Tag: Government Spending

Keynesian Economics Part 2 Investment and Output

In my last post on Keynesian economics I outlined a simple example that I think captures the core of Keynes’s economics. It will help to understand this post if you read that one first.

Keynes’s key insight was that an attempt to save by an individual does not always lead to an increase in aggregate saving. I showed how using a simple example in the last post, but we can also generalize the problem. Imagine that each consumer consumes only a fraction of their income (it does not have to be the same across individuals, but I will assume it is for simplicity). Then total consumption spending is given by

    \[C = bY\]

Where C is consumption, Y is income (and total output), and b is the fraction of income spent on consumption (the marginal propensity to consume).

Let’s say that the only spending in the economy is consumption spending. You might already be able to see that we have a problem. Total spending must always equal total income in the economy so that

    \[Y = C = bY\]

Which can only be true if Y=0, so the economy breaks down. Perhaps this scenario is easiest to see if we imagine the case where there is one worker and one firm. The worker works for the firm and gets paid Y. He then decides to buy bY of the output he just produced. The firm realizes he made too much stuff, so he cuts back on production. But this means he reduces his demand for the worker’s labor and cuts his hours. But now the worker makes less so he spends even less and the process continues until no production is carried out at all. The only way we could sustain production through consumption alone would be if nobody wanted to save at all.

If consumption spending isn’t enough to keep firm production positive, we need some demand from another source. One source could be other firms in the form of investment. If we fix income at Y and assume again households only want to consume bY, it is still possible that firms can make up the additional spending by investing (1-b)Y. Keynes argued that there is no reason to expect that investment would always exactly fill gap. If desired investment by firms is less than the difference between consumption and income, they won’t be able to sell all of their product and will cut back on production. We can see that if we write out our equation again, now with investment, it becomes

    \[Y = C + I = bY + I\]

And solving for Y gives

    \[Y = \frac{I}{1-b}\]

So the level of investment determines the level of income. It was through this logic that Keynes concluded that it was the “animal spirits” of firms that determined the state of the economy. It’s possible that the level of investment exactly corresponds to the full employment level of output of an economy, but there is nothing that guarantees that it will.

There are still a few subtleties we need to consider. The first is the role of interest rates. In the classical view of the economy, when people try to save more, they increase the supply of loanable funds, which pushes down interest rates (think of banks having excess money to lend and the only way they can get rid of it is by lowering the interest rate). That lower interest rate then makes previously unprofitable investment projects become profitable and investment rises. If the interest rate falls enough, it’s possible that the increase in investment would be enough to offset the decrease in consumption.

Keynes didn’t deny this possibility. However, he argued (I think correctly), that interest rates are certainly not the only, and likely not even the primary, factor that goes into a firms investment decision. If a firm expects demand to be low due to a recession, there is no interest rate where it will be profitable for them to make that investment. And, as we saw in the last post, by failing to make those investments, firms’ expectations become self-fulfilling and their pessimism is proven correct. Interest rate adjustments alone therefore cannot save us from a Keynesian recession.

Another potential question comes from the assumptions of the Keynesian consumption function. It is obviously unrealistic to assume that each household wants to consume the same constant fraction of their income. People like Milton Friedman have argued that what people really care about when making consumption decisions is their permanent income. If my income falls today, but I expect it to return to its previous level tomorrow, I will borrow in the bad times to keep a constant level of consumption. I think this criticism is valid, but I don’t think it stops Keynes’s story. As long as aggregate consumption is less than total output (which it almost certainly will be), we still need investment to fill the gap. We still rely on expectations of firms to be correct regarding their future demand.

By focusing on the case where investment was exactly enough to move the economy to full employment, Keynes argued that “classical” economists implicitly restricted the economy to a special case. Keynes set out to correct that theory by proposing a “general theory” where investment fluctuated unpredictably and could (and often is) less than the level that would sustain full employment. I think this contribution is extremely valuable and unfortunately often overlooked. Even modern “New Keynesian” models bear little resemblance to the economy Keynes described. Models with money at all are rare and ones that allow the type of monetary disequilibrium in Keynes’s theory are all but nonexistent.

 

Don’t Be Afraid of Trade

One of the economic concepts that is most frequently misunderstood by non-economists (and probably by economists too) is the trade deficit. First, a definition. The trade deficit refers to the difference between the amount of goods a country imports and the amount it exports. As the graph below shows, the US has had a large trade deficit for the past several decades. It has been importing goods at a much higher rate than it has been exporting them. Nobody disagrees with that definition or that fact. The debate comes in when people start to decide whether this situation is actually a problem.

Part of the problem is simply an incorrect interpretation of what the trade deficit measures. It is common for non-economists to confuse this trade deficit with the equally frequently maligned budget deficit, which measures the difference between how much the government spends and how much it takes in as revenue. Unfortunately, our own president is among those who have made this mistake. According to Trump:

“The United States has trade deficits with many, many countries, and we cannot allow that to continue … with South Korea right now, but we cannot allow that to continue. This is really a statement that I make about all trade: For many, many years the United States has suffered through massive trade deficits; that’s why we have $20 trillion in debt.”

