Economics 1420/ API 126 Spring 2009

Martin Feldstein Katherine Baickermfeldstein@harvard.edu, kbaicker@hsph.harvard.edu868 3905 492-5209

Robert Stavins Robert Lawrence Robert_Stavins@harvard.edu Robert_Lawrence@harvard.edu 495-1820 495-1118

Teaching FellowsJeffrey Clemens (Clemens@fas.harvard.edu)Stephen Miran (Miran@fas.harvard.edu)David Seif (dgseif@gmail.com)

AMERICAN ECONOMIC POLICY

Classes will be held in Emerson Hall 210 every Monday, Wednesday, and Friday, except February 16, March 6, 13 and 20 and April 24

Sections will be held once a week, at times to be arranged.

• Prerequisite: Economics 1010a or 1011a, API-101, or permission of one of the instructors.

Grades will be determined as follows:• a midterm exam given in class on March 11-- 25 percent• two four-page memos due at the beginning of class on March 16 and April 27 -- 25 percent• a final exam given on may xx -- 50 percent• Paper Option: Students have the option of writing a 20-25 page research paper (due on May 5) in lieu of the two four-page memos. The paper will count for 25 percent of the grade. Students who choose this option can count Economics 1420 as one of the courses that fulfill the economics department writing requirement.

READINGS

Martin Feldstein, "Housing, Credit Markets and the Business Cycle," in the 2007 Kansas City Federal Reserve Annual Conference Volume , Housing Finance and Monetary Policy, 2008. http://www.nber.org/papers/w13471.pdf?new_window=1

Introduction: Where are we? How did we get here? (January 28) 1.

National Bureau of Economic Research, ―Business Cycle Expansions and Contractions.‖ http://www.nber.org/cycles.html

2. Business Cycles, Inflation and Monetary Policy (January 30, February 2 and 4)

SyllabusMonday, March 09, 2009

5:24 PM

Ec 1420 Page 1

Christina Romer and David Romer, ―What Ends Recessions?‖ NBER 1994 Macroeconomics Annual, pp. 13-57.

http://www.nber.org/papers/w4765.pdf?new_window=1

John Taylor ―An Historical Analysis of Monetary Policy Rules,‖ in John B. Taylor (ed.) Monetary Policy Rules, University of Chicago Press, 1999.

http://www.nber.org/papers/w6768.pdf?new_window=1

Martin Feldstein "The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy," Journal of Political Economy, Vol. 87, No. 4, 1979, pp 749-768.

http://www.nber.org/papers/w0201.pdf?new_window=1Ben S. Bernanke, ―A Perspective on Inflation Targeting, Remarks at the Annual Washington

Martin Feldstein ―Liquidity Now!‖ Wall Street Journal, September 12, 2007

Policy Conference of the National Association of Business Economists, Washington, D.C. March 25, 2003. (A pdf will be e-mailed out the week of this lecture.)

http://www.nber.org/feldstein/wsj091207.html

Martin Feldstein ―Enough with the Interest Rate Cuts,‖ Wall Street Journal, April 15, 2008http://www.nber.org/feldstein/wsj41508.html

3. National Saving, Growth and Income Distribution (February 6)Edward Gramlich ―The Importance of Raising National Saving,‖ Benjamin Rush Lecture, Dickinson College, March 2, 2005. http://www.federalreserve.gov/boarddocs/speeches/2005/20050302/default.htmLusardi, Annamaria, Jonathan Skinner, Steven Venti. ―Savings puzzles and savings policies in the US.‖ https://depot.erudit.org/retrieve/687/000036pp.pdf

Parker, Jonathan. ―Spendthrift in America: two decades of decline in the US saving rate.‖ http://www.nber.org/papers/w7238.pdf?new_window=1

Martin Feldstein "The Return of US Saving", Foreign Affairs, May/June 2006, pp 87-93. http://www.nber.org/feldstein/returnofsaving.pdf

Martin Feldstein and Charles Horioka, ―Domestic Saving and International Capital Flows,‖ Economic Journal, June 1980, pp. 314-329. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w0310.pdf?new_window=1

Martin Feldstein “Did Wages Reflect Growth in Productivity,” Journal of Policy Modeling, 30 (2008) pp 591-94. http://www.nber.org/feldstein/WAGESandPRODUCTIVITY.meetings2008.pdf4 . Budget Deficits and the National Debt (February 9)Laurence Ball and N. Gregory Mankiw, ―What Do Budget Deficits Do?‖ Budget Deficits and Debt: Issues and Options, Federal Reserve Bank of Kansas City, 1995, pp. 95-119. https://www.kc.frb.org/Publicat/sympos/1995/pdf/s95manki.pdf

http://www.nber.org/papers/w8488.pdf?new_window=1

Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp. 0-24 & 63-80 (the remaining pages are assigned for a later class). (A pdf will be provided for those who do not have access to the NBER‘s working paper series.)

Ec 1420 Page 2

Congressional Budget Office, The Long-Term Budget Outlook, December 2007, pp 1-17. http://www.cbo.gov/ftpdocs/88xx/doc8877/12-13-LTBO.pdf

Office of Management and Budget, Budget of the United States Government: Analytical Perspectives, Fiscal Year 2008, pp. 183-187. Note: Page numbers refer to the page numbers of the document itself, not the page number of the pdf. http://www.whitehouse.gov/omb/budget/fy2008/pdf/spec.pdf

Congressional Budget Office, Economic and Budget Outlook 2009 -2019. http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outlook_Testimony.pdfhttp://www.cbo.gov/ftpdocs/99xx/doc9957/01-07-Outlook.pdf

5. Housing and Financial Markets (February 11)Martin Feldstein, ―How to Stop the Mortgage Crisis,‖ The Wall Street Journal, March 7, 2008. http://www.nber.org/feldstein/wsj03072008.html

Martin Feldstein, ―How to Help People Whose Home Values Are Underwater,‖ The Wall Street Journal, November 18, 2008. http://www.nber.org/feldstein/wsj100408.html

Martin Feldstein, ―The Problem Is Still Falling House Prices,‖ The Wall Street Journal, October 4, 2008. http://www.nber.org/feldstein/wsj100408.html

Edward L. Glaeser, ―Why We Should Let Housing Prices Keep Falling,‖ New York Times, October 7, 2008. http://economix.blogs.nytimes.com/2008/10/07/why-we-should- let-housing-prices-keep-falling/―Popping Sounds: House prices are falling just about everywhere,‖ The Economist, December 4, 2008. http://www.economist.com/finance/displaystory.cfm?story_id=12725898

Doug Diamond and Anil Kashyap. ―Everything you need to know about the financial crisis.‖ http://freakonomics.blogs.nytimes.com/2008/10/15/everything-you-need-to-know-about-the-financial-crisis-a-guest-post-by-diamond-and-kashyap/

6. Keynesian Economics: Retreat and Return (February 13, 18, 20)

Martin Feldstein, ―The Retreat from Keynesian Economics,‖ The Public Interest, 1981.

Martin Feldstein, ―Rethinking the Role of Fiscal Policy,‖ forthcoming in the American Economic Review, May 2009 (Available on American Economic Association website for January 2009 annual meeting) John Taylor, ―The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy,‖ forthcoming in the American Economic Review, May 2009 http://www.aeaweb.org/annual_mtg_papers/2009/retrieve.php?pdfid=387

Alan Auerbach, ―Implementing the New Fiscal Activism,‖ forthcoming in the American Economic Review, May 2009. http://www.aeaweb.org/assa/2009/retrieve.php?pdfid=324

http://www.nber.org/feldstein/wsj120507.htmlMartin Feldstein, ―How to Avoid a Recession,‖ Wall Street Journal, Dec 5, 2007.

Lawrence Summers, ―Why America Must Have a Fiscal Stimulus,‖ Financial Times, January 6, 2008. http://belfercenter.ksg.harvard.edu/publication/17845/why_america_must_have_a_fiscal_stimulus.html

Douglas Elmendorf and Jason Furman, ―If, When, How: A Primer on Fiscal Stimulus,‖ Brookings Institution Hamilton Project Strategy Paper, January 2008. http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx

Ec 1420 Page 3

http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx

Gregory Mankiw, ―What Would Keynes Have Done?‖ New York Times, November 28, 2008. http://www.nytimes.com/2008/11/30/business/economy/30view.html?_r=5&adxnnl=1&partner=permalink&exprod=permalink&adxnnlx=1228241156-T3%2bMqzQf

Broda, Christian and Jonathan Parker. ―The impact of the 2008 tax rebates on consumer spending: a first look at the evidence.‖ http://faculty.chicagogsb.edu/christian.broda/website/research/unrestricted/Stimulus%20Payments%20and%20Spending.pdfMartin Feldstein, ―The Tax Rebate Was a Flop. Obama's Stimulus Plan Won't Work Either,‖ The Wall Street Journal, August 6, 2008. http://www.nber.org/feldstein/wsj080708.html

Congressional Budget Office, Options for Responding to Short-term Economic Weakness, January 2008. http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf

7. Fluctuations Of The Dollar and the Trade Balance (February 23, 25)

Richard E. Caves, Jeffrey A. Frankel, and Ronald W. Jones, ―Expectations, Money, and the Determination of the Exchange Rate,‖ World Trade and Payments, pp. 581-589. (We may need to scan the book directly to create a pdf of this one.)

Martin Feldstein, ―Resolving the Global Imbalance: The Dollar and the US Saving Rate,‖ Journal of Economic Perspectives, Summer 2008. http://www.nber.org/feldstein/ResolvingtheGlobalImbalance.pdf

http://www.nber.org/feldstein/wsj042806.htmlMartin Feldstein, ―The Dollar at Home – and Abroad,‖ The Wall Street Journal, April 28, 2006.

Martin Feldstein, ―A More Competitive Dollar is Good for America,‖ The Financial Times, October 15, 2007. http://www.nber.org/feldstein/ft101507.html

8. Environment Policy (February 27, March 2, 4 , 9 ) Professor Robert Stavins

a. Basic Analytics of Environmental Policy (February 27)

Don Fullerton and Robert Stavins. "How Economists See the Environment." Nature, volume 395, pp. 433-434, October 1, 1998.

Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and Robert Stavins. "Is There a Role for Benefit-Cost Analysis in Environmental, Health, and Safety Regulation?" Science, April 12, 1996.

Lawrence Goulder and Robert Stavins. "An Eye on the Future: How Economists' Controversial Practice of Discounting Really Affects the Evaluation of Environmental Policies." Nature, Volume 419, October 17, 2002, pp. 673-674.

Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam: Elsevier Science, 2007.

b. More Analytics and an Application to Acid Rain (March 2)

Ec 1420 Page 4

Richard Schmalensee, Paul Joskow, Denny Ellerman, Juan Pablo Montero, and Elizabeth Bailey. ―An Interim Evaluation of Sulfur Dioxide Emissions Trading.‖ Journal of Economic

Perspectives, Volume 12, Number 3, Summer 1998, pages 53-68.

Robert Stavins. ―What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.‖ Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 69-88.

Robert Hahn, Sheila Olmstead, and Robert Stavins. "Environmental Regulation During the 1990s: A Retrospective Analysis." Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415. With R.W. Hahn and S.M. Olmstead.

Robert Stavins. "Regulating by Vintage: Put a Cork in It." The Environmental Forum, Volume 22, Number 3, May/June 2005, p. 12.

___________. "What Baseball Can Teach Policymakers." The Environmental Forum, Volume 22, Number 5, September/October 2005, p. 14.

c. U.S. Climate Policy (March 4)

Gilbert Metcalf. ―A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate Change.‖ The Hamilton Project, Discussion Paper 2007-12. Washington, D.C.: The Brookings Institution, October 2007.

Robert Stavins. A U.S. Cap-and-Trade System to Address Global Climate Change. The Hamilton Project, Discussion Paper 2007-13. Washington, D.C.: The Brookings Institution, October 2007.

William Nordhaus. ―To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming.‖ Review of Environmental Economics and Policy, Volume 1, Issue 1, Winter 2007, pp. 26-44.

Robert Stavins. "A Tale of Two Taxes, A Challenge to Hill." The Environmental Forum, Volume 21, Number 6, November/December, 2004, p. 12.

__________. "A Sensible Way to Cut CO2 Emissions." The Environmental Forum, Volume 24, Number 6, November/December, 2007, p. 18.

__________. "Cap-and-Trade or a Carbon Tax?" The Environmental Forum, Volume 25, Number 1, January/February, 2008, p. 16.

__________. ―Inspiration for Climate Change.‖ The Boston Globe, Op-Ed, November 12, 2008.

d. International Climate Policy (March 9)

Robert Stavins. "Beyond Kyoto: Getting Serious About Climate Change." The Milken Institute Review, volume 7, number 1, 2005, pp. 28-37.

Joseph Aldy and Robert Stavins. Designing the Post-Kyoto Climate Regime: Lessons from the Harvard Project on International Climate Agreements. An Interim Progress Report for the 14th Conference of the Parties, Framework Convention on Climate Change, Poznan, Poland, December 2008. Cambridge, Mass.: Harvard Project on International Climate Agreements, November 24, 2008.

Robert Stavins. "Linking Tradable Permit Systems." The Environmental Forum, Volume 25,

Ec 1420 Page 5

Number 2, March/April, 2008, p. 16.

9. Tax Policy (March 16, 18 and 30)

http://www.nber.org/feldstein/taxanalysis.pdfCouncil of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President,

Martin Feldstein, ―The Effect of Taxes on Efficiency and Growth,‖ Tax Notes, May 8, 2006.

Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf

Joel Slemrod, ―Methodological Issues in Measuring and Interpreting Taxable Income Elasticities,‖ National Tax Journal, 51: 773-788, 1998. (A pdf will be provided.)

Martin Feldstein, ―The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,‖ Journal of Political Economy, 1995, pp. 551-572. (A pdf will be provided.)

Reform, (Washington, DC, AEI Press), 2005, pp. 70-80. (A pdf will be provided.)

Robert E. Hall, ―Guidelines for Tax Reform: The Simple, Progressive Value-Added Consumption Tax, in Alan Auerbach and Kevin Hasset, eds, Toward Fundamental Tax

Martin Feldstein, "How Big Should Government Be?," National Tax Journal, Vol. 50, 1997, pp. 197-213. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w5868.pdf?new_window=1

10. Social Security Reform (April 1, 3 and 6):

Martin Feldstein, ―Rethinking Social Insurance,‖ 2005 Presidential Address to the American Economic Association, American Economic Review, March 2005. (A pdf will be provided.)

and the Economy, 2002, Vol. 16, Issue 1, pp. 181-224. http://www.nber.org/papers/w8592.pdf?new_window=1

Martin Feldstein and Andrew Samwick, ―Potential Paths of Social Security Reform,‖ Tax Policy

Martin Feldstein, ―Structural Reform of Social Security,‖ Journal of Economic Perspectives, 2005. http://www.nber.org/feldstein/streformofss.pdf

Alicia Munnell, ―Social Security: It Ain‘t Broken,‖ Social Security Reform, Federal Reserve Bank of Boston, June 1997, pp. 297-303. http://www.bos.frb.org/economic/conf/conf41/con41_24.pdf

Jeffrey Liebman, ―Redistribution in the Current U.S. Social Security System,‖ in Distributional Aspects of Social Security and Social Security Reform, Editors Martin Feldstein and Jeffrey Liebman, 2002, pp. 11-41. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w8625.pdf?new_window=1

http://www.nber.org/papers/w8488.pdf?new_window=1

Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp 80-106 and 121-125. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.)

Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, ―Nonpartisan Social Security Reform Plan.‖ http://www.newamerica.net/files/archive/Doc_File_2757_1.pdf

11. Unemployment Insurance (April 8)

Ec 1420 Page 6

11. Unemployment Insurance (April 8)

Martin Feldstein , ―Rethinking Social Insurance,‖ American Economic Review, March 2005, pp 13-15. (A pdf will be provided.)

Martin Feldstein and Daniel Altman, "Unemployment Insurance Savings Accounts," Tax Policy and the Economy, Vol. 21, 2006. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w6860.pdf?new_window=1

12. Oil (April 10)

Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html

John Deutch, James Schlesinger and David Victor National Security Consequences of US Oil Dependency Council on Foreign Relations, 2006 http://www.cfr.org/content/publications/attachments/EnergyTFR.pdf

Martin Feldstein and Henry Kissinger “The Power of Oil Consumers”, Washington Post,September 18, 2008 http://www.nber.org/feldstein/washpost_091808.html

Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July 2008 http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf

11. The Economics of National Security (April 13)

Martin Feldstein ―Tradable Gasoline Rights,‖ Wall Street Journal, June 5, 2006 http://www.nber.org/feldstein/wsj060506.html

Martin Feldstein, ―The Underfunded Pentagon,‖ Foreign Affairs, March/April 2007. http://www.nber.org/feldstein/the-underfunded-pentagon.pdf

Martin Feldstein, ―Defense Spending Would Be Great Stimulus,‖ Wall Street Journal, December 24, 2008 http://www.nber.org/feldstein/wsj12242008.html

Optional:Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary Update for Fiscal Year 2008, December 2007. http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm

12. Trade Policy (April 15, 17) Professor Robert Lawrence

13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker

14. Final Lecture (May 1

Schedule American Economic PolicySpring 2009

W Jan. 28 Introduction (Feldstein)F Jan. 30 Demand Management and Monetary Policy (Feldstein)

Ec 1420 Page 7

F Jan. 30 Demand Management and Monetary Policy (Feldstein)

M Feb. 2 Demand Management and Monetary Policy (Feldstein)W Feb. 4 Demand Management and Monetary Policy (Feldstein)F Feb. 6 National Saving, Productivity and Growth (Feldstein)

M Feb. 9 Budget Deficits and National Debt (Feldstein)W Feb. 11 Housing Crisis and Financial Markets (Feldstein)F Feb. 13 Keynesian Economics: Retreat and Return (Feldstein)

M Feb. 16 President‘s Day, University Holiday (No Class)W Feb. 18 Keynesian Economics: Retreat and Return (Feldstein)F Feb. 20 Keynesian Economics: Retreat and Return (Feldstein)

M Feb. 23 Fluctuations of the Dollar and the Trade Balance (Feldstein)W Feb. 25 Fluctuations of the Dollar and the Trade Balance (Feldstein)F Feb. 27 Environment Policy (Stavins)

M Mar. 2 Environment Policy (Stavins)W Mar. 4 Environment Policy (Stavins)F Mar. 6 No Class

M Mar. 9 Environment Policy (Stavins)W Mar. 11 Midterm ExamF Mar. 13 No Class

M Mar. 16 Tax Policy (Feldstein) W Maar 18 Tax Policy (Feldstein)F Mar. 20 No Class

M Mar. 23 Spring BreakW Mar. 25 Spring BreakF Mar. 27 Spring Break

M Mar. 30 Tax Policy (Feldstein)W Apr. 1 Social Security Reform (Feldstein) F Apr. 3 Social Security Reform (Feldstein)

M Apr. 6 Social Security Reform (Feldstein) W Apr. 8 Unemployment Insurance (Feldstein)F Apr. 10 Oil (Feldstein)

M Apr. 13 Economics of National Security (Feldstein) W Apr. 15 Trade Policy (Lawrence) F Apr. 17 Trade Policy (Lawrence)

M Apr. 20 Health Care Policy (Baicker) W Apr. 22 Health Care Policy (Baicker) F Apr. 24 No Class

M April 27 Health Care Policy (Baicker) W April 29 Health Care Policy (Baicker)F May 1 Final Lecture

Reading Period: May 2 - May 13

Ec 1420 Page 8

Reading Period: May 2 - May 13Final Exam: May 20 (?)

Ec 1420 Page 9

Monetary policy, inflation, unemployment, exchange rates, etc.

Taxes, budget deficits, medicare, social security

Cover a wide range of economic policy

W 12, 3pm; Tues 7pm, Thurs 2pm for section

mfeldsten@

Worst recession we have ever seen

Financial crisis

Decline in aggregate demand

Very different intellectual approacho

Different from other downturns we have experiencedo

Exciting and worrying time for economistso

Will spend time contrasting traditional recession policies vs. those in the futureo

These circumstances require a different kind of policy than other recessions

Like a disease

Its like a patient who is very sick, but who is actually healthyo

The longer term performance of the US economy—has been very good

3.1% growth in GDP for 5 years until it peaked in 2007o

better than US perfornamnce in previous years and in europeo

now its over 7%

4.6 % unemploymento

That‘s not a good thing

Better than 12% in 1980

But we had succeed in bringing inflation down to 4.5% in 2007

Inflation now is very low: 0 or negativeo

In 2007: 1.5% deficit

Fiscal deficit is exploding nowo

But now has contracted a really bad bug

Economy that was doing really well up until 2007o

Before recession in fall 2007, we had best development

Marty thinks we wil return to it, it‘s a reflection of economic policies, not coincidenceo

Are we going to be able to return to that? Or will we suffer for rest of lives?

Part of that reflects price of oilo

Other part going forward: fiscal deficit: cost of social security and medicare and Medicaid

o

Massive trade deficit, about 5% of GDP-$17Bn

Good performance was not an accidento

Reflected good monetary and tax policieso

But also some policies got us in trouble recentlyo

Current debates depend on and reflect on decisions made at analytical level

Will talk about the analytic issueso

Strong growth, low unemployment, low inflation, low fiscal deficit—remarkably better than 20 years ago

While we don‘t approach this as a historical course, we will from time to time look

Focus on all of this is on applications

Lecture 1Wednesday, January 28, 2009

1:37 PM

Ec 1420 Page 10

While we don‘t approach this as a historical course, we will from time to time look back over the past few decades

o

Reading list available online

Schedule: Shows you the schedule of classes; pretty good approximation

Do the readings! Not substitutes for lectures

The Economist magazineo

WSJo

Financial Timeso

What else might you want to read?

Look for economic indicators

One easy place: at the NBER‘s websiteo

Macroeconomic issues: there are lots of data,

2 short memos

Essentially a microfinance courseo

Public finance at 9am: government, and taxation

This term‘s first lecture: Where we are and how did we get there

People are worried that it will be up to 9% at next announcement

Increase in about 7 million unemployed

Unemployment went from 4.6% to 7.2%o

Worst economic downturn in history

A recession is a time when the economy is contractingo

Even in expansion, high unemployment

Economists take a while to say its actually a recession

Stay in expansion until get to next peak

See diagramo

What is a recession and why is it different than others?

National Bureau of economic researcho

NBER looks at a variety of monthly indicators and asks if we are in a broad sustained and deep decline in economic activity, and then makes guess about next peak

o

Look at cycles on NBER‘s homepage

The typical recession from peak to trough was 10 mos

Relatively short and mild

Not that many people got laid off and turned around quite quickly

Now: we‘re already in 12 mos, could last to 2010—probably over 24 mos

Contrast economic policies in this recession vs. typical policies used in past and which we will probably still use in future

Last peak was December 2007o

Recession: dated by NBER

Inflationo

This was true throughout the post-war period

But this time, the fed did not create the recession

It would raise Short Term interest rates until it slowed economy and brought down inflationary pressures

o

This time, the traditional remedy is not working because the fed did not push us into this recession by raising ST interest rates, so it cannot cure it that way

Asterisks: except has affect on exchange rate

We can see they‘ve been lowering to no avail

The fed would lower ST interest rateso

Federal Reserve

Overnight interst rate: 0-.25%-->has little effect

Since fed did not cause this recession, what did??

