Taxes – Divide, Confuse and Conquer

Better than reruns of Two and a Half Men are the nightly television news reports of our government’s dealing with deficits and debt.  As you know, the government deficit is defined as the difference between government revenues and government spending. The Federal government deficit according to the CBO was $1.29 trillion in 2010 and will be $1.48 trillion this year.  According to the CBO’s baseline estimates it will bottom at $610 billion in 2018 and then start rising again. As a result of all these deficits the privately held debt of the nation will rise from 62% of GDP in 2010 to about 76% by 2019. Our government, therefore,  is presently discussing plans for reducing the deficit for this year, plans for next year, and, of course, what to do about these deficits through at least 2019.

I wrote several postings in the last months about government spending but have shied away from taxation. Why? I am not sure. It might be because I just paid my annual tax payment and I feel poor. Or it might be because I am just like Albert Einstein who once said, “The hardest thing in the world to understand is the income tax.” Or Ben Franklin who said, “In this world, nothing can be said to be certain except death and taxes.” And finally Mark Train said, “I shall never use profanity except in discussing housing rent and taxes.”  Damn, why get into something that Einstein can’t understand and that reminds you of death?

Anyway, it was either this or going shopping with Betty. This one post does little to solve the issue of using tax revenues to resolve the current and future government budgeting mess. But what I have tried to do is get my arms around Roseanne Barr, err I mean get my arms around some of the many issues that make the tax debate so complicated. You see, complication is the power tool of government.  The more complicated the topic is and the more they can discuss all its ramifications, the more they can dither and do nothing about it. 

You will see below a list of many tried and true (old) aspects that relate to taxation. Hopefully you will come away from this list with a realization of how these folks in Washington are trying to evade real decisions. This list is a minefield of special interest bombs that are sure to keep the enemy from the real fighting. If debts and deficits are the number one issue it is hard to imagine (forecast) progress. It is time to demote some of these issues – at least for a while – so we can work on our biggest worry – how to reduce debt and deficits before our economy implodes. I argue below that much of the work should be devoted to the spending side while admitting that longer-term issues probably cannot totally avoid some revenue increases. 

Taxes are part of the calculation of the government budget balance, where balance equals government taxes (T) minus government spending (G)

Balance = T – G.

If G is greater than T, Balance is negative or what we call a deficit. The 2010 budget deficit was as follows:

      -$1.294 trillion = $2.162 - $3.456

A higher T with G held constant, would create a smaller government deficit. So increasing T makes mathematical sense as one discusses policies. Of course, reducing G also makes sense. But this post is about T so let’s work on that.

Federal tax revenues equaled $2.162 trillion in 2010. In 2007 T had reached a high of $2.568 but then the recession came and tax revenues fell to a low of $2.105 trillion in 2009 before starting to climb again in 2010. It may take until 2012 before tax revenues recover again and get back to their value in 2007. The baseline CBO estimate for 2013 has T at about $3.1 trillion. Baseline estimates do not incorporate any changes from the 2010 revenue laws. So T is expected to recover quite a bit even without any policy changes in 2011 or beyond. From where they were in 2010, without any change in policy they will increase by about a trillion dollars or by almost 50% in three years.

Federal tax revenues come from several sources. In 2010 the breakdown for the full $2.162 billion Federal T was as follows below. Notice that what we call our Social Security Taxes are almost as large as all individual income taxes.

                           Individual Income Taxes                $ 899 billion

                           Corporate Income taxes                    191

                           Social Insurance Taxes                      819

                           Other Revenues                                 207

When discussing a nation’s tax revenue it is incomplete to leave out the state and local governments.  In 2010, State and Local government units collected taxes of approximately $1.425 trillion making national T equal to $3.588 trillion. State and Local T was about the same in 2010 as it was in 2007 – meaning that the recession had a less proportional impact on state and local revenues. State and Local governments get their revenues from sales taxes, property taxes, individual and corporate income taxes, and various licenses and fees. Total government revenue was about 25% of GDP in 2010. It averaged 28% from 1990 to 2007.

It is important to note that tax revenues can change without any change in policy. That is, both tax revenues and government spending are automatically impacted by changes in the economy. Congress could be on vacation in a Holiday Inn Express in Illinois – a state proven to be a very popular place for state legislators – and the deficit could change in leaps and bounds simply because evil super villains caused the economy to contract and that automatically reduces tax revenues and increases government spending. Of course if super heroes in tight pants somehow cause the economy to grow rapidly, the tax revenues would gush and spending would dip – leading to an automatic surplus. We use the following fancy words to describe these automatic changes as cyclical.

Change in deficit = cyclical (automatic) change in deficit + cyclically adjusted (policy) change in deficit

The policy induced changes in taxes or spending are referred to as “cyclically-adjusted.” So when you read that the cyclically adjusted deficit got bigger, you know it was because the government enacted laws to change taxes or spending.  For example in 2010, removing the dip in the economy tax revenues (without automatic stabilizers) would have been $2.454 trillion. That compares to the $2.162 of actual T – implying that the negative state of the economy automatically decreased T by $292 billion dollars. As the economy recovers, that amount of taxation should return automatically without any policy.

Taxes can be defined as the rate of taxation multiplied by the tax base.  In a definitional sense, we raise taxes either by raising the tax rate and/or the tax base. It sounds easy to raise taxes by increasing the tax rate. It sounds like a bunch of fun if you raise the tax on other people like the neighbor who doesn’t trim his trees properly and lets his leaves fall on your lawn when you would be rather drinking mint juleps than raking leaves. The challenge is that the tax base does not stay constant as you are raising the tax rate.

Tax rates have a behavioral aspect. If you raise tax rates as a means to increase tax revenue, it is believed that the higher rates could create disincentives to produce within the taxing district. As a result a rise in the tax rate could reduce the tax base. If the latter is large enough we could get the self-defeating result that a rise in tax rates causes tax revenues to decline. Or looked at in reverse, a reduction in the tax rate that increases the tax base enough might cause tax revenues to rise. As a result of this discussion (assuming you are still awake) much of the debate about how to raise tax revenue involves beliefs or estimates of the behavioral impacts of changes in tax rates. How much does a change in tax rate impact the tax base? This is highly complicated and therefore controversial. We can argue about this until the cows come home (where did the cows go? Vegas? Asolo?).

Tax revenues are part of the process of paying for government spending.  While we might have different opinions about how large the government should be or how much it should spend, most of us agree that local, state, and federal governments have legitimate and constitutional bases for spending. The real question involves how much is enough. Federal government spending averaged approximately 20% of GDP from 1990 to 2007. It was about 24% of GDP in 2010. If taxes are levied to pay for government, then tax revenues should be the same percent of the economy.  So part of the solution for T is that we decide about G. As you know, this is not an easy one either.

Part of the spending story relates to the longer-term adequacy of taxes to meet the needs of an aging population. This focuses our attention on Medicare, Medicaid, and Social Security. Some politicians pretend that we can somehow separate these programs from the rest with little lock boxes with Al Gore’s picture on them. Others stand with arms crossed on their heaving chests and tell us we cannot jeopardize the future of our senior citizens.  It looks more like opera than government! The only thing that matters for the short-term or the long-term is the amount of tax revenues to collect relative to the government spending. 

Some people believe that tax increases will never reduce government deficits. They believe that an increase in taxes simply makes it more possible for governments to spend more. While an increase in tax revenues reduces government deficits by definition, another behavioral implication is that this increase in T gives government higher incentive to spend more.” Bertha, you just spent your whole month’s allowance in the first week.”” Dad, please give me a loan of next month’s allowance.”  “Of course, honey, because I love you more than Mom.” Right!

