Which Party is For Small Government Again?

Democrats want to expand the role of government. Republicans want to shrink it. At least, that’s what their rhetoric says. The story becomes a bit harder to believe when looking at government spending statistics. Consider two presidents as an example. President A increased spending by $357 billion over the first seven years of his presidency. Over the same period, President B increased spending by around half as much, $160 billion. Who is President A? The legendary champion of small government, Ronald Reagan. President B? None other than the evil Kenyan dictator, Barack Obama himself.

Let’s look at a graph of total spending per capita over time (data from the BEA). I don’t see any clear party breaks. The one big slowdown in spending in the 1990s coincides with Clinton (a Democrat).

gov_expenditure

Breaking the data down by president makes the point even clearer. The table below shows how much spending per capita increased over each presidents tenure.

president_spending

Note that Obama’s numbers are skewed by stimulus spending. Measuring from 2009 Q2 drops the increase to $153.

Overall, Republicans have held office for 36 years since 1953 and increased government spending per capita by $5310 during that time ($148 per year on average). Democrats were in power for 27 years and increased spending per capita by $3167 ($117 per capita). Not a single president in either party has actually reduced the size of government by this measure. A natural question is whether control of the senate or house is more important than the president. I didn’t calculate the numbers, but I doubt it would help the Republicans, who had control of the senate during the expansion in spending under both Reagan and Bush.

Bill McBride at Calculated Risk keeps a tally of public and private sector jobs added by president. By those numbers, Obama is the only president since Carter to decrease the total number of public sector jobs. Again, there is no clear relationship between party affiliation and number of jobs added.

On taxes, the picture looks strikingly different. Performing the same exercise shows that Republicans reduced taxes by $23 per capita per year, while Democrats increased taxes by $278 per capita per year. So maybe you could argue that the Republicans have kept half of their small government promise. But both parties clearly like to spend. At least the Democrats seem to care about paying for it.

What’s Wrong With Modern Macro? Part 1 Before Modern Macro - Keynesian Economics

Part 1 in a series of posts on modern macroeconomics. This post focuses on Keynesian economics in order to set the stage for my explanation of modern macro, which will begin in part 2. 


John Maynard Keynes – Wikimedia Commons

If you’ve never taken a macroeconomics class, you almost certainly have no idea what macroeconomists do. Even if you have an undergraduate degree in economics, your odds of understanding modern macro probably don’t improve much (they didn’t for me at least. I had no idea what I was getting into when I entered grad school). The gap between what is taught in undergraduate macroeconomics classes and the research that is actually done by professional macroeconomists is perhaps larger than in any other field. Therefore, for those of you who made the excellent choice not to subject yourself to the horrors of a first year graduate macroeconomics sequence, I will attempt to explain in plain English (as much as possible), what modern macro is and why I think it could be better.

But before getting to modern macro itself, it is important to understand what came before. Keep in mind throughout these posts that the pretense of knowledge is quite strong here. For a much better exposition that is still somewhat readable for anyone with a basic economic background, Michael De Vroey has a comprehensive book on the history of macroeconomics. I’m working through it now and it’s very good. I highly recommend it to anyone who is interested in what I say in this series of posts.

Keynesian Economics

Although Keynes was not the first to think about business cycles, unemployment, and other macroeconomic topics, it wouldn’t be too much of an exaggeration to say that macroeconomics as a field didn’t truly appear until Keynes published his General Theory in 1936. I admit I have not read the original book (but it’s on my list). My summary here will therefore be based on my undergraduate macro courses, which I think capture the spirit (but probably not the nuance) of Keynes.

Keynesian economics begins by breaking aggregate spending (GDP) into four pieces. Private spending consists of consumption (spending by households on goods and services) and investment (spending by firms on capital). Government spending on goods and services makes up the rest of domestic spending. Finally, net exports (exports minus imports) is added to account for foreign expenditures. In a Keynesian equilibrium, spending is equal to income. Consumption is assumed to be a fraction of total income, which means that any increase in spending (like an increase in government spending) will cause an increase in consumption as well.

An important implication of this setup is that increases in spending increase total income by more than the initial increase (called the multiplier effect). Assume that the government decides to build a new road that costs $1 million. This increase in expenditure immediately increases GDP by $1 million, but it also adds $1 million to the income of the people involved in building the road. Let’s say that all of these people spend 3/4 of their income and save the rest. Then consumption also increases by $750,000, which then becomes other people’s incomes, adding another $562,500, and the process continues. Some algebra shows that the initial increase of $1 million leads to an increase in GDP of $4 million. Similar results occur if the initial change came from investment or changes in taxes.

