Plain Sense Economics

Each term our principles of economics classes look at the issues of free trade versus protectionism. We review the theory – comparative advantage – that argues for free and open markets among nations. And we review the common arguments used to defend tariffs and other trade restrictions. At the top of this list is saving domestic jobs. We also think through the winners and losers when tariffs are imposed on foreign made goods. The biggest “losers” are consumers, who must pay higher prices on both the foreign made goods and the domestic goods.

Prof. Mark Perry, from the Univ. of Michigan Flint Campus produced data to show the cost of tariffs imposed on foreign sugar entering the United States. Hat tip to Economix for the link.  Here is a chart from his blog showing US vs. world sugar prices:

Oh – the answer is…$826,000 in annual consumer and producer costs per U.S. sugar job saved.

With a hat tip to Economix for this reference, economics staff at the Federal Reserve District Bank in Dallas have compared employment, unemployment and related measures in our current recession to those of earlier recessions and depressions. Here is an important, chilling graph from the report. One consolation is that later graphs show that the current labor picture is nowhere near as bad as the Great Depression (small consolation to those out of work today).

Unemployment in Post WWII Recessions: Source Fed/Dallas

As a followup to my earlier note on Oregon’s Measures 66 & 67, we need to take a quick look at some of the theories and rationale behind government taxes. This isn’t and can’t be an exhaustive discussion, but hopefully it is a start for our considerations. For SOU students I commend to you my colleague, Kip Sigetich’s class, Public Finance EC 319.

Here’s a quick list of reasons to tax. Each have a bit longer explanation down below.

We tax to…

1. pay for public services that are easier or more efficient to provide as a community than to pay for individually.  (AKA public goods)
2. correct for inequalities in individual wealth or income – to provide some basic level of food, shelter, medial care, etc. (AKA welfare and other social services)
3. correct for externalities.
4. Change behavior – encourage or discourage through incentives

1. Public Services/Public Goods:  There are services that many people want, but individually we could not afford to buy them. While it is possible for groups of individuals to come together privately to pool their funds and provide the service, they often run into the free rider problem. So we give government the ability to build roads, provide police and fire protection, and many other worthwhile goods and services. Often times voters have to approve the tax to pay for these. Here are some other posts on the topic.

2. Income Redistribution / Social Services: In some economies there is an explicit goal for a Robin Hood policy (take from the rich and give to the poor) – purely to even out income or wealth. In the United States and many other countries there is a social ethic or value that says that the poorest members of society should be able to live in at least some minimum level. This ethic or value is controversial, of course. Some voters support strong government efforts to improve the lives of our poorer members – along the lines of European social democracies. Other voters prefer a self-determination, self-reliance model, where citizens have opportunities but are left to their own to survive or advance in the world. And many voters are somewhere in between. In a later post we’ll show how many tax strategies focus on extracting more tax revenue from the wealthy than from the poor.

3. Correcting Externalities: In economics we call the presence of externalities a market failure. When someone outside of a market transaction is either harmed by or benefits from that transaction, we have an externality. If there is an externality then the market will produce either too much or too little of that good, and will not reach a social optimum. The most common example is factory pollution. When the factory produces a good and pollutes while doing that, others outside the factory are affected. See more on externalities here.

4. Incentives to Change Behavior: Some times we enact taxes to discourage behavior. “Sin taxes” are one such example. Tobacco taxes can be used to defray state health care costs. Generally this is a pretty inefficient mechanism since many of the “sins” are addictive and demand for them price inelastic. More often a tax on tobacco or alcohol is just a convenient way to raise revenue, and voters are more likely to support those taxes over more general income or sales taxes. A more modern application of this category is called a Pigovian tax, and the prime example being discussed is a carbon tax. Taxing activities and products that release carbon into the atmosphere should discourage and reduce those activities.  We also give tax credits for behavior we want to encourage.

