Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
Teaching Fellows
Jeffrey Clemens (Clemens@fas.harvard.edu)
Stephen Miran (Miran@fas.harvard.edu)
David Seif (dgseif@gmail.com)
Classes will be held in Emerson Hall 210 every Monday, Wednesday, and Friday, except
February 16, March 6, 13 and 20 and April 24
READINGS
1. Introduction: Where are we? How did we get here? (January 28)
Martin Feldstein, "Housing, Credit Markets and the Business Cycle," in the 2007 Kansas
City Federal Reserve Annual Conference Volume , Housing Finance and Monetary Policy,
2008. http://www.nber.org/papers/w13471.pdf?new_window=1
2. Business Cycles, Inflation and Monetary Policy (January 30, February 2 and 4)
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Christina Romer and David Romer, ―What Ends Recessions?‖ NBER 1994 Macroeconomics
Annual, pp. 13-57.
http://www.nber.org/papers/w4765.pdf?new_window=1
John Taylor ―An Historical Analysis of Monetary Policy Rules,‖ in John B. Taylor (ed.)
Monetary Policy Rules, University of Chicago Press, 1999.
http://www.nber.org/papers/w6768.pdf?new_window=1
Martin Feldstein "The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic
Policy," Journal of Political Economy, Vol. 87, No. 4, 1979, pp 749-768.
http://www.nber.org/papers/w0201.pdf?new_window=1
Ben S. Bernanke, ―A Perspective on Inflation Targeting, Remarks at the Annual Washington
Policy Conference of the National Association of Business Economists, Washington, D.C.
March 25, 2003. (A pdf will be e-mailed out the week of this lecture.)
Martin Feldstein ―Liquidity Now!‖ Wall Street Journal, September 12,
2007
http://www.nber.org/feldstein/wsj091207.html
Martin Feldstein ―Enough with the Interest Rate Cuts,‖ Wall Street Journal, April 15, 2008
http://www.nber.org/feldstein/wsj41508.html
Martin Feldstein and Charles Horioka, ―Domestic Saving and International Capital Flows,‖
Economic Journal, June 1980, pp. 314-329. (A pdf will be provided for those who do not have
access to the NBER‘s working paper series.) http://www.nber.org/papers/w0310.pdf?
new_window=1
Martin Feldstein “Did Wages Reflect Growth in Productivity,” Journal of Policy Modeling, 30
(2008) pp 591-94.
http://www.nber.org/feldstein/WAGESandPRODUCTIVITY.meetings2008.pdf
4 . Budget Deficits and the National Debt (February 9)
Laurence Ball and N. Gregory Mankiw, ―What Do Budget Deficits Do?‖ Budget Deficits and
Debt: Issues and Options, Federal Reserve Bank of Kansas City, 1995, pp. 95-119.
https://www.kc.frb.org/Publicat/sympos/1995/pdf/s95manki.pdf
Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security
Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter
Orszag, editors, 2002, pp. 0-24 & 63-80 (the remaining pages are assigned for a later class). (A
pdf will be provided for those who do not have access to the NBER‘s working paper series.)
http://www.nber.org/papers/w8488.pdf?new_window=1
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Office of Management and Budget, Budget of the United States Government: Analytical
Perspectives, Fiscal Year 2008, pp. 183-187. Note: Page numbers refer to the page numbers of
the document itself, not the page number of the pdf.
http://www.whitehouse.gov/omb/budget/fy2008/pdf/spec.pdf
Congressional Budget Office, The Long-Term Budget Outlook, December 2007, pp
1-17. http://www.cbo.gov/ftpdocs/88xx/doc8877/12-13-LTBO.pdf
Martin Feldstein, ―The Retreat from Keynesian Economics,‖ The Public Interest, 1981.
Martin Feldstein, ―Rethinking the Role of Fiscal Policy,‖ forthcoming in the American
Economic Review, May 2009 (Available on American Economic Association website for
January 2009 annual meeting)
John Taylor, ―The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal
Policy,‖ forthcoming in the American Economic Review, May 2009
http://www.aeaweb.org/annual_mtg_papers/2009/retrieve.php?pdfid=387
Alan Auerbach, ―Implementing the New Fiscal Activism,‖ forthcoming in the American
Economic Review, May 2009. http://www.aeaweb.org/assa/2009/retrieve.php?pdfid=324
Martin Feldstein, ―How to Avoid a Recession,‖ Wall Street Journal, Dec 5, 2007.
http://www.nber.org/feldstein/wsj120507.html
Lawrence Summers, ―Why America Must Have a Fiscal Stimulus,‖ Financial Times, January 6,
2008.
http://belfercenter.ksg.harvard.edu/publication/17845/why_america_must_have_a_fiscal_stimulu
s.html
Douglas Elmendorf and Jason Furman, ―If, When, How: A Primer on Fiscal Stimulus,‖
Brookings Institution Hamilton Project Strategy Paper, January 2008.
http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx
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http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx
Gregory Mankiw, ―What Would Keynes Have Done?‖ New York Times, November 28,
2008. http://www.nytimes.com/2008/11/30/business/economy/30view.html?_r=5&adxnnl=1
&partner=permalink&exprod=permalink&adxnnlx=1228241156- T3%2bMqzQf
Broda, Christian and Jonathan Parker. ―The impact of the 2008 tax rebates on consumer
spending: a first look at the evidence.‖
http://faculty.chicagogsb.edu/christian.broda/website/research/unrestricted/Stimulus%
20Payments%20and%20Spending.pdf
Martin Feldstein, ―The Tax Rebate Was a Flop. Obama's Stimulus Plan Won't Work Either,‖
The Wall Street Journal, August 6, 2008. http://www.nber.org/feldstein/wsj080708.html
Congressional Budget Office, Options for Responding to Short-term Economic Weakness,
January 2008. http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf
7. Fluctuations Of The Dollar and the Trade Balance (February 23, 25)
Richard E. Caves, Jeffrey A. Frankel, and Ronald W. Jones, ―Expectations, Money, and the
Determination of the Exchange Rate,‖ World Trade and Payments, pp. 581-589. (We may need
to scan the book directly to create a pdf of this one.)
Martin Feldstein, ―Resolving the Global Imbalance: The Dollar and the US Saving Rate,‖
Journal of Economic Perspectives, Summer 2008.
http://www.nber.org/feldstein/ResolvingtheGlobalImbalance.pdf
Martin Feldstein, ―The Dollar at Home – and Abroad,‖ The Wall Street Journal, April 28, 2006.
http://www.nber.org/feldstein/wsj042806.html
Martin Feldstein, ―A More Competitive Dollar is Good for America,‖ The Financial Times,
October 15, 2007. http://www.nber.org/feldstein/ft101507.html
Don Fullerton and Robert Stavins. "How Economists See the Environment." Nature, volume
395, pp. 433-434, October 1, 1998.
Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul
Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and Robert Stavins. "Is There a
Role for Benefit-Cost Analysis in Environmental, Health, and Safety Regulation?" Science,
April 12, 1996.
Lawrence Goulder and Robert Stavins. "An Eye on the Future: How Economists' Controversial
Practice of Discounting Really Affects the Evaluation of Environmental Policies." Nature,
Volume 419, October 17, 2002, pp. 673-674.
Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and
Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam:
Elsevier Science, 2007.
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Richard Schmalensee, Paul Joskow, Denny Ellerman, Juan Pablo Montero, and Elizabeth Bailey.
―An Interim Evaluation of Sulfur Dioxide Emissions Trading.‖ Journal of Economic
Perspectives, Volume 12, Number 3, Summer 1998, pages 53-68.
Robert Stavins. ―What Can We Learn from the Grand Policy Experiment? Lessons from SO2
Allowance Trading.‖ Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998,
pages 69-88.
Robert Hahn, Sheila Olmstead, and Robert Stavins. "Environmental Regulation During the
1990s: A Retrospective Analysis." Harvard Environmental Law Review, volume 27, number 2,
2003, pp. 377-415. With R.W. Hahn and S.M. Olmstead.
Robert Stavins. "Regulating by Vintage: Put a Cork in It." The Environmental Forum, Volume
22, Number 3, May/June 2005, p. 12.
___________. "What Baseball Can Teach Policymakers." The Environmental Forum, Volume
22, Number 5, September/October 2005, p. 14.
Gilbert Metcalf. ―A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address
Global Climate Change.‖ The Hamilton Project, Discussion Paper 2007-12. Washington, D.C.:
The Brookings Institution, October 2007.
Robert Stavins. A U.S. Cap-and-Trade System to Address Global Climate Change. The Hamilton
Project, Discussion Paper 2007-13. Washington, D.C.: The Brookings Institution, October 2007.
William Nordhaus. ―To Tax or Not to Tax: Alternative Approaches to Slowing Global
Warming.‖ Review of Environmental Economics and Policy, Volume 1, Issue 1, Winter 2007,
pp. 26-44.
Robert Stavins. "A Tale of Two Taxes, A Challenge to Hill." The Environmental Forum,
Volume 21, Number 6, November/December, 2004, p. 12.
__________. "A Sensible Way to Cut CO2 Emissions." The Environmental Forum, Volume 24,
Number 6, November/December, 2007, p. 18.
__________. "Cap-and-Trade or a Carbon Tax?" The Environmental Forum, Volume 25,
Number 1, January/February, 2008, p. 16.
__________. ―Inspiration for Climate Change.‖ The Boston Globe, Op-Ed, November 12, 2008.
Robert Stavins. "Beyond Kyoto: Getting Serious About Climate Change." The Milken Institute
Review, volume 7, number 1, 2005, pp. 28-37.
Joseph Aldy and Robert Stavins. Designing the Post-Kyoto Climate Regime: Lessons from the
Harvard Project on International Climate Agreements. An Interim Progress Report for the 14th
Conference of the Parties, Framework Convention on Climate Change, Poznan, Poland,
December 2008. Cambridge, Mass.: Harvard Project on International Climate Agreements,
November 24, 2008.
Robert Stavins. "Linking Tradable Permit Systems." The Environmental Forum, Volume 25,
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Number 2, March/April, 2008, p. 16.
Martin Feldstein, ―The Effect of Taxes on Efficiency and Growth,‖ Tax Notes, May 8, 2006.
http://www.nber.org/feldstein/taxanalysis.pdf
Council of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President,
Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf
Martin Feldstein, ―The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the
1986 Tax Reform Act,‖ Journal of Political Economy, 1995, pp. 551-572. (A pdf will be
provided.)
Joel Slemrod, ―Methodological Issues in Measuring and Interpreting Taxable Income
Elasticities,‖ National Tax Journal, 51: 773-788, 1998. (A pdf will be provided.)
Robert E. Hall, ―Guidelines for Tax Reform: The Simple, Progressive Value-Added
Consumption Tax, in Alan Auerbach and Kevin Hasset, eds, Toward Fundamental Tax
Reform, (Washington, DC, AEI Press), 2005, pp. 70-80. (A pdf will be provided.)
Martin Feldstein, "How Big Should Government Be?," National Tax Journal, Vol. 50, 1997, pp.
197-213. (A pdf will be provided for those who do not have access to the NBER‘s working paper
series.) http://www.nber.org/papers/w5868.pdf?new_window=1
Martin Feldstein, ―Rethinking Social Insurance,‖ 2005 Presidential Address to the American
Economic Association, American Economic Review, March 2005. (A pdf will be provided.)
Martin Feldstein and Andrew Samwick, ―Potential Paths of Social Security Reform,‖ Tax Policy
and the Economy, 2002, Vol. 16, Issue 1, pp. 181-224.
http://www.nber.org/papers/w8592.pdf?new_window=1
Martin Feldstein, ―Structural Reform of Social Security,‖ Journal of Economic Perspectives,
2005. http://www.nber.org/feldstein/streformofss.pdf
Alicia Munnell, ―Social Security: It Ain‘t Broken,‖ Social Security Reform, Federal Reserve
Bank of Boston, June 1997, pp. 297-303. http://www.bos.frb.org/economic/conf/conf41/con41_
24.pdf
Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security
Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter
Orszag, editors, 2002, pp 80-106 and 121-125. (A pdf will be provided for those who do not
have access to the NBER‘s working paper series.)
http://www.nber.org/papers/w8488.pdf?new_window=1
Jeffrey Liebman, ―Redistribution in the Current U.S. Social Security System,‖
in Distributional Aspects of Social Security and Social Security Reform, Editors
Martin Feldstein and Jeffrey Liebman, 2002, pp. 11-41. (A pdf will be provided
for those who do not have access to the NBER‘s working paper series.)
http://www.nber.org/papers/w8625.pdf?new_window=1
Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, ―Nonpartisan Social Security
Reform Plan.‖ http://www.newamerica.net/files/archive/Doc_File_2757_1.pdf
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11. Unemployment Insurance (April 8)
Martin Feldstein , ―Rethinking Social Insurance,‖ American Economic Review, March 2005, pp
13-15. (A pdf will be provided.)
Martin Feldstein and Daniel Altman, "Unemployment Insurance Savings Accounts," Tax Policy
and the Economy, Vol. 21, 2006. (A pdf will be provided for those who do not have access to the
NBER‘s working paper series.) http://www.nber.org/papers/w6860.pdf?new_window=1
Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street Journal, July 1, 2008
http://www.nber.org/feldstein/wsj07012008.html
John Deutch, James Schlesinger and David Victor National Security Consequences of US Oil
Dependency Council on Foreign Relations, 2006
http://www.cfr.org/content/publications/attachments/EnergyTFR.pdf
Martin Feldstein and Henry Kissinger “The Power of Oil Consumers”, Washington Post,
September 18, 2008 http://www.nber.org/feldstein/washpost_091808.html
Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July 2008
http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf
Martin Feldstein ―Tradable Gasoline Rights,‖ Wall Street Journal, June 5, 2006
http://www.nber.org/feldstein/wsj060506.html
11. The Economics of National Security (April 13)
Martin Feldstein, ―Defense Spending Would Be Great Stimulus,‖ Wall Street Journal, December
24, 2008 http://www.nber.org/feldstein/wsj12242008.html
Optional:
Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary
Update for Fiscal Year 2008, December 2007.
http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm
13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker
Schedule
American Economic Policy
Spring 2009
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F Jan. 30 Demand Management and Monetary Policy (Feldstein)
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Reading Period: May 2 - May 13
Final Exam: May 20 (?)
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Lecture 1
Wednesday, January 28, 2009
1:37 PM
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o While we don‘t approach this as a historical course, we will from time to time look
back over the past few decades
Reading list available online
Schedule: Shows you the schedule of classes; pretty good approximation
Do the readings! Not substitutes for lectures
What else might you want to read?
o The Economist magazine
o WSJ
o Financial Times
Macroeconomic issues: there are lots of data,
o One easy place: at the NBER‘s website
Look for economic indicators
2 short memos
Public finance at 9am: government, and taxation
o Essentially a microfinance course
This term‘s first lecture: Where we are and how did we get there
Worst economic downturn in history
o Unemployment went from 4.6% to 7.2%
People are worried that it will be up to 9% at next announcement
Increase in about 7 million unemployed
What is a recession and why is it different than others?
o A recession is a time when the economy is contracting
o See diagram
Even in expansion, high unemployment
Economists take a while to say its actually a recession
Stay in expansion until get to next peak
Recession: dated by NBER
o National Bureau of economic research
o NBER looks at a variety of monthly indicators and asks if we are in a broad sustained
and deep decline in economic activity, and then makes guess about next peak
o Last peak was December 2007
Look at cycles on NBER‘s homepage
The typical recession from peak to trough was 10 mos
Relatively short and mild
Not that many people got laid off and turned around quite quickly
Now: we‘re already in 12 mos, could last to 2010—probably over 24 mos
Contrast economic policies in this recession vs. typical policies used in
past and which we will probably still use in future
Federal Reserve
o Inflation
o It would raise Short Term interest rates until it slowed economy and brought down
inflationary pressures
This was true throughout the post-war period
But this time, the fed did not create the recession
o The fed would lower ST interest rates
This time, the traditional remedy is not working because the fed did not
push us into this recession by raising ST interest rates, so it cannot cure it
that way
We can see they‘ve been lowering to no avail
Asterisks: except has affect on exchange rate
Overnight interst rate: 0-.25%-->has little effect
Since fed did not cause this recession, what did??
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Since fed did not cause this recession, what did??
o Two things that are the fundamental causes of this
1.) Higher prices of risky assets
risk was underpriced
Treasury Bond: 4%; Corporate bond: 8%
Prices were too high meant that corporate bond had 6%
So the extra risk that you took, that company might default, was only
worth 2%, not 4%
o The interest rates on these risky securities might go back up
from 6% to 8%
o The price of a bond varies inversely with interest rate
o So the individual who holds that bind will take a significant
loss
o Underpricing of risk was not just corporate bonds, but also
mortgages, emerging market bonds, and the stock market
o Yield on stocks: was about 6%
o So there was this underpricing of risk by investors
Why would they be willing to do this? Why were they willing to
hold risky assest when the extra yield held with risky assest was not
very much? And these were professional investors!
o The short answer: competitive pressure
o They would say yes, we are getting little return
But we‘re paid to take those extra risks!
But if I don‘t take that risk and get that extra
2% yield, client will take money to another
money manager
Also, the money was not their money
Pension fund, hedge fund
It wasn‘t your money!
You can get paid in the short run for taking
the extra risk, maybe you‘ll be gone before it
goes down
Its like selling earthquake insurance
o Someday the earthquake will happen,
and your company will get hit bigtime
o But in meantime, you‘re making a profit,
and you‘re getting rewarded for it
o Why don‘t companies understand this idea of tail risk? We
have to experience with this risk
Also 25% fall in home pricestail risk
Very low probability of it happening
o Also, this idea that they can get their finger on the button faster
and get out sooner than everyone else
2.) high leverage, borrowing
because the risk seemed low, there was a temptation to want to
borrow more in order to lever up in order to get a higher rate of
return
they too were caught in this world
Investment banks: for every dollar of capital, they had $30 of
investments$29 of contributed funds
o But if it fell by 4%, then that $30 became $28.50, but they owe
$29
By early 2007, characterized by this underpricing of risk and high leverage
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o By early 2007, characterized by this underpricing of risk and high leverage
Indicator of this came from the subprime mortgage crisis
o Subprime loan: loan to creditor with high risk
Poor credit history, bad record of paying back in past
Policy Required to increase their lending to this group
GNMA, FRMC
If we only lent to people with good credit records, then minorities
and poor people couldn‘t get homes
Community reinvestment act
If banks took money from certain areas, they also had to give back to
those areas
o ALT-A:
High risk borrowers because couldn‘t prove their credit history
o Low probability that these people would default came from examining the
experience over the past few years
In 2005, 2007, there was an explosion of lending to these peeps
These were wonderful years, rising house prices, so it was a bad basis on
which to make judgment about how risky these loans were
In 2007 there were suddenly many more defaults on subprime loans
Repricing of risk: on all financial instruments, saw stock market
come down by 40%
House prices come down by 12 trillion
Enormous decline in wealth and in value of mortgage backed securities
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Lecture 2
Friday, January 30, 2009
1:41 PM
GDP figures for the 4th quarter: Surprised the forecasters, who said that this was going to
be an absolutely awful 4th quarter, thought it was going to fall by 5.5%
o Its not what's happening now, or whats happening in the 4 th quarter, its what
happened between the 3rd (JAS) and 4th (OND)
-3.8%
does this mean in much better shape? No—a lot of it was because of
inventory
didn‘t sell stuff in inventory because consumers didn‘t come
o so less of a decline in output
o so they‘re probably going to sell even less in 1st quarter
because they ended on such large inventories
Reasons for the economic crisis
Let‘s focus on decline in housing sector
o Central to problem
o Drove down household wealth
o Restricted the assets, capital, earnings of financial system and led to paralysis of
financial institutions
4 trilllion
3 things happened in this past decade which never came together like this before
o I.) Decline in House Prices (Ph)
o II.) Increase in leverage (loan/value ratios)
o III.) Securitization
In beginning of this decade, house pries increased at a much faster rate
o So we had an unsustainable bubble, rate of increase in house prices
2000broke out of historic pattern
60% increase in total
had been increasing 10-15% per year
now, they‘ve come down about 25%
o eroded
o they have been falling rapidly
o Schiller measure of house prices—down 18% in past year, but
still another 15% to go to original trend
Will it go back to equilibrium, or will it overshoot?
Maybe: now its become a risky asset
Now we know that you might get wiped out
People who bought house at peak got wiped
out
So equilibrium price might be lower, like in
stock market
Causes of I? House Prices Decline
o 1.) What the federal reserve did
back at the beginning of the decade, it was very concerned about deflation
at beginning of decade, there were a flurry of months when prices were
falling
why is deflation a worry? If the fed wants to cut interest rates to stimulate
the economy, it wants to cut the real insterest rate
r=i-
real interest rate= nominal interest rate - inflation
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real interest rate= nominal interest rate - inflation
.04=.06-.02
.01=.03-.02
But what if there is deflation?
.04=.02 – (-.02)
o there is the zero bound: the fed has driven the federal funds
interest rate to zero
o so .02=0+.02
o but say that deflation gets worse, that would drive the real rate
up
o may cause the real rate to be high and continue to rise as
deflation gets worse
and there's nothing the fed can do about it
2.) When there is deflation, in real terms, companies that are in debt
owe more money and will have a harder time dealing with that debt
o deflation makes the value of debt greater in real terms
Fed didn‘t want this, so pre-emptively cut interest rates and said they
would keep it low
Drove down interest rates on mortgages
Mortgage borrowing became cheaper
o Led to increase in borrowing because cost of carrying that
mortgage was lower
So the primary cause of low interest rates was federal reserve
2.) Housing Policy: Government policy encouraging buying homes
o relatively low income individuals
o tried to bring low income individuals
o if you draw money from a certain area, you must lend back to that area in form of
mortgages
so banks were forced to go out and find people and make loans to them
affordability products in the mortgage market
we‘d love to give you a mortgage, but we know you'll have a hard
time paying 6%
o so well give you a 2% rate for 2 years
o but don‘t worry about it, because housing prices are rising, so
in 2 years you can get a new mortgage to pay 6% rate
o These were ways of trying to make houses more affordable
shifted demand curve to the right
o and it succeed for a while, but now not anymore…
o 3.) Market Psychology
why am I renting when my friends are getting returns on their homes
fed the demand
at the time, there was short-sighted rationality (there is no such thing but
lets call it that)
houses going up at 10-15% per year, can borrow at 6% tax
deductable
o not taking into account that 10% wont continue: in a bubble
like any bubble, when you get far enough away
from a feasible equilibrium, prices will start to go
down
Causes of II? - Leverage
o Sometimes you could get 2 mortgages at once, so you didn‘t have to put anything
down
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o
down
o High volume of 90+% loan to value ratios
Why would they do this (the banks)?
