Naked Economics

by Wheelan, Charles

  The business cycle takes a human toll, as the layoffs splashed across the headlines attest. Policymakers are increasingly expected to smooth this business cycle; economists are supposed to tell them how to do it. Government has two tools at its disposal: fiscal policy and monetary policy. The objective of each is the same: to encourage consumers and businesses to begin spending and investing again so that the economy’s capacity no longer sits idle.

  Fiscal policy uses the government’s capacity to tax and spend as a lever for prying the economy from reverse into forward. If nervous consumers won’t spend, then the government will do it for them—and that can create a virtuous circle. While consumers are sitting at home with their wallets tucked firmly under the mattress, the government can start to build highways and bridges. Construction workers go back to work; their firms place orders for materials. Cement plants call idled workers back. As the world starts to look like a better place, we feel comfortable making major purchases again. The cycle we described earlier begins to work in reverse. This is the logic of the American Recovery and Reinvestment Act of 2009—the stimulus bill that was the first major piece of legislation under the Obama administration. The Act authorized more than $500 billion in federal spending on things ranging from expanded unemployment benefits to resurfacing the main highway near my house. (There is a big sign on the side of the road telling me that’s where the money came from.)

  The government can also stimulate the economy by cutting taxes. The American Recovery and Reinvestment Act did that, too. The final bill had nearly $300 billion in assorted tax cuts and credits. The economic logic is that consumers, finding more money in their paychecks at the end of the month, will decide to spend some of it. Again, this spending can help to break the back of the recession. Purchases generated by the tax cut put workers back on the job, which inspires more spending and confidence, and so on.

  The notion that the government can use fiscal policy—spending, tax cuts, or both—to “fine-tune” the economy was the central insight of John Maynard Keynes. There is nothing wrong with the idea. Most economists would concede that, in theory, government has the tools to smooth the business cycle. The problem is that fiscal policy is not made in theory; it’s made in Congress. For fiscal policy to be a successful antidote to recession, three things must happen: (1) Congress and the president must agree to a plan that contains an appropriate remedy; (2) they must pass their plan in a timely manner; and (3) the prescribed remedy must kick in fast. The likelihood of nailing all three of these requirements is slim. Remarkably, in most postwar recessions, Congress did not pass legislation in response to the downturn until after it had ended. In one particularly egregious example, Congress was still passing legislation in May 1977 to deal with the recession that ended in March 1975.16 At the end of the relatively mild 2001–2002 recession, the New York Times ran the following headline: “Fed Chief Sees Decline Over; House Passes Recovery Bill.” I’m not making this stuff up.

  What about the Obama stimulus? The American Recovery and Reinvestment Act was seemingly timely, but most of the money was not spent immediately (though there still can be a psychological benefit, and therefore an economic benefit, to simply announcing that lots of spending is coming). Critics of this huge economic intervention argue that it lavished borrowed government money on all kinds of unimaginable projects, some of them quite silly, and will add huge sums to the national debt. Proponents of the stimulus, such as Obama’s chair of the Council of Economic Advisers, Christina Romer, make the case that the $787 billion stimulus raised real GDP growth by 2 to 3 percentage points and saved a million jobs.17 As far as I can tell, they’re both right. I was a congressional candidate at the time, so my views are a matter of public record (for the small number of people who paid attention to them). The economy was caught in dangerous negative feedback loops—foreclosures were causing banking problems which were causing layoffs which were causing foreclosures, and so on. I was fond of saying, “A bad stimulus is better than no stimulus, and a bad stimulus is what we got.” The government needed to do something to break the cycle (in part because monetary policy was not working, as will be explained in a moment). I would have preferred that the government target more of the spending toward infrastructure and human capital investments to improve the long-term productive capacity of the nation. I agree that rising government indebtedness is a problem, as will be discussed in Chapter 11. That said, given the financial panic described earlier in the chapter and the capacity for bad economic events to beget more bad economic events, there is a reasonable argument to be made that even paying people to dig holes and then fill them in would have been a better policy choice than doing nothing.

  The second tool at the government’s disposal is monetary policy, which has the potential to affect the economy faster than you can read this paragraph. The chairman of the Federal Reserve can raise or lower short-term interest rates with one phone call. No haggling with Congress; no waiting years for tax cuts. As a result, there is now a consensus among economists that normal business cycles are best managed with monetary policy. The whole next chapter is devoted to the mysterious workings of the Federal Reserve. For now, suffice it to say that cutting interest rates makes it cheaper for consumers to buy houses, cars, and other big-ticket items as well as for firms to invest in new plants and machinery. Cheap money from the Fed pries wallets open again.

  During the depths of the “Great Recession” of 2007, however, the Fed couldn’t make money any cheaper. The Fed pushed short-term interest rates all the way down to zero, for all intents and purposes, but consumers and businesses still weren’t willing to borrow and spend (and unhealthy banks were in a poor position to lend). At that point, monetary policy can’t do anything more; it becomes like “pushing on a wet noodle,” as Keynes originally described it. This is the economic rationale for turning to a fiscal stimulus as well.

