A Spring Cleaning for American Monetary Policy

The past several months have witnessed profound transformations in the state of America’s economic outlook. Output growth has accelerated, with annualized GDP growth rates of 4.6%, 5.0%, and 2.2% in Q2, Q3, and Q4 of 2014, respectively.  This has been accompanied by similarly impressive gains in the pace of job creation, with a full year’s worth of monthly net employment gains of over 200,000, and an unemployment rate increasingly dipping into “natural rate” territory (estimated to be between 5.2 & 5.5%, though recently revised to around 5.1%).  Oil prices have plunged since late 2014, helping to spur aggregate demand.  And the FY 2016 budget released by the Obama administration in early February continued the turnaround in federal fiscal policy, with large increases in proposed discretionary spending initiatives promising to accelerate (if implemented) the transition towards a more accomodative policy stance.

Real GDP Growth has trended upward in recent quarters.  Photo courtesy of the Bureau of Economic Analysis.

Real GDP Growth has trended upward in recent quarters. Photo courtesy of the Bureau of Economic Analysis.

Monthly net payroll growth has steadily increased as output growth has accelerated

Monthly net payroll growth has steadily increased as output growth has accelerated

The U3 unemployment rate measure is slowly converging towards the estimated natural rate of unemployment (NAIRU).

The U3 unemployment rate measure is slowly converging towards the estimated natural rate of unemployment (NAIRU).

All of this points towards an economy that is rapidly strengthening and should continue to do so as the year continues.  The impacts of oil & natural gas price declines have yet to fully ripple through the economy in the form of increased manufacturing competitiveness and higher consumption.  Firming employment figures should boost aggregate demand as more earnings are recycled into discretionary household purchases.  Higher stock and housing prices will continue to translate into “wealth-effect” consumer spending.  And rising retail sales should further spur investment, boosting current and long-run growth in the process.  Ceteris paribus – all else held equal (such as geopolitical happenings) – and there is little reason to expect for strong economic growth not to continue.

With the arrival of Spring on March 20th and the accompanying wave of household cleaning, as well as this unexpected barrage of good economic news, it is a good time to take stock of the current policy trajectory.  Considering it is in the news so much, and bears so much direct import on the macroeconomy, of primary concern is the stance of monetary policy.  How soon should the Fed tighten?

Currently, the main policy tool that is modulated by the Federal Reserve, the Federal Funds Target Rate, is set in a range from 0 – 0.25% – the lowest levels in its history.  This has been the case since late 2008, and the 6+ years since then has likewise marked the longest period of accomodative policy in history.

This is set to change.

Rumor has it that a long-awaited hike in interest rates (read: Fed Funds Target Rate) will proceed by the middle to late-middle of this year, though the rate of increase will be fairly gradual, perhaps around 50 basis points to .75% by late this year.  This has been the assumption of investors for awhile now, and seems to be the likeliest course of action.  But is it a good course of action?

My views are mixed, but side with pessimists who feel that even these gradual steps are too rapid.  First among my concerns is that the American economy is still no where close to “full employment”, one of the key elements of the Fed’s dual mandate.  The Economic Policy Institute estimates that U3 rates closer to 4.0% (instead of 5 – 5.5%) are more consistent with NAIRU (n0n-accelerating inflation rate of unemployment).  This would make sense, for though unemployment is now within reach of the Fed’s estimates for NAIRU, inflation has continued to trend down (turning into outright deflation in recent months as lower oil prices feed into general prices), and wage growth remains stagnant (at 2% nominal growth, real wage growth is too low to feed into wage-push inflation).

fredgraph

Rates of inflation are well below the Fed’s 2% annual target

 

Nominal Wage Growth Tracker

As demonstrated by the Economic Policy Institute’s Nominal Wage Tracker, wages are rising too slowly to be consistent with target wage and inflation growth.

 

We would expect wage growth to strengthen as we near the natural full rate of unemployment.  Rising demand for workers while the labor supply becomes more scarce boosts the bargaining power of workers to negotiate higher wages.  This wage growth is partially a pre-requisite for higher rates of inflation (closer to the 2% target).  Higher wages means that prices usually must be increased for businesses to maintain profits, and these higher prices then necessitate further wage hikes, creating a positive upward spiral that feeds into rising inflation.  Since both nominal wage growth and inflation rates are well below target, it appears that full employment has not yet been reached.

Some will argue that the existence of monetary policy impact lags (how long it takes for a policy change to have an effect) would justify a rate increase now, as several months from now, it may well be that full employment is reached and wage and price increases are accelerating, to the point that tighter policy is needed to mitigate.  However, even if it were so that we reach full employment on current trajectory (which, if EPI is right and NAIRU is closer to 4.0%, will be a ways into the future), I still think holding off on an increase is justifiable.  For one thing, wage growth has been subpar for many years – allowing it to catch up back to pre-recession trends wouldn’t be a bad idea.  This is especially true if the Fed is worried about the sustainability of the expansion.  Wage increases are necessary for increases in consumer spending (the driving force of the U.S. economy) to be sustained.  Allowing for months, if not a few years, of above-average wage & inflation growth might not be a bad thing for the sake of sustainability.

Given the existence of multiple tools to combat inflationary pressures and to prevent higher inflation rates from being too ingrained, I think the biggest drawback of this proposal of delayed tightening is that the Fed risks overshooting its employment target (meaning that unemployment is below its natural rate for an extended period of time).  Technically, this would be a violation of its dual mandate.  However, invoking the argument about this policy helping to produce long-run economic sustainability (to maintain full employment and stable prices), a temporary overshooting of the dual mandate targets might be statutorily justified.  It all depends on the timeframe the Fed chooses to create policy, which historically has been rather short (within months/a few years).  This is the difficult balancing act the Fed must consider, and which is statutorily ambiguous.

If it were to think more of the possible long-run consequences of its policies (especially as it relates to the dual mandate), an already difficult task suddenly becomes much, much more complex.  Further thinking and a cleaning of its future policy stance is in order…

TBC

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Building a New Era of Governance – Part 2

6) Continue with efforts to reform the healthcare system.  Love it or hate it, the Patient Protection and Affordable Care Act (PPACA, e.g. Obamacare) is here to stay (sorry Project 2017); at the very least, the law will not in its entirety be repealed.  The myriad subsidies, tax credits, and benefit requirements are far too popular; to repeal them would be political suicide.  What Congress needs to do now is to focus on modulating and improving upon what already exists.  Obamacare goes a ways towards addressing the pre-existing deficiencies in the system (although in an arguably inefficient and potentially self-defeating, if not destructive, manner).  These deficiencies are not hard to identify.  American healthcare is outrageously expensive (see below), and too few people have access to the system (anomalies which are very much related, via the effects of adverse selection).  Those who do have access (especially those on employer-sponsored plans) then face rigidities such as a lack of portability and increased dependency upon a single employment setting.  Obamacare generally does a pretty good job at addressing the lack of access to care; already, it has significantly boosted insurance rates via expansions of Medicaid and the provision of individual and business tax credits/subsidies.  The renewed ability of individuals to purchase insurance has also addressed the portability issue.  However, its record on holding down long-run costs appears to be more mixed.  It has provisions that simultaneously place downward and upward pressure on costs.  For the former, the individual mandate should help by increasing the pool of healthy individuals contributing to the system (countering adverse selection), offsetting the costs of newly-enrolled less-healthy individuals.  Additionally, the law contains numerous “experiments” designed to hold down costs, such as the creation of “bundled payment plans” as opposed to the traditional fee-for-service payment model (which rewards doctors on quantity, not quality, of services rendered).  At the same time, the law contains many expensive provisions, such as the prohibition of lifetime caps on benefits and new restrictions on varying premiums based on certain risk factors.  Thus far, costs have leveled off in recent years; then again, we did go through a massive recession that put a dent in demand for health services, and spending growth has been rising as of late, albeit very modestly.  Regardless of Obamacare’s impact on cost growth in particular, an ageing populace and the continued existence of marketplace distortions calls for continued efforts to make health spending more efficient and cost-effective.  I think that Republicans in Congress can pursue policy options that are both effective and politically sustainable.  They include the following:

In both relative and absolute terms, the United States spends far more resources than other countries on healthcare (source: vox.com)

 

The growth in healthcare expenditures has slowed in recent years, though its permanence has yet to be determined

The growth in healthcare expenditures has slowed in recent years, though its permanence has yet to be determined

PPACA has had a dramatic impact on the nation's uninsurance rate

PPACA has had a dramatic impact on the nation’s uninsurance rate

a) Repeal the Cadillac Tax, replace with a gradual phase-out of the tax exclusion on employer-sponsored insurance premiums.  While FDR’s World War 2 wage and price controls arguably created the present-day Employer Sponsored Health Insurance (ESHI) system, this policy has no doubt been greatly aided by the Federal government’s decision to exclude employer sponsored insurance from taxation (and kudos to Ike for making it open-ended in 1954!).  By excluding fringe benefits from taxation, the federal government has virtually subsidized the provision of employer-sponsored insurance.  From both an employer and employee perspective, $1 in healthcare is much more cost-effective than an additional dollar in wages.  This has led to costlier plans, and an increasing proportion of overall compensation being dedicated to benefits (as opposed to wages).  Adding insult to injury, the same tax benefits do not apply to individual plans, which are typically purchased using after-tax income (although Obamacare has implicitly equalized this a bit via the provision of subsidies and tax credits for individual plans).  To try and further “equalize” treatment, the authors of PPACA included the phase-in of a 40% tax on “Cadillac” insurance plans, specifically the cost of plans that exceed pre-determined thresholds (about $10,200 for individual coverage and $27,500 for family).  I see this tax as very arbitrary – 40% on randomly selected amounts, that has no guarantee of “equalizing” tax treatment between ESHI plans and individual plans.  The thing is, we already have taxes in place (federal income & payroll taxes) that could apply to these premiums; it’s just that the government has exempted them completely.  In addition to its failure to equalize treatment and how unnecessary it is, it also does not raise anywhere near as much revenue as a hypothetical full repeal of the ESHI tax exemption would.  The Cadillac tax is estimated to raise about $80 billion between 2018 and 2023 – a six-year period.  Meanwhile, the ESHI exemption in totality costs the federal government a whopping $250 billion every single year.

The tax exclusion of employer-sponsored health insurance is by far the most costly federal tax expenditure

The tax exclusion of employer contributions to ESHI is by far the most costly federal tax expenditure

I see this as a prime opportunity for Republicans to claim credit for killing a tax (the Cadillac tax) while simultaneously making the tax treatment of healthcare more sane and raising the government badly needed revenue.  What they could do is enact legislation that repeals the Cadillac tax in its entirety, but simultaneously places caps on the tax exclusion equal to the thresholds imposed by the Cadillac tax.  In this way, benefit amounts exceeding $10,200 for individual coverage and $27,500 for family coverage will be subject to normal taxable income.  Unlike other proposals, though, I would move for these threshold amounts not to be indexed to price changes whatsoever – be it a measure of inflation, a flat rate, etc.  In this way, more and more plans will gradually be subject to the tax (much like bracket creep of the 1970s) so that the discretionary impact of the exclusion can be tempered over time.  Better yet, have the thresholds lowered on an annual basis so that eventually all “fringe” benefits will be taxed, and there will be no implicit subsidization of ESHI.  Of course, an elimination of the biggest single tax break in the federal tax code would produce enormous backlash in and of itself; indeed, it would be rather hefty tax hike.  That’s why I think the Republicans should also consider using some of the revenue generated to lower marginal tax rates (one of their favorite pastimes); any potential revenue left over could be used to lower the deficit and perhaps expand insurance subsidies for the poor and middle-class elsewhere (which would be especially appealing to Democrats).  Combined with a repeal of the (more visible and unpopular?) Cadillac tax, I think this could be a politically palpable solution.  It will help eliminate artificial demand for healthcare and give the many types of insurance options equal – as opposed to preferential – treatment.

b)  Force (or nudge) states to dismantle barriers for the purchase of insurance across state-lines.  This is an area where federalism & devolution has failed – and the federal government ought to step in.  Other than for the appeasement of insurance companies, there is no reason states should restrict consumers from purchasing policies from out-of-state companies.  This has had the effect of creating localized insurance monopolies that have artificially driven up costs.  Sure, it will take time for interstate insurance provider networks to materialize; but it’s better to start now than to continue with the status quo.  Republicans really shouldn’t encounter as much resistance from Democrats with this measure; after all, Obamacare intentionally created state-level exchanges where consumers can “shop” for different policies, with the intent that (perhaps one day) a single national exchange or market could be created.  However, Republicans may run into arguments that this will cause a decline in benefit standards as consumers seek the most cost-effective policies; however, shouldn’t Obamacare’s minimum benefit provisions (that differentiate plans into bronze, gold, silver, etc.) create a floor on a substantial portion of policies?  And if not, Congress could always mandate a bare minimum of standards to create a floor under state floors (though this would probably lead to a conservative backlash; the party establishment must proceed with caution).

c) Medical malpractice reform.  Yup, it’s a relatively small part of the overall cost picture, but even Democrats have to admit that $45 billion a year in defensive medicine is a bit much (even if a portion of it is “worthwhile”.  Although it might work better at a state-level, federal policies such as enacting caps on total payouts, raising the thresholds to file suit and concepts such as “loser pays” could all do their bit to reigning in excessive medical malpractice costs.

d) Promote cost transparency.  Obamacare has already done a wonderful thing by mandating that employers report insurance costs on employee’s W-2 forms.  This has helped in the process of getting employee’s “skin in the game”, so that they are congnizent of costs that otherwise feel disconnected  from them (what a revolutionary concept).  Congress ought to expand the variety of benefits that require W-2 reporting, and could try to find additional means for cost information to reach consumers directly.  Of course, it must be mindful of the unintended consequences of such mandates, as reporting consumes time & resources in and of itself.  Again, since transparency provisions already passed Obamacare in its original form by an overwhelmingly Democratic Congress in 2010, I don’t see why further transparency provisions can’t be a bipartisan effort.

e) Temporarily increase Disproportionate Share Hospital (DSH) payments to hospitals.  Right now, hospitals across the nation are straining to provide uncompensated emergency care for millions of uninsured Americans, care that the federal government partially pays for via DSH payments.  Unfortunately, these payments are usually not enough, forcing costs onto general insurance premiums.  As Obamacare expands and insures more people, this problem should theoretically ease somewhat, and the strains on DSH should ease.  Nonetheless, this insurance expansion in incomplete (especially since not all states are on board with expanding Medicaid), and may not be enough to substantially reduce the strains on the already overburdened DSH payment system.  So why would conservative Republicans have an incentive to increase federal spending?  Quite simply, higher DSH payments could indirectly ease insurance premiums for millions of people (allowing for less private-level “redistribution” from the insured to the uninsured”, and costs could be lowered for the federal government too in a way that offsets the increased spending on DSH.  Expanded DSH would also be appealing to Democrats, as it would serve to benefit one of their core constituencies (the uninsured poor).  It is one of those times when less requires more.

f) Loosen federal restrictions on Health Savings Accounts (HSAs).  I see HSAs as a part of the solution to get people to have skin in the game when it comes to healthcare spending.  When combined with high-deductible health plans, HSAs establish a connection between medical spending and personal savings that can help to curb the consumption of excess medical care.  The Federal government should lift existing statutory contribution limits and abolish all taxes that apply to HSA withdrawals, including for so-called “non-qualified” withdrawals.  The latter option, in addition to being more fair, would help to eliminate distortionary tax-minimizing behavior that could actually inflate health spending.  HSAs go along with the conservative notion of individual responsibility (which might explain their strong support by Republicans), and certainly Democrats shouldn’t be opposed to an increase in savings accounts (especially considering Obama’s proposed myRA retirement accounts).

