Thoughts from the Frontline

The Perils of the Fiscal Cliff

October 23, 2012

Choose your language

“Spain is not Greece” – Elena Salgado, Spanish Finance Minister, February 2010

“Portugal is not Greece” – The Economist, April 2010

“Greece is not Ireland” – George Papaconstantinou, Greek Finance Minister, November 2010

“Spain is neither Ireland nor Portugal” – Elena Salgado, Spanish Finance Minister, Nov. 2010

“Ireland is not in ‘Greek Territory’” – Irish Finance Minister Brian Lenihan, November 2010

“Neither Spain nor Portugal is Ireland” – Angel Gurria, Secretary-General OECD, Nov. 2010

“Italy is not Spain” – Ed Parker, Fitch MD, June 12, 2012

“Spain is not Uganda” – Spanish PM Mariano Rajoy, June 2012

“Uganda does not want to be Spain” – Ugandan foreign minister, June 13, 2012

            Having been to all the countries listed above, with the exception of Uganda (although I have been to 15 countries in Africa, several bordering Uganda), I am most happy to confirm that they are all different. Just as you would grant me the fact that the US is not the UK and that France is not Argentina. To paraphrase Tolstoy, dysfunctional countries come by their unhappy sets of circumstances in their own individual ways.

            How does one go about comparing the financial crisis in one country to that of another? The International Monetary Fund tried to do just that, setting off a rather torrid debate in economic circles. And while we will look today at their analysis, the upshot is that the economic models used to guide monetary and fiscal policy may not be working as they did in the past. Last week in this letter, I postulated a condition I called the Economic Singularity. Just as the singularity at the center of a black hole creates a region where mathematical models break down, a large mass of debt will create its own Economic Singularity where economic models no longer work as expected.

Given that within a few weeks a very large debate will erupt in Congress about how to deal with the “Fiscal Cliff,” with both sides displaying economic models that demonstrate the clear superiority of their chosen solutions and the utter disaster that will ensue if the opposition’s plans are enacted, I think we will find it useful to look at some of the underlying assumptions. Given the fact that almost everyone, including your humble analyst, has concluded that if the tax increases and spending cuts were to be enacted as the legislation currently dictates, a rather serious recession would follow in short order, it might help us to look at some of the assumptions behind that assessment.

In today’s letter we’ll peek over the Fiscal Cliff and see what economic models can tell us about government spending. And if we have time we’ll quickly look at an interesting study that uses economics to predict the outcome of this US presidential election.

At Mauldin Economics we have a laser-like focus on estimating what the economic climate will be in the coming year. As a bit of a preannouncement, I’ll be doing a Post-Election Summit Conference on November 20 with a few of my friends, looking at the likely direction of the economy with the certainty of the presidential and congressional elections behind us. It will be a free seminar, cosponsored by my friends at Real Clear Politics (www.realclearpolitics.com) and available on the Internet to those who register. I’ll give you more details as we get closer, but this is something you won’t want to miss. And now let’s hang our toes out over that Fiscal Cliff.

The Problem with Austerity

            The chief economist for the International Monetary Fund, Olivier Blanchard, and his associate Daniel Leigh gave us an eye-opening three-page paper, buried in a 250-page World Economic Outlook release last week (http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf). They studied an economic concept called the fiscal multiplier, which is usually defined as the change in real GDP that is produced by a shift in fiscal policy equal to 1% of GDP. In simple terms, if the fiscal multiplier is assumed to be 1.0 then a change in government spending by 1% (either an increase or decrease) would produce a corresponding change of 1% of GDP.

            Most institutional economists prior to this paper assumed the fiscal multiplier to be about 0.5. Again in simple terms, this would mean that government spending cuts equal to 1% of GDP would reduce actual GDP in the coming year by about 0.5%. The fall in GDP would of course reduce tax revenues, which means that you would have less than a 1% actual cut in the deficit. If the tax rate is 30% in this example, the deficit will be reduced by only 0.85%. That may be an acceptable outcome when an economy is growing nicely or the deficit and total debt are too high and the bond market is forcing the government to cut back.

            While Blanchard and Leigh agree that in the past the fiscal multiplier was generally about 0.5%, they suggest that in the recent fiscal crisis the fiscal multiplier has been much higher. Their study suggests that it has been at least 0.9% and perhaps as much as 1.7%. This certainly seems to be the case in Greece and Spain, as their austerity measures appear to be working in reverse.