While its more prudent to do 70-80%, the 90% would eventually
come down to 70-80% because of rising housing prices
o And that did work
o But it stopped working when we got to the peak of the curve
o What happened as a result of that is that we went from 90% to
LTV ratios, to >100% LTV
Loan is greater than underlying property
12 million individuals, 2.5 trillion mortgages are
underwater, individual owes more than house is
worth
average underwater home is 120%
Law of mortgages: if you default, they can take mortgage, and take away
house and sell it and that’s ALL they can do in US
You borrowed 200,000 for 250,000 house, but now its only worth
180,000
o Still owe 20,000
But they are non recourse mortgages, so creditor
cant resource to other assets or income
De facto: non recourse
When creditor sells house at low price, drives prices down in that
area, and increase LTV of everyone else
So we can easily overshoot as result of this decline
So house prices will continue to fall as result of this
o If housing prices fall another 15%, the average underwater
home will go to 140%
o Negative equity of 40%
o Danger is an avalanche of selling
o Rate of foreclosure doubled this year
Some people defaults because teaser rate over, lose job
o But really it‘s the high LTV of the loan
o What does this mean for the bank that holds them
Don‘t know what those mortgages are worth
Don‘t know who will pay them
People with negative equity like homes, neighbors,
hope things will turn around
Why are we paying these rates, when we can rent
across street for much less
Financial institutions don‘t know what loans on
balance sheet are worth
Causes III? Securitization
o Years ago, you went to the bank, told the bank I don‘t want to default, you don‘t want
me to default, lets work something out
o Now, most of loans are securitized
Sell loans to pension funds, other banks
So you get in trouble as homeowners, because there is no one to turn
to
You send local banks monthly check, but they already sold loan
o If you make local loans, and a big employer in town goes out of business, a lot of
people will default
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o
people will default
o But if you pool mortgages from all over country, there is much less of this risk
Even though homeowner has no one to go to
o Bankers could generate a lot more leverage to generate more risk in
o Mortgage Backed securities
A bunch of subprime loans pooled together to create a AAA security
Tranche A: risk lovers, the ones who want a high yield and who are
prepared to take the most risk
o The first hundred mortgages to default, they are stuck with it
o First hundred losses are theirs
o Chance that 100 mortgages will default is low—only maybe 20
will
o B security
Tranche B guys get losses 101-200
o More than 100 mortgages have to default before it gets to me
o So I go to a rating agency, Moodys, S&P, lets call this a AA
security
Tranch C: Losses 201-300
o AAA
Tranche D: Super senior, safer than gov‘t bonds
But the history of defaults of subprime mortgages was during rising
housing prices, great era
o So the rating agencies, stupidly, judging on an atypical part of
history, put these ratings on it
o Might as well buy 10 bonds and lever up
Suddenly discovered that there was much more risk than anyone imagined
o Subprime mortgages defaulted much more than expected
o Don‘t really know what they're worth
Thought there was no chance of default, but we don‘t know how many
will actually default
So where does this put the financial institutions
Can I raise $ from anyone else?
o No one wants to lend to them, because they don‘t know how
many losses lie ahead
Keep seeing billions of dollars of losses incurred by
financial institutions
Don‘t know what counterparty risk is
Don‘t know if they can repay them next week
o For every dollar they lend, don‘t know how much capital they have
Don‘t know what their losses are
So they‘ll make a loan to a high quality borrower for a short period of time
But wont commit for long period of time
Total gridlock
Dysfunctional credit market
Financial institutions don‘t know what they're worth, cant raise
money, don‘t know how much they can lend if they could raise
money
Even if government's lending rate is low, the financial institutions
aren‘t there to do any lending because they don‘t know what they're
balance sheets are
Dysfunctional credit markets and major collapse of demand
Household wealth fell 8 trillion because of fall of stock market
Ec 1420 Page 17
o Household wealth fell 8 trillion because of fall of stock market
o And 4 trillion for loss of Housing values
o Historically, if lost $100, consumer spending down $.04
Now might be more
Now, pensions more affected by fall in market
So consumer saving up
o Like it was years ago
o So enormous decline in consumer spending 4-5% of 12 trillion: 500 billion
o Housing starts-200 billion per year
o So 200+500=700bn fall of GDP
o Declines in consumer spending
Normally would say leave it to fed, they‘ll drive down interest rates and take care of it
o But that wont help now, huge hole
o Need to go back to regime which uses a lot of fiscal policy
Ec 1420 Page 18
Lecture 3
Monday, February 02, 2009
1:43 PM
In previous downturns, we could rely on fed‘s monetary policy to fix it (in part because fed had
caused it)
o But this one is massive, dysfunctional credit markets
o Fed not enough now
Big question: what to do?
o Increase taxes? Increase gov‘t spending?
Let‘s look at the traditional role in economic policy in managing aggregate demand
How the federal reserve has dealt with downturns in the past and will in the future
Govt announce today that saving rate was negative a year today, now 6.8%
o Real consumer spending slid 1%
Traditional Role of Monetary Policy in Managing recession
o In dealing with inflation
o We can see against that background how the intellectual climate has changed
National Saving and growth
Budget deficits and national debt directly
o Then return to credit policy
First, Fiscal and Monetary Policy
o If you go back before John Maynard Kaynes, before 30's, there was no fiscal policy
The norm was a balanced budget
The gov‘t was very small
1929=federal gov‘t was 3% of GDP
now, its 20%
o During the economic downturn of 20's, 30's
There were welfare jobs
But what about monetary policy?
There has always been an intellectual idea about what should be done for monetary policy
o On achieving low inflation, so link between increase in money and infation (increase in
price level)
o Worry about avoiding or correcting financial crisis
Protecting stock of gold
Raise interest rates depending on inflow or ourflow of gold
Did not expect gov‘t to be able to control GDP
o Saw it like the weather
Didn‘t expect them to fix it
Treat hardship by providing jobs for unemployed and monetary policy
Until this past year, monetary policy was virtually the only policy used in US and other
o Compared to fiscal policy (Changes in tax rates or gov‘t spending)
o what were advantages of monetary policy?
Short timeline for decisions and implementation
Federal reserve can take small steps while its learning
Fed began lowering interest rates in 2007 and continued lowering them for
years
As opposed to gov‘t which took huge multibillion dollar bite
Also, fed can reverse quickly
Can raise rates back up again
Monetary policy relative to fiscal policy
The fed is MUCH more politically independent
Chairman, fed independent agency
Ec 1420 Page 19
Chairman, fed independent agency
o Can report to congress
But the fed is de facto quite independent
o Unfortunately, these days it has been brought into the
administration's policy process more
o But it is much less of a political process than congress
o So for all of these reasons, monetary policy looks more attractive than fiscal policy
o How does monetary policy operate?
Should really be talking in past tense
Today, it has rates down to 0
Affecting credit market
So when we talk about fed, we‘re talking up to 2008, and how we expect the
Fed to act in the future
o So the Fed makes monetary policy by open market operation
Buys and sells treasury bills
When buy From the banks increases their reserves
Banks don‘t want to sit there looking at their reserves
And then banks want to lend that out
To do that, they lower their rates
These days, the fed has started paying interest rates on reserve, so banks
will just let them sit there and accumulate
o What does this lowering of interest rates do?
o When the fed lowers short term interest rates in the market?
This then affects lowering of long term interest rates, which affect mortgage
rates
Why? Because anyone who holds bond has cost of doing so
So it lowers the cost of carry for these bonds
o When cost of carry decreases, demand goes up, and so does price,
which is inversely related to long term rate
o Fed funds rate
This is the rate that the fed targets
The governor plus the chairmen meet to make a decision about the fed funds
rate and announce it to world
Now its between 0-.25%
Haven‘t always made fed policy by focusing on fed funds
Also looked at monetary aggregates, M1, M2
But now focusing on fed funds rate
What does this change?
o 1.) Inventory investment
inventories are financed by short term borrowing
CP!
GDP:= C+I+G+ (Ex-Im)
o 2.) Investment: Fixed investment (structures, equipment, housing),
o 3.) software
Also affects fixed investment
Housing: when interest rates down, more people qualified for homes, more
people could afford
o 4.) Consumer Durables
when interest rates up, interest rates at which auto companies, ect provide credit
affect auto demand
o 5.) Consumer nondurables
perhaps more surprising
Ec 1420 Page 20
perhaps more surprising
like going to McDonalds
1/3 of mortgages are Adjustable rate mortgages
reset every year
so as interest rates go up and down, monthly payments fluctuate
o so I have more or less to spend on everything else
o cash availability affect
o 6.) Stock market
Reduces future value of dividends
people concerned business profits will go down because businesses pay interest
on their loans
lower stock market has 2 affects on economy: has less real wealth for
households less consumer spending
and higher cost of equity for firms
o taking into account what they raised through new equity
o can afford to do more investing, etc.
o 7.) The dollar
increase in rates leads to an increase in value of dollar relative to other countries
increase in imports, decrease in exports
o 8.) Changes in Inflation expectation
even before it affects demand, it affects expectations
as fed eases rates
maybe I should buy now vs. later?
o 9.) Increases in mortgage financing
can refinance without penalty
I have 6% loan, IR drop to 5%
Do you want me to do it with you or go to another bank?
So now I have lower mortgage
o If mortgage rates come down I can refinance
These are the 9 channels which changes in IR can affect aggregate demand and level of output
and inflation
So what is the goal of the fed?
o What are they trying to accomplish?
o Primary goal of fed: LOW INFLATION
True of bank of England, European banks as well
Aim for 2%
Ben Bernanke was very interested in the idea of achieving an inflation target
before crisis
Dual mandate: low inflation and low unemployment
Inflation zone between 1-2%
Well, that‘s the least of his problems now….
Why this focus on inflation?
o Summarized by saying the Fed's goal is price stability
But their not saying that the CPI shouldn‘t change from year to year
When CPI increases at about 2% rate corresponds to no increase in the price
level
The price level is constant and the dollar income is constant
Where does bias come in? CPI doesn‘t capture new products and quality
changes
Really means no increase in maintaining same standard in terms of CPI
So why is low inflation focus?
1.) Econometric evidence that high inflation (over 10%) lowers economic growth
Ec 1420 Page 21
o 1.) Econometric evidence that high inflation (over 10%) lowers economic growth
Argentina, mexico
Instead of running ordinary business, you spent all of your time trying to
figure out how to speculate, how to collect money sooner, delay payments
o 2.) The public dislikes inflation because they see it as eroding the value of their earnings
economists don‘t like this public…
joe gets 9% bonus; inflation 7%, angry cuz he only gets 2%
If everyone gets extra 7% in pay, then it would just wash thru
If no inflation, have to fess up and cut joes pay
But when 7% inflation; can just give him 3% pay increase
Individuals know this
In early 1980s: in shelf life of soup price levels increase
Shops with narrow margins had to increase prices
14% inflation
o 3.) Even if we got down to moderate rates of inflation, makes long term planning very
difficult
o 4.) Erodes the value of financial assets
sophisticated folks should manage their money such that if inflation goes up,
don‘t leave money in checking or savings account
o 5.)even smart guys get adversely affected by tax system, which uses nominal not real rate
For pi=0, (1-.3)*.04=.028
For pi=6, (1-.3)*.1=.07-.06=.01
Wow! You just went from a real rate of 2.8% to 1%
If pi=10, (1-3)
Real return in economy stayed same, but higher inflation leads to higher
affected tax rates
Also capital gains ec
So how do we reduce inflation? What are costs and are they bad?
o Increase rates to produce significant real rates, Higher unemployment, and that turns
around economy
That produced reduction in inflation
o Is high unemployment worth it to bring inflation down?
Consensus: Yes, it is worth paying that price if inflation is getting higher than
minimal level
That wasn‘t always true
Used to think they should stop it from going higher but don‘t pay price for
going down
o Increase in unemployment is a TEMPORARY unemployment
Temporary loss of GDP
Once inflation is down, it is permanently lower
o How do I know this?
Depends on how much of increase of unemployment I need to bring down
inflation rate
Estimate is that it takes about
An increase in the rate of unemployment by 1-1.5% ( for one year) leads
to a reduction in inflation rate of 1% (permanent)
So to bring It down to 2%, need unemployment up to 2-3%
This unemployment has a cost in terms of loss of GDP
Low inflation has benefit of increase in real income
o In cyclical terms, 1% increase in unemployment rate causes GDP to fall between 2-2.25%
Oken‘s law: A cyclical rise of unemployment by 1% leads to a decline in GDP
of 2-2.25% in the same year (concurrent fall)
Not at all clear why its called a law
Ec 1420 Page 22
Not at all clear why its called a law
No particular reason why it should hold, remarkably
If we are facing inflation
o If Pi=4%, to go to pi=2%
Change in real unemployment = -2%
Change in GDP:4-4.5&
600bn lost Gdp? (check that #)
is it worth it?
o Bringing down inflation from .04 to .02 leads to reduced distortion
o Inflation causes real interest rates to fall
Intertermporal allocation of consumption
Causes more money to go into houing, and other things
Tax systemt
1% increase in gdp permanently
o So you can give up 4-4.5% one time, but it pays off in 4-5 years
o Basic point: you get a substantial annual increase in GDP for one time cost associated with
doing it
This is a 1x cost that should be avoided
But if you find yourself here, slow the economy down to get back to
square 1
Ec 1420 Page 23
Lecture 4 - Review
Wednesday, February 04, 2009
1:47 PM
Ec 1420 Page 24
Unlike European central bank, which has a single de facto mandate
How does it deal? Has to balance between the two
As in everything in economics, there's a tradeoff and have to balance those
two things
Often, central banks hide behind rhetoric
Oh , Within 2 years, labor markets will adjust, and unmeployment
will adjust
So what does the fed do in practice
o Makes a decision about the federal funds interest rate
o And communicates that to the NY federal reserve
Which operates in T-bill market to bring about desired level in fed funds
interest rate
How would you go about doing it?
Look at inflation, unemployment, inflation expectations (via survey
data)
o Treasury inflation protected security—gives real interest rate
Compare its interest rate to ordinary bond
The dollar: how do you combine them?
John Taylor: looked at what Allan Greenspan had been doing
o Can we find a rule?
o I bet what he‘s doing is looking at inflation in terms of real interest rate and
unemployment
o How he has set it as a function of unemployment rate
From 1987-1997
Taylor rule: Lets pick a desired level of inflation
We want it to be low, but not 0 (then we might have real > nominal
interest rate)
When the actual inflation rate is greater than this target rate, it will increase Iff
o If inflation is low, it will reduce I ff (federal funds rate)
o About 2%
You want to pick a sustainable long term unemployment rate so that inflation
NAIRU: Non-accelerating inflation rate of unemployment
o Target rate of enemployment
Reasonable assumption = 5.5%
Taylor said who knows what that rate is!
o I‘ll look at nominal level of GDP relative to trend at a given time, divided by GDP
Yt-Ytrend/Ytrend
If output GDP is greter than trend, then we‘ve probably gone to far--?will
be inflationary, so probably want to go lower
Simplified version of Taylors law:
o Iff,t=+1/2[t-*t] +1/2[Yt-Yt,trend/Ytrend]+.02
o
○ =*, Yt=Ytrendiff-t=.02=rff=.02
o Federal funds rate is consistent
No upward or downward pressure
∆iff= ∆t+.05∆t
o ∆i(iff=)= ½ ∆t
Seems like common sense
o But greenspans predecessors did NOT do this
o Got bad inflation
1960-1979
Ec 1420 Page 25
o 1960-1979
∆i/∆=.81
nominal rate went up by .81
so ∆rff/∆=-.19
o how could they do that?
They dealt with inflation by raising interest rates
They only raise nominal interest rates, not real
Its hard to believe they didn‘t get that right,
but they didn‘t
In some of these earlier year, great confusion about inflation
o Caused by demand, or unionsdoes not produce ongoing inflation
Unions produce higher level
o What causes inflation is higher demand sustained by increases in money supply
Always and everywhere a monetary phenomenon
This relationship is one which links inflation and unemployment to the nominal fed funds
rate
o Has the fed continued to do it?
o How does it correspond to this
o ∆(Yt-Ytrend, t/Yt)=-/2/25∆RU
until this crisis, the fed followed this rule remarkably closely
i*ff,t=1.5t-0.5[.02]-0.5(2.25)[RU-NAIRU]+.02
o NAIRU=5.5
i*ff,T=1.5T-1.125RU+.07
Jan 2000
o
○ =.022
o RU=.04
o I*=.058
o I=.054
Pretty good!
Jan 2001
o Stock market starting to fall
o
○ =.024
o RU=.042
o I*=.059
o I=.06
Still pretty good
But by July 2001, recession had been gone
o
○ =.023
o RU=.046
o I*=.063
o I=.038
o Why so dramatically different? The economy is sliding into a recession? Its only a
matter of time before unemployment slides more and inflation comes down
o Very short recession: 8 mos!
Nov 2002
o
=.019
Ec 1420 Page 26
○ =.019
o RU=.06
o I*=.031
o I=.0125
Dece 2004
o
○ =.019
o RU=.054
o I*=.039
o I=.02
o But still keeping rates low, bringing down long term rates
Start of housing bubble
December 2005
o
○ =.018
o RU=.049
o I*=.042
o I=.042
Dec 2006
o
○ =.025
o RU=.049
o I*=.055
o I=.0525
December 2007
o
○ =.041
o RU=.050
o I*=.076
o I=.0425
Today:
o
○ =-.019
o RU=.072
o I*=0
o I=0
With a few exceptions back in Nove 2002, 2003 the fed has followed the Taylor rule
o wanted to do something much more forceful to balance the economy
o big one in July 2001, accepted a much lower rate
What was the logic of doing this?
o For these much lower than you might have expected
o What greenspan called risk based policy
Ec 1420 Page 27
Lecture 5
Monday, February 09, 2009
1:50 PM
The stimulus package does not deal with market disfunctionality, and treasury defaults
o Treasury is working hard on that
Publications from Congressional Budget officego to cbo.gov
o Put out reports about the nature of the problem, what the gov‘t is doing, how they see
the nature of the recovery
o Very optimistic—see impact of fiscal policies as much greater
Finish up discussion about demand management
o Talked about two targets: inflation and NAIRU
o Fed has only one instrument: OMO
Has to balace these 2 in the short run
By following something like the Taylor rule, the economy will naturally
go back to NAIRU and gov‘t will have succeeded in bringing inflation
down to the low level that it wants
o While the Taylor rule is not really a rule, it is a way to guide where to set the fed
funds interest rate
Achieves it thru OMO
Is a kind of backward looking rule
Not using forecasts of unemployment, using backwards #
Taylor says: its safe to use numbers that everyone can check
We saw that the fed basically followed the taylor rule which was
based on estimates of behavior of alan greenspanapplied it to fed‘s
behavior years later
o Has come to be more or less right on to applied interest rate
according to Taylor rule
Between summer 2001 and 2004, the fed was much easier than the taylor rule implied
o Though taylor rule said 4%, fed kept it at 21.2% why?
Fear of deflation
If the inflation rate had gotten to what it was at the time:1%, what if it got
to 0%
If economy starts to slide into deflation, the real interest rate goes up
and there is nothing the fed can do
If interest rates are below zero, get deflationary spiral, and interest
rates would be stuck
Greenspan departed from what would be expected of their behavior
from what he saw would be the risk of their current outcome
o How bad could it be?
o And what would be the consequences of different actions
o Useful concept and how did it play out in early part of this
decade?
Statistical decision theory
o Characterize the problem by thinking about possible
Actions
I=i* (from taylor rule)
I= very low (.01)
States of Nature
Large # of these states of nature
Represent the uncertain outcomes with different actions
1.) Severe recession if i=i*
Ec 1420 Page 28
o 1.) Severe recession if i=i*
o 2.) No recession if i=.01, but there will be an increase in
inflation
think about the world in these terms
choose 4% or 1% interest rate
Loss function
o Fed was thinking in a narrow rage of functions
o Actions
Ec 1420 Page 30
But we are going to focus on K
Basic relationship
o Y=f(K,L,technology)
What happens if we increase K at a given amount of L ?
Delta Y=MPK*delta K=rho*delta k
Rho=Marginal productivity of K
o =.10 in real terms for nonfinancial sector
o Delta k = net investment = gross investment- depreciation
putting in place equipment and structures
want to link that idea to savings
net investment in the economy
have to advance
inventory, software, equipment
has to be matched by savings: resources being
produced not consumed
Net investment= net national savings plus the inflow of capital for the rest of the world
o Net I= Net national savings + net capital inflow+ ROW
Ec 1420 Page 31
Lecture 6
Wednesday, February 11, 2009
1:51 PM
Capital Stock
o Affects saving
o Net of depreciation
o 2 sources of funds available for investment
o ∆K=Net investment +Net savings + Capital from abroad
o rho=net national saving on fraction of GDP =Marginal Product of capital
∆K= rho Y+CAD (current account deficit)
o ∆Y=rho*∆K=rho*sigma*Y+rho*CAD
o ∆Y/Y=rho*sigma+rho*CAD/Y
o what does it say about changes in savings rate on rate of economic growth?
If rho=.1
Sigma=.1
Cad/y=.05
∆y/y=.01+.005=.015
HOLDING constant technology (which would add another percent)
and labor (which would add another percent)
So about .035
Impact of capital accumulation, either domestic savings or inflow of capital from ROW,
contributes to .015
o If we didn't have CAD/Y, it would drop by .005
If our savings rate goes up 5% (say from 5% to 10%) it add .05 to growth rate
o Small changes in savings rate have a huge influence on capital accumulation and
GDP
What is national saving?
o Net National Savings
State and local government saving = 0
Because they are not allowed to run deficits
o For current operations
o They can use debt to finance projects tho
Current account deficit= .05 of GDP
Business savings= Returned Equity
Household savings = used to be 7 or 8% after taxes, but they were
negative 2 or 3 years ago
Doesn‘t mean everyone is a negative saver
o But that the savings of the savers is less than the dissaving of
the dissavers
o Why?
Because of boom in wealth in which retirees looked
and saw that had so much more than they thought
they did
Federal Government= -.02-.10
Deficits can be very large relative to savings
o Can have important long run effects
Budget deficits and surpluses
o Stimulus actions unprecedented since WWII
o What is relationship to national debt
How does national debt affect the economy
Fiscal years= does not correspond to the calendar years
Ec 1420 Page 32
Fiscal years= does not correspond to the calendar years
Represent the year ending Sept 30th
Source of these numbers in the congressional budget office
Look at website!