Ec 1420 Page 11

risk was underpriced

Treasury Bond: 4%; Corporate bond: 8%

Prices were too high meant that corporate bond had 6%

The interest rates on these risky securities might go back up from 6% to 8%

o

The price of a bond varies inversely with interest rateo

So the individual who holds that bind will take a significant loss

o

Underpricing of risk was not just corporate bonds, but also mortgages, emerging market bonds, and the stock market

o

Yield on stocks: was about 6%o

So there was this underpricing of risk by investorso

So the extra risk that you took, that company might default, was only worth 2%, not 4%

The short answer: competitive pressureo

But if I don‘t take that risk and get that extra 2% yield, client will take money to another money manager

But we‘re paid to take those extra risks!

Pension fund, hedge fund

It wasn‘t your money!

You can get paid in the short run for taking the extra risk, maybe you‘ll be gone before it goes down

Someday the earthquake will happen, and your company will get hit bigtime

o

But in meantime, you‘re making a profit, and you‘re getting rewarded for it

o

Its like selling earthquake insurance

Also, the money was not their money

They would say yes, we are getting little returno

Also 25% fall in home pricestail risk

Very low probability of it happening

Why don‘t companies understand this idea of tail risk? We have to experience with this risk

o

Also, this idea that they can get their finger on the button faster and get out sooner than everyone else

o

Why would they be willing to do this? Why were they willing to hold risky assest when the extra yield held with risky assest was not very much? And these were professional investors!

1.) Higher prices of risky assets

because the risk seemed low, there was a temptation to want to borrow more in order to lever up in order to get a higher rate of return

they too were caught in this world

But if it fell by 4%, then that $30 became $28.50, but they owe $29

o

Investment banks: for every dollar of capital, they had $30 of investments$29 of contributed funds

2.) high leverage, borrowing

Two things that are the fundamental causes of thiso

By early 2007, characterized by this underpricing of risk and high leverage

Since fed did not cause this recession, what did??

Ec 1420 Page 12

By early 2007, characterized by this underpricing of risk and high leverageo

Poor credit history, bad record of paying back in past

GNMA, FRMC

If we only lent to people with good credit records, then minorities and poor people couldn‘t get homes

Policy Required to increase their lending to this group

If banks took money from certain areas, they also had to give back to those areas

Community reinvestment act

Subprime loan: loan to creditor with high risko

High risk borrowers because couldn‘t prove their credit history

ALT-A: o

In 2005, 2007, there was an explosion of lending to these peeps

These were wonderful years, rising house prices, so it was a bad basis on which to make judgment about how risky these loans were

Repricing of risk: on all financial instruments, saw stock market come down by 40%

House prices come down by 12 trillion

In 2007 there were suddenly many more defaults on subprime loans

Low probability that these people would default came from examining the experience over the past few years

o

Indicator of this came from the subprime mortgage crisis

Enormous decline in wealth and in value of mortgage backed securities

Ec 1420 Page 13

-3.8%

so less of a decline in output o

so they‘re probably going to sell even less in 1st quarter because they ended on such large inventories

o

didn‘t sell stuff in inventory because consumers didn‘t come

does this mean in much better shape? No—a lot of it was because of inventory

Its not what's happening now, or whats happening in the 4th quarter, its what happened between the 3rd (JAS) and 4th (OND)

o

GDP figures for the 4th quarter: Surprised the forecasters, who said that this was going to be an absolutely awful 4th quarter, thought it was going to fall by 5.5%

Reasons for the economic crisis

Central to problemo

Drove down household wealtho

4 trilllion

Restricted the assets, capital, earnings of financial system and led to paralysis of financial institutions

o

Let‘s focus on decline in housing sector

I.) Decline in House Prices (Ph)o

II.) Increase in leverage (loan/value ratios)o

III.) Securitizationo

3 things happened in this past decade which never came together like this before

60% increase in total

had been increasing 10-15% per year

eroded o

they have been falling rapidlyo

Will it go back to equilibrium, or will it overshoot?

Now we know that you might get wiped out

People who bought house at peak got wiped out

So equilibrium price might be lower, like in stock market

Maybe: now its become a risky asset

Schiller measure of house prices—down 18% in past year, but still another 15% to go to original trend

o

now, they‘ve come down about 25%

2000broke out of historic pattern

So we had an unsustainable bubble, rate of increase in house priceso

In beginning of this decade, house pries increased at a much faster rate

back at the beginning of the decade, it was very concerned about deflation

at beginning of decade, there were a flurry of months when prices were falling

r=i-

real interest rate= nominal interest rate - inflation

why is deflation a worry? If the fed wants to cut interest rates to stimulate the economy, it wants to cut the real insterest rate

1.) What the federal reserve dido

Causes of I? House Prices Decline

Lecture 2Friday, January 30, 2009

1:41 PM

Ec 1420 Page 14

real interest rate= nominal interest rate - inflation

.04=.06-.02

.01=.03-.02

But what if there is deflation?

there is the zero bound: the fed has driven the federal funds interest rate to zero

o

so .02=0+.02o

but say that deflation gets worse, that would drive the real rate up

o

and there's nothing the fed can do about it

may cause the real rate to be high and continue to rise as deflation gets worse

o

.04=.02 – (-.02)

deflation makes the value of debt greater in real termso

2.) When there is deflation, in real terms, companies that are in debt owe more money and will have a harder time dealing with that debt

Drove down interest rates on mortgages

Led to increase in borrowing because cost of carrying that mortgage was lower

o

Mortgage borrowing became cheaper

Fed didn‘t want this, so pre-emptively cut interest rates and said they would keep it low

So the primary cause of low interest rates was federal reserve

relatively low income individualso

tried to bring low income individualso

so banks were forced to go out and find people and make loans to them

so well give you a 2% rate for 2 yearso

but don‘t worry about it, because housing prices are rising, so in 2 years you can get a new mortgage to pay 6% rate

o

shifted demand curve to the right

These were ways of trying to make houses more affordableo

and it succeed for a while, but now not anymore…o

we‘d love to give you a mortgage, but we know you'll have a hard time paying 6%

affordability products in the mortgage market

if you draw money from a certain area, you must lend back to that area in form of mortgages

o

why am I renting when my friends are getting returns on their homes

fed the demand

like any bubble, when you get far enough away from a feasible equilibrium, prices will start to go down

not taking into account that 10% wont continue: in a bubbleo

houses going up at 10-15% per year, can borrow at 6% tax deductable

at the time, there was short-sighted rationality (there is no such thing but lets call it that)

3.) Market Psychologyo

2.) Housing Policy: Government policy encouraging buying homes

Sometimes you could get 2 mortgages at once, so you didn‘t have to put anything down

o

Causes of II? - Leverage

Ec 1420 Page 15

downo

And that did worko

But it stopped working when we got to the peak of the curveo

Loan is greater than underlying property

12 million individuals, 2.5 trillion mortgages are underwater, individual owes more than house is worth

average underwater home is 120%

What happened as a result of that is that we went from 90% to LTV ratios, to >100% LTV

o

While its more prudent to do 70-80%, the 90% would eventually come down to 70-80% because of rising housing prices

Why would they do this (the banks)?

But they are non recourse mortgages, so creditor cant resource to other assets or income

De facto: non recourse

Still owe 20,000o

You borrowed 200,000 for 250,000 house, but now its only worth 180,000

When creditor sells house at low price, drives prices down in that area, and increase LTV of everyone else

So we can easily overshoot as result of this decline

If housing prices fall another 15%, the average underwater home will go to 140%

o

Negative equity of 40%o

Danger is an avalanche of selling o

Rate of foreclosure doubled this yearo

So house prices will continue to fall as result of this

But really it‘s the high LTV of the loano

Don‘t know who will pay them

Don‘t know what those mortgages are worth

People with negative equity like homes, neighbors, hope things will turn around

Why are we paying these rates, when we can rent across street for much less

Financial institutions don‘t know what loans on balance sheet are worth

What does this mean for the bank that holds themo

Some people defaults because teaser rate over, lose job

Law of mortgages: if you default, they can take mortgage, and take away house and sell it and that’s ALL they can do in US

High volume of 90+% loan to value ratioso

Years ago, you went to the bank, told the bank I don‘t want to default, you don‘t want me to default, lets work something out

o

So you get in trouble as homeowners, because there is no one to turn to

You send local banks monthly check, but they already sold loan

Sell loans to pension funds, other banks

Now, most of loans are securitizedo

If you make local loans, and a big employer in town goes out of business, a lot of people will default

o

Causes III? Securitization

Ec 1420 Page 16

people will defaulto

Even though homeowner has no one to go to

But if you pool mortgages from all over country, there is much less of this risko

Bankers could generate a lot more leverage to generate more risk in o

The first hundred mortgages to default, they are stuck with ito

First hundred losses are theirso

Chance that 100 mortgages will default is low—only maybe 20 will

o

B securityo

Tranche A: risk lovers, the ones who want a high yield and who are prepared to take the most risk

More than 100 mortgages have to default before it gets to meo

So I go to a rating agency, Moodys, S&P, lets call this a AA security

o

Tranche B guys get losses 101-200

AAAo

Tranch C: Losses 201-300

Tranche D: Super senior, safer than gov‘t bonds

So the rating agencies, stupidly, judging on an atypical part of history, put these ratings on it

o

Might as well buy 10 bonds and lever upo

But the history of defaults of subprime mortgages was during rising housing prices, great era

A bunch of subprime loans pooled together to create a AAA security

Mortgage Backed securitieso

Subprime mortgages defaulted much more than expectedo

Thought there was no chance of default, but we don‘t know how many will actually default

Keep seeing billions of dollars of losses incurred by financial institutions

Don‘t know if they can repay them next week

Don‘t know what counterparty risk is

No one wants to lend to them, because they don‘t know how many losses lie ahead

o

Can I raise $ from anyone else?

So where does this put the financial institutions

Don‘t really know what they're wortho

Don‘t know what their losses are

But wont commit for long period of time

Total gridlock

Dysfunctional credit market

Financial institutions don‘t know what they're worth, cant raise money, don‘t know how much they can lend if they could raise money

Even if government's lending rate is low, the financial institutions aren‘t there to do any lending because they don‘t know what they're balance sheets are

So they‘ll make a loan to a high quality borrower for a short period of time

For every dollar they lend, don‘t know how much capital they haveo

Suddenly discovered that there was much more risk than anyone imagined

Household wealth fell 8 trillion because of fall of stock market

Dysfunctional credit markets and major collapse of demand

Ec 1420 Page 17

Household wealth fell 8 trillion because of fall of stock marketo

And 4 trillion for loss of Housing valueso

Now might be more

Like it was years agoo

So consumer saving up

Now, pensions more affected by fall in market

Historically, if lost $100, consumer spending down $.04o

So enormous decline in consumer spending 4-5% of 12 trillion: 500 billiono

Housing starts-200 billion per yearo

So 200+500=700bn fall of GDPo

Declines in consumer spendingo

But that wont help now, huge holeo

Need to go back to regime which uses a lot of fiscal policyo

Normally would say leave it to fed, they‘ll drive down interest rates and take care of it

Ec 1420 Page 18

But this one is massive, dysfunctional credit marketso

Fed not enough nowo

In previous downturns, we could rely on fed‘s monetary policy to fix it (in part because fed had caused it)

Increase taxes? Increase gov‘t spending?o

Big question: what to do?

Let‘s look at the traditional role in economic policy in managing aggregate demand

How the federal reserve has dealt with downturns in the past and will in the future

Real consumer spending slid 1%o

Govt announce today that saving rate was negative a year today, now 6.8%

In dealing with inflationo

We can see against that background how the intellectual climate has changedo

Traditional Role of Monetary Policy in Managing recession

National Saving and growth

Then return to credit policyo

Budget deficits and national debt directly

The norm was a balanced budget

The gov‘t was very small

now, its 20%

1929=federal gov‘t was 3% of GDP

If you go back before John Maynard Kaynes, before 30's, there was no fiscal policyo

There were welfare jobs

But what about monetary policy?

During the economic downturn of 20's, 30'so

First, Fiscal and Monetary Policy

On achieving low inflation, so link between increase in money and infation (increase in price level)

o

Protecting stock of gold

Raise interest rates depending on inflow or ourflow of gold

Worry about avoiding or correcting financial crisiso

There has always been an intellectual idea about what should be done for monetary policy

Didn‘t expect them to fix it

Treat hardship by providing jobs for unemployed and monetary policy

Saw it like the weathero

Did not expect gov‘t to be able to control GDP

Compared to fiscal policy (Changes in tax rates or gov‘t spending)o

Short timeline for decisions and implementation

Fed began lowering interest rates in 2007 and continued lowering them for years

As opposed to gov‘t which took huge multibillion dollar bite

Federal reserve can take small steps while its learning

Can raise rates back up again

Also, fed can reverse quickly

The fed is MUCH more politically independent

Chairman, fed independent agency

Monetary policy relative to fiscal policy

what were advantages of monetary policy?o

Until this past year, monetary policy was virtually the only policy used in US and other

Lecture 3Monday, February 02, 2009

1:43 PM

Ec 1420 Page 19

Can report to congresso

Chairman, fed independent agency

Unfortunately, these days it has been brought into the administration's policy process more

o

But it is much less of a political process than congresso

But the fed is de facto quite independent

So for all of these reasons, monetary policy looks more attractive than fiscal policyo

Today, it has rates down to 0

Affecting credit market

Should really be talking in past tense

So when we talk about fed, we‘re talking up to 2008, and how we expect the Fed to act in the future

How does monetary policy operate?o

Buys and sells treasury bills

Banks don‘t want to sit there looking at their reserves

And then banks want to lend that out

To do that, they lower their rates

These days, the fed has started paying interest rates on reserve, so banks will just let them sit there and accumulate

When buy From the banks increases their reserves

So the Fed makes monetary policy by open market operationo

What does this lowering of interest rates do?o

This then affects lowering of long term interest rates, which affect mortgage rates

When cost of carry decreases, demand goes up, and so does price, which is inversely related to long term rate

o

So it lowers the cost of carry for these bonds

Why? Because anyone who holds bond has cost of doing so

When the fed lowers short term interest rates in the market?o

This is the rate that the fed targets

The governor plus the chairmen meet to make a decision about the fed funds rate and announce it to world

Now its between 0-.25%

Also looked at monetary aggregates, M1, M2

But now focusing on fed funds rate

Haven‘t always made fed policy by focusing on fed funds

Fed funds rateo

inventories are financed by short term borrowing

CP!

GDP:= C+I+G+ (Ex-Im)

1.) Inventory investmento

2.) Investment: Fixed investment (structures, equipment, housing),o

Also affects fixed investment

Housing: when interest rates down, more people qualified for homes, more people could afford

3.) softwareo

when interest rates up, interest rates at which auto companies, ect provide credit affect auto demand

4.) Consumer Durableso

perhaps more surprising

5.) Consumer nondurableso

What does this change?

Ec 1420 Page 20

perhaps more surprising

like going to McDonalds

reset every year

so I have more or less to spend on everything elseo

cash availability affecto

so as interest rates go up and down, monthly payments fluctuate

1/3 of mortgages are Adjustable rate mortgages

Reduces future value of dividends

people concerned business profits will go down because businesses pay interest on their loans

taking into account what they raised through new equity o

can afford to do more investing, etc.o

and higher cost of equity for firms

lower stock market has 2 affects on economy: has less real wealth for households less consumer spending

6.) Stock marketo

increase in rates leads to an increase in value of dollar relative to other countries

increase in imports, decrease in exports

7.) The dollaro

as fed eases rates

maybe I should buy now vs. later?

even before it affects demand, it affects expectations

8.) Changes in Inflation expectationo

can refinance without penalty

Do you want me to do it with you or go to another bank?

If mortgage rates come down I can refinanceo

So now I have lower mortgage

I have 6% loan, IR drop to 5%

9.) Increases in mortgage financingo

These are the 9 channels which changes in IR can affect aggregate demand and level of output and inflation

What are they trying to accomplish?o

True of bank of England, European banks as well

Aim for 2%

Dual mandate: low inflation and low unemployment

Inflation zone between 1-2%

Well, that‘s the least of his problems now….

Ben Bernanke was very interested in the idea of achieving an inflation target before crisis

Primary goal of fed: LOW INFLATIONo

So what is the goal of the fed?

But their not saying that the CPI shouldn‘t change from year to year

When CPI increases at about 2% rate corresponds to no increase in the price level

The price level is constant and the dollar income is constant

Really means no increase in maintaining same standard in terms of CPI

Where does bias come in? CPI doesn‘t capture new products and quality changes

Summarized by saying the Fed's goal is price stabilityo

Why this focus on inflation?

1.) Econometric evidence that high inflation (over 10%) lowers economic growth

So why is low inflation focus?

Ec 1420 Page 21

Instead of running ordinary business, you spent all of your time trying to figure out how to speculate, how to collect money sooner, delay payments

Argentina, mexico

1.) Econometric evidence that high inflation (over 10%) lowers economic growtho

economists don‘t like this public…

joe gets 9% bonus; inflation 7%, angry cuz he only gets 2%

If everyone gets extra 7% in pay, then it would just wash thru

But when 7% inflation; can just give him 3% pay increase

If no inflation, have to fess up and cut joes pay

Individuals know this

Shops with narrow margins had to increase prices

14% inflation

In early 1980s: in shelf life of soup price levels increase

2.) The public dislikes inflation because they see it as eroding the value of their earningso

3.) Even if we got down to moderate rates of inflation, makes long term planning very difficult

o

sophisticated folks should manage their money such that if inflation goes up, don‘t leave money in checking or savings account

4.) Erodes the value of financial assetso

For pi=0, (1-.3)*.04=.028

Wow! You just went from a real rate of 2.8% to 1%

For pi=6, (1-.3)*.1=.07-.06=.01

If pi=10, (1-3)

Also capital gains ec

Real return in economy stayed same, but higher inflation leads to higher affected tax rates

5.)even smart guys get adversely affected by tax system, which uses nominal not real rateo

That produced reduction in inflation

Increase rates to produce significant real rates, Higher unemployment, and that turns around economy

o

Consensus: Yes, it is worth paying that price if inflation is getting higher than minimal level

Used to think they should stop it from going higher but don‘t pay price for going down

That wasn‘t always true

Is high unemployment worth it to bring inflation down?o

Temporary loss of GDP

Once inflation is down, it is permanently lower

Increase in unemployment is a TEMPORARY unemploymento

Estimate is that it takes about

An increase in the rate of unemployment by 1-1.5% ( for one year) leads to a reduction in inflation rate of 1% (permanent)

So to bring It down to 2%, need unemployment up to 2-3%

This unemployment has a cost in terms of loss of GDP

Low inflation has benefit of increase in real income

Depends on how much of increase of unemployment I need to bring down inflation rate

How do I know this?o

Oken‘s law: A cyclical rise of unemployment by 1% leads to a decline in GDP of 2-2.25% in the same year (concurrent fall)

Not at all clear why its called a law

In cyclical terms, 1% increase in unemployment rate causes GDP to fall between 2-2.25%o

So how do we reduce inflation? What are costs and are they bad?

Ec 1420 Page 22

Not at all clear why its called a law

No particular reason why it should hold, remarkably

Change in real unemployment = -2%

600bn lost Gdp? (check that #)

is it worth it?

Change in GDP:4-4.5&

If Pi=4%, to go to pi=2%o

Bringing down inflation from .04 to .02 leads to reduced distortiono

Intertermporal allocation of consumption

Causes more money to go into houing, and other things

Tax systemt

1% increase in gdp permanently

Inflation causes real interest rates to fallo

So you can give up 4-4.5% one time, but it pays off in 4-5 yearso

But if you find yourself here, slow the economy down to get back to square 1

This is a 1x cost that should be avoided

Basic point: you get a substantial annual increase in GDP for one time cost associated with doing it

o

If we are facing inflation

Ec 1420 Page 23

Affect the cost of funds more generallyo

By affecting aggregate demando

Phillips curve lower inflationo

Focusing on price stability do it by changing interest rates

Distinguish between instruments, policy, targets of policy, and intermediate targetso

Instrument: something that policy makers can controlo

Target: something that the gov‘t and policy cares about, but can‘t directly controlo

It affects that number by buying and selling T-bills

Announces targets

Inject funds into banks, so then banks will want to lend to one another

Meaning that they will buy or sell t-bills until they achieve that

Cant set how citi lends to jpmorgan

Feds don‘t actually control it

Intermediate target: ex. Fed doesn‘t literally set the federal funds interest rateo

Tindbergine

The number of targets that can be achieved is equal to or less than number of instruments they can control

o

Exampleso

Decrease T-bills, decrease money supply because take funds from bank

Can only set target for one of them, though

Look on sheet for 2 equations for change in I and change in M

Change in monetary aggregate= a+b*Treasury billo

The most important conclusion that tingenberg taught us:

Buying and selling t-billso

Ultimately there is a relationship between buying t-bills and unemployment rateo

If it decides to focus on inflation (usual), then unemployment will react because gov‘t can only control that

So the fed can decide on one or other : unemployment rate implies necessary change on t-bills which in turn affects inflation

o

Instrument that fed has

Tax credits, and OMOo

two targets: inflation, investmento

More investment means more productivity, more growth, etc.o

Now, the policy makers can set two goals: figure out the combination of the two instruments which will get you there

o

Tight money would reduce the inflationary pressure even though upset by large income tax credit this example tells us this, but its not the pt

o

Two targets, two instruments, we can achieve those 2 goalso

Now, lets assume a gov‘t has 2 instruments

In the past, when the fed sticks to its standard procedures, it only has 1 instrument really

o

Dual mandate

Unlike European central bank, which has a single de facto mandate

Well, the US has 2 targets by lawo

Nowadays, the fed has been using credit market tools

Lecture 4 - ReviewWednesday, February 04, 2009

1:47 PM

Ec 1420 Page 24

Unlike European central bank, which has a single de facto mandate

How does it deal? Has to balance between the two

As in everything in economics, there's a tradeoff and have to balance those two things

Oh , Within 2 years, labor markets will adjust, and unmeployment will adjust

Often, central banks hide behind rhetoric

Makes a decision about the federal funds interest rateo

Which operates in T-bill market to bring about desired level in fed funds interest rate

Compare its interest rate to ordinary bond

Treasury inflation protected security—gives real interest rateo

Look at inflation, unemployment, inflation expectations (via survey data)

How would you go about doing it?

And communicates that to the NY federal reserveo

So what does the fed do in practice

The dollar: how do you combine them?