This statement is complete nonsense. The trade deficit with South Korea or any other country has absolutely nothing to do with the US government’s $20 trillion debt. The debt is the consequence of perennial budget deficits that derive from the US spending a ton of money on military, social welfare, and other government programs.

The trade deficit isn’t really a debt at all. It simply represents the fact that the US buys more goods from foreign countries than they buy from us. In the short run, a trade deficit is almost certainly beneficial for the US. As Milton Friedman eloquently explains in a video I posted a while ago, what a trade deficit really means is that foreigners are giving us real goods and services in exchange for pieces of paper. We get TVs from Japan. All they get are US dollars.

However, a more careful criticism of trade deficits recognizes that trade deficits can be good for the country in the short run, but represent a cost in the long run. Noah Smith articulates such a point in this post, where he argues that the trade deficit is a “loan of real goods and services.” He gives the example of somebody in the US buying a car from Germany. If the US citizen pays in dollars, he calls this an IOU to Germany. At some point, a German will use the dollars to buy goods and services from the US. Even if the dollars were used to buy an asset like a stock, eventually that stock will be sold and the dollars from the sale will be used to buy goods and services. His logic makes sense. Every dollar must eventually come back to the US in some form or another at some point.

But thinking of the trade deficit as a debt seems to me to be either misleading or completely wrong. One confusing point here is that the trade deficit is a flow, while debts are stocks. What is the value of the debt the US has to repay? The stock of all goods and services ever imported minus all goods ever exported? The current stock of foreign dollar holdings? I’m not sure there is any consistent definition of what this debt is that we are supposed to repay. Even if there were, I don’t think the idea of the trade deficit as a debt is meaningful.

Let’s flip Noah’s story. Assume a Chinese citizen really wants to buy Apple stock since they think it will increase in value. They need dollars to buy Apple stock so they exchange some Yuan for dollars and buy stock. At the same time, Apple needs to buy parts from China to make iPhones, so it imports them, trading dollars for Yuan in the process. For simplicity, assume these two transactions exactly cancel out. Where are the IOUs here? Does either country owe a debt to the other? It certainly doesn’t seem like it to me. The stock of dollars and Yuan in either country is exactly the same as it was before the transaction.

It is even clearer that the trade deficit is not a debt if we consider what happens if Apple suddenly goes out of business. The value of their stock goes to zero and their imports also go to zero. The trade deficit that was created by Apple is gone and no US goods were ever given to China. I imagine Noah considers that analogous to defaulting on a debt, but I don’t buy that analogy at all. Does he think Apple owes a debt to all of its shareholders or just its foreign ones? Isn’t the risk of Apple’s stock price falling inherent in its purchase? If you still aren’t convinced, Daniel Ikenson also has an excellent rebuttal to Noah’s article.

The other important point to keep in mind that is implicit in the example above is that foreign countries don’t just buy goods and services from the US. They also buy assets (stocks, bonds, etc.) or invest directly by building their own factories and capital equipment here. The current account (goods and services) and the capital account (assets) are always in balance by definition. A current account deficit is always offset by a capital account surplus.

This fact means that there are two ways we can frame the US’s large trade deficit. It could be that Trump is correct and we are really just falling behind in competitiveness. Nobody wants US goods anymore so they don’t buy our exports while we eat up their imports (which again is not necessarily bad – we get goods and they get paper). Or it could be that the US is home to many of the safest and best performing assets in the world. Other countries are dying to invest in US companies (and treasury bonds) and the result is a huge capital account surplus. One statistic won’t tell us which story is more accurate, but I think it’s pretty safe to say that we don’t have to be too worried (either now or in the future) about the trade deficit.

Who Says No? A Climate Change Compromise

Many on the left are up in arms over Trump backing out of the Paris agreement. Ignoring the fact that the agreement says that countries are free to set their own targets and their own policies and is largely symbolic anyway, let’s work under the assumption that liberals actually believe that this policy is disastrous for the earth’s future. In fact, let’s start from the (perhaps ridiculous) assumption that everybody in this debate is being intellectually honest.

Then Republicans have a great opportunity. Offer Democrats a compromise. The United States will re-enter the Paris agreement. And they’ll go even further. Democrats will be given full control over all matters of the environment. Carbon taxes, cap and trade, clean energy subsidies, whatever they want. Completely blank check.

In return, Republicans get everything else. They can pass whatever tax code they want, any deregulation they want. Democrats will have no say in healthcare, no control over education, no input at all over any issue except climate.

So my question is: who says no? Republicans (and Trump) have to go back on one of their key issues and allow the Democrats free reign. But for sucking up their pride on one thing they get everything they’ve ever wanted for a whole range of others. And what about the Democrats? Sure they’d be sacrificing a lot. In their view, we’d be significantly worse off in the short run. But isn’t that worth saving the world? If the results of climate change are truly catastrophic, isn’t it worth some people in the richest country in the world not having health insurance? Isn’t it worth middle class Americans being required to take out student loans to attend college?