The multiplier effect also works in the other direction. If businesses start to feel pessimistic about the future, they might cut back on investment. Their beliefs then become self-fulfilling as the reduction in investment causes a reduction in consumption and aggregate spending. Although the productive resources in the economy have not changed, output falls and some of these resources become underutilized. A recession occurs not because of a change in economic fundamentals, but because people’s perceptions changed for some unknown reason – Keynes’s famous “animal spirits.” Through this mechanism, workers may not be able to find a job even if they would be willing to work at the prevailing wage rate, a phenomenon known as involuntary unemployment. In most theories prior to Keynes, involuntary unemployment was impossible because the wage rate would simply adjust to clear the market.

Keynes’s theory also opened the door for government intervention in the economy. If investment falls and causes unemployment, the government can replace the lost spending by increasing its own expenditure. By increasing spending during recessions and decreasing it during booms, the government can theoretically smooth the business cycle.

IS-LM

The above description is Keynes at its most basic. I haven’t said anything about monetary policy or interest rates yet, but both of these were essential to Keynes’s analysis. Unfortunately, although The General Theory was a monumental achievement for its time and probably the most rigorous analysis of the economy that had been written, it is not exactly the most readable or even coherent theory. To capture Keynes’s ideas in a more tractable framework, J.R. Hicks and other economists developed the IS-LM model.

I don’t want to give a full derivation of the IS-LM model here, but the basic idea is to model the relationship between interest rates and income. The IS (Investment-Savings) curve plots all of the points where the goods market is in equilibrium. Here we assume that investment depends negatively on interest rates (if interest rates are high, firms would rather put their money in a bank then invest in new projects). A higher interest rate then lowers investment and decreases total income through the same multiplier effect outlined above. Therefore we end up with a negative relationship between interest rates and income.

The LM (Liquidity Preference-Money) curve plots all of the points where the money market is in equilibrium. Here we assume that the money supply is fixed. Money demand depends negatively on interest rates (since a higher interest rate means you would rather keep money in the bank than in your wallet) and positively on income (more cash is needed to buy stuff). Together these imply that a higher level of income results in a lower interest rate required to clear the money market. An equilibrium in the IS-LM model comes when both the money market and the goods market are in equilibrium (the point where the two lines cross).

The above probably doesn’t make much sense if you haven’t seen it before. All you really need to know is that an increase in government spending or investment shifts the IS curve right, which increases both income and interest rates. If the central bank increases the money supply, the LM curve shifts right, increasing income and decreasing interest rates. Policymakers then have two powerful options to combat economic downturns.

In the decades following Keynes and Hicks, the IS-LM model grew to include hundreds or thousands of equations that economists attempted to estimate econometrically, but the basic features remained in place. However, in the 1970s, the Keynesian model came under attack due to both empirical and theoretical failures. Part 2 will deal with these failures and the attempts to solve them.

Links 8-7-2016

Scott Sumner is Feeling the Johnson,

Vox says Republicans should be too,

But Bob Murphy’s Not Convinced.

Maybe Denmark isn’t so Great After All

“when it comes to government support of grants from the National Science Foundation (NSF) for economic research, our sense is that many economists avoid critical questions, skimp on analysis, and move straight to advocacy.”

About that Productivity Gap

In my post yesterday, I put up this graph, which has been used by many as evidence of major economic problems.

The graph shows a growing gap between the production of an average worker and the compensation they receive for that production. The Economic Policy Institute (which is the source of the graph above), claims that this gap represents a failure of wealth to “trickle down” to workers. The economy is growing, but workers don’t see any of the benefits. I agree that this story, if true, would be deeply concerning. But I’m not so sure it’s true.