Can we find a rule?o

I bet what he‘s doing is looking at inflation in terms of real interest rate and unemployment

o

From 1987-1997

We want it to be low, but not 0 (then we might have real > nominal interest rate)

Taylor rule: Lets pick a desired level of inflation

How he has set it as a function of unemployment rateo

John Taylor: looked at what Allan Greenspan had been doing

If inflation is low, it will reduce I ff (federal funds rate)o

About 2%o

When the actual inflation rate is greater than this target rate, it will increase Iff

You want to pick a sustainable long term unemployment rate so that inflation

Reasonable assumption = 5.5%

Target rate of enemploymento

NAIRU: Non-accelerating inflation rate of unemployment

Yt-Ytrend/Ytrend

If output GDP is greter than trend, then we‘ve probably gone to far--?will be inflationary, so probably want to go lower

I‘ll look at nominal level of GDP relative to trend at a given time, divided by GDPo

Taylor said who knows what that rate is!

Iff,t=+1/2[t-*t] +1/2[Yt-Yt,trend/Ytrend]+.02o

o

=*, Yt=Ytrendiff-t=.02=rff=.02○

No upward or downward pressure

Federal funds rate is consistento

Simplified version of Taylors law:

∆i(iff=)= ½ ∆to

∆iff= ∆t+.05∆t

But greenspans predecessors did NOT do thiso

Got bad inflationo

1960-1979

Seems like common sense

Ec 1420 Page 25

nominal rate went up by .81

They only raise nominal interest rates, not real

Its hard to believe they didn‘t get that right, but they didn‘t

They dealt with inflation by raising interest rates

how could they do that?o

so ∆rff/∆=-.19

∆i/∆=.81

1960-1979o

Unions produce higher level

Caused by demand, or unionsdoes not produce ongoing inflationo

Always and everywhere a monetary phenomenon

What causes inflation is higher demand sustained by increases in money supplyo

In some of these earlier year, great confusion about inflation

Has the fed continued to do it?o

How does it correspond to thiso

until this crisis, the fed followed this rule remarkably closely

∆(Yt-Ytrend, t/Yt)=-/2/25∆RUo

This relationship is one which links inflation and unemployment to the nominal fed funds rate

NAIRU=5.5o

i*ff,t=1.5t-0.5[.02]-0.5(2.25)[RU-NAIRU]+.02

i*ff,T=1.5T-1.125RU+.07

o

=.022○

RU=.04o

I*=.058o

Pretty good!

I=.054o

Jan 2000

Stock market starting to fallo

o

=.024○

RU=.042o

I*=.059o

Still pretty good

I=.06o

Jan 2001

o

=.023○

RU=.046o

I*=.063o

I=.038o

Why so dramatically different? The economy is sliding into a recession? Its only a matter of time before unemployment slides more and inflation comes down

o

Very short recession: 8 mos!o

But by July 2001, recession had been gone

o

=.019

Nov 2002

Ec 1420 Page 26

=.019○

RU=.06o

I*=.031o

I=.0125o

o

=.019○

RU=.054o

I*=.039o

I=.02o

Start of housing bubble

But still keeping rates low, bringing down long term rateso

Dece 2004

o

=.018○

RU=.049o

I*=.042o

I=.042o

December 2005

o

=.025○

RU=.049o

I*=.055o

I=.0525o

Dec 2006

o

=.041○

RU=.050o

I*=.076o

I=.0425o

December 2007

o

=-.019○

RU=.072o

I*=0o

I=0o

Today:

wanted to do something much more forceful to balance the economyo

big one in July 2001, accepted a much lower rateo

With a few exceptions back in Nove 2002, 2003 the fed has followed the Taylor rule

For these much lower than you might have expectedo

What greenspan called risk based policyo

What was the logic of doing this?

Ec 1420 Page 27

Treasury is working hard on thato

The stimulus package does not deal with market disfunctionality, and treasury defaults

Put out reports about the nature of the problem, what the gov‘t is doing, how they see the nature of the recovery

o

Very optimistic—see impact of fiscal policies as much greatero

Publications from Congressional Budget officego to cbo.gov

Talked about two targets: inflation and NAIRUo

Has to balace these 2 in the short run

By following something like the Taylor rule, the economy will naturally go back to NAIRU and gov‘t will have succeeded in bringing inflation down to the low level that it wants

Fed has only one instrument: OMOo

Achieves it thru OMO

Is a kind of backward looking rule

Not using forecasts of unemployment, using backwards #

Has come to be more or less right on to applied interest rate according to Taylor rule

o

We saw that the fed basically followed the taylor rule which was based on estimates of behavior of alan greenspanapplied it to fed‘s behavior years later

Taylor says: its safe to use numbers that everyone can check

While the Taylor rule is not really a rule, it is a way to guide where to set the fed funds interest rate

o

Finish up discussion about demand management

Fear of deflation

If economy starts to slide into deflation, the real interest rate goes up and there is nothing the fed can do

If interest rates are below zero, get deflationary spiral, and interest rates would be stuck

How bad could it be?o

And what would be the consequences of different actionso

Useful concept and how did it play out in early part of this decade?

o

Greenspan departed from what would be expected of their behavior from what he saw would be the risk of their current outcome

If the inflation rate had gotten to what it was at the time:1%, what if it got to 0%

Though taylor rule said 4%, fed kept it at 21.2% why?o

Between summer 2001 and 2004, the fed was much easier than the taylor rule implied

I=i* (from taylor rule)

I= very low (.01)

Actions

Large # of these states of nature

1.) Severe recession if i=i*

Represent the uncertain outcomes with different actions

States of Nature

Characterize the problem by thinking about possibleo

Statistical decision theory

Lecture 5Monday, February 09, 2009

1:50 PM

Ec 1420 Page 28

1.) Severe recession if i=i*o

2.) No recession if i=.01, but there will be an increase in inflation

o

think about the world in these terms

choose 4% or 1% interest rate

Loss function

Fed was thinking in a narrow rage of functionso

Actionso

That‘s the loss function: how do you choose? Which is more likely A or B?o

A=.4

More likely that we would have no in inflation

But that would be a mistake to focus on the most likely thing

B=.6

What are the probabilities (in the absence of policy)o

Only to avoid would be to use i=.01

Would it be worth taking on if it only has 1% of happening?

Clear what the terrible outcome is

How about minimize worst outcome?o

Expected loss of I = i*: 8

Expected loss of I= .01: 3.8

But take minimal expected loss

Don‘t just go with most likely or worse possible to be avoided?

Wants to have lowest expected loss.o

Soaring house, share prices

Pursuit of greater risk to offset the fact that interest rates were so low

What happened as the result of 2 years of very low interest rates

o

He was doing the right thing as long as he limited his risks to inflation and unemployment

He could have turned to his friends in the administration and said that he needed a fiscal package because he couldn't do it using only fiscal policy

So this strategy led to excessive risk-taking and

We have to think beyond inflation and RU, have to think about asset prices and stability of financial markets

In terms of the tradeoffs between RU and inflation, he was doing the right thingo

Did Greenspan do the right thing?

Now lets talk about LT growth and relation to savings; also fiscal deficits

Time: fundamental potential growtho

Steady incline

1960: 2.5023 trillion

2003: 11.049 trillion

$2000

Chart of Real GDP per capital vs. timeo

Focus on LT: don‘t think about cyclical fluctuations and demand management

Top: Action; Left: State of Nature I=i* I=.01

A. Recession if I = i* -20 -5

b. No Recesion if I = .04; pi, i=.01 0 -3

Ec 1420 Page 29

growth @ 3.4%

if we ask relative to the population what was actually happening

1960: 181mmo

2003: 297mmo

1%o

Population

$13846$37252

@2.3% growth rate169%

@1%-->56%

@3.05278%

GDP/POP

Sometimes fall short of it

So don‘t want to think about adding up components of demand

Y is a function of labor inputs and technologyo

Human capital, people are geographically and socially mobile

Good economy in terms of allocation of labor

Small change through time in recent decades relative to what it would have been

o

All educatedo

Role of eduction is to make labor force more capable

o

These attributes are important for rates of GDP rather than growth

L=labor

Y=f(K,L,tech)o

Think about production function of how GDP is produced

Thinking about potential

Not thinking about it in demand termso

What is it that determines economic growth, real GDP?

Gov‘t publishes a productivity # every quarter

Labor Productivity= real output/employee hourso

Things that cause it to rise secularlyo

Recently, it went up a loto

Equality goes up because of more human capital

Labor productivity= f(quality of labor, K/L, technology)

Over the long term, labor productivity riseso

Defined as real output divided by man hours

Increases in Productivity

But if it were just increases in K & L we would fall short of capturing growth in GDPo

Get increase in labor productivity

Get increase in CAPITAL

Employee hours adjusted for education

Does drive GDPo

A(T) is the TFP

Y=a(t)*K^alpha*L^1-alpha

Total Factor productivityo

Increases in GDP relect increases in K and L

But we are going to focus on K

Ec 1420 Page 30

But we are going to focus on K

What happens if we increase K at a given amount of L ?

=.10 in real terms for nonfinancial sectoro

putting in place equipment and structures

want to link that idea to savings

have to advance

inventory, software, equipment

has to be matched by savings: resources being produced not consumed

net investment in the economy

Delta k = net investment = gross investment- depreciationo

Rho=Marginal productivity of K

Delta Y=MPK*delta K=rho*delta k

Y=f(K,L,technology)o

Basic relationship

Net I= Net national savings + net capital inflow+ ROWo

Net investment= net national savings plus the inflow of capital for the rest of the world

Ec 1420 Page 31

Affects savingo

Net of depreciationo

2 sources of funds available for investmento

∆K=Net investment +Net savings + Capital from abroado

∆K= rho Y+CAD (current account deficit)

rho=net national saving on fraction of GDP =Marginal Product of capitalo

∆Y=rho*∆K=rho*sigma*Y+rho*CADo

∆Y/Y=rho*sigma+rho*CAD/Yo

If rho=.1

Sigma=.1

Cad/y=.05

HOLDING constant technology (which would add another percent) and labor (which would add another percent)

So about .035

∆y/y=.01+.005=.015

what does it say about changes in savings rate on rate of economic growth?o

Capital Stock

If we didn't have CAD/Y, it would drop by .005o

Impact of capital accumulation, either domestic savings or inflow of capital from ROW, contributes to .015

Small changes in savings rate have a huge influence on capital accumulation and GDP

o

If our savings rate goes up 5% (say from 5% to 10%) it add .05 to growth rate

For current operationso

They can use debt to finance projects thoo

Because they are not allowed to run deficits

State and local government saving = 0

Current account deficit= .05 of GDP

Business savings= Returned Equity

But that the savings of the savers is less than the dissaving of the dissavers

o

Because of boom in wealth in which retirees looked and saw that had so much more than they thought they did

Why?o

Doesn‘t mean everyone is a negative saver

Household savings = used to be 7 or 8% after taxes, but they were negative 2 or 3 years ago

Federal Government= -.02-.10

Net National Savingso

What is national saving?

Can have important long run effectso

Deficits can be very large relative to savings

Stimulus actions unprecedented since WWIIo

How does national debt affect the economy

Fiscal years= does not correspond to the calendar years

What is relationship to national debto

Budget deficits and surpluses

Lecture 6Wednesday, February 11, 2009

1:51 PM

Ec 1420 Page 32

Fiscal years= does not correspond to the calendar years

Represent the year ending Sept 30th

Look at website!

Source of these numbers in the congressional budget office

Unified budget deficit

The overall budget deficit

See why unified in a minute

Talk about deficits flows at end of fiscal yearo

G=Government Spending

B=the end of fiscal year national debt

B _bar=average debt over the year

T=taxes

455BN is an ENORMOUS numer

455=2730 Bn+249-2524 (for 2008)

2009 estimates: estimate what it means to maintain current level of services: doesn‘t include anything about legislation that everyone things will pass

corporate taxes, personal gains taxes

1186=3345+195-2357

percentages of GDP

1.2=18.2+1.7+18.8

2007: the defict was 1.2% of GDP

2008: 3.2=19.2+1.7-17.7

all these numbers ar e in percent

2009:8.3=23.5+1.1-16.5

DEFt=Gt+iB_t-Tto

When we talk about the national debt: value it at a point in time at end of fiscal year

On Budget

Rev Surplus

On budget 11.8 -9.4

Off Budget 1.1 -8.3

Bt=Bt-1+DEFt+ miscellaneous borrowing to finance acquisition of assets

its really all in this enormous increase in extra spending

extra puzzle of miscellaneous borrowing

7193=5803+1186+204o

AT THE END OF 2009, the nation debt as currently projected

There were 2 very unusual items in ito

Either issue mortgages,

Bush: no they're not part of government they're just there

Injected 18Bn intoo

Now the govt in one fell swoop took this thing which if it had gone belly up would have cost the bondholders, creditors all of this money

o

Figured out the present expected value of those losses

This implies future losseso

But CBO: said we‘re going to count this as a form of govt spending

They got into terrible trouble, and the government had to put them into a conservatorship

FreddieMac and FannieMae, which have an implicit gov‘t guarantee, which have about 5 trillion dollars worth of debt which they guarantee

o

The increase in gov‘t spending was 618Bn

Ec 1420 Page 33

In effect, that is something we incurred this year when we took this on

losses

Said its worth 220Bn

220Bn non cash

So FNMAE and FRMC are a big part of this 600Bno

700 bn to play with

But we have to take into account you have some risks that they wont recover it all

o

You're putting preferred stock into troubled companies

COB said you guys are taking risks

Of 700BN of TARP, 180bn was treated as non cash expected future losses plus some risk premium

So that 220+180=400

And 18bn for F+F

So 2/3 of it is in accounting, non cash items

Troubled Asset Recovery Program: TARPo

Where did this 204 bn come from?o

But already counted as G 180 bn of that

So there was 460bn

TARP: borrowed 640 bno

Cost them 250bn of borrowing

250+460=710bn

They also bought Mortgage backed securities to drive down rateso

Borrowed 300bn from gov‘t

So there will be a repayment of 300bn in future

FDIC=great guarantor didn‘t have enough moneyo

And there will also be a repayment of FRMC and FNMA of 220bno

So: 460+250-300-220=190+14 misc=204o

Didn‘t add to aggregate demando

Yet was classified that way by CBOo

Most of that is not actually real spending

Most of increase in deficit comes from increase in gov‘t spending

What looked like enormous increase in deficit driven by increase in gov‘t spendingo

Mysterious miscellaneous borrowing

This increase of1390 bn in debt=Bt-Bt-1

B/gdp=40.8(debt held by public?)

If B/X rises Bdot/b>Xdot/Xnon GDP

Bdot/B=DEFG/X*(X/B)

WHAT IT TAKES FOR THE DEBT TO GDP to rise says that debt to GDP will increase if the deficit relative to GDP is greater than B/X times the growth rate (Xdot/X)

o

> .5 (.02)o

the only way to makeB/X start going down again is to get DEF/X<(B/X)*(Xdot/X).5(.05)

o

B/X will increase if DEFG/X>B/X * Xdot/X

Ec 1420 Page 34

Cyclically adjusted deficito

There is a rise in the fiscal deficit which is inherently temporary representing the cyclical state of the economy

What is cyclically adjusted deficit

How big is it or how much stimulation is in system

When the economy today is weak, personal and corporate tax revenues fallo

Last time, we still had a very large increase in national debt ~10%

Pot‘ll GDP at NAIRU: 13790o

GDP GAP: DELTA=-126o

But 31 Bn of that was due to cyclical

So C.A. GDP GAP: 163-31=$132 BN

~.9% of GDP

Deficit (2007): Observed deficit of 163 BNo

2007 GDP: $13670 Bn

GDP Gap to cyclical deficit ratio about ¼o

Unemployment rate in 2009= ~8.3%

250 Bn cyclically adjusted deficit

so 936 bn is cyclically adjusted deficit

418 is accounting (from last lecture)

ENORMOUS BUDGET DEFICITo

3.6% of GDP!!!!

518 bn of ―financially adjusted deficit‖

Defg (2009): 1186 BN

And what happened in the Keynesian revolution?

A country with a debt is poorer

We are passing out debt to our children, making them poorer

Except when used to finance assets : school, roadso

But this ran into opposition from these people about the making kids poorer thing

Key feature of Keynsian: we need to use fiscal deficit to stimulate the economy

o

This generated a political aversion to debt

The view that prevailed before the 1930s

What is that people used to think about budget deficits?o

What are the consequences of this?

Well, we only owe it to ourselves

1930swe didn’t have a lot of OPEC buyers, etc.

and the national debt inside the SS national trust fund

excludes the national debt held inside the federal reserveo

Gross debt: 9bn :but doesn‘t matter as much because they owe o

5.8 trillion dollars at end of 2008

What about this debt?

As a country, we are poorer because of the debto

How did the Keynsian economists get around this?

Lecture 7Friday, February 13, 2009

5:01 PM

Ec 1420 Page 35

some to themselveso

What we care about is what we owe to civilians and foreigners

Not like borrowing from a bank

This is like keeping internal records inside housedoesn’t matter

These arguments were fallacious

Gov‘t has to raise taxes to pay interest on that debt

Internally held debt: had to be serviced in the futureo

Where is the fallacy?

If we buy a tank now, how can that be a burden on children and grandchildren

Intellectual debate: we only owed it to ourselveso

Back to 1930s

Distortionary effect of the taxes to pay the interest

There is a burdendeadweight loss o

Ex 5000 Bn of debt *.02=100bn of taxes each year to pay interest

Even if all of that was just inside the economy

Significant piece of overall gov‘t overlayso

Crowds out future formation

Capital stock is lower because of borrowing

National saving rate is lower because gov‘t absorbs part of savings that would otherwise be available for capital stock

If they pay today, wont be future burden on future generation?o

Even though we owe it to ourselves

Burden: have to be servicedDW loss

And lowers capital stockfuture incomes

How does fiscal deficit compare to gov‘t borrowingo

Debt finance under general economic conditions

Under normal circumstances, whether we finance by taxes or borrowing is an important choice and that the burden of financing by borrowing is greater than the burden by taxes

I want to make a case for fiscal deficits today

Some say that all that matters is gov‘t spendingo

Now, lets think about what happens when economy is roughly at full unemployment

Key idea: Tax finance (increase in income tax) will decrease consumption

Debt finance will decrease investment

Borrowing = less investmento

Think about extreme: Taxing = less consumptiono

Some gov‘t borrowing may increase interest rates and lead to higher savings

$1 is worth more at margin than $1 of consumption?o

Wedge between Marginal product of capital and return consumers receive

reduces consumption by $100

1.) tax now $100o

reduces investment today by $100

so it reduces by $8.50 per year in future in cons_t

say Marginal product of capital= MPK= .085

2.) Borrow now $100o

Gov‘ts options

so lets look at the real net interest that individuals face

Government bond interest rate: 6.25%o

Tax 2.00%

Discount future lost cons_n by real net interest rate faced by consumer

Ec 1420 Page 36

Tax 2.00%o

Net interest rate 4.25o

Inflation 2.00o

R_n 2.25o

$377.78

That 8.5 dollar perpetuity is worth substantially more than that $100o

As long as MPK is substantially greater than real net rate of interest than taxes are going to have a smaller burden than the lost real incomes associated with borrowing

o

We can reduce consumption today by 100 or we can reduce future consumption, which because of tax wedge, represents a higher return

We‘ve run fiscal deficits every yearo

Have to modify it for circumstances like today

Think about it in terms of full employment economyo

Nevertheless there are circumstances where we may want to do it

Need a quick military buildup

Barro argues that it would be better to borrow and spread cost over long period of time

o

quadruples distortion

inversely with square

10% tax rateto 20% tax rate

Taxes distorto

the deadweight loss will be less if do it in series of small increases in tax rate

o

Better to have an increase in taxes or borrow?

Ex military expenditures during a time at war

Temporary increase in spending financed through borrowing or a tax increaseo

Now there is a kind of special case worth thinking about

Tax finance: .02*Yo

Delta T=.05*.02*Y=.0010Y

Do we want to levy a one time tax or a perpetuity of taxes equal to 1/10 of a percent of GDP?

Debt finance: i= .05o

Ex 2% of national income

E= elasticity of labor supplyo

wL= Y (GDP)o

DWL=12et^2wL

Tax=1/2E(.02)^2Wl=1/2ewL[.0004]

PV DWL=1/2EwL10^-6/4*^-2=1/4*10^-4o

DWL=1/2E[.001]^2wL(10^-6) each year

Except borrowing displaces investment!o

With reasonable assumptions about displacement of private investmento

Use debt for one time event like war

Then use borrowing: spread tax weight over long period of timeo

If you have a 1 time financing need and don‘t have a large tax wedge distorting the consumption/investment decision

MPK> NET DISCOUNT RATE APPLIED TO individual consumptiono

Want to use tax finance instead of debt finance? Check this might be other wayo

But when you‘re at full employment, $ of tax

Often monetized

Large fiscal deficit

Ec 1420 Page 37

Often monetizedo

Monetary policy independent of policy needs

Pretty good for Us, where we have good bond market

So an increase in money supply increase price level

NOT true for US

Mt=Mt-1+DEFt

M*V=P*Y

Other countries (developing), when they run deficit, they increase the money supply

Interest rates riseo

Need to crowd out private investmento

By temporarily lowering ST rates, can increase inflation

Might be pressure on fed to bring down interest rateso

But could

Not necessarily will lead to inflation in US

Bt=Bt-1+DEFto

Always tempt to use inflation to reduce debt!o

Ability to service that debt would be eased

What stops you?

Extent to which market perceives this inflation, interest rates rise and gov‘t has to pay more

Still get 3% interest

As inflation goes up, wont be able to erode the value of the debt

Weak recovery in which unemployment rate doesn‘t come down very fast

o

May be more attention to bringing down unemployment rateo

o

Finally, there will be a temptation

Guy who buys it takes the risk

If we could have higher inflation, than that would erode the real value of the debto

Ec 1420 Page 38

No class this Friday!

What was the Keynesian revolution? Why did economists eventually reject it? Why is there a new interest in fiscal policy, and how should it be applied?

Keynes wrote the General Theory in 1936, which was about the economics necessary to deal with depressions, through using fiscal policy to manipulate aggregate demand. The basic policy prescription of Keynes was to use budget deficits to reduce national savings in order to stimulate aggregate demand. Richard Kahn wrote an article in 1931 explaining fiscal multipliers, how if the government increased government spending by change in G, then GDP would increased by Change in G / MPC. This idea became central to Keynes‘s thinking.

For Keynes‘s disciples, the idea could be applied not just in depressions, but to smooth out the business cycle, to fine tune the economy, to eliminate fluctuations in GDP. Unfortunately, this didn‘t work out so well. Keynesian fiscal policy failed to deliver low unemployment and low inflation, which is what we were looking for. From the 1960s to the 1970s, unemployment and inflation both went up significantly.

