Friday, July 9, 2010

More on Prescott at the SED

Blogging never fails to be interesting for me. Given who I typically talk to and what I typically read, I would never have imagined what ideas are floating around. Here is what I learned from the comments on my last blog post:

1. There is a segment of the population that is as unhappy with economists as they are with bankers, the Congress, the executive branch, or the judicial branch, for that matter. I understand that, for people not trained in economics, economic issues can be very difficult to sort through. The difficulty is acute, in part, because the stakes are so large. Governments and central banks have the ability, through their actions, to reallocate resources in ways that favor some segments of the population relative to others. Economists (or so-called economists - you don't need a license to call yourself one) are quite willing to sign on (explicitly or otherwise) with political parties to make the case that particular policies are somehow good for everyone (in the sense of being "good for the economy" or economically efficient), when the truth is that what they are advocating has more to do with reallocating wealth and income to their base of support. Republicans do it. Democrats do it. The result is that, at any time, one can find economists, some with excellent credentials, including Nobel prizes, giving what appears to be conflicting advice. How could the average person sort out this noise? I have no particular advice to offer, other than to educate yourself. Take an economics course, read, and think.

2. Some people are scary. You know the ones I mean.

3. I got a well-reasoned reply from someone who was actually at the financial crisis workshop, which was this:
Anonymous said...

I won't claim to speak for Ed, but my understanding of the third point is a bit different than yours, Steve. I don't think he really believes that expectations of higher future taxes are depressing labor supply. As you noted, this seems a bit ridiculous. But it does seem reasonable to think that expectations of higher future taxes are depressing private investment, which as you pointed out from Bob Hall's remarks, is one of the major components GDP that is suffering right now. It seems clear that the federal government has borrowed and spent a significant amount over the last 24 months or so. And we have some big obligations looming on the horizon as well (ongoing war costs, social security, and health care, to name a few). Our national debt isn't going away anytime soon, so we either have to cut spending (not likely), monetize the debt (I doubt the Fed will allow for significantly higher inflation), or see higher taxes sometime in the future. The latter seems most likely. If nothing else, it seems we're going to see at least some tax increases as the Bush tax cuts expire. It's clear that taxes affect return on investment, and business unsure of future tax rates might be less willing to make risky investments because of that uncertainty. That was my take on Ed's argument, and it seems reasonable. Let me know if I'm way off base here.
1. It is a difficult to interpret what Ed was saying, as he was not specific enough, and certainly didn't lay out an explicit model. One thing I did not mention was the discussion of intangible capital, which relates to this paper. This may relate to the capital taxation arguments this commenter makes.

2. Whether it's anticipated labor income taxes or capital income taxes, it seems very difficult to make the case that this could be driving this large recession. We have known about the government's obligations (defense spending, health care costs, social security) for a long time now. I don't know how you make the case that the weight of these obligations somehow came home to roost in fall 2008. In terms of the actual outcomes, as Hall noted in his talk, the size of government (that's total - federal, state, and local) has not increased recently. As well, the February 2008 stimulus package included $275 billion in tax cuts. I'll leave it to someone else to determine the tax implications of the health reform bill - that one is debatable. As the comment notes, there are serious budgetary problems at all levels of government in the United States. The state governments (and this is particularly acute in Illinois and California) are forced to face the problem in the present, but ultimately the federal government will have to face the reality of its present-value budget constraint (i.e. debt is debt - the government has to ultimately find a way to pay it off). But I don't think any of this helps Prescott make his case.

3. Prescott never addressed issues related to the housing market, which is central to the conventional narrative on the financial crisis. My view of this is the following. Incentive problems in the mortgage market caused us to accumulate a large stock of housing capital, essentially on false pretenses. On top of that stock of housing capital was built a structure of collateralized credit and asset trading that was supporting a significant fraction of aggregate economic activity. Housing prices fell because the reality of the false pretenses became apparent to people who were engaged in the financial trading supported by the false-pretense-housing. Now that the false-pretense demand for housing has gone away, we are not going to be building many houses for a while, and financial markets are having to restructure themselves, by finding other ways to support credit activity than through the construction and trading of mortgage-related securities. If we are going to address issues related to capital taxation, we should think carefully about how we treat the housing sector in the US. This sector has been heavily subsidized, for no good reason, through the mortgage interest tax deduction, Fannie Mae and Freddie Mac, and through the recent activities of the Federal Reserve System. Note that this is a pure consumption subsidy, of the flow of consumption services from housing. The subsidization diverts resources from productive investment, in part by making credit more costly for firms investing in plant and equipment.


  1. You said: "Whether it's anticipated labor income taxes or capital income taxes, it seems very difficult to make the case that this could be driving this large recession."

    I agree, and I do not support the claim that expected future higher taxes caused the current recession, but I think it's plausible that expected future higher taxes are hindering the recovery on the investment side. If you look at the GDP components we've been talking about, real personal consumption expenditure (even in durables) have started to grow again, but real private nonresidential investment continues to decline. We know that companies are hoarding a lot of cash right now, and uncertainty about future taxes is likely contributing to this.