First, I wanted to make sure I could recreate the gap on my own. I used FRED to plot real compensation per hour against real gross value added divided by total hours (to proxy for productivity). I’m not sure if these are exactly the series used by EPI above, but the pictures look pretty close.

compensation_productivity_gap

Notice, however, that in order to get these data into real values, I deflated by two different price indexes – CPI for compensation and an implicit price deflator for productivity (if you aren’t sure what the difference is, here’s the BLS explanation). FRED also provides real values for each of these variables and they also use different inflation measures for each. I assume other people that have made this graph have done the same. Although it might make sense to deflate these series using different measures of inflation in some situations, it does not allow for an easy direct comparison between them. Looking at the difference between the two measures over time reveals a familiar looking gap.

inflation_gap

So what happens if instead of trying to look at real values using different (and imperfect) measures of inflation, we just put everything in nominal terms? Bye-bye productivity gap:

compensation_productivity_gap_2

Now, maybe there’s still something to be concerned about here. The CPI is supposed to measure the goods actually purchased by consumers. If the prices of these goods are growing faster than average, then the value of a worker’s compensation is lower. I’m not sure I have enough faith in either measure to even grant that point, but at the very least can we start calling it an inflation gap rather than a productivity gap?

2016: The Best Year Yet

In the last few weeks I’ve seen multiple people on Facebook claiming 2016 is the worst year in history. After I checked to make sure I wasn’t in an alternate timeline where events like the Black Death, the French Revolution, and World War II (among many others) never happened, I concluded they were probably exaggerating. Still, it seems like many people have started to believe the idea that overall welfare in the world is on a downward trend. Luckily, they couldn’t be more wrong.

Let’s take a look at some of the main complaints about the world in 2016. Our World in Data is a great source to visualize these long run trends and is where I got most of the graphs below. Check it out if you’re interested in topics I didn’t cover here.

Violent Crime

If you listen to the media, you might be a little bit scared to go outside. Mass shootings, terrorist attacks, and police brutality seem to be perpetual components of the nightly news. I of course do not want to trivialize any of these problems. Any level of unnecessary violence above zero is something we should try to eliminate. But violence has always been a part of this world. Has it been getting worse? No.

Homicide rates in the US, for example, are around their 50 year low and other countries show similar trends

You might think that restricting the focus to gun homicides would show a different trend. As Mark Perry explains, gun violence has actually fallen even as the number of guns has steadily increased.

gun_violence

We still have a long way to go, but it looks like we’re on the right track.

(off topic: notice how high US violence is relative to other countries even in the early 1900s. Might there be an explanation that has nothing to do with our gun laws?)

Poverty

In the US, you have probably heard that income inequality is up, middle class incomes have stagnated, and the poverty rate hasn’t fallen in over thirty years. All of these statistics are true on the surface, But as Don Boudreaux likes to point out, being poor today is not the same as it was in the past. In another post, he notes that most Americans today live much better than the absolute richest American a century ago. He asks how much money would be required in order for you to prefer living in 1916 than in 2016 with your current income. I don’t think I’d be willing for any sum of money. While I’m sure being rich in 1916 has its benefits, I’ll take my computer and airplanes any day.

On middle class incomes, this graph is commonly cited

I’ll deal with this apparent gap between labor compensation and productivity soon in a later post, but for now just take my word for it that it’s not exactly what it seems.

Another important point is that anybody born in the US (or any other first world country), has already won life’s most important lottery. Eliminating poverty in developing countries is a much more pressing issue. Here is what has happened to global poverty over the last 200 years. Since 1970, around the time when many would tell you the neoliberal agenda sent the world into a spiral of misery, the number of people living in extreme poverty has fallen from around 2.2 million to 700 thousand.

Healthcare

Democrats will tell you that too many people are uninsured. Republicans that Obamacare is destroying the country. Meanwhile life expectancy has been rising steadily for decades in every region of the world

life_expectancy

 

While child mortality has fallen

child_mortality

These are of course not the only factors that matter. The rise in healthcare spending (both public and private) in the US and other countries is concerning and we will need to figure out ways to deal with this issue, but once again, the trend seems to be going the right way.

You might say that I’ve cherry picked statistics to fit my story. That’s true. There’s a lot of bad things happening in the world right now. But we hear about those all the time. I think it’s important to also appreciate the stuff that is working and I do believe that the vast majority of people are far better off now than they have been at any point in the past.

Quote of the Day 8-3-2016

I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypothesis was very well unlikely to be good economics: and I went more and more on the rules – (1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I do often.
Alfred Marshall

Quote of the Day 8-1-2016

The train of logic departs from a picture that economists of a hundred years ago would recognize as familiar – Robinson Crusoe allocating effort between fish and bananas, say –  but barrels along at uncomfortable speed, picking up loads of subscripts on the way, into a fantasy land where the assumptions made about what people are able to know, to forecast and to calculate would leave them utterly bewildered and incredulous.
Axel Leijonhufvud “Episodes in a Century of Macroeconomics”