As we all know, the European Union has recently been under the lime light with their budget deficit problem – causing a lot of anxiety for investors in the U.S. I’m curious if there’s a reason why the even greater deficit in U.S. isn’t being publicized as much?

Crumbling Parthenon

The quick and honest answer is that I don’t have any special insights into the minds and souls of investors – not being one myself. Still, there are some characteristics of the European economic crisis that are different from the United States, but can provide cautionary tales for our own economic policy.

As of today the US national debt stands at $12,988 billion (that’s almost $13 trillion). In 2009 our Gross Domestic Product was $14,256 billion. So our debt is about 91% of GDP.  From news sources Greece has debt of around $368 billion, and a 2009 GDP of $357 billion – a debt load of 103%. So somewhat higher than the US but not by multiples.

So, just to repeat my earlier disclaimer – I don’t know what makes international investors tick. Here, though, are some of my concerns about Greece and Europe, and what distinguishes them from the U.S.

Greece is a member of the Euro community – i.e. they no longer have their own currency, but use the Euro instead. This should provide stability in foreign exchange markets, compared with maintaining their own currency. On the other hand, Greece no longer has sovereign control over its own monetary policy. The Euro central bank can change the supply of euros, and the Euro community in general impacts the value of the euro on the foreign exchange market. In sort Greece is dependent on others to apply some traditional rescue strategies. What Greece has in common with the United States is the need to balance government revenues and government expenses in the long run.

The concern about Greece seems to be bigger than Greece. Policy makers and observers worry about other country members of the euro community, including Spain and Portugal. They see a domino effect that threatens most of Europe. For the U.S. that means worrying about some of our best customers and understanding that the global financial structure is interdependent, with a credit crisis in Europe spreading here quickly.

I also think confidence in the central banking and political system plays a role in investor perception. We’re quick to criticize both the Federal Reserve and Congress for their actions or inactions. The world has a more sanguine view of these institutions, though. The value of the U.S. dollar has been rising in recent weeks, as investors switch to dollar-denominated securities – in particular U.S. treasury bonds. Those investors have more confidence in the U.S. than in Europe – for better or for worse.

None of this means that the U.S. debt situation is nothing to worry about. While I may not be confident in the economic policy process in Congress, I do have faith in the Federal Reserve. And in contrast to the deficit hawks I believe we still need to be spending government money to stimulate our recovery.

Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

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?

[...]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.

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.

Wall Street Journal 6/3/09

Revenues to state and local governments are sensitive to economic conditions. Sales taxes are tied to purchases, of course. Income tax revenue is often more problematic. If a state, like Oregon or California, has a progressive income tax structure (higher income citizens pay a higher tax rate) then when incomes drop not only do taxes go down but they go down even faster as people fall into lower tax brackets. Oregon is particularly vulnerable because it does not have a sales tax. California has been buffeted by this phenomenon – seeing wide swings in revenue as economic cycles pass through.

On the costs side economic recessions increase demand for state and local services and programs. These are part of automatic stabilizers, and help a bit with increasing aggregate demand. They cost money, however.

And yet, unlike the federal government most state and local governments are prohibited from running or planning a deficit. They must operate in the black, even in the face of seriously declining revenue and increasing costs.

Not a pretty picture.

Every so often, history serves up an analogy that’s uncomfortable, a little distracting and yet still very relevant.

In the summer of 1933, just as they will do on Thursday, heads of government and their finance ministers met in London to talk about a global economic crisis. They accomplished little and went home to battle the crisis in their own ways.

More than any other country, Germany — Nazi Germany — then set out on a serious stimulus program. The government built up the military, expanded the autobahn, put up stadiums for the 1936 Berlin Olympics and built monuments to the Nazi Party across Munich and Berlin. [...] Germany did escape the Great Depression faster than other countries. Corporate profits boomed, and unemployment sank (and not because of slave labor, which didn’t become widespread until later).

In addition to this analogy, which I recommend reading in more detail, there is an interesting graphic that helps understand the different approach the United States is taking to stimulate demand, versus its European partners.

