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December 21, 2007

Economist's View - 4 new articles

"Hoover Economics" at the State and Local Level

Menzie Chinn's post on the pro-cyclical nature of state and local government spending, "Make that Four Reasons Why Recession May be Averted," reminded me of this editorial written by a colleague exactly six years ago. Menzie is analyzing and disputing a claim that robust state and local government spending will help to avert a recession. As he notes, due to reasons such as balanced budget requirements at the state and local levels and borrowing constraints, in recessions revenues fall as income falls, and since the budget must be balanced, spending falls as well (and the fall in property taxes in the current case could make things worse than usual). This is about Oregon, but the principles apply to all state and local government spending where budgets are required to be in balance year by year. [For a bit of background, in Oregon (where there is no sales tax) if state revenues are more than 2% above the forecasted amount, the entire amount of the surplus must be refunded to taxpayers - I received a check a couple of weeks ago since revenues have been higher than anticipated this year even though future finances are in question if the economy falls into a recession. It works the other way too - if revenues are too low there are automatic cuts in state spending. This editorial was written when state and local government services were being cut by quite a bit due to revenue problems from the 2001 recession.]:

Commentary: State badly needs a rainy day fund, by George Evans, Commentary, The Register-Guard, December 20, 2001: Oregon's budget crisis is the direct result of the lack of a rainy day fund and indirectly due to past tax kickers. The principle of the rainy day fund is simple: income tax revenue automatically rises in boom times and falls in recessions, so common sense and a sound economic policy dictate that part of the revenue during periods of strong growth be set aside in a special fund to finance expenditures in recessions.

This is common sense, because it is a principle that would be followed by a prudent household facing systematic fluctuations in income. It is sound economics because it helps to smooth government expenditures and stabilize the state economy. Economists agree that government budgets should also be balanced over the business cycle, running surpluses in booms and using them to finance deficits in recessions. Such a policy acts as an automatic stabilizer, restraining the economy during booms and stimulating the economy during recessions.

The way to implement this policy at the state level is through a rainy day fund. The advantage of such a fund is painfully obvious now that we have entered a recession, but it should have been anticipated by setting up a rainy day fund in Oregon in the early 1990s.

What political forces prevented setting up a rainy day fund that would have avoided the current budget crisis? The principal obstacle has been the "tax kicker," which returns to households the "excess" tax revenues that are generated during booms.

I understand the argument made in favor of the kicker, that it prevents state spending from increasing if politicians are tempted to spend the excess tax revenues. But this argument fails to apply if the excess tax funds are instead set aside in a rainy day fund that can only be tapped during recessions. In contrast, the kicker operates with a perverse and devastating cyclical timing. Because the kicker deprives us of the rainy day fund, it in practice leads to downward pressure on state government spending during recessions, and therefore acts to intensify the recession. ...

The current State budget crisis would have been much less acute, and possibly entirely avoided, if a rainy day fund had been in place, and tapping the rainy day fund would have also helped reduce the extent of the recession in Oregon.

The current regime of balancing the budget year by year is bad economics. At the national level this "Hoover economics" approach to fiscal policy is widely understood to be discredited. The same principle applies at the state level. Current budgetary choices remain critical, but we are operating under artificial constraints. Not having a rainy day fund in place is subjecting us to unnecessary economic distress. Surely we can at least now agree to change our flawed budget policy design so that we are never again compelled to face a recession so unprepared.

I wonder how much additional stabilization could be achieved at the national level if all states had such a fund to stabilize their economies over the business cycle.

Paulson Sells His Plan for the Subprime Problem

Treasury Secretary Paulson has been making the rounds selling his plan to help with the mortgage crisis, a plan that has "government facilitating the [financial] industry coming together to prevent a market failure." The plan is too limited in scope to have much of an effect, so the plan and the current sales blitz is more of a political effort than a means of averting a crisis.