In my University Seminar class we are looking at the arguments, pro and con, on Oregon Measures 66 & 67. For out of state readers these measures raise taxes slightly – for higher end income earners (families with incomes over $250,000 and individuals with incomes over $125,000) and corporations (raising the minimum corporate income tax from $10 – yep a sawbuck.)

The proximate cause for these measures appearing on the ballot is a classic squeeze felt by state and local governments. During times of economic contraction state tax revenues fall quickly, particularly if their state income tax is progressive in design. Why is that? Progressive tax structures impose higher tax rates on higher income individuals. When incomes fall families pay based on those lower incomes plus they pay a lower tax rate.

The other side of the state/local squeeze is that demands on government spending go up in hard times. These increases are usually automatic. More people qualify for state assistance as their incomes fall, and programs put in place automatically have to step up.

State and local governments can’t engage in deficit spending – which is the solution used by the federal government and recommended by Keynes back in the Great Depression. They don’t have the ability to borrow for regular operating costs. (They can borrow for larger projects that have an income stream. For example, selling bonds to build a bridge and then using toll revenues to pay off the bonds.)

Oregon has a particularly progressive income tax structure, and it doesn’t have a sales tax (regressive) to add a moderating force during hard times. Its biennial (every 2 years) budget has a huge hole.

Univ. of Oregon economics professor, Mark Thoma examined the two tax measures in this opinion piece for the Portland Oregonian. There are two important pieces to his examination and I recommend you look for them in the commentary:

1. Thoma is using positive economics (rather than normative) which means he avoids adding personal values or preferences to his analysis. In an early section of the piece he compares the impact on economic efficiency between taxing more versus cutting spending to fill the budget hole. He comes out mildly on the side of increasing taxes.
2. He has some new (to me) ideas about how to escape this state squeeze between declining revenues and increasing needs. He advocates some federal solutions, including providing a loan facility for state governments at favorable interest rates, and federal grants to help states bridge this gap.

On another level but the same topic a friend of mine is likely to vote against Measures 66 & 67 – feeling that the state legislature needs to control spending, and that tax increases just reduce the pressure for more fundamental spending reform.

What do you think?

This article is for my past students in healthcare economics. You heard me rant that while expanding coverage to millions of uninsured Americans is important, there also needs to be a parallel effort to control costs. The extension of benefits will increase costs significantly, even if we take into account some (minor) savings from earlier treatment and prevention.

Alain Enthoven, recently retired from the Stanford School of Business, has been on the same soapbox for decades. His preferred model uses competition to spur innovation and cost control. Here is a recent article in the Health Affairs blog on his current thinking. It is a good read.

Gawande acknowledges that the cost of health care “…will essentially devour all our future wage increases and economic growth.  The cost problem, people have come to realize, threatens not just our prosperity but our solvency.”  “So what does the reform package do about it? …Does it institute nationwide structural changes that curb costs and raise quality? It does not. Instead what it offers is …pilot programs.”

There has been a rash of speeches, articles, and op-ed pieces exploring the origins of the housing bubble and trying to place the blame on the actions of the Federal Reserve. Some of these efforts are honorable – recognizing that we have a responsibility to understand what when wrong and how to avoid repeating those mistakes. Other criticism has more political roots.

As a quick review for my students – Our most recent and serious recession came about largely because the prices of real estate and houses accelerated dramatically, and out of proportion to other purchases or investments that the average American could make. When that bubble of high prices popped, financial institutions which had been lulled into thinking their real estate-related investments were safe, found their balance sheets decimated. This has happened several times before in our country’s history, including the technology stock bubble in the late 1990s and 2000, and as far back as the 1800s for railroad properties and precious metals. Even in the 17th century speculation in tulip bulbs caused an economic collapse.

There are two main criticisms about Federal Reserve actions in the last 3-4 years:

1. The Federal Reserve kept short term interest rates too low, for too long a time following the mild recession in 2001. Critics argue that this monetary policy encouraged risky borrowing and unnaturally inflated housing prices.
2. The Federal Reserve was lax in its oversight and regulation of the financial services sector – both over institutions, like banks, and over the risky mortgage lending practices. Regulatory faith in the power of market mechanisms was unearned, and institutions made what we now see as irrational moves.

