Mulligan on Obamacare Marginal Tax Rates

Casey Mulligan wrote a nice Wall Street Journal Oped last week, summarizing his recent NBER Working Paper (also here on Casey's webpage) on marginal tax rates.

What do I mean, tax, you might ask. Obamacare is about giving people stuff, not taxing. Sadly, no. Obamacare gives subsidies that are dependent on income. As you earn more, you receive fewer subsidies for health care, reducing the incentive to earn more. Casey tots this sort of thing up, along with the actual taxes people will pay.

Economists use the word "tax" here and we know what we mean, but it would be better to call it "disincentives" so it's clearer what the problem is, and just how painful we make it for poor people in this country to rise out of that poverty.

As you can see, the average marginal "tax" rate went up 10 percentage points since 2007, and about 5 percentage points due to Obamacare alone.

Going back to the working paper, I think this is actually an understatement. (Probably the first time Casey or I have ever been accused of that!)


First, not even Casey can add everything up, and it all adds in one direction. State and local taxes, and vast number of state, county, city and other income or asset-based transfers all add. I haven't read all his papers or the whole book yet, but did Casey get them all? For example, I just got in the mail notice for a little program offered by the state of Illinois to lower your property taxes if you earn less than $100,000 per year. Nice, but one more little incentive not to earn more than $100,000 per year, and not in Casey's calculation.

In email correspondence, Casey pulled me back from these thoughts in a way that is revealing about the calculation. I wanted to add sales tax. After all, if you earn a dollar, but you have to pay 10% sales tax to do anything with it, that's another 10% distortion, no? Casey responds no, because he wants to measure the income-compensated distortion to labor, period. If you don't work, and somehow you also get income, you still have to pay the 10% sales tax. So the sales tax does not distort that pure work-no work decision. Casey's right, but I think this clearly illuminates the conservative nature of his calculation and what it means. There are a lot more margins, wedges, and distortions out there, and he's not trying to measure them all. He's also not trying to measure the wedges and disincentives for employers to hire people, towards non-market activities, and certainly not the effects of the regulatory tangle.

Another note of conservatisim: "The results account for the fact that many people will not participate in programs for which they are eligible." This is an important issue, that at least had not sunk in for me until reading a recent CBO report. People don't sign up for all the benefits to which they are eligible. If they did, marginal tax rates would be astronomical. It also sends a warning: Just how long will it be before people in an increasingly stagnant economy figure out all the programs they are eligible for?

Drawing a single line can also be unduly calming. You might say, "well 50% isn't so bad. Europeans still work, sort of, paying 50% marginal tax rates."  But as Casey reminds us, the spread in marginal tax rates across people is enormous. For example, the paper has a nice example (p. 13, table 2) of how a typical earner will come out ahead by choosing to work part time and receive subsidies, rather than work full time. This is a case of a 100% marginal tax rate.

It's likely that the effect of marginal taxes is nonlinear. Much of the labor decision comes in chunks: work or don't work; work part time or full time; apply for benefits or don't, with transactions costs and irreversibilities.  Suppose half the population feels a 100% marginal tax rate and half feels zero. Half the population works, half does not. That is likely a much larger effect than if the whole population felt a 50% marginal tax rate.

In sum, it's probably worse than even Casey's graph. But Casey is doing the right thing in putting up a carefully documented graph and paper rather than speculating. Speculation is for blogs, not papers and not for good opeds.

And Casey's big point remains the additional effect of Obamacare and other changes to Federal programs. Whatever you think the level is, it's now 10 percentage points more than what it used to be. On average.

Dupor and Li on the Missing Inflation in the New-Keynesian Stimulus

Bill Dupor and Rong Li have a very nice new paper on fiscal stimulus: "The 2009 Recovery Act and the Expected Inflation Channel of Government Spending" available here.

New-Keynesian models are really utterly different from Old-Keynesian stories. In the old-Keynesian account, more government spending raises income directly (Y=C+I+G); income Y then raises consumption, so you get a second round of income increases.

New-Keynesian models act entirely through the real interest rate.  Higher government spending means more inflation. More inflation reduces real interest rates when the nominal rate is stuck at zero, or when the Fed chooses not to respond with higher nominal rates. A higher real interest rate depresses consumption and output today relative to the future, when they are expected to return to trend. Making the economy deliberately more inefficient also raises inflation, lowers the real rate and stimulates output today. (Bill and Rong's introduction gives a better explanation, recommended.)

So, the key proposition of new-Keynesian multipliers is that they work by increasing expected inflation. Bill and Rong look at that mechanism: did the ARRA stimulus in 2009 increase inflation or expected inflation?  Their answer: No.


This is a quantitative question. How much do the large-multiplier models say the ARRA should have increased inflation? Their answer: 4.6%. Where is it?

We know, of course, that inflation (especially core inflation) basically did nothing during the period of the ARRA, and Bill and Rong have some nice graphs. Defenders might say, aha, but except for the stimulus, we would have had a catastrophic deflation spiral. Critics might reply, that's what George Washington's doctors said while they were bleeding him. As always, teasing out cause and effect is hard.

Bill and Rong have a range of interesting facts that address this question. Here are two that I thought particularly clever. First, they look at the survey of professional forecasters, and examined how the forecasters changed inflation forecasts along with their changes in government spending forecasts, i.e. when they figured out a big stimulus is coming. I plotted the data from Bill and Rong's Table 2

Dupor and Li Table 2

As you can see, in 2008Q4 and 2009Q1, many forecasters updated their views on government spending, a few by a lot.  However, there is next to no correlation between learning of a big stimulus and increases in expected inflation, especially among the forecasters who strongly update their stimulus forecasts.

Bill and Rong's interpretation is that the stimulus failed to increase expected inflation. The main defense I can think of is to say that this evidence tells us about professional forecaster's model, not about true inflation expectations. Professional forecasters are a bunch of old-Keynesians, not properly enlightened new-Keynesians; they don't realize that stimulus works through inflation, they're still thinking about a pre-Friedman consumption function. That's probably true. But if so, it's hard to think that everyone else in the economy does understand the new truth, and changed their inflation forecasts dramatically when they learned of the stimulus.

Another nice piece of evidence: The US had much bigger government spending stimulus than the UK. The behavior of expected inflation revealed in the real vs. nominal treasury spread was almost exactly the same. (Yes, Bill and Rong delve into the TIPS pricing in the crisis.)

Source: Dupor and Li

Finally, a key point missing in most of the stimulus debate. These models predict big multipliers not just at the zero bound, but anytime that interest rates don't respond to inflation. We don't have to just rely on theory, there is some experience. New-Keynesians since at least Clarida Gali and Gertler's famous regressions have said that the Fed was not increasing interest rates fast enough in the 1970s, and the 1930s and interest-rate peg of the late 40s and early 50s are another testing ground. Using standard measures of exogenous spending increases, Bill and Rong find no impact of government spending on inflation in any of these periods.

New Keynesian stimulus analysis has been particularly slippery, on the difference between the models and the words, and on advocating the policy answers without checking or believing the mechanisms. The models are Ricardian: the same stimulus happens whether paid for by taxes or borrowing. The opeds scream that the government must borrow. The models say totally useless spending stimulates. The opeds are full of infrastructure, and roads and bridges. (At least, the "sprawl"  complaint is temporarily quiet.) The models say that spending works by creating inflation, not through a consumption function. Inflation being totally flat, and the counterfactual argument weak, you don't hear much about that in the opeds.  The models say we should be in a huge deflation with strong expected output growth. The facts are protracted stagnation. (More in my last stimulus post.) The models are models, worthy of careful examination and empirical testing. All I ask is that their proponents take them seriously, and not as holy water for a completely different old-Keynesian agenda.

Rogoff on UK Defaults

Ken Rogoff wrote a very interesting FT oped on UK finances (FT original, Rogoff webpage if you can't see FT.)

The issue: Should we worry about huge sovereign debts of advanced countries? Or was the only problem with fiscal stimulus that it was not big enough?


A little history:

Yes, from the 1800s until the first world war, the UK was a global superpower that commanded vast colonial resources and investments. Over long periods, these foreign assets yielded returns well in excess of interest on debt. But comparing government debt ratios back then, when the UK was a massive net creditor, to debt ratios today, when British foreign liabilities exceed foreign assets, is utterly misleading. Moreover, back in the 1820s, the UK was pioneering the industrial revolution; things are not quite the same today. Back then, the UK did not have to worry about pension liabilities or existential threats to the banking system that could require massive injections of cash to fix. ...

