Here is one graph that illustrates the impact on economic output from 10 post World War II recessions. No contest.

Economic Output in Recent Recessions

Flag of Turkey

In my summer Principles of Macroeconomics class we’ve been discussing the reasons why China has surged to be such a strong economic power.

In an article in The New York Times, Turkey is described as another surprising country showing remarkable growth.

Today, Turkey is a fast-rising economic power, with a core of internationally competitive companies turning the youthful nation into an entrepreneurial hub, tapping cash-rich export markets in Russia and the Middle East while attracting billions of investment dollars in return.

It’s interesting to speculate on the reasons for this economic growth. The article speaks about the policies of Prime Minister Erdogan – socially conservative but pragmatic. My guess (and it is just a guess) is that Turkey made it much easier for foreign investment dollars to flow into the country.

[Reminder to my students: investment capital is a classic scarce resource that countries cherish. They can gather it by selling exports or attracting foreign investments or by national savings. Whatever way it comes, capital allows a country to make investments in productivity, market formation, and more.]

There is a dark side to foreign investment, and that is a potential loss of control of a country’s key assets to foreign management and investors. Many countries fear this loss of economic sovereignty and put up significant barriers to foreign investment. There are many examples, particularly in mining and other natural resource extraction, where the foreign companies reap large profits, with only token royalty payments to the home country.

There can be other ingredients for economic success, including a government and legal system that protects property rights and encourages investment – whether domestic or foreign. Turkey will be interesting to watch.

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.

I think an excellent Pigouvian tax would be a tax on emails. Many emails involve a negative externality (I don’t really want to receive them) and almost all the ones I really want to get are worth much more than a penny or so to the sender. So a penny tax (say) on email would probably generate large amounts of revenue, mitigate an important negative externality, and have minimal inefficient disincentives. Since email servers are necessarily centralized and networked and all email senders are ipso facto connected to an ISP who is charging them for access the transactions costs and evasion problems seem low.

As a reminder, a Pigovian tax is one that is levied to change market behavior – typically to address a market failure like externalities or to prevent over consumption of a common good.  Mankiw extends the idea, hoping that the recipient could set the price. If someone wanted to seriously reduce the email they received – limiting to only those messages from people who really care – then they could set a high price for allowing a message to appear in their inbox.

Interesting idea. It’ll never happen, but it is interesting nonetheless.

Arthur Laffer is credited with the eponymous theory that a decrease in tax rates can lead to an increase in tax revenues. Even if the original theory may have been scribbled on a napkin, it still holds sway with the supply side contingent. The simplified explanation is that by reducing tax rates, income earning individuals and corporations will increase their efforts to improve their income. Their incentive is that they get to keep a higher proportion of their income. The added effect of this incentive is a stimulated economy with higher incomes, which lead in turn to higher tax revenues. Presidents Reagan and GW Bush were adherents to this theory.

Thanks to a mention in Paul Krugman’s blog. we learn that Laffer Curve thinking dates back at least to post Civil War days. Author Douglas Irwin notes the application:

After the Civil War, Congress justified high import tariffs (relative to their prewar levels) as necessary in order to raise sufficient revenue to pay off the public debt. By the early 1880s the federal government was running large and seemingly intractable fiscal surpluses revenues exceeded expenditures (including debt service and repurchases) by over 40 percent during that decade. The political parties proposed alternative plans to deal with the surplus: the Democrats” proposed a tariff reduction to reduce customs revenue, the Republicans offered higher tariffs to reduce imports and customs revenue.

What’s wrong with this picture?  “Intractable surpluses?” Republicans raising tariffs?  It seems like an alternative universe.

Despite the odd and interesting historical note, the Laffer Curve and its assumptions are important elements of tax policy debate today. Supporting evidence of Laffer’s assertion is hard to find – mostly because too many other factors changed when the Reagan and Bush administrations significantly reduced tax rates. For my principles of macroeconomics students, the question of whether and by how much taxes reduce economic vitality is an important one.

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?

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.

[...]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.