When we talk about the national debt: value it at a point in time at end of fiscal year
o Talk about deficits flows at end of fiscal year
Unified budget deficit
See why unified in a minute
The overall budget deficit
o DEFt =Gt +iB_t -Tt
G=Government Spending
B=the end of fiscal year national debt
B _bar=average debt over the year
T=taxes
455=2730 Bn+249-2524 (for 2008)
455BN is an ENORMOUS numer
2009 estimates: estimate what it means to maintain current level of
services: doesn‘t include anything about legislation that everyone things
will pass
1186=3345+195-2357
corporate taxes, personal gains taxes
percentages of GDP
2007: the defict was 1.2% of GDP
1.2=18.2+1.7+18.8
2008: 3.2=19.2+1.7-17.7
2009:8.3=23.5+1.1-16.5
all these numbers ar e in percent
On Budget
Rev Surplus
On budget 11.8 -9.4
Off Budget 1.1 -8.3
Bt=Bt-1+DEFt+ miscellaneous borrowing to finance acquisition of assets
AT THE END OF 2009, the nation debt as currently projected
o 7193=5803+1186+204
its really all in this enormous increase in extra spending
extra puzzle of miscellaneous borrowing
The increase in gov‘t spending was 618Bn
o There were 2 very unusual items in it
o FreddieMac and FannieMae, which have an implicit gov‘t guarantee, which have
about 5 trillion dollars worth of debt which they guarantee
Either issue mortgages,
They got into terrible trouble, and the government had to put them into a
conservatorship
Bush: no they're not part of government they're just there
But CBO: said we‘re going to count this as a form of govt spending
o Injected 18Bn into
o Now the govt in one fell swoop took this thing which if it had
gone belly up would have cost the bondholders, creditors all of
this money
o This implies future losses
Figured out the present expected value of those
losses
Ec 1420 Page 33
losses
In effect, that is something we incurred this
year when we took this on
Said its worth 220Bn
o So FNMAE and FRMC are a big part of this 600Bn
220Bn non cash
o Troubled Asset Recovery Program: TARP
700 bn to play with
COB said you guys are taking risks
You're putting preferred stock into troubled companies
o But we have to take into account you have some risks that they
wont recover it all
Of 700BN of TARP, 180bn was treated as non cash expected future losses
plus some risk premium
So that 220+180=400
And 18bn for F+F
So 2/3 of it is in accounting, non cash items
Mysterious miscellaneous borrowing
o Where did this 204 bn come from?
o TARP: borrowed 640 bn
But already counted as G 180 bn of that
So there was 460bn
o They also bought Mortgage backed securities to drive down rates
Cost them 250bn of borrowing
250+460=710bn
o FDIC=great guarantor didn‘t have enough money
Borrowed 300bn from gov‘t
So there will be a repayment of 300bn in future
o And there will also be a repayment of FRMC and FNMA of 220bn
o So: 460+250-300-220=190+14 misc=204
o What looked like enormous increase in deficit driven by increase in gov‘t spending
Most of increase in deficit comes from increase in gov‘t spending
Most of that is not actually real spending
o Didn‘t add to aggregate demand
o Yet was classified that way by CBO
This increase of1390 bn in debt=Bt-Bt-1
B/gdp=40.8(debt held by public?)
If B/X rises Bdot/b>Xdot/Xnon GDP
Bdot/B=DEFG/X*(X/B)
B/X will increase if DEFG/X>B/X * Xdot/X
o WHAT IT TAKES FOR THE DEBT TO GDP to rise says that debt to GDP will
increase if the deficit relative to GDP is greater than B/X times the growth rate
(Xdot/X)
o > .5 (.02)
o the only way to makeB/X start going down again is to get DEF/X<(B/X)*(Xdot/X)
.5(.05)
Ec 1420 Page 34
Lecture 7
Friday, February 13, 2009
5:01 PM
Last time, we still had a very large increase in national debt ~10%
o Cyclically adjusted deficit
o When the economy today is weak, personal and corporate tax revenues fall
There is a rise in the fiscal deficit which is inherently temporary
representing the cyclical state of the economy
How big is it or how much stimulation is in system
What is cyclically adjusted deficit
2007 GDP: $13670 Bn
o Pot‘ll GDP at NAIRU: 13790
o GDP GAP: DELTA=-126
o Deficit (2007): Observed deficit of 163 BN
But 31 Bn of that was due to cyclical
So C.A. GDP GAP: 163-31=$132 BN
~.9% of GDP
Unemployment rate in 2009= ~8.3%
o GDP Gap to cyclical deficit ratio about ¼
Defg (2009): 1186 BN
250 Bn cyclically adjusted deficit
so 936 bn is cyclically adjusted deficit
418 is accounting (from last lecture)
518 bn of ―financially adjusted deficit‖
3.6% of GDP!!!!
o ENORMOUS BUDGET DEFICIT
What are the consequences of this?
o What is that people used to think about budget deficits?
And what happened in the Keynesian revolution?
The view that prevailed before the 1930s
A country with a debt is poorer
We are passing out debt to our children, making them poorer
This generated a political aversion to debt
o Except when used to finance assets : school, roads
o Key feature of Keynsian: we need to use fiscal deficit to
stimulate the economy
But this ran into opposition from these people about
the making kids poorer thing
How did the Keynsian economists get around this?
o As a country, we are poorer because of the debt
What about this debt?
Well, we only owe it to ourselves
1930swe didn’t have a lot of OPEC buyers, etc.
5.8 trillion dollars at end of 2008
o excludes the national debt held inside the federal reserve
and the national debt inside the SS national trust
fund
o Gross debt: 9bn :but doesn‘t matter as much because they owe
Ec 1420 Page 35
o
some to themselves
What we care about is what we owe to civilians and foreigners
Back to 1930s
o Intellectual debate: we only owed it to ourselves
This is like keeping internal records inside housedoesn’t matter
Not like borrowing from a bank
If we buy a tank now, how can that be a burden on children and
grandchildren
These arguments were fallacious
Where is the fallacy?
o Internally held debt: had to be serviced in the future
Gov‘t has to raise taxes to pay interest on that debt
Ex 5000 Bn of debt *.02=100bn of taxes each year to pay interest
o There is a burdendeadweight loss
Distortionary effect of the taxes to pay the interest
Even though we owe it to ourselves
o Significant piece of overall gov‘t overlays
Even if all of that was just inside the economy
o If they pay today, wont be future burden on future generation?
Crowds out future formation
Capital stock is lower because of borrowing
National saving rate is lower because gov‘t absorbs part of savings that
would otherwise be available for capital stock
Burden: have to be servicedDW loss
And lowers capital stockfuture incomes
Now, lets think about what happens when economy is roughly at full unemployment
o How does fiscal deficit compare to gov‘t borrowing
o Some say that all that matters is gov‘t spending
Debt finance under general economic conditions
I want to make a case for fiscal deficits today
Under normal circumstances, whether we finance by taxes or
borrowing is an important choice and that the burden of financing by
borrowing is greater than the burden by taxes
Key idea: Tax finance (increase in income tax) will decrease consumption
Debt finance will decrease investment
Some gov‘t borrowing may increase interest rates and lead to higher savings
o Think about extreme: Taxing = less consumption
o Borrowing = less investment
Wedge between Marginal product of capital and return consumers receive
o $1 is worth more at margin than $1 of consumption?
Gov‘ts options
o 1.) tax now $100
reduces consumption by $100
o 2.) Borrow now $100
reduces investment today by $100
say Marginal product of capital= MPK= .085
so it reduces by $8.50 per year in future in cons_t
so lets look at the real net interest that individuals face
Discount future lost cons_n by real net interest rate faced by consumer
o Government bond interest rate: 6.25%
Tax 2.00%
Ec 1420 Page 36
o Tax 2.00%
o Net interest rate 4.25
o Inflation 2.00
o R_n 2.25
$377.78
We can reduce consumption today by 100 or we can reduce future consumption, which
because of tax wedge, represents a higher return
o That 8.5 dollar perpetuity is worth substantially more than that $100
o As long as MPK is substantially greater than real net rate of interest than taxes are
going to have a smaller burden than the lost real incomes associated with borrowing
Nevertheless there are circumstances where we may want to do it
o We‘ve run fiscal deficits every year
o Think about it in terms of full employment economy
Have to modify it for circumstances like today
Now there is a kind of special case worth thinking about
o Temporary increase in spending financed through borrowing or a tax increase
Ex military expenditures during a time at war
Need a quick military buildup
Better to have an increase in taxes or borrow?
o Barro argues that it would be better to borrow and spread cost
over long period of time
o Taxes distort
10% tax rateto 20% tax rate
quadruples distortion
inversely with square
o the deadweight loss will be less if do it in series of small
increases in tax rate
Ex 2% of national income
o Tax finance: .02*Y
o Debt finance: i= .05
Delta T=.05*.02*Y=.0010Y
Do we want to levy a one time tax or a perpetuity of taxes equal to 1/10 of
a percent of GDP?
DWL=12et^2wL
o E= elasticity of labor supply
o wL= Y (GDP)
Tax=1/2E(.02)^2Wl=1/2ewL[.0004]
DWL=1/2E[.001]^2wL(10^-6) each year
o PV DWL=1/2EwL10^-6/4*^-2=1/4*10^-4
Use debt for one time event like war
o Except borrowing displaces investment!
o With reasonable assumptions about displacement of private investment
If you have a 1 time financing need and don‘t have a large tax wedge distorting the
consumption/investment decision
o Then use borrowing: spread tax weight over long period of time
But when you‘re at full employment, $ of tax
o MPK> NET DISCOUNT RATE APPLIED TO individual consumption
o Want to use tax finance instead of debt finance? Check this might be other way
Large fiscal deficit
Often monetized
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o Often monetized
o Bt=Bt-1+DEFt
Pretty good for Us, where we have good bond market
Monetary policy independent of policy needs
Other countries (developing), when they run deficit, they increase the
money supply
So an increase in money supply increase price level
NOT true for US
Mt=Mt-1+DEFt
M*V=P*Y
Not necessarily will lead to inflation in US
But could
o Interest rates rise
o Need to crowd out private investment
o Might be pressure on fed to bring down interest rates
By temporarily lowering ST rates, can increase
inflation
o Always tempt to use inflation to reduce debt!
o If we could have higher inflation, than that would erode the real value of the debt
Ability to service that debt would be eased
What stops you?
Extent to which market perceives this inflation, interest rates rise and
gov‘t has to pay more
Guy who buys it takes the risk
Still get 3% interest
As inflation goes up, wont be able to erode the value of the debt
Finally, there will be a temptation
o Weak recovery in which unemployment rate doesn‘t come
down very fast
o May be more attention to bringing down unemployment rate
o
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Lecture 8
Wednesday, February 18, 2009
8:02 PM
What was the Keynesian revolution? Why did economists eventually reject it? Why is there a
new interest in fiscal policy, and how should it be applied?
Keynes wrote the General Theory in 1936, which was about the economics necessary to deal
with depressions, through using fiscal policy to manipulate aggregate demand. The basic policy
prescription of Keynes was to use budget deficits to reduce national savings in order to stimulate
aggregate demand. Richard Kahn wrote an article in 1931 explaining fiscal multipliers, how if
the government increased government spending by change in G, then GDP would increased by
Change in G / MPC. This idea became central to Keynes‘s thinking.
For Keynes‘s disciples, the idea could be applied not just in depressions, but to smooth out the
business cycle, to fine tune the economy, to eliminate fluctuations in GDP. Unfortunately, this
didn‘t work out so well. Keynesian fiscal policy failed to deliver low unemployment and low
inflation, which is what we were looking for. From the 1960s to the 1970s, unemployment and
inflation both went up significantly.
Four reasons why economists rejected fiscal policy to deal with business cycle:
1) We realized the fiscal multiplier was much, much smaller than early textbooks suggested.
Instead of a multiplier of something like 5, we saw that changes in government spending
had a multiplier of about 1.5, and tax cuts had a multiplier of about .8.
2) Investors would know that interest rates would rise in the future when the government has
to compete with private investors to have money to spend. When those in the bond market
know that interest rates will go up in the future, they‘ll wait to buy bonds until the price
falls, and then the price will fall immediately and interest rates will rise immediately. When
the government raises the fiscal deficit in the short run, it had the direct effect which
increases GDP, but it also has the interest rate effect of increasing real long term interest
rates. This depresses housing and business investments which reduces GDP.
3) We realized that there were long lags when implementing fiscal policy. There are
recognition lags, as it takes some time to realize you‘re going into a recession. There are
also legislative lags, as it takes time to get fiscal policy through the Congress. There are
implementation lags. Finally, there are impact lags between the time when the money starts
to flow and when it changes aggregate demand.
4) There was also uncertainty about the state of the economy about how to know if we were in
a recession, what exactly the multipliers were, etc. So, economists became much more
cautious about implementing fiscal policy.
All of this led to a sense that we should rely much more on monetary policy and less on fiscal
policy, because there is no long term debt or interest rate problem by using monetary policy.
There are also much shorter lags when using monetary policy. Also, with monetary policy you
can move in small steps, only cutting the interest rate a little bit. Or, if you realize you‘ve gone
too far, you can bring the interest rate back up a little. Monetary policy is just much more
flexible.
Conceptually, some economists began to question Keynesian policies in the 1960s and 1970s.
However, the policies were still very much Keynesian, and they pushed unemployment so low
that it stimulated inflation to sky rocket.
Ec 1420 Page 39
Keynes thought the great depression was caused by too much savings. Thus, the USA literally
implemented policies to disincentivize savings, like social security, taxing return to savings
much more heavily than return to labor, etc.
Keynes was also very focused on the short run. He said that ―In the long run, we‘ll all be dead‖
in response to the idea that we don‘t need fiscal policy because eventually the economy will get
back on track by itself.
By the 1970s and 1980s, people realized that these policies weren‘t working, and that savings
was important, faith in government activism fell, etc.
Monetary policy is currently ineffective, because our credit markets are broken and not providing
credit.
All the issues that Prof. Feldstein brought up in lecture are still valid, but most economists still
think we need a fiscal stimulus.
We ought to ask of each project when designing the stimulus, what‘s the change in GDP from
this project (how much bang are we going to get from increased aggregate demand?), and how
valuable is this activity to society?
Ec 1420 Page 40
Lecture 9
Monday, February 23, 2009
8:03 PM
Capital $100
In addition to that bank put out sign and said I‘m a bank come and make deposits
People make deposits and deposited $800
Those are the liabilities of bank = $900, what it owes to depositors and equity holders
Then it loans out money so say $900
So total assets = $900
Note that for every dollar of capital they have 8 dollars of deposits so that why did they need to
have capital there
Let‘s say that what we see is that some loans go sour, don‘t repay so that the value of the loans
falls to 850
So assets are only $850, not that they‘ve been paid off, they went sour, defaulted on those loans
So what‘s happening? Still owe 800 to depositors, so what‘s changed is capital, capital that's left
only $50
So bank regulator says you‘re living too dangerously, if you lose another 50 you would have no
capital and another 50 you wouldn‘t be able to repay depositors
So regulators can say you can‘t live that way, have to raise more capital or you have to shrink the
number of loans you make, which means you don‘t want as many deposits so you‘ll shrink that
as well since you pay interest on the deposits and having them sit there is not good
Govt comes and looks at bank and says you‘ve got a lot of bad loans there, no one really knows
how many bad loans you have, so nobody wants to invest in you and give you more capital,
you‘re not earning new profits to build up capital, so either shrink a lot (meaning less credit in
economy and economy shrinking) or we the govt will infuse some capital in, as part of the TARP
plan, the govt went in and dropped $10 billion here or there
So in addition to private 50 capital, put in govt 50 capital then you will have your original 900
and not only that, you could actually go and do more lending and expand
But bank isn‘t really sure that it really has 850 of good loans, maybe only 750, so afraid to do
additional lending so banks hold back on that, and that‘s what‘s happening now
Variety of proposals
One is to inject more capital, another is for govt to buy up some of these loans, now talk about
govt taking over entire bank and restructuring
But too much to discuss, basically are two kinds of bad assets
1. Residential mortgages, 1 out of every 4 mortgages is underwater – loan exceeds value of
house –
2. commercial mortgage – corporate loans, credit card debt, auto loans, so more complex
problem than people are confident to solve
Feldstein thinks diff solutions for mortgage part and non-mortgage part
Hard to value b/c don‘t know what kind of defaults are coming along as house prices continue to
fall
Really are two separate problems in the mortgage area, president announced program which
deals with one and not other
1. affordability – people took out mortgages with low interest rates that have gone up (teaser
rates) or someone in the household lost income b/c of loss of job or other reason so ability to
afford monthly payments has gone down
so mr. banker why don‘t you lower the monthly payments to 38% of disposable income of that
household and if you do that, says the govt, then if you want to lower it further to 31% (why
that‘s the magic number, I don‘t know) then we in Washington will share the burden with you,
the govt will subsidize that reduction in interest rate
in no doubt will help some people stay in their homes; what we know from mortgages that have
been fixed in this way, still a large number of them default b/c of 2nd problem
2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house
Ec 1420 Page 41
2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house
is worth, why shouldn‘t I throw in the keys rent for a few years, come back and buy a similar
house at a lower price, govt hasn‘t dealt with this
Why?
S-INV=EX-IMP
Why? If we save more than we invest,
Saving is household, business, govt combined, if we save more than invest, we have excess
resources, what do we do with them? We can export them to rest of world
On other hand, if we invest more than we save, then we have to get physical resources from
some place—rest of the world
This is not some powerful theorem of economics, not some empirical finding, this is an
accounting identity known and loved since beginning of economics
GDP or Y = C + I + G + NX
What is Y – C – G = national saving
So national saving = I+(Exp-Imp)
Or S-I = Exp-Imp
What makes it hold? What is the market process?
The answer: exchange rate, the price that makes this work
When savings rate goes up, that leads to a fall in the dollar, which makes U.S.
Makes interest rates lower, lower the dollar, increase exports and decrease imports
Let‘s start with nominal exchange rate
Nominal exchange rate is by definition is number of foreign currency units per dollar
The people who do the exchange rate statistics sometimes do it in reverse but we will always
mean the number of foreign currency units per dollar
You can imagine
For example 115 japanese yen would be exchange rate b/n yen and dollar
But saying all other things equal, means prices haven‘t changed, so think of a measure that takes
prices into account and that‘s the real exchange rate
What matters for trade purposes is the real exchange rate
Japanese yen and think that initially the exchange rate was 110 yen per dollar
Ec 1420 Page 42
Japanese yen and think that initially the exchange rate was 110 yen per dollar
Let‘s imagine what happens if the prices in u.s. unchanged, and prices in japan are unchanged,
but what happens if the yen goes from 110 to 100 yen per dollar, so dollar declines in value
Only get 100 yen now
Think about buying something, a camera, the camera costs $22,000 yen
So at 110 yen per dollar, that‘s equal to $200
But now at 100 yen per dollar, that‘s equal to $220
Now let‘s consider a slightly diff scenario in which the yen now is going to stay at 110 yen per
dollar but instead is that prices in japan are going to increase by 10%, so the camera that used to
cost 22,000 is now going to cost 24,200 yen so $220
So we can get the same impact on the American consumer either by keeping prices in two
countries the same and have exchange rate move by 10% or we can keep the exchange rate the
same, and prices in japan go up 10% and cause price in dollars to change
Summarize that by saying real exchange rate = nominal exchange rate x (price in u.s./price in
other country)
Put a star/asterisk on something to refer to other country
Real exchange rate = e x (P/P*)
You can add them all up and compare to all exchange rates by weighing depending on amount
goods sent abroad
Try to understand why it is the exchange rate moves, what causes the movements of the
exchange rate
The exchange rate is a single variable in complex general equilibrium system
You can‘t say X moves the exchange rate, but helpful to identify some of factors
1. changes in price levels at home and abroad
if the price level goes up in mexico, what‘s going to go up, the nominal exchange rate should go
up to keep the real exchange rate the same
this theory is called the purchasing power parity
does it work? Sort of, it works in the long run, if you imagine that price level of mexico doubled,
obviously something would happen to peso to dollar exchange rate, b/c otherwise no one would
buy
when there are big moves associated with high inflation rates, the purchasing power parity works
pretty quickly, when there are small differences in inflation there‘s a long run tendency for
purchasing power parity to hold, but it is something that links price levels
2. balancing trade
the u.s. is fortunate in sense that it‘s able to borrow from rest of the world
if there is a trade surplus, then the currency appreciates, if deficit, currency depreciates
now come to something that isn‘t just a long run tendency but something that happens in real
time, a condition that has to hold in financial markets
Ec 1420 Page 43
you‘re an investor with 1 year horizon, here‘s question, you could buy u.s. treasury bill with 3
percent yield
i for u.s. is 3%
or buy a german one, i*=4% yield
the exchange rate is .8 euros per dollar
but if everyone agreed no change in exchange rate then everyone would invest in german
currency, causing it to be bid up, so that would change exchange rate
when would it stop? When the condition is held
when .04=.03+.01
i*=i+E(change in e/value of e)
going to get 3% here, but if I expect dollar going to become 1% more valuable then I‘m
indifferent
here‘s a picture
difference b/n foreign interest rate and u.s. interest rate
at the beginning of year has to be expected that dollar come down
if look halfway thru the year, still getting higher interest rate but now only for 6 months so at end
of 6 months euro has to work it‘s way half way back so next six month has only half of a percent
to fall
so when go away and think about this, make sure that you are firm in understanding in diff b/n
change in exchange rate and the expected change in the exchange rate in the coming period
Ec 1420 Page 44
Lecture 10
Wednesday, February 25, 2009
8:04 PM
Determinants of exchange rate ($)
1. PPP and nominal rate
2. balancing trade
3. ‗‘ S+D currencies
4. speculation
5. govts
we were talking about minute by minute determination of exchange rate – the supply and
demand of currencies
fundamental to that is interest parity condition, that the foreign interest rate must be equal to the
domestic interest rate plus the expected percentage change in value of exchange rate
look at graph, euro becomes suddenly more valuable (if interest rate increase is 1%, the
exchange rate drop is 1% and then gradually appreciates)
be sure you clearly understand the diff in statement ―the expected change in the exchange rate at
that point‖
the distinction b/n that and the instantaneous change of the exchange rate
when interest rate jumps by 1%, the immediate effect is that value of dollar falls by 1%, but
expected to increase at 1% annual rate going forward
this is a riskless picture of the world
more realistic would be i*=i+(expected change in exchange rate)+risk premium for foreign
currency
let‘s say you think that dollars are much much safer than even euro currencies, b/c you read in
newspaper that Greece may go bankrupt
so have
i*=.04
i=.03
risk premium=.005
so expected increase in dollar is only .005
have to bear in mind risks may change
done all this in nominal terms, but what about real?
The same relationship holds for real interest rates and real exchange rates and won‘t take the
time to do it but
If did real interest rate = real interest rate in U.S. + change in the real exchange rate
i*-pi*=(i-pi)+E(change in nominal rate times fraction of prices/initial value)+risk
if you have a temporary surge in interest rates, then the ten year rate wouldn‘t move, but saw
back then, a sustained increase in the long term interest rates
let‘s look at that calculation, w/ help of friendly diagram
with respect to trade it was overvalued, but perfect equilibrium for trades b/c interest rate is
higher in US than abroad so other set has to be compensated by form of appreciation of euro vs.
dollar for interest differentiation
this shows you how relatively small movements in interest rates can have powerful effects on
exchange rate
budget deficit may cause a substantial increase in interest rates, which lead to a move in the
exchange rate, making large swings in the trade balance
Ec 1420 Page 45
so far we‘ve left out speculation
people anticipate where the dollar has to end up
look at the interest differential
and they make investments based on that
but we also know that in any financial market, speculators react to rumors, the govt may be
doing this or some foreign govt doing that, and they react
many of the investors – guys looking at screen – ―the trend is my friend‖
―momentum traders‖ – look at what‘s happening at market, don‘t have underlying philosophy,
and they bet on the trend, they mean from now until lunchtime
so when you actually try to look at the numbers, there are anomalies, people who made bets
based on rumors, all we can do is say that there are these speculative things, so shouldn‘t expect
equations to hold perfectly
great deal of uncertainty associated with it
still the fundamental forces of trade balance, purchasing power parity and interest parity
condition continue to provide basic driving force
Now if it‘s an unwarranted speculation, hedge funds thinking Thailand is pretty vulnerable,
momentum traders will join us, we‘ll borrow bhat, sell it at high price, then buy it back at low
price, purely speculative
Thailand has enough reserves that they can fight back, so what we‘ve seen after the 1997-99
asian crisis is that asian countries that had relatively small reserves, built up large reserves so if
there was a speculative attack, they could fight back, Taiwan $200 billion, china $1 trillion?
