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Monday, June 28, 2010

National Debt For Beginners [continued]



[Continued]
No, Really: How Much Debt Is OK?
There are two plausible ways of resolving the argument over the sustainability of government debt, neither of which is conclusive. The first is empirical economic research. Here, the world's appointed authority is the International Monetary Fund, which is especially interested in analyzing debt sustainability because it is the institution that will be called in when government debts risk becoming unsustainable. The IMF has concentrated most of its attention on emerging-market countries, because it has been assumed both that developed countries are less likely to default, and that even if they did there is little the IMF, with its limited resources, could do about it.
That said, the IMF has done extensive research on debt sustainability, including attempts to estimate the sustainable debt levels for specific countries. Abdul Abiad and Jonathan Ostry, two IMF economists, have a paper on "Primary Surpluses and Sustainable Debt Levels in Emerging Market Countries" (this is their research, not official IMF policy), which outlines two analytical approaches to estimating debt sustainability — one based on a country's past performance at paying off debt, the other based on a model of economic fundamentals. Applied to a sample of 15 emerging-market countries, both the historical approach and the model-driven approach put the median sustainable debt level at around 30 percent of GDP (although across the sample the estimates range from less than 10 percent to more than 100 percent).
It would be a mistake to apply this single number to a country like the U.S., though. For one thing, developed countries in general can sustain higher levels of debt than emerging markets, among other reasons because they have higher revenue-to-GDP ratios. The IMF's September 2003 World Economic Outlook has some charts comparing government debt levels in industrial and emerging-market countries. Industrial countries in aggregate had public debt levels above 70 percent of GDP for most of the 1990s; yet no industrial country has defaulted on its debt in the post-World War II period. Empirical studies have shown at most a weak correlation between the amount of U.S. government debt and the interest rate the Treasury Department has to pay to borrow money.
The other way to see how much debt is too much is to ask the market. If investors think there is a risk that they won't be paid back, they will demand a higher interest rate, for the same reason that subprime mortgages have higher rates than prime mortgages. Interest rates on U.S. Treasury bonds are at historic lows, because people looking for a safe place to put their money are falling over themselves trying to lend to the U.S. government. The U.S. is able to borrow money cheaply despite everything we know about the recession, the government deficit, the Obama stimulus package and the looming retirement savings problems.
So the short answer to the question of how much debt is sustainable is simple: We don't know. If we were close to the edge of some fiscal cliff, the market would warn us, under ordinary circumstances. But these are not ordinary times: Due to the upheaval in all markets, there is a level of demand for Treasuries that is . . . how shall we put this . . . probably not justified by economic fundamentals, and as a result market signals don't work as well as they should. Right now, the markets are saying that the U.S. government is as good a place to lend money as any and are implicitly giving us time to sort out our fiscal problems. At what point that will change, though, no one can predict.

Zombies Have Already Killed The Deficit Commission


June 21, 2010, 12:12 pm


It must have sounded like a good idea (although not to me): establish a bipartisan commission of Serious People to develop plans to bring the federal budget under control.
But the commission is already dead — and zombies did it.
OK, the immediate problem is the statements of Alan Simpson, the commission’s co-chairman. And what got reporters’ attention was the combination of incredible insensitivity – the “lesser people”??? — and flat errors of fact.
But it’s actually much worse than that. On Social Security, Simpson is repeating a zombie lie — that is, one of those misstatements that keeps being debunked, but keeps coming back.
Specifically, Simpson has resurrected the old nonsense about how Social Security will be bankrupt as soon as payroll tax revenues fall short of benefit payments, never mind the quarter century of surpluses that came first.
We went through all this at length back in 2005, but let me do this yet again.
Social Security is a government program funded by a dedicated tax. There are two ways to look at this. First, you can simply view the program as part of the general federal budget, with the the dedicated tax bit just a formality. And there’s a lot to be said for that point of view; if you take it, benefits are a federal cost, payroll taxes a source of revenue, and they don’t really have anything to do with each other.
Alternatively, you can look at Social Security on its own. And as a practical matter, this has considerable significance too; as long as Social Security still has funds in its trust fund, it doesn’t need new legislation to keep paying promised benefits.
OK, so two views, both of some use. But here’s what you can’t do: you can’t have it both ways. You can’t say that for the last 25 years, when Social Security ran surpluses, well, that didn’t mean anything, because it’s just part of the federal government — but when payroll taxes fall short of benefits, even though there’s lots of money in the trust fund, Social Security is broke.
And bear in mind what happens when payroll receipts fall short of benefits: NOTHING. No new action is required; the checks just keep going out.
So what does it mean that the co-chair of the commission is resurrecting this zombie lie? It means that at even the most basic level of discussion, either (a) he isn’t willing to deal in good faith or (b) the zombies have eaten his brain. And in either case, there’s no point going on with this farce.