g) Eliminate the Employer Mandate.  One of Obamacare’s most controversial provisions is that employers with 50 or more “Full Time Employees” (FTEs) provide them with health insurance or pay a penalty.  An FTE is defined as someone who works 30 hours or more.  This has lead to huge disagreements over the provision’s impact on the labor market, with critics claiming that this provision is weakening the 40-hour workweek by incentivizing employers to cut back on workers’ hours to avoid the mandate and associated penalties.  Proponents have countered that most workers already work more than 40 hours a week, and thus are at little risk having their hours drastically cut to below 30/week.  In response to a recent bill to move the threshold from 30 hours to 40 hours, these proponents have also said that this bill makes cuts in workers’ hours much more likely, as so many work 40 hours (or a little more) per week.  Both sides have points; but really, it almost doesn’t matter.  The employer mandate, like much of Obamacare, creates arbitrary thresholds that threaten to severely distort the economy and strangle business decisions.  The 50 FTE threshold has already led to an increase in “49er” businesses, who artificially limit their employee count to less than 50 to avoid the mandate and payment of penalties.  Additionally, I feel the employer mandate exacerbates an existing major problem with American healthcare: the very fact that so much of it is provided by employers!  This 4th-party payment system is incredibly non-transparent and non-portable, disregarding the economies of scale it provides via pooling, and explains a major part of the cost dilemma.  As such, I think the mandate deserves repeal.  Since Republicans will obviously fail at repealing the law, they might as well go after a single provision of it to incrementally enact positive change.  Although repeal of the mandate is also likely to fail, it is still worth a shot, especially considering how the new 114th Congress has already decided that targeting the mandate will be one of its first legislative acts.  Perhaps this will also give some Democrats who are weary of the net impact of Obamacare to finally demonstrate their political independence from a surprisingly unpopular law.

Building a New Era of Governance – Part 1

*Note: the views expressed in this posting are my own, and do not in any way represent the views of any other group or institution, public or private


Last Tuesday, November 4th, it is fair to say that the second Republican “wave” since 2010 swamped Congress and state governments across the nation. In Congress, the GOP managed to pick up at least 7 seats in the Senate (giving them a majority of 52, over the key threshold of 51), as well as at least 12 seats in the House (increasing their majority to at least 244). Gubernatorial elections also proved to be a route for the Democrats, as the Republicans snatched up another 3 governor-ships from the Democrats.

Despite these impressive gains, however, they will prove to be utterly meaningless unless Republicans in Congress can seize this opportunity to act in a bold, pragmatic, and bipartisan manner to go about conducting the nation’s business. More than anything, people are simply disgusted and fed up with what is shaping up to be (by many measures) one of the least productive governmental terms in American history (see chart).  While some may view inaction as a good thing (less activity means a smaller government = good, right?) I do not see this stagnation as benefiting anyone.  Even if few bills are passed, old ones already enacted are left to atrophy and will not be updated regularly to adapt to changing circumstances, creating new problems.  Additionally, it takes legislation to repeal legislation; inaction does not mean the government is in fact getting any smaller (and assuming a smaller government is even desirable in the first place).

Overall, as many pundits have noted, it is best to view the results of this election as an expression of disillusionment with a lack of leadership on either side of the aisle and a desperate plea for governance, as opposed to an endorsement of some ideological mandate. Especially when it comes to Congress, people are incredibly irritated that its members are well-paid, work part time (with much of their time spent campaigning), and yet very little of the country’s increasingly urgent problems are attended to. It is true, what many business-minded people would say: if the government were a private entity, they would’ve pushed out of the market a long, long time ago.

4.10.14.2

In terms of bills passed per legislative session, the 113th Congress is shaping up to be among the least productive in recent history

It is true that the outlook for an increase in Congressional productivity remains bleak, at least for the next two years. It’s a well-established pattern by now that American government doesn’t do too much unless a single political parties occupies both the Whitehouse and controls both chambers of Congress. However, this need not be an excuse for inaction; in fact, it cannot. The following is an agenda that I think Republicans can pursue that will not only help to solve the problems the public wants solved (and in a way that is congruent with the wishes of the electorate), but to help to build a new era of lasting American governance.

1) Lengthen the terms of the President, House, and Senate.  Of the many issues facing the country, this one (along with the next two agenda items) may seem like one of the least deserving of our attention.  However, relatively short Senate, Presidential, and (especially) House terms I believe has had a dramatic impact on the productivity of individual members.  Since elections come so frequently, many in the federal government must be in a near constant campaign mode that not only distracts them from legislative work but serves to polarize their “views”, making bipartisan consensus much more difficult.  At least attempting a Constitutional amendment, though quite unlikely to pass, could get the ball rolling on a future reform down the road.  Enactment of this reform, along with the following agenda item, could help to address the entrenched legislative paralysis.

2) Find a way to tie Congressional & Presidential pay to performance.  This one would be tough to implement (requiring another Constitutional amendment) and to find sufficient political support for, but I think it is an absolute must if we are to make meaningful legislative activity a core incentive for our politicians.  In my view, an independent committee (much like a state-level Civil Service Commission) would simply be given power to set Congressional & Presidential salaries and benefits upon a non-biased, impartial “performance review”.  This commission would be made up of individuals equally divided between the main political parties and would themselves be subject to background checks to ensure institutional independence

Many other potential reforms, such as a partial or complete scrapping of First-Past-The-Post (FPTP) representation in favor of more proportional representation and the outsourcing of congressional redistricting to independent commissions could help to both decrease the partisanship of the federal legislature and increase the “representative-ness” of individual members of Congress.  Ironically, the prospects of these reforms passing is weak at best; nonetheless, they would be crucial for the government to enact productive agendas in the future, and thus should be given priority in the agenda of the 114th Congress, even if chances of passage are slim.

As for other politically-feasible policy objectives that should be on the Congressional calendar:

3) Immigration reform.  No, seriously.  As discussed in more detail in my post “Why Republicans Should Embrace Comprehensive Immigration Reform”, the United States is in desperate need of both low and high-skilled labor, especially as the population ages in the coming decades.  Allowing in more immigrants (especially high-skilled) is not only politically reachable but is in line with a Republican emphasis on supply-side economic reforms.  Emphasis on increased border security (which is a prerequisite for any action for the party base, even if redundant and impractical) could be combined with reforms and/or increased funding to streamline the legal naturalization process.  At the very least, both Democrats and Republicans agree on the need for more high-skilled immigrants and an increase on the cap for H-1B work visas.  Increasing visa caps could help stem the tide of illegal immigrants (which Republicans are more concerned about anyway) via the substitution effect.  For best chances of passage, I would leave out measures that deal with illegal immigrants currently residing in the U.S. – a piecemeal, incremental approach would work best here.  Overall, immigration reform is an almost cost-free method to spur the economy in both the short and long-term, and considering how long it has been on the national agenda, it is incomprehensible that some sort of agreement cannot occur.

Due in part to an aging population, the U.S. Labor Force Participation Rate has reached levels not seen since 1978, increasing the need for new sources of labor

4) Corporate tax reform 

Again, opportunities for bipartisan agreement are rife here.  Everyone knows the corporate tax code is an unmitigated disaster, with high rates, too many loopholes, lost revenue, and distorted economic activity.  Make the system more territorial, modify depreciation schedules, scale down MNC deferral opportunities, eliminate tax expenditures, and reduce marginal rates.  Specific expenditures that are especially worthy of the chopping block are special preferences for oil & gas operations, insurance companies, corporate jets.  This operation need not be revenue-neutral, either; although this would technically constitute a tax “increase”, the removal of distortions and tax compliance hurdles will act as a counter-acting tax cut.  The government can gain revenue by increasing effective rates while simultaneously increasing growth and leaving businesses feeling better off than they do under the current tax regime.

