Guest Post: Making Sense of the Balanced Budget Amendment

The guest post below is by Andrew Hanson, who blogs regularly over at Amateur Philosophy (you can also follow him on Twitter here.) Andrew is up to date on the DC pulse, and he is a wealth of knowledge about current policy developments. He always brings interesting points to the table, and best of all, he thinks like an economist! I'm thrilled that Andrew has taken the time to write today's guest post on the balanced budget amendment.

 

Greetings, Zackonomics readers! I'm Andrew Hanson. I'm a fellow 2009 Teach For America alumnus, and I blog at Amateur Philosophy on philosophy, economics, and public policy. Zack and I struggled together while teaching algebra to a quite memorable group of eighth graders. 

One of the most interesting aspects of the past five years is how hard-won economic knowledge seems to have been lost by many in the public policy realm, and zombie ideas have again gained influence. Many of these ideas are associated with the Tea Party Movement, which became particularly influential in the 2010 congressional elections. However, they've also gained influence in other conservative and libertarian circles as well. There are many examples. The so-called "Gold Buggers" have called for a return to the gold standard. The Hangover Theory has returned, suggesting that recessions are the punishment we deserve for unwarranted excesses and malinvestment during the boom. Inflation hawks have been crying out in fear of hyperinflation because of the Federal Reserve's decision to "print" more money. The most recent zombie idea is that the federal government is a family that needs to "tighten its belt" when times are tough. The Balanced Budget Amendment, a proposal that would amend the constitution to mandate that the federal government keeps the budget balanced on an annual basis. 

Let's focus on the Balanced Budget Amendment, why it's bad economics and bad policy. First, there is a long-term federal budget problem that can only be resolved by cutting health care costs and the Medicare entitlement. But balancing the budget this year and every year after that wouldn't help solve that problem; it would make it worse.  To understand why, we have to first think about why the federal government might want to run budget deficits in general. The primary reason the U.S. economy isn't growing is that there isn't enough demand for goods, services, and investments to take advantage of our productive capacity. Factories and workers are sitting idle when they could be engaging in productive activities. 

Economists know that recessions are accompanied by a fall in aggregate demand, and though it cannot prevent recessions completely, the federal government can make output and employment less volatile by adopting "automatic stabilizers", changes in fiscal policy that stimulate aggregate demand without policymakers signing any new laws or measures. The tax system, for example, collects less in taxes when output falls because taxes are tied to the level of economic activity: income, earnings, and profits. Government spending, such as unemployment insurance, can also act as an automatic stabilizer. As unemployment rises, the government spends more on unemployment insurance to make up for the lost spending in the economy. More automatic stabilizers, such as tying the payroll tax to the level of unemployment are being proposed now as well. 

A Balanced Budget Amendment would require the government to raise taxes and cut spending during a recession, which would further depress aggregate demand, and make the recession longer and far more painful. Instead, the federal government should try to balance the budget over the course of the business cycle, but even that may be asking too much. The federal government never needs to balance its budget completely; it just needs to keep the federal debt as a percentage of GDP at a reasonable level. Kenneth Rogoff and Carmen Reinhardt, economists at Harvard, have detailed exactly what levels are crisis and what countries can afford in their book "This Time It's Different". Their basic conclusion is that anything over 90% of GDP is quite dangerous, while a government could run the federal debt at 50% of GDP basically forever.

The Paradox of Thrift

It is hard to disagree with the fact that individual thrift is a good thing. However, collective thrift can be a bad thing, as we are seeing right now. Economists call this the paradox of thrift, and the idea is credited to John Maynard Keynes. In the following discussion of this paradox, it is important to distinguish between the short-run and the long-run.

In the short-run, sudden increases in the aggregate savings rate can be harmful to economic growth. We saw this happen during the Great Recession, and it is still and issue right now. According to the BEA, the personal savings rate was 5.4% of disposable income in June of this year. From 2005 to 2007, the savings rate averaged between 1.6% and 2.2% of disposable income (depending on the measure used.) When the savings rate more than doubles in a short period of time, it will be felt throughout the economy.