National Debt For Beginners


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About This Primer

Simon Johnson, former chief economist of the International Monetary Fund, and James Kwak produced this report in collaboration with NPR's Planet Money. You can find more from Johnson and Kwak on their Web site:
National Debt Clock
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In October 2008, the unofficial National Debt Clock in New York City had to add a "1" in the dollar sign field to accommodate the total debt count of $10.2 trillion.
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Companies like Caterpillar stand to benefit from the U.S. plan for deficit spending on infrastructure. In January, Caterpillar announced 20,000 layoffs, roughly 18 percent of its workforce.
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February 4, 2009
With the annual U.S. government deficit recently projected at $1.2 trillion (not counting additional spending expected from the fiscal stimulus package now before Congress) and President Barack Obama warning about "red ink as far as the eye can see," government debt is once again near the top of the policy agenda. Which raises the question: What is government debt? And what's so bad about it?
What Is Government Debt?
For this article, we'll be talking only about debt issued by the federal government, not by state and local governments.
Let's say the federal government projects that it will need $100 billion more than it's bringing in from its existing tax programs. The government could raise taxes by enough to cover the shortfall. But that could be politically unpopular. It would also leave people with less disposable income. As a result, they'd spend less, so businesses would make less, so they'd lay people off, so they'd spend less, and so on. This does not mean that it is never a good idea to raise taxes, only that it is not a reliable way to close budget gaps.
Another way to close a budget gap is for the Federal Reserve to "print" another $100 billion or so, but that can lead to inflation. Imagine there were the same amount of stuff in the world, but suddenly everyone had twice as much money: The price of everything would simply double, and no one would be any better off.
Instead, governments prefer to raise money in the credit markets, which means that they issue bonds, just like private companies. A bond is a promise to pay money in the future; for example, a 10-year bond is a promise to pay a flat amount (the face value) in 10 years, and a percentage of that flat amount each year until then. When a government issues bonds, investors bid to buy those bonds; the amount of money they pay is therefore the amount that the government raises. (For more on bonds and bond yields, see Interest Rates for Beginners.) Now that you understand what government debt is, it's time to ask:
Is Debt OK?
It is accepted among virtually all economists that some government debt, sometimes, is a good thing. In a recession, tax revenues fall, and you need more money for social programs such as unemployment insurance, so the government should go into deficit. Fiscal conservatives, however, would say that these deficits during hard times should be balanced by surpluses during good times, so that over the long term the government budget remains in balance.
While this simple notion is appealing, there is no particular reason it must be true. Imagine that the government has some amount of debt, say 20 percent of its gross domestic product, or GDP, at the beginning of the year. Assume it retires none of the debt, but it does pay off the interest on the debt, and its budget is exactly balanced. The next year, debt will be less than 20 percent of GDP, because GDP almost always goes up. Clearly the government can sustain the same level of debt by running small deficits forever, as long as GDP is increasing, because GDP is a close proxy for the tax base. And the higher your level of economic growth, the more additional debt you can take on each year.
There are some negative effects of government debt, to be sure. Government bonds compete with corporate bonds for investors' money, which pushes up interest rates for everyone. And if the government is absorbing a larger proportion of the capital available, there is less for the private sector.
But debt is not necessarily all bad; as with households and companies, it depends on what you are doing with the money you borrow. For example, it can make sense for you to borrow money to pay for college or professional school, because higher education increases your lifetime earning potential. For many people, the increase in expected earnings more than compensates for the cost of the debt.
The same logic explains why companies take on debt. If you want to build a new factory for your faster-than-light hovercraft, you don't want to have to wait 20 years until you've accumulated enough profits from your sub-light hovercraft to pay for it; you want to borrow the money now, build the factory, and use the gigantic profits from the faster-than-light hovercraft to pay back the debt.
Whenever you hear someone say, "The government should be run like a company: Your revenues have to exceed the amount you spend," you should stop listening, because that's not how companies are run. On the other hand, government makes no distinction between expenditures that are productive investments bound to grow the tax base — roads, bridges, schools, school loans, basic research, etc. — and expenditures like entitlement programs.
The new Troubled Asset Relief Program, designed to rescue American financial institutions, actually made things more complicated, because now there is another category of government expenditure. With TARP, the government is acting like a bank, or actually a private equity fund, buying shares in private-sector companies and paying for the investments with borrowed money. Those investments all have value, and the government is going to recover that value at some point by selling its shares back to the banks. But many people probably see TARP simply as $700 billion that is gone forever. The Congressional Budget Office projected the final loss at $180 billion (calculated as the amount Treasury is paying for the securities, minus the value of the estimated cash flows Treasury will get from them).
The broader point is that there is a difference between borrowing money to drop it in large packages over other countries, borrowing money to invest in things we want our children to have, and borrowing money to buy assets that have real value.
How Much Debt Is OK?
The key issue is fiscal sustainability: the ability of a government to pay off its debt in the future, essentially by shifting its current obligations onto future taxpayers. (Again, borrowing money that your children will have to pay back is not necessarily a bad thing; it depends on whether you use it to improve the world they will live in.) Investors start getting worried when government debt looks like it will keep getting bigger (as a proportion of GDP), demographic trends look bad (with far more retirees than workers), and there seems to be no political appetite to confront the problem. If the debt gets too large, the government will eventually face a choice between several unpopular measures — including defaulting on the debt or imposing severe austerity in order to afford the debt payments.
In the U.S., the last time fiscal sustainability was a major concern was the 1980s, when annual government deficits — the amount by which spending exceeded tax revenues in a given year — reached a post-World War II high of more than 6 percent of GDP (data, p. 316). Deficits began falling in the mid-1980s, and especially after the end of the 1990-91 recession and the beginning of the Clinton administration, but total debt — the cumulative amount owed by the government — kept growing (because even small deficits still add to debt) until it peaked in 1996 at 67 percent of GDP (data, p. 126).
Still, the deficits that seemed so frightening in the 1980s were tamed by little more than a couple of moderate tax increases (by Presidents George H.W. Bush and Clinton) and the economic boom of the 1990s, to the point where the federal deficit faded as a political issue. And looking further back, even the World War II-related government debt — which reached 122 percent of GDP in 1946 — was paid down without much negative impact on the economy, thanks to strong demographic and productivity growth.
In this decade, however, the 2001 recession, George W. Bush's two major tax cuts, the Iraq War, and of course the current recession have weakened the government's fiscal position. Now the Congressional Budget Office is projecting a 2009 deficit in excess of 8 percent of GDP, a new post-World War II high. That's before counting the Obama administration's stimulus plan. In addition, Social Security and Medicare are expected to face funding shortfalls totaling in the trillions of dollars, beginning next decade.