We realized the fiscal multiplier was much, much smaller than early textbooks suggested. Instead of a multiplier of something like 5, we saw that changes in government spending had a multiplier of about 1.5, and tax cuts had a multiplier of about .8.

1)

Investors would know that interest rates would rise in the future when the government has to compete with private investors to have money to spend. When those in the bond market know that interest rates will go up in the future, they‘ll wait to buy bonds until the price falls, and then the price will fall immediately and interest rates will rise immediately. When the government raises the fiscal deficit in the short run, it had the direct effect which increases GDP, but it also has the interest rate effect of increasing real long term interest rates. This depresses housing and business investments which reduces GDP.

2)

We realized that there were long lags when implementing fiscal policy. There are recognition lags, as it takes some time to realize you‘re going into a recession. There are also legislative lags, as it takes time to get fiscal policy through the Congress. There are implementation lags. Finally, there are impact lags between the time when the money starts to flow and when it changes aggregate demand.

3)

There was also uncertainty about the state of the economy about how to know if we were in a recession, what exactly the multipliers were, etc. So, economists became much more cautious about implementing fiscal policy.

4)

Four reasons why economists rejected fiscal policy to deal with business cycle:

All of this led to a sense that we should rely much more on monetary policy and less on fiscal policy, because there is no long term debt or interest rate problem by using monetary policy.There are also much shorter lags when using monetary policy. Also, with monetary policy you can move in small steps, only cutting the interest rate a little bit. Or, if you realize you‘ve gone too far, you can bring the interest rate back up a little. Monetary policy is just much more flexible.

Conceptually, some economists began to question Keynesian policies in the 1960s and 1970s. However, the policies were still very much Keynesian, and they pushed unemployment so low that it stimulated inflation to sky rocket.

Lecture 8Wednesday, February 18, 2009

8:02 PM

Ec 1420 Page 39

Keynes thought the great depression was caused by too much savings. Thus, the USA literally implemented policies to disincentivize savings, like social security, taxing return to savings much more heavily than return to labor, etc.

Keynes also had a lot of faith in government activism.

Keynes was also very focused on the short run. He said that ―In the long run, we‘ll all be dead‖ in response to the idea that we don‘t need fiscal policy because eventually the economy will get back on track by itself.

By the 1970s and 1980s, people realized that these policies weren‘t working, and that savings was important, faith in government activism fell, etc.

Now, why is there renewed interest in fiscal policy?

Monetary policy is currently ineffective, because our credit markets are broken and not providing credit.

We‘re looking at an unprecedentedly large fall in wealth.

All the issues that Prof. Feldstein brought up in lecture are still valid, but most economists still think we need a fiscal stimulus.

We ought to ask of each project when designing the stimulus, what‘s the change in GDP from this project (how much bang are we going to get from increased aggregate demand?), and how valuable is this activity to society?

Ec 1420 Page 40

Capital $100In addition to that bank put out sign and said I‘m a bank come and make depositsPeople make deposits and deposited $800Those are the liabilities of bank = $900, what it owes to depositors and equity holdersThen it loans out money so say $900So total assets = $900Note that for every dollar of capital they have 8 dollars of deposits so that why did they need to have capital there

Let‘s say that what we see is that some loans go sour, don‘t repay so that the value of the loans falls to 850

So assets are only $850, not that they‘ve been paid off, they went sour, defaulted on those loansSo what‘s happening? Still owe 800 to depositors, so what‘s changed is capital, capital that's left only $50

So bank regulator says you‘re living too dangerously, if you lose another 50 you would have no capital and another 50 you wouldn‘t be able to repay depositors

So regulators can say you can‘t live that way, have to raise more capital or you have to shrink the number of loans you make, which means you don‘t want as many deposits so you‘ll shrink that as well since you pay interest on the deposits and having them sit there is not goodGovt comes and looks at bank and says you‘ve got a lot of bad loans there, no one really knows how many bad loans you have, so nobody wants to invest in you and give you more capital, you‘re not earning new profits to build up capital, so either shrink a lot (meaning less credit in economy and economy shrinking) or we the govt will infuse some capital in, as part of the TARP plan, the govt went in and dropped $10 billion here or thereSo in addition to private 50 capital, put in govt 50 capital then you will have your original 900 and not only that, you could actually go and do more lending and expand

But bank isn‘t really sure that it really has 850 of good loans, maybe only 750, so afraid to do additional lending so banks hold back on that, and that‘s what‘s happening now

Variety of proposalsOne is to inject more capital, another is for govt to buy up some of these loans, now talk about govt taking over entire bank and restructuring

But too much to discuss, basically are two kinds of bad assets1. Residential mortgages, 1 out of every 4 mortgages is underwater – loan exceeds value of house –

2. commercial mortgage – corporate loans, credit card debt, auto loans, so more complex problem than people are confident to solve

Feldstein thinks diff solutions for mortgage part and non-mortgage partHard to value b/c don‘t know what kind of defaults are coming along as house prices continue to fall

Really are two separate problems in the mortgage area, president announced program which deals with one and not other

1. affordability – people took out mortgages with low interest rates that have gone up (teaser rates) or someone in the household lost income b/c of loss of job or other reason so ability to afford monthly payments has gone downso mr. banker why don‘t you lower the monthly payments to 38% of disposable income of that household and if you do that, says the govt, then if you want to lower it further to 31% (why that‘s the magic number, I don‘t know) then we in Washington will share the burden with you, the govt will subsidize that reduction in interest ratein no doubt will help some people stay in their homes; what we know from mortgages that have been fixed in this way, still a large number of them default b/c of 2nd problem

2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house

Lecture 9Monday, February 23, 2009

8:03 PM

Ec 1420 Page 41

2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house is worth, why shouldn‘t I throw in the keys rent for a few years, come back and buy a similar house at a lower price, govt hasn‘t dealt with this

dollar and the trade deficitUS has massive trade deficit, 5% of US GDPThat puts us in a precarious position b/c we have to finance trade deficit with foreign capital, someone has to loan to us to afford to buy more goods from rest of world than we sell

Exports were 1.1 trillion dollarsBut imported nearly 2 trillion dollarsSo managed to have trade deficit of 800 billionSo we‘re good at services but not as good as our appetite for goods from the worldTrade surplus on services, trade deficit on goods, on net, trade deficitForeigners have investments in the u.s.; tend to be overwhelmingly done by foreign govts investing in bonds, particularly govt bonds

Our receipts on our investments abroad are817 billionOur payments on investments to foreigners is 736 billionSo we have a small positive income surplusIn addition to that, have so-called unilateral transfers, they can be foreign aid, whatever they are, they are payments for which you get back a thank you note, but not a sale in the sense that shipment of goods or services or receipt, -110 billionSo end up with a shortfall of 731 billion dollar?Means the amount we need to finance b/c we sell less to the world than buy and even allowing for extra income b/c of investments abroad, that total amount is 731 billion about 5% of GDP

In 1998, the balance on goods and services was 166 billionBy 2007, it was 700 billionIn most recent qtr, running at slightly higher number

Why?S-INV=EX-IMPWhy? If we save more than we invest,Saving is household, business, govt combined, if we save more than invest, we have excess resources, what do we do with them? We can export them to rest of world

On other hand, if we invest more than we save, then we have to get physical resources from some place—rest of the world

This is not some powerful theorem of economics, not some empirical finding, this is an accounting identity known and loved since beginning of economics

GDP or Y = C + I + G + NXWhat is Y – C – G = national savingSo national saving = I+(Exp-Imp)Or S-I = Exp-ImpWhat makes it hold? What is the market process?The answer: exchange rate, the price that makes this workWhen savings rate goes up, that leads to a fall in the dollar, which makes U.S. Makes interest rates lower, lower the dollar, increase exports and decrease importsLet‘s start with nominal exchange rateNominal exchange rate is by definition is number of foreign currency units per dollarThe people who do the exchange rate statistics sometimes do it in reverse but we will always mean the number of foreign currency units per dollar

You can imagine For example 115 japanese yen would be exchange rate b/n yen and dollarBut saying all other things equal, means prices haven‘t changed, so think of a measure that takes prices into account and that‘s the real exchange rate

What matters for trade purposes is the real exchange rateJapanese yen and think that initially the exchange rate was 110 yen per dollar

Ec 1420 Page 42

Japanese yen and think that initially the exchange rate was 110 yen per dollarLet‘s imagine what happens if the prices in u.s. unchanged, and prices in japan are unchanged, but what happens if the yen goes from 110 to 100 yen per dollar, so dollar declines in value

Only get 100 yen nowThink about buying something, a camera, the camera costs $22,000 yenSo at 110 yen per dollar, that‘s equal to $200But now at 100 yen per dollar, that‘s equal to $220Now let‘s consider a slightly diff scenario in which the yen now is going to stay at 110 yen per dollar but instead is that prices in japan are going to increase by 10%, so the camera that used to cost 22,000 is now going to cost 24,200 yen so $220 So we can get the same impact on the American consumer either by keeping prices in two countries the same and have exchange rate move by 10% or we can keep the exchange rate the same, and prices in japan go up 10% and cause price in dollars to changeSummarize that by saying real exchange rate = nominal exchange rate x (price in u.s./price in other country)

Put a star/asterisk on something to refer to other countryReal exchange rate = e x (P/P*)

You can add them all up and compare to all exchange rates by weighing depending on amount goods sent abroad

Try to understand why it is the exchange rate moves, what causes the movements of the exchange rate

The exchange rate is a single variable in complex general equilibrium systemYou can‘t say X moves the exchange rate, but helpful to identify some of factors 1. changes in price levels at home and abroadif the price level goes up in mexico, what‘s going to go up, the nominal exchange rate should go up to keep the real exchange rate the same

this theory is called the purchasing power paritydoes it work? Sort of, it works in the long run, if you imagine that price level of mexico doubled, obviously something would happen to peso to dollar exchange rate, b/c otherwise no one would buywhen there are big moves associated with high inflation rates, the purchasing power parity works pretty quickly, when there are small differences in inflation there‘s a long run tendency for purchasing power parity to hold, but it is something that links price levels 2. balancing tradethe u.s. is fortunate in sense that it‘s able to borrow from rest of the worldif there is a trade surplus, then the currency appreciates, if deficit, currency depreciates

now come to something that isn‘t just a long run tendency but something that happens in real time, a condition that has to hold in financial markets

3. balancing the supply and demand for currencies in financial marketsinvestors don‘t want currencies per se, they want to have those currencies and invest them typically in some short-term interest bearing security

have to ask themselves what is going to happen next to the exchange ratesomething called the equilibrium condition in the financial market is called the interest parity condition

if you invest in u.s. two-year govt bonds you will get an interest rate today of roughly 3 percent, if you invest in german two-year bonds you will get interest rate of 3.5 percent

but while getting extra half percent could lose value if german currency depreciatesso when do you decide when you‘re indifferent b/n the twostart with simple view = interest rate available on foreign deposit (i*)and that has to be equal to u.s. comparable risk rate (i) + (percentage change in exchange rate)hypothetical example:you‘re an investor with 1 year horizon, here‘s question, you could buy u.s. treasury bill with 3

Ec 1420 Page 43

you‘re an investor with 1 year horizon, here‘s question, you could buy u.s. treasury bill with 3 percent yield

i for u.s. is 3%or buy a german one, i*=4% yieldthe exchange rate is .8 euros per dollarbut if everyone agreed no change in exchange rate then everyone would invest in german currency, causing it to be bid up, so that would change exchange rate

when would it stop? When the condition is heldwhen .04=.03+.01i*=i+E(change in e/value of e)going to get 3% here, but if I expect dollar going to become 1% more valuable then I‘m indifferent

here‘s a picturedifference b/n foreign interest rate and u.s. interest rateat the beginning of year has to be expected that dollar come downif look halfway thru the year, still getting higher interest rate but now only for 6 months so at end of 6 months euro has to work it‘s way half way back so next six month has only half of a percent to fallso when go away and think about this, make sure that you are firm in understanding in diff b/n change in exchange rate and the expected change in the exchange rate in the coming period

Ec 1420 Page 44

Determinants of exchange rate ($)1. PPP and nominal rate2. balancing trade3. ‗‘ S+D currencies4. speculation5. govts

interest parity conditioni*=i + E((change in e)/(value of e))

we were talking about minute by minute determination of exchange rate – the supply and demand of currencies

fundamental to that is interest parity condition, that the foreign interest rate must be equal to the domestic interest rate plus the expected percentage change in value of exchange rate

look at graph, euro becomes suddenly more valuable (if interest rate increase is 1%, the exchange rate drop is 1% and then gradually appreciates)

be sure you clearly understand the diff in statement ―the expected change in the exchange rate at that point‖

the distinction b/n that and the instantaneous change of the exchange ratewhen interest rate jumps by 1%, the immediate effect is that value of dollar falls by 1%, but expected to increase at 1% annual rate going forward

this is a riskless picture of the worldmore realistic would be i*=i+(expected change in exchange rate)+risk premium for foreign currency

let‘s say you think that dollars are much much safer than even euro currencies, b/c you read in newspaper that Greece may go bankrupt

so havei*=.04i=.03risk premium=.005so expected increase in dollar is only .005have to bear in mind risks may changedone all this in nominal terms, but what about real?

The same relationship holds for real interest rates and real exchange rates and won‘t take the time to do it but

If did real interest rate = real interest rate in U.S. + change in the real exchange ratei*-pi*=(i-pi)+E(change in nominal rate times fraction of prices/initial value)+risk

if you have a temporary surge in interest rates, then the ten year rate wouldn‘t move, but saw back then, a sustained increase in the long term interest rates

let‘s look at that calculation, w/ help of friendly diagram

with respect to trade it was overvalued, but perfect equilibrium for trades b/c interest rate is higher in US than abroad so other set has to be compensated by form of appreciation of euro vs. dollar for interest differentiationthis shows you how relatively small movements in interest rates can have powerful effects on exchange rate

budget deficit may cause a substantial increase in interest rates, which lead to a move in the exchange rate, making large swings in the trade balance

Lecture 10Wednesday, February 25, 2009

8:04 PM

Ec 1420 Page 45

so far we‘ve left out speculationpeople anticipate where the dollar has to end uplook at the interest differentialand they make investments based on that

but we also know that in any financial market, speculators react to rumors, the govt may be doing this or some foreign govt doing that, and they react

many of the investors – guys looking at screen – ―the trend is my friend‖―momentum traders‖ – look at what‘s happening at market, don‘t have underlying philosophy, and they bet on the trend, they mean from now until lunchtime

so when you actually try to look at the numbers, there are anomalies, people who made bets based on rumors, all we can do is say that there are these speculative things, so shouldn‘t expect equations to hold perfectlygreat deal of uncertainty associated with itstill the fundamental forces of trade balance, purchasing power parity and interest parity condition continue to provide basic driving force

what about govt intervention?Traditionally govts whose currencies came under attack (latin American currencies in 80s, asian currencies in late 90s), often those countries tried to preserve value of currency by entering the market, govt would buy currencyThailand – the govt would come in and buy the thai currency, buy the thai bat, so speculators How did they do that? They had reserves in central bank, but they ran out, so bhat just collapsedThat‘s the story of countries around the world that have tried to preserve value of currency when under attack

Counterspeculation by govt has not been successfulThe markets know how much the country has in reserves, and if they see trying to maintain exchange rate that‘s unsustainable in long run, they will keep speculating, and the govt has not been able to stop it

Now if it‘s an unwarranted speculation, hedge funds thinking Thailand is pretty vulnerable, momentum traders will join us, we‘ll borrow bhat, sell it at high price, then buy it back at low price, purely speculativeThailand has enough reserves that they can fight back, so what we‘ve seen after the 1997-99 asian crisis is that asian countries that had relatively small reserves, built up large reserves so if there was a speculative attack, they could fight back, Taiwan $200 billion, china $1 trillion?

Then there‘s a diff kind of intervention and that is purposely trying to keep their currencies lowJapan did it for a long timeChina has been doing it, in order to make foreign goods less attractive domestically, they reduce the value of their currency

Why does that speculation work?b/c if you‘re japan wanting to keep yen weak, you could do it; you could print yen and buy dollars

and speculators say they‘ve pushed it artificially low, we‘ll buy, then govt can just print more yen

in any case, govts have shown a willingness to do that, to spend vast amounts of resources to drive down their currencies

in general, govts don‘t do that, the Chinese claim they‘re not doing that, they certainly were doing that for a while, doing it much less, and the Japanese were clearly doing it and stopped years ago

what‘s the situation now and what‘s going to happen going forward?We have an enormous current account deficit, foreign investment is exceeding u.s. investment in

Ec 1420 Page 46

We have an enormous current account deficit, foreign investment is exceeding u.s. investment in rest of world, there is a capital inflow

The result of that is that foreign investors in US have accumulated 15 trillion in u.s. assetsWe have foreign assets abroad, but they‘re in excess of 15 trillion which is equal to about our entire GDP so there has to be a point where people get nervous about holding too many dollars in their portfoliosDo the Chinese really want to have 2 trillion in US bonds when there‘s a risk that dollar could fall by 10%? That would be $200 billion loss, $200 loss per person, a large loss for them

Is there an incentive for investors to keep doing it? That depends on interest ratesRight now, interest rate is slightly higher on euros than dollars, so unless you think there‘s a risk premium for holding euros, or that you believed dollar was going to appreciate to offset the interest differential – which is hard to believe as a long run proposition when we have 700 billion trade deficit, euro has 0?So dollar is going to have to come downWhy have we recently seen dollar strengthen?History of the last ten years is that dollar starting coming down at beginning of this decade, came down 25% ,and why did it come down? b/c of market recognition that it was too high, ultimately it had to come down, so it had an expectation, also the fact that interest rates were slightly higher in Europe than in u.s.Than in 2007, dollar moved back up again, not b/c of big improvement in trade balance (oil prices complicated this process) but b/c of risk premium, desire for most liquid and safest currency in world (though germany isn‘t likely to default on debt)What happens when investors around the world want to hold more dollars? They can‘t hold more dollars b/c we have a current account deficit of 700 billion – how much money is going to come into US net rest of the world –but they can bid up dollar and bid up prices of short term treasury bonds, so dollar rose and interest on short term treasuries went down, quantities couldn‘t change, availability couldn‘t change, so had to show up in the price

Going forwardWe have to move toward trade balance, various technical arguments, but basic is this: we have been enjoying receiving more goods and services from rest of world than we give back in form of goods and servicesFor last decade, we‘ve been getting trillion dollars of extra goods from rest of the world and just handing them IOUs, at some point have to get back on path in which dollar is gradually coming down and make progress with shrinking deficit

How would the imbalance actually end?One piece of that end would be a reduced demand for dollar bondsForeign govts, foreign private investors might decide that they don‘t want to keep adding to their portfolios, they have too much risk, and are worrying about what‘s going in the US economy

So they say enough is enoughWhat happens then if the rest of the world says we don‘t want to do that anymoreIn short run nothing happensAs long as producers want to send those goods, they can, just send it on creditAs long as there is that trade deficit, we will continue to get those funds but the question is at what exchange rate, what interest rate

If investors reluctant to buy US bonds at existing rates, then offer higher interest rates to attract them

Higher interest rates, make it more attractive so funds continue to come in, also have damping effect on US economy

S-I will go up, consistent with rise of exports-importsChange in foreign attitudes in their demand for US bonds and US currencies

Second thing that could happen would be a spontaneous rise in household saving rateIt got down to low negative numbers, most recent reading is up to 3.6%

Ec 1420 Page 47

It got down to low negative numbers, most recent reading is up to 3.6%So S-I will go up, so exports-imports go upMechanism so make that happen is fall in the dollarIf dollar doesn‘t fall what happens to the economy

Should the US do anything about this? Try to accelerate this process? Maybe not trying to lean the other way

The statement ―a strong dollar is good for the US economy‖ certain sense that is true – you can buy things from rest of the world more easily but that adds to trade deficit

Strong dollar at home, competitive dollar abroad – new bumperstickerThe dollar fall from 2002 to 2007 had no intervention by US, no attempt to slow it downBut we do keep making this silly remark

ImplicationsDollar is going to come down over next several yearsShrink trade deficit – good for US manufacturers and service firms, restaurants and others, people will substitute towards US goods away from foreign goods

As a whole1. eliminating trade deficit means more GDP goes abroad, so that‘s a serious lossif we normally grow at 2.5% a year, and now giving up 4% of GDP And spread over 5 years, that‘s .8% each year subtracted

2. terms of trade effect – what we buy from rest of the world, what we exchange our stuff for, has become more expensive, so the cost of those goods reduces our standard of living

what happens in the long run depends on what happens with our savings rateif it goes up, and if we can translate that higher savings into not a fall in GDP But an increase in net exports, yes there will be a transition period during which incomes will grow less quickly, if savings rate is higher, ability to grow domestic investment will be higher, and the potential GDP growth rate will be higherwatching a race b/n offsetting factors, whether rate of capital accumulation is high enough to offset other slowdowns, tax laws and social security will help determine that

Ec 1420 Page 48

Economics 1420 Final: Article Summaries

Introduction: Where are we? How did we get here?1.

Martin Feldstein –“Housing, Credit Markets and the Business Cycle” (2007)Housing sector is at the root of 3 problems:

Sharp surge in house prices after 2000, 3.4% decline in house prices (2006 to 2007)o

Decline in housing construction –such declines precursed 8 of the last 10 recessionso

Credit was cheap/easy to obtain

Fed cut interest rate to 1% in 2003, kept it low – caused promotion of mortgages with low temporary “teaser” rates, mortgage money was easier to obtain

Why did home prices surge over past 10 years?o

If house prices now decline, there will be serious losses of household wealth, causing a decline in consumer spending

o

Falling house prices1)

Investors took comfort in apparent risk transfer to structured products

Less sophisticated investors were buying structured products without understanding level of risk involved

Hedge funds/PE firms substantially increased their leverage

Risk became underpriced –difference in interest rates between US treasury bonds and riskier assets were much smaller than before

o

Subprime mortgages –mortgages loans to high risk borrowers with low or uncertain incomes, high ratios of debt to income, and poor credit histories

o

Borrowers with subprime credit ratings took adjustable rate loans to get in on the house price boom

o

These loans were bundled into large pools of mortgages and sold –risk of these pools was definitely underestimated

o

Subprime problem unfolded with high default rates on subprime loanso

Combination of subprime defaults and widening of credit spreads – triggered a widespread flight from risk

o

Investors and lenders also became concerned that they did not know how to value complex, risky assets

o

Widening credit spreads2)

Starting in 2001, combination of lower mortgage rates and rapid rise in house prices led to widespread refinancing with equity withdrawals

A lot of the new borrowing was used to finance consumer spending

Decline in house prices/increase in mortgage interest rates shrinks the amount that people can spend, increasing household saving and decreasing aggregate demand

High potential for substantial decline in consumption in response to lower home equitywithdrawals through home equity loans and mortgage refinancing

o

This effect is in addition to the reduced wealth caused by fall in home priceso

Declining mortgage credit for consumer spending3)

Possible Implications for Economic PolicyThese problems point to a potentially serious decline in aggregate demand/economic activity-Fed has said its willing to lend against good collateral at a discount rate that exceeds fed funds rate-But much of credit market problem reflects more than lack of liquidity: lack of trust, inability to value securities, concern about risk

-

One view: focus on price stability, so don’t change current monetary policyo

Other view: look at both goals, thus decrease Fed funds rate for two reasons:

How should Fed balance goals of keeping inflation down and achieving full employment growth?-

Article Summaries Before MidtermTuesday, March 10, 2009

1:12 AM

Ec 1420 Page 49

Dramatic decline in residential construction is an early warning of a coming recession

Adopt a risk-based “decision theory” approach in responding to current economic environment –due to all of the causes above

Other view: look at both goals, thus decrease Fed funds rate for two reasons:o

National Bureau of Economic Research “Business Cycle Expansions and Contractions”http://www.nber.org/cycles.html

Business Cycles, Inflation and Monetary Policy2.