This is part of a much longer interview Secretary Paulson did with the LA Times as part of the attempt to sell the policy. In this part of the interview, Paulson attempts to identify the market failure that justifies government intervention, but it's hard to call the attempt successful. He does talk about coordination failure among lenders that prevents private sector solutions from emerging, and he references resource constraints that prevent lenders from underwriting new loans on a case by case basis on better terms to prevent foreclosure, but he doesn't explicitly explain the market failure and he does not project the sense that he has a firm grasp of the nature of the market failure he is asserting:

These are Not Normal Times, Commentary, LA Times: ...Market failure defined

Peter Hong: Could you be a little clearer on what you mean by "market failure"?

Henry Paulson: As I've said, chaos. If ever there is a role for government to bring the private sector together to deal with a situation that — when I say market failure I say that we have an unprecedented situation, and the private sector has to find a way to deal with that. Otherwise you're going to see them drowning in people who can't make resets, whom they would ordinarily want to keep in a home.

And again, I think if you take the time, call in servicers, talk to people at Wells Fargo and others, take the time to really understand it, they'll see that once you get into the process of underwriting a new loan — refinancing or modification — and you go through all the paperwork they have to go through and collect the data, that takes a long time. And they don't have the resources to do that and handle the volume at the same time.

Tim Cavanaugh: Well, wait a second, they had the resources to do it and handle the volume when they wrote the loans in the first place.

Henry Paulson: Well, it's different than — these were securitized. I'm not going to defend what went on, but I haven't talked to anyone out there, who is knowledgeable about the industry and is in the industry, who says they have the resources to handle all the underwritings to handle the modifications.

Tom Petruno: Some would argue that it was lax underwriting that got us into trouble in the first place: no assets, no income, no problem. So we're asking the underwriters to go to fast-track — not ask too many questions and give these people a break. It's...

Henry Paulson: Well again, the lenders are giving themselves a break also. They're acting in a way that's in their interest. This is not — I think you all — I see I've got a skeptical group here. It's amazing: I've spent my life in the private sector, and it's amazing how many people I've met who've never spent a day in the private sector who think any kind of government involvement is somehow hurting market.

Tim Cavanaugh: This ain't Stockton!

Tom Petruno: We're all in the private sector here!

Henry Paulson: No, I mean various idealogues I've discussed this with, because the fact is, if you understood my point, lenders like to keep people in a home, keep payments coming. Who are they helping if they keep getting bogged down?

Jim Newton: Well given that it's in their interests, why is the government needed to bring this along?

Henry Paulson: Because it's a diffuse industry, and I think some of the bigger, more sophisticated people understood this earlier. There's a whole host of issues, including accounting issues and others that slow this down.

Tim Cavanaugh: But you're not going to do their accounting for them. What's the service that you're providing?

Henry Paulson: It just took a while for people — and it wasn't like there was resistance; this group kept growing and learning and working and being added to. It's amazing to me, the skepticism out there when you have the servicers covering the industry, they've got their investors coming together, they had all the regulators there.

I thought the skepticism would be of another source. We've got a housing downturn created by a whole series of lax lending processes, easy credit, runups in markets that were unsustainable. This effort doesn't solve that problem. This is one piece of the issue. And this will not in and of itself solve what's happening in the housing market. What this will do is make a difference in that we won't have housing prices driven down in ways that distort the market because the industry can't get organized to solve the problem.

Tim Cavanaugh: Is it distortion in the market when the market was already distorted up to a degree that maybe wasn't unprecedented, but was certainly unusual in American history?

Henry Paulson: So you'd like to see it distorted down too. Well, that's — reasonable people can disagree. I think that would be a market failure and I think that's why the market players came together ... There's a theory here that the process that led to this problem was so flawed, that let's hope that the unwind can be so messy that people will get what they deserve.

Jon Healey: No no no, it's more about learning. The risk to investors in securitization were masked somehow, because they found themselves surprised.

Tom Petruno: They claim they were surprised ...

Jon Healey: Yeah, they claim they were surprised, but if you look at some of these writedowns...

Henry Paulson: Right. Again, I don't think this is doing anything to mask the risk. I think this is an innovative way and a practical way [ entire interview...]