During the 1930s, Britain defaulted on debt to the US accumulated during the first world war and its aftermath. ...

It is often stated that after the second world war the UK debt reached almost 250 per cent of gross domestic product and was brought down merely through growth and inflation. This is a myth ...

Then there is the high-inflation era of the 1970s – another de facto default. Last but not least, what about the UK’s serial dependence on International Monetary Fund bailouts from the mid-1950s until the mid-1970s? This is hardly a country with an indestructible credit status. ...

Being a UK bondholder has had its ups and downs.

Looking forward, an important point: a country needs to be substantially below its ultimate borrowing limit, or it loses its ability to fight crises going ahead.

..a euro collapse would have triggered a stampede out once investors realised that the UK banks and trade would be savaged, a flexible currency notwithstanding. In that scenario, UK leaders would have been forced to close massive budget deficits almost overnight. That would have been truly catastrophic austerity. ...

We now know the euro did not collapse. [yet -- JC] With 20-20 hindsight, yes, the UK could have borrowed more. But we do not have hindsight at the moment decisions have to be taken. 

Kan and Carmen Reinhart have been at the receiving end of Paul Krugman's tender commentaries lately, and I'm interested to see Ken taking up the issue. Krugman likes to lambaste people for "predictions" that he imagines they made which didn't come out. On the euro blowing up, Ken seems to be offering a taste of his own medicine, made more bitter by the fact that Krugman actually did say what Ken says he said:

...This was the big call – the one that everyone was focusing on. To state that credit risk was gone by 2010 is ludicrous. None other than The New York Times columnist Paul Krugman prognosticated the euro’s early demise regularly from April 2010 to July 2012. His big call has turned out – so far – to be dead wrong.

I will be curious if we see more of that from Ken. Stay tuned.

Litterman on carbon finance

I just read a very nice article by Bob Litterman in CATO's "Regulation" on the finance of carbon taxes. It includes a review of some of the recent academic calculations.

(Related, Ronald Bailey at Reason.com takes on the Administration's latest cost of carbon estimates, and reviews Robert Pindyk's recent NBER working paper "What do the models tell us?" also covered by Bob.)

Like just about every economist, Bob favors a carbon tax or tradeable emissions right over the vast network of regulatory controls on which we are now embarked. I might add that getting rid of the large subsidies for carbon emissions implicit in many country's policies would help before we start taxing.

But let's get to business, how big should the carbon tax be?


It's a hard question. The economic costs of warming are hard to assess. Moreover, they come in a century or more, when presumably our descendants are much wealthier than we are, and hopefully have technologies we have not imagined. Or civilization will have collapsed so they have a lot more pressing problems. How do we trade off costs now and uncertain benefits in a century?  What discount rate should we use?

Bob has good points on this question that I hadn't thought of, and are good applications of finance thinking (as you'd expect from Bob) which is sort of my excuse for covering it here.

Carbon beta

First, climate costs are likely to have a strong negative beta, and thus climate investments have a large positive beta.

Here's the thinking. The rate of economic growth over the next century is a major uncertainty. Will the historically unprecedented growth of the post WWII era continue, say 2% real per capita? Or does our current scleroscis settle us into 1% growth? Or are the end-of-growth prognosticators right? When you compound over a century, these add up to truly major uncertainties over how wealthy our descendants will in fact be.

But they also add up to truly major uncertainties over how much carbon we will emit in the meantime. If growth stops, carbon emissions stop too. Yes, it's not one for one (a perfect correlation). Technology choice matters; everything from windmills to deregulated nuclear power to driverless cars and trucks makes a difference. But there is a strong positive correlation.

So, if carbon is a bigger problem, our descendants are more likely to have lots of money, technology, and resources to deal with it. If they are poorer, then carbon is likely to be a lesser problem. In finance language, projects with a strong positive beta require a much higher expected return, and a high equity-like discount rate. This consideration drives us to tax less now.

Catastrophes

But, Bob goes on, how do you price catastrophe risk? Though the central tendency of the present value of economic costs of carbon emissions are surprisingly low -- even moving all of Florida up to the Georgia border is only money after all, and you have a century to do it -- there is a chance that things are much worse.

We're all thinking about "black swans" and "tail risk" these days. Shouldn't we pay a bit more carbon tax now, though the best guess is that it's not a worthwhile investment, as insurance against such tail risks?

The problem is,

Massachusetts Institute of Technology economist Robert Pindyck... argues that too many non-GHG-related low-probability, high-damage scenarios exist. He writes, “Readers can use their imaginations to come up with their own examples, but a few that come to my mind include a nuclear or biological terrorist attack (far worse than 9/11), a highly contagious ‘mega-virus’ that spreads uncontrollably, or an environmental catastrophe unrelated to GHG emissions and climate change.” He concludes that society cannot afford to respond strongly to all those threats.

Indeed. (Fun for commenters: come up with more. Asteroid impact. Banking system collapse. Massive crop failure from virus or bacteria. Antibiotic resistsance....) If we treat all threats this way, we spend 10 times GDP.

It's a interesting case of framing bias. If you worry only about climate, it seems sensible to pay a pretty stiff price to avoid a small uncertain catastrophe. But if you worry about small uncertain catastrophes, you spend all you have and more, and it's not clear that climate is the highest on the list.

This thought fits nicely into the modern research on "ambiguity" and "robust control" (for example see Lars Hansen and Tom Sargent's webpages for a portal). This line of thought often argues that you should pay a lot of attention to unlikely catastrophes, especially when it's hard to quantify their risks. And Pindyck's point (as I see it) gets to the central problem with that line of thought: you have to draw an arbitrary circle about which unlikely events you pay a lot of attention to, and which ones you pay no attention to.

If you worry about anvils falling from the sky, maybe you miss the piano falling from the sky. And if you worry about anvils, pianos, dynamite, and so on,  you just don't get out of bed in the morning.

It's also related to the tendency people have, in Kahneman and Tversky's famous analysis, to overweight some small probability events -- nuclear reactors, airplane crashes, terrorism -- and to ignore others -- coal dust, cab crashes on the way to the airport.

The same observation: One of my skepticisims of the current almost exclusive focus on carbon and global warming in the environmental community is that we may miss the real environmental problems. Most of the world breathes awful air and drinks awful water. Climate change is not even on their list of environmental problems. And the environmental effects of social or economic collapse or another war might dwarf warming.

All in all, I'm not convinced our political system is ready to do a very good job of prioritizing outsize expenditures on small ambiguous-probability events.

Alternative investments

Once we reduce things to money, which is what economists do, a bunch of unconventional and unsettling analysis opens up. (This isn't in Bob's piece, mea culpa only.) The economic case for cutting carbon emissions now is that by paying a bit now, we will make our descendants better off in 100 years.

Once stated this way, carbon taxes are just an investment. But is investing in carbon reduction the most profitable way to transfer wealth to our descendants?  Instead of spending say $1 trillion in carbon abatement costs, why don't we invest $1 trillion in stocks? If the 100 year rate of return on stocks is higher than the 100 year rate of return on carbon abatement -- likely -- they come out better off. With a gazillion dollars or so, they can rebuild Manhattan on higher ground. They can afford whatever carbon capture or geoengineering technology crops up to clean up our messes.

Put that way, though, the first question might be why we are leaving our descendants with $18 trillion of Federal debt, and a bill for $70 trillion or so of unfunded liabilities. Once we reduce the question to investment now to benefit the economic well-being of our descendants, it's not at all clear that investing in carbon reductions is the best place to put our money.

The greatest thing we can invest in for the economic well being of our 100 year descendants is strong, decades-long  economic growth. Needless to say, the overall economic policy mix and especially the environmental policy mix is not pointing in that direction. A lot of environmental policy actively discourages growth.

Nonlinearities

Bob points out one good case against this analysis. It is possible that carbon abatement is a very special investment with very special state-contingent rate of return.

There is a very small chance that climate effects may not just reduce subsequent growth, but may cause it to plummet catastrophically. Such scenarios require positive feedbacks; for example, warmer temperatures cause the release of methane from the currently permanently frozen tundra, triggering catastrophic warming impacts beyond the ability of future generations to adapt. How should society today rationally price the possibility of such unknown, very-low-probability outcomes in the future?

In my investment context, reducing carbon emissions now has a very special property that alternative ways of investing money don't have -- it turns off this low probability but huge negative-return scenario.