    Here's someone a lot smarter than me who makes this argument and adds other salient points as well:

  2. Partial rebut to my own last comment...I was looking at the wrong investment series. Real private nonres investment actually increased very slightly the last 2 quarters, but it's been essentially flat for the last year and the YoY % change is still negative. Investment overall still appears to be recovering quite sluggishly.

  3. One comment: the type of tax rate increase matters. Expectations of higher future dividend tax rates, for example, can generate large declines in investment, hours worked, and output.

    These may, in fact, be the tax rates that Ed has in mind.

  4. "Debt is debt and has to be paid off"

    I know this seems like a real basic question but why does it have to be paid off? If the resources were truly idle (don't want to argue about trade-offs or crowding out) and the government borrowed money and it resulted in increased output how could that be bad?

    Taxes equal debt in terms of today's impact. Long-term it certainly would have distributional issues but I am utterly baffled when people say it has to be paid back.

  5. First anonymous:

    Yes, I agree. In principle, risk associated with future taxation could matter for the recovery. As always, we have to sort out how quantitatively important this is.

    Second anonymous:

    Maybe I was too cryptic. All I wanted to say was that, if the government is not going to default, the government is always faced with having to ultimately pay off its debt, if only in the very distant future. How does it do that? (i) It needs to raise future taxes; (ii) It can default implicitly by engineering a surprise inflation and reducing the real value of the debt. Debt-holders don't like to be surprised, though - strategy (ii) implies a loss of credibility. As I think you're implying, it could be advantageous for a government (or a country) to borrow in the present, just as it is for an individual, but of course this is never a free lunch - one has to pay off one's debts.

  6. Alan Blinder had a novel idea once: instead of theorizing about price stickiness why not ask
    firms why they don't change their prices? Bob Hall can theorize that firms are frozen by fear of government actions. When you ask CFO's, as Duke University did, or small business owners as Paul Krugman wrote about today, you discover that weak consumer demand is what business fears most and is what is slowing investment. This is just the old accelerator model of investment rearing it's ugly head.

  7. Adding to what malcolm said, where is the evidence for the assertion that worries about future tax hikes lower labor supply today?
    Without evidence to back it up, the assertion is just like pulling a rabbit out of a hat: 'It is anticipated future labor income taxes'. If that requires ridiculously large elasticities, try 'It is anticipated future capital taxes'. If that also doesn't work out, try 'It is anticipated future (insert at will) taxes'. Can anyone who subscribes to this line of argument supply any real world evidence for their views?

  8. You can divide the economy into any number of arbitrary sectors--call one, say, "govt sector" and the other "pvte sector". If the flow of spending from one is greater than the flow of spending in the other, we have a deficit. Seemingly rational people become strange when discussing deficits; however, keep calm because this is just the (change in the) amount of money we owe to ourselves, the consequence of the arbitrary divisions we've imposed on the economy.

  9. One has to pay off one's debts if there is an end-point to those debts. All one has to do otherwise--assuming one is an "ongoing concern"--is to pay the market interest rate on those debentures.

    So the three reasons for actually paying off debt are: (1) the interest cost is going to become too high compared to revenues, (2) activities are winding down/cannot be refinanced [this may be a special case of {1}], or (3) one can [a]refinance at a lower rate and/or [b] produce a greater return from paying off debt than investing.

    The third is generally the reason corporate debt gets paid off, but (3b) is theoretically impossible for the government in an economic model such as you are presupposing (has and is willing to exercise the power to tax).

    We should be able to presume that (2) is also not going to happen in a developed economy (though looking at UK data from ca. 1890-1948 produces the special case of no longer being the World's Reserve Currency, with attendant arbitrage possibilities).

    That leaves (1) or (3a). The latter is happening as a matter of course and has been since at least the GWB Treasuries decision to shift a lot of funding to short-term.

    So unless we believe the market is understating future inflation expectations or overstating economic growth expectations (i.e., r<[{pi} + i^e]) at some point on the curve, the only reason to reduce debt currently is because there are excess revenues.

    Unless the market believes (as it may have from late 2001 until late 2003/early 2004) that the concentration in short-term debt is suboptimal at best and irrational at worst, the argument of uncertainty in long-term projects depends on "long"-term interest rates (5 to 10 year range) and/or the attendant corporate borrowing spreads being too high.

    We know part of the answer for small businesses--the market portion (corporate borrowing spread) is too high, especially in the face of d/e/p/r/e/s/s/e/d/ reduced AD.

    But small businesses don't drive overall economic growth until and unless they start to become large businesses. And a marginally-profitable small business is never going to become a large business.

    So the question comes back to growth in the mid- and large-cap businesses, which are rather more able to manage shifts in taxes--especially if they are also worrying about government default affecting their business.

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