Taxes are also used for income redistribution. Most countries use higher tax rates on the rich to help lower income persons, who have lower or zero tax rates; or who receive transfer payment from the government.  Each time a government decides to raise taxes there is an inevitable debate about how much of the tax increase ought to be levied against the rich, the middle class, and the poor.

One report from the Tax Foundation http://www.taxfoundation.org/blog/show/27134.html  that used one set of data to show that the US actually has a very progressive tax system – meaning that when we compare ourselves to other nations, our rich pay the largest share of taxes absolutely and relative to income. In other words, the top 10% of the income earners in the USA pay a higher share of Federal government taxes than the comparable set of rich folks in Sweden, Finland, Canada, Australia, Germany and many more. This report shows one side of the argument. Others question specifics of such a report. Still others might acknowledge its truth and still lament that something must be done to stop an apparent movement of income and wealth from the poorest to the richest citizens.

Jeffrey Sachs  http://www.ft.com/cms/s/0/8836f284-592a-11e0-b9f6-00144feab49a.html   decries cuts to austerity programs that hurt low income families and tax cuts that largely benefits the rich. While he acknowledges that some attention needs to be paid to the spending side, he emphasizes that taxes need to be raised – especially on the rich. Recent news about GE’s tax situation in 2010 just added fuel to that fire.

Taxes are used to promote other economic ends….this is where the word loophole comes in. A loophole is a tax regulation that allows someone to avoid a tax that others pay. If a company locates a new factory in your town they may not have to pay local taxes for several years. If you pay interest on the mortgage on your primary residence you are allowed to reduce your tax payment by writing off your mortgage interest against your taxable income. When you receive a tax loophole you plainly see the incentive effect it creates – the positive impact it has on you and the economy. When others receive a loophole and you don’t, you often see it as a drain on the government’s taxes and a waste of taxpayer money. So loopholes are very controversial. 

The government could raise a lot more revenue if it closed all loopholes. But such a closing would have negative impacts on policies to attract new companies, would make housing more expensive, and more.  Accordingly any tax changes that close loopholes will set off a chorus of howling guaranteed to stall progress

Taxes are used for short-term stimulus or stabilization. Whether it was an extension of the Bush tax cuts or Obama-inspired tax changes, it is clear that much was done to offset a recession. One would think that it is not controversial to remove these tax changes once the recovery set in. But the questions continue. Will removing tax cuts some two years after the beginning of the recovery risk damage to a fragile economy? I doubt it but many leaders are wringing their hands (that must hurt) daily (in in front of numerous cameras) to show their support and kinship with working people.

My take from all this is that taxes are abnormally low right now because of a combination of cyclical effects from the recession as well as legislated changes in policy as part of a short-term stimulus package. As the economy improves, tax revenues will increase automatically. As we move into a more stable expansion period legislation can remove tax changes designed for short-run stimulation. Thus, one can “vote for” higher tax revenues simply based on these two elements which shouldn’t be highly controversial. Second, taxes are low compared to extrapolations of government spending in the near-term and long-run. This is where it gets sticky. 

But this is where one needs to create some priorities about government spending. To me the main issue now is the financial health of the country. Because that is my first concern, I think the main focus ought to be on a believable plan to attack future deficits. To do that means most of the focus has to be on the spending side. Raising taxes for this purpose is not going to be very effective since spending always seems to adjust to revenues.  But it might entail some tax increases.  It will be easy to scream about every impact on distribution of income, on legitimate uses of government spending, on the old versus the young, etc. But if we let all those issues distract us from the central one – then we very seriously risk being the generation of people who let government turn us into a second class nation.

The Fed meets a Fork on the Road to Oz. But is it an illusion?

These days the Fed sounds discombobulated. One Fed official says that we have to start thinking about withdrawing monetary stimulus and the next day another Fed official worries publicly that the economy is still too weak to contemplate raising interest rates above 0.25%. Bernanke always claimed that he would know when to withdraw the stimulus – and he would! Darn right! Like Bernanke I always know when to have my last JD of the evening but on occasion I sometimes have another one or two more as a night cap. It would be rude to not offer a night cap to good friends. Bernanke may have the same problem and the recent lack of unanimity of Fed officials underscores the real problem he has. In this post I try to do two things. First, explain why he will continue to have a challenge with the night cap thing and second, why there are good ways around this dilemma that involve mostly fiscal policy. But excuse me for a moment, as I can’t seem to find my JD.

That’s better. Now where was I? Night caps and Fed policy. Expansionary policy and government entitlements have a lot in common. Once you let the cat out of the bag it wants to stay out of the bag. You give a borrower a low interest rates and he will sacrifice two goats and a short child (this is Indiana the home of John Wooden) to keep those rates low. How unfair to raise interest rates just when the average family decides it wants to expand its family room to house its Best Buy nineteen surround sound speakers and 70 inch 3-D Samsung TV set. Imagine all the companies basing their expansion plans on a low cost of capital who might be forced to defer these investments because the Fed raised rates to 1%! Do you think for a second that once the Fed leaks more than a faint rumor of monetary tightening that Bernanke won’t hear a deafening moan and cry of why it is still TOO SOON to reverse monetary thrust?

Larry Dear – it is 11 pm and it is time for us to go home. But Honey Dear – there is still some onion dip residue on the corner of the coffee table and the host says we should stay and talk more about the pros and cons of using Coyote piss to control deer feeding in our backyard. It would be impolite to leave while some of the lights are still on. You might think I am crazy but this is what you are already hearing. The recession was over 7 quarters ago. 7 Quarters? If I remember my math correctly that is almost two years ago that we started the recovery. Consumer spending grew by more than 4% in the fourth quarter of 2010. And yet, the Fed is following through with another $600 billion in monetary stimulus. Geez, I’d hate to see Bernanke with a bottle of JD. Charles Evans, President of the Federal Reserve Bank of Chicago said on March 28, 2011

“Despite recent improvements to the outlook, we are not yet at that point” when “a change in the stance of monetary policy will be necessary,” Evans said today in the text of a speech in Columbia, South Carolina. “Slow progress” in lowering unemployment “and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate.”

Geez Chuck, please tell me when it is time to shut the lights out. One analyst says that unemployment will not reach former lows until 2019. Are you going to wait until then? Everyone sees shoots of inflation popping up here and there. Are you going to wait until it is spreading like a wildfire to get out your hose? Please tell us if you can – how high does inflation have to be before you think it needs your attention? For how many months must it ravage us before you deem it a national problem? If inflation does start rising while the unemployment rate is still 9% or higher, then my buckaroo, what are you going to do then?

And this brings us to the fork in the road and my second point. It is well-known and pretty much correct that when the unemployment rate is high and the inflation rate begins to rise, this creates a VERY DIFFICULT TRADEOFF for the Fed. Remember that the Fed has one tool and this tool can only be applied to AD in one way at a point in time. If unemployment is the main problem today then it uses monetary policy to expand demand output, and employment – knowing that the negative consequence might be higher inflation. Instead, if inflation is public enemy #1 on another day the Fed will use its policy to reduce AD with resulting lower inflation – knowing that the negative consequence of slower growth might be higher unemployment.

So this is what we mean by the fork in the road. The Fed is at or very close to this fork when unemployment is still above 9% and the inflation rate is starting to rise. Toto (a dog) wants Dorothy to take the right fork and the Scarecrow (no brain) prefers the left direction. Dorothy has been traveling a long time and would just like to get to Oz where she can take off those tight shoes and have a very cold, shaken not stirred very dry Bombay Sapphire martini.