Inequality And Crises

Paul Krugman - New York Times Blog
June 28, 2010, 4:41 am


Slides (pdf) for my talk to the Luxembourg Income Study.

The Obama recession?



God bless Detroit. Photo: Sweet Juniper
On the threat of a third economic depression, @Haddie Nuff writes:
[D]on't forget that in 1937, convinced that declining unemployment and production that was almost back to the levels of 1929, meant that the depression was whipped, FDR cut back on spending out of fear that additional spending would lead to inflation, among other things. The result was that the economy rapidly declined and slipped into what was called the 'Roosevelt recession'.
It wasn't until the massive spending required by the attack on Pearl Harbor that dragged us into WWII that the economy recovered. It took us until the 1980s to pay off that massive debt, but the resulting years were pretty good for the average American and overall the country did well.
Now is not the time to cut back on government spending, yet that's what going to happen. Krugman is also right; we're going to slip into a depression, if we're not there already. It seems we can learn nothing from the past.

Krugman: Third Depression on the way


Nobel-winning economist Paul Krugman notes today that the Great Depression was preceded in the 19th century by the Long Depression, and might be followed by a third depression that we'll get to name because we'll get to live it. Krugman writes:
We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost -- to the world economy and, above all, to the millions of lives blighted by the absence of jobs -- will nonetheless be immense.
On a global scale, Krugman's talking about the G20's new resolve to shut off government spending and slash national debts by 2013. In the U.S., he means President Obama's lining up with deficit hawks in the medium-term and inability to pass a jobs bill now.
National debt can be a millstone and a lifesaver. It's not automatically one or the other. Want to get way smarter about it?