Then there‘s a diff kind of intervention and that is purposely trying to keep their currencies low
Japan did it for a long time
China has been doing it, in order to make foreign goods less attractive domestically, they reduce
the value of their currency
Why does that speculation work?
b/c if you‘re japan wanting to keep yen weak, you could do it; you could print yen and buy
dollars
and speculators say they‘ve pushed it artificially low, we‘ll buy, then govt can just print more
yen
in any case, govts have shown a willingness to do that, to spend vast amounts of resources to
drive down their currencies
in general, govts don‘t do that, the Chinese claim they‘re not doing that, they certainly were
doing that for a while, doing it much less, and the Japanese were clearly doing it and stopped
years ago
what‘s the situation now and what‘s going to happen going forward?
We have an enormous current account deficit, foreign investment is exceeding u.s. investment in
Ec 1420 Page 46
We have an enormous current account deficit, foreign investment is exceeding u.s. investment in
rest of world, there is a capital inflow
The result of that is that foreign investors in US have accumulated 15 trillion in u.s. assets
We have foreign assets abroad, but they‘re in excess of 15 trillion which is equal to about our
entire GDP so there has to be a point where people get nervous about holding too many dollars in
their portfolios
Do the Chinese really want to have 2 trillion in US bonds when there‘s a risk that dollar could
fall by 10%? That would be $200 billion loss, $200 loss per person, a large loss for them
Is there an incentive for investors to keep doing it? That depends on interest rates
Right now, interest rate is slightly higher on euros than dollars, so unless you think there‘s a risk
premium for holding euros, or that you believed dollar was going to appreciate to offset the
interest differential – which is hard to believe as a long run proposition when we have 700 billion
trade deficit, euro has 0?
So dollar is going to have to come down
Why have we recently seen dollar strengthen?
History of the last ten years is that dollar starting coming down at beginning of this decade, came
down 25% ,and why did it come down? b/c of market recognition that it was too high, ultimately
it had to come down, so it had an expectation, also the fact that interest rates were slightly higher
in Europe than in u.s.
Than in 2007, dollar moved back up again, not b/c of big improvement in trade balance (oil
prices complicated this process) but b/c of risk premium, desire for most liquid and safest
currency in world (though germany isn‘t likely to default on debt)
What happens when investors around the world want to hold more dollars? They can‘t hold more
dollars b/c we have a current account deficit of 700 billion – how much money is going to come
into US net rest of the world –but they can bid up dollar and bid up prices of short term treasury
bonds, so dollar rose and interest on short term treasuries went down, quantities couldn‘t change,
availability couldn‘t change, so had to show up in the price
Going forward
We have to move toward trade balance, various technical arguments, but basic is this: we have
been enjoying receiving more goods and services from rest of world than we give back in form
of goods and services
For last decade, we‘ve been getting trillion dollars of extra goods from rest of the world and just
handing them IOUs, at some point have to get back on path in which dollar is gradually coming
down and make progress with shrinking deficit
Second thing that could happen would be a spontaneous rise in household saving rate
It got down to low negative numbers, most recent reading is up to 3.6%
Ec 1420 Page 47
It got down to low negative numbers, most recent reading is up to 3.6%
So S-I will go up, so exports-imports go up
Mechanism so make that happen is fall in the dollar
If dollar doesn‘t fall what happens to the economy
Should the US do anything about this? Try to accelerate this process? Maybe not trying to lean
the other way
The statement ―a strong dollar is good for the US economy‖ certain sense that is true – you can
buy things from rest of the world more easily but that adds to trade deficit
Strong dollar at home, competitive dollar abroad – new bumpersticker
The dollar fall from 2002 to 2007 had no intervention by US, no attempt to slow it down
But we do keep making this silly remark
Implications
Dollar is going to come down over next several years
Shrink trade deficit – good for US manufacturers and service firms, restaurants and others,
people will substitute towards US goods away from foreign goods
As a whole
1. eliminating trade deficit means more GDP goes abroad, so that‘s a serious loss
if we normally grow at 2.5% a year, and now giving up 4% of GDP And spread over 5 years,
that‘s .8% each year subtracted
2. terms of trade effect – what we buy from rest of the world, what we exchange our stuff for,
has become more expensive, so the cost of those goods reduces our standard of living
what happens in the long run depends on what happens with our savings rate
if it goes up, and if we can translate that higher savings into not a fall in GDP But an increase in
net exports, yes there will be a transition period during which incomes will grow less quickly, if
savings rate is higher, ability to grow domestic investment will be higher, and the potential GDP
growth rate will be higher
watching a race b/n offsetting factors, whether rate of capital accumulation is high enough to
offset other slowdowns, tax laws and social security will help determine that
Ec 1420 Page 48
Article Summaries Before Midterm
Tuesday, March 10, 2009
1:12 AM
Economics 1420 Final: Article Summaries
Martin Feldstein – “Housing, Credit Markets and the Business Cycle” (2007)
Housing sector is at the root of 3 problems:
1) Falling house prices
o Sharp surge in house prices after 2000, 3.4% decline in house prices (2006 to 2007)
o Decline in housing construction – such declines precursed 8 of the last 10 recessions
o Why did home prices surge over past 10 years?
Credit was cheap/easy to obtain
Fed cut interest rate to 1% in 2003, kept it low – caused promotion of mortgages with
low temporary “teaser” rates, mortgage money was easier to obtain
o If house prices now decline, there will be serious losses of household wealth, causing a
decline in consumer spending
2) Widening credit spreads
o Risk became underpriced – difference in interest rates between US treasury bonds and
riskier assets were much smaller than before
Investors took comfort in apparent risk transfer to structured products
Less sophisticated investors were buying structured products without understanding
level of risk involved
Hedge funds/PE firms substantially increased their leverage
o Subprime mortgages – mortgages loans to high risk borrowers with low or uncertain
incomes, high ratios of debt to income, and poor credit histories
o Borrowers with subprime credit ratings took adjustable rate loans to get in on the house
price boom
o These loans were bundled into large pools of mortgages and sold – risk of these pools was
definitely underestimated
o Subprime problem unfolded with high default rates on subprime loans
o Combination of subprime defaults and widening of credit spreads – triggered a widespread
flight from risk
o Investors and lenders also became concerned that they did not know how to value complex,
risky assets
3) Declining mortgage credit for consumer spending
o High potential for substantial decline in consumption in response to lower home equity
withdrawals through home equity loans and mortgage refinancing
Starting in 2001, combination of lower mortgage rates and rapid rise in house prices
led to widespread refinancing with equity withdrawals
A lot of the new borrowing was used to finance consumer spending
Decline in house prices/increase in mortgage interest rates shrinks the amount that
people can spend, increasing household saving and decreasing aggregate demand
o This effect is in addition to the reduced wealth caused by fall in home prices
Ec 1420 Page 49
o Other view: look at both goals, thus decrease Fed funds rate for two reasons:
Dramatic decline in residential construction is an early warning of a coming recession
Adopt a risk-based “decision theory” approach in responding to current economic
environment – due to all of the causes above
Purpose: The authors analyze the role that monetary and fiscal policy have played in recovering from
the 8 recessions in the US since 1950, in order to (1) determine if government action actually aids
recovery and (2) make recommendations about what policies should be used in future recessions.
Thesis: Monetary policy has been enacted shortly after the beginning of most recessions and has been
the source of most postwar recoveries; fiscal policy hasn’t been enacted until the trough was reached
and typically was too small to have much of an effect.
Summary:
- Record of Policy Actions Since 1950
o Monetary policy: nominal and real interest rates typically fell by several percentage
points before most troughs
o Fiscal policy: “high-employment surplus to trend GDP” (adjusts for the impact of
economic activity on govt receipts and expenditures) only fell slightly around troughs
and shows that discretionary fiscal policy only tended to become slightly expansionary
late in recessions; on the other hand, automatic fiscal policy (i.e., the lower taxes and
higher unemployment benefits that occur during recessions) was much more
expansionary
- Sources of Policy Changes
o Nearly all monetary and most fiscal changes were anti-recessionary, but the largest
fiscal expansions were taken to speed up growth
- Lessons from Postwar Economic Policies
o Monetary Policy:
Can respond quickly to changes in economic conditions
Most periods of high inflation are not the result of anti-recessionary monetary
policy carried to far, as often asserted
o Fiscal Policy
Limited fiscal stimulus can be undertaken rapidly, but is limited to actions that
can be taken without Congressional approval
No examples of major anti-recessionary spending changes; most large fiscal
actions were taken in response to slow recoveries
- Effects of Policy Actions
o estimate contributions of monetary and fiscal policy to recessions and recovery
o results are varied, but suggest that monetary policy has been crucial in ending
recessions while fiscal policy has not contributed much
- Other Related Issues
o There is little evidence that discretionary policy has had a consistent stabilizing
influence, and there are actually several instances in which expansionary policy has
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influence, and there are actually several instances in which expansionary policy has
actually exacerbated fluctuations
o The component of fluctuations that is due to shifts in government policy is highly
persistent and accounts for a large part of the persistence of overall output
movements
Thesis: A monetary policy rule in which the interest rate responds to inflation and real output
aggressively is the best policy rule. The Fed has followed a policy similar to this since the late 1980s, and
this policy likely contributed to the macroeconomic stability of the era. On the other hand, the Fed was
much less responsive to inflation and real output deviations in the earlier gold standard era or the 1960s
and 70s, which may have contributed to the suboptimal economic performance during these periods.
Summary:
- A monetary policy rule for the interest rate provides a useful framework for examining US monetary
history, and can be derived from the quantity equation of money (MV = PY).
o Specifically, Taylor uses the following functional form: r = + gy + h( - *) + rf
o r = short term interest rate, = inflation rate, y = percent deviation of real output from
trend, and g, h, *, and rf are constants
o The two key response coefficients are g (= responsiveness to real output deviations) and 1+h
(= responsiveness to inflation deviations); differences in these coefficients makes a big
difference for the effects of policy (for example, if h < 0, then increase in inflation causes a
rise in the nominal interest but a fall in the real interest rate, which actually puts further
upward pressure on inflation)
- A monetary policy that responds to inflation and real output is an implication of many different
monetary systems, including constant money growth, the international gold standard, and ‘leaning
against the wind’ (i.e., when the Fed sets short-term interest rates in response to events in the
economy)
- The monetary policy rule has evolved dramatically over time in the US, and these changes have been
associated with equally dramatic changes in economic stability
o The size of the coefficients g and (1+h) has increased over time, and are now close to the
values suggested by the famous “Taylor Rule”
o This evolution of monetary policy is best understood as a gradual process of the Federal
Reserve learning how to conduct monetary policy; macroeconomic events, economic
research, and policymakers at the Fed have gradually brought forth changes in the US’s
monetary policy regime
o Rules in significant time periods:
Gold standard era (1879-1914): short-term interest rates were very unresponsive to
fluctations in inflation/real output (i.e., low g, h) lowest degree of economic
stability, once we adjust for the gold standard effects
1960 – 1979: slightly more responsive, but h still <1
1986 - 1997: interest rate much more responsive greatest degree of economic
stability
- A monetary policy rule in which the interest rate responds to inflation and real output more aggressively
than during the 1960s and 70s or than during the international gold standard era, and more like the late
1980s and 90s, is a good policy rule
- “policy mistakes” (periods when the Fed deviated from the good policy rule described above) have
occurred 3 times and have been associated with either high and prolonged inflation or drawn out
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periods of low capacity utilization
o 1st episode: the early 1960s - too tight monetary policy, led to slow growth
o 2nd episode: late 1960s-1970s – too easy monetary policy, led to the Great Inflation
o 3rd episode: early 1980s –too tight monetary policy, which led to capacity underutilization
Martin Feldstein – “The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy”
-Long-run unemployment independent of level of inflation—monetary policy temporary
-Are short run benefits of monetary expansion greater than LR costs of inflation?
-Feldstein believes that it’s almost always better to have low inflation
-Inflation is an implicit tax on money balances
-Inflation causes an immediate decrease in welfare dependent on the change in inflation, the elasticity
of real money demand, and the size of the real money stock
-If the economy is growing at its potential rate, inflation and elasticity should be constant
-Money supply grows at same rate as real economy
-So when we’re considering the costs of inflation, we need to calculate:
-The size of future losses (which depends on growth rate of economy)
-And the present value of those losses
-Losses from inflation will theoretically be infinite if the growth rate of welfare losses exceeds the rate
we use to discount future losses
-It seems like many real-life situations fall into this category
-Economic policy should focus on reducing inflation rather than increasing unemployment in the short-
term
-Additionally, if deflation is the optimal solution, we should always embark on this policy
immediately – more costly to wait
-If the growth rate of the economy exceeds the social discount rate, inflation is never justified
Ec 1420 Page 52
policy objective that can be reached by a relatively simple policy framework primarily based on one
economic forecast. From the public's perspective, the central bank's commitment to a policy framework,
including a long-run inflation target, imposes discipline and accountability on the central bank. This
serves to anchor inflation expectations, making the private sector a partner in the policymaking process.
Ec 1420 Page 53
National Saving = Private Savings – Budget Deficit = I – Borrowing
-Keeping investment larger than savings implies a growing debt stock
-High national savings leads to higher future living standards by either:
-Financing investment directly
-Reducing foreign borrowing
-“Twin deficits” – budget deficits and current account deficits are often linked
-National saving has dropped because household private saving has fallen AND because budget deficits
have increased
-Currently, the debt to GDP ratio is steadily climbing
-It grew sharply in the 80s (tax cuts, increased spending)
-And fell during the boom years of the 1990s
-Budget deficits can be expected to increase further (Medicare, Social Security) if drastic changes aren’t
made to these entitlement programs
-Proposed reforms to Social Security should increase national savings
-Increase in payroll taxes
-Add-on, mandatory private savings accounts
-Bush proposes carving individual savings accounts from existing payroll taxes
-This would increase private savings
-But decrease public savings
-And so have no effect
-Automatic enrollment in employer defined-contribution accounts
-Individual Retirement Accounts w/ tax benefits
-Would these actually increase the savings rate or just divert current savings
-Would the increase in private savings offset the fall in public?
-How long can we run budget deficits?
-Few other countries have run trade deficits for more than five years
-Maybe we have a case of co-dependency?
-US unwilling to save
-Rest of world keeps their currency weak, exports to US
-Are other countries building stocks of assets to deal with aging populations?
-Could explain huge investment in US capital
-Home-bias eroding – open capital markets are weakening the link between domestic saving and
investment
-We don’t know which of these is the right answer
-But raising national savings is certainly the safest option regardless
-US would gradually cut budget deficit
-Monetary policy could offset decreased expenditure
Lusardi Skinner and Venti – “Savings puzzles and savings policies in the US”
Savings rate has fallen from double digits to less than zero in the last 20 years
o Half can be attributed to stock market gains expended by households
Stock market gains drive down the savings rate
o 30% goes from savings into bonds
o More wealth allows consumers to consume more
Savings rate measure by the NIPA (National Income and Product Accounts)
o Very narrow and potentially defective way to measure savings rate
Despite this decline in savings, national saving and foreign capital flows have
remained strong
o Cannot measure if people are ready for retirement or recession
Study shows that about half of the population will keep enough for retirement,
and the other half won’t
o Still provides a measure of how much people are saving
Low income and low savings groups have stayed the same
Households with little wealth in 1989 still have little in 1998
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o Households with little wealth in 1989 still have little in 1998
o Position has not changed and still do not appear to save anything
o Saving is made difficult since low-income workers often aren’t offered/given pensions
Have no designated fund or habit that encourages saving
S = rW + E – T – C
o Savings = (rate of return)*Wealth + Earnings – Taxes – Consumption
Savings = Contributions + Interest and Dividend Earnings – Benefits Paid
Capital gains probably account for most of the decline in the savings rate
o NIPA’s measure of the savings rate excludes capital gains, so it does not show how much
people earn from investment
Half of Americans hold stocks
The top 1% of American households may keep up to 53% of household holdings
in stocks
Those Americans that gained the most in the stock market also saw their savings
rate decline
Another contributing factor to long-term decline in savings rate: easier availability of debt
Many households have gained significant wealth even though the savings rate slipped
o A segment of the population remains that does not save enough
The focus of the paper is NOT on the past five years but the larger trend from 1980 that saw a boom of
6% in consumption/income
Seven Conclusions:
1. Lower savings is not due purely to a rise in durable goods. That is, households increased consumption
has not been on lasting purchases
2. Higher consumption cannot be explained by a “crowding-in” effect. That is, if higher household
consumption was matched with decreases in government spending we might conclude that there was
“crowding in” but government spending has also increased.
3. Changes in household wealth/income can explain, at most, 1/5 of the increase in consumption. The
consumption boom began BEFORE wealth/income began to rise so we can’t say this is causal
4. During the period of high consumption, the growth rate of real consumption/capita was low and real
interest rates were high. This is surprising, we would expect that higher r would cause an increase in
savings.
5. Changes in the age distribution of the country were found to not be significant in explaining the
consumption boom.
6. Relaxed liquidity constraints that make accessing credit easier can only explain about 1/3 of the
increase in consumption.
7. Consumption/income ratio has gotten larger with each successive generation.
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relaxed liquidity has allowed younger generations to access more credit
This is a combination of two theories but seems to be better than either theory alone
- The increase in consumer spending / decreasing in savings is the primary reason for large
trade deficit
- A large amount of the capital inflows that are coming in are likely from governments
o This means the capital inflows aren’t dependable into the future because we can’t
predict their action, a reason we need to decrease our dependence
- There is a coming rise in household savings
o House prices/share prices will not increase at same rate
o Mortgage rates have stopped falling (this is 2006)
o Then eventually we will be less dependent on foreign capital for investment
Which other countries need to prepare for, ie. They will have fewer exports
o Potential for a recession if the trade deficit does not adjust quickly to higher savings
rate, causing a slowdown in growth of output and employment
Feldstein and Horioka – “Domestic Saving and International Capital Flows” (1980)
Two views on saving and capital flows:
1. With “perfect world capital mobility” there should be no relation between saving and domestifc
investment
2. With portfolio preferences and institutional rigidities impeding capital flow, domestic saving and
domestic investment should coincide
a. Evidence has shown #2 to be most true
Paper reconciles this with the fact that short term capital is highly mobile internationally and the
existence of substantial international flows of long-term portfolio and direct investments
Implications for knowing this information
1. Optimal Savings policy affected because in a closed economy the country gets all the benefit
of the pretax marginal product of capital. In a capital-mobile world, most incremental saving
Ec 1420 Page 56
of the pretax marginal product of capital. In a capital-mobile world, most incremental saving
will leave country and so country only benefits from net-of-tax-return of investor (doesn’t
get tax revenue)
2. Tax incidence: owners of capital bear tax on capital in closed economy. In capital mobile
country – burden could be shifted from domestic labor to foreign capital owners
Seems reasonable that capital flows among countries to eliminate short term arbitrage in yields
- However, risk aversion considerations effect long-term arbitrage potential
o Thus, changes in savings rates or tax rates can occur without incudcing international
capital flows
- Also, there are restrictions on capital export
- Also, there are institutional rigidities, such as in the U.S. savings institutions must be
invested in local mortgages
- Also some evidence that investors are not maximizing returns net of tax
- Also most capital outflow is used for marketing, overcoming trade restrictions, and not
necessarily finding most profit
Due to all these considerations, must look at empirics to find answer.
Evidence shows that nearly all of incremental savings remains in country of origin!
Rest of paper describes statistics and facts and numbers.
Conclusion: International differences in domestic savings rate among major industrial countires have
resulted in almost equal corresponding differences in domestic investment rates. Yet, this is compatible
with short-term liquidity, since most capital is actually not available for arbitrage among long-term
investments. Also it is compatible with long-term portfolio and direct investments, since much of this is
not direct maximum profit seeking
Ec 1420 Page 57
a. The immediate effects of budget deficits
i. The effects of budget deficits all follow from the fact that deficits reduce
national saving.
1. National saving is the sum of private and public saving. When the
government runs a budget deficit, public saving is negative, which reduces
national saving below private saving.
ii. A decrease in public saving produces a partially-offsetting increase in private
saving.
iii. Another way to define national saving is current income not used immediately
to finance consumption by households or purchases by the government.
1. S = Y- C – G
2. S = I + NX
iv. **When budget deficits reduce national saving, they must reduce investment,
reduce net exports, or both. The total fall in investment and net exports must
exactly match the fall in national saving.
1. In reducing net exports, budget deficits create a flow of assets abroad.
2. These changes are brought about by changes in interest rates and
exchange rates.
3. A decline in national saving reduces the supply of loans available to
private borrowers, which pushes up the interest rate.
4. A rise in interest rates increases the demand for the domestic currency in
the market for foreign exchange, causing the currency to appreciate.
a. Domestic goods are more expensive for foreigners.
b. Budget deficits in the United States
i. It is hard to find empirical work on the effects of budget deficits, since countries
do not run fiscal policies as controlled experiments (identification problem).
ii. Beginning in the 1980s, the U.S. began to run a deficit.
1. As compared to the period of 1960-1981, the period of 1982-1994 saw
public savings fall 2.4% of GDP, private savings fall .4%, national savings
fall 2.9%, domestic investment fall .8%, and net exports fall 2%.
c. Long-run effects of deficits: output and wealth
i. When a government runs deficits for a sustained period, a stock up debt is built
up. The accumulated effects of the deficits alter the economy’s output and
wealth.
1. When deficits reduce investment, the capital stock grows more slowly
than it otherwise would.
2. National income falls when foreigners receive more of the return on
domestic assets.
ii. Deficits also alter factor prices: wages and profits.
1. Because budget deficits reduce the capital stock, they lead to lower real
wages (smaller marginal product of labor) and higher rates of profit
(greater marginal product of capital).
d. Long-run effects of deficits: future taxes
i. The resulting government debt may force the government to raise taxes when
the debt comes due.
ii. The government may never need to raise taxes. Instead, it can roll over its debt.
1. **As long as the rate of GDP growth is higher than the interest rate, the
ratio of debt to GDP falls over time. Thus, the economy can grow its way
out of the debt.
2. However, future interest rates and GDP are uncertain.
3. The government may be forced to increase taxes or cut spending.
4. **By raising taxes or cutting spending initially, the government can reduce
the risk of more difficult fiscal adjustments later.
II. The size of the effects
a. A parable
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II. The size of the effects
a. A parable
i. Assume: “one night, the debt fairy travels around and replaces every U.S.
government bond with a piece of U.S. capital.” This would affect:
1. The burden of debt service – A debt service of ~1% of GDP would be
eliminated.
2. The level of GDP – The creation of capital raises GDP by ~6%.
3. The real wage – Rises by ~6%.
4. The return to capital – Falls from 12% to 10.3%.
b. Is this the right calculation?
i. Experiment is correct if economy is closed and fiscal policy does not affect net
private saving.
ii. Capital inflows partly offset the crowding out of capital by debt.
iii. It is uncertain how private saving responds to the deficit.
c. Are these effects a big deal?
i. “The 3 to 6% fall in income due to government debt can be viewed as only a
moderate problem.”