It turns out (and I am taking substantial liberties in this paragraph that could land me in real trouble with little people) that either one of those two paths is riddled with munchkins or evil witches or Joe Biden. Either path will get you to Oz but either path also has its negatives. But there is another path – a less popular one advocated by Macroman (no heart) that offers a clear and safe path to Oz. This path has no tradeoffs. This path decreases BOTH inflation and unemployment. The Scarecrow shouts that this is impossible. Toto pees on the Scarecrow’s stalky toes in concurrence. We pan our cameras to a scene with many dancers and singers – the refrain something like “we’re off to see the Wizard, and the Phillips Curve says there must be a tradeoff….” Or something like that.

But Macroman glides in on a broom and explains the glories of a shifting Phillips Curve – or more simply some brief words about why it is possible to reduce both inflation and unemployment. The Fed is in a fix. They say that they will refrain away from monetary expansion but they have already backed themselves into a no-win corner that offers very negative consequences in the short-run – either too much inflation or too much unemployment.

There is no better time to think about policies designed to reduce both inflation and unemployment together. These policies go to the heart of the business equation which says that reducing business costs and raising business productivity allows for simultaneously higher output, higher employment and lower inflation. Wow – is that really possible? It seems crazy because our policy makers are so stuck on the single horse we call AD that they cannot easily see or easily explain other policy alternatives. It may also reflect the fact that many of our legislators never took a course in microeconomics. Do you need a course in micro to graduate from law school? Sorry, all this Oz stuff (ie JD) is making me a little crazy.

By the way, these kinds of policies aimed at business costs and productivity are not novel or new. Virtually every transforming nation that moved from a centrally planned production system to a market driven economy legislated and implemented a host of policies aimed at strengthening business competitiveness. I won’t go through a list of things the US could do – at least not in this posting – but it takes very little imagination to understand these things. (1) Permanent increases in employment and prices come from firms. (2) Some government regulations and taxes may unnecessarily impose costs on business, and (3) constrain attempts to be more productive. I will let the politicians decide which of these things could be quickly evaluated and legislated.

My message is simple. Monetary policy officials are already too late to do what is necessary. They are still at the punch bowl. Monetary policy presently offers only bad choices with well known negative tradeoffs and consequences. There are other policies designed especially for these kinds of times and the Fed has no control over them. It would be better if the spotlight shifted from the Fed back to our government. The tools are there and they need to use them.

The Fed Fails to Understand Supply and Demand

Several Fed leaders keep expressing concern about letting go of QE2 and monetary stimulus too soon. One worried that the economy was too fragile to stand an end to QE2. Another said specifically that rising interest rates would put us in a double-dip recession.

Let’s understand a few things. First, banks are sitting on tons of money and not lending it out. Mostly they are buying government bonds. Reversing QE2 means taking that money out of the system that is doing nothing but sitting there. It is like taking away half of your kid’s score of candy on Halloween night. The kid is not going to eat three large grocery sacks of candy. Taking it away does nothing. Second, would an increase in the Fed funds rate from basically zero to 1 or 2 percent really cause tsunami-like ripples in the financial system? Please. You guys gotta be kidding me.  Third, what is this talk about a fragile economy? Check it out. We are growing at 3+% and the recession was over almost two years ago. If the recovery was a golden retriever, the new born puppy would weigh 80 pounds in 2 years. Sure, the economy is not growing fast enough. Sure the economy has some soft spots. But please – 0% interest rates for another year!  Admit it, you are hooked on stimulus and you just can’t get off.

But a bigger point is that these leaders simply are confused and have not learned their lessons of supply and demand. I apologize if I have to use highly technical terms like supply and demand, but I will try to make this as painless as possible. (Go drink two ounces of your favorite alcoholic beverage to prepare for this.)  Now you are ready. 


Here is the key point. It is true that if the Fed made a clear signal that they were going to raise interest rates in the future, some long-term rates might begin to rise by 100 basis points or more. It is also true that higher interest rates might increase the cost of borrowing and might induce some households and business to NOT borrow. If businesses and households do not borrow then they don’t spend and this threatens spending and output and employment. Okay – I get all that. But the truth is that borrowing and spending is not very high anyway. Why? Because both borrowers and lenders are worried about the future. As I said above, banks are sitting on tons of cash and they are NOT LENDING IT because they are worried they won’t be repaid. They are worried it won’t be repaid because these goofy Fed (and Treasury) people keep telling them how weak the economy is.

The problem is what we sometimes called a supply-constrained disequilibrium in the credit market. We don’t have a demand (for loans) problem – we have a supply problem since bankers don’t want to lend out the money. Imagine that Fed and Treasury folks started emphasizing the glass half-full -- i.e.focusing on all the good or positive parts of the economy and the bankers and borrowers became more optimistic about the future. With stronger confidence a credit supply response might be faster and more elastic than a demand increase. In terms of basic supply and demand what you have is a situation in which a renewed confidence causes supply to increase more than the demand – and a fall in the price of credit. If demand increases but supply increases even more – then prices fall! Here is the interpretation in a nutshell in terms of banking and loans:

o   The Fed stops QE because the economy has shown strength

o   Bankers decide to make more loans

o   Spenders borrow more money

o   Interest rates on business and consumer loans fall though in time will begin to rise back to normal historical averages

o   Higher spending leads to more output and employment

But the Fed is afraid to do this right now. They focus on the negative and they spread hand-wringing concern about weakness in the economy. It is no wonder a tightening of money would scare people and lead to a bad result. Your little kid is afraid to learn to swim. Why? Every time he gets near the pool his parents hover and make sure he knows how dangerous it is. The kid won't get near the water..  Some Fed officials need a good dunking in the pool. Only then will the pool party begin. 

The Fed, food, fuel, and foolishness

     True or False? Ben Bernanke called up my local grocer and asked that he reduce the price of T-Bone Steaks.

     True or False? Ben Bernanke doesn’t understand inflation?

I am writing this post because of what I think is a lot of confusion about prices, inflation, and monetary policy.  The most likely answer to the above two questions is false.Bernanke does not call my grocer and he does know something about inflation though he may not be explain what he knows very well.

Some background on this topic can be found at my earlier post on January 26^th at  http://larrydavidsonspoutsoff.blogspot.com/search/label/Inflation%20or%20Deflation

Price change is REALLY bothering a lot of us now. I am especially offended when Big Red Liquors raises the price of Jack Daniels. But we all know that I can save money by switching to Old Rotgut with little change in outcome. We all also know that a lot of people are being seriously negatively impacted when they buy tomatoes, corn, gas, and a lot of other things. So price change is a very serious matter.

The confusion comes (1) when we call this price change inflation and (2) when we start wondering why the Fed doesn’t do something about it. So let’s work on the first point first – what does price change have to do with inflation?

Inflation has more than one definition. For example, we can inflate an inner tube or a penile pump. In these cases inflation has a very general and vivid meaning.  More seriously, inflation can also be a measure of how much prices are impacting a nation at a given point in time. We measure this definition of inflation as the percentage change in an index of prices. An index of prices is a simple mathematical tool that averages together the prices of many items. When we talk about the Consumer Price Index we are speaking about a number that averages together the prices of all the things a typical urban consumer buys. Wow – that’s a load. One thing to know about the CPI and any price index (for example we also have a Producer Price Index) is that since it is an average of all these prices it is possible that one price might go up 1000% one month yet the overall index might not budge. That is, despite increases in the prices of corn or tomatoes, if the price of Blackberries (and I don’t mean the fruit) goes down, the average of all prices might not change at all.

So it is possible that you are getting whacked by rising prices in the grocery store or at the gas pump yet the published CPI figures are saying there is no change in the national price level or inflation. A reading of no change tells you a couple of things. First, the average urban consumer is paying about the same as they were before for all items. Second – IF YOU ARE NOT THE AVERAGE URBAN CONSUMER then this publication of the CPI tells you almost nothing. Yup, that’s right – it tells you zip. If you don’t have a car and you gag on fruits and vegetables while you sit at your computer playing Resident Evil-4 until 4 am, then it might be that you are spending a lot less today on the items whose prices are rising the most. Of course, if you are just the opposite – a fruit-eating  vege-loving media-phobe then your  cost of living is rising dramatically.