            Gavyn Davies of the Financial Times views the IMF research finding from the perspective of England, where the government is taking 40%. The results are less than pleasing:

“If, however, the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would reduce real output by 1.7 per cent. The second round effects of this reduction in output would reduce tax or raise transfers by 0.68 per cent. The net overall improvement in the budget deficit would therefore be only 0.32 per cent. The economy would be in recession, and the budget deficit would hardly improve at all. Even if this were acceptable to governments, it would not be acceptable for very long to their electorates.

“This pessimistic arithmetic is not that far away from describing what has actually happened in some countries, like the UK, in the past two years. Furthermore, if we take this arithmetic as a given, there is more bad news to come. The major four advanced economies are now all planning to tighten fiscal policy in the years ahead by an average of 1 per cent of GDP per annum.

“…With a fiscal multiplier anywhere near the upper end of the Blanchard/Leigh suggested range, the effects of these policy changes would eliminate any chance of a rebound to normal growth rates in the advanced economies for some time to come. Interestingly, the planned fiscal tightening in the troubled economies of the eurozone is no longer any greater than it is for the major economies, because of the recent relaxation of some budget targets. Even so, it is hard to see how these plans could be sustained if the fiscal multiplier is at the upper end of the possible range.”

But there is a problem with this analysis, as Davies and others point out. It assumes that the results in one country will pretty closely match those in any other country. However, if you take out Greece and Germany, as an example, you pretty much remove the increase in the fiscal multiplier. Not that that would stop Paul Krugman and his fellow Keynesians from trumpeting this analysis as a reason to eschew all forms of austerity. In any case, the research does call attention to the dangers of creating economic models that are used to guide public policy. Davies continues:

“…The decline [in the IMF model of the fiscal multiplier] occurred mainly because economists became much more aware of the need to make assumptions about monetary policy when making the estimates. If the central bank is assumed to hold monetary growth or inflation at a given target rate when fiscal policy is tightened, then interest rates will decline and this will offset some of the negative effects of the fiscal change on output. The multiplier will be lower.

“The opposite is also true. Now that interest rates are stuck at the zero lower bound, central banks cannot reduce policy rates when fiscal policy is tightened, and the multiplier is correspondingly increased.” (emphasis mine)

I have mentioned several times a paper by the powerhouse economic couple Christina and Paul Romer (she was the chairperson of Obama’s Council of Economic Advisers), which showed that the multiplier for tax cuts or tax increases is around 3 in the US. Accordingly, a tax increase or cut equivalent to 1% of GDP should affect the US economy by 3%.

Davies notes that Larry Summers and Brad DeLong have argued that the multiplier should be assumed to be a minimum of 1.0 under present circumstances. [Their work] explains very clearly why the multiplier should be much higher than normal when the economy is stuck in a recession with interest rates at the zero lower bound. Another noteworthy paper, by Auerbach and Gorodnichenko, says that the multiplier during recessions might be around 1.5-2, while in expansions it drops to zero.” Additionally, Robert Barro of Harvard has suggested that the tax multiplier is 1.

            In another article, Professor Carlos Vegh of the University of Maryland said lots of evidence suggested that multipliers would differ greatly from country to country; and “the whole exercise of trying to forecast growth for many different countries using essentially a single multiplier, whatever the value may be, is, in and of itself, an exercise in futility”. (FT)

            You can pretty much pick a fiscal multiplier that works for your desired outcomes and find an academic study that will support it. And that is the point. Economists want to create models. It is in their DNA (perhaps defectively, I admit). And sometimes they have to make assumptions in order to make the models look like something that might be useful. The problem is that politicians, in particular, don’t look at the underlying assumptions but use the parts of the studies that most closely reflect their particular biases. The IMF report above uses data from many countries that are, indeed – as our quotes at the top suggest – unlike each other. Comparing Greece to Germany and then using that data to suggest policies for Spain and Ireland is a dubious practice. There are just not enough data points for such conclusions to be statistically valid – but that won’t stop the politicians from using the IMF study if it supports the policy outcome they prefer. The IMF, for what might be very good reasons explained way down in the footnotes, excluded countries such as New Zealand and the Baltics that had better outcomes from austerity policies. Their inclusion would alter the study.