III. Deficits and economic well-being
a. By the measure of GNP, deficits are unambiguously harmful.
i. Based on consumption, budget deficits are a type if income redistribution. This
occurs because of the change in the timing of taxes and because of changes in
factor prices.
b. Who wins and who loses?
i. **Pecuniary externalities – A shift in the tax burden will cause the demand for
some goods to rise, and the demand for other goods to fall.
ii. **Under a deficit, current taxpayers gain and future taxpayers lose.
1. Wages fall, harming workers, and returns on capital rise, benefiting capital
owners. These changes are pecuniary externalities.
iii. **The winners from budget deficits are current taxpayers and future owners of
capital, while the losers are future taxpayers and future workers.
c. Are the redistributions desirable?
i. Ability-to-pay: Income should be redistributed from those who are better-off to
those who are worse-off.
1. When crowding out raises the returns to capital and reduces wages, the
wealthy gain at the expense of the less wealthy.
ii. Because budget deficits shift taxes forward in time, they benefit relatively poor
current taxpayers at the expense of relative rich future taxpayers.
d. Should you worry about deficits?
i. If you save more to give to your children, you need not worry about deficits.
1. However, national income may be depressed by more than estimated.
2. A large poor population might threaten living standards of the wealthy.
IV. A hard landing?
a. How a hard landing might occur
i. **Hard landing - A rising debt-income ratio in a country may at some point lead
to a sharp decrease in demand for the country’s assets arising from a fall in
investor confidence.
1. Investors may fear government default, or policies aimed at not paying
back loans.
2. This is especially true if the debt is external (owed to foreigners).
3. Since much of the U.S. debt is owned domestically, a hard landing is less
likely.
ii. Latin American countries that had “hard landings” had less debt than the U.S.,
but most of it was external.
b. The costs of a hard landing
i. A hard landing would cause: a sharp fall in the price of domestic assets, a fall in
the stock market, an increase in interest rates, a depreciation of domestic
Ec 1420 Page 59
i.
the stock market, an increase in interest rates, a depreciation of domestic
currency, and an increase in exports.
1. In turn, there would be lower levels of physical investment.
ii. A hard landing could trigger a general financial crisis through an increase in
bankruptcies
c. A call for prudence
i. The fear of hard landings may be the most important reason for seeking to
reduce budget deficits.
Elmendorf, Liebman and Wilcox – “Fiscal Policy and Social security Policy During the 1990s” (2002)
Two Fundamental changes in US fiscal policy in 1990s:
o 1. Dramatic improvement in current and projected budget balance
o 2. Shift to a new political consensus in favor of balancing the budget excluding Social
Security rather than the unified budget.
Few changes in Social Security policy.
1. Improvements in budget balance:
o 1990 – CBO projected unified budget deficit exceeding $100 billion during fiscal year and
remaining next five years.
o 1992 – CBO projected budget def. would hit $350 billion and fall by half over next 4 years
and turn up again to pass $400 billion in 2002
o 2001 – budget recorded third consecutive unified surplus, CBO projected with unchanged
law, surplus would total more than $5.5 trillion over next decade. Stemmed from favorable
developments in economy and deliberate policy changes to reduce deficits.
o The remarkable improvement in budget outlook during 1990s can be much attributed to
policy actions, but also because of an economic boom and higher tax revenues.
2. Balancing budget excluding SS (rather than unified)
o Always thought it was important to balance the unified budget
o Summer 1999, political consensus shifted to excluding Social Security when balancing the
budget. Aimed to put SS into 75-yr actuarial balance.
o Part of the shift was because of projected long-term imbalances in the SS and Medicare.
They would require reform because of the aging population and rising cost of health care
(still a problem).
o In 1998 Clinton declared that saving Social Security was a priority and he would not support
any uses of the surplus besides for SS until the reform was accomplished.
o Despite Clinton’s policy reform efforts, Congress did not adopt the central features of his
budget framework SS and Medicare reforms were not enacted.
Major point: Clinton’s ideas on the reform of budget reporting (on-budget instead of unified) and Social
Security were worthwhile and ended up being a missed opportunity.
Office of Management and Budget – Budget of the United States Government: Analytical Perspectives,
2008
Very long-run budget projections can be useful in sounding warnings about potential problems. The key
drivers of the long-range deficit are, not surprisingly, Social Security, Medicare, and Medicaid. These
entitlements are projected to grow much faster than the rest of the economy for the next several
decades. Under current law, there is no offset anywhere in the budget large enough to cover all the
demands that will eventually be imposed by these programs.
An Unsustainable Path
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An Unsustainable Path
The budget is on an unsustainable path. Without comprehensive entitlement reforms by 2080, rising
deficits will drive debt to GDP ratios above their peak levels reached at the end of World War II.
Comprehensive entitlement reform could help avoid a budgetary crisis.
Economic Outlook
Current recession is anticipated to last until second half of 2009
Ec 1420 Page 61
- Current recession is anticipated to last until second half of 2009
o Economic output over next 2 years will average 6.8% below its potential
o Recession was caused by drop in house prices, which undermined solvency of financial
institutions and functioning of financial markets
- Near-Term Economic Outlook (2009-2010)
o Real GDP will drop 2.2% in 2009, not including effect of stimulus package
o Recovery in 2010 is anticipated to be slow because credit will continue to be tight as a result
of a slow recovery of financial institutions from their losses
o Excess supply of houses will suppress house construction
o Spending will still be muted due to reduced wealth of consumers
o Lowering of tax liabilities and increased Federal spending on unemployment insurance will
somewhat stabilize economy. But state spending will not increase.
o However, economic outlook will be uncertain because of lack of historical precedence of the
degree of trouble in the financial market
There might be further losses on mortgage-backed securities that will continue
to contribute to the credit freeze
- Outlook from 2011 to 2019
o The gap between actual and potential GDP will not be closed until 2015
- Housing Market
o National average price of a house will fall by an additional 14% between 3rd quarter 2008
and 2010 because of high number of vacant homes
o Foreclosure rates are likely to remain high while house prices continue to fall during the
next year
- Financial Market
o Late September 2008: financial market on the verge of freezing up
o Stock market plunged: further depressing household spending
o In addition to cutting Fed Reserve rate, the Fed had also extended its loan facilities to buy
troubled assets from banks
o Treasury provided 1st round of bailout money to banks and auto industry in late 2008 in
order to get credit to flow again (Troubled Asset Relief Program)
o However, it is too early to see if these actions will have an permanent effect
- Personal Consumption Spending
o Decline in employment, large decrease in wealth, and tight credit conditions all contributed
to reduce in consumption, which will continue to be restrained in the coming year as
unemployment rises even more.
Tight Credit decreases banks’ willingness to lend to consumers
Budget Outlook
- Baseline budget projection is designed to serve as a benchmark that legislators can use to assess
the potential effect of political decision, but not intended as a forecast of future budgetary
outcomes
o Thus, CBO’s baseline budget projection does not incorporate potential changes in policy
such as the stimulus package
- Outlooks for 2009: very bad…
o Enactment of stimulus package will further add to a $1.2 trillion budget deficit (8.3%GDP) in
2009
o Operation of Fanny Mae and Freddie Mac are included in federal budget because of their
takeover by the government
Adds $240 billion to total outlays
o Drop in tax revenue and increase in federal spending on bailouts also contributes to deficit
o Outlays: discretionary spending (Iraq, Afghanistan) and mandatory government spending
such as unemployment compensation, Medicare, Medicaid, Social Security
Unemployment compensation expected to double
The 3 entitlement programs anticipated to grow at 8% this yr
Discretionary spending expected to grow 4.6%
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The 3 entitlement programs anticipated to grow at 8% this yr
Discretionary spending expected to grow 4.6%
o Revenue
Tax revenue from both income and corporate income tax decreased from 17.7%
to 16.5% of GDP due to sharp drop in values of assets and losses in the financial
industry
- Outlook for 2010 to 2019
o Deficit will decline to 4.9% GDP in 2010 due to increase in tax revenue from alternative
minimum tax and the expiration of Bush’s tax cuts
o Will continue to fall to 3.3% in 2011
o Outlays:
Increase in Federal spending comes mostly from Medicare and Medicaid, which
grows by 7% a year
o Revenues will increase as a result of the expiration of previous tax cuts that restores tax rate
back to its level in 2001 and from growth in individual’s real income
- Budget Projection under Alternative Scenarios
o Used to project how different fiscal policies might affect baseline budget projection
o Spending on War in Iraq and Afghanistan: 2 scenarios
1. Troop level would be rapidly reduced in 2 yr period, allowing discretionary
spending from 2010 to 2019 to be $281 billion less than baseline estimate
3. Troop level would be reduced gradually over 4 yr period: discretionary
spending from 2010 to 2019 exceed baseline by $165 million
o Revenue:
Modification of Alternative Minimum Tax: lowers revenue
Feldstein – “How to help people whose home values are underwater” (2008)
MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse
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MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse
mortgages, while also injecting mortgage-replacement loans to stabilize the current positive-equity
mortgages, is best way to stabilize the economy.
Ec 1420 Page 64
that.
The Economist: “Popping Sounds: House prices are falling just about everywhere” (2008)
Housing prices in Las Vegas are 31.3% lower this year (2008) than last.
The housing slump in America is being echoed around the globe
In America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities
Ec 1420 Page 65
The housing slump in America is being echoed around the globe
In America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities
covered by the case-shiller index
Housing prices in China during the third quarter fell by over 16% in some cities
This article was very short and basically just said that housing prices are falling over the globe
Diamond and Kashyap: “Everything you need to know about the financial crisis”
Why has the stock market been so erratic for the last two weeks? (october 1 -14 2008)
Fundamental concern that the banking sector is going to collapse which will drag down the economy.
- the banking sector drives the economy because banks are integral to public confidence with
investing
- if lending markets freeze then the economy stalls
- this has been offset by rumour that the banking sector will be bailed out by government
intervention
What is the government doing about this?
1. Working to prevent the collapse of the banking system in the short term
- it is trying to do this by guarantying certain debt
- these guarantees are temporary (up to three years) and are aimed at enhancing stability
- it is also buying the preferred stock of banking companies
- this helps ease concern that banks cannot absorb their losses from the loan and security
investments they've made
2. Working to promote lending while the banking system recovers
- For very highly rated companies it will lend short term money directly
- this is so these companies which would otherwise be unable to have access to funds can resume
normal planning and spending
Why can't the market correct for this? Why should taxpayers have to pay for the mistakes made by
banks?
- The problem has become too large to be left to the market to correct.
- The Banking sector is paramount to the economy and the government is simply trying to keep the
banks solvent
- The private sector has no motivation to correct the problem because the banks are in such
extreme distress
Why are banks so hard to value now?
- "This crisis started because of losses related to mortgage-related securities and loans. The value of
such assets is very difficult to assess, in large part because the securities are not trading, and so
there is some guesswork in establishing their value"
Will the government plan work or are there risk?
1. The plan must be setup to ensure that banks emerge with enough capital to survive
- if they don't it’s a great waste of taxpayers’ money
2. The plan needs to be set up to avoid further panics
3. The taxpayers liability needs to be protected
Ec 1420 Page 66
expansionary fiscal and monetary policy to stimulate spending
NOT TRUE: In 1979 unemployment=6% (higher than average), but econ wasn’t in recession. Spells
of unemployment were short (mostly less than 4 weeks), usually under 25, especially teens
looking for part-time work or people new to labor force looking for first job. Those who lost job
were laid off and waiting to return (75% went back to original job).
Most of unemployment in American economy was due to adverse incentives and artificial barriers
(results of government policy) NOT inadequate demand
o Existing high unemployment benefits add to total unemployment by encouraging delay to
work. Under Keynes, it would relieve financial hardship without adverse effects
o In Keynes, there is inadequate demand, so minimum wage can raise wages without reducing
employment; in fact, min wage raises unemployment among those with low skills
Keynesian thinking exacerbated unemployment problem and contributed to rising inflation.
(Increasing inflation was caused by excess demand from expansionary monetary and fiscal
policies)
The Keynesian Fear of Saving
Keynes shows lack of interest/outright fear in savings
Capital accumulation is irrelevant: Depression brought high unemployment and low rate of
utilization of existing plants and equipment. Increase in demand could lead to higher output
without addt’l capital. Adding new capital might increase capacity, but not actual output.
Increased savings is harmful: Too much savings is the root of the depression (households want to
save more than firms want to invest)
Keynes’ ideas led to anti-savings policies (seen more in Britain/US than Europe)
The possibility of new depression from inadequate spending seemed to be less serious issue than
urgent need to replace and rebuild capital stock that had been damaged
US and Britain have some of the lowest savings rate (US=15% of GNP)
o 60% of that is needed to replace stock that is wearing out
o Only 6% of GNP has actually been devoted to increasing new capital stock aka net
investment
That’s about half other industrial countries
Half of that goes to housing an inventories
Leaving 3% of GNP for real stock of plant/equip
o Stock of Plant and Equipment grew by 3.8%, # workers in labor force grew 2%, amount of
capital per worker only grew 1.8% (about half of other countries)
o In more recent years, share of national income dropped, growth of labor increased, meaning
capital per worker is unchanged, perhaps even falling
Growth and the Investment Imperative
Additions to the stock of plant and equip can earn real net rate of return (before tax, after
adjusting for inflation/depreciation) of about 11%
o Giving up $1 of consumption today leads to additional $0.11 each year for indefinite future.
Reason why American should save and invest more because investment translates into increased
productivity, greater national income, and higher standard of living
Faster capital accumulation does NOT create jobs/reduce unemployment
Increased rate of investment does NOT eliminate/reduce inflation
Our low rate of savings reflects series of policies that trace back to Keynesian fear of savings: tax
rules that penalize savings, social security which makes savings unnecessary, credit market rules
that encourage large mortgages/extensive consumer credit, large gov’t deficits that absorb private
savings
o Impact of sum of all policies is greater than of individual policies taken alone
Now, no longer fear that savings will lead to unemployment and we understand that higher
savings is needed for increased investment.>> label of “supply-side economists”
Tradition of easy money goal should be rejected in favor of tight money, high real interest rates,
and fiscal incentives to encourage investment in plant and equip
The Faith in Government Activism
Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should
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Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should
develop spending policies to eliminate social problems
Pre-Keynes view= economy functions best when it is disturbed the least
Depression changed that view>> lack of faith in market system>>belief in active gov’t stabilization
and general confidence in gov’t ability to solve social problems
Keynes’ calling on gov’t to spend changed perceived role of the gov’t
o Gov’t spending is no longer limited to necessary public services, like defense/court system,
and could be used to stabilize employment and output
o This lead to idea that gov’t should use its power to interfere in ind mkts to cure social prob
(gov’t health care, housing, social security)
The Uncertain Future
Keynes’ thoughts are deeply ingrained and will be difficult to change
Democratic political process may not be forward looking enough-many policies reduce unemploy
in short run, but increase in long run; also difficult to develop policies to encourage savings
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lower incomes, and further reductions in spending
Leads to reduction by additional $200B, Automatic stabilizers offsets about 1/3 of this, leaving
GDP gap of $400B
Need to increase by $400B in 2009, 2010: MUST turn to fiscal
Avg recession lasts 12 months, this one, already longer
Suggest: Permanent tax cut of $500 per employed person>> annual tax cut of $70B, increase in
consumer spending by $50B
R&D tax credit could help to offset decline in private R&D
Obama is postponing tax increase for high-income ind. Until 2011, but they look ahead. Taxes on
dividends and capital gains are scheduled to increase, but promise to leave the rates unchanged
would raise share prices, offsetting some of the fall in the market, leading to more spending and
increased business investment
Gov’t still needs to spend $300B to $400B (speed of outlays is important; as is avoiding
bottlenecks—ie bridges are important, but there are limited number of bridge engineers)
Spending Priorities
Health, energy, education, infrastructure, and support for poor
Some = from fed, but much from state/local
Surprising that:
o defense isn’t part of it, and that military spending will decrease
o Military training can be used to decrease unemployment, can lead to education in variety of
technical skills
o Temporary increases in FBI/intelligence would be good too
o No increase for research spending
What if it Fails?
Gov’t spending could increase more
Fiscal stimulus could shift from increased spending to substantial permanent reduction in personal
and corporate taxes
Fall in value of dollar (either spontaneous or planned) that is large enough to eliminated today’s
large trade deficit, thus boosting exports
John Taylor – “The Lack of an empirical rationale for a revival of discretionary fiscal policy” (2009)
There has recently been a dramatic revival of interest in discretionary fiscal policy, and the purpose of
the paper is to review empirical evidence during the past decade and determine whether the evidence
calls for such a revival (he concludes it does not).
Taylor uses empirical evidence from two temporary tax rebates is 2001 and 2008 to show that even
though the rebates were given during the recession (Lack of good timing is not to be blamed) there is
virtually no increase in aggregate demand.
Taylor then runs a regression to test whether the rebates had a positive effect on consumption and he
includes a lagged dependent variable to allow for lagged effects on changes in income. He then adds
controls such as the price of oil which would be expected to have a depressing effect on consumption.
He still finds that the rebates had a statistically insignificant effect on consumption.
Taylor then posits that we should continue to focus on the Automatic stabilizers and more lasting long
run reforms (i.e tax reform, entitlement reform, infrastructure spending) rather than discretionary
countercyclical actions. He runs a regression to test how the automatic stabilizers have effected the GDP
gap (potential gdp – actual gdp) and he concludes that they have become more instrumental over the
years.
He also concludes that the effectiveness of monetary policy over the past decades is all the more reason
that we should never turn to discretionary fiscal spending.
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that we should never turn to discretionary fiscal spending.
Conclusion:
A decade ago there was widespread agreement that fiscal policy should avoid countercyclical
discretionary actions and instead should focus on the automatic stabilizers and on longer term fiscal
reforms that positively affect economic growth and provide appropriate government services, including
infrastructure and national defense. In this paper I briefly summarized the empirical evidence during the
past decade on (1) the temporary rebate programs of 2001 and 2008, (2) macro-econometric model
simulations, (3) the changing cyclical response of the automatic stabilizers, and (4) the role of monetary
policy in a zero interest situation. Based on this review I see no empirical rationale for a revival of
countercyclical discretionary fiscal policy.
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The strong support for fiscal policy intervention reflects a renewed belief in policy activism
that had already appeared before the present crisis.”
b. We are still relying on past approaches to discretionary policy.
i. Since discretionary policy is traditionally not favored, much attention has not
been given to its design.
ii. We need to pay more attention to policy design this time around.
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decreased because their spending is most urgent, least likely to have credit
3. Must be clearly temporary or threat of huge deficits will raise long term interest rates and lower
confidence in long term growth.
His plan (looks small in retrospect): payments to people paying income or payroll taxes, increases
in unemployment insurance for long term unemployed, and food stamps benefits. It would be
quick and temporary. Any further stimulus would be provided by measures to reduce future
deficits and increase confidence in the long run.
Elmendorf and Furman –“If, When, How: A Primer on Fiscal Stimulus” (2008)
Martin Feldstein and Lawrence Summers have argued that fiscal stimulus may be necessary to help
economy in serious economic downturn where monetary policy and automatic stabilizers fail
o May include tax cuts and/or spending increases
o Fiscal stimulus is more immediate than encouraging investment and can occur more quickly
Principles of Fiscal Stimulus
o Timely –should be enacted in certain circumstances at the right time
o Targeted – should raise short-run output and end up in the hands of the most vulnerable and struggling
o Temporary – should increase short-run output and not increase long-term deficit
When to Intervene?
o History of Great Depression intervention
o Monetary policy is first line of defense – quicker and does not require legislative approval
Often best because economists should be the ones to analyze data and forecast results, not
Congressmen with limited knowledge
o Automatic stabilizers are good intermediary between monetary and fiscal policy
o Fiscal stimulus is important if monetary policy is powerless
Principle 1 : Fiscal Stimulus Should be Timely
o Difficult to time it appropriately
o Immediate tax cut or spending increase is good if growth is supposed to be much weaker than
forecasted
o Usually used in conjunction with monetary policy and automatic stabilizers
Principle 2 : Fiscal Stimulus Should be Well-Targeted
o Direct tax cuts should be targeted to those who need it most (typically low-income persons who spend it
quickly)
Principle 3 : Stimulus Should be Temporary
o Fiscal stimulus can raise short-term economic output to move to outer bound of economic possibilities
frontier, but this is a short-term increase
o Would be best if it is repaid within five to ten years
Good Examples of Effective Options
o Extend unemployment benefits temporarily
o Increase food stamps temporarily
o Issue flat, refundable tax credits temporarily
Less Effective Options
o Increase infrastructure investment
o Create temporary investment tax incentives
Ineffective Options
o Reduce tax rates, or make 2001/2003 tax cuts permanent
Goal is to build better long-run policy
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components of GDP and explains why they are low.
*Consumption: Consumer confidence was very low (house prices decreased, 401(k)s shrunk,
unemployment high). This leads to greater saving. If everyone saves at the same time, there is a huge
drop in consumption, leading to lower incomes.
*Investment: Usually decreased consumption leads to increased investment. But the housing market
was in shambles, as prices continued to decline, and there was lower residential investment as fewer
new homes were being built. Financing business investment was difficult, as the stock market was
down, interest rates on corporate bonds up, and the banking system in a precarious position.
*Net exports: Despite a recent depreciation of the dollar and increase in net exports, net exports were
most likely not going to continue to increase. The financial crisis spread from the United States to the
rest of the world, and people have been sending their capital back to the US thinking that this is the
safest place. This has caused an appreciation of the dollar that should lead to a fall in exports.
*Government purchases: Plan is for government to increase infrastructure spending with stimulus,
hopefully leading to multiplier of greater than one. This works in the short run, but would add to the
budget deficit and threaten the ability of the government to pay for its future obligations (such as Social
Security and Medicare for boomers).
Mankiw warns that the Fed has already cut the interest rate to practically its lower bound of zero,
so it can’t increase aggregate demand through rate cuts anymore. But the Fed can also signal that
it plans to keep longer term interest rates low and will work to avoid deflation. It has also been
buying mortgage debt.
Broda and Parker – “The impact of the 2008 tax rebates on consumer spending: a first look at the
evidence.”
Between May and July of 2008, the government distributed approximately $90 billion in tax rebates to
American households. They find that households are doing a significant amount of extra spending
because of these rebates. They find that the typical family increased its spending on nondurable goods
such as food, mass merchandise, and drugs by 3.5% when its rebate arrived relative to a family that had
not yet received its rebate. Of the families who received rebates, low income and low asset households
increase their spending at nearly double the rate of the average American family. Moreover, shoppers
are spending a higher fraction of their rebates at supercenters such as Walmart and Target relative to
their normal behavior. Their findings suggests that tax rebates, especially ones made to low-income
families, are an effective way to stabilize consumer spending during downturns.
Feldstein – “The tax rebate was a flop. Obama’s stimulus plan won’t work either” (2008)
Tax rebate program was enacted because of the growing risk of a recession.
o Congress feared monetary policy alone would not be effective because of the dysfunctional
credit markets.
The hope was that the tax rebate would boost consumer confidence as well as available cash.
o It was hoped that households would spend a substantial fraction of the rebate dollars,
leading to more production and employment.
o Brookings Institution study – Each dollar of revenue loss would increase real GDP by more
than a dollar if households spent at least 50 cents of every rebate dollar.
