Milton Friedman On Government

An educational video providing material for thought. The bright professor Milton Friedman in an interview about taxation, government intervention and many more.

Same Treatment In The Two Sides Of The Atlantic

As expected, a last minute deal could not be a bold deal or one that would “fix” the problem. It just gives a breather, until the problem comes back to us again. The techniques to approach serious problems are extremely identical in the two sides of the Atlantic!: Push the can down the road. It is impossible for the human phycology to do the optimal; to stand above the short term goals and pressures. This is a universal law. Washington did exactly what Brussels did, given the battle they found themselves into. No supremacy of the New World was demonstrated in handling the same problem and this “plan” is not a fix, the same way that the recent deal in Europe is not a fix.

Roubini On Risks

Past Performance, Future Forecasts, And Taxes

Not surprisingly, the central piece in the talk continues to be the mounting debt and policies that could address that, and more specifically the taxes. The Bush tax-cuts are perhaps going to be the coming election’s campaign theme.

Related to the talk on taxes, WSJ today publishes an article “The Democratic Fisc” which uses the White House’s budget office numbers, published on Friday last week, to have a look at the past performance and future outlook of the U.S. economy. WSJ says “the main message is that tax revenues are smaller, spending is greater, and the deficits are thus larger than the White House has been saying”.

The article compares the current period with the 1981-82 recession which is similar in its severity with the one the current administration inherited. What strikes me are the following differences between these two periods:

	1981-1987	2009-20012
Budget Deficit:	less than 6% of GDP	current 9.9% of GDP, it is expected to rise to 10%, before it declines to 5.6% of GDP
Revenues:	17.3% of GDP, despite pro-growth tax cuts	14.5% of GDP, expected to increase to 15.8% in 2011 when big tax increases hit
Policy:	tax cuts across-the-board	spending, temporary tax rebates, jobless benefits

The findings, from the above table, clearly raise the long debated question about the effectiveness of spending and tax cuts. I will return to this later.

Some other factors that enhance the bleak future economic outlook are described by (1) the expectation that deficits will not shrink bellow 3.4% of GDP over the next ten years, (2) the ratio of debt-to-GDP will continue to increase over the same period, (3) there is no plan yet to fight debt, (4) spending is expected to increase and (5) taxes are increasing -- this is not a request of the fiscal commission, which means that perhaps more taxes are coming.

Austerity vs Stimulation: The Questionable Effectiveness Of Spending

Austerity measures are usually combinations of government spending cuts and increased taxes. Stimulating practices, on the other hand, are consisted of combinations of the exact opposite actions, increasing government spending and/or reducing taxation. Therefore, it is clear that perhaps one has to choose one or the other, austerity or stimulation.

The above premise is based on the belief that one can create stimulation in the economy by increasing government spending or reducing taxes, and that one can save money by cutting spending or increasing taxes. But how much of it is true? Are the policies that help the country’s balance sheet hurt the economy’s growth? This article attempts to answer both questions.

It is always the case in economics, that an action generates more than one effect and often times these effects move in opposite directions. This is the case also here. Let us start with the alleged austerity measures and their effects.

Austerity Measures

1. Spending Cuts
   1. Effect on Output: Output may decline.
   2. Effect on Balance Sheet: Interest rates may decline.
2. Tax Hikes
   1. Effect on Output: It may decline.
   2. Effect on Revenues: Collected taxes may go up or down.

Spending Effect on Output

In what follows I will discuss the consequences of spending cuts, or increasing spending, on output. I focus on this because this is the most relevant topic these days. The current economic situation is described by anemic growth and high debts. In order to address one we may deteriorate the other and vice versa. Currently the discussion has focused on whether one, for example the U.S., should engage in tight fiscal policy, and more specifically, in cutting spending. This week FT hosts a debate on the same topic inviting articles from renowned economists.

Whether spending has an effect on output is summarized by the value of the spending multiplier. This is a number that stands for the number of dollars is generated in output by one dollar spent by the government. Advocates of spending policies justify their opinions on spending multiplier greater than 1.0. How much of it is true?  

The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one.

For example, Barro and Redlick (paper link, WSJ article) find that defense spending has a multiplier of 0.6-0.7 at the median unemployment rate – while holding fixed average marginal income-tax rates – and there is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is 12%. Estimating spending multipliers for non-defense spending is problematic as the nondefense government purchases are positively correlated with the business cycle and it is difficult to establish causality. Is it the spending that created growth or the growth that spurred government into spending? Barro and Redlick think the latter.

The same ideas are reiterated also in Wednesday’s FT article by Kenneth Rogoff. He believes that:

“At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilize the banking system.”

In addition, a rough method I employ gives me a spending multiplier of 0.6, less than 1.0, rendering spending an ineffective policy. Finally, there are people who argue that the multiplier is negative, in which case, spending by the government decreases the output. This is also called crowding out.

There are however economists who argue that the multiplier is greater than one. Christina Romer, head of the President Obama’s Council of Economic Advisers, and Mark Zandi, from Moody’s, claim that the multiplier is 1.6. Note that, Keynes believed that the U.S. multiplier in the 1930s was 2.5.

Policy Implications

It is clear, now, that if the value of the multiplier is what the consensus has it in the academic community, around 0.6 or lower, cutting spending will have a small effect on output, as it is also the case that giving another stimulus package will generate little additional growth in the economy. Clearly, the opposite is true if the multiplier is 1.6 or higher, like some people advocate. However, the benefits of any policy have to be weighed with the benefits or costs of contingency scenarios. A policy creates repercussions that also need to be evaluated. For example, spending cuts may or may not decline the economy’s output, but it also has an effect on the country’s balance sheet, the expectations of both the bond investors and the consumers. A policy decision is an act of balancing the fears of all the groups that are involved in a given situation. (For more, read on the big number of factors that affect the value of debt.)