The Perils of the Fiscal Cliff

            In the third quarter of 2011 the US Congress agreed to rather severe tax increases and spending cuts that would kick in as of January 2013, as a way to get a deal done to increase the debt ceiling. In addition, the Social Security payroll tax cut and extended unemployment benefits are also scheduled to go away in January. All told, if nothing changes, this abrupt shift in fiscal policy would result in a hit to the economy of about $650 billion, or a little more than 4% of GDP, at a time when the economy is likely growing less than 2% a year.

            Let me break down the major components of the Fiscal Cliff:

  1. Abolition of the Bush tax cuts, which amount to $265 billion, of which $55 billion is for the “wealthy” and $210 billion for the “middle class” (everyone else). Almost no one on either side of the aisle wants to actually go forward with axing the tax cuts for the middle class. Republicans want to hold on to the top-level tax cuts, and to my mind that’s a bargaining chip (see below).
  2. The Budget Control Act, or the debt-ceiling deal, comes in at roughly $160 billion, with $110 billion of that in sequestration, mostly for defense; and there seems to be a growing consensus that not all of these cuts should be made.
  3. The 2009 stimulus will also roll off (this is the 2% Social Security break and extended unemployment benefits). This amounts to $140 billion all on its own, or almost 1% of GDP. Almost everyone agrees that these tax cuts were supposed to be temporary.
  4. The “ObamaCare” $24-billion tax increase on high-income households  is almost sure to be allowed to go through.
  5. Technically, there is $105 billion in the temporary “doc fix” and Alternative Minimum Tax, which every year are supposed to expire and every year are postponed, which of course allows Congress and the president (whoever is in control) to project lower deficits in the future, even though those cuts never happen.

If you add the $105 billion of fixes in #5 and the middle class tax cuts, you get $315 billion, or almost half of the Fiscal Cliff, which reduces the impact to 2% of GDP. Take some of the sting out of defense and you get to less than 0.5%.

But this creates a big but… What is your fiscal multiplier? It is not so simple as looking at what the IMF manufactures as a number and then extrapolating. Without trying to be cute, the US is not Greece or Spain or Germany; we are perfectly capable of creating our own unique brand of chaos. It is all debt-related to be sure, but the similarities begin to break down when you look at the gory details.

Not all tax increases or tax cuts have the same multiplier, just as not all spending increases or spending cuts do. There is a big difference, as Gavyn Davies pointed out, between a fiscal multiplier of 0.5 and one of 1.7. Before we get into what our multiplier might be, let’s review a few facts.

If Something Can’t Happen…

There is a rule in economics: If something can’t happen, it won’t. That may seem a tad obvious, but so many people are prone to think that the current trend can go on forever. This time is different, we tell ourselves. Meanwhile I and many others – David Walker, David Stockman, Alan Simpson, David Bowles, et al. – are telling you that so much of what we’re doing is unsustainable that big changes in present trends, as much as we might not like to think about them, are inevitable. So what we must think about now is what will happen when major change is either forced on a country or else entered into willingly. Sometimes you have to think the unthinkable.

Look at the projected debt for the US, compiled by the Heritage Foundation, based on realistic assumptions, not compiled while wearing rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will begin to demand much higher rates than we currently experience, driving up our interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary – like the military, education, and Medicare spending.

One way or another, the projected budget deficits – whether the one from the Heritage Foundation or the official government projection – are going to come down. We can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices will result in entirely different outcomes.

In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can substantially change health care, along with other discretionary budget items, or we can raise taxes, or some combination. Each path has consequences.

The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done. But that is also why politicians seem to be advocating both objectives – their first order of business is to make sure they get re-elected.

The point of the exercise, to my mind, is to reduce the deficit over 5-6 years to some sustainable level below the growth rate of nominal GDP (which includes inflation). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.

GDP = C + I + G + Net Exports

Either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. As a reminder to long-time readers and a quick intro to new readers, let’s quickly look at a basic economic equation:

GDP = C + I + G + Net Exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports – Imports). This is true for all times and countries.

Now, what typically happens in a business-cycle recession, as businesses produce too many goods and start to cut back, is that consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending. The theory is that when the economy recovers you can reduce government spending as a percentage of the economy and pay down the borrowed debt – except that has not happened for a long, long time. Government spending has just kept going up for decades. Sometimes taxes would rise faster than spending, as during the all-too-brief Clinton-Gingrich years. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the stimulus, it was the absolute size of government relative to GDP that increased as well.