Romer and Romer – “What Ends Recessions” (1994)Title: What Ends Recessions?Authors: Christina D. Romer and David H. RomerYear: 1994

Purpose: The authors analyze the role that monetary and fiscal policy have played in recovering from the 8 recessions in the US since 1950, in order to (1) determine if government action actually aids recovery and (2) make recommendations about what policies should be used in future recessions.

Thesis: Monetary policy has been enacted shortly after the beginning of most recessions and has been the source of most postwar recoveries; fiscal policy hasn’t been enacted until the trough was reached and typically was too small to have much of an effect.

Monetary policy: nominal and real interest rates typically fell by several percentage points before most troughs

o

Fiscal policy: “high-employment surplus to trend GDP” (adjusts for the impact of economic activity on govt receipts and expenditures) only fell slightly around troughs and shows that discretionary fiscal policy only tended to become slightly expansionary late in recessions; on the other hand, automatic fiscal policy (i.e., the lower taxes and higher unemployment benefits that occur during recessions) was much more expansionary

o

Record of Policy Actions Since 1950-

Nearly all monetary and most fiscal changes were anti-recessionary, but the largest fiscal expansions were taken to speed up growth

o

Sources of Policy Changes-

Can respond quickly to changes in economic conditions

Most periods of high inflation are not the result of anti-recessionary monetary policy carried to far, as often asserted

Monetary Policy:o

Limited fiscal stimulus can be undertaken rapidly, but is limited to actions that can be taken without Congressional approval

No examples of major anti-recessionary spending changes; most large fiscal actions were taken in response to slow recoveries

Fiscal Policyo

Lessons from Postwar Economic Policies-

estimate contributions of monetary and fiscal policy to recessions and recovery o

results are varied, but suggest that monetary policy has been crucial in ending recessions while fiscal policy has not contributed much

o

Effects of Policy Actions -

There is little evidence that discretionary policy has had a consistent stabilizing influence, and there are actually several instances in which expansionary policy has

o

Other Related Issues-

Summary:

Ec 1420 Page 50

influence, and there are actually several instances in which expansionary policy has actually exacerbated fluctuationsThe component of fluctuations that is due to shifts in government policy is highly persistent and accounts for a large part of the persistence of overall output movements

o

Taylor – “An Historical Analysis of Monetary Policy Rules” (1999)Title: An Historical Analysis of Monetary Policy RulesAuthor: John TaylorYear: 1998

Thesis: A monetary policy rule in which the interest rate responds to inflation and real output aggressively is the best policy rule. The Fed has followed a policy similar to this since the late 1980s, and this policy likely contributed to the macroeconomic stability of the era. On the other hand, the Fed was much less responsive to inflation and real output deviations in the earlier gold standard era or the 1960s and 70s, which may have contributed to the suboptimal economic performance during these periods.

Summary:

Specifically, Taylor uses the following functional form: r = + gy + h( -*) + rfo

r = short term interest rate, = inflation rate, y = percent deviation of real output from trend, and g, h, *, and rf are constants

o

The two key response coefficients are g (= responsiveness to real output deviations) and 1+h (= responsiveness to inflation deviations); differences in these coefficients makes a big difference for the effects of policy (for example, if h < 0, then increase in inflation causes a rise in the nominal interest but a fall in the real interest rate, which actually puts further upward pressure on inflation)

o

A monetary policy rule for the interest rate provides a useful framework for examining US monetary history, and can be derived from the quantity equation of money (MV = PY).

-

A monetary policy that responds to inflation and real output is an implication of many different monetary systems, including constant money growth, the international gold standard, and ‘leaning against the wind’ (i.e., when the Fed sets short-term interest rates in response to events in the economy)

-

The size of the coefficients g and (1+h) has increased over time, and are now close to the values suggested by the famous “Taylor Rule”

o

This evolution of monetary policy is best understood as a gradual process of the Federal Reserve learning how to conduct monetary policy; macroeconomic events, economic research, and policymakers at the Fed have gradually brought forth changes in the US’s monetary policy regime

o

Gold standard era (1879-1914): short-term interest rates were very unresponsive to fluctations in inflation/real output (i.e., low g, h) lowest degree of economic stability, once we adjust for the gold standard effects

1960 – 1979: slightly more responsive, but h still <1

1986 - 1997: interest rate much more responsive greatest degree of economic stability

Rules in significant time periods:o

The monetary policy rule has evolved dramatically over time in the US, and these changes have been associated with equally dramatic changes in economic stability

-

A monetary policy rule in which the interest rate responds to inflation and real output more aggressively than during the 1960s and 70s or than during the international gold standard era, and more like the late 1980s and 90s, is a good policy rule

-

“policy mistakes” (periods when the Fed deviated from the good policy rule described above) have occurred 3 times and have been associated with either high and prolonged inflation or drawn out

-

Ec 1420 Page 51

1st episode: the early 1960s - too tight monetary policy, led to slow growtho

2nd episode: late 1960s-1970s – too easy monetary policy, led to the Great Inflationo

3rd episode: early 1980s –too tight monetary policy, which led to capacity underutilizationo

periods of low capacity utilization

Martin Feldstein –“The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy”

-Are short run benefits of monetary expansion greater than LR costs of inflation?-Feldstein believes that it’s almost always better to have low inflation

-Long-run unemployment independent of level of inflation—monetary policy temporary

-Inflation is an implicit tax on money balances

-If the economy is growing at its potential rate, inflation and elasticity should be constant-Money supply grows at same rate as real economy

-Inflation causes an immediate decrease in welfare dependent on the change in inflation, the elasticity of real money demand, and the size of the real money stock

-The size of future losses (which depends on growth rate of economy)-And the present value of those losses

-So when we’re considering the costs of inflation, we need to calculate:

-It seems like many real-life situations fall into this category

-Losses from inflation will theoretically be infinite if the growth rate of welfare losses exceeds the rate we use to discount future losses

-Additionally, if deflation is the optimal solution, we should always embark on this policy immediately –more costly to wait

-Economic policy should focus on reducing inflation rather than increasing unemployment in the short-term

-If the growth rate of the economy exceeds the social discount rate, inflation is never justified

Ben Bernanke –“A Perspective on Inflation Targeting” (2003)Bernanke supports inflation targeting and thinks the Federal Reserve should eventually adopt it. In this speech, he offers his view of inflation targeting and considers its benefits in what he considers to be its best-practice form.

Best-Practice Inflation Targeting: One ViewBernanke break down inflation targeting into two components: (1) a particular framework for making policy choices, and (2) a strategy for communicating the context and rationale of those policy choices to the broader public.

(1) The Policy Framework of Inflation TargetingBy policy framework, Bernanke means the principles by which the policy committee decides how to set its policy instruments, typically a short-term interest rate. He describes his view of best-practice inflation targeting as constrained discretion. Constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy (this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control (the "constrained" part of constrained discretion).

The Communications Strategy of Inflation TargetingThe second major element of inflation targeting is its communications strategy. The goal of a communications strategy is to focus inflation expectations and explain the policy framework to the public. Targeting inflation enhances central banks’ communications because an inflation target is a clear policy objective that can be reached by a relatively simple policy framework primarily based on one

Ec 1420 Page 52

policy objective that can be reached by a relatively simple policy framework primarily based on one economic forecast. From the public's perspective, the central bank's commitment to a policy framework, including a long-run inflation target, imposes discipline and accountability on the central bank. This serves to anchor inflation expectations, making the private sector a partner in the policymaking process.

Misconceptions about Inflation Targeting1. Inflation targeting involves mechanical, rule-like policymakingInflation targeting is a policy framework, not a rule.2. Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives.There are no "inflation nutters" heading major central banks. Inflation targeting central bankers’ dirty little secret is that they do care about output.3. Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability.Bernanke is nervous about the recent trend of separating central banking and financial supervision: “I have always taken it to be a bedrock principle that when the stability or very functioning of financial markets is threatened, as during the October 1987 stock market crash or the September 11 terrorist attacks, that the Federal Reserve would take a leadership role in protecting the integrity of the system. I see no conflict between that role and inflation targeting.”

Inflation Targeting at the Federal ReserveInflation targeting is a long-term goal for Bernanke’s Federal Reserve. The Fed has taken short-term steps in that direction by increasing transparency and enacting more forward-looking, proactive policies, most notably its publication of long-term forecasts for inflation, unemployment, and GDP. By publishing these forecasts, the Fed has effectively targeted inflation in a way that does not raise the same difficult political and communication issues that an explicit inflation target does.

Martin Feldstein –“Liquidity Now!” (2007)Fed needs to cut Fed Funds rate substantially, starting at current 5.25% to 4.25% and possibly even less-Three separate but related forces are threatening economic activity: credit market crisis, decline in house prices/home building, reduction in consumer spending

-

Already weakening the economy –slowing employment growth and declining real spendable incomes-Fed action to lower interest rates won’t solve credit market problems, but will help the economy: by stimulating demand for housing/autos/consumer durables, encouraging more competitive dollar to stimulate increased NX, raising share prices to increase both business investment and consumer spending, freeing up spendable cash for homeowners with adjustable-rate mortgages

-

Martin Feldstein –“Enough with Interest Rate Cuts” (2008)Time for Fed to stop reducing fed funds rate – benefit is small compared to potential damage-Lower interest rates could raise already high prices of energy/food, will drive up commodity prices by making it less costly for commodity investors/speculators to hold larger inventories of oil and food grains

-

Also induces investors to add commodities to their portfolios -- will bid up prices of oil/commodities-Rising food and energy prices can contribute significantly to inflation rate and cost of living in US-

Will have little effect on housing constructiono

Has not brought down mortgage interest rateso

Will not stimulate demand for individuals/businesses trying to get credito

Also, reducing fed funds interest rate from current 2.25% is not likely to do much to stimulate demand-

National Saving, Growth and Income Distribution3.

Gramlich – “The Importance of Raising National Saving” (2005)

National Saving = Private Savings –Budget Deficit = I – Borrowing-Low national savings rate is a huge concern – an issue that hasn’t gotten nearly enough attention

Ec 1420 Page 53

National Saving = Private Savings –Budget Deficit = I – Borrowing-Keeping investment larger than savings implies a growing debt stock

-Financing investment directly-Reducing foreign borrowing

-High national savings leads to higher future living standards by either:

-“Twin deficits” –budget deficits and current account deficits are often linked-National saving has dropped because household private saving has fallen AND because budget deficits have increased

-It grew sharply in the 80s (tax cuts, increased spending)-And fell during the boom years of the 1990s

-Currently, the debt to GDP ratio is steadily climbing

-Budget deficits can be expected to increase further (Medicare, Social Security) if drastic changes aren’t made to these entitlement programs

-Increase in payroll taxes-Add-on, mandatory private savings accounts

-This would increase private savings-But decrease public savings-And so have no effect

-Bush proposes carving individual savings accounts from existing payroll taxes

-Automatic enrollment in employer defined-contribution accounts

-Would these actually increase the savings rate or just divert current savings-Would the increase in private savings offset the fall in public?

-Individual Retirement Accounts w/ tax benefits

-Proposed reforms to Social Security should increase national savings

-Few other countries have run trade deficits for more than five years

-US unwilling to save-Rest of world keeps their currency weak, exports to US

-Maybe we have a case of co-dependency?

-Could explain huge investment in US capital-Are other countries building stocks of assets to deal with aging populations?

-Home-bias eroding –open capital markets are weakening the link between domestic saving and investment

-How long can we run budget deficits?

-But raising national savings is certainly the safest option regardless

-Monetary policy could offset decreased expenditure-US would gradually cut budget deficit

-We don’t know which of these is the right answer

Stock market gains drive down the savings rate

Half can be attributed to stock market gains expended by householdso

30% goes from savings into bondso

More wealth allows consumers to consume moreo

Savings rate has fallen from double digits to less than zero in the last 20 years

Despite this decline in savings, national saving and foreign capital flows have remained strong

Very narrow and potentially defective way to measure savings rateo

Study shows that about half of the population will keep enough for retirement, and the other half won’t

Cannot measure if people are ready for retirement or recessiono

Still provides a measure of how much people are savingo

Savings rate measure by the NIPA (National Income and Product Accounts)

Households with little wealth in 1989 still have little in 1998Low income and low savings groups have stayed the same

Lusardi Skinner and Venti –“Savings puzzles and savings policies in the US”

Ec 1420 Page 54

Households with little wealth in 1989 still have little in 1998o

Position has not changed and still do not appear to save anythingo

Have no designated fund or habit that encourages saving

Saving is made difficult since low-income workers often aren’t offered/given pensionso

Savings = (rate of return)*Wealth + Earnings – Taxes – Consumption o

S = rW + E – T – C

Savings = Contributions + Interest and Dividend Earnings –Benefits Paid

Half of Americans hold stocks

The top 1% of American households may keep up to 53% of household holdings in stocks

Those Americans that gained the most in the stock market also saw their savings rate decline

NIPA’s measure of the savings rate excludes capital gains, so it does not show how much people earn from investment

o

Capital gains probably account for most of the decline in the savings rate

Another contributing factor to long-term decline in savings rate: easier availability of debt

A segment of the population remains that does not save enougho

Many households have gained significant wealth even though the savings rate slipped

Parker – “Sprendthrift in America: two decades of decline in the US saving rate”

This article refutes several mono-causal theories about why there has been such a boom in consumption

Consumption is up 6 percentage points since 1980

Increases in consumption/income has stopped risingThe decline in personal saving has been offset by government and business saving

In the past five years:

The focus of the paper is NOT on the past five years but the larger trend from 1980 that saw a boom of 6% in consumption/income

Seven Conclusions:1. Lower savings is not due purely to a rise in durable goods. That is, households increased consumption has not been on lasting purchases2. Higher consumption cannot be explained by a “crowding-in” effect. That is, if higher household consumption was matched with decreases in government spending we might conclude that there was “crowding in” but government spending has also increased.3. Changes in household wealth/income can explain, at most, 1/5 of the increase in consumption. The consumption boom began BEFORE wealth/income began to rise so we can’t say this is causal4. During the period of high consumption, the growth rate of real consumption/capita was low and real interest rates were high. This is surprising, we would expect that higher r would cause an increase in savings.5. Changes in the age distribution of the country were found to not be significant in explaining the consumption boom.6. Relaxed liquidity constraints that make accessing credit easier can only explain about 1/3 of the increase in consumption.7. Consumption/income ratio has gotten larger with each successive generation.

This is slightly questionable because over a 20 year period people would notice if these expectations did not come to fruition

Forward looking households may be anticipating high future incomes

There has been a shift in household preferences towards consumption todayFederal transfers (Social Security and Medicare) are increasing consumption of the elderly, while relaxed liquidity has allowed younger generations to access more credit

Possible explanations for the increase in consumption?

Ec 1420 Page 55

This is a combination of two theories but seems to be better than either theory alonerelaxed liquidity has allowed younger generations to access more credit

In 2003/2004 the combined net savings of households, businesses, and government were about one percent of Gross National Income, rate was at the lowest level in 50 years

-

Decrease in savings and corresponding increase in consumption has led to rise in imports-Savings: difference between what households receive in after-tax income and what they spend on goods and services

-

Net household savings turned to -1 percent in 2005 from 7 percent in mid-1990s (the level high enough to finance most investment in business infrastructure/ equipment, housing)

-

Rising prices of stocks and homes made Americans wealthiero

Stocks nearly doubled in past decade, despite tech bubble crasho

People thought they didn’t have to save as much because of these things

Real estate values up 50% in last 5 yearso

Most cash from this was used for consumption

Home mortgage debt increased by 3 trillion in past 5 years

Decreasing mortgage rates allowed for mortgage refinancingo

Reasons for savings decline:-

¾ of U.S. net investment is now from foreign capital inflowso

Rate of net capital inflows was 5 fives that of 1997 and 2x 2001o

Accounted for 6.4% GDP in 2005o

Low savings rate has forced the U.S. to “become increasingly dependent on funds from the rest of the world to finance domestic business investment”

-

Foreign investors get these dollars from current account deficit (imports/exports)-Thus our dependence on foreign capital can be reduced only be reducing current account deficit, which will require slowdown in growth of consumer spending

-

The increase in consumer spending / decreasing in savings is the primary reason for large trade deficit

-

This means the capital inflows aren’t dependable into the future because we can’t predict their action, a reason we need to decrease our dependence

o

A large amount of the capital inflows that are coming in are likely from governments-

House prices/share prices will not increase at same rateo

Mortgage rates have stopped falling (this is 2006)o

Which other countries need to prepare for, ie. They will have fewer exports

Then eventually we will be less dependent on foreign capital for investmento

Potential for a recession if the trade deficit does not adjust quickly to higher savings rate, causing a slowdown in growth of output and employment

o

There is a coming rise in household savings-

Dependency Theory

Feldstein –“The Return of US Saving” (2006)

Feldstein and Horioka –“Domestic Saving and International Capital Flows” (1980)

With “perfect world capital mobility” there should be no relation between saving and domestifc investment

1.

Evidence has shown #2 to be most truea.

With portfolio preferences and institutional rigidities impeding capital flow, domestic saving and domestic investment should coincide

2.

Two views on saving and capital flows:

Paper reconciles this with the fact that short term capital is highly mobile internationally and the existence of substantial international flows of long-term portfolio and direct investments

Optimal Savings policy affected because in a closed economy the country gets all the benefit of the pretax marginal product of capital. In a capital-mobile world, most incremental saving

1.Implications for knowing this information

Ec 1420 Page 56

of the pretax marginal product of capital. In a capital-mobile world, most incremental saving will leave country and so country only benefits from net-of-tax-return of investor (doesn’t get tax revenue)Tax incidence: owners of capital bear tax on capital in closed economy. In capital mobile country – burden could be shifted from domestic labor to foreign capital owners

2.

Thus, changes in savings rates or tax rates can occur without incudcing international capital flows

o

However, risk aversion considerations effect long-term arbitrage potential-

Also, there are restrictions on capital export-Also, there are institutional rigidities, such as in the U.S. savings institutions must be invested in local mortgages

-

Also some evidence that investors are not maximizing returns net of tax -Also most capital outflow is used for marketing, overcoming trade restrictions, and not necessarily finding most profit

-

Seems reasonable that capital flows among countries to eliminate short term arbitrage in yields

Due to all these considerations, must look at empirics to find answer.Evidence shows that nearly all of incremental savings remains in country of origin!Rest of paper describes statistics and facts and numbers. Conclusion: International differences in domestic savings rate among major industrial countires have resulted in almost equal corresponding differences in domestic investment rates. Yet, this is compatible with short-term liquidity, since most capital is actually not available for arbitrage among long-term investments. Also it is compatible with long-term portfolio and direct investments, since much of this is not direct maximum profit seeking

Many studies have shown that wages have not kept up with productivity increases since 1970

-

o

Should be using the “product price”, the nonfarm output price index

This is because CPI includes prices of imports and of services provided by owner occupied homes, among other things

People deflate the nominal wages using CPIo

Fringe benefits and non-cash payments have risen greatly so must consider these

Focus on wages rather than total compensationo

Two main mistakes have led to this incorrect assessment-

Once you factor these things in, wages have kept up with productivity-Also, the figures line up even closer when you consider non-financial (industry) income, because this eliminates many high earners which distory

-

There is a lagged effecto

Since 2000, the wages have not kept up, but that’s likely due to the lag and maybe increase in capacity utilization, but needs further analysis

o

“Changes in productivity are not immediately reflected in compensation”-

Summary: “Real compensation should be measured using the same price index that is used to calculate productivity”

-

Feldstein –“Did Wages Reflect Growth in Productivity” (2008)

Budget Deficits and the National Debt4.

Ball and Mankiw – “What do Budget Deficits Do” (1995)Federal Reserve Bank of Kansas City – 1995

Budget deficits and the economyI.The immediate effects of budget deficitsa.

Ec 1420 Page 57

National saving is the sum of private and public saving. When the government runs a budget deficit, public saving is negative, which reduces national saving below private saving.

1.

The effects of budget deficits all follow from the fact that deficits reduce national saving.

i.

A decrease in public saving produces a partially-offsetting increase in private saving.

ii.

S = Y- C – G1.S = I + NX2.

Another way to define national saving is current income not used immediately to finance consumption by households or purchases by the government.

iii.

In reducing net exports, budget deficits create a flow of assets abroad. 1.These changes are brought about by changes in interest rates and exchange rates.

2.

A decline in national saving reduces the supply of loans available to private borrowers, which pushes up the interest rate.

3.

Domestic goods are more expensive for foreigners.a.

A rise in interest rates increases the demand for the domestic currency in the market for foreign exchange, causing the currency to appreciate.

4.

**When budget deficits reduce national saving, they must reduce investment, reduce net exports, or both. The total fall in investment and net exports must exactly match the fall in national saving.

iv.

The immediate effects of budget deficitsa.

It is hard to find empirical work on the effects of budget deficits, since countries do not run fiscal policies as controlled experiments (identification problem).

i.

As compared to the period of 1960-1981, the period of 1982-1994 saw public savings fall 2.4% of GDP, private savings fall .4%, national savings fall 2.9%, domestic investment fall .8%, and net exports fall 2%.

1.Beginning in the 1980s, the U.S. began to run a deficit.ii.

Budget deficits in the United Statesb.

When deficits reduce investment, the capital stock grows more slowly than it otherwise would.

1.

National income falls when foreigners receive more of the return on domestic assets.

2.

When a government runs deficits for a sustained period, a stock up debt is built up. The accumulated effects of the deficits alter the economy’s output and wealth.

i.

Because budget deficits reduce the capital stock, they lead to lower real wages (smaller marginal product of labor) and higher rates of profit (greater marginal product of capital).

1.Deficits also alter factor prices: wages and profits.ii.

Long-run effects of deficits: output and wealthc.

The resulting government debt may force the government to raise taxes when the debt comes due.

i.

**As long as the rate of GDP growth is higher than the interest rate, the ratio of debt to GDP falls over time. Thus, the economy can grow its way out of the debt.