Stabilization Policy

Currently, there are quite a few people advocating the use of tax cuts to combat a potential slowdown in the economy due to the financial crisis. That is certainly an option, if the tax cuts are well-targeted so that they do, in fact, provide the intended stimulus to the economy, and if they can be put into place quickly enough to hit before the economy recovers on its own. But there is another aspect of using tax cuts for stabilization policy that needs to be in place that would be difficult to achieve in the current political environment.

If we are going to use tax cuts as a fiscal policy tool to stabilize the economy, we have to be willing to move the tax rate in both directions, up as well as down. We are quite willing, currently, to move the tax rate down but when people like Martin Feldstein call for a temporary tax cut to stimulate the economy, if such a policy were to be enacted does anyone doubt the difficulty of raising taxes again later even with automatic expiration provisions?

Backing up slightly, why do we need to increase taxes again instead of leaving them where they are? This is stabilization policy, not growth policy, and the goal is to keep the economy anchored as closely as possible to the target rate of output. If in each successive business cycle the tax rate is lowered, but it is never raised again, there will eventually come a time when the tax rate cannot be lowered any further. If a severe recession then hits, and monetary policy isn't providing the needed stimulus or interest rates are already so low that further decreases will be ineffective, then fiscal policy will be unavailable as a backup stimulus device, much to our detriment.

Instead, assuming as in most models that the target rate of output is centrally located, the goal is to bring the economy up when the economy is dragging (use tax cuts that increase the deficit) and to slow the economy down when it begins to overheat (use tax increases that reduce the deficit). Managed properly over business cycles, tax cuts in bad times, tax increases in good times, the economy will stabilize around the target and there will be no long-run consequences for the deficit or the size of government. But if we insist that only tax cuts are available, that there is a ratchet effect in place and taxes can never be increased again, then - abstracting for the moment from changes in government spending or assuming that changes in spending are infeasible for use as a stabilization tool - at some point we could well run out of options.

There is nothing special about using tax changes for stabilization policy, changes in government spending can also be used. Changes in government spending may even be preferred in some cases, and combinations of changes in government spending and changes in taxes can also be used to stabilize the economy around the long-run growth path if that is the preference. Want a smaller government? Use tax cuts to stimulate the economy in recessions, and use reductions in government spending to slow the economy when it threatens to overheat and be inflationary. Want a larger government? Do the opposite, increase government spending whenever the economy is lagging, and increase taxes to slow the economy when it begins to overheat.

The point is that stabilization policy - changes in taxes or changes in government spending - does not necessarily change the size of government in any particular direction, that is a policy choice. Traditionallyf stabilization policy maintains a constant budget balance in the long-run and whether to use tax changes or spending changes is a matter of effectiveness, not a matter of ideology about the size of government. Unfortunately, disputes over this issue can make it difficult to use fiscal policy as a stabilization tool. Even when both sides agree something needs to be done, different ideas about the size and functions of government can cause differences in the choice of tax changes or changes in spending as the means of stimulating or slowing the economy leading to policy gridlock.

In the political arena, gridlock can also occur when growth policy and stabilization policy are confused in order to block certain types of policies. For example, a tax increase during a robust economic expansion to pay off the tax cut enacted in the previous slowdown may be blocked by objections that it will slow economic growth. But that is the point of the policy in the short-run - the increase in the tax rate is supposed to stop the economy from overheating - just as the cut in taxes was intended to stimulate the economy on the other side. It's the average tax rate over the long-run that matters for for growth (the stability of taxes also matters which is one of the reasons to prefer changes in government spending over changes in taxes as the stabilization tool). Politically, in the current environment, it is difficult to do anything to pay off the debt when the economy is expanding, increases in taxes or cuts in spending, because one of the primary objections is that it will slow growth. But if we are serious about stabilization policy we have to somehow realize that the good times are the best choice for paying off the debts we accumulated when things weren't going so well.

