growth far more than that, and that the Clinton tax increases significantly decreased our trend growth. Unsurprisingly (to me, anyway), a long-term plot of U.S. output doesn’t show any of these things.

Does Cochrane really believe in this huge supply-side effect? It appears he does:

[T]he ‘‘supply siders’’ in the Reagan administration advocated lower tax rates, and larger short-term deficits, arguing that lower tax rates would spur growth and lead to larger tax revenues. The lower tax rates of the Reagan administration were in fact followed by two decades of economic growth, leading to strong surpluses as shown in Fig. 1. The present values of the surpluses that occurred validated the quick end of inflation in the early 1980s. 

Here is the aforementioned Fig. 1:

 

Do you see the “strong surpluses” that followed Reagan’s tax cuts? If so, maybe you should consider a job as a “technical analyst” on Wall Street…because all I see is a deficit, followed by a small surplus after Reagan partially reversed his tax cuts, followed by a very big surplus after the Clinton tax increases, followed by a deficit after the Bush tax cuts…

So, I conclude that Cochrane’s “dynamic Laffer curve” analysis is not supported by any evidence presented here (or any evidence of which I am aware).

Cochrane’s second assumption is that stimulus deficits are structural and permanent (i.e. a negative shock to the present value of all future budget surpluses). This just seems unrealistic to me; in the real world, spending from, say, the ARRA has already pretty much finished. In fact, the assumption seems to be basically political in nature. Cochrane mentions (in the quote above) that Reagan-era supply-siders advocated “larger short-term deficits”…by commending this policy, Cochrane appears to assume that deficit spending by Republican administrations can be reversed, but that deficit spending by Democrats never will.

Finally, we have the notion that these permanently higher deficits will lead to capital flight – the so-called “attack of the bond vigilantes.” This assumption is embodied in a posited decrease in the stochastic discount factor, i.e. a rise in expected interest rates. But Cochrane’s model is forward-looking; as he explicitly states (page 3), this should make long-term interest-rates spike as soon as (or actually well before) the higher deficits are announced. As many, many people have pointed out, nothing like this has yet happened so far to the U.S. economy, despite the explosion in deficits described by Cochrane. If a “fiscal inflation” is in our future, either it doesn’t follow Cochrane’s implied model of expectations, or it is, as yet, completely hypothetical to even the most far-sighted observer. 

So to make a long story short, the “Sum of All Right-Wing Fears” scenario is really just a “Sum of All Standard Right-Wing Assumptions.” Tax increases decrease revenue. Democrats are addicted to deficits. Bond vigilantes are ready to abandon U.S. Treasuries.

It seems to me that all three of these ideas have been rebutted (or at least candidly discussed) a million bazillion times in the past. But by cloaking them in math and burying them amid a bunch of reformulations of present-value equations and econ-specific jargon, John Cochrane was able to pour old wine ($370/bottle wine, no less) into a new glass, and keep smart non-econ people from seeing that that was what he was doing.

Well, for a little while, anyway.

At any rate, I invite everyone to go through and read the rest of Cochrane's paper and find more errors or good points that it makes. In particular, I didn't have the time to look at his claim that monetary policy is ineffectual. I’m sure there are a bunch more assumptions about things like causality, stability, expectations, unmodeled behavior of aggregates, etc. that I didn’t have time to go through and identify. After all, I’ve got a dissertation to write…or something…

Long-term or short-term? MU!

Paul Krugman says that there's not much that government policy can do to promote long-term growth:

Changing the economy’s long-run growth rate is hard. We’ve had almost 25 years of “new growth theory” research, with every possible regression run, looking for the keys to faster growth; my sense is that we’ve basically come up dry.

Karl Smith agrees:

[We] heard the President during the townhall talk about life long education, infrastructure, etc.

Yet, either the government has been amazingly consistent in providing the right balance of these goods, or they just don’t matter that much. Because long term growth has been incredibly consistent, even including the Great Depression and WWII. 

Now I am all for stabilization policy (as long as it comes in the form of infrastructure spending and QE instead of tax rebates). But I also tend to think that the long term matters a lot. And in America's current situation, I don't think there's that much of a tradeoff between the two!

Smith's point is, I think, fairly well rebutted by Brad DeLong, who notes that not every country seems as resilient to economic shocks as the U.S. It might be that our government was just amazingly consistent in the 20th century. And as both DeLong and I have noted, past performance is no guarantee of future results. (Update: M.S. at The Economist also offers a rebuttal to K. Smith.)