And now massive deficits are projected for a very long time, unless we make major changes. The problem is that taking away that deficit spending is going to have the reverse effect of the stimulus – a negative stimulus, if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. It is the “G” component of the above equation, which was first developed by Irving Fisher during the Great Depression. The negative stimulus should be a short-term effect –most economists agree it will last 4-5 quarters – and then the economy may be better, with lower deficits and smaller government.

In order to get the deficit under control, we are talking about reducing the deficit on the order of 1% of GDP every year for 5-6 years. That is a very large headwind on growth, especially in a 2% Muddle Through economy. GDP for the US is now on an anemic 2% growth trend, with very weak final demand. Think what it would be if the full anticipated 2% of spending cuts and tax increases were put into force. It would be very hard to attain positive growth in 2013.

Furthermore, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you favor. Large tax increases will inevitably reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there will be a cost to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with the facts, based on well-established research. Now, that is different from the argument that says we should allow the cuts to expire anyway.

Those who argue that reducing spending will also have an effect are equally correct. Government has been a large contributor to consumer income and therefore personal consumption, part of the “C” in the above equation (along with business consumption). The chart below, produced by Bridgewater last April, shows the additional effect of government spending on disposable income for the US consumer. Notice that without government support, disposable income would now be significantly lower. Letting the “one-time” Social Security stimulus (which has already been extended for two years) go away, along with extended unemployment benefits, will result in a decline in GDP of almost 1% and the loss of a significant contribution to disposable income.

            There are no easy choices. If we do nothing about the deficit, we will quickly find ourselves close to the black hole of too much debt. Yet, trying to do too much too quickly will bring the economy perilously close to recession, which will mean increased government expenses and decreased revenues, making it hard to balance the budget. Forget Greece and Spain; ask the United Kingdom how well their austerity efforts are doing. This is a country making a serious and credible attempt to reduce their deficits, and sadly, they have fallen back into recession.

            No matter what economists with their models and politicians with their agendas will try to tell you, there is no “easy button.” While there may be a correct path to reducing the deficit and keeping us out of recession, that path is not going to be clear from the models. What we will hopefully do is get the direction correct and ease slowly into confronting the deficit-reduction facts. My thought is that if there are going to be tax increases and spending cuts, they should be phased in quarter by quarter. It might be better to simply hold the line on spending on all but essential items, cutting spending where possible to allow for spending growth in areas like health care. The bond market will behave as long as Congress defines a very clear and credible path to a manageable deficit.

            Both Republicans and Democrats will have to compromise. This election is primarily about the direction of the compromise. It is my sincere hope that both parties do not waste this crisis. There will be no better time to engage in comprehensive tax reform than the first six months of next year. True tax reform could actually be a significant stimulus to the economy and partially offset the drag of reducing the deficit. Tax reform in combination with a serious energy policy that encourages more rapid expansion of domestic production, plus control of health-care expenditures, will let us reduce the “fiscal multiplier” – especially important, given that monetary policy is severely constrained with interest rates at the zero bound.

            Finding the right policy mix will be difficult. There has to be deficit reduction each and every year, to be credible, but not so much as to push the economy into recession. Frankly, we will be lucky to find that right mix, given the nature of the political process. Whatever happens, each party will blame the other when there are problems and take credit when there are successes. That is the nature of the political beast.

            From an investment standpoint, the fact that earnings are coming out much weaker so for this earnings season does not bode well for the future. Apart from ephemeral enthusiasm from time to time, volatility will be the rule of the day – even more so than in the past few years. The risk of a “tail event” will increase, given the very real possibilities of exogenous shocks from Europe and Japan. This is not a time to be casual or to think that recent past performance in the equity markets is indicative of future results. This is a theme that we will be returning to often over the next few months.

Economic Indicators for the Election – It’s the Economy, Stupid!

            My focus in Thoughts from the Frontline is to comment on macroeconomic and investment issues. I try to venture into the political arena only with regard to the prospects for the economy and investments, rather than blatantly espousing my political views (which long-time readers can discern in any case).

