Impact of the US Payroll tax cut...and tax hike

This is a very informative (and short) piece by economists at the NY Fed on the effect of the 2011 US payroll tax cut and its recent expiration.

Here's a good summary:

Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.

Reference

Zafar, B., van der Klaauw, W., My Two (Per)cents: How are American Workers dealing with the Payroll Tax Hike, Federal Bank of New Work, Liberty Street Blog.

A kind word for Paul

Paul Krugman's recent posts on the abuse use by politicians of economic studies as a way to support ideologically-driven fiscal austerity have been right on. Here's from his latest:

...the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions. Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

I made a similar point in an earlier column when I wrote that austerity was a

...prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

...[F]iscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".

This is why I continue to think that the ones who are really responsible for austerity are the politicians who support this view. Economic studies were used to provide cover for these leaders' preferred set of policy choices.

Anyway, there's no matching Prof. Krugman's performance these last few months. Not only have his forecasts been right on, but his retrospective look at why things unfolded the way they did has been downright flawless.

Moving past the 90 percent threshold: Focusing on growth

Now that the proposition of a 90 percent threshold (of public debt-to-GDP above which countries' economic growth would significantly slow) associated with the work of Carmen Reinhart and Ken Rogoff has been refuted, it's important that the debate now turn to the critical issue of how best to achieve growth moving forward.

On this point, one important aspect to keep in mind is that the uses toward which public debt is directed and the composition of public debt tend to have a significant impact on a country's economic growth.

A recent study by the IMF entitled "Public Debt and Growth" appears to support this view. The study, which examined the public debt dynamics in over 30 countries, found that, although the elasticity of growth with respect to public debt is -0.02, the elasticity of other variables that positively impacts growth offsets this number. For instance, as Iyanatul Islam has noted, the study shows that the elasticity of growth to initial years of schooling is above 2.0.

In other words, it's quite likely that public debt directed toward productive uses has the effect of supporting growth by cancelling out some of the negative effects associated with high public debt that impede growth.

These are the sort of issues policymakers should be discussing moving forward. I think it would go a long way to help us get out of the economic doldrums we're facing today.

Reference

Manmohan and Jaejoon, Public Debt and Growth, IMF, July 2010

Are investors seeing the writing on the wall?

John Carney reports that Wall Street is now showing signs of turning against fiscal austerity.

Apparently, the Reinhart-Rogoff fiasco has something to do with it. Perhaps.

Or is it the realization that the narrowing US federal budget deficit since the start of the sequester in early March may signal the end of bountiful corporate profits?

As I've explained before, contrary to conventional wisdom, business profits are actually positively impacted by government budget deficits. Here is my take from a macro accounting standpoint:

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

Now, it's true that under normal circumstances other factors such as household consumption and saving behavior and trade flows can significantly affect how these variables interact. However, in the current context where household spending has been largely subdued by deleveraging concerns, and exports weakened by sluggish growth in Europe, the UK and elsewhere around the world, the budget deficit consists of an important source of demand and (from a national accounts perspective) of corporate profits.

Nod to the St. Louis Fed: NIPA tables now on FRED

This is news worth sharing for all those policy wonks out there. The St. Louis Fed has added over 10,000 new data series from the Bureau of Economic Analysis (BEA) National Income and Product Account tables to its excellent FRED database and research tool. FRED now counts over 70,000 series of data.

The addition of these new series means the days of cutting and pasting NIPA data from the BEA website unto an Excel worksheet to create charts are over. (As everyone now knows, using Excel worksheet to handle data can be risky business...)

Also, since I'm on the topic of FRED, I'll also mention that the St. Louis Fed added earlier this year data for US federal deficits and surpluses as a percent of GDP. This saves us the extra step of calculating the fraction of GDP every time we produce charts of the US government's fiscal position.

To those who don't use FRED, I should mention that it offers a very simple research tool for data analysis and for creating charts that are useful for socio-economic and financial analysis. I highly recommend it. It's free (although I seem to recall you must register).

Inequality in the recent business cycle

This is a good speech by Governor Sarah Bloom Raskin of the Federal Reserve (also available in audio here). It was given during the Hyman Minsky Conference held at the Levy Institute earlier this week.