The Third Depression



Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.
Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.
We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.
And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.
In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.
But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.
In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.
As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.
Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.
It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.
So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.
And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.



Does income inequality cause financial crises?



Paul Krugman posted some slides (pdf) this morning from a talk he gave exploring the connection between inequality and major economic crises. They're a bit incomplete without Krugman's accompanying remarks, but in them, Krugman says that he used to dismiss talk that inequality contributed to crises, but then we reached Great Depression-era levels of inequality in 2007 and promptly had a crisis, so now he takes it a bit more seriously.
The problem, he says, is finding a mechanism. Krugman brings up underconsumption (wherein the working class borrows a lot of money because all the money is going to the rich) and overconsumption (in which the rich spend and that makes the next-most rich spend and so on, until everyone is spending too much to keep up with rich people whose incomes are growing much faster than everyone else's).
I've long been interested in this question but, unfortunately, am not a Nobel-level economist, and so don't have great answers. One theory that's made intuitive sense to me is that the problem is not just the demand for credit but the accompanying supply of idle money. When someone making $25,000 a year gets a raise, they spend it. When someone making $2,500,000 a year gets a raise, they invest it. And the more money there is sitting around, the more demand there is for high-yield investments, which means the more reward there is for people who can invent new investment vehicles with high yields. Hence, you have explosive innovations in weird financial instruments that look good for a while because the risk is underpriced but end up making the system more fragile when their risks come clear and everyone flees.
By Ezra Klein  |  June 28, 2010; 3:48 PM ET

Research Desk responds:


 Could raising the income cap save Social Security?

By Dylan Matthews
jpeg asks:
Back during the GWB years and the push to privatize Social Security, I did a bit of a thought experiment. What if Social Security was changed so companies no longer had to contribute their portion of Social Security, but Social Security was collected on all individual income with no cap? From what I found, it seemed like this would easily solve any "problem" with the funding of Social Security. Finding data for this was difficult and I wasn't sure of the veracity of some of the data so I kind of chalked it up to "too good to be true" and forgot about it.
Let's put jpeg's specific proposal to one side and first look at the general question of how raising the payroll tax cap could affect Social Security's finances. Currently, wages over a certain yearly total ($106,800 this year) are exempted from Social Security payroll taxes. Medicare's payroll tax has no such cap. This has raised the question of how raising the cap could extend Social Security's solvency. Janemarie Mulvey and Debra Whitman of the Congressional Research Servicelooked at this question in 2008 by evaluating three different proposals. The first would raise the cap so that 90 percent of wages are taxed (CRS estimates this would mean a cap of $171,600 in 2006) and pay higher benefits to those affected; the second would eliminate the cap and pay higher benefits; and the third would eliminate the cap for taxes but would not increase benefits. Here is how the proposals would affect the actuarial state of Social Security, as compared to its current trajectory:
actuarial_impact_of_social_security_cap_proposals.png
Alternately, here's how much of the Social Security shortfall is eliminated by each proposal:
shortfall_ss_graph.png
While all proposals put a dent in the shortfall, completely eliminating the cap without increasing benefits actually creates a long-term surplus, and eliminating the cap while increasing benefits comes close. The nature of Social Security as a social insurance, rather than welfare, program suggests that the latter proposal may be more palatable, as it retains the connection between what wage-earners pay into Social Security and what they get out of it.
Now, jpeg's proposal to eliminate the business-side tax would amount to slashing the Social Security tax in half. The CRS estimates that almost $100 billion in annual revenue would result from eliminating the cap, but that doesn't come close to half of the $654 billion (PDF) in revenue Social Security taxes brought in for 2009. To be sure, such a drastic cut could have a stimulative effect, and it's very possible that it would result in less than a 50 percent reduction in revenues, but it seems unlikely that the revenue loss would be smaller than $100 billion. Some cut in rates may be in order if the tax's cap is raised or eliminated, but one this drastic would probably go too far.
By Ezra Klein  |  June 28, 2010; 2:48 PM ET