Not Exactly, Mr Krugman.

Paul Krugman expressed his view against austerity measures at this time. Even though I also think that we should not take austerity measures right now, I have to disagree with the argument he gives in his posting entitled “Self-defeating Austerity”. The point of the article is that austerity measures have a toll on output which will decrease the government revenues (taxes). Therefore a tight fiscal policy, at this time, will be detrimental for the economy as well as the budget deficit.

Is this right? The devil lies in the details and indeed this is where it again lies in the argument Krugman gives. The key assumption to his argument is the spending multiplier, which is assumed to be 1.4. This means that every dollar spent by the government generates 1.4 dollars in the economy. It is not difficult to understand that if such a multiplier is really at works, then cutting spending really hurts the economy, while pilling up debt “pays for itself”.

Spending Multiplier Debate

So the question is whether the spending multiplier is as high as 1.4. The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one. There are also people who argue that the multiplier is negative, in which case, spending by the government reduces output. For a more complete discussion of this debate, click here.

In addition, a rough estimate I come up with by reversing Krugman’s argument I find that the spending multiplier is 0.6, much less than the 1.4 used in his article, rendering spending an ineffective policy.

Back to Krugman’s Argument

The whole argument is that since 1% of GDP spending could produce 1.4% GDP growth, cutting it, shrinks the economy by 1.4%, while the savings amount to only 0.65% of GDP, since a 0.25 marginal tax effect implies that the government losses 0.35% of GDP in taxes.

Now, using an arguably more accurate multiplier estimate of 0.6, we have that a 1% of GDP cut in spending, shrinks the economy by 0.6% and results to savings of 0.85% of GDP. These numbers describe a much more appealing picture in favor of fiscal tightening.

Evaluating the Benefits of Spending Cuts

In addition, Krugman calculates the current benefits of not getting additional debt. Assuming that an increase in spending is coming from borrowing at a real interest rate of 3%, the government by not borrowing saves the expense of 3%*1% of GDP or 0.03% of GDP. This amount, using the same marginal tax rate as above, implies that the government does not have to generate an additional 0.03%/0.25 of GDP or 0.12% of GDP. Given that the current interest rates are way lower than 3%; this number is actually an overstatement of the current debt benefits from cutting spending.

Even though the current interest rates are not high, so perhaps this exercise may not be relevant now, I would like to calculate the general benefits of spending cuts, i.e. the maximum benefits, by considering a case in which the interest rate constraint is binding, i.e, when debt reaches its ceiling, so that the reader gets a feeling of the benefits of these policies in extreme cases, when they are really needed. In those days interest rates increase rapidly to very high values, like 10%-20%. With a 10% real rate, the same computation done above implies that, the savings from servicing the new debt amount to 0.4% of GDP.

However, measuring the benefits of spending cuts just by looking at how much less debt we need to service, in a strictly output-measure sense, is not complete. There are other benefits which are difficult to quantify,[1] like the increased confidence of the bond community on the sovereign entity’s bonds and the benefits from escaping default. Alleviating fears and escaping from the worst, which are worthy way more than 0.4% of GDP.

Parameters as Functions of the State of the Economy

My next comment has to do with the partial approach that we usually employ in economics.[2] The costs calculated above are marginal costs when all the other parameters are fixed to the assumed values. However, these parameters are not constant in the economy. They too change with the state of the economy. For example, the marginal tax rate changes; it increases (or decreases) if taxes are increased and it declines if output declines. The same is true about the spending multiplier; it can increase if the government becomes more efficient, if the economy improves, or if the quality of projects increases. Also, it decreases as it crowds out private sector’s investments and it perhaps increases as the private sector holds on on investing, anticipating high taxes in the future. The same, at last, is true about the interest rate; it is considered to be procyclical, it increases as the credit quality of the country deteriorates, and it increases as fears or expectations about inflation increase.  

Acknowledging this fact but also ignoring to some extent, for now, and taking his argument to the extreme can reveal some of its weaknesses, which I have already mentioned. Assuming that the marginal tax effect and the multiplier are as above, the new revenue is always 0.35% of the previous period’s GDP. What is the interest rate that would make taking additional debt impossible to service? This rate would be such that r%*1% = 0.35%, hence r=35%! This means that this scheme could be played as long as real long interest rates are less than 35%. Of course, we all know that a scheme like this would have stopped way earlier, most probably at rates around 15% (this is itself arbitrary but historically justifiable).

A Spending Multiplier Estimate

Reversing the above exercise, we can estimate maximum multiplier that can sustain the above pilling up debt scheme. As the country’s balance sheet deteriorates, both the marginal tax effect and the multiplier change. Assuming that the tax effect is less volatile than the spending multiplier, we can estimate the maximum value the multiplier can get in order to facilitate servicing debt at 15%. Multiplier = 15%/0.25 = 0.15/0.25 = 0.15*4 = 0.6. So, an estimate for the spending multiplier we get by reversing Krugman’s argument is 0.6. This means that for each dollar spent in the economy by the government, the economy increases its output by 0.6 dollars, revealing that government spending is not a very efficient use of the public money.

A More Robust Answer Why We Do not Need Austerity Measures

Instead of going on and giving examples that are based on questionable estimates, a much more direct and unquestionable approach is to look at what the markets say. Interest rates are bottom low. For more, read on my answer to this question.

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[1] Putting a number on these benefits depends on the level of interest rates, the amount of debt, the growth rate of debt, the state of the economy and other factors.

[2] This is a general comment, not necessarily against Krugman’s argument, of course. After all, he warns against generalizations of his argument and taking it to the extreme.