  I conceded earlier in this chapter that GDP is not the only measure of economic progress. Our economy consists of hundreds of millions of people living in various states of happiness or unhappiness. Any president recovering from a horseshoe accident would demand a handful of other economic indicators, just as emergency room physicians ask for a patient’s vital signs (or at least that is what they do on Grey’s Anatomy). If you were to take the vital signs of any economy on the planet, here are the economic indicators, along with GDP, that policymakers would ask for first.

  Unemployment. My mother does not have a job, but she is not unemployed. How could that be? This is not one of those strange logic riddles. The unemployment rate is the fraction of workers who would like to work but cannot find jobs. (My mother is retired and has no interest in working.) America’s unemployment rate fell below 4 percent during the peak of the boom in the 1990s; it has since climbed over 10 percent. Even that may understate the number of people out of work. When Americans without jobs give up on finding one, they no longer count as unemployed and instead become “discouraged workers.”

  Anyone who cares about unemployment should care about economic growth, too. The general rule of thumb, based on research done by economist Arthur Okun and known thereafter as Okun’s law, is that GDP growth of 3 percent a year will leave the unemployment rate unchanged. Faster or slower growth will move the unemployment rate up or down by one-half a percentage point for each percentage point change in GDP. Thus, GDP growth of 4 percent would lower unemployment by half a percentage point, and GDP growth of only 2 percent would cause unemployment to rise by half a percentage point. This relationship is not an iron law; rather, it describes the relationship in America between GDP growth and unemployment over the five-decade period studied by Mr. Okun, roughly 1930 to 1980.

  Poverty. Even in the best of times, a drive through Chicago’s housing projects is ample evidence that not everybody has been invited to the party. But how many Americans are poor? Indeed, what exactly constitutes “poor”? In the 1960s, the U.S. government created the poverty line as a (somewhat arbitrary) definition of the a
mount of income necessary to buy the basic necessities. Having been adjusted for inflation, the poverty level remains as the statistical threshold for who is poor in America and who is not. For example, the current poverty line for a single adult is $10,830; the poverty line for a family of two adults and two children is $22,050.

  The poverty rate is simply the fraction of Americans whose incomes fall below the poverty line. Roughly 13 percent of Americans are poor, which is no better than we were doing in the 1970s. The poverty rate rose steadily throughout the 1980s and then drifted down in the 1990s. The overall poverty rate disguises some figures that would otherwise leap off the page: Roughly one in five American children is poor as are nearly 35 percent of black children. Our only resounding success is poverty among the elderly, which has fallen from 30 percent in the 1960s to below 10 percent, largely as the result of Social Security.

  Income inequality. We care about the size of the pie; we also care about how it is sliced. Economists have a tool that collapses income inequality into a single number, the Gini index.* On this scale, a score of zero represents total equality—a state in which every worker earns exactly the same. At the other end, a score of 100 represents total inequality—a state in which all income is earned by one individual. The countries of the world can be arrayed along this continuum. In 2007, the United States had a Gini index of 45, compared to 28 for France, 23 for Sweden, and 57 for Brazil. By this measure, the United States has grown more unequal over the past several decades. America’s Gini coefficient was 36.5 in 1980 and 37.9 in 1950.

  Size of government. If we are going to complain about “big government,” we ought to at least know how big that government is. One relatively simple measure of the size of government is the ratio of all government spending (local, state, and federal) to GDP. Government spending in America has historically been around 30 percent of GDP, which is low by the standards of the developed world. It’s climbing right now, both because the stimulus is driving up government spending (the numerator) and because GDP has been shrinking (the denominator). Government spending in Britain is roughly 40 percent of GDP. In Japan, it is over 45 percent; in France and Sweden it is more than 50 percent. On the other hand, America is the only developed country in which the government does not pay for the bulk of health care services. Our government is smaller, but we get less, too.

  Budget deficit/surplus. The concept is simple enough; a budget deficit occurs when the government spends more than it collects in revenues and a surplus is the opposite. The more interesting question is whether either one of these things is good or bad. Unlike accountants, economists are not sticklers for balanced budgets. Rather, the prescription is more likely to be that governments should run modest surpluses in good times and modest deficits in tough times; the budget need only balance in the long run.

  Here is why: If the economy slips into recession, then tax revenues will fall and spending on programs such as unemployment insurance will rise. This is likely to lead to a deficit; it is also likely to help the economy recover. Raising taxes or cutting spending during a recession will almost certainly make it worse. Herbert Hoover’s insistence on balancing the budget in the face of the Great Depression is considered to be one of the great fiscal follies of all time. In good times, the opposite is true: Tax revenues will rise and some kinds of spending will fall, leading to a surplus, as we saw in the late 1990s. (We also saw how quickly it disappeared when the economy turned south.) Anyway, there is nothing wrong with modest deficits and surpluses as long as they coincide with the business cycle.