            That being said, I ran across a very interesting presidential election forecasting methodology based on economics and not on polls. Ken Bickers and Michael Berry, professors of political science at the University of Colorado Boulder and the University of Colorado Denver, respectively, built a model based on the economics of each individual state and how it has voted since 1980. Their model has “predicted” with reasonable accuracy the winner of every presidential election since 1980. The model includes economic data from all 50 states and the District of Columbia, incorporating both state and national unemployment figures as well as changes in real per-capita income, among other factors. This feeds right into James Carville’s famous line in 1992 (as the campaign director for Clinton): “It’s the economy, stupid!”

            My personal political guess is that what the authors are actually modeling are the independent voters in the various states. Single-issue voters on social issues find reasons to override their economic interests and tend to dominate primary-season politics, so while the final November election result may be interpreted as a referendum on social issues, it more likely to resemble Carville’s world, at least if the professors’ analysis is right. I offer their work (and a link, below, to 12 other models) as a different way to look at the election 15 days from now.

            According to their Bickers and Berry’s analysis, Romney is projected to receive 330 of the total 538 Electoral College votes. President Obama is expected to receive 208 votes – down five votes from their initial prediction and well short of the 270 needed to win. The focus of their study is on state-level economic stress. I think the approach of using economic-stress models to predict election outcomes is a very interesting one. Their model was within five electoral votes in Obama’s 2008 trouncing of McCain.

            In addition to state and national unemployment rates, the authors analyzed changes in personal income since the prior presidential election. Research shows that these two factors, unemployment and income, affect the major parties differently: voters hold Democrats more responsible for unemployment rates, while Republicans are held more responsible for fluctuations in personal income. Accordingly – and depending largely on which party is in the White House at the time – either factor can either help or hurt the major parties disproportionately.

            The authors also provided caveats. Their model had an average error rate of five states and 28 Electoral College votes. Factors they said might affect their prediction include the timeframe of the economic data used in the study and the fact that states very close to a 50-50 split might fall in an unexpected direction due to factors not included in the model. Right now their study is an interesting curiosity, but if it is as close to right this time as it has been in some past elections, it might have a serious impact on future campaigns. You can see the full report and their data at http://www.colorado.edu/news/releases/2012/10/04/updated-election-forecasting-model-still-points-romney-win-university.

I should note that PS: Political Science & Politics, a peer-reviewed journal of the American Political Science Association, has published collections of presidential election models every four years since 1996, but this year the 13 featured models showed the widest split ever in outcomes. Five predict an Obama win, five forecast a Romney win, and three rate the 2012 race as a toss-up. As with economic models and austerity programs, you can find something that makes the case for your favorite candidate. Serious data wonks and political junkies (I am both, so doubly cursed) can revel in all 13 models at http://journals.cambridge.org/action/displayJournal?jid=PSC.

Brazil, Uruguay, Argentina, Chicago, New York, and North Dakota

            I leave next Sunday for Brazil, Uruguay, and Argentina for almost two weeks, where I will be with my South American partner, Enrique Fynn of Fynn Investments (based in Uruguay). But I get to take almost a week off to go to Cafayete, Argentina, where my friends at Casey Research have developed a wonderful resort in the northern Argentina wine country. Lots of good friends, great conversation, and a laid-back life await me, and I hope to get in some rest and relaxation as well as get a few books read. I will check back in Tuesday night, when I will be watching the election results into what will probably be the early hours of the morning – I doubt this election will be called as quickly as the last one. And of course I will be writing this letter.

            When I get back I’ll head to Chicago for a day to be with my partners at the Schwab Impact conference. Then it’s on to New York for the Post Election Summit Conference I mentioned. The day after Thanksgiving I will head up to what may already be a very cold North Dakota to speak at a conference and tour the Bakken oil and gas region. And then it’s back to New York for the annual Festivus party (and fund-raiser), hosted by Todd Harrison and my friends at Minyanville.

            It really is time to hit the send button. For a variety of reasons, some perfectly reasonable and some not so much, this is the latest I have ever hit the send button in 13 years. It is Monday evening and time to go eat sushi with the kids, as Abbi and her fiancé are in town from Tulsa and will have one last evening with Dad and some siblings before heading back tonight. I will work harder at getting this letter out on time, on my new schedule.

I would be remiss without mentioning the passing of an old friend. Big Tex was 60 years old and 52 feet tall. He was an iconic statue at the State Fair of Texas, welcoming the millions as they came through the entrance with his trademark greeting: “Howdy, folks this is Big Tex. Welcome to the great State Fair of Texas.” In what was probably an electrical fire, his clothing burned in less than ten minutes. Big Tex had been my fair buddy from early childhood. If kids (or parents) got lost in the day before cell phones, they met back up at his feet. Every little kid knew where Big Tex was. Ten minutes, and a lifetime of memories up in smoke.