5) Replace the sequester with targeted cuts & incremental, implement long-term reforms

The era of yawning short-term fiscal deficits is over – temporarily, at least.  Indeed, America has witnessed its fastest pace of fiscal consolidation since World War 2, with deficits as a percentage of GDP falling from 9.8% of GDP in FY 2009 to 2.8% of GDP in FY 2014 – a swing of 7% in just 6 fiscal years.  This has come about due to a variety of factors, including economic growth, slightly higher taxes and broad-based cuts to discretionary outlays.  It is this last option that is cause for concern, however, as the cuts initially enacted in the Budget Control Act of 2011 (the founding legislation of the so-called “sequester”) are quite blunt.  They also come at a time when discretionary spending is approaching record lows as a percentage of GDP, and arguably when increased federal spending on items such as infrastructure are desperately needed and interest rates remain at historic lows.  Additionally, they have subtracted from economic growth in the short-term, lengthening the time needed to close the output gap between real and potential GDP.  As has been projected for decades now, the biggest threat to American fiscal sustainability is the coming explosion in mandatory spending.  Therefore, the new GOP-led Congress must enact gradual but effective entitlement reform now – the longer it waits (as past Congresses have), the more abrupt the future adjustment.

Fiscal policy has not been this contractionary since the end of World War 2

Fiscal policy has not been this contractionary since the end of World War 2

Economic growth since 2009 has increased revenues and decreased "automatic stabilization" spending.  Meanwhile, higher taxes have also increased revenues, and new spending cuts have been enacted.

Economic growth since 2009 has increased revenues and decreased “automatic stabilization” spending. Meanwhile, higher taxes have also increased revenues, and new spending cuts have been enacted.

Non-defense discretionary spending has fallen to record lows as a percentage of the American economy

Non-defense discretionary spending has fallen to record lows as a percentage of the American economy…

...even as interest rates remain at record lows

…even as interest rates remain at record lows

Debt Held

The true threat to America’s finances comes from the coming explosion in mandatory “entitlement” spending. Congress much enact tough reforms now to stem this tide of red ink.

 

To be continued…

The Endurance and Transformation of American Poverty

For the first time in several years, the September 2014 Census Bureau report on the state of poverty and income within the United States contained encouraging news: incomes were up (slightly), and the poverty rate was down (from 15.0% in 2012 to 14.5% in 2013). It appears that, 5 years since the resumption of economic growth following the Great Recession, growth is finally translating into improvements in basic social indicators. With the output gap (between real observed GDP and potential GDP) now down to around 4% (from a peak of just over 7% of GDP), and with U3 unemployment beginning to approach its estimated natural rate of around 4.5-5.5% (it reached 5.9% in September 2014), the relative bargaining power of workers is slowly but surely improving, allowing for upward pressure on wages and income to materialize.  Despite these improvements, however, poverty as defined by the government’s federal poverty rate remains at multi-generational highs, and is likely to remain elevated for several years to come.

Output Gap

Resources are not being used to their full potential in the US economy

Poverty rate

Poverty rate remains at multi-generational highs

US Unemployment rate nearing estimated "natural rate"

US Unemployment rate nearing estimated “natural rate”

 

This is depressing, but it fails to tell anywhere near the whole story.  First, we must come to terms with the fact that the actual existence of poverty is all relative, dependent on the constructed definition of the observer.  Since there will almost always be disparities in income (assuming the absence of a genuine proletarian revolution), then there will always be a class of peopled who are “in poverty”, even if their real incomes and living standards would historically have qualified them as middle class or higher.  As such, we can never really eliminate “poverty”, in the sense that that definition is relative and always transforming as absolute conditions shift.    Secondly, the poverty statistics we currently use are woefully simplistic.  Our main poverty metric is calculated based upon the food budget of a typical family using thresholds from 1955 – when the share of income dedicated to food was very different than it is today.  Furthermore, the current poverty thresholds and definitions also do not take into account many forms of governmental assistance (food stamps, Medicaid, etc.) in its calculation that would significantly reduce the number of people listed in poverty.  Perhaps most importantly, though, improvements in product quality and the introduction of new goods & services have zero impact on poverty statistics.  This is important – for though the overall discretionary purchasing power of people is being squeezed (as necessities like healthcare, education, etc. rise in cost), many consumer goods & services are not only far more affordable than they used to be but there is now a greater variety of goods with new qualities and capabilities.  Even as overall discretionary purchasing power is stagnating, quality and variety continue to rise, to the benefit of all consumers.  The stats don’t reflect any of this, hinting that the actual poverty rate might be overstated and that American well-being has continued to improve over time.

Of course, this is in no way diminishing the hardships that those labeled at or near poverty experience within this country.  Indeed, we still are not considering all the variables that impact American poverty.  While consumer goods & services become cheaper and better qualities & characteristics are developed, this comes at the cost of the termination of employment in many sectors, such as low-end manufacturing and various low-skill professions.  Theoretically, these workers could be retrained to perform more higher value-added tasks; in reality, the United States lags in post-secondary completion rates and overall educational quality (mostly at the primary level), making such transitions more difficult.  Additionally, the United States is not particularly generous in offering temporary assistance to those who are unemployed due to market forces (consider the example of the Trade Adjustment Assistance program).  Ironically, this skills shortage in the American labor force and the structural unemployment that results makes it more difficult for consumers to purchase these higher-quality lower-priced goods and services, leading to large imbalances and counteracting many of the benefits of these improved and emerging consumer options.

So, to sum up:

1) Poverty will always exist as long as there are disparities in income (desirable, to a point) and it is (like everything) a human construct.  This does not mean it stays the same; rather, it evolves as overall conditions evolve

2) American poverty metrics are far from giving any rational sense of the true state of poverty in America

3) There are indications that poverty is both less and more widespread than is thought, with positive and negative influences counteracting one another

Certainly, lowering the prevalence of absolute “poverty” would be desirable for society, and not just for the obvious benefit of those so labeled as “the impoverished”.  Greater inclusiveness and higher earnings power boosts the overall macro-economy (consumption, productivity, etc.) and helps to promote social cohesiveness.  But first, we have to acknowledge that not only are the current measurements of poverty severely flawed and in desperate need of an update, but we must accept that we will never completely eliminate relative “poverty”.  As long as it is a relative concept that is allowed to vary as conditions change, it will always be said to exist, even if it vastly different from what it was in earlier periods.  The fight against poverty is therefore a continuous process whose end goal is the indefinite improvement in the living standards.  To say we can ever “win” the War on Poverty is, I think, misleading; because to say we can ever win implies that there is a set limit to how much living standards can ever rise.  Once we accept these points, we can proceed to rethink our goals and proceed to make genuine progress in improving American well-being.

 

The Imperative of Tax Reform in a Distracted World

Taxes. Nobody likes them, nobody wants them, and they’re only considered good when they’re going one direction: down. But they are fundamentally necessary for any society to function. In fact, if levied at moderate rates and the revenues they generate are properly spent, taxes are key for societal prosperity.

In America’s case, taxes are generally somewhat lower, especially at the federal level, compared to other developed countries . This is not to say that Americans don’t pay a significant amount of tax. Being a country with a sizeable tax burden and one that is relatively low tax are not mutually exclusive concepts. Still, at the federal level, marginal income tax rates and top rates are generally lower than those prevailing in Europe, and a Federal sales tax simply does not exist (also unlike Europe). When factoring in state and local taxes, levels are equalized a bit more, but burdens still are generally lower in America.

Figure-2

Americans’ average tax burdens generally lower than peer countries

However, looking at rates and the revenue bite is only a part of the burden story. As is often said, America’s federal tax code is, quite simply, horrendous. In addition to the normal complexities of a progressive system (e.g. different rates for different brackets at various stages of income generation), the tax code is stuffed with various deductions, exemptions, credits, and loopholes that impose a not-so-insignificant burden on all Americans.  In the aggregate, this complexity is in itself a massive tax (or set of taxes). Precious time and real dollars must be spent to navigate and understand the code, resources that could be used for far more productive uses. The real tragedy of all this complexity is that it ultimately benefits no one in the end. The government does not generate revenue from complexity (indeed, it loses revenue from the loopholes and from reduced economic activity). Society as a whole wastes resources that could otherwise generate positive returns to try and minimize their burdens. The result is the potential for slower growth and lower living standards than would have been the case.

In this way, the net economic burden of America’s federal tax code could actually be on par with (or even exceed) the burden experienced in European countries (especially when including state and local codes). It is naturally rather difficult to put a value on this non-revenue burden, though most estimates place it at at least a few hundred billion dollars annually for the country as a whole.