Okay – so you might be spending more on some things and less on others and you didn’t realize it all averages out. Or you might, because you are different from the average consumer, be paying a lot more (or a lot less) than what the CPI is telling you. Either way, FROM A PERSONAL STANPOINT the CPI can be a very misleading index of the impact of prices on you and your family. So the CPI might have risen by 4% last month and Larry’s CPI might have been 0% or 20%.  It depends very much on what Larry has been buying. 

That brings us to our second major point – what can the Fed can do about inflation when it is rising too fast. The first thing to note is that the Fed does not call up grocers or gas station clerks – that is not written in its charter. The FED has no magical or direct connection to the prices of individual items. So if gas prices are too high – this is not anything the Fed is empowered to directly work on. So let’s start with the idea that the Fed cannot help you with your own inflation problem.

So what can the Fed do? Basically it can do what it always does – use its control over money to influence the growth of aggregate demand (AD) and expectations about the growth of future AD.  If people believe that AD is growing too fast, then they will translate this into a higher expected future inflation rate. The Fed can try to restrain these expectations by tightening the growth of the money supply.  Notice that this more or less impacts prices of all goods and services more or less proportionately. So if YOU ARE PRIMARILY CONCERNED WITH FOOD OR ENERGY PRICES, then Fed policy is not a very powerful way to focus on your main concerns.  It is like having only one kind of pill in your medicine chest. Clearly it might be better to have separate pills for such maladies as common cold, allergy, upset stomach, and a weak stream.

The Fed is doing its job when it DOES NOT aim at prices of particular goods and instead is working on a nation’s overall inflation problem. Inflation in this sense is best defined as a PERSISTENT and SIMULTANEOUS increase in most of the items that comprise the price index. Persistent means that the Fed believes the price changes will last a while – long enough for its broad tools to impact the nation’s AD. Simultaneous means that the inflation problem is widespread enough in terms of various goods and services that impacting it through the nation’s AD makes some sense.  AD is not a good tool to focus on men’s blue walking shorts or dill pickles – but it is designed to have success on the whole basket of goods purchased by consumers.

That is why the Fed focuses its policy analysis on a measurement called core or median inflation – these are measures that largely omit or ignore short-term changes in highly volatile food and energy prices so the Fed can focus on the persistent changes in most of the items. The FED knows when food and energy prices are rising and they know this hurts people. But the Fed avoids this information much like Odysseus tried to gaze away from the Seirenes.  Will it sounds seductive to be all things to all people, focusing too strongly on the wrong targets can only lead to eventual failure.

Today it seems that much of the inflation that is distressing us so much is not the result of too much current aggregate demand in the US but it more the result of food and energy prices rising. While we might wish that the Fed would lean against this storm of price increases, it might not be something we really want. To have much of an impact on food and energy prices the Fed’s restraint would also bring with it declines in prices of many items which have not been rising rapidly. This might hurt many producers who have not yet fully recovered from the last recession.

So what can you do? Probably what you usually do when a difficult set of circumstances largely out of your control challenges you and your family. You do a little thinking (for most of you that means arguing) and see how you can minimize the damages. Look down and notice that you have feet! Maybe you can walk more. I know someone who drives to the grocery store at least once a day. That someone could take fewer trips to the grocery store. That someone will probably not be very nice to me after she reads this. You can take vacations closer to home and you can eat less popular fruits and vegetables. Let’s face it, we have a lot of control over what we buy and it might be fun eating Brussels sprouts and turnips as we skate to work and skip to our favorite lunchtime cantinas with $5-off coupons. Okay so maybe that’s not so much fun – but at least we know that most bouts of rising food and energy prices don’t last a long time. 

The real inflation threat to us, however, is if the Fed keeps fighting a recession that is long-gone and ends up increasing AD too high for too long and we get the real thing – rising inflation and rising inflationary expectations. That unfortunately will last a while and won’t be so easy to avoid. A future post will look into that issue in more detail and technicolor.

US Oil Production, Self-Sufficiency, and Fuel Price Futility

I think the US ought to produce more energy.  I think we probably ought to produce more oil and gas. But I do not believe that we should do these things so that we can keep the price of oil low in the USA. I keep hearing people talk about oil or energy self-sufficiency as a means to keep oil prices low in the USA. This is crazy talk or maybe just wishful thing.  Let’s produce more oil here but let’s not raise expectations about something that isn’t going to happen. We are not going to become self-sufficient and even if we did it would not allow us to control the price we pay for oil.

We can no more protect US citizens from the global price of oil than we can stop a tsunami going 550 miles per hour. Oil prices are determined by global supply and demand. In economics we often begin our thinking about pricing as a process of determining full cost and then adding a mark-up for a reasonable profit. This makes us think about production and distribution costs. Let’s suppose it costs about $60 to produce and distribute a barrel of oil. Add a $20 profit and you get a price of $80 per barrel. I don’t know if those numbers are accurate but let’s suppose they are close. But that’s nothing but a starting point for the price of a barrel on the world market on a given day. If the world economy is booming and the demand for oil is very high, then firms will produce more and that raises their costs – and may also be a time when they take higher profits. So a barrel might be priced at $100 or more when the world experiences strong economic growth. Next consider a time when the demand for oil is very low – it is possible that the price of a barrel of oil is only $60 on that day. Add psychological effects, speculators, government or OPEC announcements and you can easily see why the price on a given day could be well above $100 or well below $60. Fun, eh?

But you might protest. If we can produce a bunch of oil in the US – who cares what the world price is? We produce it here and we consume it here. Suppose we are self-sufficient. We could price US barrels at US prices. With lots of US production we could keep the home price low. That’s a nice story but it ignores two other economic ideas about prices – opportunity costs and replacement costs.

An opportunity cost is what you have to lose in order to gain something else. Let’s see how opportunity cost comes into play if the US were to be self-sufficient in oil.   If I can sell a barrel of oil on the world market for $100 and I can sell that same barrel of oil in the US for only $60, then what is a barrel of oil really worth and where would I want to sell it? You can play the Star Spangled Banner all you want – but in that case economics says the price of oil is $100 and the economy is made more efficient and productive when we buy and sell at the market price. Clearly US suppliers would rather receive $100 per barrel and they will attempt to do so. Resurrecting legal and other barriers to prevent this sort of behavior is possible but not consistent with a market economy. If, on the other hand, temporary conditions had the world price of oil at $40 while US prices were $60, you can bet you’d see the benefit in letting US consumers buy oil on world markets. 

More production in the US marketplace does not insulate us from world oil prices. The replacement cost story arrives at a similar conclusion. I fume about replacement costs every time my local gas stations are so quick to raise prices after a rise in world oil prices. It seems to take them only 10 seconds to translate a rise in the world price of oil into another 10 cents per gallon for gas in Bloomington. I may fuss and fume but this is really good business on their part. Sure, the gas in their pumps at that moment came from cheaper oil. But what does it take to replace the gas in those pumps? What is the real price of oil? It is now higher and the gas station would be wasting resources if it charged for its gasoline as if oil prices were much lower.  If higher oil prices are a sign of relative scarcity then stations that do not quickly raise prices are wasting a scare resource by setting gas prices as if oil with highly abundant.

In short, oil prices reflect the world demand and supply of oil. While a country or a single business can deviate from the world price for a time, it makes no sense to continue to do so. The more you try to create barriers between your price and the world’s, the more pressure there is to subvert your effort – because strong global economic forces will be impacting those who demand and supply the oil at home.