I assume they will build another newer and better Big Tex, with more up-to-date electronics and motion and all that. But for some of us, that large voice and frozen smile was the symbol of good times and bad (for you) fried food. That corn dog eaten in the shadow of Big Tex will always linger in the memories of more than a few of us here in Texas.

Have a great week. This will be a fast one for me, as there is so much to get done before I head for parts south.

Your ready to take in the last debate analyst,

John Mauldin

Discuss This

16 comments

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Jeff Little

Nov. 8, 2012, 6:09 p.m.

I agree with the articles sentiment that economics is complex and if you don’t like the answers you can move on to the next commentator, but I am dissatisfied with the untangling of the various positions.

The first rule in math is always keep track of your units and work with good categories.  “Though shalt not mix apples and oranges!”  The classic example of this is when an economist talks about the savings rate with the implication that it represents future potential consumption.  When you realize that the fastest way to increase the savings rate is to move dollars from hands that would spend it immediately to hands that would never spend it in a million years on consumer goods, you realize that using the same term for savings rate outside the radius of consumption and savings rate within the radius of consumption is a category mistake and predictions made based on modeling one of the two will often have the opposite sign if you apply it to the other.

Similarly, the multiplier for tax cuts or increases is a bad category.  Progressive tax changes and regressive tax changes will have drastically different economic effects and the closer interest rates are to zero, the bigger the difference between those multipliers will be.  In fact, if you look at another time like today, when interest rates were stuck near 0 and we were depressed by “capacity gluts” and reactions to that, we somehow found the political will to increase the top tax rate by 150% in what surely had to be the most progressive tax increase in history.  This was the US in 1932 and the result was a change from double digit shrinkage to double digit GDP growth within a span of about 18 months.

The multiplier on tax cuts is plainly and simply a meaningless term based on a category error assuming that tax cuts against capital dollars will have the same effect as tax cuts against consumption dollars.  The next time someone tries to sell you on a study that purports to find this elusive number, kindly remind the person that the average American is about 4 days pregnant.  Unfortunately that probably means it’s a bit too late to put granddad on the pill.

But if you want to know how to fix things, then a good place to start would be with the Great Moderation.  Our last year of > 5% growth was 1984.  Before 1970 we had 5% plus years all the time, but starting around 1980, growth dropped by about a third.  This was the same time that National trade deficits started to rocket upward, incarceration rates jumped, and that national debt reversed its long drop as a percentage of GDP from 125% in 1945 to 30% in 1980.  If you simply reverse what happened at that point, then you should be on a great track to start fixing all these problems.

The reasons for a lot of this should be obvious, but it is worth talking about the connection between distribution of wealth and trade deficits.  Recall that when the number of dollars aiming at tacos goes down and the number of dollars aiming at taco bells goes up, the only possible result is a decrease in ROI.  A similar trend happens in the bond market, which is why in an environment like we have had since 1980 where stock and bond returns have been driven largely by monetary expansion targeted specifically targeted at capital dollars, we have seen heavy correlation, whereas in a lower P/E environment driven more by fundamentals like we had in the new deal era (1933 - 1960) stocks and bonds were inversely correlated.  Anyway, with rapid capital inflation and slow to negative consumer inflation, we had capital bubbles form in the US.  Money flowing into these capital bubbles kept the dollar strong, and put us at a strong export disadvantage as part of an ironic currency manipulation against ourselves.  Or to put it another way, money flowing in to participate in capital bubbles must be matched by money flowing out to purchase goods as part of basic equilibrium theory for supply and demand of currencies.

Anyway, back to point, the heavy similarities between US today and US in 1932 should be a huge source of optimism for those people trying to push a renewal of New Deal policies.  To understand the math behind this, we must start creating economic categories with homogeneous impacts lest we misread our math and put granddad on the pill, so to speak.  The most fundamental place to start is a dollar you put in the hands of a poor person will behave differently than a dollar you put in the hands of a rich person, and understanding this must be a litmus test for putting faith in an economists models and predictions.

Ronald Nimmo

Nov. 1, 2012, 9:08 a.m.