Since personal income taxes represent a sizeable portion of the federal tax code (and its various complexities), many proposed “solutions” to the federal tax code burden (assuming it is labeled as a problem) focus on restructuring the federal income tax. One of the most popular proposals is replacing the current structure with a flat personal income tax.

policybasics-taxrevenues-f1

The Income Tax is the single largest source of Federal Tax Revenue

There are many laudable benefits to a flat tax. For one, it would be much easier for each taxpayer to calculate his or her “effective tax rate”. With a progressive income tax, rates change as income progresses. For (hypothetical) example, each dollar of taxable income within the $1 to $9,999 range would have a rate applied to each dollar, say, 10%. However, dollars within the $10, 000 through $19,999 bracket would have a different rate, say 15%, applied to each dollar. Naturally then, this makes calculating the effective tax rate (the total amount of tax as a percentage of total income) rather difficult. With a flat tax, however, there are no brackets – for all taxable income, the same rate is applied to each dollar. This makes the flat tax rate and effective tax rate essentially equal (assuming no credits, deductions, exemptions, or loopholes). In this way, unlike the current income tax structure, an individual can know with much greater certainty how much of their income will be withheld.  The need to outsource tax liability calculations to a firm is reduced, if not eliminated, freeing up resources and largely destroying a major source of federal lobbying efforts.

Second, in my view, a flat tax conceivably has something for everyone to like. It is simple, transparent, and does not penalize people who generate more income, which is especially important to conservatives . They see it as being neutral and as a means to boost individual productivity, efficiency, savings, and investment. However, a flat tax still makes people with higher income pay more in absolute amounts. The difference is that the proportion of income that goes to taxes is the same for everyone. For a simplistic example, let’s say there are two individuals A and B. Say A has a taxable income of $100 and B has a taxable income of $1000. If a flat rate of 10% is applied, A will pay $10 in tax while B will pay $100. B, being higher income, still pays more than A in taxes. But the proportion payed is the same for both A and B. This seems fair and attractive to both ends of the American political spectrum.

Third, the elimination of brackets and all of the other complexities riddling the current code would likely boost public confidence in the government and would reduce the feeling that a person is being unfairly taxed at arbitrary rates within arbitrary brackets.  This increased confidence might boost tax collection and faith in political institutions, which has been severely lacking in recent years.

Of course, the flat tax has many drawbacks. One of the most important concerns raised by critics of the flat tax is that it lacks the counter-cyclical elements of progressive income taxes.  For example: during a recession, incomes generally fall.  Falling incomes will place individuals in lower top tax brackets (meaning they have to “progress” through less brackets).  This means a lower effective tax rate – in essence, the structure of a progressive tax code means that it provides an effective tax cut during recessions or periods of slow economic activity.  In other words, it acts as an automatic stabilizer.  This is not so for flat taxes – the rate is always the same, regardless of changes in income.  The only route for effective tax cuts in a flat-tax world is via discretionary fiscal policy – actual legislative action – to reduce the applied rate.  This runs into the problems of policy lags – recognition lags, implementation lags, and impact lags.  It takes time for policymakers to identify economic conditions and the need for change, more time to actually make and implement a policy change, and even more time for an implemented change to have an affect – by which point, the policy change may be inappropriate for the macroeconomic environment.  If policymakers ever move towards a flat tax one day, they may have to consider a revamp of federal automatic stabilization systems for smoothing out the business cycle – and if not, the onus of economic stabilization will continue shifting towards monetary policy.

A second and virtually identical concern is the lack of progressiveness of flat taxes.  The US income tax code is currently considered among the most progressive in the developed world.  However, overall progressiveness in America’s redistribution systems is rather low, as many other federal, state, and local taxes are regressive, and “social assistance” programs, regardless of their impact of work incentives, are fairly skimpy by rich country standards.  Make the income tax code flat, and you remove a major source of progressiveness in America’s redistribution systems and would almost certainly increase after-tax income inequality.  Depending on your views regarding redistribution and income inequality, this could be either a good thing or a bad thing.

Regardless of whether a flat tax is pursued or not, it is (quietly) agreed by both the American Left and the American Right that the tax code needs radical simplification.  Right now, though, the imperative of tax reform has been pushed to the side to make way for a focus on ISIS, poverty reduction, immigration, and healthcare issues (to name a few), and ironically, the complexities that tax reform would attempt to solve helps to further ensure that such reform never takes place.  It is overcoming this entrenched policy stagnation that is the great task of our times.

Caught Between Iraq and a Hard Place

Just a few years ago, things were looking up for the Middle East.  The Arab Spring , in which peoples across the region rose up to overturn oppressive and authoritarian governments (many of them dictatorships), spread like wildfires in 2011 and 2012 across the region, raising the prospects of the establishment of liberal democratic institutions.  World oil prices, having plunged during the Great Recession (with some indices reaching a low of approximately $30/barrel in late 2008 and early 2009), rebounded sharply as the aughts came to a close, propping up the region’s oil-dependent economy.  After a brief conflict with Gaza, the Israeli-Palestinian conflict grew quieter, and there existed emerging optimism that American-led interventions would finally be drawing to a close.

What a difference a few years can make.  The Arab Spring has collapsed, having produced only one quasi-legitimate democracy (Tunisia).  Many authoritarian governments remain intact, and even the ones that were overthrown (such as the regime of Egyptian President Hosni Mubarak) were replaced by illiberal “democracies” that have since slid back towards authoritarian tendencies (or outright coup d’états).  Oil prices gains have stalled, having yet to reach their mid-2008 peak, and the Israeli-Palestinian conflict has yet again reared its ugly head.

Of the many fires now consuming the region, however, none are quite as disheartening as the disintegration of Iraq.  The steady march of the so-called “Islamic State” (IS) across much of northern and central Iraq has caused horrific casualties and undermined the already struggling legitimacy of the regime in Baghdad (which has pretty much collapsed with Nouri al-Maliki’s resignation on August 14th, 2014) .  That this follows a multi-trillion dollar 9-year American-led war there, whose purported objectives was to establish a peaceful, legitimate Iraqi liberal democracy, makes this disintegration especially galling.

Barely two and a half years after pulling out the last American troops there, the US is (according to Vox.com) yet again contemplating sending in troops of some form or another, mainly to help save the minority Yazidi population currently trapped by the IS.  The decision as to whether to pursue further intervention into the broader conflict, however, is muddied by a few complicated factors:

  • Who exactly are the “good guys” and “bad guys” here?  This seems like a ridiculous question, especially considering the horrific brutality of IS tactics and the fanatical ideology they espouse.  However, just as in the Syrian Civil War, the existing alternatives to IS rule (including the pre-IS status quo) aren’t exactly ideal either.  Indeed, the (now nonexistent) Shia-dominated government of Nouri al-Maliki has reportedly continued to persecute Iraq’s Sunni minority, and has not formed a government representative or inclusive of Sunnis.  While most Sunnis do not appear to favor IS either, many are frustrated with the regime in Baghdad.  If the US intervenes in support of the Iraqi government, it would be doing this with full knowledge that it, like the IS, has also committed many abuses.  A choice has to be made between the lesser of two evils – you really can’t win here.
  • The IS is providing needed social services to many Iraqis.  According to PBS, the IS has established and funded a variety of social services to much of the population in its territorial control.  While this is obviously a tactic to buy-off the population and garner support, it does provide a modicum of short-term human security (and thus, potentially, stability).  Also, some services, such as healthcare, education, power, and water, etc.  have the potential to promote economic development and diversification (and thus long-run stability), although whether growth & development or quality services come first is admittedly a longstanding chicken-and-egg controversy in the economics profession.  Diversification, especially, is key to long-term economic prosperity in Iraq, which still disproportionately relies on oil production to generate wealth and to provide fiscal resources.  Such dependency reflects a classic case of the resource curse, whereby the resource at hand (in this case, oil) stunts development in the long run by appreciating the currency and making industrial exports uncompetitive.  Thus, ironically, the IS could be indirectly (and inadvertently) promoting the long-run social and economic well-being of the country via its provision of these services, and efforts to stop it could do the opposite.  Of course, this ignores the profound violence and economic disruption caused by the IS, not to mention the groups’ many other non-negligible negative qualities.  But it is something to consider by the Americans and the Iraqi state (and other involved actors) as they consider how to move forward.  Perhaps a reshuffling of Iraqi budgetary priorities is in order?
  • Substantial American opposition to US military intervention.  Simply put, Americans are really, really war-weary.  They are tired of the very real human and financial costs of war, and feel like Iraq (among other interventions) is a hopeless basket case that should just solve its own problems.  The difficulty that Barack Obama and the American government faces is the conflict between pragmatic action (which, given the uncertainty and number of variables involved, has yet to be defined) and appeasing the electorate (mostly for the sake of his party, as he is no longer eligible for reelection, although presidential legacy is always an influencing factor as well).
  • Would US intervention help or hurt Iraqi, American, and global interests?   What exactly are those interests in the first place?  These questions are very, very broad.  First, it must be asked which Iraqi domestic scenario is in the interests of the Iraqi people.  A Shia-dominated government?  A Sunni government?  A mixed government?  State partition?  Some have even questioned, especially since the Iraq war, whether democracy is even in Iraq’s best interest at this time, considering cultural factors and lack of established democratic precedent in the country.  This relates to the debate as to whether growth and form of government are best compatible, and which should be emphasized first.  For America and the globe, there are questions as to whether a certain Iraqi domestic situation is best for regional stability, especially when it comes to providing a counterbalance to the hostile Shia-dominated government of Iran.  How about oil price stability?  Since the commodity price surge of the 2000s, the global economy has certainly adjusted to higher prices and more prepared for price shocks via structural efficiency gains (note that the Great Recession was preceded by an oil price shock in which prices exceeded $100/barrel; prices have since consistently been around $100/barrel, and yet global growth has long since resumed).  Thus, conflict in Iraq might not be as much of an economic red flag as it once was.  But it still is important.  Considering all of these different questions (a non-exhaustive list which has been provided here),  it then has to be determined whether American military intervention of any form would help or hurt all of those interests.

Personally, I have no concrete opinion as to what course of action I think should be pursued.  Like so many subjects in the realm of public policy, each action has its costs and benefits, the net effect of which is extremely difficult to ascertain.  Literally millions, if not billions, of variables are at play here.  Yet in the end, a choice must be made by America’s leaders, even if that choice is ultimately to do nothing.  Regardless of what they choose, they can be assured to face unflinching judgement by millions of people with an understandable yet fatally simplistic view of the world who, like the rest of humanity, are limited in the amount and scope of information available to them.  That is the unfortunate reality of politics – a reality that, in this case, is further exacerbated by the life-and-death nature of the situation. It is an unenviable position for any policymaker to be in.  Invoking the old phrase, they are truly caught – caught between a rock and a hard place.

Why Republicans Should Embrace Comprehensive Immigration Reform

The escalating child migrant crisis has once again brought our ailing immigration system back into the mainstream spotlight.  As usual, both sides revert back to their usual arguments.  Republicans take the migrant crisis as being a result of loose borders and lax executive enforcement, and many call for more deportation of both the child migrants and all illegal aliens within the United States.  In contrast, Democrats generally argue for making it easier and faster to become a citizen and to implement gradual amnesty. Though both sides have legitimate concerns and arguments, I (surprisingly) mostly side with Democrats on this issue, and I strongly believe that Republicans should reconsider their stance on immigration reform.  Here’s why:

  1. We need more immigrants, legal or illegal, and badly.  Contrary to the beliefs of many, virtually all types of immigrants – legal or illegal, skilled or unskilled, etc. – benefit the country economically (though legal immigrants are, of course, preferable to illegal immigrants).  Skilled immigrants make up a large proportion of  innovative business start-ups, while low-skilled immigrants lower prices for consumers & employers and take jobs that natives are less inclined to perform.  All groups add to national GDP, and (unlike in many European countries), they usually contribute more to overall tax revenues than they consume via social programs, helping to balance budgets at the federal, state, and local levels.  As such, there is a strong economic argument to expanding legal immigration and making legal naturalization avenues more efficient.  Macro-economically, more legal immigrants could serve as both a short and long-term economic stimulant to the moribound US economy, adding to short and long-term supply and demand.  Due to the retirement of the baby boomers, the US labor force will continue to contract in the coming decades, producing labor shortages that an influx of immigrants could help fill (and freeing up natives to perform other jobs, thus boosting job creation).  Additionally (and largely due to the aforementioned retirement of the baby boomers), America faces long-run fiscal challenges that more legal immigrants (with their contribution to higher GDP and higher tax revenues) could help to alleviate.  Considering that Republicans are broadly regarded as the “party of business” and of fiscal conservatism, Republicans should thus be embracing legal immigration.  Instead, though they pay lip service to legal immigration, their laser-like focus on illegal immigration and accelerating enforcement measures overshadows their support for legal immigration.  Ironically, an increasing of legal immigration via immigration reform would help to solve illegal immigration and the presence of large numbers of undocumented workers.
  2. Continued deportation of unauthorized immigrants is impractical and costly.  Currently, there are over 11 million unauthorized immigrants residing within the United States.  Many Republicans argue that deportation should be ramped up to deal with them.  I disagree.  First of all, despite the perception among many, deportation rates have stabilized at relatively high levels in recent years – rates have not fallen off a cliff, so it’s not like this strategy isn’t being actively pursued.  Second, can you imagine trying to deport all 11 million + immigrants from the US?  Deportation already costs the government quite a bit, with the Department of Homeland Security reportedly requesting approximately $230 million in budgetary authority for the deportation of undocumented immigrants just in fiscal year 2015.  That is for the current rate of about 400,000 people a year, which is, of course, partially offset by continued inflows of unauthorized immigrants.  Logistically, deportations of a larger scale would undoubtedly create massive strains on the system.  Additionally, the removal of 11 million people would be hugely destructive economically – lowering productivity, raising prices, and disrupting both the creation and operation of businesses, at a time when the US has yet to fully recover from the 2007-2009 recession.  Of course, we also cannot forget the costs of splitting up families, which imposes deep scars the social fabric of the nation.  If anything, deportation should be scaled down.
  3. Resources devoted to immigration enforcement are at historical highs – and further enforcement measures, like building a wall, will not stop illegal immigration.  As partially mentioned above, immigration enforcement (such as deportations) is hardly on decline.  Indeed, according to The Economist, border enforcement costs about $20 billion a year, which is more than all other federal law enforcement agencies combined.  Yet, despite all these costs, we clearly still have enforcement problems, and until we reform the immigration system, we always will.  Why?  The reason is simple: the economic incentives for people to immigrate to the United States are overwhelming.  Even for low-skilled immigrants, pay is usually several times greater in the United States than it is in their country of origin.  No matter how much the federal government devotes to border enforcement and trying to prevent people from immigrating (legally or not), people will keep trying to come here – and many will find ways to succeed.  Since these forces will not be disappearing anytime soon, it would be better to work with the force, not against.
  4. Current immigration policy is tantamount to anti-trade protectionism – the antithesis of Republican ideology.  Republicans, in accordance with their belief in free markets, tend to be much more supportive of free trade than liberal Democrats.  However, the current legal immigration system is based largely on a series of quotas.  According to Vox.com, on the employment side a maximum of 65,000 H1B visas (for high-skilled workers) and 66,000 H2B visas (for low-skilled workers) are issued by the federal government annually.  Both of these quotas are usually hit pretty quickly, indicating that employer demand in the US is far outstripping supply.  These quotas are artificially restricting the supply of workers, raising employment costs and decreasing growth prospects.  Additionally, the number of “green cards” supplied tends to be less than demanded, especially for people without US-based relatives or prospective employers.  These restrictions do not let the market to operate efficiently, which goes against Republican notions of free market capitalism.  Not to mention, these quotas help to drive the illegal immigration that everybody is so furious about.
  5. Current immigration proposals do not grant unconditional amnesty – nor should they.  Last time I checked, the current mainstream immigration reform bills passed by House committees in the summer of 2013 allowed unauthorized residents to gain citizenship only after meeting several conditions, including paying several fines and going through vigorous checks.  Republicans are right to be weary of the granting of unconditional amnesty – unauthorized immigrants did, after all, technically break the law, and the rule of law must be upheld for the republic to function properly.  However, the current bills (and any bill that is likely to be passed) will not let unauthorized immigrants  off the hook.  Now, many Republicans say that any form of amnesty, conditional or not, is both unfair (as others still had to wait to become naturalized) and undermines the rule of law.  I think the fines help to partially offset this, punishing those who broke the law.  Though it (understandably) seems unfair that immigrants would be able to gain a “special” route to citizenship this way, such a route is, on net, still much more practical than sending those residing here illegally “to the back of the immigration line”.  Doing so would be too costly economically, difficult logistically, and would overwhelm the already strained legal immigration system.
  6. Republicans could use immigration reform to their political advantage.  Everyone knows that Hispanic voters tend to lean Democratic, and that this persuasion is becoming increasingly costly for Republicans electorally.  As the Hispanic population continues to grow in influence, the political parties increasingly need their support in order to win elections.  Right now, Republican opposition to immigration reform and a perceived anti-immigrant ideology is hurting the party.  Embrace immigration reform, and the Republicans could vastly improve their political fortunes.