That's a good point -- but it means the entire case for a strong carbon tax now relies on how likely such extreme nonlinearity is.

Economics after all? 

I suspect this sort of analysis will be profoundly unsettling -- how about infuriating -- to people who worry about carbon and other greenhouse gases. It's not just about money, I suspect they might say, it's not about giving our descendants wealth; it's about giving them a healthy planet. The economist might say, so what's that worth to you? Some finite number, no? Sure, we inundate Florida, but our descendants are $100 trillion richer, so they can afford to rebuild Florida on higher ground. Problem solved with $90 trillion extra in the bank. Somehow I doubt Greenpeace will go back to saving whales even if that argument were decisively proved.

As much of a died-in-the wool economist as I am, I have to admit some sympathy. (Or maybe "ambiguity?") Consider species extinction. Our short time on Earth coincides with a greater mass extinction than the asteroid that killed off the dinosaurs. And the extinction rate is not abating.

Now, I can't point to an economic cost, and people who hold up development projects to save some small species have a hard time doing the same. The best arguments I have read (admittedly not an expert) is of the sort that there might be some snake in the rain forest has a medically useful venom. More generally, "biodiversity is good." These is again, the  small probability of huge but unquantifiable benefit option-value argument.

Really, is that the best we can do when staring at the K-T boundary, and realizing that future alien geologists will see a more dramatic layer, with far more interesting chemistry, where we lived? The feeling nags that it can't be a good thing for us to move on from the dinosaurs to see if we can beat the Permian-Triassic extinction in the spectacular-geology department. (Global warming is a is a tiny component of extinction -- we got megafauna with spears.) I welcome suggestions on how to voice this view in economic terms.

Perhaps systematically worrying about small and unquantifiable probability events isn't such a bad thing. But paying attention to vague unquantifiable worries leads to a lot of stupidity, like banning genetically modified crops.

Back to carbon taxes

With all that in mind, where do I stand on carbon taxes? Usually, when something is this muddy, it means we're asking the wrong question, and I think that's the case here.

I think we're way too focused on the amount of the tax and way too unfocused on its operation.

I think we should be talking about a carbon tax in place of  all the rest of our rather calamitous energy policy. Subsidies for windmills, for rich people to buy Tesla cars, HOV lanes, fuel economy standards, subsidies for photovoltaic roofs, tax credit for energy efficient appliances, certified buildings, ethanol, high speed trains, low speed trains, and on and on. Throw out the whole department of energy, the EPA's ability to regulate climate emissions, and every other nagging energy regulation, and give us a carbon tax instead (and real-time tolling to eliminate congestion). Set the level of the carbon tax at the cost of all this other junk, and achieve better results at a fraction of the cost.

The first-order issue is the monstrous inefficiency and increasing corruption of our energy regulation. Get the clean carbon-tax system in place, then we can talk about the level of the tax. In that world, a tax rate twice or even three times too high will have much fewer distortions than what we have now, and will produce both better growth and a cleaner environment.

Alas, as with the consumption tax and any other perfectly obvious policy, we can't seem to trust that the deal will be kept.

The Value of Public Sector Pensions

The unfunded promises of public sector pensions are in the news, with the Detroit bankruptcy. Josh Rauh at Stanford and Hoover has a nice blog post on the subject titled "Public Sector Pensions are a National Issue''. (Josh and Robert Novy-Marx wrote a very influential paper (ssrn manuscript) alerting us to the size of the state and local pension bomb.)

Josh's baseline number for the value of underfunded pensions: $4 trillion. Why so big, and why is this a surprise? Because many governments calculate their funding by assuming they will earn 8% per year. Discounting a riskless liability (pensions) at a risky rate is a basic error in finance. It's made all the time. University presidents are notorious for demanding their endowments "reach for yield" in order to "make our rate of return targets."

Reading this piece sparks a few thoughts about the risks posed by pensions and other unfunded liabilities.

Let's report risks

How to make the error clearer? Perhaps focusing on present values and arguing about discount rates obfuscates the issue. Let's talk about risk. Maybe it would clear things up if pensions had to report a "shortfall probability" or "value at risk" calculation like banks do. OK, you are assuming an 8% discount rate because you're investing in stocks. What's the chance that your investments will not be enough?   Coincidentally, when I saw Josh's piece I was putting together a problem set for my fall class that illustrates the issue well.

Here is the distribution of how much money you will have in 1, 5, 10, and 50 years if you invest in stocks at 6% mean return, 20% standard deviation of return. I added the mean in black, the median (50% of the time you earn more, 50% less) and the results of a 2% risk free investment in green. (The geometric mean return is 4% in this example.)

(Note: there is a picture here. I've noticed this blog is getting reposted here and there in text-only form. Go to the original if you want the pictures)

The mean return looks pretty good. After 50 years, you get $20 for every dollar invested, or contrariwise an accountant discounting a promise to pay $20 of pensions in 50 years reports that the present value of the debt is only $1. But you can see that stock returns (these are just plots of lognormal distributions) are very skewed. The mean return reflects a small chance of a very large payoff.

In these graphs the chance of a shortfall is 54, 59, 62, and 76% respectively. As horizon increases, you are almost guaranteed not to make the projected (mean) return! The median returns -- with 50% probability of shortfall, in red -- are a good deal lower. And the modal "most likely" return is below the riskfree rate in each case.

How is it that people get this so wrong? Let's look at the distribution of annualized returns in each case. Remember, these are exactly the same situations, we're just reporting a different number.

In these pictures, the distribution of annualized returns is symmetric, the mean and median are the same, and the distributions get narrower and narrower for longer horizons.

Comparing the two graphs, you see that annualized returns are profoundly misleading about the risks you're taking. Annualized returns have a standard deviation that goes down at the square root of horizon. But the actual return has a standard deviation that goes up at the square root of horizon, and exponentiating makes it skewed with the larger and larger chance of underperformance. Money matters, not annualized returns.

So as usual, when arguments are getting nowhwere, perhaps we need to shift the question: please report your shortfall probabilities. And your plans for what you do with shortfalls.

In  many of those cases, the plan for shortfall  comes down to "the Federal Government bails us out" (or ERISA bails out private plans.) Well, if that's true, then we have a different and interesting discounting question. Maybe 8% is the right number if someone else pays the losses!

Finance also teaches us to think about "state contingent payoffs." What does the whole world look like in the bad events? If cities and states can't pay their pensions, this very likely because stocks have performed badly, and because we've had 20 years of sclerotic growth, no growth in tax revenues, to fund the pensions. Stock returns are not uncorrelated with other aspects of state, municipal, and corporate finance. Investing in stocks to fund pensions is like selling fire insurance on your house, rather than buying it. If the house burns down, then you pay the insurance company.

What debt really matters?

Even $4 trillion is not all that huge in the grander scheme of things.  The official Federal debt is $18 trillion. But if you add the present value of unfunded pensions, social security, medicare, Obamacare, and so on you can get numbers like $50 trillion or more. Which, it should be perfectly obvious, are not going to get paid, especially if we stay on the current slow growth trajectory.  But how important is this present-value observation?  Should we routinely add up all the unfunded promises, discount them properly using the Treasury yield curve, and report the grand total?

I worry most about runnable debt. Promises to pay people trillions in the far off future are a different thing than rolling over marketable debt every year. If it looks likely we won't be able to pay pensions in 20 years, there's not all that much pensioners can do about it. If it looks like we won't pay off formal short-term debt, markets can fail to roll over, leading to an immediate financial crisis.

So, much as I value Josh's calculation, and zinging those who want to minimize the necessity of ever paying off debt, it does seem there is a difference between marketable debt that needs to be rolled over every year and promises to pensioners and social security that may eventually be defaulted on, but can't cause an immediate crisis.

The cash flows do matter. If the government has promised to make pension and other payments that on a flow basis drain all its revenues, something has to give. As it has in Detroit.

A too-clever thought

A good response occurred to me, to those cited by Josh who want to argue that underfunding is a mere $1 trillion. OK, let's issue the extra $1 trillion of Federal debt. Put it in with the pension assets. Now, convert the pensions entirely to defined-contribution. Give the employees and pensioners their money now, in IRA or 401(k) form. If indeed the pensions are "funded," then the pensioners are just as well off as if they had the existing pensions. (This might even be a tricky way for states to legally cut the value of their pension promises)

I suspect the other side would not take this deal. Well, tell us how much money you think the pension promises really are worth -- how much money we have to give pensioners today, to invest just as the pension plans would, to make them whole. Hmm, I think we'll end up a lot closer to Josh's numbers.