Government statistics show that between 10% and 20% of the rebate dollars were spent.
o The rebate added nearly $80 billion to the permanent national debt but less than $20 billion
to consumer spending. (Rebates amounted to $78 billion, additional consumer spending
amount to $12 billion.)
o Savings rose by $62 billion, showing that consumers saved much of the money.
o GDP figures are supported by the more detailed monthly data on income and spending.
There is also evidence in monthly retail sales.
o “Although press stories emphasizing that the rebates induced additional consumer spending
were technically correct, they missed the important point that the spending rise was very
small in comparison to the size of the tax rebates.”
“Although someone who receives a permanent annual salary increase of $1,00 typically
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small in comparison to the size of the tax rebates.”
o “Although someone who receives a permanent annual salary increase of $1,00 typically
would increase his annual spending by an almost equally large amount, a $1,000 rise in
wealth caused by a share price increase or a tax rebate would raise spending only gradually
over a number of years.”
o **This confirms earlier studies that showed that one-time tax rebates are not a cost-
effective way to increase economic activity.
With this in mind, Obama’s proposal to distribute $1,000 rebate checks to low and middle income
workers should be evaluated.
o Cost of plan would be $65 billion. It would be funded through an extra tax on oil companies.
Tax on oil companies would reduce investment, keeping oil prices high.
o According to past evidence, Obama’s plan to send $1,000 rebate checks would do little to
raise consumer spending and stop the decline in employment.
“The distinction between one-time tax rebates and permanent changes in net income is also important
for the debate about Obama’s proposal to raise income and payroll taxes. “
o Permanent tax increases reduce consumer spending and aggregate demand.
o Taxpayers, anticipating a future tax hike, may reduce current spending.
o Increasing future taxes is no way to stimulate the economy.
The combination of continued weakness in housing activity and prices, the ongoing problems in the
mortgage and broader financial markets, and persistently high price of energy have raised the risk of
slow growth and recession (this was prior to when it was common knowledge that the economy was in a
recession).
Automatic stabilizers and actions by the fed will be our first line of defense against a recession, but if
that fails, a fiscal stimulus should be used and it should focus on two things: focusing on right time
period when it is most likely needed and increasing economic activity as much as possible. (A stimulus
meaning household get increase tax cuts and transfer payments, business get investment tax credits,
and the government consider buying goods directly in the economy to increase demand. The paper
spends about 15 pages in details analyzing approach and expected results of achieving this).
The stimulus should be consistent with Long-Run Fiscal Objectives, and the size of the stimulus should
depend on our goals (i.e. enough money so that economic forecast do not project a recession, enough
money to reduce chance of recession to an acceptable value, enough money to address the sharp drop
in economic growth.)
The proposal specific to the housing markets are changing the terms on troubled mortgages, promoting
the restructuring of Mortgage Loans, changing bankruptcy law, expanding opportunities to refinance
subprime mortgages, expanding authority of the FHA, Fannie, and Freddie, Increasing Federal Assistance
to community based organizations, allow state and local governments to issue tax-exempt bonds for
refinancing, and government purchases of subprime mortgages. This is a comprehensive list and the
concepts of the proposal are pretty self-explanatory. The paper goes through each in detail, so if you are
unclear on one or want to learn more, just go back to the paper and look for the bold heading.
Conclusion:
Even if the individual options have small effects, some of the options taken together may help the
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Conclusion:
Even if the individual options have small effects, some of the options taken together may help the
economy by reducing the risks of a self-reinforcing downward spiral. In the case of the proposals for
restructuring and refinancing mortgages, the main effects come from the help given to creditworthy
borrowers who can avoid foreclosure and the attendant losses for both borrowers and lenders.
Caves, Frankel and Jones – “Expectations, Money and the Determination of the Exchange Rate”
Assumptions: no transaction costs, capital controls, barriers to international investors
Exchange rate= relative price of foreign versus domestic assets (not GOODS)
--they are very volatile, just like the price of bongs, equities, gold, and other assets
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modeling it as relative price of foreign money instead of goods
o Money demand variables: S(bar)= (M/M*)/(Y/Y*) times ƒ(i-i*)
Increase Y»decrease in S, increase in i-i* » increase in S
These effects are the reverse of those in the Mundell-Fleming model
Mundell: Increase in Y means higher demand for imports and deteriorated
trade balanced means depreciation
New equations assumes flexible prices so Y is always at level of potential
output (all resources are fully employed), in this context if income
increases, can only be due to higher level of national resources or
improvement in efficiency all changes in output are changes in potential
output, which is sign of economic strength and leads to appreciation
Mundell: increase in interest differential requires an appreciation of the
currency. In new equation, increase in interest differential is associated
with a depreciation of the currency
S(bar)= (M/M*)/(Y/Y*) times ƒ(∆se
o If expectations regarding what will happen in the future change, even if no other variables
change today, then today’s exhange rate will change
o A high interest rate is not a sign of strength for a currency, it reflects expected future
depreciation and is thus a sign of weakness
o PPP in terms of rates of change: ∆s(bar)= ∆p-∆p*, ∆se =∆pe -∆p*e
o Real interest parity: i-∆pe=i*-=∆pe*
Expectations of Money Growth
What determines the expected inflation rate?
In simple montarist model: rate of money creation drives everything
Given rate of increase of price level presupposes as money growth rate of same magnitude
If money growth rate were NOT fully reflected in inflation rate (real money supply increasing), LM
curve would shift to right and real income would be increasing >> no steady state
Permanent increase in the money growth rate leads to permanent increase in inflation by same
amount, public recognizes change, expected depreciation and interest rate increase by same
amount, and demand for currency falls
Magnification effect: The percentage change in the exchange rate in any given interval of time
can be greater than the percentage change in the money supply during that interval (see page
543/4 for graph)
Hyperinflation
Germany 1923: price level and exchange rate were increasing at same rate (real exchange rate
reached steady state), but in the transition to steady state, price level and exchange rate had gone
up more than money supply; real money balances fell
Worse the hyperinflation, the more extreme the fall in real money holdings>>NOT true that in
monetarist model no change in monetary variable can have an effect on any real variable
Ec 1420 Page 76
Future changes are discounted pack to the present
Feldstein – “Resolving the Global Imbalance: The Dollar and the US Saving Rate” (2008)
Title: Resolving the Global Imbalance: The Dollar and the US Saving Rate
Author: Martin Feldstein
Year: 2008
Thesis: The recent surge in the US’s current account deficit (to a peak of $811 bil in 2006) is
unsustainable, and its decline must be brought about by a higher US saving rate and a decline in the
dollar. These changes will happen naturally because of various market forces, but can be accelerated by
government actions at home and abroad.
Summary:
- The US current account deficit cannot be sustained because the way in which it has been financed in
recent years is not sustainable.
o Until around 2000, the US was able to finance its entire current account deficit by attracting
equity investments from primarily private investors.
o Now, the US debt is mainly financed by foreign governments’ purchase of debt (Treasuries)
in order to sustain their export surpluses and protect themselves against speculative
attacks. Foreign investors will reduce their demand for dollar bonds soon for 3 reasons: (1)
foreign govts can get a higher return by investing in their own economies (2) portfolio
diversification (3) future decline of value of dollar (will reduce value of dollar investments)
with no sufficient rise in the interest rate for compensation
- A more competitive dollar is the mechanism that will cause the deficit to decline.
o Mechanism by which dollar will fall: foreign exporters deposit dollars for goods they export
to US in commercial banks, which then give to central bank central banks want to reduce
dollar reserve holdings, so they sell the dollars increased supply of dollars causes dollar to
depreciate.
- Other necessary factors for the decline in the US current account deficit:
o Higher US National Saving Rate (= household + corporate + govt saving)
The primary reason for the US’s low national saving rate was low household saving,
which was primarily caused by the rapid rise in household wealth and the high level of
mortgage refinancing with equity withdrawl; both forces are weakening and will likely
cause a rise in the household saving rate in the near future (sidenote: both have
reversed, so savings rate has risen since this article was written)
o Increased Incentive to Purchase US Goods – this will come from the depreciation of the
dollar (which makes US good relatively cheaper)
o Reduction of Trade Surpluses in China and Many Other Countries
China has achieved a very lare trade surplus (10% of GDP) by artificially depressing the
value of their currency, the yuan; this is achieved by purchasing large quantities of
foreign reserves
The key to shrinking China’s trade surplus to to reduce the remarkably high national
saving rate (40+% of GDP)
Other countries must also reduce trade surpluses as part of global adjustment – this
can be achieved without reducing domestic employment/growth if they pursue
appropriate fiscal and regulatory policies (ex: revenue-neutral proconsumption tax
changes)
- in 2006, the IMF proposed a plan to achieve coordinated action to reduce global imbalances. However,
their effort is doomed to failure becaue it is missing the key ingredient: the recognition that resolving
the global trade imbalance requires a fundamental realignment of currencies (in particular, a
depreciation of the dollar)
Ec 1420 Page 77
Feldstein – “The Dollar at Home – and Abroad” (2006)
-Politicians have traditionally emphasized “strong dollar”
-Feldstein “We need a strong dollar at home and competitive dollar abroad.”
-By a “strong dollar at home,” Feldstein means we need low inflation
-By “competitive dollar,” Feldstein means an exchange rate that favors exports
-We had this situation in late 1980s – low inflation, fall in value of dollar cut trade deficit
-The US can achieve optimal situation because we borrow in our own currency – we don’t have to worry
about a depreciating currency making it difficult to afford foreign currency debts
-A more competitive dollar would encourage consumers to buy American goods
-We don’t know exactly how much the trade deficit will decrease given a certain amount of depreciation
of the dollar
-Two secondary reasons to immediately strive for a depreciated dollar
-The longer we wait, the more debt we accumulate to the rest of the world
-While we have an overly strong dollar now, the debt we are accumulating decreases future
consumption – we will need to devote more resources to servicing and paying off the debt
-One more important and time-sensitive reason
-An immediate increase in exports could sustain the economy, replacing the fall in
consumption caused by the credit crunch
-Because NX will not react immediately, it’s important to start now
-To achieve competitive dollar, we need a higher US savings rate and a narrowing gap between US and
foreign interest rates
-The US government should publically announce that it tends to pursue this policy of a more competitive
dollar – markets will do the rest
-The US should also probably meet with the Asian countries that own massive reserves in dollars
first
History
Tax Equity and Fiscal Responsibility Act (TEFRA) – Scaled back large Reagan tax cuts.
Budget Enforcement Act (BEA) – During a 1990 summit to combat the recession, the BEA brought
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Budget Enforcement Act (BEA) – During a 1990 summit to combat the recession, the BEA brought
new budget rules.
2008 – The general consensus in support of a large fiscal stimulus represents a marked change
from the 1982 and 1990 episodes.
Estimates show that both revenue and expenditure policies have been countercyclical and budget-
stabilizing, with larger responses on the expenditure side.
o The lack of a recession during the 1990s weakened the case for intervention.
o Still, the stage was set for policy decisions during the current recession.
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Lectures 11 and 12?
Friday, February 27, 2009
11:00 PM
Ec 1420 Page 80
Lectures 13 and 14
Wednesday, March 11, 2009
11:09 PM
Ec 1420 Page 81
Lecture 15
Monday, March 16, 2009
10:21 PM
Tax Policy
taxes transfer funds, they also change behavior. In changing behavior, they create DWL.
Evaluating a tax system:
(1) Efficiency effects and DWL
(2) Fairness/distribution issues
(3) Simplicity
Income tax
DWL = ( ½ )t2()wH
H = hours
• = elasticity of labor supply
Itemize deductions: someone can choose to enumerate things on which he spends money (e.g.
mortgage interest, charitable contributions, state/local taxes, etc.)
Some of these items can be deducted from taxable income
Higher income tax payers are more likely to itemize deductions, b/c they’re more likely to own houses,
spend on charity, etc.
High taxes on itemized deductions » downward sloping demand and horizontal supply; so people
demand more
DWL shows up as reducing taxable labor income
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DWL shows up as reducing taxable labor income
DWL = ( ½ ) t2 ( ) (TLI)
• =elasticity of taxable labor income
TLI = taxable labor income
Ec 1420 Page 83
Lecture 18
Wednesday, April 01, 2009
9:48 PM
Social Security Lecture 1
- Feldstein thinks social security is the most important fiscal problem facing us today
- Today we’re spending a lot of time on the financial crisis today, when we’re out of this, we’ll face the
issues of how much money we’ve spent right now – how can we fund social security and medicare??
Costs of these are growing because number of people in group getting benefits is growing.
- Feldstein will focus on Social Security (much of it carries over to Medicare though)
- SS actuaries say that social security costs will rise by 6% themselves, and Medicare will rise even faster
- Medicare costs per retiree have been rising faster than GDP in general, no one knows how to slow that
down
- Major driver of taxes in future will be increases in SS and medicare
- These are so-called entitlement programs because they are not subject to annual appropriation by
Congress
- Question: how do we continue to provide benefits for retirees without the dramatic increases in tax
breaks?
- Start by talking more generally on how to think about pensions, structure of pensions. In US, we have a
pay-as-you-go, defined benefit program (this isn’t the only way to structure this)
- Then we’ll talk about how our program generally works
- Then impact of SS on economy – how does it affect labor supply, savings
- Demographic problem, aging of population – challenges going forward
- Finally will talk about ideas for SS reform
Ec 1420 Page 84
a. Defined-contribution – employer promises a certain percent and then employee can
pick where the money gets invested, how much to put into stocks/bonds, etc.
b. Employer puts in a percentage of wages, benefit is based on how employee’s
investment choices pan out
c. It is investment based, so it leads to increase in capital stock
o Companies have been moving from defined benefit to defined contribution for 3 main
reasons:
b. More mobile labor force – people change jobs more often so made more sense to
have DC
For someone who changes jobs a lot, he gets very little money because wages
have gone up a lot since he had some of his older jobs. Everytime he moves, he
stops the accumulation of that pension. Overall, gets very very little in real
terms.
c. Shifts the risk and responsibility from the company to the employee, individuals prefer
this too
d. Some companies tend to promise more in benefits than they can deliver. When the
company gets in trouble, the government has an insurance program that insures this
pension program – this gets funded by taxing companies that have defined benefit
plans. This tax has been rising rapidly. So companies get out of this tax by closing
down their DB plan and moving to a DC plan.
o Where does the rate of return come from in a notional DC plan or a pay-as-you-go DB plan?
e. This is true because of the growth of the tax base. Due to the growing number of
workers and growing wages of workers.
f. Ex. People live for 2 periods.
1st period – young, earn wage w, N people and pay taxes t – so total taxes paid
Ec 1420 Page 85
1st period – young, earn wage w, N people and pay taxes t – so total taxes paid
are: wNt
2nd period – old, retire, get benefits, benefits at time t+1 = taxes collected at
time t + 1
So is Bt+1/Tt greater than one? This equals t t+1/tt = wt+1Nt+1/wtNt
This equals (1+g)(1+n) = 1+g-n = 0.03 (in example)
o g – growth rate of wages
o n – growth rate of population
g. so this rate of return just comes from the implicit growth in tax base
o problem with pay-as-you go system – generates much lower return than other systems (3%
versus and maybe 6 or 7%)
o Differences between notional DC plan and paygo DB plan? What caused governments to
switch from DB to DC paygo plan?
h. Allows people to see the differences between the taxes they pay and the benefits they
are eventually going to get
i. This tax is very different from the personal income tax
j. If I understand the formula well enough, I can probably understand what the increase
in my benefits will be. This type of system makes it much more transparent.
k. Appearance that it is a pure tax is changed – reality is that you’ll get some back
This is true in DB plan too, but DB formula is so complicated that people don’t
understand that.
l. While these advantages exist, this system still has really low rate of return
- Do we want to stay in DB, paygo plan or do we want to switch to more clarity with DC, paygo or do we
want to switch to DC, IB or a combination of what we have and DC, IB?
- Why do we have a SS program at all?
o Roosevelt believed we could provide benefits while taxing younger people who would
eventually get benefits later
o As economists, was it a good reason to create SS benefits with this program? Usually we
make decisions like this due to a market imperfection/externality. Feldstein cannot find any
externalities here.
o There are missing markets – there are imperfect annuity markets, and no real annuity
markets. Less of a missing market now than there was before.
o Real reason for our SS program: combination of 2 things
m. Myopia (short-sightedness)
People do not save for themselves.
Back then, people died earlier. Then, many people didn’t get to age 65 and then
they’d just move in with family. But now life expectancy is about 7 years
greater.
n. Gaming
So why don’t we just wait until people get to age 65 and see if they have any
money. If people don’t have money, then we’ll give them money. This is called a
“means test.” So this makes people with lower incomes not want to save
because they’ll just get the same amount from the money from the
government.
o. We have no idea of telling the people who are plain short-sided from the ones who
are trying to game the system.
- We have a DB, pay-as-you-go system. How does it work? Etc. – talk about on Friday
4/3/09
Ec 1420 Page 86
4/3/09
Social Security Reform
- Today: how social security works in the US
- Pay as you go, DB program
Benefit part:
- Depends on your wages and how much you worked
- Average index monthly earnings (AIME) – take inverse of person’s wage in month t, multiply by average
wage of that month
o sum of Wit/Wt over 35 years of your highest earnings
o AIME = 1/420 sum (from 1 to 420) Wit/Wt
- Primary Insurance amount (PIA) – amount of benefit that a retiree would get (without a spouse) if they
retired at a normal age
- Graph of PIA versus AIME – looks like four line segments that start out really steep and levels out at the
top
o As you get older, you get more benefit, but at a decreasing rate
- Rule used to be that you can get your benefit at 65, now the rule is that if you were born after 1938, you
have to wait longer (2 months more per year—creeps up to age 67 max)
- This formula looks quite re-distributive –everyone pays the same amount of tax, but benefits are
decreasing returns over time
- How does this look?
o Someone with median earnings ($40,307) would get benefits of $16846 per year or 42% of
their immediate, pre-retirement income
o Someone with maximum earnings ($90,737) would get benefits of $26220 per year or 29%
of their immediate, pre-retirement income
o Someone with lower incomes ($18,138) would get benefits of $10224 per year, or 56% of
their immediate, pre-retirement income
- This makes it look like this is a very redistributed program by percentages
- However, statistics say there is not redistribution for 3 reasons:
o People in higher incomes start working later, so they pay for less years than the poorer
people who generally start working at age 18 (everyone only gets benefits for 35 years of
their work, even if they worked much longer)
o Life expectancy depends on earnings – if you are a high income person, you are much more
likely to reach age 65 and get benefits, and you are much more likely to last longer than 65
and receive benefits every year
o 2-earner households. Social security was made for a single-worker home. If there is a
spouse, they have the choice of getting 50% of the primary earner’s PIA or they have the
choice of getting their own PIA. Women generally drop out of labor force for many years so
they get more if they earn 50% of husband’s PIAs. It’s a strange system, where a woman can
pay in for many years and get no benefits because of it (because they get money because of
husband’s earnings.) If one spouse dies, surviving spouse gets 100% of higher PIA.
- Marginal tax rate is the PIA minus the actuary expected value of future benefits
Ec 1420 Page 87
- Marginal tax rate is the PIA minus the actuary expected value of future benefits
- For people who are working not in their top 35 years, they get nothing back for what they put in
- For woman who are going to collect on behalf of their husband, they get nothing for what they put in
- If you choose to retire early (within 36 months of retirement age), you get a lower benefit based on how
early you retire (FRA – 36 months)
o Many people are choosing this route
- If you choose to delay retirement, there is an actuarial adjustment. Benefits rise by 7% per year.
- Historically, SS began as a much smaller program. When it began in the 1930/1940s, it began as a 2%
tax. By 1960, it was a 6% tax. By 1980, it was a 12% tax including Medicare. Since 1990, it is a 15.3% tax
including Medicare.
- Bt+1/Tt = (thetat+1/thetat) (Wt+1 Nt+1 / W2 N2)
- If you were lucky enough to be working in the 40s and then getting benefits in 80s, you paid only 2%
while workers in 80s were paying 12%…get a much higher rate of return
- Example: Joe was born in 1923, works from 1948 to 1988, has max salary
o In lifetime, taxes paid by both him and his employers were total: $68000
o Benefits that he gets in 1989 for himself/spouse are: $15000 (CPI indexed)
p. In less than 6 years, he would get everything he paid in plus interest
o His life expectancy was 16 years, so he expected to get $255,000 total before he died
- This good deal was there because of the growing population and growing tax rate
- Our generation will be hurt by the demographic shift – more retired people and not a growing tax rate.
We will get a negative rate of return because we are at the higher end of the spectrum.
- Effect on Saving:
- Replacement rate –how much of income you get back through SS
- Replacement rates for pre-tax income: 41%, 60+% if individual has spouse
- Replacement rates for after-tax income: 70%
- (will be indexed for inflation, so will keep pace with inflation)
- An old couple, has a house that’s paid for, has medical bills paid by Medicaid, medicare would cover
them if they needed to go to a nursing home. So they have little incentive to save at this point.
- 2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to
Ec 1420 Page 88
- 2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to
survive after retirement, so they calculate how much they need to save to get 70% of pre-retirement
income.
o Savings w/o SS – enough for 70% of pre-retirement income
o Savings w/0 SS – enough for 20% of pre-retirement income
- Because of social security, savings when people are young is about 2/7 of savings if there were no SS
4/6/09
Social Security Reform
- Question: since SS reduces saving during working years but also reduces dis-saving during retirement
years, what is the net impact on aggregate saving for the economy as a whole?
- Why don’t they just cancel out? They would cancel out in an economy that wouldn’t grow. If each
generation of savers were the same size and had the same growth as the previous economy. But in
reality, the economy grows – more young people, higher average incomes
- Thus, for economy as a whole, we see a positive savings rate
- Over the past few decades, savers started saving less. And retirees started consuming more – dissaving
of dissavers increased. Thus aggregate savings rate in economy came down from 10% in early 1980s to
essentially 0 currently.
- Now with collapse of wealth, household savings rate has returned to 5%...estimated to increase as
wages rise –so people can gradually increase their consumption and their saving.
