In his Nobel Prize speech this past Thursday, 2011 laureate Thomas Sargent made a very interesting link between the multi-country crisis in Europe and a similar situation in America’s infancy, bringing together 13 independent states. The speech itself is oddly uninspiring, and starts with some of the math for which Sargent was recognized in being award the Nobel Prize, but you can watch it here for extra gems I may have missed.

Original 13 States

Sargent noted that the new American country faced an economic crisis in the late 1780s. The first U.S. Constitution, the Articles of Confederation, left the original 13 states largely independent, with a weak, and poor Federal Government. The states and the Federal government had collective debts totaling over 40% of GDP. The 14 different governments found that investors were very skeptical of government bonds, which meant very high interest rates, and those bonds being sold in the secondary market for deep discounts. (Jump forward to 2011 to a nearly identical problem faced by the European countries.) Sargent’s observation; “Fiscal crises often produce political revolution.” This was apparent in 1787 as the United States lurched into an uncertain future.

Alexander Hamilton

Alexander Hamilton, a 32 year old Secretary of the Treasury, joined President Washington and other founding fathers in framing a new, more permanent U.S. Constitution. As part of this legal realignment, Hamilton proposed a solution to these lingering, expensive debts:

• The Federal government would assume all of the states’ debts (i.e. a bailout.)
• All trade and most fiscal policies would be centralized in the Federal government.
• The Federal government would have an enhanced ability to tax.
• There was essentially no monetary policy at the moment. The U.S. minted a silver dollar – similar to other silver pieces minted in Europe. Its value was tied to the value of silver. In essence the U.S. was on a silver standard for the first decades of its existence.

Sargent noted the results of Hamilton’s moves:

• The creditors, who held the old bonds, were kept whole and rewarded the new Federal government with more lending capacity.
• The government bonds were no longer sold at a discount, and interest rates fell to manageable levels.
• There was increased liquidity – i.e. improved availability of credit for businesses and government
• The Federal government enjoyed significantly greater tax revenues.
• Not right away, but eventually the Federal government signaled that it would no longer bail out state or local governments for their debts, and in quick succession, states passed balanced budget amendments to their state constitutions.

For history buffs, Hamilton’s first report to Congress, on public credit is an interesting read.

Europe

Now, let’s make the links to the European debt crisis. For a variety of reasons many European governments are faced with the same challenges as the fledging United States in the 1780s. Some countries, most notably Greece, mismanaged their fiscal policies, with generous government spending and lackluster tax collection. Some countries rode the surf wave of the financial bubble, allowing local banks and sometimes sovereign funds to speculate heavily. (Ireland comes to mind here.) Others, like Spain, are almost innocent bystanders with modest debt but heavily hit by the housing/credit crisis. All of these countries face investor skepticism towards their sovereign debt, which means they need to pay high interest rates if anyone is interested in buying their bonds.

As we have discussed in an earlier post, the countries who share the Euro currency have no independent monetary policy. That power is held by the European Central Bank which has been reluctant to be a lender of last resort or the source of monetary stimulus. Germany, as the strongest economy on the continent, and to some extent France, have struggled with the question of bailouts to troubled countries, maintenance of the Eurozone community, and their own political concerns at home.

Angela Merkel

In a marathon negotiating session this past week, German Chancellor Angela Merkel drove a resolution to this crisis which involves greater fiscal policy discipline and coordination among the European countries, and the strengthening of a multi-national lending fund to help struggling countries. As an interesting side note Great Britain, which has been a party of past European treaties but did not join the Euro currency, rejected the new treaty and will be on its own.

In his Noble speech, Sargent left the conclusions to his audience. Are we seeing Europe following the path of the original 13 states of the U.S. in the formation of a much more centralized Europe? Will the global investment community reward this action with lower interest rates on European debt? Will the member countries change their behavior, with the example of bailouts fresh in their memory?

Jeff Stahler - Columbus Dispatch

In Macro class today we talked about what is really a dual decision. First, should our national policy encourage spending or saving? Second, should government actions favor consumption or investment?

First, some definitions and a smidgen of theory. There is a simple dichotomy over  how a family or a nation uses their income. They can spend it (i.e. consume) – which means purchasing goods and services that provide benefits right now. Or they can save it – by putting it in the bank or paying off debts, or even purchasing stock with it. Presumably the savings will improve things in the future (more on that later in this post.) Personal savings (excluding business and government action) have declined as a percent of income since 1980 and probably longer. The personal savings rate was 3.6 percent as of September 2011 (source: FRED). That meant we spent or consumed 96.4 percent.

Savings fuel investment. When households save, businesses save, and the government runs a surplus, this provides funds which can then be borrowed for investment purposes. Done correctly those investment activities will reap economic benefits in the future. If the government operates with a deficit, this adversely offsets personal and business savings. Government borrowing removes funds from the investment pool – a term called “crowding out.”