Details

I used a geometric Brownian process, dp/p = mu dt + sigma dt with mu = 0.06 (6%) and sigma = 0.20 (20%). The T year arithmetic return is then lognormally distributed R_T = exp( mu - 1/2sigma^2)T + sigma root T e) with e~N(0,1). It has mean E(R_T) = exp(mu*T)=exp(0.06*T), median exp[mu-1/2sigma^2)T] = exp(0.04*T) and mode exp[(mu-3/2*sigma^2)T] = exp(0)=1.

Mankiw on the 1%

Greg Mankiw has an intereting new article draft, titled "Defending the 1%"  It's mistitled really, as the main point I got out of it is the more interesting question, "Can transfers really help the bottom 50%?"

It's a very well written (as one would expect) and survey of economic issues surrounding the idea of greatly expanded taxation of upper income people to fund transfers. Go read it, I won't do it justice in a summary.

As Greg notes, much of the success of the 1% is not rent-seeking, nor inherited wealth, but entrepreneurs who innovated and got spectacularly wealthy in the process.

It's not clear how Steve Jobs getting hugely rich hurts the rest of us. (Greg makes a few jabs at financial profits, but readers of this blog know that's a more nuanced issue.) It's not clear how any of us even know if Jobs had $100 million, $1 billion, or $1 Gazillion when he died, though it makes a huge difference to measured inequality.  And I like Greg's emphasis that it doesn't make much philosophical or moral sense to draw national borders around income-transfer moral philosophy.  Look for the kidney story too.

Greg chose not to argue with the very tricky measurement issues, instead just quoting Pikkety and Saez' numbers.  That's a good issue for another day -- other measures give very different results.

One of Greg's main points is that our inequality is the result of an interplay between supply and demand for talented skilled people.

I am more persuaded [than by Stiglitz] by the thesis advanced by Claudia Goldin and Lawrence Katz (2008) in their book The Race between Education and Technology. Goldin and Katz argue that skill biased technological change continually increases the demand for skilled labor. By itself, this force tends to increase the earnings gap between skilled and unskilled workers, thereby increasing inequality. Society can offset the effect of this demand shift by increasing the supply of skilled labor at an even faster pace, as it did in the 1950s and 1960s. In this case, the earnings gap need not rise and, indeed, can even decline, as in fact occurred. But when the pace of educational advance slows down, as it did in the 1970s, the increasing demand for skilled labor will naturally cause inequality to rise. The story of rising inequality, therefore, is not primarily about politics and rent-seeking but rather about supply and demand.

Having stated it this way, I'm disappointed Greg didn't explore supply more. Why is it that America has not responded this time by increasing the supply of skilled workers? The obvious suspects are easy to name, and do not bode well for the left's suggestion that permaent confiscatory taxation plus transfers are the answer to the "problem."

Greg does a good job of painting the standard incentive problem with tax and transfer redistribution. However, he states it in its classic, static form. More transfers means less work effort. In reality, hours of work don't really respond that much, as there are only so many hours in a day and income and substitution effects offset. To make this come alive, we need to think harder about the margin of working vs. not working.

And investing. Here the two points come together, and I don't think Greg's article nor the literature put the pieces in one place. We need a dynamic perspective. If inequality comes from a mismatch between supply and demand for skill, then keeping the incentives in place to acquire skill is vital. If there is a strong income-based transfer scheme in place, yes, there  is less incentive to work overtime. And yes, there is less incentive to work at all at least legally. But most of all, there is less incentive to go to school, to pick hard courses (face it, art history is a lot more fun than python and Java 101), pursue expensive advanced graduate education or innovate. One can imagine a spiral, or inequality laffer curve: Demand for skill outpaces supply, inequality rises, we put in place an income based transfer scheme, less people acquire skils, inequality rises...

Greg has a great section, "listening to the left" which I will now invite as well. Forget about the 1%. Pretend wealth grows on trees. Let's just think of the fortunes of the bottom 50%. Can we actually help them? Is there any historical precednent of a successful society that pays large means-tested amounts to young and working-age men and women, without destroying their incentives to gain skills and become middle class, to say nothing of the next Steve Jobs?

Social security doesn't count; the question is sending checks to young, healthy, but low-skilled working age people.  Short-term doesn't count. I want to know of an instance in which, maintained over a generation or two, such a system did anything more than perpetuate an unskilled largely dysfuncitonal underclass, which achieved much more than reliably voting for politicians who endorse its transfers. (The model "send money to Democratic voters" does explain the proposed policies pretty well!) The reputed wonders of living in Sweden or other welfare states don't count: their benefits are in kind, and not means tested.

It's easy to come up with incentive-destruction horror stories, American welfare, European dole, and so on.  Small cash transfers coupled with restricted educational opportunities and large labor market wedges, as faced by refugees and many European immigrants, seem particularly destructive. Tom Sowell writes whole books of examples.  But it's too easy to listen to the choir. To those of you advocating large cash transfers, when has this ever worked?   I'm curious to hear a clear historical precedent for the policies you advocate for the US. 

Job market doldrums

Three recent views on the dismal labor market pose an interesting contrast.

Alan Blinder wrote a provocative WSJ piece on 6/11, Fiscal Fixes for the Jobless Recovery. A week prviously, 6/5, Ed Lazear wrote about The Hidden Jobless Disaster. And John Taylor has a good short blog post Job Growth–Barely Keeping Pace with Population

All three authors emphasize that the unemployment rate is a poor measure of the labor market. Unemployment counts people who don't have a job but are actively looking for one. People who give up and leave the labor force don't count. Employment is a more interesting number, and the employment-population ratio a better summary statistic than the unemployment rate. After all, if unemployment falls because everyone who is looking for a job gives up, I don't think we'd see that as a good sign.

Source: Wall Street Journal

Ed Lazear made this interesting chart. As he explains,

Every time the unemployment rate changes, analysts and reporters try to determine whether unemployment changed because more people were actually working or because people simply dropped out of the labor market entirely... The employment rate—that is, the employment-to-population ratio—eliminates this issue by going straight to the bottom line, measuring the proportion of potential workers who are actually working.

While the unemployment rate has fallen over the past 3½ years, the employment-to-population ratio has stayed almost constant at about 58.5%, well below the prerecession peak. Jobs are always being created and destroyed, and the net number of jobs over the last 3½ years has increased. But so too has the size of the working-age population. Job growth has been just slightly better than what it takes to keep the employed proportion of the working-age population constant. That's why jobs still seem so scarce.

The U.S. is not getting back many of the jobs that were lost during the recession. At the present slow pace of job growth, it will require more than a decade to get back to full employment defined by prerecession standards....

Why have so many workers dropped out of the labor force and stopped actively seeking work? Partly this is due to sluggish economic growth. But research by the University of Chicago's Casey Mulligan has suggested that because government benefits are lost when income rises, some people forgo poor jobs in lieu of government benefits—unemployment insurance, food stamps and disability benefits among the most obvious. The disability rolls have grown by 13% and the number receiving food stamps by 39% since 2009.
....

John Taylor makes the point nicely with another graph, which contrasts the labor force participation rate to the BLS' forecast of what should have happened from demographic effects.

The graph comes from a recent paper Chris Erceg and Andrew Levin.

I part company a bit with Lazear on his conclusions

... the various programs of quantitative easing (and other fiscal and monetary policies) have not been particularly effective at stimulating job growth. Consequently, the Fed may want to reconsider its decision to maintain a loose-money policy until the unemployment rate dips to 6.5%.

If low employment is "structural," resulting from the worker-side disincentives as well as employer-side disincentives -- policy uncertainty, regulatory threats, NLRB, Obamacare, Dodd-Frank, EPA, and so on -- then the problem isn't lack of "demand" in the first place. If the problem has nothing to do with the Fed, and if $2 trillion of QE didn't do anything to help it, why does the solution have anything to do with the Fed?

The greater surprise is to hear so much agreement from Alan Blinder:

The Brookings Institution's Hamilton Project, with which I am associated, estimates each month what it calls the "jobs gap," defined as the number of jobs needed to return employment to its prerecession levels and also absorb new entrants to the labor force. The project's latest jobs-gap estimate is 9.9 million jobs. At a rate of 194,000 a month, it would take almost eight more years to eliminate that gap.