- SS increases saving and dissaving, but in a growing economy has the same net effect
- If each individual reduces his or her saving by 5/7th, then aggregate saving will decrease by 5/7th
- Net impact of SS:
o Creates a smaller savings rate
o --
o Lower productivity, lower growth in productivity
- What is forcing politicians to take this problem seriously? The aging population. In the future, there will
be more retirees for workers.
o Currently, we have 3 workers per retiree. By 2020, there will be only 2 workers per retiree.
o Because of the retirement of the baby boom generation – this is accelerating the trend of
rising number of retirees per worker
- Implication of this?
o We must have a 50% increase in the tax rate
o Right now, we have 3 workers paying 12.4%, then we must have 2 workers paying 19% (50%
higher)
q. However, with the smaller tax base – we need an even higher tax rate to get same
revenue
r. Personal tax rate/payroll tax would probably actually have to rise to 22%
- Net impact: 10% increase in personal tax rates. This has an enormous impact on DWL.
o Today we have combined marginal tax rate of 0.25 + .05 + .15 = .45, it will go up to .55
o DWL of tax will increase by 50% (is proportional to square of tax rate)
- What is the alternative?
o Cut benefits: could scale back benefits by a third
o Change retirement age
o Change inflation index – so benefits don’t automatically increase with inflation
- All of these changes impact different groups of people in different ways, all of these would be hard to
pass
- There is a better way – partially or fully finance benefits in an investment based way
o This is the way our private pensions work
- Advantages to this plan:
Ec 1420 Page 89
- Advantages to this plan:
o Has higher rate of return. Don’t have to save as much during working years
- Lets compare a paygo system and IB system
o Paygo system rate of return of 3%, IB system of 7%
o Person works from age 25 to 65 and gets benefits from 65 to 85. So simplify by saying
person does ALL of saving at age 45 (right in the middle) and ALL of their dissaving at age
75 – this model fits actual numbers very well
o Person saves $1000 over 30 years
s. with 3% rate of return gets $2427 in benefits later
t. with 7% rate of return gets $7612 in benefits later
o implication: 19% payroll tax could go down to 6% tax in IB plan
- Question: can we get from a paygo system to an IB system?
o Transition generation might have to make a huge sacrifice, paying double taxes to support
retirees and to support new program
o Answer: yes, we can – if we do this gradually we can shift systems. We can gradually shift
- Second question: How risky would this be?
o Answer: it would be quite risky. If we went to a pure investment-based system – would
impose risks which most people would say are too high.
- Let’s think about an IB system with savings rate of 4%, where we invest 60% in stocks, 40% in bonds
o At age 67, median annuity that could be paid out would be 1.41 x “benchmark”
o Lets look at the 30th percentile of retirees – 0.92 x “benchmark”
o At 10th percentile of retirees – its only 0.52 x “benchmark”
o At 1st percentile – its only 0.26 x “benchmark”
o This is too high of a risk for individual retirees
- Mixed System:
o Use IB to provide high returns, use paygo to provide less risky base
- Is it possible to 1) retain the current retirement income of retirees, 2) not raise the payroll tax rate from
12.4%, 3) not use general revenue funds/not run a deficit further than what is allocated for this, 4)
achieve a permanent solution (a lot of plans only achieve temporary solutions), and 5) to avoid serious
risk?
o Feldstein’s research project
o Strategy: mixture of paygo system and personal retirement accounts (PRA) that would
generate IB annuity
o idea is to gradually reduce paygo benefits relative to current law
v. we wouldn’t actually reduce benefits, they would just grow more slowly
o while substituting PRA annuities for missing paygo benefits
o if we combine these two, could we maintain retirement income? YES.
- How this scheme would operate?
o Paygo accounts would continue
o Everyone would get a PRA account – should it be mandatory or voluntary, if its voluntary
should it be automatic enrollment? (automatic enrollment has a very high impact on
participation rates)
o Each individual, in order to participate, must put in 1.5% of covered wages from out of
pocket (referred to as an “add-on”)
w. The amount that has to be paid is very small (1.5%) in the transition period
o If the individual does that, then the government will match by taking 1.5% of covered wages
from the payroll revenue (referred to as a “carve-out” system)
Funds are invested in diversified portfolio – 60% stocks, 40% bonds (diversified, no strong
Ec 1420 Page 90
o Funds are invested in diversified portfolio – 60% stocks, 40% bonds (diversified, no strong
bets on one thing)
o Why individual accounts? Why PRA way?
x. Main reason: to avoid potential government interference in investment practices.
These accounts grow really rapidly—funds that accumulate in this way add up to 50%
of GDP. Thus, Congress would pass rules saying that you couldn’t invest in companies
that outsource jobs/bad industries/etc. There would also be pressure to invest in
social investments, housing etc. This would be bad, would cause smaller rate of
returns for peoples’ accounts. It would also cause a huge interference in markets.
o Feldstein has analyzed this based on personal retirement accounts. Has found a real rate of
return of about 7%. Calculations reduce this number to 5% (to have a margin for
uncertainty, for accounting purposes). At retirement, persons would receive an annuity
based on same combination of stocks/bonds. If individuals die early, before they reach
annuity stage, this would trigger bequest benefit – all of these funds would go to heirs.
- We can’t afford to continue paygo system, so we will gradually decrease paygo benefits
o Someone who has been in this system for 15 years would get paygo benefits equal to 91% of
benchmark
o Someone who has been in this system for 20 years would get paygo benefits equal to 85% of
benchmark
o Someone who has been in this system for 40+ years would get paygo benefits of 60% of
benchmark
- Replace lost income from paygo benefits with personal account annuities
- Combined amount:
o Benefits of 150%
o 2050: benefits of 120%
o 2070+: benefits of 130%
o We don’t need benefits so much higher than benchmark so could scale back too
4/8/09
Finishing Social Security Reform
- From last time, we talked about how the transition to a mixed system would be feasible
- What’s wrong with this new system?
Ec 1420 Page 91
this is due to the way Chile/Mexico set up their SS program.
z. These countries gave their people a lot of choices, with a lot of different systems to
choose from. This caused administrative costs to rise. They didn’t give the people
incentives to pick from the most cost-efficient programs.
aa. Ways to avoid administrative costs: Best alternative is to have funds collected by
payroll. Limit frequency by which people can change plans. Investments must be in
broad indices so you don’t pay fancy management fees. Estimated that costs would be
less than 30 basis points (30 hundredths of a percent).
o Redistribution (check this?)
bb. Current system is not very redistributive. We could make new system redistributive by
adjusting payroll tax to make it more redistributive or adjusting benefits.
o Risk
cc. Pure IB plans are risky. In a mixed system, risks are much much lower.
dd. 15 years from now: the only risk you would have are between 91% to 100% of amt
you put in, in 20 years: 85%, 40 years: 60%
What does this mean? In 40 years from now, if stock market literally goes to
zero, you’ll only have 60% of what you put in. (Stock markets don’t go to zero,
though.)
ee. Median: In 40 years, a person putting in 3% of wages, has a 50% chance of getting
1.06 + 0.60 = 166% of benchmark
ff. 30th percentile: in 40 years… combined benefit will be 1.29% of benchmark
gg. 10th percentile: in 40 years…combined benefit will be 100% of benchmark
hh. Thus, there’s a 90% chance that you’ll do just as well in this system as what you put in!
ii. Looking further, at 1th percentile combined benefit would be 80%, this is a low risk,
1 in 100 people
Ec 1420 Page 92
Lecture 19?
Monday, April 06, 2009
10:05 PM
Social Security Lecture 2
- In reality, the economy grows so the saving of the savers exceeds the dissaving of the
dissevers.
- What happened recently has been quite unusual: we used to have a savings rate of
approximately 10 percent. As people became wealthier, people saved less during their
working years and the retirees consumed more. The savings of the savers was less and the
dissaving of the dissevers was more. The savings rate declined to nearly 0 in the past
several decades. In the recent recession in abruptly climbed to 5 percent.
- Even though Social Security discourages savings and encourages dissaving, it has the same
net effect in a growing economy. The net impact of Social Security is to create a lower
national savings rate, a lower increase in the Capital Stock, and hence lower productivity.
- The action-forcing event: The aging of the population. Going forward, we can predict with
certainty that there will be more retirees relative to the number of workers. By 2020, there
will be only 2 workers per retiree. The reason that this transition will happen very fast is
the retirement of the baby boom generation. The baby boom accelerates a trend that is the
rising number of retirees per worker.
- If we want to retain the same formula that we do today, if we go from three workers per
retiree to two workers per retiree, we are going to have to increase taxes per worker by 50
percent. The higher marginal tax rate shrinks the tax base, implies higher tax rate to get
same amount of revenue, the personal income tax revenue will go down as a result of the
shrinking of taxable labor income. We may need to go up to about a 22 percent payroll tax.
Net effect of increase of 10 percent in marginal tax rates.
- We have a combined a marginal tax rate today of about 45 percent. This would go up to 55
percent. Deadweight losses are proportional to the square of the marginal tax rate – There
is about a 50 percent increase in the deadweight loss of the tax.
- What is the alternative? 1. To cut benefits – We would need to scale benefits back by one
third. 2. Change the retirement age. Push the retirement age forward by four or five years
then the cost of the program will be cut by one third. 3. Change the inflation indexing so
that it doesn‘t already increase with inflation. These different ways of dealing with it affect
different group in the population differently. None of this is politically easy to image
passing.
- There is a better way: partially of fully finance benefits on an investment-based way.
Employers take some of salary and invests it and continues to pay paychecks when workers
retire.
- Advantages of investment based program: 1. Higher rate of return so that you don‘t have to
set aside as much during working years.
- Compare Paygo and Investment Based system: Someone who works from 25, retires at 65,
and passes away at 85. Think of all saving at 45 and all of retirement consumption at 75
because these lie in the middle of the working and retirement spans. Saves $1,000 at 45 and
gets $2427 with a 3 percent rate of return. With a 7 percent rate of return, they will receive
$7,612. The implication is that you need only one third as much saving with a seven
percent return than with a 3 percent return.
- If you do it gradually, it is possible to get from a pure Paygo system to a pure Investment
Based system in which the tax rate would come down to just 6 percent. How risky would
this be? Quite risky – A pure Investment Based system would pose huge risks for the
average retiree.
- Say we have Investment Based system in which savings rate is 4 percent versus 12 percent.
We invest in a portfolio where stocks are 60 percent and bonds are 40 percent. The median
benefit per median retiree would be 1.41*Benefits that Median retiree would expect to get
under current law. The median worker would be ok but let‘s look at the 30th percentile.
They would receive 92 percent of the benchmark, at the 10th percentile, it is only 52 percent
Ec 1420 Page 93
They would receive 92 percent of the benchmark, at the 10 th percentile, it is only 52 percent
of the current benefits. At the first percentile, the benefits would be only 26 percent. If we
did this at 77 rather than retirement age, we would find even lower annuities relative to the
benchmark.
- We could go to a pure Investment Based system where the government provided
guarantees of topping off benefits.
- Marty wants to consider a compromise of a mixed Paygo and Investment Based system. He
wants a system that can do the following: 1. Not use general revenue funds, 2. Not raise
payroll tax rate, 3. Keep benefits of current retirees, 4. Achieve a permanent solution, and
5. Avoid too much risk. Mixture of current system and current retirement accounts that
generate an annual annuity. Reduce Paygo benefits relative to current law and substitute
PRA annuity for missing Paygo benefits. If we combine these two, we can maintain
retirement income.
- How would it work? 1. Paygo accounts continue, 2. Everyone would get a personal
retirement account (do we make voluntary or mandatory or automatic enrollment), 3. In
order to participate, each individual must put in 1.5 percent of covered wages from out of
pocket – the amount that needs to be paid is very small in transition (carve out) and
government will match by taking 1.5 percent of the payroll tax from the payroll revenue
(add-on because we add more money to the current system), 4. these funds invested in a
diversified portfolio – the same 60-40 mix of stocks and bonds, 5. You can only change
once a year. We will limit tax rate to 12.4 percent. Gradually reduced Paygo benefits.
- Why individual accounts rather than a single central account? 1. Avoid potential
government interference in investment decisions. Personal accounts grow very rapidly. The
funds accumulated in this way would grow to 50 percent of GDP. The Social Security
administration would have a lot of say in how the economy operates. The temptation to
allocate funds away from a variety of things would be bad and there would be the pressure
to do things like social investing in housing, schools, healthcare, etc., and a great
interference in the economy, and a system of private accounts with managers would protect
it from government expropriation.
- For past 60 years, a 60-40 portfolio produced a real rate of return of 7 percent but
administrative reasons reduced this to 5.5 percent. At retirement, individuals would get an
annuity based on stocks and bonds. If individuals die early, all of the funds accumulated
before started annuity would go to people that I designate as my heirs. People often opt for
ten year certain – promise that individual will get benefits for at least 10 years and if
individual dies during those years, benefits go towards heirs.
Ec 1420 Page 94
Lecture 22
Monday, April 13, 2009
10:19 PM
Economics of National Security
Global economic downturn
o Destabilize economies
Threats
Military threats
o Major powers
Russia
Cold war
o We raised the military stakes and their economy could not keep up
with theirs
o Russia could not keep hold of the empire
Russia’s triple threat.
o Russia still has nuclear technology
o Russia is dangerously unprotected
Nuclear material to be stolen/purchased
o Russia has gas reserves that control gas pipelines
Russia has energy policy that threatens European allies
China
Chinese conflict with Taiwan
Chinese military buildup
o Use it to justify confrontation with Taiwan
o Resources in China is low as is GDP per capita but growing very fast
o Military strength depends on aggregate GDP and % spending on
defense
China will likely eventually spend more on military than
America
o Small nuclear powers
North Korea
Small and poor
Demonstrated nuclear capabilities
Japanese worry that NK will attack them
Could raise money by selling nuclear material to another country or
extremists
Iranians
Developing nuclear weapon
o Enriching uranium
o Delivery mechanism
Dangerous to their neighbors
Nuclear capabilities allows them to be aggressive in a non nuclear way
Pakistan
Entire government unstable
o Stateless terrorists
Al qaeda
Organized international force
Train terrorists
Organized terrorism greater threat in Britain because of large Pakistani
population
Will America face alienated population that will damage this country?
Oil
Why would countrys stop shipping to the US
Ec 1420 Page 95
o Why would countrys stop shipping to the US
This would require more than one country to cooperate in not shipping
If cooperation/intimidation of rich states, then those states (UAE) could bankroll
others into financing their activities
Stateless terrorist actors can disrupt flow of oil
o Dependence on oil has grown over time
Sensitive to global price of oil
Risks to trade with other countries dependent on countries who need oil
Cyberterrorism
o Cyberespionage
o Cyber attacks
Foreign power to shut down our utilities
Risk of extortion/terrorism
Studying strategy of warfare by Tom Schelling
o Mutually assured destruction between US and USSR was stable outcome
o USSR used to worry that US could strike first, neutralize their capacity and win the war
Mitigate this risk by having second strike capability
Advised that we teach the Russians this to arrive at nash equilibrium
o Game theory to stateless actors
Understanding sources of terrorism
o Poverty causes terrorism seems to be a myth
More educated and more affluent are more in favor of suicide bombing
Reducing poverty through economic growth would take decades to make a
difference
Economic weapons
Sanctions on Iran and North Korea
Sanction cut off access to banks for NK
Need access to cash for luxury goods
NK leader agreed to restart six party talks
Oil
o Outside of US state companies control oil and major source of budget
o Since demand is quite inelastic we can increase supply which should lead to significant
reduction in price
Optimizing defense spending
o Take it out of economic growth (although fiscal deficits)
o Tax expenditures can be diverted to national security
Ec 1420 Page 96
Lectures 23 and 24
Wednesday, April 15, 2009
10:33 PM
Ec 1420 Page 97
Lecture 25
Monday, April 20, 2009
10:09 PM
Health Care Policy Lecture 1
Ec 1420 Page 98
Role of insurance in driving care
o Insurance is valuable for risk averse people because health care is highly variable and
potentially very expensive
Moral hazard drives higher consumption
o When price is lower consume more
o Health insurance lowers price of marginal consumption
Moral Hazard vs. Risk protection
o Purpose of insurance is to insulate from costs in bad state of the world
o Fundamental tradeoff between risk protection and moral hazard
Patients and physicians affected
Pay based on outcome or pay based on symptoms?
o Both extremes skew incentives of physicians and patients
o Try to provide risk protection but all imperfect
Physicians bears a lot of risk and does not want to treat for someone with
bad health conditions
Any way around it?
Contracting problem –capitation, pay for performance, cost plus
Adverse Selection in Health Insurance Markets
o Buyers: potential enrollees with different propensities to use services
o Sellers: Health plans competing for enrollees
o Asymmetric information: enrollees know more about health status than insurers
Individuals have an incentive to wait to get an insurance until sick
Young healthy people know that have de facto social insurance as
hospitals cannot deny them care
Insurers have an incentive to attract healthier enrollees
Premium spiral where unhealthy people buy into insurance plan causing
insurance company to raise premium and the cycle repeats
Ideally want health people to buy into insurance and lock in at low premium
Avoiding Adverse Selection
o Choices among plans foster competition, but facilitate adverse selection
o One of reasons group market is appealing – ready – made risk pools
Employer sponsored market
Non-group market
Who bears burden of Employee Sponsored Insurance
o If workers fully value benefits and wages are unconstrained, workers pay for benefits in
form of lower non benefit compensation
o May not be in tha world
Mandated benefits may not be fully valued
o Note that employer mandates and individual mandates likely to have quite different effects
Additional Consequences of Tying Insurance to Employment
o Job lock
Because workers risk losing insurance when change jobs, less likely to move if
sick
o Hinges on difference in underwriting between group and non-group markets
Individuals underwriting in non-group market; health status affects premium
Why is ESI preferred to non group market
o Economies of scale
Less costly to adminster
Bargaining clout
o Adverse selection limited
Can be undermined by choice among plans- more on this below
o Tax favored treatment of health insurance
If pay care out of pocket, paying with after tax dollars
Current Tax Treatment of Health Insurance
Premiums paid through employer not subject to taxation
Ec 1420 Page 99
Current Tax Treatment of Health Insurance
o Premiums paid through employer not subject to taxation
History rooted in WWII price controls
Makes a big difference on margin
o Huge but hidden public expenditure
“tax expenditure” on ESI larger than federal share of Medicaid spending
Unlevel Playing Field
o Two bviases
Against those who obtain insurance on non group market
Against out of pocket spending
o Who benefits the most from current treatment
Higher income
Regressive
Improving Efficiency of ESI
o Next week will discuss health reform proposals that include changing tax treatment of ESI
o On private side, movement towards managed care
Associated with dip in cost growth in mid 90s
Recent movement towards lighter managed care
o Choice among plans can promote competition
Case Study: Harvard University
Summary
o Insuance likely to promote higher spending
Balance of risk protection and moral hazard
o Most private HI in US through employers
Promoted by tax code
Fosters risk pooling
Favors inefficiently high spendin
Review
Review
Private health insurance dominated by employer sponsored insurance (ESI)
Lawrence Goulder and Robert Stavins. "An Eye on the Future: How
Economists' Controversial Practice of Discounting Really Affects the
Evaluation of Environmental Policies." Nature, Volume 419, October
17, 2002, pp. 673-674.
Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and
Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam:
Elsevier Science, 2007.
Council of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President,
Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004
_erp.pdf
This paper finds that there is a significant response of taxable income to changes in marginal tax
rates, meaning that a change in income tax rates has substantially less impact on tax revenue than
if there were no behavioral response to marginal tax rates.
o High marginal tax rates create significant DWLes by inducing taxpayers to change
their behavior.
Ways that changes in marginal income tax rates make individuals alter their taxable income.
Changes in:
o labor supply
affects females more than males
short run: change how hard you work
long run: change location and types of jobs
o the form that employee compensation is taken
untaxed compensation is preferred such as fringe benefits i.e. health insurance,
corporate cars, in-house sports facilities, etc.
o portfolio investments
high marginal tax rates encourage individuals to invest assets in ways that
reduce the portion of return included in taxable income, i.e. bonds and high-
dividend stocks are reduced in favor of untaxed municipal bonds
o itemized deductions and other expenditures that reduce taxable income and taxpayer
compliance
In sum, people change their behavior and taxable income in response to changes in the marginal
tax rate. Taxable income can be changed by varying the labor supply and other forms of
compensation, like investing and also the extent of spending on tax-deductible activities.
Detailed Summary:
Goals of tax reform: simplification, incentives for capital formation, progressive
distribution of tax burden, economic efficiency
Taxes are typically on consumption because taxing income creates too many distortions
Best structure: Value Added Tax (VAT): its simple provides right incentive for capital
formation, rate is low so it is effective. Problem: lack of progressivity
VAT taxes all business receipts except export sales, business deducts all operating
expenses
Another= personal consumption tax on all good purchased (like VAT except collected only
from businesses that sell final product to consumers)
Cash flow consumption tax: businesses pay no tax, households file complex returns
accounting for all inflows and outflows of cash (more complicated, not really considered
much)
Attempts to redistribute burden of VAT (make it more progressive)
o Reducing taxes on necessities (not quite enough)
o Offset VAT taxes with rebate for families earning subsistence level or less (cash
rebates create administrative problems, people who are eligible might not know it and
file for it)
Steps to a Progressive VAT
Split VAT into two coordinated taxes:
One; Tax on all businesses, just like European VAT except business tax gives a deduction
for compensation, carry forward is granted at market interest rates for tax losses ( rapidly
growing business will have a negative tax base since investment exceeds cash flow)
Two: personal consumption tax
Base is same as before (all consumption), but splitting gives option of exempting lower
income people from the personal consumption tax
Refer to this design as a flat tax, but people believe flat taxes put too much burden on
middle class (where taxation starts) and not enough on prosperous
Can fix this by having differing rates for different levels
Need to have business rate = to top consumption rate (otherwise rich people will find ways
to label earnings as business)
Unlike Euro-VAT, a progressive VAT families would have to fill out personal
consumption forms, BUT they would be very simply (post-card sized)
Meets all four goals!
o Simple: taxes fit on a post-card
o Right incentives for capital formation
o Fair : exemptions and progressive rates in personal tax
o Efficient: top rate is no more than 30%
US Pursuit of Tax Reform
Attempts to correct current system by: Providing vehicles for tax deferrals (ie, retirement,
college) and Lowering interest rates on return to capital
Summary: Government simply represents a transfer of wealth from the private to the public
sector through taxes. The economic burden caused by government depends on (1) the taxes
required to raise incremental revenue and (2) the deadweight loss that results from those taxes.
Both in turn depend on behavioral responses of taxpayers.
Introduction: Feldstein prefaces his argument by citing the inevitable increases in government
expenditures that will result from the aging population (i.e. Medicare, Medicaid and Social
Security). By 2030 Government expenditures will have to rise from 9% to 17% just to pay for
these three. What about increases in education, research, and defense? Thus, economists can play
an important role in estimating the total cost plus the dead weight loss of financing such a
government program.
Section I: The official method used by the Treasury and Congress underestimates the amount of
tax increase required to raise a certain amount of revenue. Because they do not take changes in
GDP into account, they cannot use the observed responses of revenue to past changes in tax rates
as a basis for estimating how future changes in tax rates would alter taxable income and tax
revenue, thus they underestimate the substitution and income effects.
Section II: Behavioral Effects of a Tax – Dead Weight Loss:
1. reduces the supply of labor and in the long run the amount of capital and thus a loss in
revenue results from the loss in taxable income from labor and capital
2. induces a substitution towards untaxed fringe benefits and more pleasant working
conditions from taxable income.
3. induces spending on tax deductible items like debt financed spending secured by real
estate, charitable gifts, and healthcare
4. changes intertemporal allocation of consumption
Conclusion:
1. Deadweight losses needed to be better understood by public officials so the
desirability of incremental government spending can be better analyzed – it depends on the
total cost (reduction income, disposable income, consumption, and thus GDP) as well as
the deadweight loss, which includes the income, labor and substitution effects described
above.
2. Better estimates of the changes in taxes rates and the resulting chages in revenue are
needed – this scan be achieved by included effects that alter GDP and looking at past
experiences.
3. Deadweight loss includes not only labor supply effects, but all changes in taxable
income. Past experience estimates a cost of 2 dollars for every 1 dollar of incremental
government spending.