Consider the issue in a broader sense. All of us trade. There was once a day when we lived in caves and we did everything for ourselves. We learned quickly that families could form and they could allocate specific assignments to the members. This division of labor made it possible for individual family members to specialize with the result that family leisure and output would increase.  Some members were hunters and some were gatherers – and then they traded. This result from division of labor and specialization continues today. We trade unthinkingly for almost everything. Most of us are very specialized and we trade the money we earn from this specialization for everything we need. All countries trade and we have learned that the benefits of trade come regardless of the size or income of a country.

We are not forced into trading – we do it to reap the benefits of division of labor and specialization. The United States buys a lot from the rest of the world and oil is part of that trade. We may not like it when the world price of oil rises but we clearly gain overall from not doing everything ourselves. Trade is a net positive for us despite the fact that there are times when we feel imprisoned by it.   

The best thing the US can do is to try to influence the world demand and supply of oil. Since we are a very large and influential nation we have the clout to try to raise world supply relative to world demand. If we want the price of oil to be lower we should forget about separating ourselves from world markets and do the opposite – engage with other countries to solve the problem.  After the oil shocks of the 1970s we learned that both conservation and production incentives can succeed. These lessons need to be applied on the world level. Most nations are like the US – primarily importers of oil who would gain from a lower world price. So we should have plenty of allies as we seek real solutions. Engagement is the key.  We have a strong selfish incentive to work harder at home on production and conservation. Success means fewer imports and a stronger trade balance.  A stronger trade balance means higher growth and less needs for foreigners to support our international debts.  The idea here is NOT to be self-sufficient and to make our price lower than the world’s price. The idea here is to contribute to a more orderly world market for oil and energy.

In summary we may never be able to control oil prices at home but there is plenty to gain by working hard at home while negotiating with trading partners to raise world energy supply while incentivizing conservation of these scarce energy resources. Even if other countries do not follow, A US plan to conserve and produce oil and other forms of energy will pay dividends. 

The National Debt is okay because we owe it to ourselves. Right?

We owe it to ourselves. Nancy Pelosi among others has uttered this phrase as part of a rationale for why we should not worry about US Federal government deficits and debt. There are a couple of issues I would like to address. First, it is not true that we owe it to ourselves. Second, even if it were true, there would be good reasons to address the deficit issue. Let’s start with a simple but useful analogy.

I am retired so let’s suppose I need some money to finance a cruise to someplace really nice, like Alabama. 

So let’s say I need $1,000. I have some choices:

o   I can borrow the money from myself – that is, I can take the money out of my saving account. I promise to not spend some money later so I can replenish my saving account.

o   I can borrow the money from Betty. That is, I can ask her to take money out of her saving account. I promise to repay her in the future.

o   I can borrow the money from a bank in the USA. The IU Credit Union will deposit money into my checking account and after filling out 3000 pages of forms and leaving a blood and sperm sample, I promise to repay them in one year.

o   I can borrow the money from a bank in China. The People’s Bank of China will deposit money in my account along with coupons for three egg rolls at my local Chinese restaurant. I promise to pay my loan at the end of a year’s time.

If I repay the loans as promised then there is no big deal. But let’s suppose that after the Alabama cruise I get cruise-fever and can’t stop myself from going on cruise after cruise until I have ballooned to 300 pounds, sold my house, traded my collection of IU coffee cups, and basically declared bankruptcy. Does it matter how I borrowed the money? The answer is both yes and no.

It doesn’t matter how I borrowed the money in one sense – since there will be a negative repercussion in any case if I don’t repay. But the kind of unintended consequence depends on the source of the borrowing.

If I borrowed the money from myself then I cannot repay my own saving account. No big deal, right? Wrong! That saving account is what I was planning to use for important things in the future. Perhaps I was going to use that saving account to pay healthcare expenses or assisted-living housing. Getting into financial difficulty today has a real cost. It matters even if I borrow the money from myself. Postponing the repayment of the debt to myself means I transfer enjoyment from the future into the present. I might regret that later.

If I borrowed the money from Betty then we have a somewhat similar dilemma. If I do not repay her then we have an intra-household distribution effect. She has savings for important reasons too – for example all the nails on her fingers and toes must be attended to regularly by a licensed nail-professional. (I know I know – I am being very sexist here and I deserve whatever you decide to heap on my head. Please be nice.) Not paying my debt to Betty or postponing it means living with her ugly, ragged but personally-sharpened nails. I will regret that later.

If I borrowed the money from a USA bank and I do not repay it, then we have a national distribution impact.  My repayment was counted on by the bank to meet account withdrawals. If I fail to repay then bank depositors cannot withdraw funds they need for payments. Or perhaps the bank has lower profits or bigger losses. The stock values of my bank may decrease. Someone gets hurt financially and this has further impacts on others. Not paying my debt to the bank or postponing it means that the nation suffers.

If I borrowed money from a foreign institution and I do not repay it then we have an international distribution effect. This would be the same as the national distribution effect except that the impacts go to the foreign bank, foreign depositors, and owners of the foreign bank’s stock. Since fewer renminbi would be purchased in this case it would also reduce the value of the foreign currency. That raises the value of the dollar and makes it more difficult to sell US exports to trading partners. Not paying my debt leads to future impacts on foreign countries and the US (since we trade with China).

So Yes, it matters where I borrowed the money since the identity of the lender determines the nature of the distribution effects. But notice that in all cases there IS A DISTRIBUTION EFFECT and it is negative.  So in that sense it doesn’t matter.

You might say, I am missing the fact that an expected positive current impact was created and we have to pay for that benefit in the future. The expectation is that I will be able to pay my loan in the future. The problem arises only when something happens to prevent that. So it depends very much on what I presently use the loan for. If I use the loan proceeds for a productive investment, then the investment promises to pay enough to me so that I can pay the loan balance in the future. If I used the loan to finance a temporary change in consumption, then there is less chance for the payoff.

When Nancy Pelosi says we owe it to ourselves she is using a concept called net debt. Gross debt of the USA rises when the US government sells bonds or borrows – it is the value of the liability. But some or all of those bonds become assets to US citizens who hold those bonds. Suppose all the bonds were held by US citizens. When we subtract this asset value from the gross debt value we get a net debt equal to zero.  As a nation, we simply owe the debt to ourselves and thus we have zero net debt. But as the above cases suggest, we cannot ignore the expected distribution effects that arise when a debt is not repaid – or when we expect the debt will not be repaid.

When Nancy Pelosi says we just owe it to ourselves she is implying that we don’t have to worry about US gross debts that are owned by US citizens. But clearly she is being myopic and not considering the implications to ourselves once it becomes apparent that we are not managing that debt. We should worry about that debt to ourselves precisely because not paying it causes real and painful distribution impacts. Not paying off the debt means that the tax payers gains from the reduction of the liability. But not paying off the debt also means that holders of the debt do not receive their due. The net change debt change to the nation is zero – but the effect on the nation goes well beyond the concept of net debt as explained above.

We should have learned a great deal about debt mismanagement and how citizens of countries that have endured financial crises were harmed by it. Notice how much interest rates in Greece and Ireland rose once it became apparent that these countries might not be able to fully honor their debts. Those high interest rates insure slower economic growth and higher unemployment. And what about all those pensioners who held “safe” government bonds only to find out they were worth much less today than they were yesterday? When they are forced to cut back on their spending or sell their houses, how does that help them or their countries? These are the real world distribution effects arising from a nation that goes into debt because of unwise spending.