1.

However, future interest rates and GDP are uncertain.2.The government may be forced to increase taxes or cut spending.3.**By raising taxes or cutting spending initially, the government can reduce the risk of more difficult fiscal adjustments later.

4.

The government may never need to raise taxes. Instead, it can roll over its debt.ii.

Long-run effects of deficits: future taxesd.

The size of the effectsII.A parablea.

Ec 1420 Page 58

The size of the effectsII.

The burden of debt service –A debt service of ~1% of GDP would be eliminated.

1.

The level of GDP – The creation of capital raises GDP by ~6%.2.The real wage – Rises by ~6%.3.The return to capital – Falls from 12% to 10.3%.4.

Assume: “one night, the debt fairy travels around and replaces every U.S. government bond with a piece of U.S. capital.” This would affect:

i.A parablea.

Experiment is correct if economy is closed and fiscal policy does not affect net private saving.

i.

Capital inflows partly offset the crowding out of capital by debt.ii.It is uncertain how private saving responds to the deficit.iii.

Is this the right calculation?b.

“The 3 to 6% fall in income due to government debt can be viewed as only a moderate problem.”

i.Are these effects a big deal?c.

Deficits and economic well-beingIII.

Based on consumption, budget deficits are a type if income redistribution. This occurs because of the change in the timing of taxes and because of changes in factor prices.

i.By the measure of GNP, deficits are unambiguously harmful.a.

**Pecuniary externalities –A shift in the tax burden will cause the demand for some goods to rise, and the demand for other goods to fall.

i.

Wages fall, harming workers, and returns on capital rise, benefiting capital owners. These changes are pecuniary externalities.

1.**Under a deficit, current taxpayers gain and future taxpayers lose. ii.

**The winners from budget deficits are current taxpayers and future owners of capital, while the losers are future taxpayers and future workers.

iii.

Who wins and who loses?b.

When crowding out raises the returns to capital and reduces wages, the wealthy gain at the expense of the less wealthy.

1.

Ability-to-pay: Income should be redistributed from those who are better-off to those who are worse-off.

i.

Because budget deficits shift taxes forward in time, they benefit relatively poor current taxpayers at the expense of relative rich future taxpayers.

ii.

Are the redistributions desirable?c.

However, national income may be depressed by more than estimated.1.A large poor population might threaten living standards of the wealthy. 2.

If you save more to give to your children, you need not worry about deficits.i.Should you worry about deficits?d.

A hard landing?IV.

Investors may fear government default, or policies aimed at not paying back loans.

1.

This is especially true if the debt is external (owed to foreigners).2.Since much of the U.S. debt is owned domestically, a hard landing is less likely.

3.

**Hard landing - A rising debt-income ratio in a country may at some point lead to a sharp decrease in demand for the country’s assets arising from a fall in investor confidence.

i.

Latin American countries that had “hard landings” had less debt than the U.S., but most of it was external.

ii.

How a hard landing might occura.

A hard landing would cause: a sharp fall in the price of domestic assets, a fall in the stock market, an increase in interest rates, a depreciation of domestic

i.The costs of a hard landingb.

Ec 1420 Page 59

In turn, there would be lower levels of physical investment.1.

the stock market, an increase in interest rates, a depreciation of domestic currency, and an increase in exports.

i.

A hard landing could trigger a general financial crisis through an increase in bankruptcies

ii.

The fear of hard landings may be the most important reason for seeking to reduce budget deficits.

i.A call for prudencec.

Elmendorf, Liebman and Wilcox –“Fiscal Policy and Social security Policy During the 1990s” (2002)

1. Dramatic improvement in current and projected budget balanceo

2. Shift to a new political consensus in favor of balancing the budget excluding Social Security rather than the unified budget.

o

Two Fundamental changes in US fiscal policy in 1990s:

Few changes in Social Security policy.

1990 – CBO projected unified budget deficit exceeding $100 billion during fiscal year and remaining next five years.

o

1992 – CBO projected budget def. would hit $350 billion and fall by half over next 4 years and turn up again to pass $400 billion in 2002

o

2001 – budget recorded third consecutive unified surplus, CBO projected with unchanged law, surplus would total more than $5.5 trillion over next decade. Stemmed from favorable developments in economy and deliberate policy changes to reduce deficits.

o

The remarkable improvement in budget outlook during 1990s can be much attributed to policy actions, but also because of an economic boom and higher tax revenues.

o

1. Improvements in budget balance:

Always thought it was important to balance the unified budgeto

Summer 1999, political consensus shifted to excluding Social Security when balancing the budget. Aimed to put SS into 75-yr actuarial balance.

o

Part of the shift was because of projected long-term imbalances in the SS and Medicare. They would require reform because of the aging population and rising cost of health care (still a problem).

o

In 1998 Clinton declared that saving Social Security was a priority and he would not support any uses of the surplus besides for SS until the reform was accomplished.

o

Despite Clinton’s policy reform efforts, Congress did not adopt the central features of his budget framework SS and Medicare reforms were not enacted.

o

2. Balancing budget excluding SS (rather than unified)

Major point: Clinton’s ideas on the reform of budget reporting (on-budget instead of unified) and Social Security were worthwhile and ended up being a missed opportunity.

Office of Management and Budget –Budget of the United States Government: Analytical Perspectives, 2008Very long-run budget projections can be useful in sounding warnings about potential problems. The key drivers of the long-range deficit are, not surprisingly, Social Security, Medicare, and Medicaid. These entitlements are projected to grow much faster than the rest of the economy for the next several decades. Under current law, there is no offset anywhere in the budget large enough to cover all the demands that will eventually be imposed by these programs.

The Impending Demographic TransitionThe first members of the baby boomers just started to retire. In the next several decades, the elderly population will steadily increase, putting serious strains on the budget. By the time most of the baby boomers have retired, the ratio of workers to Social Security beneficiaries is projected to decline from its current level of 3.3 to 2. From that point forward, it is expected to continue to decline because of lower fertility and improved mortality. The problem posed by the demographic transition is a permanent one.

An Unsustainable Path

Ec 1420 Page 60

An Unsustainable PathThe budget is on an unsustainable path. Without comprehensive entitlement reforms by 2080, rising deficits will drive debt to GDP ratios above their peak levels reached at the end of World War II. Comprehensive entitlement reform could help avoid a budgetary crisis.

CBO – The Long-Term Budget Outlook, Dec. 2007Federal Budget

Future of long-term fiscal situation is uncertain, but definitely unsustainable (debt is growing faster than the economy in the long-term)

Concerns: rising cost of healthcare, aging of US pop.

To avoid problematic future deficits, revenues must rise as a share of GDP or spending must fall

This increase is expected to be caused by higher costs per patient, rather than an increased number of patients covered by Medicare/aid.

o

Rise in healthcare spending is largest contributor to growth projected for federal spending, making it the country’s central challenge for long-term federal fiscal policy.

o

Medicare/aid as a % of GDP is at 4% today. CBO projects it will rise to 12% by 2050 and 19% by 2082 (the total amt the Federal Gov spends today is roughly 19% of GDP).

Aging population will exaggerate these pressures. Social Security spending is at 4% of GDP today. CGO projects it will rise to 6% in 25 years and stabilize thereafter.

Extended-baseline scenario: adheres to current law, extends CBO’s baseline for the first decade and extends it past that time frame. Assumes that policy adjustments made in the past will not occur (stick with current law). Projects that revenues would be higher than ever before. Increases in real income, pushes people into higher tax brackets. Favorable in the near future, but rising deficits would be very detrimental in the long-term.

o

Alternative fiscal scenario: continue today’s underlying fiscal policy. Deviates from the CBO’s baseline because it incorporates changes in policy that are expected to occur because they have occurred in the past. Revenues would remain constant as a share of GDP. Large fiscal gap, debt would climb rapidly. Threatened by the spiraling costs of interest payments.

o

Two scenarios for long-term projections based on different assumptions:

Under both scenarios, total primary spending (all except interest payments on fed debt) would grow sharply in coming decades. Both scenarios have unsustainable fiscal path, but differ in projections of revenues and timing.

Cause rise in amount of government debt, displacing private capital and increasing borrowing from abroad

o

Exacerbate uncertainty. Greater chance that policy changes would occur suddenly, creating difficulties for households. Should announce before changes take place so people have time to adjust their plans for savings and retirement.

o

Raise the cost of interest on federal debt, creating additional costs for lawmakers to deal with. Policymakers would be less able to finance other national spending priorities and be left with less flexibility to deal with unexpected developments. Economy would be more vulnerable to a crisis.

o

Cost of delaying action

Biggest challenge: rising costs of healthcare. Second is social security and the aging population.

o

Must develop policies now. Delaying action only increases the size of the tax increases needed to eventually close the fiscal gap.

o

Major points

CBO – Economic and Budget Outlook 2009-2019

Current recession is anticipated to last until second half of 2009Economic Outlook

Ec 1420 Page 61

Economic output over next 2 years will average 6.8% below its potentialo

Recession was caused by drop in house prices, which undermined solvency of financial institutions and functioning of financial markets

o

Current recession is anticipated to last until second half of 2009-

Real GDP will drop 2.2% in 2009, not including effect of stimulus packageo

Recovery in 2010 is anticipated to be slow because credit will continue to be tight as a result of a slow recovery of financial institutions from their losses

o

Excess supply of houses will suppress house constructiono

Spending will still be muted due to reduced wealth of consumerso

Lowering of tax liabilities and increased Federal spending on unemployment insurance will somewhat stabilize economy. But state spending will not increase.

o

There might be further losses on mortgage-backed securities that will continue to contribute to the credit freeze

However, economic outlook will be uncertain because of lack of historical precedence of the degree of trouble in the financial market

o

Near-Term Economic Outlook (2009-2010)-

The gap between actual and potential GDP will not be closed until 2015o

Outlook from 2011 to 2019-

National average price of a house will fall by an additional 14% between 3rd quarter 2008 and 2010 because of high number of vacant homes

o

Foreclosure rates are likely to remain high while house prices continue to fall during the next year

o

Housing Market-

Late September 2008: financial market on the verge of freezing upo

Stock market plunged: further depressing household spendingo

In addition to cutting Fed Reserve rate, the Fed had also extended its loan facilities to buy troubled assets from banks

o

Treasury provided 1st round of bailout money to banks and auto industry in late 2008 in order to get credit to flow again (Troubled Asset Relief Program)

o

However, it is too early to see if these actions will have an permanent effecto

Financial Market-

Tight Credit decreases banks’ willingness to lend to consumers

Decline in employment, large decrease in wealth, and tight credit conditions all contributed to reduce in consumption, which will continue to be restrained in the coming year as unemployment rises even more.

o

Personal Consumption Spending-

Thus, CBO’s baseline budget projection does not incorporate potential changes in policy such as the stimulus package

o

Baseline budget projection is designed to serve as a benchmark that legislators can use to assess the potential effect of political decision, but not intended as a forecast of future budgetary outcomes

-

Enactment of stimulus package will further add to a $1.2 trillion budget deficit (8.3%GDP) in 2009

o

Adds $240 billion to total outlays

Operation of Fanny Mae and Freddie Mac are included in federal budget because of their takeover by the government

o

Drop in tax revenue and increase in federal spending on bailouts also contributes to deficito

Unemployment compensation expected to double

The 3 entitlement programs anticipated to grow at 8% this yr

Discretionary spending expected to grow 4.6%

Outlays: discretionary spending (Iraq, Afghanistan) and mandatory government spending such as unemployment compensation, Medicare, Medicaid, Social Security

o

Outlooks for 2009: very bad…-

Budget Outlook

Ec 1420 Page 62

The 3 entitlement programs anticipated to grow at 8% this yrDiscretionary spending expected to grow 4.6%

Tax revenue from both income and corporate income tax decreased from 17.7% to 16.5% of GDP due to sharp drop in values of assets and losses in the financial industry

Revenueo

Deficit will decline to 4.9% GDP in 2010 due to increase in tax revenue from alternative minimum tax and the expiration of Bush’s tax cuts

o

Will continue to fall to 3.3% in 2011o

Increase in Federal spending comes mostly from Medicare and Medicaid, which grows by 7% a year

Outlays:o

Revenues will increase as a result of the expiration of previous tax cuts that restores tax rate back to its level in 2001 and from growth in individual’s real income

o

Outlook for 2010 to 2019-

Used to project how different fiscal policies might affect baseline budget projectiono

1. Troop level would be rapidly reduced in 2 yr period, allowing discretionary spending from 2010 to 2019 to be $281 billion less than baseline estimate

3. Troop level would be reduced gradually over 4 yr period: discretionary spending from 2010 to 2019 exceed baseline by $165 million

Spending on War in Iraq and Afghanistan: 2 scenarios o

Modification of Alternative Minimum Tax: lowers revenue

Revenue:o

Budget Projection under Alternative Scenarios-

Housing and Financial Markets5.

Housing prices down 10% since 2006, forecasted to fall another 15-20%. Danger of falling further with defaults and foreclosures.

o

Securitization of mortgages makes foreclosures more difficult to prevento

Because mortgages are "no recourse loans", homeowners whose mortgages > value of house have incentive to default

o

Housing crisis background

Incentivize bankers to reduce mortgage-loan balances - does not work because of syndication of mortgage loans

o

Home Owners' Loan Corporation (from depression) - requires too much bureaucracyo

Other proposals

Federal government lends 20% of individual mortgage at adjustable interest rate based on two-year treasury debt

o

Interest payments tax deductible, individuals must repay government first.o

Lowers total interest but not total debt. In exchange, decrease the amount of debt they escape by defaulting on mortgage, cannot default on government loan.

o

Participation attractive to home owners whose mortgages are in danger of exceeding value, but not those who already have mortgage > value

o

Proposed Solution: voluntary loan substitution program

reduce the number of homeowners who have the incentive to defaulto

makes remaining mortgage debt more secure for creditorso

program can be running within monthso

no net effect on government debto

Benefits of proposed solution

Feldstein –“How to stop the mortgage crisis” (2008)

Feldstein –“How to help people whose home values are underwater” (2008)MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse

Ec 1420 Page 63

MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse mortgages, while also injecting mortgage-replacement loans to stabilize the current positive-equity mortgages, is best way to stabilize the economy.

12 million negative-equity homes with an average negative equity gap of $40,000o

Most mortgages in the US are “no recourse” loans: creditor can take the property if the owner defaults, but not other assets or income

o

Negative-equity homeowner has incentive to default because future income and other assets will not be affected

o

Negative-equity homeowner: Mortgage debt exceeds value of home

But only 400,000 of the 12 million homes with negative equity would benefit because creditors are unwilling to make large write-downs without government assistance

Hope for Homeowners: provide government guarantee of the mortgage if the creditor writes the loan down to 95% of the property's current value

o

But homeowner still has incentive to default because has to pay full amount eventually.

FDIC Proposal: reduce the monthly mortgage payment to fraction of the homeowner's income by stretching out the repayment schedule of the mortgage or providing a temporary reduction in the interest rate on the mortgage

o

Homeowner would sell the house as quickly as possible and buy another one so that he can keep all of the appreciation on the new home.

Academics: creditor writes down the mortgage debt now but gets a share of any future appreciation when the house is sold

o

Existing proposals do not eliminate the incentive to default

To induce homeowners to substitute for a full-recourse loan, there must be substantial write-down in their current outstanding loan balance.

o

Creditors have an incentive to accept some write-down in exchange for the much greater security of a full-recourse loan

o

“Mortgage replacement loan” would have attractive interest rate & payment schedule

Even if housing prices fall another 20%, all mortgages would still have positive equity

Involve no actual government spending and therefore no increase to budget deficit

Replace 20% of existing positive-equity homeowner’s mortgage with a separate, full-recourse loan from the government

o

Key to preventing further defaults and foreclosures: shift no-recourse mortgages into loans with full recourse

Mortgage: $240,000 & House: $200,000o

Homeowner takes on $200,000 full-recourse loan

Gov’t pays 1/3 and creditor pays 2/3 of $40,00 gapo

But avoids the extra loss that comes with selling a foreclosed property and achieves a much more secure loan.

Creditor writes down $27,000 for certaino

Total Cost to Taxpayers: at most $156 billiono

Example

Feldstein –“The Problem Is Still Falling House Prices” (2008)MAIN ARGUMENT: The recent financial recovery plan that Congress enacted will not rebuild lending and credit flows. That requires a program to stop a downward overshooting of house prices and the resulting mortgage defaults. A mortgage-replacement loan program may be the best way to achieve that.

Ec 1420 Page 64

that.

destroys household wealth and the capital of financial institutions o

Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

o

Bailout Bill doesn’t stop this spiralo

Fundamental cause of the crisis: the downward spiral of house prices

Individuals with loan-to-value ratios greater than 100% have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining.

o

Homeowners default on mortgageCreditors foreclose houseHouse added to stock of unsold homes housing prices depressed furtherincreases # of negative equity homesmore defaults!

o

Depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions

o

Downward Spiral of Home prices

New buyers and those with mortgages currently eligible

Full recourse Loan: allows the government to take other property or income in the unlikely event that the individual does not pay

A 30-year amortization of the government loan would make the payments low

Life-insurance policy would protect taxpayers if the borrower dies before the loan is repaid

Homeowner replaces 20% of the mortgage with a low-interest full recourse loan from the government, subject to a maximum of $80,000

o

reducing the monthly payments of principal and interest by 20%.

If the homeowner takes this loan, creditors would have to accept the 20% mortgage repayment

o

Marty’s Proposal: Mortgage Replacement loans

Doesn’t do anything for people who already face foreclosureo

Mortgage-replacement loans cannot solve all the problems of the housing sector.

Glaeser –“Why should we let housing prices keep falling” (2008)

the crash in the real estate market caused wall street and global economy to collapse-some suggest that this means the government should prop up the housing market-

Current financial crisis caused by unsuccessful bets on the Real Estate Market

Three reasons why this is a poor idea:

in new York, san Fran housing prices were out of control, problem is not housing decline, but previous unsustainable growth of market

-

government needs to reduce supply side barriers not artificially inflate them-

1. Government "has no business trying to make housing less affordable to ordinary Americans"

government "doesn't have the tools to rewrite laws of supply and demand"-after initial reductions in interests rates (100 basis points) further intervention has little effect-

2. Most of the suggested intervention proposals by the government will be expensive failures

example fannie mae and Freddie mac show that there are high costs "of having government sponsored enterprises play mortgage lender to the nation"

-3. An increase in government intervention will create long term problems

Author concludes by saying housing isn't something to speculate on the short term but rather live in and enjoy for the long run

The Economist: “Popping Sounds: House prices are falling just about everywhere” (2008)Housing prices in Las Vegas are 31.3% lower this year (2008) than last. The housing slump in America is being echoed around the globeIn America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities

Ec 1420 Page 65

The housing slump in America is being echoed around the globeIn America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities covered by the case-shiller indexHousing prices in China during the third quarter fell by over 16% in some citiesThis article was very short and basically just said that housing prices are falling over the globe

Diamond and Kashyap: “Everything you need to know about the financial crisis”Why has the stock market been so erratic for the last two weeks? (october 1 -14 2008)

the banking sector drives the economy because banks are integral to public confidence with investing

-

if lending markets freeze then the economy stalls-this has been offset by rumour that the banking sector will be bailed out by government intervention

-

Fundamental concern that the banking sector is going to collapse which will drag down the economy.

What is the government doing about this?

it is trying to do this by guarantying certain debt-these guarantees are temporary (up to three years) and are aimed at enhancing stability-it is also buying the preferred stock of banking companies-this helps ease concern that banks cannot absorb their losses from the loan and security investments they've made

-

1. Working to prevent the collapse of the banking system in the short term

For very highly rated companies it will lend short term money directly-this is so these companies which would otherwise be unable to have access to funds can resume normal planning and spending

-

2. Working to promote lending while the banking system recovers

The problem has become too large to be left to the market to correct.-The Banking sector is paramount to the economy and the government is simply trying to keep the banks solvent

-

The private sector has no motivation to correct the problem because the banks are in such extreme distress

-

Why can't the market correct for this? Why should taxpayers have to pay for the mistakes made by banks?

"This crisis started because of losses related to mortgage-related securities and loans. The value of such assets is very difficult to assess, in large part because the securities are not trading, and so there is some guesswork in establishing their value"

-Why are banks so hard to value now?

Will the government plan work or are there risk?

if they don't it’s a great waste of taxpayers’ money-1. The plan must be setup to ensure that banks emerge with enough capital to survive

2. The plan needs to be set up to avoid further panics3. The taxpayers liability needs to be protected

Keynesian Economics: Retreat and Return6.

Keynes’ thinking has been very influential

Early rejectors: Milton Friedman, Friedrich Hayek

Keynes wrote “The General Theory of Interest, Income, and Employment” In 1935 (British econ had high rate of unemployment for 15 years)

Feldstein –“The Retreat from Keynesian Economics” (1981)

“Unemployment is due to inadequate demand for labor”

Keynes’ view intended to explain how high rate could persist and how to lower it

American policy makers of 60’s and 70’s assumed it was true for them (unemployed=pool of prospective workers who would remain unemployed until the aggregate spending increased>>expansionary fiscal and monetary policy to stimulate spending

Misdiagnosing Unemployment

Ec 1420 Page 66

expansionary fiscal and monetary policy to stimulate spendingNOT TRUE: In 1979 unemployment=6% (higher than average), but econ wasn’t in recession. Spells of unemployment were short (mostly less than 4 weeks), usually under 25, especially teens looking for part-time work or people new to labor force looking for first job. Those who lost job were laid off and waiting to return (75% went back to original job).

Existing high unemployment benefits add to total unemployment by encouraging delay to work. Under Keynes, it would relieve financial hardship without adverse effects

o

In Keynes, there is inadequate demand, so minimum wage can raise wages without reducing employment; in fact, min wage raises unemployment among those with low skills

o

Most of unemployment in American economy was due to adverse incentives and artificial barriers (results of government policy) NOT inadequate demand

Keynesian thinking exacerbated unemployment problem and contributed to rising inflation. (Increasing inflation was caused by excess demand from expansionary monetary and fiscal policies)

Keynes shows lack of interest/outright fear in savings

Capital accumulation is irrelevant: Depression brought high unemployment and low rate of utilization of existing plants and equipment. Increase in demand could lead to higher output without addt’l capital. Adding new capital might increase capacity, but not actual output.