So, should we encourage people to spend or save right now? Saving brings up good images of a frugal nation, putting aside current desires for a better future. On the other hand, saving does nothing to stimulate demand right now as we struggle to return to full employment. For an extreme example consider Japan in the 1990s, which suffered what is sometimes called “the lost decade.” A real estate bubble popped, causing a typical recession, but then even with low interest rates businesses and families saved rather than spent. They entered what Paul Krugman calls a liquidity trap. Robust economic growth didn’t return for 10 years.

Were someone to ask me this first, spend or save, question, I would recommend incentives to spend – in the short and medium run. Restoring economic activity to its full potential is our most important priority right now – more important than the national debt and more important than future investment. A program to encourage more personal savings would be counter productive.  As the economy starts growing on its own steam, we could then switch to more emphasis on savings.

Consume or Invest?

Now to our second, related question. As government considers fiscal policy (government spending and taxation) it would be wise to target those efforts strategically. Some government spending and some tax cuts will encourage consumption. This can be an appropriate goal during recessionary times, because the added consumption will add directly to GDP. In econ-jargon we call this shifting aggregate demand higher (to the right). If we were considering tax cuts, then targeting low and middle income families will yield the most effective bang for the buck. Lower income families spend more of new income on consumption. Higher income families, having met many of their day-to-day requirements put proportionately more of that new income to saving (including stock purchases.)

Let’s consider what to do once the economy is starting to grow on its own. Do we continue to encourage consumption, or should we shift to investment? I prefer the latter. Investment means putting off the benefits or happiness of current consumption, and directing resources to a better future. Using our tax cut scenario from above, we could argue that cuts should go to higher income families, since they are more likely to save, which in turn should encourage investment. Unfortunately for the advocates of this position there is theory but not much in the way of verifiable results to support this approach.

So, if the economy is growing or starting to regain its momentum, our other choice is to use government spending on thoughtful investments. Pushing aside some of the political wordsmithing, President Obama’s preference for spending on infrastructure fits with this goal. It asks a lot of Congress and the White House to choose investment projects wisely – the lobbying wolves are seldom at bay. There’s an old saw in the grant funding world, that if money is going to support more pigs, successful applicants learn to become pigs. This makes it difficult to thoughtfully target that spending.

My take on this is to be skeptical of general tax cuts – particularly those that funnel most of the money towards higher income families. Tax cuts will fuel consumption at all levels of income, though more consumption among lower income families. And there is scant evidence that money kept by higher income families truly generate savings that lead to thoughtful investment in our future.

Greece Flag

So, who cares about the Greek debt crisis? It’s a small country, a long ways away.

Answers:

Greece as a Country: “We care!”

The Euro currency countries: “We care!”

Europe Generally: “We care!”

U.S. and International Financial Community: “We care!”

Stock Investors: “We care!”

All right, already.  Here’s why they care.

The background

Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.

What Can Greece Do?

When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.

Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.

BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.

Euro

How Does the Crisis Affect the Euro?

The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.

When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.

Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.

Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.

Why the Large Bailouts by European Governments?

Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In addition many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.

European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.

Why the International Community and Stock Investors Worry

The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.

Say's Law or Keynes'?

If we can peel away the political posturing, there is an important argument in the issue of how best to generate a recovery in our country’s economy. Put simply, the question is whether producers (employers) are the answer and we should do everything we can to encourage them, or whether we should do something to encourage demand for their products.

Jean-Baptiste Say gets naming rights for the law that says that production will encourage demand and thus more production. Proponents of Say’s Law argue that producers can ramp up production which will in turn foster demand for those products, and that demand will flow to greater production elsewhere. The law assumes that business will not hoard capital funds, but will invest them in greater production. In today’s dialogue, when we hear calls to reduce business taxes or relieve business of the uncertainty or burden of government regulation, it is the ghost of Say who is speaking. This position holds that unfettered business will invest in more production and growth, and that will, in turn, generate new jobs and economic opportunity. It is roughly accurate to put the label of supply side economics with this group.

In the other corner is John Maynard Keynes. Keynes argued that the economy depends on the demand for goods and services, and that when necessary the government should encourage that demand through added spending or tax cuts. Keynes felt that encouraging demand, by placing more money in the hands of consumers, would stimulate businesses to ramp up production, which in turn increases employment. Today, Keynesian proponents argue for more government spending, and broad based tax cuts (not the kind of cuts targeted only at businesses).

Both approaches have some grounding in economic theory. The Keynesian approach has a better track record in real life, and there are signs in our current, sluggish recovery, that business is not following the assumptions built into Say’s Law. When President Hoover was faced with the early years of the Great Depression, his advisers followed the main stream economic thinking of the time, which was Say’s Law. In addition, main stream economic thought in the late 1920s/early 1930s felt that the economy was naturally cyclical and would eventually mend itself. Hoover pressed his political base, the producers and manufacturers, to ramp up production. They would have none of it.   President Roosevelt took his cue from Keynes’, adding government spending and employment to Federal policy, as a way to pump money into the hands of consumers, which then increased demand for goods and services. For the Great Depression, the Keynesian approach seemed effective while the Say’s approach was not.