.... policy makers should be running around like their hair is on fire.

Lazear said "a decade."  More suprising agreement on the impotence of monetary policy:

The Federal Reserve has worked overtime to spur job creation, and there is not much more it can do.

As you might imagine, I'm not such a fan of Blinder's suggested fixes. He starts with traditional simple Keynesian recommendations that  the government should hire people and "spend" more. No need to refight that here. The more interesting recommendations follow as he warms up to his latest clever scheme.

... the basic idea is straightforward: Offer tax breaks to firms that boost their payrolls.

For example, companies might be offered a tax credit equal to 10% of the increase in their wage bills over the previous year. ...

Another sort of business tax cut may hold more political promise....Suppose Congress enacted a partial tax holiday that allowed companies to repatriate profits held abroad at some bargain-basement tax rate like 10%. The catch: The maximum amount each company could bring home at that low tax rate would equal the increase in its wage payments as measured by Social Security records.

For example, if XYZ Corporation paid wages covered by Social Security of $1 billion in 2012 and $1.1 billion in 2013, it would be allowed to repatriate $100 million at the superlow tax rate. The reward for boosting its payroll by $100 million would thus be a $25 million tax saving. That looks like a powerful incentive.

...companies could claim the tax benefit only for individual earnings below the Social Security maximum ($113,700 in 2013). No subsidies for raising executive pay.

I find this most interesting at the level of basic philosophy; how we think about economic policy.

There are huge, longstanding, tax and regulatory disincentives to hiring people. Income tax, payroll taxes, health care and other mandates, and NLRB, OSHA, and so on. There are the high marginal taxes to labor implied by social insurance programs, as Mulligan points out.  If we want to increase the incentive for companies to hire people and people to take the jobs, why add another tax break to an obscenely complex tax code, rather than fix some of the existing disincentives? 

Is this really the right way to run a country? When "policy makers" want more employment, they slap on a complex, tax break on top of a mountain of disncentives. Presumably they then will remove this tax break, and pages 536,721 to 621,843 of the tax code describing it, despite the lobbying by large corporations who have figured out how to exploit it for billions of dollars, once the Brookings Institution decides that there is "enough" employment (!), and "policy-makers" no longer need to encourage it? 

How are the existing hundreds of bits of social engineering in the tax code working out? Do we really need more of this?  Isn't it time to return to a tax code that raises money for the government at minimal distortion?

The contrast between the benevolent "policy-maker" (no dictator ever had such power) and the reality of how the tax code in this country is actually enacted is pretty striking.

I have to say, I'm a bit disappointed in the end by both. They agree that the US economy is about 10 million jobs short. Something big is in the way. Lazear at least mentions some candidates, though many are long-standing. But the stirring conclusion from Lazear is only to continue a loose monetary policy that he says has been ineffective so far, and the conclusion from Blinder is the sort of clever scheme that economists cook up in late-night cocktail parties piling one more quickly-exploitable bit of social engineering on top of a tax code rife with them. Neither recommendation comes close to 10 million jobs, or addressing any sort of clear story why those jobs have vanished.

Alternative Maximum Tax

This is an Op-Ed for the Wall Street Journal, original here on April 15 2013

Source: Wall Street Jouirnal

They keep coming back, like the villains of a good zombie movie, chanting "more taxes, more taxes." Long ago, Congress passed the alternative minimum tax, or AMT—a simple flat rate to ensure that in an insanely complex tax code, no one escapes paying something. Now we need an alternative maximum tax as a simple, rough-and-ready way to limit the tax zombies' economic damage. Call it the AMaxT.

With Monday's deadline for filing tax returns looming, let's start a national conversation: How much is the most anyone should have to pay? When do taxes indisputably start to harm the economy and produce less revenue—when government takes 50% of people's income? 60%? 70%?

I like half, but the principle matters more than the number. Once the country settles on a number, each of us gets to add up everything we pay to government at every level: federal income taxes, yes, but also payroll (Social Security, Medicare, etc.) taxes, state, city and county taxes, estate taxes, property taxes, sales taxes, payroll taxes and unemployment insurance for nannies, household workers, or other employees, excise taxes, real-estate transfer taxes, and so on and on, right down to your vehicle stickers and those annoying extra taxes on your airline tickets.

On April 15, once this total hits the alternative maximum tax, you've done your bit and federal income taxes can take no more. You compute federal income taxes as usual, but then you get to reduce the "tax due" that the total is less than the alternative maximum.


The zombies howl that the top federal tax bracket is still "only" 40%. Surely "the rich" can contribute a bit more? They forget that the economic damage of taxes comes from the total tax bite, not just the federal income tax.

Marginal taxes are a purer measure of economic damage. If you earn one more dollar, how much do you get to keep? Marginal rates are higher than average rates in a progressive system: If the government takes 100% of income above $100,000, then somebody earning $150,000 pays a 33% average tax rate but has no incentive to work at all after he reaches $100,000. Ideally, we would limit marginal rates, but this is not practical in a simple backstop like the AMaxT.

American governments also like to hide taxing and spending by passing mandates and regulations, forcing people and businesses to spend on their behalf. Ideally, we would limit this economic damage as well, but this is also not practical in an alternative maximum tax.

However, both considerations mean that the true economic damage will be higher than the AMaxT rate, so we should leave some headroom in setting that rate.

Every cent of corporate taxes comes out of some person's pocket, in higher prices, lower wages, or lower returns to investors. For example, even the tax zombies don't dream that we stick it to the big oil companies by charging gas taxes. To limit this damage, every single cent of tax that government assesses, at all levels, should be assigned to somebody and count against that person's alternative maximum tax. It is easiest to assign all corporate taxes to shareholders. When corporations send you the annual 1099 dividend form, they also report all taxes paid by your shares, which count against your AMaxT. Some taxes could similarly be assigned to workers and reported on W2 forms.

Yes, there are details to work out. People get big tax bills in some years, such as when they pay estate taxes. Incomes fluctuate. Smart tax lawyers could game the system.

This isn't hard to fix. For example, we could use an average of several years' income or, better yet, scale the AMaxT limit to consumption rather than income.

Liberals might object to a maximum tax, since it leaves out all the benefits that we get from government. In setting the maximum level of taxation, shouldn't we consider the nice roads, free schooling, police, national defense, thoughtful regulation, and other benefits and services?

This is a valid consideration if one argues about what's "fair." But I propose the AMaxT entirely to limit the economic damage of taxation, a goal you must consider even if you think it's "fair" to take every cent of a rich person's income.

To limit economic damage, benefits are irrelevant. Suppose that the government levies a 100% income tax, but it is so good at providing services that each of us gets back twice the value of what we put in. Good deal? Yes. Functioning economy? No. Each person gets services whether they do or don't pay taxes. But with a 100% income tax, nobody works, nobody pays any taxes, and nobody actually gets any services.

How many people are really being taxed at outrageous rates? I don't know. The U.S. tax system is so complex, with so many layers of taxing authority, that nobody really knows. Still, an alternative maximum tax is a win-win bet.

If there really are few people who pay an extraordinarily high percentage of their income, then liberals shouldn't object. They won't lose any revenue and will enjoy snickering "I told you so." If it turns out that there are lots of people being so taxed, then we will sharply reduce the unintended, multiplicative effect of taxation, and we will measure that fact. A canary in the coal mine is as valuable chirping as choking.

The disincentive effects of heavy taxation settle in gradually. For the first year or two, all people can do is hire smarter lawyers and work a little less hard. It takes years for businesses to retrench, close, never get started or fail to expand; for people and companies to move abroad; for students to give up investing in an expensive M.B.A., medical school or engineering degree; for people to stay put rather than follow lucrative opportunities, or to retire early. All this shows up slowly and gradually drags down an economy and its tax revenues.

So the AMaxT is most important for the backstop promise it makes to young people and entrepreneurs. Yes, start a company, go to school, work hard, invest, hire people. We guarantee you that no matter what happens, no matter how loud the zombies chant, no matter what clever "revenue enhancers" they come up with, you will get to keep some reasonable fraction of what you earn. Go for it.

( One more point that got cut for length: With an alternative maximum tax, people might abandon complex tax dodges in favor of simply taking the alternative maximum.)

Updates: Several people have pointed out that this system advantages states with high income taxes. Good point. Since state and federal income taxes are both due April 15, let's amend the proposal to let you cut back proportionally on both federal and state income taxes. Oh, and credits against next year too.