  Let me offer two caveats, however. First, if a government runs a deficit, then it must make up the difference by borrowing money. In the case of the United States, we issue treasury bonds. The national debt is the accumulation of deficits. Beginning around 2001, the United States has been consistently spending more than we take in. It adds up. The U.S. national debt has climbed from a recent low of 33 percent of GDP in 2001 to a projected 68 percent of GDP by 2019. If the debt becomes large enough, investors may begin to balk at the prospect of lending the government more money.

  Second, there is a finite amount of capital in the world; the more the government borrows, the less that leaves for the rest of us. Large budget deficits can “crowd out” private investment by raising real interest rates. As America’s large budget deficits began to disappear (temporarily) during the 1990s, one profoundly beneficial effect was a fall in long-term real interest rates, making it cheaper for all of us to borrow.

  Current account surplus/deficit. The U.S. current account deficit in 2008 was around $700 billion. Is it time to rush to the supermarket to stock up on canned goods and bottled water? Maybe. The current account balance, which can be in surplus or deficit, reflects the difference between the income that we earn from the rest of the world and the income that they earn from us. The bulk of that income comes from trade in goods and services. Thus, our balance of trade, which again can be in surplus or deficit, is the largest component of the current account. If we are running a trade deficit with the rest of the world, then we will almost always be running a current account deficit, too. (For the purists, the U.S. current account would also include dividends paid to Americans who own foreign stocks, remittances sent home by Americans working overseas, and other sources of income earned abroad.)

  When the current account is in deficit, as ours is now, it is usually because a country is not exporting enough to “pay” for all of its imports. In other words, if we export $50 billion of goods and import $100 billion, our trading partners are going to want something in exchange for that other $50 billion worth of stuff. We can pay them out of our savings, we can borrow from them to finance the gap, or we can sell them some of our assets, such as stocks and bonds. As a nation, we are consuming more than we are producing, and we have to pay for the difference somehow.

  Oddly, this can be a good thing, a bad thing—or somewhere in between. For the first century of America’s existence, we ran large current account deficits. We borrowed heavily from abroad so that we could import goods and services to build up our industrial capacity. That was a good thing. Indeed, a current account deficit can be a sign of strength as money pours into countries that show a promising potential for future growth. If, on the other hand, a country is simply importing more than it exports without making investments that will raise future output, then there is a problem, just as you might have a problem if you squandered $100,000 in student loans without getting a degree. You now have to pay back what you borrowed, plus interest, but you have done nothing to raise your future income. The only way to pay back your debt will be to cut back on your future consumption, which is a painful process. Countries that run large current account deficits are not necessarily in financial trouble; on the other hand, countries that have gotten themselves into financial trouble are usually running large current account deficits.

  National savings. We all tuck money away for our individual needs: college, retirement, etc. Businesses save money, too, by retaining profits rather than paying them out to the owners of the firm. Those private savings decisions, along with the government’s decision to run a deficit or surplus, have a profound impact on our economy. The simple reason is that savings are necessary to finance investment, and investment is what makes us more productive as a society. If you put 10 percent of your income in the bank, then somewhere else in the country that money will end up building a plant or financing a college education. If Americans do not collectively put savings in the bank, then we must either forgo important investments or borrow from abroad. Again, this assumes that foreign investors are willing to lend at a reasonable rate, which may not be the case for an economy in a precarious state. Over time, countries’ investment rates show a striking correlation with their domestic savings rates.

  The U.S. national savings rate tells a cautionary tale. Personal saving fell steadily from over 9 percent in the 1960s and 1970s to 6 percent in the 1980s to below 5 percent in the mid-1990s to roughly zero by th
e end of the 1990s.18 When the recession hit in 2007, the personal savings rate started to climb again. Governments (Washington, D.C., and the states) have been running deficits, or “dissaving.” (U.S. businesses were the only ones setting any money aside until households were shocked into saving by the recession.) We can and have borrowed from abroad to finance our national investment—at a cost. Nobody lends money for nothing; borrowing from abroad means that we must pay some of our investment returns to our foreign lenders. Any country with significant exposure to foreign lenders must always worry that when times get tough, the herd of international investors will get spooked and flee with their capital.

  Demographics. Americans are getting older, literally. As economist Paul Krugman has noted, the age distribution in America will eventually begin to look as it does in Florida. That is good for the companies that manufacture shuffleboard equipment. It is not so good for government finances. The bulk of government benefits, notably Social Security and Medicare, are bestowed on Americans who are retired. These programs are financed with payroll taxes imposed on younger Americans who are still working. If the ratio of young Americans to older Americans begins to change, then the financial health of programs like Social Security and Medicare begins to change, too.

  Indeed, we can explain the importance of demographics and fix Social Security all in the next two paragraphs. Social Security is a “pay-as-you-go” program. When American workers pay into Social Security (that large FICA deduction on your paycheck), the money does not get invested somewhere so that you can draw on it twenty or thirty years later, as it would in a private pension fund. Rather, that money is used to pay current retirees. Straight from young Peter to old Paul. The program is one big pyramid scheme, and, like any good pyramid scheme, it works fine as long as there are enough workers on the bottom to continue paying the retirees at the top.