The speech focuses on the obstacles to recovery associated with household debt deleveraging and the decline in wealth for low-income households since the financial crisis. That low- and middle-income households held a disproportionate share of wealth in housing prior to the crisis meant they were highly exposed by the decline in house prices.

Raskin notes:

...[W]hile total household net worth fell 15 percent in real terms between 2007 and 2010, median net worth fell almost 40 percent. This difference reflects the amplified effect that housing had on wealth changes in the middle of the wealth distribution. The unexpected drop in house prices on its own reduced both households' wealth and their access to credit, likely leading them to pull back their spending. In particular, underwater borrowers and heavily indebted households were left with little collateral, which limited their access to additional credit and their ability to refinance at lower interest rates. Indeed, some studies have shown that spending has declined more for indebted households

Although later in the speech Governor Raskin discusses the Fed's strategy to address these issues (mainly by the use of unconventional monetary policies aimed at lowering long-term interest and mortgage rates), there is unfortunately no mention of the possible role of the Fed's current quantitative easing (QE) strategy in amplifying wealth inequality via the use of unconventional policies.

Since the start of the Fed's asset purchases programs (i.e., QE), we have seen stock indexes recover their losses while the decline in house prices has stayed flat (see charts below - Note: Increases in the monetary base is a good indicator of the magnitude of QE). In a context where the Fed is also hoping QE to sustain economic activity through the "wealth effect" channel (whereby a rise in asset prices causes investors to feel more secure about their wealth and, consequently, spend more), it's only normal to question whether current strategy is contributing (albeit unintentionally) to the wealth gap.

Source: Federal Reserve

Source: Federal Reserve

Public investment and productivity growth: How to provide properly for the future

Just as I was thinking about the moral aspects of economic policy, here comes Paul Krugman with a fantastic commentary on how governments today are shortchanging future generations by not taking advantage of record low interest rates and not spending on productivity-enhancing public investments:

Fiscal policy is, indeed, a moral issue, and we should be ashamed of what we’re doing to the next generation’s economic prospects. But our sin involves investing too little, not borrowing too much — and the deficit scolds, for all their claims to have our children’s interests at heart, are actually the bad guys in this story. 

So true. This reminds me of something the late economist Robert Eisner wrote:

...balancing the budget at the expense of our public investment in the future is one way that we really borrow from our children - and never pay them back. (1996)

The reason for this is that the "deficit equals bad" crowd is completely oblivious to the fact that public investment adds to the stock of productive assets that help to enhance private sector productivity in the long run. And public spending on infrastructure, education, basic research and the development of new technology is essential to achieve the level of productivity necessary to improve our standard of living in the future.

And at a time when we are facing an aging population, increasing our future productivity growth should be a (if not the number one) priority.

A good explanation for this is provided by Francis Cavanaugh, former senior US Treasury Department economist and former CEO of the Federal Retirement Thrift Investment Board, who argues that

Significant productivity increases will be necessary as a diminished labor force is called on to support an expanded group of retirees. Without such increased production per worker, a shortage of goods will lead to price increases, and it is likely that the baby boomers will suffer a significant decline in the purchasing power of their retirement dollars. Inflation could soon decimate their retirement savings. That's the economic reality; if you're not working, you're dependent on the productivity of those who are. (1996)

In other words, the best protection against the potential losses that come with an aging population is to take measures today aimed at increasing the productivity growth of tomorrow. This should be the long term goal of policymakers right now.

So Prof. Krugman is right: contrary to what most politicians and commentators believe about how to improve our long-run prospect, slashing government spending is exactly the wrong thing to do at this time. 

References

Cavanaugh, F., The truth about the national debt, Boston: HBSP, 1996

Eisner, R., "The balanced budget crusade", The Public Interest, Winter 1996

Josef Steindl on why austerity fails: A Keynesian-Kaleckian view of stagnation policy and the endogenous budget deficit

This policy of stagnation is likely to continue, since governments are preoccupied with inflation and the public debt. Budget deficits can only disappear if private investment soars again. This is unlikely in view of excess capacity, which would only disappear if there were fiscal expansion. Josef Steindl (1979)

Surely the person who wrote the statement above would have no difficulty explaining what's wrong with the world economy today.