Data from http://www.bea.gov/national/nipaweb/Nipa-Frb.asp?Freq=Qtr

The pre-recession savings rate turned out to be unsustainable as many people had nothing to fall back on. Since the financial crisis and the related bursting of the housing bubble, consumers have held onto more of their money out of both fear and necessity. The sudden increase in the savings rate that occurred in 2008 is akin to a shock to aggregate demand. A shock to AD decreases national income, which in turn decreases savings despite the increase in the marginal propensity to save. Economist Paul McCulley of Pimco described the paradox like this:

If we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person's spending is another's income--the fountain from which savings flow.

This is an excellent description of the paradox of thrift in the short-run. Essentially, the paradox of thrift says that saving more of your money can be good for the individual, but if we all decide to do it at the same time, it can actually be worse for all of us than if we did nothing at all. This reminds me of game theory's famous prisoner's dilemma. Now, let's shift our view to the long-run.

In the long-run, collective thrift (i.e. a higher marginal propensity to save) is a usually a good thing, which is consistent with most people's intuition. To borrow Paul McCulley's lingo, savings are the fountain from which investment flows, assuming people aren't simply hoarding money.

So, what can we do about the the paradox that we face? My conclusion is that policymakers should encourage consumers to avoid having extremely low savings rates during economic expansions. Yes, low savings rates can stimulate growth in the short-term since more money is being quickly funneled back into the economy via consumption. However, low savings rates are counter-productive in the long-run. We still live in a world with business cycles, and when recessions rear their ugly heads, individuals and households need a financial buffer. When someone loses a job, past savings can be shifted to cover bills and living expenses if needed. In addition to individuals having this essential buffer, higher collective savings over the long-run are good for the economy since savings is the mechanism for investment. Policymakers can help over the long-run by limiting uncertainty and maintaining trust, so that savings are invested productively.

While the paradox of thrift does have some valid criticisms (here and here), it is an interesting concept that has important implications for our economy.

Graduate School

I am officially a graduate student in economics! Just over one week ago, I started my Master's degree in Applied Economics. The two tracks that I am deciding between are "Data Analytics" or "Applied Micro and Policy". I would love to do both of them, but the program is only three semesters long, so my capacity is limited.

Unfortunately, I have not been posting to the blog much lately due to the fact that I have been in the process of relocating to a new city for my graduate program. However, my goal is to post at least 3 to 4 times per week by the end of the the year, and writing that here will hopefully be an effective commitment device!

Now, I should get back to studying for my three-week Math Econ course. The Cobb-Douglas production function, Taylor's Theorem, and Hessian matrices await!

Look for posts soon... and don't forget to follow me on Twitter as an easy way to get updates for this blog.

Monetary Economics Links

With the United States debt ceiling debate coming to a head, the recently released downward revisions of GDP data from the last few years, and talk of a second recession (or that there was never a recovery in the first place), I have been reading more than usual about monetary policy and macroeconomics. Here are some articles, posts, and other stuff I have been reading and found interesting enough to share here.

The "little depression" just got bigger by Brazilian economist Marcus Nunes

Recessions compared by GDP % change and employment % change

Greg Mankiw thinks Bernanke and the Fed have done a decent job

Scott Sumner on thinks Mankiw was too easy on Bernanke and that he should work for the Fed

Tim Harford's clever debt ceiling analogy

A letter to Timothy Geithner on what could happen if the debt ceiling isn't raised

NPR Planet Money Podcast: Would US credit rating downgrade matter?

Matt Yglesias on the difference between Inflation Targeting vs Price Level Targeting

Paul Krugman thinks more government spending is needed (I disagree, for long term concerns. Perhaps the optimist in me believes there are other ways to stimulate the economy... For starters, how about addressing all of the uncertainty related to the debt ceiling debate.)

Paul Krugman rips on the Maestro

Update: Tyler Cowen defends Greenspan

Apple has more cash in reserves than the US Treasury (this is all over the place a popular news story right now, but still amazing)

Update: A somewhat pessimistic view of the Sunday debt deal by Ezra Klein

I realize this compilation is somewhat all over the place, but it is worth reading.