There is much risk of future declines associated with reneging on one’s debts even if we really owe it to ourselves. But it is not even a close call to say that we owe the debt to ourselves. Foreigners owned about $1 trillion in US government bonds in 2001 – by 2010 they owned over $4 trillion. They now hold more than 50% of federal debt owned by private investors and 31% of the total public debt. Should events lead to the US government being considered more like Greece or Ireland in the future, we would clearly have strong negative impacts on investors around the world. In addition to the government bonds, foreigners own another $13 trillion or so in private US bonds, stocks, and bank accounts – assets whose worth would also suffer from a US government debt problem.  

We need to face the facts. We spent decades getting into a fiscal crisis. We cannot wish it away with silly notions like “we owe it to ourselves.” Even if we did owe it to ourselves a debt problem would have very harmful impacts. But we owe the debt to countries everywhere and the harmful impacts will come from everywhere. The bottom line is that it doesn’t much matter if panic selling of US assets starts with John Smith or Lan Huang – if people think that US assets are worth less the results will not be pleasant. 

Aftershocks and Afterthoughts about US Economic Vulnerability in 2011

As I write this moment world stock markets are down again -- perhaps over-reacting but reacting nevertheless to a new bout of major uncertainty. Some forecasters believe this is the beginning of another economic meltdown. It is too soon to be making judgments like that but ff nothing else it should remind us about the fragility of the US economy and how vulnerable we are to shocks. In this post I continue my ranting about the urgent need to come to some agreement about future US deficits and debt. To not make progress makes us ever more susceptible to every shock that comes around. We are not making adequate progress largely because our political parties would rather squabble about traditional and sensitive issues than do the hard work of finding a way out of our debt mess. One morning last week, the headline in my local newspaper featured Vi Simpson, a respected leader of the state’s democratic party, declaring that the Republicans had declared war on the working man and the middle class. Yes, this usually intelligent and helpful representative of the Hoosier government used the “W” word. And she said it in public.

So now we are at war in Iraq, Afghanistan, and Indiana. Of course, the war she speaks of also has fronts in Wisconsin, Ohio, and DC. So I will now scream at the top of my lungs – YOU STUPID REPUBLICANS – YOU GOT WHAT YOU DESERVE. And the result is that moderate Americans who just want to see the economy improve have yet again been sucker punched by extremes in both parties. Are we so myopic (nice word for stupid) that we don’t see the game they play to perpetuate their own power? When are we going to recall all these extremists in our government and replace them with people who will focus on the whole country?

Surely when the Republican leadership meets they sometimes discuss the fact that their Democratic opponents and especially the extreme wing of that party can be pretty rough if not loud and ugly. What were the Republican leaders thinking when they decided that 2011 was the opportune time to take back all they had lost in recent years? Let’s make it impossible for gays to marry. Let’s throw water balloons at union members. Let’s re-write abortion laws. Let’s gut really popular government programs. Let’s make schools more like they used to be in the1950s during the Sputnik scare. Did I miss anything?

Really – was 2011 with a divided government the best time to irritate the other party by focusing on all their hot buttons? Really – was 2011 the time to let all the extremes in both parties elevate all their hot buttons so much that the REAL ISSUE does not have a chance to be debated and confronted in a contentious but eventually cooperative environment?

Some people say that this is politics as usual. But I beg to differ. This is politics at its worst because the leaders of both parties let their extremes dominate. I am not kidding when I say that I wish for the time when parties acted like real parties. They always had extreme factions – but there was a time when these extremes were thrown a few crumbs and told to sit in the corner. But look at Reid and Pelosi – they are a joke.  Boehner isn’t much better. They help these extremists throw Molotov cocktails at the rest of us.

The way we all go along with this destructive behavior makes you wonder if there is some elusive or hidden benefit we receive by smiling as the USS Titanic leaves port. Perhaps we like the freedom that allows all sides to express their opinions. Okay – that’s fine. Whether or not the armed forces have a “don’t ask don’t tell” policy is very important to many people. But do we really want to spend all our time RIGHT NOW debating that issue instead of coming to a real compromise on government deficits and debt? When the Titanic was going down people didn’t argue about unions. They focused on how to save themselves. The times require a solution to the most pressing issues. Yet we let the extremes persuade us that it is better to let the ship go down while we spend our last precious moments arguing whether Miller Lite is less filling or less tasty. 

Why do we sanction this destructive behavior? I think there are three key reasons. First, none of us like to admit that we have to go backward before we can move forward again. We got hit by a car, have numerous injuries, face a long rehab, and we are faced with the fact that there is no wonder drug to makes us immediately well again. Second, the rehab program is not without controversy. Good physicians disagree on the best programs because the body is complicated enough that no one can know exactly how a program will work. Third, we know there will be side-effects from the treatments and we fear the unknown. Faced with a very difficult situation it is understandable that we humans may want to postpone decisions even knowing that postponing may make things worse. As a result we are easily distracted and those at the EXTREMES see this as easy fodder for them.

So what do they do as we worry about very difficult and imminent challenges? They divert our attention to things that are guaranteed to arouse us emotionally. Hey guys, don’t worry about the Titanic going down – let’s watch re-runs of Charlie Sheen? Or maybe you would prefer Oprah? Let’s solve poverty today. Or maybe we should make sure rich people pay a larger share of taxes. PLEASE. These ARE important issues and we need to address them – but right now we have to sober up and focus all our energy on deficits and debt. Let’s not be duped by the extremists. We are smarter than that. Spillovers from the recent earthquake and tsunami ought to remind us of that!

Government Spending and the Law of Gravity

Despite having no real propensity in physics, I found myself in that course at Georgia Tech in 1965. I vividly remember a tutor, Professor E. E. Bortell, chanting for the benefit of us slow learners “What Goes Up Must Come Down.”  Actually Professor Bortell would say loudly – “What goes up must…..” and we could chime in “Come down.”  We did it over and over. It was fun and it kept us awake.

So what does that have to do with government spending? I checked the historical record and found that the federal government of the USA spent almost $93 billion in 1945. In subsequent years it went down to $55 billion, $34 billon, and $30 billion. It was pretty clear why the government spent less in those years – World War II was over and it was not necessary to keep spending at that rate. It took until 1961 before government spending reached $93 billion again.

We all understand that some things are temporary. We wear braces for a while but then discard them when our teeth are straighter.  Girls wear training bras until their stuff gets trained and boys get in fights until they learn that stuff about the girls. What goes up eventually comes down. Or does it? Even in the case of World War II there was some debate about the government reducing its spending. Alvin Hanson was a professor who believed in the Secular Stagnation Hypothesis and argued that reducing government deficits after WWII would bring back the Great Depression. In his view spending from the war only stopped the Great Depression temporarily. Without government spending the economy would forever be destined to economic purgatory (or worse).

Is that beginning to sound familiar? If we reduce government spending today, some experts believe surely we will have a double dip and it won’t be chocolate chip. The government didn’t listen to Hanson in the 40s and government spending was allowed to return to a more normal peacetime level. The government deficit had reached an intolerable $15 billion (almost 22% of GDP) in 1945 and returned to surplus for the next three to five years. Today we have a similar situation – we had a temporary surge in government spending during the recession of 2008/2009 and it is time to remove the surge. Or is it? Listening to our friends in government, you would think that what goes up ought to stay up.

Let’s think about the rhetoric as it relates now to the current budget-cut debate.  Think about the emotional and spirited language and gesturing you are seeing on the television. “By God man, you can’t cut that program. Think of all the misery you will cause.” But what does CUT really mean? What I show below is that most of what people are calling cuts are really what we might call a Restoration of Trend – or a return to a more normal growth path.