Increased savings is harmful: Too much savings is the root of the depression (households want to save more than firms want to invest)

Keynes’ ideas led to anti-savings policies (seen more in Britain/US than Europe)

The possibility of new depression from inadequate spending seemed to be less serious issue than urgent need to replace and rebuild capital stock that had been damaged

60% of that is needed to replace stock that is wearing outo

That’s about half other industrial countries

Half of that goes to housing an inventories

Leaving 3% of GNP for real stock of plant/equip

Only 6% of GNP has actually been devoted to increasing new capital stock aka net investment

o

Stock of Plant and Equipment grew by 3.8%, # workers in labor force grew 2%, amount of capital per worker only grew 1.8% (about half of other countries)

o

In more recent years, share of national income dropped, growth of labor increased, meaning capital per worker is unchanged, perhaps even falling

o

US and Britain have some of the lowest savings rate (US=15% of GNP)

The Keynesian Fear of Saving

Giving up $1 of consumption today leads to additional $0.11 each year for indefinite future. o

Additions to the stock of plant and equip can earn real net rate of return (before tax, after adjusting for inflation/depreciation) of about 11%

Reason why American should save and invest more because investment translates into increased productivity, greater national income, and higher standard of living

Faster capital accumulation does NOT create jobs/reduce unemployment

Increased rate of investment does NOT eliminate/reduce inflation

Impact of sum of all policies is greater than of individual policies taken aloneo

Our low rate of savings reflects series of policies that trace back to Keynesian fear of savings: tax rules that penalize savings, social security which makes savings unnecessary, credit market rules that encourage large mortgages/extensive consumer credit, large gov’t deficits that absorb private savings

Now, no longer fear that savings will lead to unemployment and we understand that higher savings is needed for increased investment.>> label of “supply-side economists”

Tradition of easy money goal should be rejected in favor of tight money, high real interest rates, and fiscal incentives to encourage investment in plant and equip

Growth and the Investment Imperative

Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should

The Faith in Government Activism

Ec 1420 Page 67

Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should develop spending policies to eliminate social problems

Pre-Keynes view= economy functions best when it is disturbed the least

Depression changed that view>> lack of faith in market system>>belief in active gov’t stabilization and general confidence in gov’t ability to solve social problems

Gov’t spending is no longer limited to necessary public services, like defense/court system, and could be used to stabilize employment and output

o

This lead to idea that gov’t should use its power to interfere in ind mkts to cure social prob (gov’t health care, housing, social security)

o

Keynes’ calling on gov’t to spend changed perceived role of the gov’t

Keynes’ thoughts are deeply ingrained and will be difficult to change

Democratic political process may not be forward looking enough-many policies reduce unemploy in short run, but increase in long run; also difficult to develop policies to encourage savings

The Uncertain Future

Feldstein –“Rethinking the role of fiscal policy” (2009)What are the principles for designing a potentially useful fiscal stimulus? And what will happen in the current fiscal stimulus fails?

After the war, most American macroeconomists focus on contribution of Keynesian fiscal policy to preventing unemployment

Further analysis showed Keynesian multiplier was much smaller than earlier assumed (reduced by a crowding out of interest; leakage of demand through imports; effect on exchange rate)

Difficult for economists to assess the current state of business cycle; even harder to asses where economy was heading and how much it would be affected by stimulus. All uncertainty means fiscal policy could increase cyclical volatility

Long lags between gv’t decisions means that stimulus could occur at wrong point in cycle

Rise in both inflation and unemployment in the 1960s made it clear that Keynesian fiscal strategy wasn’t working

Focus shifted from fiscal to monetary (can adjust more rapidly) low inflation rate since 1980’s reinforced case for monetary policy

Rise and Fall of Fiscal Activism

Current downturn is different from previous recessions, monetary policy is not effective

Past recessions generally began after Fed raised interest rates sharply to counter excess inflation, Fed felt it succeeded, revered policy, and lowered the interest rate

Not due to high interest rates, could not be fixed by reversal of Fed policy

Comes from: under-pricing of risk and resulting excessive leverage

Fed tried to reduce, but mortgage and security rates remained high

Temporary one-time tax rebate was chosen as fiscal stimulus (could get bipartisan support and get implemented quickly); unfortunately consumer spending increased only weakly (80 billion tax cut, 12 billion increase in spending)

MPC real income=.7, MPC tax cut=.13

Federal Reserve and Treasury have taken steps to improve credit markets: policies prevented further meltdown of a credit availability in banks, money market mutual funds, and ability of firms to issue commercial paper; measures haven’t increased credit or solved issue.

Recent Revival of Fiscal Policy

Fall in the stock market and value of owner occupied real estate has depressed household wealth by @10T

Wealth effects imply decline of annual consumer spending by $400B (implies lower production, lower incomes, and further reductions in spending

Leads to reduction by additional $200B, Automatic stabilizers offsets about 1/3 of this, leaving

Designing Current Fiscal Package

Ec 1420 Page 68

lower incomes, and further reductions in spendingLeads to reduction by additional $200B, Automatic stabilizers offsets about 1/3 of this, leaving GDP gap of $400B

Need to increase by $400B in 2009, 2010: MUST turn to fiscal

Avg recession lasts 12 months, this one, already longer

Suggest: Permanent tax cut of $500 per employed person>> annual tax cut of $70B, increase in consumer spending by $50B

R&D tax credit could help to offset decline in private R&D

Obama is postponing tax increase for high-income ind. Until 2011, but they look ahead. Taxes on dividends and capital gains are scheduled to increase, but promise to leave the rates unchanged would raise share prices, offsetting some of the fall in the market, leading to more spending and increased business investment

Gov’t still needs to spend $300B to $400B (speed of outlays is important; as is avoiding bottlenecks—ie bridges are important, but there are limited number of bridge engineers)

Health, energy, education, infrastructure, and support for poor

Some = from fed, but much from state/local

defense isn’t part of it, and that military spending will decreaseo

Military training can be used to decrease unemployment, can lead to education in variety of technical skills

o

Temporary increases in FBI/intelligence would be good tooo

No increase for research spendingo

Surprising that:

Spending Priorities

Gov’t spending could increase more

Fiscal stimulus could shift from increased spending to substantial permanent reduction in personal and corporate taxes

Fall in value of dollar (either spontaneous or planned) that is large enough to eliminated today’s large trade deficit, thus boosting exports

What if it Fails?

John Taylor – “The Lack of an empirical rationale for a revival of discretionary fiscal policy” (2009)There has recently been a dramatic revival of interest in discretionary fiscal policy, and the purpose of the paper is to review empirical evidence during the past decade and determine whether the evidence calls for such a revival (he concludes it does not).

Taylor uses empirical evidence from two temporary tax rebates is 2001 and 2008 to show that even though the rebates were given during the recession (Lack of good timing is not to be blamed) there is virtually no increase in aggregate demand.

Taylor then runs a regression to test whether the rebates had a positive effect on consumption and he includes a lagged dependent variable to allow for lagged effects on changes in income. He then adds controls such as the price of oil which would be expected to have a depressing effect on consumption. He still finds that the rebates had a statistically insignificant effect on consumption.

Taylor then posits that we should continue to focus on the Automatic stabilizers and more lasting long run reforms (i.e tax reform, entitlement reform, infrastructure spending) rather than discretionary countercyclical actions. He runs a regression to test how the automatic stabilizers have effected the GDP gap (potential gdp –actual gdp) and he concludes that they have become more instrumental over the years.

He also concludes that the effectiveness of monetary policy over the past decades is all the more reason that we should never turn to discretionary fiscal spending.

Ec 1420 Page 69

that we should never turn to discretionary fiscal spending.

Conclusion:

A decade ago there was widespread agreement that fiscal policy should avoid countercyclical discretionary actions and instead should focus on the automatic stabilizers and on longer term fiscal reforms that positively affect economic growth and provide appropriate government services, including infrastructure and national defense. In this paper I briefly summarized the empirical evidence during the past decade on (1) the temporary rebate programs of 2001 and 2008, (2) macro-econometric model simulations, (3) the changing cyclical response of the automatic stabilizers, and (4) the role of monetary policy in a zero interest situation. Based on this review I see no empirical rationale for a revival of countercyclical discretionary fiscal policy.

Tax Equity and Fiscal Responsibility Act (TEFRA) –Scaled back large Reagan tax cuts.

Budget Enforcement Act (BEA) –During a 1990 summit to combat the recession, the BEA brought new budget rules.

2008 – The general consensus in support of a large fiscal stimulus represents a marked change from the 1982 and 1990 episodes.

The lack of a recession during the 1990s weakened the case for intervention.o

Still, the stage was set for policy decisions during the current recession.o

Estimates show that both revenue and expenditure policies have been countercyclical and budget-stabilizing, with larger responses on the expenditure side.

Auerbach –“Implementing the New Fiscal Activism” (2009)

Explaining the New ActivismI.Automatic stabilizers have been weakened over time by the indexation of the individual income tax and reductions in marginal tax rates.

a.

The zero-nominal-interest rate bound limits monetary policy. b.Investment Incentives and Stabilization PolicyII.“Business fixed investment is volatile and forward-looking. The former characteristic makes investment an obvious target for stabilization policy while the latter characteristic suggests the need for caution in adopting any such policy.”

a.

“Such incentives aim to increase investment, but even if well -timed, their anticipation might be destabilizing, as provisions targeted at new investment can discourage investment prior to enactment.”

i.

Government investment policy changes can be predicted to a considerable extent.

ii.

Temporary investment incentives can exert a more powerful short-run impact by encouraging the speed-up of projects.

iii.

Bonus depreciation was introduced as a temporary measure in 2002 allowing a 30% immediate write-off of qualifying investments.

b.

For firms without taxable income that may become taxable only years later, bonus depreciation is of little value.

i.

This may be an important issue now, given the sharp surge in losses.ii.

Adapt corporate tax rules to make them more symmetric with respect to the treatment of tax losses

1.

Adapt investment incentives that allow for the transfer of the tax benefits.2.

There are two approaches to dealing with this situation.iii.

Bonus depreciation increases the incentive to invest by increasing the present value of depreciation deductions.

c.

Household tax cuts should be constructed in a way that would influence the timing of household decisions, as through a temporary reduction in consumption taxes.

d.

ConclusionsIII.“The current recession provides compelling circumstance for renewed fiscal policy activism. The strong support for fiscal policy intervention reflects a renewed belief in policy activism

a.

Ec 1420 Page 70

The strong support for fiscal policy intervention reflects a renewed belief in policy activism that had already appeared before the present crisis.”

Since discretionary policy is traditionally not favored, much attention has not been given to its design.

i.

We need to pay more attention to policy design this time around. ii.

We are still relying on past approaches to discretionary policy.b.

Looking at economic indicators late, such as credit conditions, housing, and consumer sentiment, in 2007, Feldstein predicted that the American economy was headed for a recession. He suggested lowering interest rates to increase output and employment, as the threat of inflation with this policy would do less damage than a deep recession. He predicted that the coming recession would be deeper and last longer than recent recessions. Looking at the credit market at the time, Feldstein predicted that interest rate cuts would not be as powerful a stimulus as they recently were. The credit crunch was caused by low confidence in creditworthiness of those seeking credit and accuracy of asset prices, on top of low liquidity. A great deal of capital was being used to recuperate recent losses and balance their balance sheets. A lower interest rate would reduce monthly payments for people with adjustable-rate mortgages, increasing the amount of excess cash they have to spend. New loans for people and business would also clearly have lower rates, increasing borrowing.Feldstein argued that a fiscal stimulus was necessary to avoid a recession. He recommended a tax rebate that would start automatically if the economy worsened (perhaps if unemployment increased) in 2008 and stopped automatically if it improved. This would increase household and business confidence in the case of a recession. It would also work automatically to correct the negative effects of a recession, such as unemployment, very quickly, instead of having to wait for the legislative process to come up with a plan after the recession has already started. The Fed would not raise rates during the tax cut, as the Fed wants to avoid the recession and this SR stimulus puts less inflationary pressure on the economy than lowering the interest rate. Using fiscal instead of monetary policy would also put less pressure on the exchange rate, as a rapidly declining dollar (caused by increased US money supply) might lead to retaliatory action by trading partners, even as a lower dollar would shrink the trade deficit. Fiscal policy would cause less of an increase on asset prices, such as real estate. Using both fiscal and monetary policy would cause a more balanced increase in demand for assets.

Feldstein –“How to Avoid a Recession” (2007)

Summers writes early in 2008 that a recession was likely because of low employment, weak holiday spending, increasing oil prices, poor housing data, and writedowns in the financial sector. The Fed would probably continue to cut rates. Now would be a good time to enact a fiscal stimulus. He believed in a diversified policy for four reasons:

Lawrence Summers –“Why America Must have a fiscal stimulus” (2008)

1. Outcomes less uncertain with diversified stimulus2. Middle class families were suffering and fiscal stimulus is more direct aid to them than monetary policy which mainly affects financial institutions3. Using fiscal policy to address this would mean the Fed wouldn’t need to cut interest rates so much, meaning the dollar won’t fall so drastically, inflation wouldn’t increase so much, and everything would be more stable

Demand would also be more stable with fiscal policy, offsetting a decrease in consumer spending which would lead to job losses and further decreases in spending. Troubled financial institutions meant that people were less able to borrow against their home equity or with credit cards. Summers also cautioned 3 things about fiscal policy:

4. Because interest rates wouldn’t need to be so low, there’s less of a risk of a bubble

1. Must be timely, so should be enacted right away2. Only works if spent, so should be targeted to those with low incomes and those whose incomes have decreased because their spending is most urgent, least likely to have credit

Ec 1420 Page 71

decreased because their spending is most urgent, least likely to have credit

His plan (looks small in retrospect): payments to people paying income or payroll taxes, increases in unemployment insurance for long term unemployed, and food stamps benefits. It would be quick and temporary. Any further stimulus would be provided by measures to reduce future deficits and increase confidence in the long run.

3. Must be clearly temporary or threat of huge deficits will raise long term interest rates and lower confidence in long term growth.

Elmendorf and Furman –“If, When, How: A Primer on Fiscal Stimulus” (2008)

Martin Feldstein and Lawrence Summers have argued that fiscal stimulus may be necessary to help economy in serious economic downturn where monetary policy and automatic stabilizers fail

May include tax cuts and/or spending increaseso

Fiscal stimulus is more immediate than encouraging investment and can occur more quicklyo

Principles of Fiscal Stimulus

Timely –should be enacted in certain circumstances at the right timeo

Targeted –should raise short-run output and end up in the hands of the most vulnerable and strugglingo

Temporary –should increase short-run output and not increase long-term deficito

When to Intervene?

History of Great Depression interventiono

Monetary policy is first line of defense –quicker and does not require legislative approvalo

Often best because economists should be the ones to analyze data and forecast results, not Congressmen with limited knowledge

Automatic stabilizers are good intermediary between monetary and fiscal policyo

Fiscal stimulus is important if monetary policy is powerlesso

Principle 1 : Fiscal Stimulus Should be Timely

Difficult to time it appropriatelyo

Immediate tax cut or spending increase is good if growth is supposed to be much weaker than forecasted

o

Usually used in conjunction with monetary policy and automatic stabilizerso

Principle 2 : Fiscal Stimulus Should be Well-Targeted

Direct tax cuts should be targeted to those who need it most (typically low-income persons who spend it quickly)

o

Principle 3 : Stimulus Should be Temporary

Fiscal stimulus can raise short-term economic output to move to outer bound of economic possibilities frontier, but this is a short-term increase

o

Would be best if it is repaid within five to ten yearso

Good Examples of Effective Options

Extend unemployment benefits temporarilyo

Increase food stamps temporarilyo

Issue flat, refundable tax credits temporarilyo

Less Effective Options

Increase infrastructure investmento

Create temporary investment tax incentiveso

Ineffective Options

Reduce tax rates, or make 2001/2003 tax cuts permanento

Goal is to build better long-run policy

Mankiw – “What would Keynes have done?” (2008)the current economic downturn. Keynes believed downturns were caused by low aggregate demand. This causes employers to fire workers, leading to less demand, leading to more layoffs, etc. This cycle stops when either an event or polic increase aggregate demand. Mankiw breaks down the 4

Ec 1420 Page 72

components of GDP and explains why they are low.*Consumption: Consumer confidence was very low (house prices decreased, 401(k)s shrunk, unemployment high). This leads to greater saving. If everyone saves at the same time, there is a huge drop in consumption, leading to lower incomes.*Investment: Usually decreased consumption leads to increased investment. But the housing market was in shambles, as prices continued to decline, and there was lower residential investment as fewer new homes were being built. Financing business investment was difficult, as the stock market was down, interest rates on corporate bonds up, and the banking system in a precarious position.*Net exports: Despite a recent depreciation of the dollar and increase in net exports, net exports were most likely not going to continue to increase. The financial crisis spread from the United States to the rest of the world, and people have been sending their capital back to the US thinking that this is the safest place. This has caused an appreciation of the dollar that should lead to a fall in exports.

Mankiw warns that the Fed has already cut the interest rate to practically its lower bound of zero, so it can’t increase aggregate demand through rate cuts anymore. But the Fed can also signal that it plans to keep longer term interest rates low and will work to avoid deflation. It has also been buying mortgage debt.

*Government purchases: Plan is for government to increase infrastructure spending with stimulus, hopefully leading to multiplier of greater than one. This works in the short run, but would add to the budget deficit and threaten the ability of the government to pay for its future obligations (such as Social Security and Medicare for boomers).

Broda and Parker – “The impact of the 2008 tax rebates on consumer spending: a first look at the evidence.”Between May and July of 2008, the government distributed approximately $90 billion in tax rebates to American households. They find that households are doing a significant amount of extra spending because of these rebates. They find that the typical family increased its spending on nondurable goods such as food, mass merchandise, and drugs by 3.5% when its rebate arrived relative to a family that had not yet received its rebate. Of the families who received rebates, low income and low asset households increase their spending at nearly double the rate of the average American family. Moreover, shoppers are spending a higher fraction of their rebates at supercenters such as Walmart and Target relative to their normal behavior. Their findings suggests that tax rebates, especially ones made to low-income families, are an effective way to stabilize consumer spending during downturns.

Feldstein –“The tax rebate was a flop. Obama’s stimulus plan won’t work either” (2008)

Congress feared monetary policy alone would not be effective because of the dysfunctional credit markets.

o

Tax rebate program was enacted because of the growing risk of a recession.

It was hoped that households would spend a substantial fraction of the rebate dollars, leading to more production and employment.

o

Brookings Institution study –Each dollar of revenue loss would increase real GDP by more than a dollar if households spent at least 50 cents of every rebate dollar.

o

The hope was that the tax rebate would boost consumer confidence as well as available cash.

The rebate added nearly $80 billion to the permanent national debt but less than $20 billion to consumer spending. (Rebates amounted to $78 billion, additional consumer spending amount to $12 billion.)

o

Savings rose by $62 billion, showing that consumers saved much of the money.o

GDP figures are supported by the more detailed monthly data on income and spending. There is also evidence in monthly retail sales.

o

“Although press stories emphasizing that the rebates induced additional consumer spending were technically correct, they missed the important point that the spending rise was very small in comparison to the size of the tax rebates.”

o

“Although someone who receives a permanent annual salary increase of $1,00 typically

Government statistics show that between 10% and 20% of the rebate dollars were spent.

Ec 1420 Page 73

small in comparison to the size of the tax rebates.”“Although someone who receives a permanent annual salary increase of $1,00 typically would increase his annual spending by an almost equally large amount, a $1,000 rise in wealth caused by a share price increase or a tax rebate would raise spending only gradually over a number of years.”

o

**This confirms earlier studies that showed that one-time tax rebates are not a cost-effective way to increase economic activity.

o

Tax on oil companies would reduce investment, keeping oil prices high.

Cost of plan would be $65 billion. It would be funded through an extra tax on oil companies.o

According to past evidence, Obama’s plan to send $1,000 rebate checks would do little to raise consumer spending and stop the decline in employment.

o

With this in mind, Obama’s proposal to distribute $1,000 rebate checks to low and middle income workers should be evaluated.

Permanent tax increases reduce consumer spending and aggregate demand.o

Taxpayers, anticipating a future tax hike, may reduce current spending.o

Increasing future taxes is no way to stimulate the economy. o

“The distinction between one-time tax rebates and permanent changes in net income is also important for the debate about Obama’s proposal to raise income and payroll taxes. “

CBO – Options for responding to short-term economic weakness (2008)This paper first reviews the economic situation and then assesses different fiscal approaches to giving a temporary boost to aggregate demand in the economy. The last section examines policy options geared specifically toward the housing and mortgage markets.

The combination of continued weakness in housing activity and prices, the ongoing problems in the mortgage and broader financial markets, and persistently high price of energy have raised the risk of slow growth and recession (this was prior to when it was common knowledge that the economy was in a recession).

Automatic stabilizers and actions by the fed will be our first line of defense against a recession, but if that fails, a fiscal stimulus should be used and it should focus on two things: focusing on right time period when it is most likely needed and increasing economic activity as much as possible. (A stimulus meaning household get increase tax cuts and transfer payments, business get investment tax credits, and the government consider buying goods directly in the economy to increase demand. The paper spends about 15 pages in details analyzing approach and expected results of achieving this).

The stimulus should be consistent with Long-Run Fiscal Objectives, and the size of the stimulus should depend on our goals (i.e. enough money so that economic forecast do not project a recession, enough money to reduce chance of recession to an acceptable value, enough money to address the sharp drop in economic growth.)

The three questions used to assess stimulus are as follows:1)Are the proposals likely to be cost-effective, 2) are they likely to be timely (given bureaucratic inertia), and 3) how uncertain are its economic effects.

The proposal specific to the housing markets are changing the terms on troubled mortgages, promoting the restructuring of Mortgage Loans, changing bankruptcy law, expanding opportunities to refinance subprime mortgages, expanding authority of the FHA, Fannie, and Freddie, Increasing Federal Assistance to community based organizations, allow state and local governments to issue tax-exempt bonds for refinancing, and government purchases of subprime mortgages. This is a comprehensive list and the concepts of the proposal are pretty self-explanatory. The paper goes through each in detail, so if you are unclear on one or want to learn more, just go back to the paper and look for the bold heading.

Conclusion:Even if the individual options have small effects, some of the options taken together may help the

Ec 1420 Page 74

Conclusion:Even if the individual options have small effects, some of the options taken together may help the economy by reducing the risks of a self-reinforcing downward spiral. In the case of the proposals for restructuring and refinancing mortgages, the main effects come from the help given to creditworthy borrowers who can avoid foreclosure and the attendant losses for both borrowers and lenders.

Fluctuations of the Dollar and the Trade Balance7.