2. Actions required to eliminate shortfall are within the bounds of previous change.
-the deficit amounts to 2.23 percent of taxable payrolls
-thought experiment: fund 75 year deficit by increasing employee-employer tax from 12.4 to
14.6% immediately, a large but not unprecedented increase
-Medicare program costs are also rapidly growing
-system should not be left until 76th year then try to figure it out
3. Economic and demographic assumptions made for 75-year projection are reasonable.
- demographic assumptions- fertility and mortality ( AKA people in labor force and
how long people receive benefits)
- economic assumptions- CPI and tax rates, also, growth in wages (real wage
differential)
- miscalculating real wage differential by .6 percent would be equivalent of increasing
deficit by .6 percent of taxable payroll ( a relatively modest amount during 75 years)
- 1997 ―low cost‖ 75 yr projection is a surplus of .21 percent of taxable payroll
- 1997 ―high cost‖ 75 yr projection is a deficit by 5.54 percent of taxable payroll
- LONG TERM UNCERTAIN
4. Deficits reemerged in 1983 due to upsurge of disability case load and technical
problems (not Greenspan commission recommendations)
- Factors for costs increasing- increase years with deficit as time passes, increased disability
caseload, and rising disability costs.
- lower costs through improved CPI and increased immigration
Take away message: Social Security needs modest repair if action is taken today (written in
1997). It is not fundamentally broken.
In the 1990s, there was a huge budget surplus, which were expected to continue
Surpluses came from tax increases and fiscal discipline, which were reversed under
next administration
Committing to short run reductions in deficit lower future short term interest rates and
current long term interest rates, stimulating the economy in the present
In the 1990s there was a huge increase in investment, in part because the deficit
reduction freed resources for saving, helping to lead to expansion of economy
Projected need for entitlement reform with aging population and rising healthcare
costs
There was debate about changing social security policy, with an emphasis placed on
investing in equities (through the trust fund or personal accounts), Clinton supported
lockbox, but no new system was adopted
Preserving budget surpluses would help solve the entitlement problem
Reeeeally long article
Jeffrey Liebman, “Redistribution in the Current U.S. Social Security
System,” in Distributional Aspects of Social Security and Social Security
Reform, Editors Martin Feldstein and Jeffrey Liebman, 2002, pp.
11-41. (A pdf will be provided for those who do not have access to the
NBER’s working paper series.) http://www.nber.org/papers/w8625.pdf?
new_window=1
Annual Redistribution
Individuals under 18 receive 2x the benefits as they pay in taxes since
few children have labor income while some receive benefits for their
parents that are disabled or deceased
Individuals 30-49 receive benefits= 8% of taxes paid
Over 65 receive benefits 30x what they pay
46% of SS goes to families whose non-SS income is below the poverty
line
annual benefits for males are 68% of taxes paid, for women are 120%
of taxes paid
benefits/taxes ratio is highest in the south with high number of retirees,
lowest in the west with young working population
low education levels get higher ratio of benefits/taxes, reverse is true
for highly educated (primarily reflecting the increase in education over
time thus correlated to age)
Intracohort Lifetime Redistribution
Payroll taxes are proportional up to a cap, the benefit formula replaces a
higher fraction of lifetime earning for lower earners than for higher
earners
This is altered by two factors
o Higher earners tend to live longer
o Spousal benefits in which spouses of higher earners get more than
spouses of lower earners, even if the spouses themselves earned
equal amounts
Findings
A substantial number of high income individuals receive greater
transfers than the typical low-income individual does
o Part of this can be attributed to spousal benefits, wives receive
higher transfers because they have longer life expectancy
o This is not the full difference though. Among males variation is due
to life expectancy, marital status, earnings of secondary earners,
share of earnings earned in years outside the highest 35 years, and
timing of earnings
Differences in transfer across race and education groups are not
statistically significant
Significant amount of redistribution based on income and a significant
amount that is not income related
**Variation in transfers at a given level of income is due to different
mortality rates for people in different demographic groups, variation in
earnings levels by secondary earners, and to marital status differences.
The three authors come up with a plan, LMS Plan (their last names), full of compromises to aid
in politicians coming to an agreement about Social Security changes.
1.Benefit Cuts
-reduction in PIA factors and an increase in retirement age
-reduces aggregate spending by 35% relative to current benefit formulas
-benefit cut for retirement is larger by 43% for typical worker because not reduced for disables
and young survivors
-cuts implemented by changing PIA and increasing full benefit age
i. Changing PIA Formula
-benefits reduced for higher earners
ii. Increasing Retirement age
-FBA of 68 and EEA of 65
iii. Protecting Disabled and Child Beneficiaries from Benefit cuts
2. New Revenue
-Mandatory Account Contribution of additional 1.5% mandatory account contribution in
Personal Retirement account (PRA)
-end practice of government using SS Surplus to fund general operations.
-Raising Taxable Maximum by gradual increase in payroll tax cap to 90% of earnings
3. Mandatory PRAs
-3% of earnings, funded half by new contributions and half directed from SS trust fund, with full
annuitization required upon retirement
-all payments paid as annuities, fixed and inflation-adjusted
MAJOR COMPROMISES
Revenue Increases Vs. Spending Reductions
-benefit cuts 2.7 percent of payroll and revenue increases equal 2.5 percent
Size of Accounts
-3%, PRAs large enough to accumulate wealth but not overshadow traditional benefits
Level of Progressivity
-Revenue and Tradition benefits more progressive but not to undermine support for universal
social insurance
IV.Economically Beneficial
-future SS surpluses and revenues are invested in PRAs
-raising national Savings
VI.Balanced Compromise
-political compromise
-compromises on solvency, adequacy, and funding
-amounts of taxes, amount of choice
Detailed Summary:
Unemployment insurance distorts benefits, this program aims to fix that
Unemployed ind receive the same cash amounts during unemployment as now
Person with positive UISA can completely internalize cost of unemployment, and wouldn‘t
have incentive to inefficiently increase frequency or duration of unemployment
Feasibility of account depends on extent to which unemployment is concentrated in
subgroup of ind
Use Panel Study of Income Dynamics (PSID) to see that 5% of employees would retire or
die with negative account balances, and that about half of all benefits from UISAs would
go to such ind
Therefore, cost to gov‘t with UISA is less than current system, which permits a reduction in
payroll tax and distortionary effects of existing benefit system
Current system: ind gets about 50% of previous gross wage (1997 ave weekly benefits =
$193), benefits are subject to income tax, but not SS payroll tax, benefits are levied on
firms by state gov‘t
Current system reduces costs of being unemployed, and can increase frequency or duration
of spells (people search excessively for job)
UISA removes the incentives- costs are internalized, people search for right length of time
Feldstein runs through a variety of ways to design the UISA program, (like limited amount
in fund to 3 times average wage, just above average wage, or making people more likely to
be unemployed have a higher fund) but I don‘t think we‘d need to run through this in detail
(Pages 8-12 if you‘re curious)
Analysis with/ PSID data shows that individuals are 95% sensitive to cost of
unemployment benefits; about 7% would ever go into negative funds; UISA gives people
stronger incentives to avoid unemployment,
Distributional effects: someone who never taken unemployment insurance gains because
they don‘t have to pay the taxes and get to keep the funds from their UISA, someone who
ends with a negative balance- the gov‘t contribution must come from a tax, but the tax is
smaller than under previous system
Lowest quintile would lose $95 over 25 years, largest gains $468
Reduction of about 60% of taxpayer burden
Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street
Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html
Ec 1420 Page 125
Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html
In order to explain the source of the price rises in food and energy, Feldstein first looks at
perishable agricultural commodities, specifically corn:
· In the short run, the supply of corn cannot change much in response to a global
increase in demand.
· Since demand for corn is very price insensitive, it takes a very large price increase to
bring global demand in line with global supply.
· In the past year, global demand of corn rose by 10% à It took a 100% increase in the
price of corn to offset this rise in demand.
Good news:
· Any policy that causes the expected future oil price to fall can cause the current
price to fall, or to rise less than it would otherwise do. Thus, it is possible to bring down
today‘s price of oil with policies such as increases in government subsidies to develop
technology that will make future cars more efficient, tighter standards that gradually
improve the gas mileage of the stock of cars, etc.
· In addition, an increase in the expected future supply of oil would also reduce today‘s
price. The fall in the current price would induce an immediate rise in oil consumption that
would be matched by an increase in supply from OPEC producers that have inventories of
oil.
In summary, any steps that can be taken to increase the future supply of oil or to reduce the
future demand for oil in the US or elsewhere can lead to both lower prices and increased
consumption today.
Lack of sustained attention to energy issues is undercutting U.S. foreign policy and national
security
Other nations (Russia, Iran, Venezuela) have used their energy resources to pursue their strategic
and political objectives.
Energy consumers, like the U.S., are increasingly dependent on imported energy. This increases
strategic vulnerability and constrains ability to pursue broad range of foreign policy and national
security objectives.
Also put in competition with other importing countries (China and India), creating
Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July
2008 http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf
· In the past year, the price of oil rose by 85%, from $65/barrel to $120
· During the same period, the dollar fell by 15% relative to the euro, and 12% relative
to the yen
· Link between the two?
Would the price of oil have increased less if oil were priced in euros instead of dollars?
· Oil market is global, so the price reflects total world demand and total world supply
· The increasing demand for oil from all countries, but particularly from the rapidly
growing emergent- market countries like China and India, has been a huge force in pushing
up the price of oil
· The currency in which oil is priced would have no significant or sustained effect on
the price of oil when translated into any currency – market equilibrium is the same when
translated into all currencies
· However, the rising price of oil does contribute to the decline of the dollar. The
increasing cost of oil imports widens the US trade deficit. The dollar has declined in order
to be more competitive and thus shrink the trade deficit to a sustainable level.
· Thus, as oil prices keep rising, it will be more difficult to shrink the US trade deficit
and the dollar will depreciate even more rapidly.
Optional:
Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary
Update for Fiscal Year 2008, December
2007. http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm
Where we stand:
United States Trade Representative 2009 Trade Policy Agenda.
http://ustr.gov/Document_Library/Reports_Publications/2008/2008
_Trade_Policy_Agenda/Section_Index.html
Big Picture: Managing trade policy in face of crisis is a great challenge. Trade is very
important for the US, it brings in $1tril/year and accounted for all economic growth in
2008. Am. People are nervous about globalization because they see that it ―takes jobs‖ US
Policy needs to reassure Am. People (through improving education, fixing unemployment
insurance, creating training prog for people who lose jobs). US cannot withdraw from trade,
because countries we trade with can find new partners, putting the US at a serious disadvantage.
Detailed Summary:
Needs:
Protectionist policies can aggravate the recession (it happened in the 1930‘s)
Post 9/11: G-20 summit led to a pledge to avoid new restrictions for 1 year
Need to reverse the erosion of US foreign policy/global standing
Initiative on global warming: has HUGE impact on global standing
Must restore confidence on American people: trade balance has provided all US econ
growth over past year, but people view globalization as source of job insecurity, stagnant
real ways, and growing income disparity
Will address these need with:a new narrative, a competitiveness agenda, and an adjustment
policy
The Trade Policy Study Group Report to the President Elect and the
111th Congress , available at
http://iie.com/publications/papers/20081217presidentmemo.pdf
Year: 2008
Thesis: The United States needs a comprehensive new trade policy to increase its competitive
stance and maintain domestic support in the context of a rapidly globalizing world economy.
Summary:
Trade will need to be addressed by the new Administration/Congress for four reasons:
o Trade is an important part of the policy response to the global financial/economic
crisis. Protectionism will only worsen the current situation (as occurred during the
Great Depression).
o Cooperative trade policy is essential for reversing the erosion of US foreign policy
and global standing in recent years.
o Planned initiatives on global warming will necessarily include a trade component.
o Trade and America‘s role in the global economy will need to be addressed as part of
an effort to restore American confidence/optimism.
The proposed new strategy includes four components
o A new narrative: new policies that allow Americans to succeed in a globalizing
world, including policies that (a) strengthen our ability to compete/innovate, (b)
upgrade the educational level and quality of our workforce, (c) increase the
portability of health care, etc and (d) refocus trade policy to target the markets that
will be central to our economy in the future.
o A competitiveness agenda: increased private and public investment in activities that
promote productivity gains and the creation of high-skill, high-wage jobs; this
includes investment in infrastructure, R&D, education, training, new technologies,
etc. We also must reduce the federal deficit, which harms our competitiveness by
crowding out private investment and causing the overvaluation of the dollar.
o A new adjustment policy: much stronger and effective national program of safety nets
and empowerment initiatives, including reforms of health care, unemployment
insurance, etc.
o A new approach to trade policy: US should lead international trade negotiations (in
the Doha Round, NAFTA, other FTAs, etc) for three reasons – (a) international trade
supports US ec growth, (b) good trade deals reinforce US foreign policy, and (c) US
trade negotiations ensure that US interests won‘t be disadvantaged as other major
trading partners form trade agreements with each other.
Challenges:
(1) Summers, Lawrence “America needs to make a new case for trade”
Financial Times, April 27 2008
http://www.ft.com/cms/s/0/0c185e3a-1478-11dd-
a741-0000779fd2ac.html
Thesis: The traditional economic arguments for supporting trade policy, while valid, are no
longer sufficient. Instead, policymakers have to convince the American citizenry that global
success is in their best interest, which is not immediately obvious for several reasons.
Summary:
- American economic policy has traditionally supported globalization, but the
recession likely will put this in question. This support is based on four valid economic
arguments:
o Trade has many benefits via comparative advantage (for exporters,
consumers, and the economy as a whole).
o Trade agreements are good mercantilism for the US, for two reasons. First,
the US already has low trade barriers and thus will not need to reduce as much
as trading powers. Second, not having trade agreements with countries with
whom our competitors do will put us at a competitive disadvantage.
o Increased income inequality in US is due to technology, not trade.
o Acknowledged that not everyone wins out, but that trade agreements
should be accompanied with polices to reduce income inequality/insecurity.
- However, just because trade barriers harm our economy, it is not immediately
obvious that the US is helped by the success of its trading partners. There are several
reasons why global success may harm us:
o American producers benefit from having larger markets to sell into, but
also have to face more competition.
o Developing countries increasingly export goods that were traditionally
produced by the US, which puts downward pressure on US wages.
o Growth of developing countries puts pressure on energy and environmental
resources, thus raising their prices.
o Global growth encourages the development of stateless elites who are loyal
to global economic success and their own prosperity, rather than the interests of
their home nation. (i.e., rich CEOs who dislike regulation, taxation, etc)
- Therefore, these arguments above must be addressed in order to convince
Americans that global economic success is actually in our best interest.
US now imports more manufactured goods from third world than advanced economies
Trade improves lives of third world workers, but at the expense of real wages of many or
most American workers, this problem is getting worse
Highly educated workers (a minority) benefit from trade
Should not lead to increased protectionism, but strengthened social safety net
13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker
Manning, W., et al., Health Insurance and the Demand for Medical
Care: Evidence from a Randomized Experiment, American Economic
Review, Vol. 77, No. 3, June 1987.
Design of the Rand Health Insurance Experiment:
o Enrolled families in 6 cities from 1974 to 1977; assigned to 1/14 fee-for-service
insurance plans or to a prepaid group practice
Fee-for-service plan had different levels of cost sharing: coinsurance rate and
upper limit on annual out-of-pocket expenses
o Dependent variable: health care services (not dental or psychotherapy)
o Independent variables: health care plan coverage + controls
o Statistical methods: ANOVA and estimates based on a four-equation model
Empirical results:
o Main effects of the insurance plan:
differences in expenditures across plans reflect variation in the number of
contacts (visits) rather than the intensity
No significant differences among the family coinsurance plans in the use of
inpatient services, probably due to the upper limit on out-of-pocket expenses b/c
70% exceeded their upper limit
o Use by subgroups:
Income groups: probability of use of any outpatient medical service increases
with income with larger increases for family pay and individual deductible plans
than the free plan; probability of use of inpatient services declines with income
for the family pay plans net result is shallow U-shaped
Age groups: adults have significantly lower use of inpatient services on family-
pay plans than they do on the free plan
Health status: no differential response btw healthy and sickly—unusual b/c of
the cap on out-of-pocket expenses
Sites: least access to doctors had the second highest probability of any use
Period of Enrollment: duration of plan (3 or 5 years) did not matter for
Newhouse, J., Medical Care Costs: How Much Welfare Loss?, Journal
of Economic Perspectives, Vol. 6, No. 3, Summer 1992
· Magnitude of health expenditure increase
o Real medical care expenses per capital have grown at 4%/year for 50 years (more
rapid in 1960s)
o Growth in medical costs is different b/c of moral hazard and tax treatment of health
insurance excessive insurance b/c costs are misaligned
o But the moral hazard/risk sharing story is in a one-period model; distinguish between
one-period from multiple period
Accounting for the medical expenditure increase: method is to identify a series of factors,
determine how much of the change they might account for, and account the residual to
technological change
o Aging: only accounts for a tiny fraction in the increase based on how their spending
changed if just measuring the population age increases
o Increased insurance: factor-of-five increase in real expenditure per person from
1950-1980 is perhaps 8x as large as one could account for solely from the effect of
increased insurance on demand in the one-period model.
Largest single component of increase in real medical expenditure has been in
the hospital sector, but the coninsurance for hospital visits has been about the
same while expenditure has risen 50%
o Increased income: medicare is a normal good so increased income could account for
increase in expenditure; elasticity measured around 0.2 – 0.4
o Supplier-induced demand: if physicians have considerable discretion in treating
ignorant consumers, to what degree might they have induced more and more
demand? As supply of doctors increases, they demand higher costs to protect their
incomes hypothesis not supported by the evidence.
o Factor productivity in a service industry: medicare is a service so if productivity gains
are lower for medical care, then the relative medical prices would rise over time, and
b/c demand is inelastic, expenditures would also rise. Very difficult to measure—
many reasons for why there‘s no empirical basis for decomposing the medical care
expenditure increase into increase in price vs. quantity
Technological change in medical care
o Other factors probably account for 50% of rise in expenditure; rest due to technology
o Highest increase in cost come from hospitals—where the newest technology is
Was technological change induced by insurance?
o Fallacious argument that insurance makes things more affordable and therefore more
expensive technologies was the result and is a welfare loss
What has been done about medical costs?
o Initial cost sharing by patients has increased—probably will not change the long-term
rate of cost increases
o Increased enrollment in health maintenance organizations: rate of growth in HMO
spending appears similar over an entire sector
o Adoption of prospective payment systems: paying a lump sum per type of admission
rather than the additional cost of a procedure length of hospital stay decreased, but
bottomed out soon
Mandated benefits are one way governments can ensure universal access to a good
The other is public provision
Today the issue is whether it is good to provide mandated health insurance, so those who
are not normally covered will be
Economists standard view is of mandated benefits as a tax
Employee provided benefits can be efficient if they can be provided at a lower cost then
their value to employees then it can be cost effective compensation
The paternalism argument supports the idea that mandated benefits will correct an
undervaluing of a good in the market
There is a positive externality associated with health insurance
Prevention of contagious diseases spreading
Also, there is an unwillingness to refuse care to those who can‘t afford it
These creates an even larger externality
Also, it is more efficient to mandate health insurance because the market outcome does not
provide universal insurance
The adverse selection will cause employees to set a high price so only sick people will pay
for insurance and everyone loses money
Mandated benefits are a more efficient way to provide benefits than public provision
Allows employers to tailor policies to individuals and avoids government provision trap –
those willing to pay for high quality care will settle for provided middle quality care
Also avoids deadweight loss of tax
The deadweight loss associated with mandated benefits is lower than that of a tax
Also, effects on employment are much less than with a tax
For health insurance a lump sum tax might be an efficient form of government provision,
but this is not politically feasible
Since all get same benefits a payroll tax is largely more inefficient than employer provision
Major problem with mandated benefits is only help those with jobs
In those cases public provision is necessary
Wage rigidities also hurt this program by not allowing wages to fall in exchange for
i.Reality
-Private health insurers will not charge uninsured sick people a premium lower
than their expected costs.
-Uninsured Americans need health care, not health insurance. Insurance is about reducing
uncertainty in spending. It is impossible to ―insure‖ against an adverse event that has already
happened, for there is no longer any uncertainty about this event.
i.Reality
-empirical evidence does not support
i.Reality
-having insurance my increase quality of care you get, but it is not a guarantee that you will get
high quality care
-Americans receive less than 60% of recommended care
- Yet the likelihood of getting high-quality care has more to do with geography than with
insurance status or spending
-John Wennberg- in fact, in areas where the most is spent on Medicare beneficiaries, they are
least likely to get high-quality care. Mammograms, flu shots, the use of beta-blockers and aspirin
for heart attack patients, rapid antibiotics for pneumonia patients, and the use of simple lab tests
to evaluate the management of diabetes are all lower in higher-spending areas. Higher spending
is not even associated with lower mortality, which suggests that more generous insurance
provision does not necessarily translate to better care or outcomes.
-SO…discard the simplified notion that more spending guarantees better care or even basic
preventive care
Myth 4: Employers Can Shoulder More Of The Burden Of Paying For Insurance
i.Reality
-workers bear costs of benefits in the form of lower wages
- Regardless of a firm‘s profits, valued benefits are paid for primarily out of workers‘ wages.
Workers may not even be aware of how much their total health premium is; however, employers
make hiring and salary decisions based on the total cost of employment, including both wages
and benefits such as health insurance, maternity
leave, disability insurance, and retirement benefits.
- employers may respond in other ways: employment can be reduced for workers whose wages
cannot be lowered, outsourcing and reliance on temp agencies may increase, and workers can be
moved into part-time jobs where mandates do not apply
i.reality
- encourages the use of care with very Low marginal benefit and that greater cost sharing would
help reduce the use of discretionary care of questionable value. But there is also evidence that
patients under use drugs with very high value
-even $5–$10 increases in copayments for outpatient care can result in some patients‘
being hospitalized as a result of cutting back too much
- Capping total insurance benefits is also short-sighted and imprudent: not only does evidence
suggest that such caps result in adverse clinical outcomes, worse adherence, and increased
hospital and ER costs, but the presence of caps means that patients are not insured against
catastrophic costs—exactly what insurance is supposed to protect against the most.
i.Reality
- our health care system is not delivering the consistently high-quality, high- value care that we
should expect
- we cannot afford to wait to act
- without regulatory safeguards, even the insured sick will be at risk of losing the insurance
protections to which they are entitled
- Private insurance fundamentally cannot provide the kind of redistribution based on underlying
health risk or income that social insurance can
- Single-payer systems are also slow to innovate— as suggested by the fact that it took Medicare
forty years to add a prescription drug benefit, long aftermost private insurers had done so.
- Reforms that promoted higher- value insurance could both extend coverage so that more people
benefit from the protections that insurance affords and ensure that those protections are secure
for those who fall ill
TAKE-AWAY: comprehensive reform proposal that aimed both to extend insurance protections
to those who lack them and to improve the value of care received by those who are insured
would be more likely to succeed at each goal than proposals that focused on just one
Iglehart, J., The American Health Care System: Medicaid, New England
Journal of Medicine, Vol. 340, No. 5, 1999.
Cutler, D., and J. Gruber, The Effect of Medicaid Expansions on Public Insurance, Private
Insurance, and Redistribution, American Economic Review, Vol. 86, No. 2, May 1996
Health Reform