Regarding Krugman's argument…Well, just because "New Growth Theory" hasn't found any definitive answers doesn't mean that there aren't any. After all, growth theory is working with terrible data. Countries are not selections from a random sample, and the time series of post-WW2 growth is not very long.

What about the development literature? I think it provides more of a reason to believe that policy could matter for the long-term. When we look at a poor as well as rich countries, we see a large and persistent variance in levels of income. Convergence is only conditional on institutions and other country-specific variables.

Now, I acknowledge that it seems unlikely that the U.S. will make policy mistakes significant enough to tumble us out of the ranks of the rich countries. But there's no rule that the principles of development economics don’t apply to us! In particular, much of the development literature emphasizes the importance of institutions for living standards; there seems to me no reason to assume that once a country reaches the highest levels of per-capita income, its institutions are forever guaranteed to be top-notch.

This is my big worry about the current crisis. When I think of what might hold down our long-term growth, I think about political-economic equilibria and the quality of our institutions. What if an economic shock is severe enough to knock a country out of a good (but fragile) political-economic equilibrium - where factions basically agree on the need for public good provision and sound macro policy - and into a bad one, where no one can agree on anything?

Casual observation says that this may be what happened to Japan. A prolonged slump (compounded by macro policy mistakes) was followed by decades of political chaos that have seen prime ministers come and go like fashion trends. Gridlock has led to too-low taxes and massive debt, while trade and immigration policies remain stuck in the past. Now, personally, I think Japan's political institutions were never particularly good, but I also think that what virtue they had proved to be fragile to external events.

Looking at our current crisis over the debt ceiling, I can't help but worry that something similar is happening to us. Our nation needs to raise taxes, but we can't. Our infrastructure is falling apart, but we can't fix it. We seem to have reached a political-economic equilibrium in which the Republican Party, either by filibusters or by cyclical election victories, will always have the clout to throttle spending on public goods and prevent the taxes and health-care reform that are needed to close our own unsustainable deficits – and because Republicans are ruled by primary elections in the South and by Grover Norquist, their incentives will not soon align with the nation’s. As our roads and our health care system deteriorate, I am comforted neither by a long-term log-log plot of U.S. GDP nor by the limited usefulness of New Growth Theory.

Mark Thoma argues that long-term-ism is a basically conservative policy stance, since the RBC people and the "structural unemployment" people urge us to ignore stabilization policy and focus on things like lowering taxes. I don't think that's necessarily true, for two reasons. First, just because the long-term is important does not mean that conservative policy ideas are right. Conservatives' main mistake is to ignore market failures; yes, this leads them to ignore stabilization policy, but it also makes them ignore public goods. Second, just because the short-term is important does not mean that the long-term is not. The same political-economic dysfunction that stops us from implementing timely and appropriate stabilization policy also stops us from rebuilding our roads.

All that being said, here's the upshot of my post: I certainly am NOT saying we should ignore stabilization policy. If short-term policy and long-term policy were really in conflict right now, I would say we should carefully balance the two. But I don't think they are in conflict! We shouldn’t be afraid that raising taxes will harm the macro situation, because (as John Taylor and Paul Krugman both point out) tax cuts make poor stimulus. And spending more on infrastructure would be good for both short-term employment and long-term efficiency. So I really think there is no tradeoff right now.

And I think that with the kind of dysfunctional political economy we’ve got, both long-term rhetoric (of the type Obama is using) and short-term rhetoric are needed to bring people back to their senses.

I now tweet, apparently

I am now on Twitter, @Noahpinion.

Is that the proper format for linking to one's Twitter account? Heck if I know!

Government and growth: a Rorschach test

 

Tyler Cowen links approvingly to a new paper by Andreas Bergh and Magnus Henrekson of the Research Institute of Industrial Economics, calling the paper "useful and wise". The paper shows a negative relationship between government size and GDP growth among rich countries. The upshot:

An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate. We discuss efforts to make sense of this correlation, and note several pitfalls involved in giving it a causal interpretation.

Notice that last sentence, especially the phrase "pitfalls involved in giving [the correlation] a causal interpretation." This is indeed very wise. Here are three (of the many) possible interpretations of Bergh and Henrekson's findings:

Interpretation 1: Government is good for a rich country. More government allows a country to reach a higher level of per capita GDP. Since rich countries experience conditional convergence, countries with large governments have low growth because their large governments raised per-capita GDP and hence caused growth to slow.