Josef Steindl was a great Keynesian-Kaleckian economist who was a master in the art of national accounts analysis. He was a close associate of Michal Kalecki and authored several articles on the important role of government and private debt in the economy. A quick glance at some of the titles of Steindl's work reveals that his articles on these issues might be of some relevance right now. (For more on Josef Steindl, see Nina Shapiro's excellent article published last year in Monthly Review)

Steindl's work was aimed primarily at uncovering the causes of economic stagnation. According to Steindl's "stagnation theory", one reason why economies trend toward stagnation is due to the behavior of firms when they refuse to reduce prices sufficiently relative to wages during periods of low demand. Low wages relative to prices lead to a fall in demand for goods and services, which in turn compels firms to reduce investment and creates a vicious cycle of falling profits and further cost reduction and reduced investment (resulting in additional unused capacity and unemployment and falling demand).

Steindl also argued that economies stagnate as a result of "stagnation policy", ill-advised government austerity measures intended to reduce or eliminate budget deficits when the economy is weak. Contrary to conventional wisdom, Steindl argued that austerity policies only make matters worse under such circumstances.

Steindl criticized austerity because he understood that the government's financial balance in the modern era was largely an endogenous variable that is determined primarily by changes in the financial position of other sectors of the economy, not by the autonomous policy decisions of the fiscal authorities. It is the influence of government automatic stabilizers and the growing importance of both consumer credit and foreign trade in the modern economy that render the government's financial balance largely endogenous.

The core of Steindl's approach to macroeconomic analysis is intuitive and similar to that of other Keynesian economists, including James Tobin (1963), Robert Eisner (1986) and Wynne Godley, all of whom analyzed the workings of the economy by examining how different sectors of the economy interact with one another. He divided the economy into four sectors (the government, households, businesses and the foreign sector) and examined how money flowed between them.

Steindl's analysis focused on credit flows and on how changes in one sector impacted other sectors. In doing so, Steindl basically applied an elementary principle of accounting to national economies: for every borrower there must be a lender. His method relied heavily on the use of national accounts data to identify trends and changes in financial flows. According to Steindl,

[t]he instrument for analysing the circular relations in an economy are the national accounts. They are a double entry book-keeping for the society, whole groups like households, business or government being represented by separate accounts, as are also activities like investment, consumption and so on. The systematic development of national accounting received its great impetus from Keynes and his theory [...] It offers a convenient way between the sterility of the Walrasian general equilibrium and the limited scope of the partial analysis of Marshall, because it is couched in terms of variables which are statistically measurable and at the same time relevant for national economic policy.(1985)

Steindl understood that, in terms of national accounts, the government deficit finds its counterpart in the surplus of at least one other sector of the economy. Since the surpluses and deficits of the various sectors (government, households, foreign and business) must balance, Steindl recognized that a huge deficit in one sector is always offset by surpluses elsewhere.

The endogenous budget deficit and the fallacy of austerity

Steindl was critical of the ("pre-Keynesian") tendency of many economists to view government budget deficits as an irritant to be eliminated. According to him, deficits in the modern era accomplished the opposite: they helped to boost aggregate demand when the economy is weak.

As mentioned above, Steindl viewed the budget deficit as a passive symptom of a weak economy rather than a problem to be actively addressed: actively trying to eliminating budget deficits would only worsen the situation. Steindl recognized that the size of the budget deficit is largely determined by the spending flows occurring among the other sectors of the economy. In this sense, he viewed the budget deficit largely as an endogenous variable that can't be easily controlled by policymakers. On whether the government has the ability to control the size of the budget deficit by changing its level of expenditures and/or revenue, Steindl argued the following:

While it is possible, in principle, to control the volume of government spending or taxation, the same is not true for the budget deficit. This is determined by the level of GDP resulting from the interplay of lending and borrowing of the various sectors. Let me refer to the well-known identity

( I – S_B) + (X – I) + (G – T) = (S_H – H)

Which says that the budget deficit G – T together with the borrowing of business I – S_B and of the outside world X – M equals the lending of households (i.e., excess of household saving S_H over investment in dwelling houses H) of households S_H – H.