Now maybe there are some issues that are as important as climate. If you think Republican control of the military would lead to nuclear war, then of course that can’t be part of the deal. Fine, keep that one. I’ll even throw in gun control, another issue that seems to be of vital importance for the left.  You can come up with your own list of some other issues you would never want to compromise on to save the world. But that list should be very small.

So who says no? I can’t imagine any Republican ever denying the above compromise. But I also doubt a single Democrat would take it. If that prediction is right, we are left with three possible conclusions. The first, which I think we can rule out, is that Democrats believe giving Republicans complete control over anything would be worse than the end of the world. The second, which could be true, is that they believe they can convince Republicans of the correctness of their view without conceding too much. Considering their lack of success to this point, and the apparent urgency with which they believe something needs to be done, this also seems unlikely. So we are left with the third, and in my opinion most likely, option: Despite their rhetoric, Democrats are simply not that concerned about climate change.

Some Thoughts on Universal Basic Income

People who oppose redistribution from the rich to the poor generally give two types of arguments against it. Perhaps the more obvious argument comes from a natural rights perspective – the person who created the wealth has a right to do whatever they want with it. However, if you don’t believe in free will (as I don’t), then this reasoning doesn’t make much sense. If you weren’t truly responsible for the circumstances that led you to create the wealth in the first place, why should you get to keep all of it? Shouldn’t some of it go to all of the people that had any influence on getting you to that position?

The stronger argument derives from incentives. Taking from the productive to give to the unproductive makes being unproductive far more attractive and we end up with a society where perfectly capable people choose not to work because they expect others to support them. Any attempt to solve poverty needs to deal with this issue, which makes designing anti-poverty measures difficult.

Our current welfare system has some checks in place that attempt to circumvent incentive problems, but it doesn’t solve them completely. Many of our current welfare programs involve cutoff levels where benefits begin to be reduced and eventually disappear altogether. This type of program introduces an implicit marginal tax on low income earners. Not only do they have to pay a higher official tax rate as their income rises, but they also lose some of the benefits they received at a lower income.

A simple way around this problem is to never phase out those benefits – to give them to everyone. This idea forms the backbone of the Universal Basic Income (UBI). One of the most complete proposals for a UBI comes from Charles Murray (yes, the same Charles Murray who gets kicked off college campuses because of his dangerous right wing ideas). In his version (laid out in his book In Our Hands), each American over the age of 21 would receive $13,000 per year in benefits unconditionally. Of this money, $3,000 has to be spent on health insurance, but the rest comes with no strings attached.

Of course, such a plan would be incredibly expensive. However, as Murray points out, our current system is already expensive. According to his calculations, if we eliminated our entire welfare system (including Social Security and Medicare), we could more than pay for the UBI. Getting rid of these programs would be difficult politically, but Murray offers several reasons why doing so would be desirable for almost everyone. Most notably, he estimates that poverty would be all but eliminated under his program vs the approximately 15% that remains under our own system.

Murray’s justification for some level of redistribution is similar to my own:

Inequality of wealth grounded in unequal abilities is different. For most of us, the luck of the draw cuts several ways: one person is not handsome, but is smart; another is not as smart, but is industrious; and still another is not as industrious, but is charming. This kind of inequality of human capital is enriching, making life more interesting for everyone. But some portion of the population gets the short end of the stick on several dimensions. As the number of dimensions grows, so does the punishment for being unlucky. When a society tries to redistribute the goods of life to compensate the most unlucky, its heart is in the right place, however badly the thing has worked out in practice
Charles Murray (2016) – In Our Hands

If we accept that some redistribution is desirable, a UBI seems like a more efficient way to carry it out than our current welfare setup. One common argument against the UBI is that it doesn’t make sense to waste resources on the rich. Bryan Caplan has given some arguments along these lines and argues that phasing benefits out gradually would avoid the implicit marginal tax rate problems without needing to give benefits to everyone. And it makes sense. If our goal is to eliminate poverty why not focus our efforts there?

But I don’t think that argument really works when you consider that a UBI is inextricably linked to the tax system. A UBI doesn’t look so universal after you consider that the rich are going to be paying for almost all of it. Everyone might get a check for $13,000, but top income earners pay far more than that in taxes. Their net benefit from government programs would still be strongly negative even after receiving the UBI. Depending on your perspective towards redistribution, this feature could actually be a negative, but given that redistribution is going to happen anyway, the UBI seems like a more efficient way of actually doing it.

It’s obviously not without fault, but I do think a UBI would be an improvement over our current system and I definitely recommend reading Murray’s book (it’s not that long) to anyone who wants to help the poor but believes we can do better than we do now.

 

Links 8-21-16

“In the land of the free, where home ownership is a national dream, borrowing to buy a house is a government business for which taxpayers are on the hook.”

“If you think that there has never been a better time to be alive — that humanity has never been safer, healthier, more prosperous or less unequal — then you’re in the minority. But that is what the evidence incontrovertibly shows.”

Noah Smith criticizes heterodox macro

And then addresses some of the responses

The Solution to High Rents: Build More Houses. Who would have thought?

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.