Most industrialized countries have laws on the books that automatically increase government spending when the economy is slow. Spending on food stamps, unemployment insurance, and other benefits to poor people go up as more people qualify for assistance. And with a progressive tax rate system, a decline in income not only means lower income taxes, but a lower income tax rate. (The result taxes drop more rapidly than income.) We call these phenomena automatic stabilizers. The dark portions of the bars above show these automatic increases in government spending. The lighter colored portions show discretionary spending – which requires an act of the legislature. Great Britain and several European countries have stronger social safety nets, so their automatic spending is greater as a percentage of GDP. The United States is less. So, we are more likely to increase discretionary spending in hard economic times. The members of the European Union, as Leonhardt points out, have been willing to increase government spending, but not to the degree that we have in the U.S. There are more complicating factors – see Germany as an example – but this is an illuminating discussion.

The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones.

A good accompanying read is the Congressional Budget Office’s preliminary estimate of the impact of President Obama’s proposed budget. (CBO was organized in 1974, to give members of Congress an independent, non-partisan ability to project budgets and their impacts. Previously Congress had to rely on estimates provided by the Executive Branch.) The CBO’s director has started a blog, and this post nicely summarizes the CBO estimates:

As estimated by CBO and the Joint Committee on Taxation, the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010–2019 period. CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.

CBO’s projections of future deficits are higher than those coming from the Administration. The differences are greater than rounding error, and point to the importance of having a separate group crunching the numbers.

The greater question, however, is whether this ballooning Federal deficit is good policy or not. Now back to Robert Frank’s comments. As he points out, there is a kind of quiet consensus that, in the short term, we must endure significant Federal deficits as we try to stimulate demand and climb out of the recession. The greater debate is whether the additional costs proposed by the Administration – that go beyond short term stimuli – are good investments. I happen to think so (in general – more details to learn) and there’s no question that Congress will do more than tinker with the plan. Even so, the deficit estimates are sobering.

This leads us to the fiscal (sometimes called the Keynesian) multiplier – where government stimulus funds (added spending or tax cuts) cascade through the economy and increase GDP by some factor that is hopefully greater than 1. The more we spend newly arriving money, the more cascades and increases the multiplier. The more we take that new money and use it to pay off debt, buy stocks, or save it, the lower the resulting multiplier.

I’ve purposefully not dug into the specifics of the various House and Senate bills that are now headed for a collision in the conference committee this week. They were changing quickly and sometimes quietly, and absent gluing myself to an online source for large parts of the day I couldn’t keep up.

So, with those substantial disclaimers, here are my thoughts on what I know so far:

• We need spending that stimulates demand in the economy. By theory the most efficient way to do that is to increase government spending. Tax cuts, in theory, are helpful, but less so.
• Paul Krugman and others worry that all of the spending figures sloshing back and forth between the two houses of the legislature are insufficient to fill the gap between current GDP and our potential GDP. I don’t know enough to contest their figures, so I worry, too.
• I’m not sure the tax cuts that remain in the stimulus package will be very helpful, but I need to learn more about them. I find Milton Friedman’s permanent change in income hypothesis (only permanent changes in income spark changes in spending) persuasive. Mankiw’s proposal for a cut in the payroll tax sounds like the best kind of tax cut, if we must have one. It helps working people, which is good in itself, and working people are more likely to spend new disposable income, which is also good.
• States and local governments are hugely squeezed in hard times, since their tax revenues drop, and yet they don’t have the ability to engage in deficit spending. Any kind of money to help them maintain their social safety net and build/repair infrastructure is money well spent. As of early this week, this piece seemed to be either gone entirely or substantially reduced. We’ll see what the conference committee does with it.
• I’m in favor of many of the policy initiatives added by the Democrats as part of this package, but their inclusion muddies the waters, and gave Republicans more to complain about. The total dollars involved are supposed to be small, and some of the initiatives might stimulate spending, but I would have preferred a crisp, clear stimulus package, with laser like focus on closing the GDP gap.

We’ll all stay tuned…