Which of these sectors plays an active role depends on institutional circumstances. The budget deficit, in connection with Keynesian policies, used to be regarded as an active element, incurred on purpose by the government. In present circumstances it is more likely to play a passive role, and to be dominated by the other sectors. This is due to the large share of taxation in an additional GDP, to the strong and quick reactions of consumers to a change in income and to the fact that the foreign balance is more often dominated by outside influences than by domestic policy (by the GDP). In consequence attempts at reducing the budget deficit by retrenchment are mostly doomed to failure. [...]

If the foreign account is balanced, the budget deficit has simply to fill the gap between the household financial saving and the borrowing of business. This will apply to some approximation in countries where the role of the foreign balance is small as compared with that of other sectors. It will fully apply to all countries taken together because they form a closed system. For them the budget deficit given the financial surplus of the households, will be largely settled by the amount of private investment. On the other hand, in countries where the foreign balance can take large values it will, together with private investment, dominate the size (and sign) of the budget deficit. In both cases the budget deficit is predominantly suffered rather than contrived.

The conclusion is not pleasant to contemplate for the treasurer because it means that he can control the deficit, if at all, only by indirect routes: Business investment, and a fortiori the foreign balance, are not easy to control. (1983) (my emphasis)

That said, according to Steindl, there are circumstances in which the budget deficit can be made to decrease. Such favorable conditions are the same as those which lead to growth in private sector investment, namely, a satisfactory utilization of capacity and a growing market. In this regard, Steindl concludes that

[o]n certain conditions it would seem therefore that the best way to combat a deficit is to increase spending. The conditions are that there are unemployed resources, and that the additional spending is not drained away by imports. In these circumstances a policy of "reflation" should have a good chance of succeeding without adding to the budget deficit at all. On the one hand, the built-in stabilisers in modern welfare state are very strong. About half of the additional spending will come back to the treasury. On the other hand we have a modern destabiliser in the form of consumer's credit and durable goods consumption which will prevent the multiplier from being too low. This response of consumption will be very quick in contrast to the response of business investment which may take one or two years at least. In the interval business will merely accumulate additional saving. At the same time the consumers, owing to the expectation of a persistently higher level of income, will increase their spending on durables more than their disposable income has increased; they will therefore, taken all together, dissave (borrow) on balance, at the margin. (1983)

Now, it's important to point out that Steindl wrote the above at a time when growth in consumer credit could function as a way to counter the deflating effect of deficit reduction. Today, this is not the case, as consumers are seeking to repair their balance sheets following the financial crisis. This means that the only solution would be the one articulated in Steindl's quote found at the top of this post.

To conclude, there is growing appreciation these days among economists and commentators of the self-defeating nature of austerity and deficit reduction measures. The difficulties that many European nations are now facing in their quest to bring down deficits is consistent with Steindl's view that government austerity is exactly the wrong strategy for reducing the size of the budget deficit and bringing down debt during a period of slow growth.

PS: I recently stumbled upon this comment by economist Herbert Simon discussing Steindl's brand of economics:

It is pleasant, in an econometric world that has become idolatrous of mathematical "elegance," to encounter an author who thinks that mathematics is a tool - one of several - to aid in carrying out reasoning about economic matters.

References

Eisner, R., How Real is the Federal Budget? (New York: Free Press), 1986

Steindl, J., “The Role of Household Saving in the Modern Economy”, Banca Nazionale del Lavoro Quarterly Review, p.83, March, 1982

Steindl, J., "J.M. Keynes: Society and the Economist", Keynes' Relevance Today (London: MacMillan) 1985.

Steindl, Josef. “The Control of the Economy”, Banca Nazionale del Lavoro Quarterly Review, pp. 235-248, 1983

Shapiro, N., "Keynes, Steindl, and the Critique of Austerity Economics", Monthly Review, Vol 64, No.3, 2012

Simon, H., "Random Processes and the Growth of Firms: A Study of the Pareto Law" by Josef Steindl: Review, Journal of the American Statistical Association, Vol. 61, No. 316 (Dec., 1966), pp. 1232-1233

Tobin, J., Deficit, Deficit, Who's Got the Deficit, January 1963. New Republic, 1/19/63, Vol. 148 Issue 3, p10.