A colleague writes: Perhaps you know this, (I didn't) but the corporate system you describe is close to the franking credits used in Australia, New Zealand, Malta and maybe other countries. In essence, rather than declare the dividends they receive on their income taxes, shareholders report the corporation’s before-tax earnings that supported the dividends (the grossed-up dividend) and include the taxes the corporation paid as a credit against their taxes. For your purposes, this system already assigns the corporate taxes to the shareholders. (If your tax rate is 0, you actually get a check back from the government for the amount of taxes the corporation paid on your behalf.)

On the issue, how many people are there who pay more than half. Total, on budget, federal state and local spending is about 42% of GDP. Tax expenditures bring that up to 46%. Off budget, mandates, etc. bring us easily over 50%. The average person is already paying something like his income in taxes, either now or later (when the debt comes due). Europe's numbers only look bigger because they collect it all in one place.

Allen Sanderson has a nice related Op-Ed adding up some state and local taxes in Illinois

Fun debt graphs

I was having a bit of fun making graphs for a talk. Are we all fine and debt is no longer a problem? I went back for a closer look at the CBO's long term budget outlook and The budget and economic outlook 2013 to 2023. All numbers from these sources.

 Above, I plot the CBO's long term outlook, in the alternative fiscal scenario (i.e. the one that is even faintly plausible).  As you can see, though they think the deficit gets better for a bit, then the entitlements disaster is still with us.

Of course, this will not happen, the only question is what adjusts.  If bond markets get a whiff that we actually will try these paths, we have a crisis on our hands.

So what can adjust? Revenue is historically about 20% of GDP no matter what tax rates are.  Doubling Federal revenue, while of course states, cities and counties keep taxing us, seems like an unlikely prospect. I'm all for cutting spending, but really, cutting spending in half, and by more than 20 percentage points of GDP? Well, it's in the Ryan budget, but it's a lot. So, what else can we do?

Answer: Growth. Tax revenue equals tax rate times income, and income equals todays income times growth. Greater growth makes all the difference.

To illustrate this point, I made a simple calculation. Suppose growth is 1% and then 2% greater than the CBO projects. What effect does that have? To keep it very simple, I assume that spending stays the same, and revenue stays the same fraction of GDP. Thus, I just divide spending/GDP by a 1% and then 2% growth rate (e^(0.01 t)) and we have the new spending as a fraction of the larger GDP.

This is pretty amazing, no? If we just had two percentage points GDP growth greater than the CBO's forecast (which is a bit above 2% in the out years) the whole budget would be solved without fixing anything.

This thought sent me back to look at the CBO's economic assumptions,

Uh-oh. The CBO thinks we are going to quickly enter a period of 4% growth, go back to trend, and then start growing smartly. Tax revenue = tax rate x income, that's a lot of revenue.  The CBO, the Fed, and everyone else (me too for a few years) has been forecasting this bounce back growth just around the corner for a while now. What if it doesn't happen, and 1.5% growth without catching up to trend is the new normal?

To keep it simple, I redid the above chart now just assuming 1% and 2% less growth than the CBO.

Is that Greece, or Cyprus?

So, the real budget news that could matter has little to do with tax rates or spending. What matters most of all is whether we break out of this sclerotic growth trap.

I found this graph pretty chilling as well: 

Really, what chance do you think there is that defense, nondefense discretionary and other mandatory spending will decrease form 4% of GDP to 2.5-3% of GDP in 10 years?

The net interest line is interesting. That's a huge rise. Why? Here are the other economic assumptions

You see the strong GDP growth, 4% for several years, in the top left panel. Inflation, bottom left, apparently has nothing to do with deficits, the Phillips Curve is alive and well.

But, the CBO is projecting interest rates to rise sharply in 2016, back to a low-normal 4% 3 month and 5% 5 year rate. This causes the $850 billion a year in interest costs highlighted in the previous graph, about the same numbers I was bandying about in "Monetary Policy with Large Debts" when worrying whether the Fed could actually do that to deficits.

From the deficit view, a Japanese lost decade of low interest rates would keep this from happening (or postpone it). Of course any financial event leading to higher interest rates would increase these interest payments a lot. 

Growth in the UK?

I thought European "austerity," meaning mostly large increases in marginal tax rates on anyone daring  to work, save, invest, start a company or hire people, while spending stays north of 50% of GDP, was a pretty bad idea.

So I was glad to read the tiltle, when a friend sent me a link to the Telegraph, announcing Osborne to unleash raft of policies to kick-start growth. Great, I thought, after trying everything else, the British will finally try the one thing that will work.


The byline was only a bit disappointing

The Government is to reveal a series of major new measures to boost national and regional growth ahead of the Budget to show its “pro-business” strategy is working

Pro-business is usually a code word for protection and subsidy. But there are plenty of worse code words.

And then it all falls apart

The measures will include:

• Billions of pounds of central government funding directed at boosting regional growth and a backing for Michael Heseltine’s plans for new local spending powers;

• The planning go-ahead for the Hinkley Point C nuclear power station;

• Support for housebuilders and for first-time buyers trying to get mortgages;

• A push on major infrastructure projects, including the Merseyside Gateway and the “super-sewer” in London, and more government guarantees for such projects;

... The Bank of England could also be given a broader mandate to support growth.

...billions of pounds of central government funds should be made directly available to the regions and cities such as Birmingham...

Lord Heseltine’s report made far-reaching recommendations for stimulating economic growth. The Government will unveil plans enabling Local Enterprise Partnerships and businesses to bid regionally for money that is now allocated centrally.

It's not all bad. Allowing a nuclear power plant to operate is nice, and some plans to lower corporate taxes a bit. But the blossoming of free enterprise in the land of Adam Smith, alas, this is not. Keynes still rules.  

Taxation of capital and labor

"Redistributing from Capital to Workers: An Impossibility Theorem" is a fine post by Garrett Jones on Econlog, explaining the theorem that the optimal tax on capital is zero. It's the best blog-post length, evenhanded, accessible summary I've seen. It includes all sorts of links where you can see arguments in detail, an unusually scholarly approach for a blog post.

His one-sentence summary

 Under standard, pretty flexible assumptions, it's impossible to tax capitalists, give the money to workers, and raise the total long-run income of workers. Not, hard, not inefficient, not socially wasteful, not immoral: Impossible.

Monetary policy with large debts

This is a Wall Street Journal Op-Ed, March 4 2013. They titled it "Treasury needs a better long game," but the most important question is whether the Fed can keep any independence, if 5% interest rates will cause $900 billion interest costs. There is a pdf version of the oped on my webpage. 


Sooner or later, the Federal Reserve will want to raise interest rates. Maybe next year. Maybe when unemployment declines below 6.5%. Maybe when inflation creeps up to 3%. But it will happen.

Can the Fed tighten without shedding much of the record $3 trillion of Treasury bonds and mortgage-backed securities on its balance sheet, and soaking up $2 trillion of excess reserves? Yes. The Fed can easily raise short-term interest rates by changing the rate it pays banks on reserves and the discount rate at which it lends.

But this comforting thought leaves out a vital consideration: Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest.

Will Congress and the public really agree to spend $900 billion a year for monetary tightening? Or will Congress simply command the Fed to keep down interest payments, as it did after World War II, reasoning that "Fed independence" isn't worth that huge sum of money?


This additional expenditure would double the deficit, which tempts a tipping point. Bond markets can accept fairly big temporary deficits without charging higher interest rates—buyers understand that bigger deficits for a few years can be made up by slightly larger tax revenues or spending cuts over decades to follow. But once markets sense that deficits may be unsustainable, and that bond buyers may face default, restructuring or inflation, they will demand still-higher interest rates. Higher rates mean higher deficits—leading to a fiscal death spiral.

Many economists think the tipping point starts when total government debt (federal, state and local) exceeds 90% of GDP. We are past that value, with large state and local debts, continuing sclerotic growth and a looming entitlements crisis to boot. This, not the "balance sheet" or other monetary or institutional constraints, will be the Fed's quandary—can the monetary authority really dare to risk a fiscal crisis?

The obvious answer is to fix the long-run deficit problem, with the reform of runaway spending, entitlement programs and a pro-growth tax policy. So far that is not happening.

Still, the Fed and the Treasury can buy a lot of time by lengthening the maturity of U.S. debt. Suppose all U.S. debt were converted to 30-year bonds. Then, if interest rates rose, Treasury would pay no more on its outstanding debt for 30 years. And if the country couldn't solve its fiscal problems by that time, it would deserve a Greek crisis.