Considering all of the outstanding issues on the federal policy radar, it is understandable that immigration reform might not top the policy agenda at the moment.  But until Washington is ready to devote its full attention to the issue, Republicans should seriously consider revising their views on the subject.  Too much is at stake for them not to do so.

Can We Solve Market Imperfections by Changing Societal Norms?

In economic policy discussions, there is a lot of talk about the government intervening in the market to solve for market imperfections or failures, whether it be too many negative externalities, too little positive externalities, disequilibrium due to wage and/or price stickiness, etc.  These are usually assumed to be constants that only the government can really take corrective action to address.  However, I think that many of these market imperfections stem from prevailing societal norms and modes of thinking, an underlying structure that frames how the market actually operates.

For example, take the example of pollution.  The market tends to overproduce pollution, as the private costs of pollution do not usually match the societal costs of pollution.  Or, at least, it might not seem to private actors that private costs match societal costs.  In reality, though, perceived private costs are likely much lower than actual private costs, as many of the effects of pollution are indirect.  For example, a company might release air pollution that damages the health of either its employees or its customers.  This lowers productivity, reducing potential income both for the company and society (who could use that money to buy company products).  Even though these indirect costs might be substantial, it is the norm for businesses not to think beyond direct costs and thus to undervalue both the private costs and societal costs of their actions, causing them to overproduce pollution.  This is further reinforced by the widespread belief that environmental protection tends to hurt business, causing a market underproduction of environmental protection relative to optimal private & societal production.  If we could change these norms and modes of thinking, we could potentially help solve the negative externality of environmental pollution.

Another example of how norms can cause market imperfections (and how changing them could thus solve such market imperfections) is in the case of wage and price stickiness.  As I’ve mentioned on this blog before, there exists certain modes of operation when businesses set prices and wages.  Prices for many products, for example, are usually only adjusted a few times a year (out of habit, law, and/or fear of disgruntled consumers), and in certain industries it is the norm to adjust the number of employees before modulating wages (or vice-versa).  Wages, too, do not usually change rapidly, out of habit, law, and/or out of fear of disgruntled employees.  For both prices and wages, laws restricting their flexibility stems from societal norms, and consumer/employee disgruntlement that would result from such flexibility would stem from established consumer/employee expectations of stability.  Unfortunately, this wage/price stickiness tends to cause disequilibrium (a deviation in actual output from potential output) and (at least temporarily) can exaggerate (rather than mitigate) expansions and contractions in the business cycle.   Perhaps, if we changed these modes of operation and societal thinking, we can make wages and prices more flexible, helping the market to naturally smooth out the business cycle itself rather than relying on governmental counterbalancing.

The great thing about adjusting societal norms is that it could theoretically lessen (though not eliminate) the need for government intervention to solve for market imperfections.  The problem, however, is twofold: first, adjusting norms is obviously rather hard.  Additionally, changing norms can itself ironically require governmental intervention so as to affect an actual change.   Regardless, as we seek alternative methods of boosting the economy, it merits consideration.

Our 5-Year-Old Recovery: A Belated Birthday Wish

So much has been happening lately that it’s hard to know what is most deserving to talk about. Outside the US, the biggest news is that the middle east is further accelerating its long post-Arab Spring slide, with Iraq plunging back into civil war and tensions between Israel and Palestine yet again escalating.  Here at home, meanwhile, the Supreme Court has ruled against the Obama Administration on issues ranging from mandated contraception vs. religious freedom to “recess” presidential appointments.

Perhaps the strangest news, however, is that the current business cycle expansion (the economic recovery” turned 5 years old in June.  This comes at the heels of revelations that just a month prior, we finally reached pre-recession levels of total employment (really no achievement at all, since growth in the potential labor force thoughout all this time still leaves a massive jobs gap.  Not only is it unprecedented that the 5th birthday of the recovery comes only one month after a return to pre-recession employment levels, but it’s also unprecedented that such a large output gap remains at a point where we’re likely closer to the next recession than the end of the last one.   At 61 months, it is now past the average of 58 months for all post-war recoveries.

Now that the party has died down, its time to face some ugly truths.  First of all, longevity does not imply good health.  Despite repeated predictions, this recovery has proven to be neither broad-based nor robust, and unfortunately, its running out of time to ever show sustained periods of health.  From indicators ranging from GDP growth to income growth to productivity growth (etc, etc), there has been sub-par performance.  There are many plausible reasons why (both supply and demand-side explanations), which have been discussed to the point of exhaustion.  I’ll re-list the main ones anyway:

  • contractionary fiscal policy
  • inadvertently contractionary monetary policy? (see Vox.com explanation)
  • lingering effects of private debt deleveraging on consumer spending
  • lack of public investment in physical & nonphysical capital
  • High energy costs
  • Business uncertainty (due to regulations, policy ambiguity, shaky macroeconomic environment, etc.)
  • High or complex taxes, especially corporate taxes

Considering that this year is shaping up to be another economic disappointment recovery-wise, and the recovery’s rapid aging, we now face the troubling prospect of entering the next recession far from having truly recovered from the last one.  By recovered, I mean not just a complete closing of the output gap.  My definition also includes labor market healing, such as a reversal of skills erosion and a return to full employment, as well as meaningful gains in median income and wealth.  Since it is increasingly likely that none of this will happen, would a small recession now be far more painful than usual?  And what will we do policy-wise?  Monetary policy is, at least in terms of fed funds targeting, is as loose as it can get, and its doubtful the federal government will be willing to pursue aggressive fiscal stimulus like they did in 2008 and 2009.

Although it is good news that the recovery is 5, and I wish it a belated happy birthday, its longevity should not make us complacent about past, present, or future performance.  Overall, past performance has been weak, present performance is weak, and it is likely that, in the near future, only more pain will appear.  It’s a rather sad, but realistic, outlook.

The clock is ticking…

Finding Balance in U.S. Foreign Policy

Finding the “right” foreign policy mix is never easy for the typical nation.  Each must weigh the national interest, resource availability, power relations & hierarchy, ethics, and the global common good, to name a few considerations.  Unfortunately for America, however, these considerations are, in some ways, far more difficult for it to answer, and much more complex than the decisions others face.  For America is not the typical nation.