At a meeting of the American Economic Association in Atlanta this week, Chm. Bernanke rejected the idea that monetary policy caused the housing bubble, but he did acknowledge that weakness in regulatory efforts played a major role.

U of Oregon professor, Mark Thoma, has a nice piece on these issues:

I have been more defensive of the Fed’s actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.

I’ve gotten on this soapbox before – though the Federal Reserve is a human, fallible organization it is staffed and led by thoughtful professionals and should continue to be protected from political second guessing. There is no member of Congress, including Rep. Barney Frank, who can bring more intellectual and effective knowledge to bear on this issue than Bernanke and his staff.

Cornell’s Robert Frank wrote today in The New York Times,

[...]there are really only three basic truths that policy makers need to know about deficits: First, it’s actually good to run them during deep economic downturns. Second, whether deficits are bad in the long run depends on how borrowed money is spent. And third, eliminating deficits entirely would not require any painful sacrifices.

This is worth a read. He may over state the case for continued, thoughtful additions to our national debt, but his piece is a good reminder that fiscal policy is not really like balancing your family’s budget.

This article in The Wall Street Journal describes the British economist, A. C. Pigou.

Here’s an excerpt:

In the years leading up to his death, in 1959, he was a reclusive figure, rarely venturing from his rooms at King’s College. His novel ideas on taxing polluters and making health insurance compulsory were met with indifference: Keynesianism was all the rage.

We’ve talked about Pigou, and his Pigovian taxes in other posts. As the article reminds us Pigou recognized that sometimes market dynamics fail to address social needs. One set of these market failures (or imperfections as they are also called) is externalities. These occur when players that are not a part of a transaction are affected by the transaction. Neighbors living next to a polluting plant do not participate in the sale of the goods or power produced by the plant, yet they incur a cost. The friends of a child who has been immunized benefit from that child’s vaccination, yet they don’t get involved in the cost-benefit decision made by the child’s parents. Both are cases of externalities. A Pigovian tax can help remedy a negative externality, providing incentive to the polluter to change their behavior.

This is a supplement to our discussion, in Principles of Macroeconomics, about unemployment.

In this piece, by Univ. of Oregon professor Mark Thoma, you will find a review of the three kinds of unemployment and a discussion of what “normal” or “natural” employment is.

Will There be a “New Normal” for Unemployment?

Thoma also writes in his very popular, Economist’s View blog, and has a number of his upper division lectures available on YouTube.

Hat tip to U of Oregon prof, Mark Thoma, for pointing to this piece by Jeffrey Sachs in the Financial Times.

Obama Has Lost His Way on Jobs

The Obama administration’s stimulus policies are not well-targeted. The Republican alternatives are even worse. Both sides are missing the key fact: the US economy needs structural change that requires a new set of economic tools.

For my principles of macroeconomics students, here is the context…

The BEA announced an annualized growth in GDP of 3.5% for the third quarter of 2009. What’s not to like about the return of positive changes in GDP? The only cloud over this report is whether the growth is sustainable. There is a fair amount of consensus that much of this growth was due to the federal government stimulus package, including the cash for clunkers program.

The intent of fiscal policy (when faced with a recessionary gap) is to shift aggregate demand to the right, and to some extent prime the pump for more growth after that. We know that fiscal policy is an imperfect policy tool – it is often late in coming, heavily leveraged through the fiscal multiplier, and often a mixture of thoughtful solutions and political foolishness. What it can do, however, is provide a way for the government to be strategic with its investments. Monetary policy gives us less opportunity to help an economy chart a different, better course.

Sachs proposes solutions in three areas:

1. Boost exports – through devaluation of the dollar and financing assistance to “customer” countries who buy our goods.
2. Greater investment in education and training
3. Investment in projects with high social return

We can and should debate these, but the important issue is to do our fiscal policy spending thoughtfully.