Maturity structure of US debt.

Alas, the maturity structure of U.S. debt is quite short. I estimate that our government rolls over 40% of its debt every year, and 65% within three years. (I account for Federal Reserve holdings, coupon payments and use market values.) Thus the fiscal impact of higher interest rates will come quickly.

Mr. and Mrs. Smith shopping for a mortgage understand this trade-off. Mr. Smith: "Let's get the adjustable rate, we only have to pay 1%." Mrs. Smith: "No, honey, that is just the teaser rate. If we get the 30-year fixed at 3%, then we won't get kicked out of the house if rates go up."

Amazingly, nobody in the federal government is thinking about this trade-off. Instead, each agency thinks only for itself.

The Fed is still buying long-term bonds in an effort to temporarily drive down long-term interest rates by a few basis points. It has concluded it can survive the loss in mark-to-market value of its bond portfolio that higher interest rates will imply, when they come, by suspending its customary interest-rebate payments to the Treasury. If the Treasury was counting on that roughly $80 billion per year, that is Treasury's problem. If higher rates cost the Treasury $900 billion a year, that is Congress's problem.

The Treasury's Bureau of Public Debt controls the maturity of federal debt issues. It has been gently borrowing longer in response to low long-term rates, but not enough to substantially alter the government's interest-rate risk. The bureau also views its job narrowly—which is to finance whatever deficits Congress determines, not to take actions that mitigate future deficits. Congress and the administration are busy with other matters.

Ironically, the Fed's buying and the Treasury bureau's selling have neatly offset, leaving very little change in the maturity structure of debt in private hands.

What to do? First, the Treasury and Fed need a new "accord" to decide who is in charge of interest-rate risk, most likely the Treasury, and then grant it clear legal authority to manage that risk. The Fed should then swap its portfolio of long-term bonds for a portfolio of short-term Treasuries and forswear meddling in the maturity structure again.

Second, the Treasury should seize its once-in-a lifetime opportunity to go long. Thirty-year interest rates are at 2.8%, a 60-year low. Many corporations and homeowners are borrowing long to lock in low funding costs. So should the Treasury.

You may complain that if the Treasury borrows long, then long-term rates will rise. If so, it is better that everyone knows that now. It means that markets aren't really willing to buy long-term government debt, that the 2.8% yield is only a fiction of the Fed's current buying, and that it won't last long anyway. Better fix the fiscal hole, fast.

[WSJ cut: Moreover, if buying and selling a lot of bonds is a problem, the Treasury should engage in an aggressive swap program. In a swap, the Treasury pays a counterparty a fixed rate (say, 2.8%) and receives floating rates, with no bond changing hands. The First Bank of Podunk uses swaps to manage interest rate risk, when it doesn’t want to buy and sell assets. So can the Treasury.

You may complain about counterparty risk. But swaps are collateralized, so each counterparty does not lose if the other one defaults. And if the thousands of pages of Dodd-Frank regulation, and the army of stress testers can’t ensure that too-big-to-fail banks properly manage simple interest rate risk, then we really should have a law-book bonfire. ]

You also may argue that 2.8% long term-debt is more expensive than 0.16% one-year debt. There are two fallacies here. First, the 2.8% long-term yield reflects an expectation that short rates will rise in the future, so the expected cost over 30 years, as well as the true annual cost, are much closer to the same. Second, to the extent that long-term bonds really do pay more interest over their life span, this is the premium for insurance. Sure, running a restaurant is cheaper if you don't pay fire insurance. Until there is a fire.

A much longer maturity structure for government debt will buy a lot of insurance at a very low premium. It will buy the Fed control over monetary policy and preserve its independence. If Fed officials realized the risks, they would be screaming for longer maturities now.

But we don't have long to act. All forecasts say long-term rates will rise soon. As the car dealer says, this is a great deal, but only for today.



Notes: See this earlier blog post or pdf essay for more. I hope to sell WSJ on the second part, keeping the balance sheet big and Treasury floating-rate debt, sometime soon.

If you think I'm pessimistic or making up numbers, here are the CBO's baseline budget projections 

By 2023, the CBO thinks interest payments on the debt will be $857 billion, essentially the entire deficit!  The CBO assumes (see p. 67 here) that interest rates start rising in 2016 and in 2018 stop at 4% one year and 5.2% ten year rates. What if the Fed really wants to tighten?

Moreover, the cheery forecast of return to a balanced primary budget relies on an assumption of spectacular growth (p. 68) -- 3 years of 4% growth bringing us back to "potential" (see p.36) -- in-your-dreams tax revenues, and the rosy-scenario "baseline" expenditure cuts. What if the primary deficit is also $900 billion dollars?     
 

Bloomberg TV on debt and magic

I did a short interview on Bloomberg TV this morning. Nothing new for readers of this blog, but fun anyway. Coffee just starting to kick in at 6:15 AM. As always, walking home I figured out 10 better ways to answer.

Two cents on the trillion dollar coin, and a debt-limit schedule

The Fed and Treasury say they're not going to try the trillion-dollar coin idea to avoid the debt limit. But the episode is very revealing about how our fiscal and monetary policies work, (or don't, as the case may be), numerous misconceptions floating around, and leads to a thought on a better way to approach the same objectives, which might be a useful compromise for both sides.

I. Why the limit binds

First, just to be clear, let me clarify the playlist: 

• Debt: US government bonds, issued by the Treasury. Promises to pay for your healthcare is not "debt," and if the government reneges on that promise it's not a "default."
• Cash: Bills and coins.
• Reserves: Essentially checking accounts at the Fed. Banks may freely obtain cash in return for reserves and vice versa.We often say "the Fed prints money" when in fact what it does is to create reserves.

In the first debt-limit debate, I was initially puzzled that it was a problem at all. The "debt limit" does not include currency or reserves, though both are functionally US government debt. That seems like an unfortunate oversight:  Why can't the government just pay its bills by printing money, i.e. creating reserves? Sure, you might worry about inflation sooner or later, but this is a legal question. The government can print money to pay its bills, no?

Well, no, which is really interesting.

For the Fed to "print money," meaning to create reserves, it has to buy some other asset. Though the Fed can manufacture money costlessly, it legally can only do so by buying assets. The Fed cannot engage in fiscal policy, and printing up checks and sending them to taxpayers -- or even dropping cash from helicopters -- is fiscal, not monetary policy.

And the debt limit applies to all Federal debt outstanding, including debt held by the Fed. So, as long as the Fed buys only Treasury bills, the debt limit does, in fact, stop the government as a whole from "printing money" (creating reserves) to pay bills. To do so, the Treasury has to issue debt, borrowing the money, pay its bills, and then get the Fed to buy the debt, so that in the end there is more money outstanding. But a debt limit stops this operation.

Well, the Treasury has the actual printing presses that make good old fashioned cash. Why can't the Treasury  just print up money and use it to pay bills? (Or, deposit the cash at the Fed, thereby get reserves, and transfer the reserves by writing checks.) No, that's illegal too. The Treasury prints the bills, but they can only be issued by the Fed, and in return for already-created reserves.

So the architects of our monetary system and debt limit weren't so dumb after all. Though we have a fiat money system, and, drawing a circle around the whole government, it should be able just to print money and give it to people (social security) or buy tanks and stuff with the printed money, the debt limit does pretty well constrain the government budget.

To emphasize, this isn't about a fight between Treasury and Fed. They can agree they want to print money to evade the debt limit. But they still can't do it. It's a limit on what the  government as a whole can do.

II. Clever solutions

So, our army of clever lawyers and policy wonks is hard at work finding loopholes, either ways to create "debt" that doesn't count as debt, or ways to print money to pay bills anyway.

Here's where the trillion dollar coin idea came up. Apparently, though the Treasury is not allowed to print money or regular coins and pay bills with them, it can issue "commemorative" coins and sell them directly.  So, most simply, it could in principle, pay for a trillion dollars of deficit by minting a trillion dollars worth of commemorative coins. (Coins are just metallic dollar bills; they don't have a metallic value equal to face value.)

That's not very practical. But as a little favor to the platinum lobby, there is no limit to the denomination of platinum coins the Treasury can issue. So, the idea is this: make a trillion dollar coin out of platinum. Deposit the coin at the Fed, just as the Treasury now deposits cash. The Fed creates a trillion worth of reserves in the Treasury's checking account, and the Treasury can merrily write checks.