It seems to me that this paragraph states that it is valid to count Government spending twice in the equation GDP = C + I + G + Net Exports.
Counting it as G and also as apart of C seems like double counting to me. This kind of redundancy would seem to undermine the accuracy of the equation.

“Those who argue that reducing spending will also have an effect are equally correct. Government has been a large contributor to consumer income and therefore personal consumption, part of the “C” in the above equation (along with business consumption). The chart below, produced by Bridgewater last April, shows the additional effect of government spending on disposable income for the US consumer. Notice that without government support, disposable income would now be significantly lower”

Brian Gladish

Oct. 24, 2012, 7:32 a.m.

When the “G” in the GDP equation is taken unquestioningly as positive economic activity, we are in a keynesian fantasy that promotes the welfare/warfare state a a wealth-creating engine.  I’m not buying it.

http://radicalliberal.blogspot.com/2010/06/gdp-fixation-every-friday-i-receive.html

Dallas Kennedy

Oct. 24, 2012, 3:52 a.m.

A thoughtful piece, but I must dispute the Keynesian framework. The GDP identity is an accounting truism, but it doesn’t get at all to the sources of economic growth. At best, it gives you a snapshot of current spending. Consumption, investment, and government are paid for from current production. If the current production isn’t big enough, the difference must be borrowed. Certainly, in the near term (over months or quarters), the “fiscal cliff” will impose a recession on the US economy.

But the longer-term picture is shaped by investment and potential return. That in turn is shaped by demographics, technology, and the tax and regulatory environment.

What has many confused is the obsolete way of looking at the US economy as a quasi-closed system, which is natural in the Keynesian framework. Better to think of the “US dollar universe,” which consists of the US, much of the world’s financial system, the commodity markets, and parts of the developing world’s economy (at least that part that is export-oriented). This is the result of “globalization”—“dollarization,” really. Certain parts of that system run permanent surpluses and do the saving; other parts run permanent deficits and do the excess consuming.

But, Congress’ laws don’t directly govern those parts of the US dollar universe outside the US. If they did, the whole problem would make sense and might even have a solution. But they don’t; the “dollarization” of the world’s economy (forcing the rest of the world to recycle, not our surpluses, but our deficits) is a result of Fed policy. The Fed is a pseudo-fourth branch of government and has transformed the situation so as to make much of our traditional political conceptions irrelevant.

Denis Smalley

Oct. 24, 2012, 1:29 a.m.

John’s analysis of the GDP constituents is correct. Unfortunately, the analysis of the derivatives of the GDP such as the “multiplier” are all over the map (as John points out). Big business supporters often whine about corporate taxes and claim they should be free to “create wealth” without government interference. This mistaken line of thinking is captured in Krista G. statement as follows:

“The truth is that government spending must come from somewhere since the government cannot create wealth on it’s own.  Government must take resources from the private sector in order to spend them.  Now, how can that be efficient?  Can the government really spend resources more efficiently than the private enterprise that created those resources?  Impossible!”

I argue this notion is rhetorical and it flies in the face of logical thinking. Wealth in its simplest definition is simply the collection of assets and assets can be created by the government as easily as the private sector (actually, more easily). Thus, the government can certainly “create wealth” just as private enterprise can. The government makes, through legislation and executive powers, regulations that often favor one group engaged in business over another. This effectively shifts assets or “creates wealth” just as as efficiently as private industry does. Private industry loves this when the governmental acts favor their accumulation of assets but whine and gnash their teeth when it does not. The government, in fact, owns (controls) most of the “resources” that exist as in the land, minerals, air space, etc. and they grand private enterprise the right to use, extract, or operate within those resources, provided the tax is paid to do so. To think otherwise is to misunderstand the modern concepts of “land ownership”, “estates”, and taxation.

The roles of Government includes allowing everyone (including business) to enjoy the resources that exist in a relatively equal manner. An example is the water resources that exist in the US. Should not anyone who wants to use this resource be allowed to do so so long as they do not taint the resource for others? But private industry would love to seize this resource and “generate wealth” by selling the rights to its use. That is clearly not in the general public’s interest. The left’s view is that healthcare, retirement security, and care for the poor should be managed more like water resources and that individuals have a right to these things. The right’s view is that business should be free to “create wealth” for certain individuals at the expense of the general public, that being individuals and that they should not be excessively taxed to furnish healthcare, retirement security, or care for the poor but instead, the middle class should shoulder this burden. 