My focus in this posting is on what is called Federal Discretionary Spending (DS). What I am showing here could easily be expanded beyond the roughly $1.4 trillion we spent on discretionary programs in 2010. DS increased by $306 billion in the three years between 2007 and 2010. That was a 29% increase in three years. In the three years before, 2004 to 2007, DS increased by $146 billion or by 16%.  By any description, the last three years showed a HUGE growth of government wherein spending on DS was approximately double the growth in the previous three years. What value would DS have reached if it grew by the 16% instead of the 29%? Answer – about $1.2 billion or about $135 billion less than the actual amount achieved in 2010.  If in 2011 you took back or removed that extra $135 billion would that be a CUT or a Restoration of Trend?

You say I am playing with words. But this exercise is not about games – it is about making clear that HUGE TEMPORARY INCREASES in government spending are not entitlements that must last forever.  Taking back the $140 billion is NOT A CUT – it is restoring government growth to a sustainable pattern.  Notice that in the above exercise we are letting DS grow buy 16% in three years.  How many of you had increases in spending of 16% between 2007 and 2010?

Below I show the Restoration of Trend Amounts (in millions of dollars) for specific components of DS. The first column shows how much could be reduced from the program to allow it to grow in 2007 to 2010 by the same growth rate as it grew in 2004 to 2007.

Because of the technique used the items for the components do not add up to the total outlay amount. What you see here is how much we could reduce the spending in 2011 compared to its amount in 2010. For example, the education budget could be reduced by $44 billion dollars – and still allow the growth rate to have been 9% from 2007 to 2010. Notice that education spending actually increased by 83% in those three years. Would it really be a huge negative impact to give up some of that explosive growth? Did people become so addicted to the temporary increase that they cannot live with a 9% raise?

I won’t go through the table line by line but notice the last column and the extremely fast growth of spending during 2007 to 2010. Spending on Energy in those years increased by 179%. Except for the two line items at the bottom of the table, spending in 2007-2010 was much faster than in 2004 to 2007. This implies a few things. First, these increases were meant to be temporary.  Second, they are clearly unsustainable. Third, as the first column shows, there is much that could be reduced from 2011 spending and still allow a very rapid increase in spending. I am not suggesting that we remove exactly those amounts in the first column. We could remove more – we could remove less. But surely a prudent policy begins with understanding that these are in no way real cuts.


Note -- I had some trouble getting this table into the post. If it looks too  small to you I think you can just click on it and it will expand to a larger size. Sorry I am pretty lame at this kind of thing!

                   

Debt, Democracy, and a Double-Dip Economy

We are used to planning for the future knowing that things never work out exactly like we thought they would. Formally or not, we base our plans and actions on highly probable outcomes. I know that whenever I eat pasta I get sauce on my shirt and sometimes in my hair. It is predictable. So I wear a shower curtain at the dinner table. That’s what we do. We plan and prepare for events that have highly likely outcomes. And accordingly we do NOT plan for EVERY possible outcome. Some things are highly unlikely with almost zero possibility. While eating, I might learn that Madonna is going to join us for pasta primavera. For such a possibility I should be wearing only my best shower curtain. But, of course, I don’t because there is no way she is going to show up in Bloomington for dinner at my house. Accordingly we don’t worry about Martians or Charlie Sheen at the dinner table.

But there are events that fit in between the highly probable and improbable and we give them our attention.  We might say that we have a contingency or back-up plan for things that might happen, even if the probability is low. We buy life insurance policies when we are young because it is a prudent thing to do despite the fact that we might live through seven colonoscopies. Business firms hold costly inventories in the case that buying for their products is higher than normal. To NOT prepare for these possibilities is to be imprudent or we might call it risky behavior. NOT preparing for one-in-a-million unlikely events is excusable. Not preparing for somewhat unlikely events is not.

Today we don’t seem to know one unlikely event from the other. A terrorist plot to fly airplanes into tall buildings on US land used to be unthinkable – but now we spend a lot of money protecting ourselves from that kind of behavior. A financial crisis grips the US and the world – something that few of us prepared for but now has governments rethinking regulation and how markets should function. A revolution breaks out demanding democracy in Northern Africa and the Middle East – surely a plot for a futuristic novel but now all of us are scrambling to deal with the likely contagion.  One might argue that we should have known that all these things would happen. But the truth is that not enough people REALLY thought any of them would around the time they unfolded. They were pretty-much black swans. A black swan is a major event with very low probability – sort of like me driving to town without Betty telling me I picked the wrong route.

Today we are pausing to ask about the possibility of another major economic crisis or if such an outcome fits this black swan description right now.  To resolve this issue we have to calculate the probability of another economic collapse.  If a strong downturn is really highly unlikely, then it would be wasteful and costly to try to prevent it. But if it is not a black swan and there is something we could do, then we would conclude that our policy makers have their heads in the sand.

Recent events make me want to revisit the likelihood of another recession. We were cruising along pretty well in the last months – with lots of data pointing to a firmer economy. We are now seven quarters beyond the official end of the last recession.  Risk factors are well known and discussed frequently – the housing market needs more time to heal, government budgets need fixing, and emerging markets are causing threatening price rises of commodities, including oil. But the general consensus of most economists and the stock market is a rosy outlook with a small probability of a recession.

So why is Larry so cranky? I ranted recently about jeopardy – the idea that these risk factors should be given more of our attention. I particularly believe that government deficits and debt need our immediate attention.  Can we handle the debts now? Sure! But that’s not the point.  The point is whether or not we can handle the consequences arising from a few low probability events or shocks.  And last week pointed out how very unprepared we are.  Last week the political disturbances abroad caused oil prices to shoot up and our journalist herd quickly taught us how to spell S-T-A-G-F-L-A-T-I-O-N.  Last week we read and heard again about the 1970s and how and why a large and sustained rise in the price of oil might cause simultaneously higher unemployment and inflation.

A few journalists and economist s wrote more thoughtful explanations about why an oil crisis of the proportions we are experiencing today might not lead to as much economic wreckage as in the recessions of 1974 and 1980. But the point has been made. A black swan flew into our lake and left a big poo-pee. Maybe our economy will stick its nose up and go on with growth anyway. Or – maybe some white swans will join her and make the mess much worse. Right now we don’t know.

But this illustrates our choices. If we had a more normal debt position such an event might knock us around for a while – but having a large chain around our necks make us weaker and unable to deal with a large oil/commodities price shock right now.  If you had six months of earnings saved and in the bank when a bout of unemployment hit you, life would go on. If you have nothing but debts when unemployment strikes that is a much different situation. In that case it really hurts and you have few good options.

If stagflation hits the US – whether because of oil or the prices of other commodities – the US government budget position and debt will worsen even further.  The recession part of stagflation means that tax revenues will decline and spending will increase. The inflation part means many things – but surely interest rates will rise and cause mandatory government spending to increase.  And as most people know – stagflation puts the government and Fed in a no-win battle with inflation and unemployment.  Using traditional demand-focused policy tools, any policy designed to slow the rising inflation will make the unemployment worse. A policy more focused on the recession and unemployment will make the inflation worse. With fragile confidence today, can we really flirt with these outcomes?

Is the probability of stagflation high enough to warrant a faster and stronger approach to US debt problems? I think so. Clearly recent days indicate that the demand for democracy and the impact on oil prices is no longer a black swan.  But is the probability of continued disruption of oil markets high enough to warrant all the difficult political and economic changes that go with a fiscal solution? Clearly the expected payoff of a solution is huge. Imagine the newspaper story detailing the immense losses connected with the following headline – US unemployment rate rises past 10% as the consumer price index reach 6% in 2011. Why don’t we demand more from our representatives in government?  Let’s get this debt under control before the next sneeze becomes pneumonia. 

The Federal Budget Debates Focus on Spending Cuts. What Cuts?