If the Fed goes along and sells its roughly $1 trillion dollars of Treasury securities, it can soak up that new cash, putting debt in private hands. For the first trillion, the government isn't even "printing money," it is exactly as if the Treasury borrowed a trillion dollars by issuing a trillion of new debt.

(Small update: Many commenters note agency debt. Thanks. As the Fed has about a trillion dollars of Federal debt, so the other agencies have about $5 trillion dollars.  Selling the Social Security "trust fund" would work exactly the same way, and effectively borrow money without busting the debt limit. And it's a lot bigger. Tom Saving explains here. To fund payments other than Social Security, the Treasury would have to come up with some way of telling Social Security "we promise to pay you back" that didn't count as "Federal Debt." I don't know the laws that limit this action. But it's surprising that so much blogosphere creativity has gone in to spending the Fed's $1 trillion rather than the much larger pot of agency debt.)

James Pethokoukis at the AEI covers a few more clever ideas. There are various ways that the  US government could essentially send tradeable IOUs in place of checks, as California did, avoiding its "balanced budget" rules and the prohibition on states issuing currency.  Cash is, in the end, no more or less than a tradeable IOU of the US government.

A less obvious and more realistic option strikes me as important going forward. I assumed above that the Fed only buys Treasury bills when it creates reserves out of thin air. But that's no longer true. During the financial crisis, the Fed bought commercial paper, and lent directly to various financial institutions. (It called the loan an "asset" on its balance sheet, so it seems like the Fed is buying something of value.) Now it is buying and holding mortgage-backed securities.

This is fiscal policy. When the Fed lends directly or buys assets other than Treasuries, the total debt + money increases. The traditional restriction that the Fed should only buy Treasuries separates it from fiscal policy. As some of James' clever ideas point out, you just have to be a bit clever to channel this newly-created money to social security recipients.

III. Default

One of the silliest constantly-repeated red herrings is that running in to the debt limit will force the US to default on its debts and cause a global financial disaster. (This goes right up there with "Greek default will force it off the Euro" in the fallacies-casually-repeated-as-facts department.) 

Just yesterday, driving in to teach my Saturday morning MBA class, Scott Simon's soothing voice on NPR introduced a trillion-dollar coin piece with the statement

... it will certainly be no laughing matter if the U. S. Congress refuses to raise the borrowing limit and the U. S. government defaults on its debt. ...

No Scott, (or NPR writers). If a $100 bond comes due, the Treasury can sell a new $100 bond to pay off the principal without increasing the total amount of debt.  And there's still $2.5 trillion of tax revenue coming in. That's plenty to cover interest payments. If anything, the law is pretty clear that interest payments on the debt are the last thing the government can stop paying, not the first.

This is simply a red herring. Social security checks might stop, farm price support payments might stop, they might have to send the TSA home from airports and let the NRA take care of security (joke here, please don't go nuts). All this might cause a lot of hardship, but there is nothing forcing the government to default. Default would be a choice.

OK, NPR can be forgiven for passing along this trope. But what's Paul Krugman doing with this obvious... I'm having a hard time finding a polite word...piece of misinformation? Writing in the actual Times, which is supposed to be fact-checked:

Finally, just consider the vileness of that G.O.P. threat. If we were to hit the debt ceiling, the U.S. government would end up defaulting on many of its obligations. This would have disastrous effects on financial markets, the economy, and our standing in the world.

Parse that carefully for Clintonian veracity. "Defaulting on its obligations" could mean not paying promised farm price supports, or delaying payments (as the State of Illinois does) to vendors, not actual default on Federal debt. So it's just a nanometer this side of factually incorrect. But you'd have to be very knowledgeable not to infer from the following sentence "disastrous effect on financial markets" that Krugman is not talking about actual "default" (a term meaning "not paying back bonds") from this more metaphorical sort of "default" (meaning breaking an implicit promise).

In his blog, he's less circumspect

By contrast, nobody really knows what happens if America defaults, even briefly. The whole structure of world financial markets is built around the use of Treasury bills as the ultimate safe asset; what happens if they lose that status? It would certainly be an interesting experiment, but one best carried out if you have plenty of bottled water and spare ammunition in your basement.

I agreed on the consequences of default. But, as much as he dislikes Republicans and the debt ceiling, passing on the canard that hitting the ceiling implies a default on Treasury debt is just a little... here we go a search for a polite word again...misleading, no matter how useful it would be to the give-in-and-spend side of the debate if those obstructionist Republicans were to believe it.

Update: In an official statement, the White House chimes in

“There are only two options to deal with the debt limit: Congress can pay its bills or it can fail to act and put the nation into default. When Congressional Republicans played politics with this issue last time, putting us at the edge of default, it was a blow to our economic recovery, causing our nation’s credit rating to be downgraded. The President and the American people won’t tolerate Congressional Republicans holding the American economy hostage again simply so they can force disastrous cuts to Medicare and other programs the middle class depend on while protecting the wealthy. Congress needs to do its job.”

My emphasis. The war on the English language continues. End update

However, there is some news here about the long-run chance of US default. I started this whole blog with my previous view that the US can always print its way out of fiscal trouble. While we might have inflation, a nation that borrows in its own currency should always be able avoid the costs of explicit default.

Now it's not so clear. The laws limiting spending by money-printing in the face of a debt limit are surprisingly effective.  Faced with really disastrous spending cuts - and a trillion per year is more than just farm price supports and windmill subsidies -- and not being able to print money, our government might in fact be tempted to default. Not in a big way, but in the usual muddle that governments do. It could delay interest payments for example, or force exchange of maturing debt for new longer-term debt. But Krugman's right, such shenanigans would seriously impact the stature of US debt in financial markets, which tolerate inflation but do not tolerate explicit default.

Moreover, let's think about what happens when the "debt limit" is not imposed by Congressional action, but by bond markets refusing to lend anymore. I had always thought this would mean monetization and inflation. But the chance it could mean default, truly Greek-style, is raised, at least up from zero, by these limits on monetization.

These are far-off low-probability scenarios. Still, the possibility of explicit default -- not now, not next year, but once things get really bad -- is not as remote as I had thought.

Which, by the way, is not necessarily a bad thing. Governments who really cannot monetize their debts but must repay them or face the horrible costs of default tend to figure out how to balance their budgets, and they get better interest rates.

IV A better ceiling? 

These occasional battles over the debt ceiling are pretty obviously not an ideal way to run fiscal policy. But they do have an important function in the political battle to limit spending.

Such devices are important. Though we hear repeated over and over that the debt limit just finances the same spending that Congress passes, any household knows that a budget is a good idea. When one spouse wants to go get another six pack, the other one may be able to point to a budget and enforce spending priorities.

And for Congress too, a budget would be a useful and  better way to limit spending. Lay out both taxing and spending, preferably over a number of years, and then stick to it. The budget then takes on the force of an overall constraint; Congress can say to a worthy petitioner, "We would love to help, but if we give it to you we have to take it from someone else; the budget won't let us do it."

However, the law requiring Congress to pass a budget seems not to have the same force as this set of laws governing the debt ceiling. (Ironic tone). Also, budget numbers are so full of accounting tricks and gimmicks, that even passing a budget can fail to have the strong force limiting spending that one would hope. It was budget rules that gave us "temporary" Bush tax rate changes in the first place.  

By contrast, the actual amount that the government has to go out and borrow is a hard number, and it seems to pose a stronger constraint than the budget act. That makes it a blunt instrument, but a more useful instrument than the fine instrument that seems not to work.

But occasional crises are obviously not a good way to impose a bit of discipline. So, herewith a modest proposal in two parts:

First, fix the remaining loopholes. No platinum coins.  Federal "debt" should include Federal Reserve liabilities (cash and reserves) net of Treasury debt held by the Fed. Harvest the creative work of the blogosphere from the past few months, and reinforce the ceiling.

Second, in place of a single ceiling, that is then periodically raised by a few trillion after a big fight, put in a ceiling path. If $1 trillion deficits ($80 billion per month) seem like a lot, renew the debt ceiling at $50 billion per month this year, and $40 billion per month next year.

So, the law reads, "the debt ceiling shall be $16,050 billion on March 1 2013, $16,100 on April 1 2013, $16,150 on May 1 2013..."  (I'm obviously simplifying)  This is a constraint on spending that would not cause a periodic game of chicken, and might actually have some force.