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April 18, 2009

Economist's View - 4 new articles

Tax Cuts, Household Balance Sheets, and the Duration of Recessions

Greg Mankiw:

It May Be Time for the Fed to Go Negative, by N. Gregory Mankiw, Commentary, NY Times: ...What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. ... The problem today ... is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools...

So why ... not lower the target interest rate to, say, negative 3 percent? ... The problem with negative interest rates ... is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive. ... At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. ... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal..., such an incentive isn't a flaw — it's a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. ...

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt...

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In ... the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. ...

This reminds of the the gift card idea to make sure people spend their tax cuts. Under these proposals, instead of giving people tax cuts, which they are likely to save instead of spend, the government gives them cards worth a given amount, say $1,000, and has the cards expire after, say, three months (you could stagger the issue of the cards over a three month time period so that purchases don't bunch up at the beginning and the end). The connection to the above is, of course, that the expiring gift card is just like the "expiring" money drawn through the serial number lottery (except, of course, that in one case it was a "gift" from the government, while in the other it is your savings). In both cases you are inducing people to spend rather than save through the threat that their saving will become worthless in the future (hyper-inflation does this too).

The reason for gift cards is to prevent the tax cuts from being saved. Initially, I opposed tax cuts that would mostly be saved rather than spent because it wouldn't stimulate aggregate demand, and that's what the economy needed. But I've changed my mind about that, and I think tax cuts can be an important part of the solution in a recession like this one.

Here's why. This recession has wiped out a lot of balance sheets in the financial sector, and it has also done severe damage to the balance sheets of individuals, especially those with a large proportion of their savings in financial assets or real estate (equity in their homes). Those households are not going to spend until those savings for retirement and other purposes are replenished, so how soon the end of the recession comes depends, in part, on how fast those balance sheets are repaired. Tax cuts help to do this, some types better than others. The effect of these balance sheet repairing tax cuts may not be immediately obvious since they are going toward saving, but it helps the recession end earlier than otherwise. Big ticket items, in particular, are less likely to be purchased so long as balance sheets still have big, missing pieces.

So tax cuts should be part of a recovery package, and they can be used in two ways. Some tax cuts can be used to stimulate the economy immediately by helping families who are having trouble and cannot save even if they want to, they have no choice but to consume it all, and part can be targeted at speeding up the recovery by helping households make up for losses. We have to understand, though, that this component of the package will not stimulate aggregate demand immediately, the main effect is to bring an end to the recession sooner, and other measures - increase government spending or additional tax cuts targeted at people who will spend it all - must be increased to compensate.

Recessions can be characterized by their depth and their duration, and my initial opposition to tax cuts underplayed, I think, the role they can play in reducing the duration. I still think the best and most certain way to stimulate aggregate demand is through government spending, and that government spending can itself help to end a recession sooner, but there's a role for tax cuts too. Not in every recession, at least not to the same extent, it's not always the case that a recession wipes out household balance sheets like this one did. But when that happens, household balance sheets are one of the things that must be repaired before we can fully recover.

"Bank Regulators Clash Over Endgame"

The bank stress tests are nearly complete, and there's apparently a debate over what to do with the stress test information on individual banks. Shouldn't Geithner have known what they were going to do with the stress test information before announcing the program in February? Or maybe figured out what those plans were over the last two months as they've been conducting the tests? Did they have plans and then realize they hadn't fully thought them through? Didn't we learn the dangers of going to battle without thinking carefully about the endgame and planning accordingly?

This exercise was supposed to build confidence in the system, but that doesn't happen when you put a policy in place before thinking it through thoroughly. Instead of testing banks, it's ending up as a test of Geithner's credibility as a policymaker, and instead of building confidence, it threatens to undermine it:

Bank Regulators Clash Over Endgame of U.S. Bank Stress Tests, by Robert Schmidt, Bloomberg: The U.S. Treasury and financial regulators are clashing with each other over how to disclose results from the stress tests of 19 U.S. banks, with some officials concerned at potential damage to weaker institutions.

With a May 4 deadline approaching, there is no set plan for how much information to release, how to categorize the results or who should make the announcements... While the Office of the Comptroller of the Currency and other regulators want few details about the assessments to be publicized, the Treasury is pushing for broader disclosure.