Interpretation 2: Government is bad for a rich country. The countries that are now rich finished converging long ago, and are now diverging, due to institutional differences. Because large governments are an inferior institution, countries with small governments are outgrowing those with large governments.

Interpretation 3: Government is neither good nor bad for a rich country within the observed levels. As countries become richer (and therefore grow slower, as in Interpretation 1), they exhibit a social preference for more government services. Hence, the causation is from GDP to government size.

Which interpretation do you believe? I predict that it will depend on your politics. Socialists will tend to favor Interpretation 1, libertarians will tend to favor Interpretation 2, American liberals will probably tend to favor Interpretation 3. It is my guess that Tyler Cowen favors Interpretation 2, but I could be wrong.

What do other scholars say? In a survey of growth economics, Xavier Sala-i-Martin of Columbia University writes:

The size of the government does not appear to matter much [for rich countries]. What is important is the “quality of government” (governments that produce hyperinflations, distortions in foreign exchange markets, extreme deficits, inefficient bureaucracies, etc., are governments that are detrimental to an economy).

This would tend to fit with my own priors, and my own politics.

So why did Tyler Cowen post the link? Did he want to give us a Rorschach test? Did he hope that we'd naturally gravitate toward Interpretation 2, and conclude that government is bad? I think that when linking to papers, it's good practice to vet the papers carefully and present them in a neutral fashion. In the case of Bergh and Henrekson's paper, the following paragraph struck me as the most telling:

Finally, while there is close to a consensus on the sign of the correlation [between government size and growth], there is also consensus on the fact that causality is very hard to establish with certainty using the method of instrumental variable estimation—or any other method currently available. In fact, it is close to conceptually meaningless to discuss a causal effect from an aggregate such as government size on economic growth. Thus, several scholars in our view have rightly concluded it is more fruitful to analyze separately the mechanisms through which different taxes and expenditure affect growth. Not all taxes are equally harmful, and some studies identify public spending on education and public investment to be positively related to growth.

To me, that seems very useful and wise indeed.

Extended Replacement Coverage on Home Insurance

The recent devastation caused by the spring tornadoes is a sobering reminder that catastrophes can strike at any time. When a total loss occurs, homeowners coverage is designed to reconstruct a home under normal conditions. But following a catastrophe, increased demand for building materials and labor can cause these costs to rise significantly, potentially leaving policy limits inadequate.

Fortunately, many insurance companies offer extended dwelling coverage to help prevent such shortfalls.

How it works

Two coverage levels give you options: Extended dwelling coverage is available at levels of 25% or %50% of additional Coverage A amounts, allowing people to choose the level that fits their needs.
Example: A home is insured for a Dwelling Limit (Coverage A) of $100,000. Following a total loss, reconstruction cost amount to $120,000. Without extended dwelling coverage, the policy holder could incur significant out of pocket expenses or be forced to make difficult rebuilding choices to reduce the costs. With 25% or 50% in extended dwelling coverage, the home would have those extra costs covered (i.e. 25%-Dwelling is increase to $125,000 or 50%-Dwelling is increased to $150,000).

Now Ron Paul wants to debase the currency?

 

Oh dear sweet Jehovah.

First Republicans, after spending years warning about the danger of a debt default, decide to not only recommend a U.S. sovereign default, but actively push for one in Congress.

Now, after Republicans spent years warning us about the (then nonexistent) possibility of hyperinflation, Ron Paul comes out and suggests a policy that would be a huge step toward hyperinflation.

Specifically, Ron Paul wants to have the Fed destroy its holdings of U.S. Treasury bonds. This would be retroactive seigniorage; it would mean that the money that the Fed printed in the past to buy those Treasury bonds was actually printed to pay off the U.S.'s sovereign debt.

As any Econ 101 student knows, large-scale sustained seigniorage is what causes hyperinflation. Now, the Fed doing a one-off round of retroactive seigniorage would not be enough by itself to push us into Weimar Republic territory - in particular, because the money has already been printed. But it would also send a signal that the Fed is no longer an independent central bank, and that Congress feels free to strong-arm the Fed into paying off U.S. sovereign debt with printed money at any time in the future. That would be a signal that much more seignorage is on the way, which would push us into hyperinflation. (Tyler Cowen sees this possibility, but rather euphemistically labels the future seigniorage "QEIII".)