I keep hearing about cuts in spending – and how various groups will be hurt by the cuts. This is strong evidence supporting the view that the government spending process never ends. Nothing is ever temporary. Nothing is ever enough. People get quickly accustomed to higher levels of government spending and feel entitled. No wonder they demonstrate in the streets when a program is challenged.

Data I present and discuss below suggest that the period from 2007 to 2010 saw huge increases in the growth rates of government. But that is only part of a story that begins with Y2K. Government spending has been growing about twice as fast as it was during the previous decade. DURING THE 2000s GOVERNMENT GREW TWICE AS FAST AS DURING THE 1990s.  The record shows that virtually every major spending category contributed to this spending bonanza. Since the two recessions of the 2000s contributed to this spending explosion, there is plenty of evidence to support the idea that what was supposed to be temporary was truly not.  When or where did Keynes say it was okay to stimulate the economy with government spending increases and then make the new spending level permanent?

Ideologues in both parties make it difficult to solve this problem. Why? Because they delight in infuriating each other with finger-pointing and guilt tripping. It’s all Reagan’s fault! Look at deficits in the 1980s. It is Bush’s fault – look at the growth of government under his rein. It is Obama’s fault – look at the last two years.

The extremes of each party act in this immature way because they want to stick up for their constituencies. They see the present crisis as a time to help out their labor union friends or stick it to the rich. Others want to gouge Planned Parenthood or get rid of healthcare reform.

But they are missing the point. Neither Planned Parenthood nor unions caused our current problem – a budgetary mess – one that is not simply an issue of the last few years. What I show below is that defense, discretionary non-defense, and mandatory programs have all grown at much faster rates in the last decade and especially in the last three years. I won’t repeat the data about the national debt – you know indebtedness is too high and rising too fast. In my last blog I wrote about jeopardy. While we might be able to sustain high national debt for a while longer – inaction means we raise the possibility of a financial crisis worse than the last one. So we need to get moving.

So why not admit that our immediate problem is not about the needs of special interests – but rather is about attacking a mountain of debt. If government spending rose by about $1 trillion in the last recession and much of that increase was to fight a recession, surely we can find ways to reduce that spending by $500 billion or more in the name of restoring normalcy and greatly reduce the chance that a financial sneeze will turn into a devastating situation with even more draconian policy choices.

I’d like to suggest that we go back to annual government spending  growth rates of about 3-4% – but that isn’t going to get rid of the debt soon enough. Even freezing spending to current 2010 levels isn’t going to provide much relief.  Taking the budget back to levels that existed in 2007 is not as hard as it seems. As the economy improves, automatic stabilizers in taxes and spending should improve the deficit by $200 to $300 billion. That’s a good start and we shouldn’t ignore that contribution. But it isn’t enough.

Automatic stabilizers accounted for $312 billion of the overall budget deficit in 2009 and $359 billion in 2010 – meaning that roughly 25% of the deficit deterioration was caused by the automatic (without legislation) responses of spending and taxes to the downturn. Or put another way – the budget deficit increased by about $964 billion in 2009. The automatic responses or non-legislated changes in spending and taxation to a downturn in the economy accounted for about $279 billion of that increase. The remainder, or $685 billion, was how much legislated policy change contributed to the higher deficit in 2009.

The upshot is that we could return to government spending of $2.7 trillion and a deficit of about $340 billion that existed in 2007 if we focus on legislated spending decreases that total about $700 billion in the coming years. The automatic stabilizer contribution will disappear on its own accord as the economy recovers. While the number $700 billion looks large if we describe it as a cut from the expected outlays in 2011 of $3.7 trillion, they look at lot more reasonable when you realize they are from what was supposed to be a very temporary and is now a very bloated (burp) level of government. If you gain 30 pounds of unwanted fat over the holidays you accomplish very little by saying that you are going to freeze your calorie intake after Christmas. What you need to do is have a plan to eat fewer Twinkies.

The following table summarizes the issue. The first and second columns show that government spending was about $1.8 trillion in 2000 and it subsequently increased to about $3.5 trillion by 2010. That’s an increase of about $1.5 trillion – or an annual compounded growth rate of 6.8% per year.  The third and fourth columns show what federal government outlays “would have been” in 2010 had government spending grown at a compounded 3.6% per year (same as the previous decade) or at 5% compounded per year. These amounts ($2.548 trillion/$2.914 trillion) are clearly less than the actual amount of spending in 2010 of nearly $3.456 trillion. The final column shows the extra or excess spending – actual in 2010 less what it might have been if growing at 3.6% or 5%. As you can see the range is from $542 to $900 billion.  Even if government had grown as fast as 5% per year we would still be able to reduce over $500 billion out of government spending. Friends – this $500 billion is not a cut – even if government had grown at 5% per year for 10 years it would have increased by $1.125 trillion during the decade. Of course if we think government should have grown at only 3.6% per year then we could reduce government spending by $908 billion and still have a government that showed considerable growth for a decade.

Total Fed. Outlays: Actual, Ideal, and Actual Less Ideal  

   (1)        (2)           (3)              (4)              (5)                   

2000     2010   2010 3.6%   2010 5%  Excess3.6/5             

1,789    3,456    2,548          2,914        908/542

Here are some further figures to ponder (All from the Congressional Budget Office http://www.cbo.gov/budget/budget.cfm )

Government Outlays        Compounded annual growth rates

2007 to 2010               8.2%

            2000 to 2007               6.2%

            1990 to 2000               3.6%

It is worth recalling that the increase in government spending after 2007 came at a time when the budget deficit was $342 billion and helped move it to $642 in 2008, $1.6 trillion in 2009, and $1.4 trillion in 2010. CBO estimates a deficit of $1.5 trillion in 2011.

This same decade-doubling pattern of spending growth shows up with respect to discretionary Domestic Non-Defense spending – with the annual rate of spending growing at twice the rate of the 1990s. Discretionary Defense spending also grew rapidly from 2007 to 2010 but it grew less fast than non-defense discretionary outlays and the decade of 2000 appears to be making up for no growth in Defense spending in the previous decade (and of course a reaction to global terrorism).  In 2010 Defense spending was $689 billion or about 20% of total government spending of $3.5 trillion. Domestic Non-Defense spending was about $614 billion or 18% of total government outlays.

Government Outlays: Discretionary Spending         
Compounded annual growth rates

Domestic Non-Defense       Defense

2007 to 2010               10.2%                           7.9%

2000 to 2007               6.4%                             9.3%

1990 to 2000               5.1 %                           -0.2%

The biggest part of the budget ($1.9 trillion in 2010 or about 55% of total spending) comes from what we call Mandatory spending. Between 2007 and 2010 total Mandatory spending increased by 9.5% per year. That compares to 6.2% between 2000 and 2007 and 5.3% in the 1990s. Consider these increases from 2007 to 2010:

            Compounded annual growth rates, 
Mandatory Spending           2007 to 2010

            Total                                     9.5%
             Social Security                    29.2%

            Medicaid                             12.6%

            Social Security                       6.5%

            Medicare                               6.0%

Mandatory spending, as the name implies, is not quickly changed. But since it is a major part of annual federal government spending and the budget deficit, it is too large to be ignored in this discussion. Since these programs are open-ended and change automatically with the economy, we can expect that spending on Social Security, Medicaid, and other programs will a decline automatically as the economy continues to recover. I discussed this above. But it is not unreasonable as we think beyond the next few years into the coming decade that restructuring of Mandatory spending be a key part of a fiscal solution. Evaluations of recent budget proposals show short-term deficit remediation followed by a period of deterioration…because of Mandatory spending increases as the baby boom generation ages.  Any plan that only addresses the next few years is going to be deemed a failure. So why waste time with solutions that are bound to fail?