Here's David Wessel touching upon some of the same issues in his latest Capital column for the WSJ. The discussion above was mainly about fiscal policy, particularly the choice between taxes and spending as the primary fiscal policy instrument. This is a nice summary of the issues involved in a different policy choice, whether to use monetary policy or fiscal policy to stimulate the economy:

Don't Count on a Stimulus Plan, by David Wessel, WSJ: With the Federal Reserve struggling to find the right medicine for a sickly economy that may be resistant to traditional remedies, talk of using fiscal stimulus -- spending increases or tax cuts -- is growing louder.

For years, the conventional wisdom ... has been that recession-fighting is best left to the Fed. It can cut interest rates quickly when the economy weakens. Fiscal stimulus, the argument goes, is a great idea -- in theory. The reality is that Congress and the president inevitably move so slowly that the stimulus arrives too late...

Yes, a sluggish economy got a well-timed boost from the Bush tax cuts in 2001, but the past quarter century suggests that relying on the Fed to fight recession usually works. Still, when deficit-fearing Harvard University economists Martin Feldstein ... and Lawrence Summers ... begin prescribing fiscal stimulus (and when former Fed Chairman Alan Greenspan -- incorrectly, by the way -- is viewed as a fellow traveler), it's time to listen carefully.

That the economy needs help isn't at issue. The issue is whether to mix fiscal stimulus with monetary policy... What are the arguments for doing so?

• The Fed isn't doing enough because it doesn't realize how ill the economy truly is. This case is built on the premise that the White House and Congress are better than the Fed at diagnosing the short-term swings in the economy. And it ignores the fact that the Fed could offset a fiscal stimulus it deemed imprudent by keeping interest rates higher than they would otherwise be. A lousy argument.

• The Fed's rate cuts aren't working ... as usual amid the widespread reluctance of lenders to lend. True... This bolsters the case for fiscal stimulus, but makes a better argument that the Fed and ECB need to be more aggressive.

• The Fed can't cut rates because it fears a dollar crash. At the Fed, the gradual decline in the dollar is viewed as a tonic for the economy; it'll help boost exports, though it does exacerbate the central bank's inflation anxiety. But cutting rates too much too fast could trigger a market-rattling, confidence-shaking plunge in the dollar. To the extent that specter stands in the way of the Fed..., then tax cuts or spending increases are indicated. Stronger argument.

• The usual channels through which Fed monetary policy works are clogged. Lower interest rates usually help... in part by stimulating housing construction. But housing is such a mess now that trimming the Fed's target interest rate ... wouldn't have the usual oomph. ... Strong argument, unless conditions improve significantly in the next several weeks.

• The Fed can make decisions swiftly, but, as Nobel laureate Milton Friedman taught, monetary policy works with long and variable lags. Giving Americans money to spend -- for example, through a tax cut that shows up in their paychecks next spring -- could have a much quicker impact on consumer spending. If, and this is a huge if, Congress and the president move swiftly, they could complement the Fed's efforts.

That really is the big rub. ..: Do it soon. Aim it at people who will spend the money. Don't worsen the long-term government deficit. History isn't encouraging about the likelihood of quick action. President Bush and Democrats in Congress agree on almost nothing these days. ... [And on the deficit,] Laurence Meyer, a former Fed governor [says]: "There's no such thing as a temporary tax cut anymore..."...

Turn from what the fiscal physicians are prescribing to what is actually likely to happen. That is what Mr. Greenspan is doing. He would prefer politicians do nothing, letting housing prices (and securities pegged to mortgages) fall until investors see them as bargains and start buying, stabilizing the economy. But with so many homeowners in pain and so much anxiety about the economy, he knows politicians want to do something. He says he would rather they offer "emergency aid, similar to what government does in natural disasters," than tear up contracts between borrowers and lenders or prop up housing prices and prolong the crisis.

The ... best political forecast is that nothing will come of this talk of fiscal stimulus. But should the economy continue to deteriorate early next year, or if a big financial institution totters, or if the Fed looks impotent or paralyzed, talk will give way to action and -- if the economy looks bad enough -- could produce legislation that President Bush might accept.

links for 2007-12-20

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