So what the heck is Ron Paul thinking? Paul is a well-known supporter of the gold standard, which policy-wise is the exact opposite of hyperinflation. Is he simply betting that we'd decide to go back on the gold standard after we got tired of pushing around wheelbarrows full of billion-dollar bills? Or does he just know absolutely nothing about economics?

More generally, what is with the Republicans trying to push us into the very doomsday scenarios that they've always warned us about? Hyperinflation and sovereign default are basically THE worst self-inflicted disasters that we have ever seen befall a modern rich economy. And the only reason that there is any worry, whatsoever, that either of these things might happen to the U.S. is that the Republican Party seems to be flirting with the idea of intentionally causing them. The GOP seems to no longer be the "party of business", but a mad-dog populist gang that is running around chucking sticks of dynamite in all directions.


Update: Greg Mankiw agrees that Paul's idea is crazy, but is actually less worried than I am about the signal of future seigniorage that would be sent by revoking the Fed's independence in order to pay off our debt. Dean Baker actually likes the idea, and thinks we could deal with any inflationary effects by raising reserve requirements. So he's really cavalier about revoking central bank independence.

Update 2: A bunch of people (including Greg Mankiw and Andy Harless) are saying "But the Ron Paul plan just transfers money from one part of the government to another, and hence would be harmless." I tried to explain above why I don't think that's the case, but let me try again. Yes, having the Fed destroy a bunch of government bonds would be harmless if we only did it once, and if people believed we were only going to do it once. If we did it again and again as a regular policy, we would have to get the Fed to keep printing more and more money so that we could destroy U.S. Treasuries again and again. That would cause hyperinflation. But suppose we only do it just this once. Could we convince people that it was only a one-time thing? I doubt it. First of all, doing the Ron Paul plan even once requires revoking the independence of the Fed, which tells people that Congress is now willing to use the Fed to implement fiscal policy. That by itself is a huge policy change. Second of all, if the Ron Paul plan achieved results that pleased lawmakers (i.e. reducing headline federal debt), that would tend to make the lawmakers want to do it again. And again. So there is every reason to think that the Ron Paul plan would lead to popular expectations of large-scale seigniorage...and hence to hyperinflation. In any case, it's an absolutely enormous risk. To take that risk, for the sole purpose of reducing headline debt (while leaving net debt unchanged), is, as Greg Mankiw says, crazy.

Taylor seems to agree with the Keynesians, but claims he doesn't

 

John Taylor has what I consider to be a pretty good post about the stimulus. He points out that if we evaluate the stimulus' impact using the same models that we used to predict its impact, we don't gain a lot of added value from the backward-looking part of the analysis. That is very true. He then points out the extreme difficulty of evaluating the stimulus (or other policy interventions) without basically assuming your conclusion through the choice of the model used to construct the counterfactual. This is also true.

He then presents a paper that he has written that attempts to evaluate the ARRA. According to Taylor, he has clear evidence that the stimulus didn't work.

This, of course, sent alarm bells ringing through my head. According to my Efficient Marketplace-of-Ideas Hypothesis, if there were an easy way to show convincingly that the stimulus failed, somebody would already have shown it. Previous studies purporting to show the failure of stimulus have been less than convincing. So I went into this paper expecting to find serious problems.

But instead I found Taylor pretty much agreeing with the Keynesians...

Taylor evaluates the ARRA by looking at changes in specific components of output - federal government purchases, state government purchases, and private consumption. According to Keynesian theory, if stimulus works it should work by raising either G (in the case of a rise in government purchases) or C (in the case of tax refunds or increased transfers). So Taylor just looks to see the degree to which this actually happened.

First, he shows that personal consumption doesn't appear to have been much affected by the tax rebates and transfer payments that made up a big chunk of the stimulus:

This graph looks convincing; you see bumps in stimulus income, but no bumps in consumption. Of course, Taylor is assuming a particular lag structure for his model; it's quite possible that the rise in spending due to tax rebates and transfers didn't occur immediately, but were spread out over the next few quarters, so that you wouldn't expect to see contemporaneous bumps. Similarly, when Taylor generates counterfactuals to show that consumption didn't rise, he picks a specific lag structure. Maybe he tried alternate specifications and didn't report them because they showed the same thing? Or maybe not.