Indeed, since the fall of the Soviet Union in 1991, America has found itself in the somewhat awkward position of being the world’s last remaining superpower.  Even today, despite the rise of China and other emerging nations, the United States by far retains the world’s largest economy in absolute terms, and a military might (and budget) that dwarfs any other.  This has undoubtedly brought multiple benefits – vast geopolitical influence, favorable terms of trade, cultural hegemony, etc.  Being as it is at the top of the world system, however, it has also evoked intense scrutiny and criticism of its behavior.  For the world expects, in return for the benefits of unipolar hegemony, certain services in return, namely international security (especially for trade routes), a respect for sovereignty, economic and non-economic aid, and a respect and maintenance of international institutions, agreements, and norms.  Since the end of World War 2, this American-led and American-arranged world system has existed, and has been remarkably successful.  Since 1945, no global wars have occurred, inter-state peace has been (for the most part) maintained,  and new phases of globalization and free trade have flourished, benefiting both America and participants in the world system.

With the collapse of its political, ideological, and economic rival in 1991, however, and with no other country anywhere near matching America in its economic and military clout, the last 20 years have placed new strains on this American-led world system.  Whereas before the rivalry between the Soviet Union and the U.S. helped in some ways to restrain the other, now there was virtually no one to restrain the one remaining superpower.  Although America has, in my opinion, used its unique position to benefit the world on net (not only since 1991 but since the world system came into being in 1945), it still has been difficult for it to strike a good balance between restraint and the need to be assertive on the world stage.

Take, for example, America’s behavior following 9/11.  Up until that terrible event, American military spending and aggressiveness had been on decline.  This was due in part to the Cold War’s end, which meant that much related spending could be unwound.  Additionally, finding itself as the new unipole, and perhaps not wishing to abuse that status, America decided to ease any interventionist impulses (UN-related mishaps in Somalia in 1993 didn’t help).  No doubt, also, that the unique characteristics of America’s government at the time – a domestic-focused Democratic president and budget-conscious Republican Congresses – helped to shape the retrenchment of the 90s.  9/11 quickly changed all of that, and an “offense is the best defense” strategy soon prevailed, no doubt shaped by the unique neoconservative influence of the Bush Administration.  Defense spending surged, and because the 9/11 attacks came from non-state actors that tended to reside in states that “harbored” them, a new focus on militarily intervening in hostile and/or unstable states emerged.  The resultant wars in Afghanistan and (especially) Iraq that began not long after 9/11 have since provoked furious debate as to their necessity and “legality” within the world system.  Was America fulfilling its duties to maintain long-term global stability and acting according to its sovereign right to defend itself?  Or was this an imperial overstretch in which America attempted to impose its will on others?

Perhaps the answer is both, and when one takes a look at the considerations facing policymakers at the time, in some ways America’s actions look quite rational.  First of all, Afghanistan was harboring al Qaeda (the group responsible for 9/11), who needed to be rooted out to prevent future attacks.  Second, to help further prevent terrorist attacks, some “nation-building” of Afghanistan was required.  All of these could be said to benefit both the US and the world (at least theoretically speaking – for actual results, that’s a whole other matter ). Following 9/11, Afghanistan therefore seemed like a reasonable place to intervene.

But why Iraq?  After all, Iraq had no direct connections with al Qaeda, and it certainly wasn’t the only other hostile state in the world at the time (e.g. Iran, North Korea, etc.)  The original rationale, because Iraq was thought by several nations to have WMDs, doesn’t exactly explain why the U.S. decided to intervene solely there, as other hostile nations had or were attempting to gain WMDs.  Nor does the need to bring “democracy” and “freedom” – again, if that were really a main consideration, then the United States should have intervened in a significant portion of the world that lacks those criteria.  No, I think the real reasons are a blending of the following:

a) America badly needed to (or thought it needed to) project power into the Middle East to show that it was in control of the world system following 9/11.  Why the Middle East?  Because, it generally is the region where Islamic terrorism originated and where the ideology is fomented (though certainly not the only region of the world).  In this way, its invasion of Iraq was actually a quasi-response to 9/11.

b) Iraq had repeatedly been uncooperative with UN weapons inspections throughout the 1990s, and that (combined with past use of WMDs, such as using chemical weapons during the 1980s) violated international norms.  In a way, America was punishing noncompliance to international norms and a respect for international security, though ironically in some ways it did so by violating established international norms (e.g. going forth with the invasion of Iraq without UN authorization).  This punishment could also be seen as a message for other regimes (like Iran and North Korea) to get their act together (this arguably worked somewhat as intended, for at least the Libyan regime gave up its WMD pursuits following the 2003 invasion of Iraq).

c) Plans for regime change had long been discussed and advocated by people within both the Clinton and Bush administrations, as Saddam’s regime was widely perceived as a threat.  Failure to remove him from power during the Gulf war was seen as a weakness for the United States.  Since 9/11 was also seen as a moment of weakness, this was the perfect time to demonstrate that America had power and would “get the job done”.  Rahm Emanel’s “never let a crisis go to waste” statement naturally comes to mind.

d) Rightly or wrongly, Iraq (along with Afghanistan) was seen as an opportunity to spread democracy and other American values, arguably to help better maintain world security (refer to the democratic peace theory).

Clearly, these are rational reasons for America’s turn towards interventionism, which can arguably be said to help maintain both the global system and secure American interests (both of which are not necessarily mutually exclusive concepts).  Then again, many of America’s actions (in Iraq especially) seemed unrestrained and negligent.  For example, in the post-invasion phase, Paul Bremer made serious errors as leader of the Coalition Provisional Authority (e.g. basically temporary governor of Iraq).  He unilaterally abolished the Iraqi military, initiated a “De-Ba’athification” program that rooted out Ba’ath Party influences, and failed to hand over sovereignty and self-governance to the Iraqis quickly.  These quasi-totalitarian actions (and lack of action) not only looked like an overreach, but they directly contributed to the insurgency and instability in the years following the invasion, an instability that threatened to cause wider instability in the international arena. An even wider question is whether Iraqi culture is even compatible with democracy.  Was it being imposed?  Was it right for them?

I think America had both maintenance of of the world system, self interest, and, perhaps, some quasi-imperialistic ambitions in mind when it comes to Iraq.  By imperialistic, I don’t necessarily mean creating a colony or subjugating the Iraqis to American rule in the long-run.  I do mean, however, an attempt to impose American-style governance and values in the naive belief that this could only enhance American and world security.  And in the post-9/11 environment, we felt justified in being so bold, seeing it as necessary to preserve our image as leader of the world system.  Imposing American values and maintaining a secure international order  (including America’s position at the top) became one in the same to us.  Regardless of our intentions, however, it is unclear whether intervention in Iraq can ultimately be said to have benefited either America or the world.  While a hostile regime was removed, its replacement by a “democratic” Shi’a regime makes it vulnerable to Iranian influence, and Saddam’s fall removed a check to Iranian behavior.  The conflict was very costly in terms of lives and finances.  Additionally, our negligent actions and non-actions post-invasion ironically have arguably made Iraq a new breeding ground for terrorists, making us worse off security-wise.  Only time will tell what becomes of Iraq.

The shift away from overreach began during the remainder of the Bush administration and has continued into the Obama presidency, regardless of various troop “surges”.  Iraqi sovereignty returned to them slowly, and a recognition that costly military intervention must be followed by costly  post-invasion nation building (lest the world system be more threatened than before invasion) has caused the United States to adopt a policy of “selective engagement” during the Obama years, with the least amount of military intervention as possible.  The problem is, the pendulum risks swinging much too far towards non-interventionism and non-assertiveness, depriving the world of proper American leadership and a fulfillment of its hegemonic duty as implicit maintainer of world security.  Inaction following Syria’s breach of Obama’s vague “red line” and an unwillingness for any military presence in Iraq or Afghanistan (despite continued internal security concerns) undermines the United States’ credibility, its position as hegemon, and threatens the security of the world system it maintains.  In some ways, I think too much emphasis is being placed on diplomacy.

Like the 1990s, military spending and aggressiveness are again on the decline.  But surely, the pendulum will swing back, perhaps this time to help address the rise of China, or just generally to correct for too much retrenchment in the late 2000s-present.  Regardless of America’s actions, China’s rise will surely disrupt or even upend the world system that has existed since the end of World War 2.  The considerations America has faced during its “unipolar moment” since the 1990s have been uniquely complex.  Now, with the construct of the entire world system shifting, striking a good foreign policy balance will be more difficult than ever before.