Today, many commentators note that corporate America is sitting on large cash reserves, and that they are waiting for consumer demand to strengthen before investing in more production or growth. If that is the case, then more business tax cuts or incentive programs are not likely to speed up the recovery.

As students and citizens, we will do well to consider the conflicting economic theories at work here, and ignore the emotional baggage that hinders civil dialogue.

More seriously, Reich has been consistently beating the drums that our country’s number 1 issue is high unemployment, not the debt. You can follow him on Facebook or Twitter.

Credit Greg Uchrin

The U.S. has a temporary reprieve on the debt ceiling limit – tax revenues have come in higher than expected in the early part of the year, reducing the needed pace of borrowing by the U.S. government. While this has pushed the deadline for Congressional action back by a month or more, the rhetoric in Washington continues to be intense. As quick background…Congress periodically authorizes  new limits to borrowing to cover new debt. Public radio’s Planet Money has a good, short description of the ceiling. That ceiling needs to be adjusted upwards by Congress in order for the Treasury Department to sell more U.S. bonds (i.e. borrow more).

The coming vote on raising the debt ceiling is giving the Republicans a chance to push for a less-government/less-spending program. Speaker Boehner issued a challenge earlier this week, as reported in The New York Times,

‘Without significant spending cuts and changes to the way we spend the American people’s money, there will be no debt limit increase,’ Mr. Boehner told members of New York’s business and finance community. ‘And cuts should be greater than the accompanying increase in debt authority the president is given.’ Mr. Boehner said those cuts should be in the trillions of dollars, not billions.

So, what would happen if trillions, or even just $100 – $300 billion was cut from Federal spending? University of Oregon economics professor, Mark Thoma, was asked this question and wrote about it in MoneyWatch.

Thoma’s bottom line is

Even a much smaller cut, say $100 billion over the next year, would still wipe out 500,00 jobs over that time period — 2 months of job creation at present rates — and set the recovery back considerably.

For students in macroeconomics there are some good reminders of basic economic forces. I recommend reading the MoneyWatch posting. Look for these important uses of macroeconomic theory:

• The multiplier (AKA the Keynesian Multiplier). When the government spends money, that initial increase in spending adds directly to GDP. Government spending is one of the four main elements of GDP, along with Consumption, Investment, and Net Exports. Then, depending on how that money is used (spent vs. saved) those funds cascade through the economy, prompting more spending (usually personal consumption). That means the original government expenditure has an impact on GDP that is a multiple of the original amount. In theory that multiplier could be as high as 5, but applied research suggests figures between 1 and 2. Thoma makes a point that was new to me, that the multiplier can be different depending on the state of the economy – lower when the economy is closer to full employment, and higher during recessionary times. (Note to self – look this up.)
• Okun’s Law. Okun saw a relationship between changes in GDP and changes in unemployment. He observed empirically that a two percent drop in GDP was associated with a one percent rise in unemployment.

Putting it all together – Thoma estimates that a $600 billion drop in government spending over two years ($300 b in one year) will reduce GDP by two percentage points and raise unemployment by 1 percent. That is about 3 million workers losing their jobs. That would rip the guts out of our recovery.

For my students, see how many of today’s economic issues you can find in this video and compare them to our look at the Great Depression.

One argument for preserving tax cuts, or lowering them generally is that they will increase incentives to work harder and longer. The Laffer Curve is based on this premise, saying that lower tax rates encourage more work and more investment, which results in more economic activity and growth, which in turn results in higher total tax revenues.

Harvard’s Gregory Mankiw started a gentle and funny conversation about this premise. In this op-ed piece in The New York Times Mankiw notes that when offered additional work opportunities, he often turns them down, because…

In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

Mankiw’s article focuses on marginal tax rates – an important economic consideration. Rather than looking at a family/worker’s average tax rate, he argues that incremental increases in income are faced with higher tax rates. He goes on to say that these high marginal tax rates discourage him from accepting additional, incremental work – to the detriment of the economy.

This is the essence of what has been called supply side economics – freeing up the production/supply side of the economy will result in economic growth. While there is some strong theory behind these claims, the actual results have been hard to prove.

Stephen Colbert lampooned Mankiw in this piece.

And then a comedy troupe at Mankiw’s Harvard University added their punch.

[The] Washington stimulus has become the policy that dare not speak its name. This wouldn’t be surprising if we were talking about a failed program. But, by any reasonable measure, the $800-billion stimulus package that Congress passed in the winter of 2009 was a clear, if limited, success.

The Congressional Budget Office estimates that it reduced unemployment by somewhere between 0.8 and 1.7 per cent in recent months. Economists at various Wall Street houses suggest that it boosted G.D.P. by more than two per cent. And a recent study by Mark Zandi and Alan Blinder, economists from, respectively, Moody’s and Princeton, argues that, in the absence of the stimulus, unemployment would have risen above eleven per cent and that G.D.P. would have been almost half a trillion dollars lower.

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.