I would agree that government should not compete with private business and in fact, other than regulating business to reduce it’s tendency to rape Mother Earth and all its inhabitants, government’s role in business should be minimal. But I also argue that business should be taxed more than individuals as the government provides many resources that businesses enjoy the benefit of and use to generate wealth for a much smaller population than the general populous.

aemaher@bigpond.net.au

Oct. 23, 2012, 7:20 p.m.

Is it correct to assume that when the ‘Fiscal Multiplier’ has exceeded 1.0 then using the GDP equation it is fair to assume C and I have become dependant on some component of the G? Because in essence this equation is no longer linear. Extending that thought out, is there not a multiplier that could be given for I and C on GDP at different points in the economic cycle?

Daniel Kennedy 94695649

Oct. 23, 2012, 4:04 p.m.

Clearly it is possible to significantly reduce the cost of compliance with government without either cutting spending or raising taxes. Just one example – it is estimated that the cost of compliance with federal income tax law is approximately $400B a year. I suspect a moderately rational income tax law could cut that at least in half and a truly simplified tax law could cut it by say $300B a year – not too shabby an annual stimulus.

In general the only real purpose of any bureaucracy is to grow. It’s immaterial whether the bureaucracy is in the private or public sector - its only purpose is to grow. Fortunately, the private sector has a pruning mechanism. Unfortunately, the public sector doesn’t. Every page, every sentence, every word of legislation and regulation is fertilizer that enables bureaucrats to grow the bureaucracy and the power of the state. Similarly, so does increasing the population of those dependent on the state.

Currently public sector bureaucrats are punished for efficiency and problem solving - they lose funding and therefore status and power. For a sample from an endless list of examples ask yourself:
• Why, as the end of a fiscal year approaches, does every government bureaucracy rush to spend every remaining cent of funds?
• What would happen to the Drug Enforcement Agency if the drug problem were “solved”?
• Why is there a Bureau of Indian Affairs in the 21st century and why have American Indians still not assimilated?
• Why is American education poorer but vastly more expensive today than before the creation of the Department of Education?
• What has the Department of Energy accomplished re energy independence?
• What has the Environmental Protection Agency accomplished other than insuring “dirty” jobs and processes move to such ecological wonderlands as China, India, Bangladesh, etc.?

How does one incentivize government bureaucrats to not accumulate of power?

Girish Vinod

Oct. 23, 2012, 1:20 p.m.

I would like to know what effect rise in gas and oil production would have on deficit reduction as that will drive growth and industry turning into net exporter instead of importer of this resource.

Gary Levin 30989

Oct. 23, 2012, 10:19 a.m.

John- as always, love your articles, this one in particular. Great summary of the issues. The health care law-the PPACA - will reduce Medicare spending to providers by 716 Billion over 10 years or about 14% per year (simplified)- this is the official CBO estimate. Ryan’s plan proposes the exact same amount via a different route. Either way it will reduce spending albeit not enough to ‘bend the curve’ of health care spending. The great hope is placed on Accountable CAre Organizations (ACOs) and disease management (DM) yet there are controlled studies for both that clearly demonstrate neither work (financially) adequately!  The CBO just published their 10 year study results for DM and proven that while cose-effective, it does not return an ROI.  ACOs had a 5 year demonstration project, and the data analysis for some of the best medical systems in the country were published in the NEJM which clearly showed ACOs reduced spending ONLY for dual eligibles (medicare-medicaid) and even that was insufficient (1% or less).  Your theme is that budget deficits simply can’t go that high..and neither will medicare spending—because when the final results come in across the country (implementation starts this January), they will fail. The most likely scenario is that the legal and clinical infrastructure the gov’t created through ACOs will enable Medicare to capitate all provider systems, converting medicare from an indemnity plan into a fixed-budget (more predictable) capitated type system. Surely that will fix the growth rate. It may also get the gov’t out of micromanaging health care.  I actually support that capitated type environment and look forward to it.

ralphsf@gmail.com

Oct. 23, 2012, 8:56 a.m.

The problem with all analysis of this kind is that your very basic starting premise is incorrect.  Thus all logical arguments made after that point are good and solid but unfortunately irrelevant.  Problem assumption is that going into a recession would be bad.  They are necessary and beneficial.  They are part of true capitalism free from the machinations of human intervention which always has unintended consequences.

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