Tim Harford on The Importance of Trial and Error

This TED Talk by economics writer Tim Harford is a snapshot of his new book, Adapt: Why Success Always Starts with Failure. If you find the talk interesting, I would highly recommend reading the book, which was thought-provoking and interesting throughout.

Corporate Profits Recover as Individuals Struggle

While corporate profits are recovering nicely, wages and salaries are stagnant. Check out recent posts at the Curious Capitalist here and Freakonomics here about how the current economic recovery strongly favors corporations and stockholders. The posts are based on this study from Northeastern University. The Great Recession differs greatly from recessions of the past, as does the current recovery.

To date, through the first quarter of 2011, the nation’s recovery from the 2007-2009 recession is both a jobless and a wageless recovery. (p. 23)

And here is a table comparing the current recovery to previous ones. (click to enlarge)

Center for Labor Market Studies, Northeastern University (p. 20)

 Hopefully, the recovery of jobs and wages will come with time, but how long this lag will be is debatable. Keep in mind, this recession was largely due to the sub-prime mortgage crash  - and resulting drop in home values - which is very different from prior recessions.

Signs of Economic Progress: China

In a recent discussion with a relative who does extensive business with the Taiwanese and Chinese, he talked about the changes he has witnessed occurring in China over the last decade. One story in particular stuck with me.

In a town in mainland China, there is a nice restaurant that he visits with his business partners on each trip. Ten years ago, the clientele were 90% Tiawanese and 10% Chinese. Now, he says, the clientele are 90% Chinese and 10% Tiawanese!

Although this is anecdotal evidence, and some of the changes could be due to changing demographics in the area, I think that this is also a sign of rising wages and a growing Chinese middle class. As a result of opening itself up to foreign investment and international trade, China continues to be one of the fastest growing economies in the world. Next step for the Chinese government, human rights.

Geopolitics of the Arctic

The geopolitical and economic implications of a receding Arctic icecap are something to keep an eye on. Global warming is old news to most, but I found this specific instance noteworthy.

The time-frame in the summer when the Arctic waters are passable by ship appears to be increasing. This is a big opportunity for shipping companies to cut down on transportation costs. The video below from the Economist touches on shipping, fishing, and the possibility for more offshore drilling. I am somewhat skeptical about the extent that drilling would be cost efficient in these waters given such a small window of time and the high fixed costs for drilling. Also, staunch opposition from environmentalists will make it politically difficult for oil companies to drill in this area. However, assuming that the melting trend continues, this area could become a hotbed for international conflict over the next century as countries and oil companies jockey for position in the region.

When a Weak Dollar Is Good for the US

The NY Times reports that the trade deficit has shrunk. One of the main reasons has to do with the dollar:

In recent months, a weaker dollar has made goods from the United States less expensive overseas, while exports have also climbed in price as demand rose in developing countries.

Economic Reflections by Music Industry Experts

Warner/Chappell Music

Today I had the opportunity to sit in on several panel discussions with people from all walks of the Nashville music industry as a part of my professional development as a teacher. These discussions included experts from songwriters, to publishers, to television show producers, to musicians. The panel members discussed the importance of radio, royalties and copyright issues, advertising, the studio recording process, and the history of Music City among many other things. It was really a unique and intriguing day. There were two quotes from the panel discussions that I wanted to share here because they stuck out in my mind:

Technology has made [entrepreneurship] possible, the economics have made it mandatory.

This quote is from Ron Routson, COO of Film House, about the role entrepreneurship has been playing in the industry. The quote is to the point and captures what has happened in the industry over the last decade.

Some people say owning a studio is like owning a boat... the two happiest days are the day when you buy it and the day when you sell it.

The second quote came from Patrick McMakin Sr. who is the Director of Operations of Belmont University's Ocean way Nashville Recording Studios. I enjoyed the humor here, but it also speaks to just how difficult it is to run a studio profitably. I always had the impression that studios were super profitable, but with high overhead costs and more people recording themselves at home, keeping a studio above breakeven is difficult, according to McMakin.

Looking forward to Day 2 with more music business experts tomorrow.