The Deficit and the Great Recession

I've thought about this for awhile, and I've come to the conclusion that the solution to the current deficit versus growth problem is pretty simple. Right now, the problem is growth. We appear to be finally in a nascent recovery. The stock market broke 13,000 for several days now. Unemployment claims have moved downward to an average which will bring down unemployment Fourth quarter economic growth is now measured at a healthy 3%.

Let me stress the word nascent. Now is still not the time to focus on deficit reduction. A contraction of government spending could send growth down into low digits and continue our economic stagnation. We need to maintain our current level of spending with longer unemployment benefits, the payroll tax deduction and maintenance of key safety net programs that will boost spending.

After growth appears to have stabilized, the problem for economic policy-makers should shift to inflation. All the money pumped into the economy will begin to tighten. This is now the time to begin cutting the deficit. You do this for two reasons. One to slow economic growth and prevent inflation. The other is to ensure that current generation pays its economic debts rather than shifting them to our kids.

The Eurozone Crisis - Things are not always what they seem

The popular story that has circulated in the richest countries is that this is a morality tale. The extravagant behavior of the Irish and Mediterranean Countries led to the crisis. Rather than working,they danced, rather than saving and investing, they spent. (known here as the Zorba the Greek Syndrome).

After the fall of communism, Germany, France, and other more developed countries sought to integrate Eastern Europe as well as countries on the periphery like Greece, Italy, Greece and Spain into the European economy. The Euro was created to avoid currency fluctuations and improve stability in trade.

The problem was that there was a European monetary system but separate fiscal systems in each country. This worked out fine until the stress of the great recessions exposed the weakness of the alliance. The nations on the periphery failed to manage their economies, spent more then they could afford and failed to invest. This led to a huge debt that would be difficult or possible to pay back. Follow this link to a comic version of the story

Consequently, the banks who had purchased government bonds from those countries were facing potential defaults from the peripheral countries. The potential of huge losses spread fear of a contagion that would lead to widespread bank failures throughout Europe and a double dip recession. Only through the generosity of the richer countries could Europe be saved from the proliferous periphery.

Here's the problem, with the exception of Greece, the debt problems of the peripheral countries was not much worse and in some cases better than the wealthier European countries. Furthermore, the moral faults of those nations was clearly misplaced. Investment and capital formation was as great or greater and the work ethic actually appears stronger (see the above graphs).

Then what was the cause of the crisis? The answer appears to be quite the opposite. The alternative explanation is that the adoption of the Euro resulted in a flow of capital to the periphery to take advantage of the cheaper labor and new markets. When the recession hit, the capital reversed it's direction leaving a massive current accounts deficit. Since all of the counties had one currency, they were unable to devalue their currency to balance the outflow. I'll cover more this in my next blog.

Productive and Unproductive Labor

I'm definitely guilty of overusing the above graph but what it illustrates so well is the level of greed that motivated the leaders of the world's investment banks. Their bonuses were so large that they eventually exceeded the net income of their companies bankrupting the companies and allowing them to escape with billions as they helped bring down the world economy.

This is an example of a problem that is ill-described in traditional economics - the problem of unproductive versus productive labor. In the case of the financial crisis, it appears that a larger and larger proportion of our nation's output was siphoned off to a growing parasitical class which used their very rich human capital to create new financial instruments and marketing techniques which in fact created no wealth. In fact, they appeared to have destroyed a lot of human, physical and financial capital in a process that added nothing to our society.

The concept of productive versus unproductive labor has a history in Marxist economics. In Marx's complex and unfinished work, Theories of Surplus Value, in Chapter 4, Marx lays out a description of what he believed added value to the economy and what appeared to subtract value from society.

Marx made a couple of big mistakes here. One was that capitalists (or today's entrepreneurs or managers) didn't add value, only labor did. He assumed that the creativity, acumen and management ability of a capitalists was no different than any other kind of labor. There is considerable evidence that the risk-taking and management expertise of capitalists is perhaps a different factor of production than other forms of labor.

However, his analysis of finance capital appears particularly germane today. Thomas Philippon in an article last month "Has the U.S. Finance Industry Become Less Efficient?, argues that, "Surprisingly, the finance industry has become less efficient: the unit cost of intermediation is higher today than it was a century ago. Improvements in information technology seem to have been cancelled out by increases in trading activities whose social value is difficult to assess."

The sad part of Phillippon's analysis is that wasted capital in finance does not seem to have diminished as the great recession has dragged on. The question appears to be, Have we learned anything?

The Deficit- Creating our Own Nightmare

Listening to politicians in Washington, there is no doubt that America's huge deficit is leading to the end of the world as we know it. They never fail to describe in horror the effects of ballooning government spending on the future of our children.