Anyway, the arbitrary lag specification means that this model is not in any way conclusive. But it is still suggestive. And what it suggests is that tax rebates and transfer payments don't make for particularly good stimulus, because in a balance-sheet recession people will just use the money to pay down their debts. Helping people pay down debts may be good in its own right; but this is a reason why Keynesians often argue that government spending is a better approach to stimulus than tax rebates.

On that note, Taylor notes that federal expenditures didn't rise by very much due to the ARRA:

The most striking finding in Figure 3 is that only a small part of ARRA went to purchases of goods and services by the federal government. Measured as a percentage of GDP the amounts were immaterial: At the maximum effect, which occurred in the third quarter of 2010, federal government purchases due to ARRA reached only 0.21 percent of GDP and federal infrastructure only 0.05 percent of GDP.

These amounts are too small for the stimulus package to have had a significant effect on the overall economy. In this case the debate over the size of the government purchases multiplier is largely moot because the government purchases multiplier had virtually nothing to multiply at the federal level.

This precisely echoes the complaints that Keynesians had about the ARRA: not enough federal government purchases, not enough infrastructure spending.

Finally, Taylor looks at state-level spending, and concludes that the ARRA grants mainly replaced state borrowing with federal borrowing:

Figure 6 shows that in the absence of the 2009 stimulus grants, net borrowing by state and local governments would have been greater than it was with the grants. This is consistent with the view that state and local governments tried to smooth their expenditures in the face of temporary changes in income, much as households without borrowing constraints did...State and local governments used the stimulus grants to reduce their net borrowing (largely by acquiring more financial assets) rather than to increase expenditures[.]

This analysis is subject to the same caveat about lag structure as the earlier consumption analysis. But it also seems basically plausible to me, and highly suggestive that states mainly pocketed their ARRA grants instead of spending them on building roads and such.

Finally, Taylor presents a hypothesis that ARRA grants actually made states shift their spending from purchases to transfer payments, which (if this indeed happened) would have actually reduced GDP.

So to sum up, Taylor's paper says that ARRA didn't increase GDP because it didn't increase government purchases, and even hurt GDP to the extent that it reduced government purchases. This sounds exactly like a Keynesian critique of the stimulus bill - government purchases are good medicine for recessions, and we didn't do nearly enough of them! But somehow Taylor interprets his pro-Keynesian assumptions as an anti-Keynesian conclusion:

More generally, the results from the 2000s experience raise considerable doubts about the efficacy of temporary discretionary countercyclical fiscal policy in practice. In this regard the experience with the stimulus packages of the 2000s adds more weight to the position reached more than 30 years ago by Lucas and Sargent (1978) and Gramlich (1978, 1979).

What? But Lucas, Sargent, etc. thought that government purchases wouldn't raise GDP. That runs counter to Taylor's entire critique, which is that ARRA didn't raise government purchases enough!

Readers may go through this paper with a finer-toothed comb than I used, and may find significant methodological flaws that I overlooked. Please be my guest. But that won't change the larger point that Taylor is being a lot more Keynesian than he seems to think he's being.

So this makes two prominent conservative economists who have criticized Democrats for not being Keynesian enough (the other being Martin Feldstein). Is it possible that what these guys don't like is really just...well...Democrats?

Update: Mark Thoma points out that this is not the first time John Taylor has criticized the ARRA for not including enough government purchases.

Update 2: Paul Krugman concurs. John Taylor responds:

Now, I know that Krugman...would like a stimulus package with higher proportions going to...government purchases...But experiences from the 1970s raise serious doubts about the political and operational feasibility of such discretionary fiscal policy. So do recent experiences in many other countries...In a simple Keynesian model, all the government has to do to combat a recession is quickly increase government purchases, but the difficulty with doing so in practice is one of the classic arguments against discretionary fiscal policy.

So Taylor is arguing that the type of Keynesian policy that Keynes himself suggested, and which modern-day Keynesians want, is simply politically infeasible. Fine. I myself am quite receptive to that argument, actually. But then there's the China example, which Taylor himself cites as an example of a rapid increase in government purchases in response to a recession. How does Taylor explain that? Is it autocracy, or maybe some kind of central planning, that is supposed to make real stimulus politically feasible in China but not here? And then there's another question: even if (real) stimulus turns out not to be politically feasible, does that mean that economists shouldn't recommend it, if it would be the best policy? I mean, the fact that Medicare privatization is politically infeasible hasn't stopped John Taylor from urging us to do it.