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