Here's the problem. It ain't that bad.

According to the nation's official budget scorekeeper, the nonpartisan Congressional Budget Office, if politicians simply do nothing, the deficit will fall from today's 8.5% in 2010 to 1.2% in 2021. The historical average from 1971 to 2007 was 2.8%.

So what's the catch? Real simple. Congressional leaders are simply unable to let the current tax cuts expire. Allowing taxes to rise to their pre-2001 level in late 2012 would drop the deficit to less than half their historical average. Don't let the pre-2001 tax level scare you, taxes as a percentage of GDP were below the post-war average in the late 90s, the budget was balanced and the economy was roaring.

That doesn't mean we pull the trigger if the economy is still growing slowly and it doesn't mean that we don't still have work to do on the budget.

What it does mean is that current hyperbole is simply out of control.

The Myth of Overuse: Health Care Co-payments

There are few things people agree on when it comes to health care reform but one of them is the importance of provider co-pays in reducing health care costs. Liberals and conservatives alike delight on the ability of this simple device to reduce overuse of health care resources. Businesses and governments who fund health care payments enjoy the cost savings of co-pays while benefiting from the warm glow of serving the greater good of health care reform and cost containment.

The assumption is that health care consumers make a trade-off between the price of the care and its true benefits. This usual policy logic dictates that we use elasticity of demand (the change in quantity demanded divided by the change in price) for a category of care to set co-payments. The data indicates a high demand elasticity meaning that the care is of low value. If a small change in price results in less use, than the value of the care must not be very high.

But what if that isn't how people make decisions? What if people have biases in judging in making decisions? A particular difficulty with medical procedures is that many people tend to judge them much worse before than after the procedure. Their fear of the procedure makes them subject a bias again the care that is confirmed by the co-pay. People suffer from a great deal of confusion and anxiety when making health care decisions.

What if people aren't very good had judging the medical risks of various procedures? Could people myopically discount adverse health outcomes?

There is disturbing evidence that small changes in co-pays have huge effects utilization.

While there everyone agrees that co-pays create lower utilization rates, the important question is, do co-pays end up limiting overconsumption of medical care or does it lead to underconsumption of medical care. Do patients reduce the amount of care they purchase based on inaccurate assumptions of risk thus leading to higher long term costs for consumers as well as higher social costs for society?

This is particularly likely to be true in the case of low-income patients. A $50 co-pay may reduce overconsumption by high income patients while creating underconsumption for low income patient.

There are alternatives to simple using a meat ax on health care. Differential pricing could be valuable in this process. One idea would be to increase the co-pay as the number of visits increase. Another would be to set the co-pay as a percentage of income. Co-pays may just be another excuse to cut services to those of us who are less well off.

The Media and Confidence

This morning's Seattle Times headline screamed "Greek Debt Vote Rocks Markets" . The article went on to proclaim that "U.S. stocks plunged as investors fretted that Europe's problems, believed largely resolved, now appear far from settled and threaten a week recovery." The Dow Jones fell nearly 300 points.

Today, the market has already made up over 2/3 of yesterday's loss buoyed by good news of private sector job creation.

Hmmm. Do you think that the uptick will make the Times headline? Did the Times headline last week's good news on GDP growth?

The point is that people tend to take in news with the emotional part of the brain not the rational part. The constant outflow of bad news accumulate into declining consumer confidence. Any good news is generally off the media radar screen.

In reality, a recovery is very slowly building and markets have been relatively stable on a monthly basis over the past year. But consumer confidence has lagged. We are mere mortals who forecast the future primarily on the mood of today, when things are good, they are good forever. When they are bad, they are bad forever. The Seattle Times is merely doing it's job, but the effect is to tamp down consumer confidence.

Lack of Confidence, Frustration and Alienation

The Congressional Budget Office just released a report Monday indicating that household income between 1979 and 2007 grew by 275% for the top 1% of earners and fell by 2 to 3% for middle class Americans. This disparity has risen even more since 2007.

There are many, many ramifications of this growing income disparity for public policy. One is the sense of unfairness that Americans feel both about the economy and our government. This sense of alienation has contributed to the volatility and polarization we are seeing in politics today. The lack of response by Democrats and Republicans alike has led to spontaneous movements like the Tea Party and Occupy Wall Street.

Secondly, if a higher proportion of the nation's income and wealth is going to the very richest, a segment that spends significantly less of their income than the middle class, could that be contributing a lack of consumer demand in the economy?

On top of this, recent BLS data indicates that the wages of college graduates has fallen steeply since 2000 as college tuition has increased and student debt has sky-rocketed. The estrangement and frustration felt by young people today does not forebode well for the future productivity of our country as college debt increases to record levels in response to sky-rocketing tuition.