Tag Archives: fiscal cliff

8 Policy Recommendations for Newly Elected Members of Congress

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On December 3, 2014, I participated in a panel of Harvard University’s Bipartisan  Program  for  Newly Elected Members of Congress.   After establishing that the median US household has not shared in recent strong economic gains, I went on to consider policy remedies.

I offered the Congressmen eight policy recommendations.  Some will sound popular, some very unpopular; some associated with “liberals”, some with “conservatives.”   I would claim that they all have in common heavy support from economists, regardless of party – even the very unpopular ones.

  • Enable universal pre-school education
  • Spend on infra-structure
    o   For now, the spending could be financed by Treasury borrowing: 1% is a very attractive interest rate!
    o   For the longer term:  Finance roads and bridges by putting the Federal Highway Trust Fund on a sound footing.
    o   That means restoring real gas taxes to their past levels and putting the tax rate on an upward path over time.  Very unpopular of course.  But the best time to start this process is now, when gas prices are falling and inflation is low.
  • Take steps today to put social security on a sound footing for the long term
    o   We spent the last three years getting fiscal policy exactly backwards
    o  The US fiscal problem, measured for example by the path of the federal debt, is in future decades, not today.
    o  We hurt the economy during 2011-2013 by cutting spending and raising taxes and have done nothing to address the big future deficits in social security and medicare, exactly the opposite of what we should have been doing: allowing deficits while the economy has been weak, while taking steps to address entitlements on a long-term basis.
    o   Specific policies to put social security on sound footing:
    * Raise the retirement age (while accommodating blue collar workers);
    * and slow the rate of growth of dollar benefits for future retirees.
    *  At the same time, make payroll taxes less regressive:
    * Exempt low-income workers.
    * Raise the maximum-income threshold (from $118,500).
  • Reverse the long-term rise in household debt: housing, auto, and student loans
    o  Reduce especially the heavy policy tilt toward getting American families up to their eyeballs in mortgage debt that they can’t afford (which mainly drives up housing prices, without much raising home ownership rates for the middle class).
    o  Require a serious minimum down payment
    o  Require that mortgage-originators keep “skin in the game.”
    o Curtail tax deductibility of mortgage interest, which benefits the well-off (the deduction generally gives households earning $65,000 a year less than $200 in tax savings.
        * Reduce deductions at upper end (like Rep. Dave Camp’s proposal to cut from $1m to $500k)
         * Especially stop subsidizing mortgages that are used for something other than purchase of residence (i.e., second home or “cash out” home equity line of credit).
    o  Car-dealers should not have been exempted from the Consumer Finance Protection Bureau.
    o   Most college educations are still a good deal, and worth going into debt for if that is the only way a student can go.
    * But some enterprises are bad deals.
    * Government should expand student grants and loans, but require that the college or university have a decent record regarding rates of graduation and employment.
  • Tax reform
    o   We can’t afford to cut tax revenues.
    o   But we can reduce the most distortionary tax polices (those that most discourage work or encourage harmful activities) and raise a given amount of revenue in a less distortionary way.
    o   For the corporate tax system, that means cutting the overall tax rate some, but making up the lost revenue by eliminating wasteful exemptions, like oil subsidies.
    o   For household taxes, I have in mind:
    * Expanding the Earned Income Tax Credit, especially for young single workers who miss out;
         * and eliminating the payroll tax on lower-income working Americans (currently their marginal tax rate is often higher than anybody’s; currently 63% of taxpayers pay more in payroll taxes than income taxes);
        * but making up lost revenue by curtailing distortionary deductions (e.g., mortgage debt).
  • Allow fracking
    o   in every state, while allowing individual communities to opt out.
    o  Actually encourage it by expediting LNG export facilities.
    o  But regulate fracking carefully, e.g., to prevent methane leaks.
    o  It is good for jobs, manufacturing, national security and even — if carefully done — the environment (because natural gas is cleaner than coal).
  • Resume US global economic leadership:
    o   Pass Trade Promotion Authority (for WTO, TPP & TTIP)
    o   Pass IMF quota reform
  • Do No Harm:   Avoid going back to the dysfunctional fiscal policy of the past.  The uncertainty created by the morass of cliffs, shutdowns, debt-ceiling standoffs (Figure 5) together with the reality of the sequesters, held back growth by at least 1 per cent per annum during 2011-13.  (“The Cost of Crisis-Driven Fiscal Policy”  MacroAdvisers, Oct. 15, 2013.)  One reason growth has been stronger lately is that 2014 is the first year in the last four when Congress has not impeded growth very actively.
    o Dysfunctional fiscal politics hurt the economy in 2011-2013, not just directly (e.g., through the sequester), but also indirectly through the risks for business created by policy uncertainty.  (See Figure 5.)

Figure 5: Economic Policy Uncertainty

Picture5_dysfunctionalfiscalpoliticshurteconomy2011to2013

 

 

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Black Swans of August

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       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (“don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther – or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   “Governments of advanced countries don’t default.”   “European governments don’t default.”  Enough saidGreece‘s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

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