The disarray highlights what threatens to be a lose-lose situation for Treasury Secretary Timothy Geithner: If all the banks pass, the tests' credibility will be questioned, and if some banks get failing grades and are forced to accept more government capital and oversight, they may be punished by investors and customers. ...

Fed officials have pushed for the release of a white paper laying out the methodology of the assessments in an effort to bolster their credibility. ... A statement on the methods is scheduled for release April 24. ... The 19 companies may get preliminary results as soon as April 24, a person briefed on the matter said.

Regulators, all of which regularly administer exams to the lenders they oversee, have privately expressed concern about the tests and whether they will be effective, the two people said.

While weaker banks deemed to need additional capital will be given six months to raise it, financial markets may have little more than six minutes of patience before punishing them if the information is publicly released, one official said.

Geithner has said he crafted the stress test program in an effort to provide more transparency about the health of banks' balance sheets. ... How the market handles the results is a chief worry of banks and regulators... Banking lawyers and industry officials said that the Treasury needs to be very clear with the public about the reviews, which by their design test events that may not happen. ...

The Cost of CAFE Standards

How much does it cost in terms of lost profit per vehicle to mandate a one mile per gallon increase in fuel efficiency? According to this research, not as much as you might think:

The cost of CAFE standards: Not as high as we thought?, Greed, Green and Grains: Yesterday's TREE Seminar featured Jim Sallee of the University of Chicago. Sallee presented an interesting paper that uses a clever yet simple method to estimate the cost to car companies of meeting CAFE standards. Here's the abstract:

Automakers can comply with fuel economy regulations by exploiting a loophole that gives a bonus to flexible-fuel vehicles. Under certain conditions, firms will equate the marginal cost of using the loophole, which is observable, with the unobservable costs of other compliance strategies, such as selling smaller cars or upgrading technology. After verifying that these conditions hold empirically, we estimate that tightening standards by one mile per gallon would cost automakers $8–$18 in lost profit per vehicle. Our estimates are considerably lower than other recent estimates based on structural identification. Our approach may help reveal compliance costs for other regulations.

So car companies can achieve CAFE standards by either making their cars more fuel efficient or, alternatively, exploiting a loophole that allows them to instead make more "flex fuel vehicles" that can run on both ethanol (E85) or regular gasoline. The CAFE credit they get for these conversions combined with the cost of converting a regular gasoline car to a flex-fuel car turns out to be between $8 and $18 per car per MPG.

Okay, first off, this has NOTHING to do with whether the loophole is a good idea--whether we should be encouraging car companies to make flex-fuel vehicles or whether ethanol policy generally makes any sense. Save those thoughts for another day. The point is that car companies will choose the lowest-cost method of meeting the CAFE standard. And since achieving that standard using flex-fuel loophole is probably less than $18 per car, the cost of changing the overall standard can't cost more than this amount, at least for small changes. Cool idea. And that 's a very small cost per car--much less than estimated in earlier studies. Most of the paper is a careful dotting of all eyes and tees to verify the assumptions one needs to draw this inference. I'm trying very hard to find a flaw and cannot. Okay, so if this number is right we should all be very sick to our stomachs because it implies the costs of reducing carbon emissions, at least on the margin, is very, very low. So why aren't we doing this already? (No, I'm not advocating stricter CAFE; gas taxes or a cap-and-trade system would be the better policy route.) Update: To put this number in perspective: Rather than an upper bound of $18 per MPG per car, let's bump it up to $20 to be conservative. Then consider that a typical driver drives about 14,000 miles/year, or to be conservative let's say it's 10,000 miles, suppose a car's useful life is 10 years (again conservative), and that a typical new car currently gets about 25 MPG (also conservative). Then then it costs $20 in car company profits save about 154 gallons of gas, or about 13 cents per gallon. If I wasn't so conservative (especially with regard to current MPG), the cost could easily be half this amount. Since this is more than order of magnitude less than the price of gas, even at today's cheap prices, one may wonder why consumers' aren't happy to pay this cost. Note, however, that this is a measure of impact on automobile company profits, not the price of the car, so that would be reading the analysis wrong. Still, it's an incredibly low number.

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