Caves, Frankel and Jones –“Expectations, Money and the Determination of the Exchange Rate”Assumptions: no transaction costs, capital controls, barriers to international investorsExchange rate= relative price of foreign versus domestic assets (not GOODS)--they are very volatile, just like the price of bongs, equities, gold, and other assets

If dollar is expected to lose value in the future against the yen, then the Japanese investors will subtract the expected rate of dollar depreciation from the dollar interest rate when contemplating the purchase of US assets

If investors do not care about any factors other than the expected rates of return on the two countries assets, then they will by the asset with the higher expected return and sell the other, until the expected rates of return are equalized

holds onliy if investorys treat domestic currency and foreign currency assets as perfect substitutes in their portfolios

it is an equilibrium condition

much stronger hypothesis than covered interest parity

∆se= i-i* is the uncovered interest parityo

any deviations would mean that investors could risklessly make as much money as they wanted (VERY unlikely that such options exist)

covered interest parity, the arbitrage condition: i-i*=fd (forward discount)o

Expected rate of depreciation of the domestic currency (∆se)= nominal interest differential ( i-i*)

Interest Rate Parity Conditions

It is as if there is one bond under (1) assumptions: no transaction costs, capital controls, barriers to international investors and (2) diff countries assets are perfect substitutes. Investors are indifferent to which country’s bonds they hold

Purchasing Power Parity countries goods can be aggregated together so long as their relative prices are fixed

Monetary approach to the balance of payments: focuses on international flows of money

Monetarist Model: adds assumption that prices are perfectly flexible so that goods and labor mkts always clear

Return to assumption of price flexibility despite evidence against it because one good and one bond is good starting point and PPP is a decent approximation for LR

Mundell-Fleming model assumed fixed prices in SR

Adding the bar means it is taken seriously only in the LRo

PPP assumption: S (bar)=P/P* S(bard)=level of the exchange rate (the “spot” price of a foreign exchange), P=domestic price level, P*=foreign price level

The Monetarist Model of Exchange Rates, With Flexible Prices

Assumes demand for money is decreasing function of interest rate (wish to hold less money when other assets pay a high rate of return), and increasing function of Y (greater need for money to make transactions with when income is high)

o

M/P = L(i,Y) M/P=real supply of money, L=real demand for money

S(bar)= (M/M*)/ [L(i, Y)/ L*(I*, Y*)]o

Exchange rate is defined as the price of foreign currency in terms of domestic currency; now modeling it as relative price of foreign money instead of goods

o

Combine M/P equation with PPP: (*indicate for foreign country)

Exchange Rate Price of Money

Ec 1420 Page 75

modeling it as relative price of foreign money instead of goods

Increase Y»decrease in S, increase in i-i* » increase in S

Mundell: Increase in Y means higher demand for imports and deteriorated trade balanced means depreciation

New equations assumes flexible prices so Y is always at level of potential output (all resources are fully employed), in this context if income increases, can only be due to higher level of national resources or improvement in efficiency all changes in output are changes in potential output, which is sign of economic strength and leads to appreciation

Mundell: increase in interest differential requires an appreciation of the currency. In new equation, increase in interest differential is associated with a depreciation of the currency

These effects are the reverse of those in the Mundell-Fleming model

Money demand variables: S(bar)= (M/M*)/(Y/Y*) times ƒ(i-i*)o

If expectations regarding what will happen in the future change, even if no other variables change today, then today’s exhange rate will change

o

A high interest rate is not a sign of strength for a currency, it reflects expected future depreciation and is thus a sign of weakness

o

PPP in terms of rates of change: ∆s(bar)= ∆p-∆p*, ∆se =∆pe -∆p*eo

Real interest parity: i-∆pe=i*-=∆pe*o

S(bar)= (M/M*)/(Y/Y*) times ƒ(∆se

What determines the expected inflation rate?

In simple montarist model: rate of money creation drives everything

Given rate of increase of price level presupposes as money growth rate of same magnitude

If money growth rate were NOT fully reflected in inflation rate (real money supply increasing), LM curve would shift to right and real income would be increasing >> no steady state

Permanent increase in the money growth rate leads to permanent increase in inflation by same amount, public recognizes change, expected depreciation and interest rate increase by same amount, and demand for currency falls

Magnification effect: The percentage change in the exchange rate in any given interval of time can be greater than the percentage change in the money supply during that interval (see page 543/4 for graph)

Expectations of Money Growth

Germany 1923: price level and exchange rate were increasing at same rate (real exchange rate reached steady state), but in the transition to steady state, price level and exchange rate had gone up more than money supply; real money balances fell

Worse the hyperinflation, the more extreme the fall in real money holdings>>NOT true that in monetarist model no change in monetary variable can have an effect on any real variable

Hyperinflation

If people expect a constant growth rate of domestic money, it is easy to understand; expected interest differential, nominal interest differential, forward discount, expected rate of depreciation ALL equal expected money growth rate differential

A 1% increase in money supply has 1% increase in price level and exchange, but no further effects.

o

With random walk: people know the money supply will probably change, but it could go up or down, best forecast is zero, which means: expected inflation differential, expected depreciation rate, and interest rate differential ALL=0

When Money Supply Follows a Random Walk

Expecting the money supply to increase in the future will cause today’s exchange rate to increase

The effect on today’s exchange rate is smaller the further into the future is the expected increase

Future changes are discounted pack to the present

When the Money Supply Is Expected to Jump in the Future

Ec 1420 Page 76

Future changes are discounted pack to the present

Feldstein –“Resolving the Global Imbalance: The Dollar and the US Saving Rate” (2008)Title: Resolving the Global Imbalance: The Dollar and the US Saving RateAuthor: Martin FeldsteinYear: 2008

Thesis: The recent surge in the US’s current account deficit (to a peak of $811 bil in 2006) is unsustainable, and its decline must be brought about by a higher US saving rate and a decline in the dollar. These changes will happen naturally because of various market forces, but can be accelerated by government actions at home and abroad.

Summary:

Until around 2000, the US was able to finance its entire current account deficit by attracting equity investments from primarily private investors.

o

Now, the US debt is mainly financed by foreign governments’ purchase of debt (Treasuries) in order to sustain their export surpluses and protect themselves against speculative attacks. Foreign investors will reduce their demand for dollar bonds soon for 3 reasons: (1) foreign govts can get a higher return by investing in their own economies (2) portfolio diversification (3) future decline of value of dollar (will reduce value of dollar investments) with no sufficient rise in the interest rate for compensation

o

The US current account deficit cannot be sustained because the way in which it has been financed in recent years is not sustainable.

-

Mechanism by which dollar will fall: foreign exporters deposit dollars for goods they export to US in commercial banks, which then give to central bank central banks want to reduce dollar reserve holdings, so they sell the dollars increased supply of dollars causes dollar to depreciate.

o

A more competitive dollar is the mechanism that will cause the deficit to decline.-

The primary reason for the US’s low national saving rate was low household saving, which was primarily caused by the rapid rise in household wealth and the high level of mortgage refinancing with equity withdrawl; both forces are weakening and will likely cause a rise in the household saving rate in the near future (sidenote: both have reversed, so savings rate has risen since this article was written)

Higher US National Saving Rate (= household + corporate + govt saving)o

Increased Incentive to Purchase US Goods – this will come from the depreciation of the dollar (which makes US good relatively cheaper)

o

China has achieved a very lare trade surplus (10% of GDP) by artificially depressing the value of their currency, the yuan; this is achieved by purchasing large quantities of foreign reserves

The key to shrinking China’s trade surplus to to reduce the remarkably high national saving rate (40+% of GDP)

Other countries must also reduce trade surpluses as part of global adjustment – this can be achieved without reducing domestic employment/growth if they pursue appropriate fiscal and regulatory policies (ex: revenue-neutral proconsumption tax changes)

Reduction of Trade Surpluses in China and Many Other Countrieso

Other necessary factors for the decline in the US current account deficit:-

in 2006, the IMF proposed a plan to achieve coordinated action to reduce global imbalances. However, their effort is doomed to failure becaue it is missing the key ingredient: the recognition that resolving the global trade imbalance requires a fundamental realignment of currencies (in particular, a depreciation of the dollar)

-

Ec 1420 Page 77

Feldstein –“The Dollar at Home – and Abroad” (2006)-Politicians have traditionally emphasized “strong dollar”

-By a “strong dollar at home,” Feldstein means we need low inflation-By “competitive dollar,” Feldstein means an exchange rate that favors exports

-Feldstein “We need a strong dollar at home and competitive dollar abroad.”

-We had this situation in late 1980s – low inflation, fall in value of dollar cut trade deficit-The US can achieve optimal situation because we borrow in our own currency –we don’t have to worry about a depreciating currency making it difficult to afford foreign currency debts-A more competitive dollar would encourage consumers to buy American goods-We don’t know exactly how much the trade deficit will decrease given a certain amount of depreciation of the dollar

-The longer we wait, the more debt we accumulate to the rest of the world-While we have an overly strong dollar now, the debt we are accumulating decreases future consumption –we will need to devote more resources to servicing and paying off the debt

-Two secondary reasons to immediately strive for a depreciated dollar

-An immediate increase in exports could sustain the economy, replacing the fall in consumption caused by the credit crunch-Because NX will not react immediately, it’s important to start now

-One more important and time-sensitive reason

-To achieve competitive dollar, we need a higher US savings rate and a narrowing gap between US and foreign interest rates

-The US should also probably meet with the Asian countries that own massive reserves in dollars first

-The US government should publically announce that it tends to pursue this policy of a more competitive dollar –markets will do the rest

Written in late 2007, Feldstein explains that the dollar is correcting itself by falling, on its way to a huge fall needed to shrink the current account deficit. At the time, the CAD was $800 billion, or 6% of GDP. The deficit is financed by capital inflow from foreign investors, mainly through purchasing US bonds. Why would foreigners want to keep buying $800 billion (or more with rising interest payments on external debt) of US debt every year? Foreign governments buy most of this debt. How long will they want to do this, especially as the dollar will eventually fall? They must sell these bonds to other foreigners if the trade deficit is to stay as it is. The amount of bonds held by foreigners can only decrease if America has a trade surplus. If foreign investors decide they don’t want to keep getting US bonds at this exchange rate, the dollar has to fall far enough that people do not believe it will continue to fall or US interest rates must increase to compensate for risk.A falling dollar would increase net exports, lowering chances of a recession, so it would be good for America. It would be all right for America’s trading partners if they stimulate demand in other categories of GDP besides net exports. If they instead lower their interest rates or their governments interfere with the exchange market, keeping their currencies weak against the dollar, US net exports will not increase, and America will not avoid a recession. Americans might blame foreigners, leading to protectionist policies. The fed can offset potential inflation in the US with its increased demand for American goods (as they are relatively cheaper than foreign goods with a weak dollar) by sticking to goal of price stability.

Feldstein –“A More Competitive Dollar is Good for America” (2007)

Implementing the New Fiscal Policy ActivismAlan J. Auerbach – May 2009American Economic Review

Tax Equity and Fiscal Responsibility Act (TEFRA) –Scaled back large Reagan tax cuts.

Budget Enforcement Act (BEA) –During a 1990 summit to combat the recession, the BEA brought

History

Ec 1420 Page 78

Budget Enforcement Act (BEA) –During a 1990 summit to combat the recession, the BEA brought new budget rules.

2008 – The general consensus in support of a large fiscal stimulus represents a marked change from the 1982 and 1990 episodes.

The lack of a recession during the 1990s weakened the case for intervention.o

Still, the stage was set for policy decisions during the current recession.o

Estimates show that both revenue and expenditure policies have been countercyclical and budget-stabilizing, with larger responses on the expenditure side.

Explaining the New ActivismIV.Automatic stabilizers have been weakened over time by the indexation of the individual income tax and reductions in marginal tax rates.

a.

The zero-nominal-interest rate bound limits monetary policy. b.Investment Incentives and Stabilization PolicyV.“Business fixed investment is volatile and forward-looking. The former characteristic makes investment an obvious target for stabilization policy while the latter characteristic suggests the need for caution in adopting any such policy.”

a.

“Such incentives aim to increase investment, but even if well -timed, their anticipation might be destabilizing, as provisions targeted at new investment can discourage investment prior to enactment.”

i.

Government investment policy changes can be predicted to a considerable extent.

ii.

Temporary investment incentives can exert a more powerful short-run impact by encouraging the speed-up of projects.

iii.

Bonus depreciation was introduced as a temporary measure in 2002 allowing a 30% immediate write-off of qualifying investments.

b.

For firms without taxable income that may become taxable only years later, bonus depreciation is of little value.

i.

This may be an important issue now, given the sharp surge in losses.ii.

Adapt corporate tax rules to make them more symmetric with respect to the treatment of tax losses

1.

Adapt investment incentives that allow for the transfer of the tax benefits.2.

There are two approaches to dealing with this situation.iii.

Bonus depreciation increases the incentive to invest by increasing the present value of depreciation deductions.

c.

Household tax cuts should be constructed in a way that would influence the timing of household decisions, as through a temporary reduction in consumption taxes.

d.

ConclusionsVI.“The current recession provides compelling circumstance for renewed fiscal policy activism. The strong support for fiscal policy intervention reflects a renewed belief in policy activism that had already appeared before the present crisis.”

a.

Since discretionary policy is traditionally not favored, much attention has not been given to its design.

i.

We need to pay more attention to policy design this time around. ii.

We are still relying on past approaches to discretionary policy.b.

Ec 1420 Page 79

Lectures 11 and 12?Friday, February 27, 2009

11:00 PM

Ec 1420 Page 80

Lectures 13 and 14Wednesday, March 11, 2009

11:09 PM

Ec 1420 Page 81

Tax Policy

taxes transfer funds, they also change behavior. In changing behavior, they create DWL.Evaluating a tax system:(1) Efficiency effects and DWL(2) Fairness/distribution issues(3) Simplicity

DWL = (½) t2 ( )QPt= T/P (tax rate)

= elasticity of labor (Q/P)•Lump-sum tax: no tax distortions (b/c tax rate = 0)

Income tax

DWL = ( ½ )t2( )wHH = hours= elasticity of labor supply•

Ways that taxes affect labor:Participation (taking the summer off, retiring early)HoursReducing human capital supply (formal education, on the job training, other kinds of experience)If getting extra educationChoice of occupationSome jobs pay more, more risky, more physically burdensome, etc. Extra pay is subject to taxes, so people will supply less of itEffortRisk takingSome jobs safer (smaller chance of big bonuses or getting fired)Higher average reward for risk path, but government takes some of this reward, so limits the amount of risk taking

How do taxes affect labor income?Depends on form of compensation: Wages (which are taxed)Fringe benefits » government cannot take (e.g. health benefits, parking, etc.)

Fringe benefits: (see graph)If price of fringe benefits reduced by (1-t) where t= tax rate, then people demand more, and there is a distortionTaxes reduce gross income, and change the form of compensation to lower taxable labor income (and increase in fringe benefits)

Itemize deductions: someone can choose to enumerate things on which he spends money (e.g. mortgage interest, charitable contributions, state/local taxes, etc.)Some of these items can be deducted from taxable incomeHigher income tax payers are more likely to itemize deductions, b/c they’re more likely to own houses, spend on charity, etc.High taxes on itemized deductions » downward sloping demand and horizontal supply; so people demand more DWL shows up as reducing taxable labor income

Lecture 15Monday, March 16, 2009

10:21 PM

Ec 1420 Page 82

DWL shows up as reducing taxable labor income

Marginal tax rates reduce taxable labor income byReducing labor supplyChanging the form of compensation into forms that are not taxableFor those who itemize, by consuming more of “favorable consumption items” (items that can be tax -deductible)They all reduce taxable income by the same amountAll are “equally bad”, b/c all distort by (1-t)Increase spending on favorable (deductible) consumption items and increase fringe benefits by (1-t), reduce labor income by (1-t)

DWL = ( ½ ) t2 ( ) (TLI)=elasticity of taxable labor income•TLI = taxable labor income

1986 Income Tax cuts:Reagan and O’NeillTook top tax rate, 50% at the time, and lowered it to 28%, and lowered other rates as wellMade it “revenue” and “distributionally” neutral:Revenue remained the same, b/c these “loop holes” were removed as wellBig increase in taxable income from high income individualsElasticity discovered to be ~1 at this time, but there is debate (could be as low as .5)However, both substantial numbers, and show us that DWL is significant

Implications for increase in marginal tax rate from 30% to 40%:t=.3 »» .32 = .09t=.4 »» .42 = .16DWL = (½)(.07)TLI•Revenue = .05 TLI•

DWL/Rev = .7•Revenue paid + DWL = $1.7 If everyone’s tax rate is raised proportionally, DWL/Rev is .6Every dollar spent has an additional cost of $1.6 from society

Ec 1420 Page 83

Social Security Lecture 1Feldstein thinks social security is the most important fiscal problem facing us today-Today we’re spending a lot of time on the financial crisis today, when we’re out of this, we’ll face the issues of how much money we’ve spent right now –how can we fund social security and medicare?? Costs of these are growing because number of people in group getting benefits is growing.

-

Social Security (OASDI –old age survivors and disability insurance) -- $489Bo

Medicare -- $434Bo

nothing comes close in terms of any other part of budget, defense is next biggest at 4% of GDP

a.Together –$923B, 6.7% of GDPo

Figures for 2007 fiscal year:-

Medicare costs will rise, as more people get older-

Feldstein will focus on Social Security (much of it carries over to Medicare though)-

SS actuaries say that social security costs will rise by 6% themselves, and Medicare will rise even faster-Medicare costs per retiree have been rising faster than GDP in general, no one knows how to slow that down

-

Major driver of taxes in future will be increases in SS and medicare-These are so-called entitlement programs because they are not subject to annual appropriation by Congress

-

Question: how do we continue to provide benefits for retirees without the dramatic increases in tax breaks?

-

Start by talking more generally on how to think about pensions, structure of pensions. In US, we have a pay-as-you-go, defined benefit program (this isn’t the only way to structure this)

-

Then we’ll talk about how our program generally works-Then impact of SS on economy – how does it affect labor supply, savings-Demographic problem, aging of population –challenges going forward-Finally will talk about ideas for SS reform-

We have a private pension and SS system in US-SS program is universal, everyone in US is covered by SS-Private pension depends on if your employer provides it-

Types: Defined benefit, Defined contribution / Investment-based, Pay-as-you-goo

Defined benefit might look like this: benefit = 0.02 (number of years you worked for company) (final wage). If N = 20, benefit = 0.40 (final wage)

a.

Investment based: Saving by the company in form of stocks and bonds – designed so these stocks and bonds can finance benefits that have been promised

b.

Emulates private saving by individual – instead of individual saving money, company saves it and gives it later

c.

Since its an investment based program, this ultimately increases capital stock of country (which occurs when individual saves too)

d.

Defined benefit + Investment-based:1)

Over time, companies have been moving away from DB programs and towards DC programso

Defined-contribution –employer promises a certain percent and then employee can a.Defined contribution + Investment-based:2)

Programs:-

Lecture 18Wednesday, April 01, 2009

9:48 PM

Ec 1420 Page 84

Defined-contribution –employer promises a certain percent and then employee can pick where the money gets invested, how much to put into stocks/bonds, etc.

a.

Employer puts in a percentage of wages, benefit is based on how employee’s investment choices pan out

b.

It is investment based, so it leads to increase in capital stockc.

For someone who changes jobs a lot, he gets very little money because wages have gone up a lot since he had some of his older jobs. Everytime he moves, he stops the accumulation of that pension. Overall, gets very very little in real terms.

More mobile labor force –people change jobs more often so made more sense to have DC

b.

Shifts the risk and responsibility from the company to the employee, individuals prefer this too

c.

Some companies tend to promise more in benefits than they can deliver. When the company gets in trouble, the government has an insurance program that insures this pension program – this gets funded by taxing companies that have defined benefit plans. This tax has been rising rapidly. So companies get out of this tax by closing down their DB plan and moving to a DC plan.

d.

Companies have been moving from defined benefit to defined contribution for 3 main reasons:

o

This is what social security isa.Pay-as-you-go means that the benefits that are paid out to all of the ppl in a single year are equal to the taxes that are collected in that year

b.

Defined benefits = taxes at time ti.Paygo means Bt = Ttc.

Now, we actually collect a little more in taxes than we deal out in benefits (just to smooth things out, not to invest like in other systems)

d.

Tax financedi.Benefits pay out all of the money collected in taxes, thus there is no savingii.No increase in capital stockiii.

Key things:e.

Defined benefit + Pay-as-you-go:3)

In this case, there is a notional defined contribution plan – Italy has this, Sweden has this, China thinks it has a DC, IB plan but actually has a notional DC plan

a.

How does this work? You get an account. Every year, a certain percentage of your wage is credited to that account. The taxes that you pay are used to finance existing benefits (not saved). This is a defined contribution because you are not promised a certain amount of benefits, but you are promised a certain rate of return on your contributions. (ex. If you’re required to put in 10% of your wages every year, then we will give it a rate of return, say 3% -- then you’ll get this 3% return whenever you ask for it)

b.

Very much like an IB account, but there is no savingsc.Where does this rate of return come from?d.Money as you get back as a retiree is more than you ever paid in in taxes. How does this work if there is no real investment in taxes?

e.

Defined contribution + Pay-as-you-go:4)

This is true because of the growth of the tax base. Due to the growing number of workers and growing wages of workers.

e.

1st period – young, earn wage w, N people and pay taxes t – so total taxes paid

Ex. People live for 2 periods.f.

Where does the rate of return come from in a notional DC plan or a pay-as-you-go DB plan?o

Ec 1420 Page 85

1st period – young, earn wage w, N people and pay taxes t – so total taxes paid are: wNt

2nd period – old, retire, get benefits, benefits at time t+1 = taxes collected at time t + 1

So is Bt+1/Tt greater than one? This equals tt+1/tt = wt+1Nt+1/wtNt

g – growth rate of wageso

n – growth rate of populationo

This equals (1+g)(1+n) = 1+g-n = 0.03 (in example)

so this rate of return just comes from the implicit growth in tax baseg.

problem with pay-as-you go system –generates much lower return than other systems (3% versus and maybe 6 or 7%)

o

Allows people to see the differences between the taxes they pay and the benefits they are eventually going to get

h.

This tax is very different from the personal income taxi.If I understand the formula well enough, I can probably understand what the increase in my benefits will be. This type of system makes it much more transparent.

j.

This is true in DB plan too, but DB formula is so complicated that people don’t understand that.

Appearance that it is a pure tax is changed – reality is that you’ll get some backk.

While these advantages exist, this system still has really low rate of returnl.

Differences between notional DC plan and paygo DB plan? What caused governments to switch from DB to DC paygo plan?

o

Do we want to stay in DB, paygo plan or do we want to switch to more clarity with DC, paygo or do we want to switch to DC, IB or a combination of what we have and DC, IB?

-

Roosevelt believed we could provide benefits while taxing younger people who would eventually get benefits later

o

As economists, was it a good reason to create SS benefits with this program? Usually we make decisions like this due to a market imperfection/externality. Feldstein cannot find any externalities here.

o

There are missing markets – there are imperfect annuity markets, and no real annuity markets. Less of a missing market now than there was before.

o

People do not save for themselves.

Back then, people died earlier. Then, many people didn’t get to age 65 and then they’d just move in with family. But now life expectancy is about 7 years greater.

Myopia (short-sightedness)m.

So why don’t we just wait until people get to age 65 and see if they have any money. If people don’t have money, then we’ll give them money. This is called a “means test.” So this makes people with lower incomes not want to save because they’ll just get the same amount from the money from the government.

Gamingn.

We have no idea of telling the people who are plain short-sided from the ones who are trying to game the system.

o.

Real reason for our SS program: combination of 2 thingso

Why do we have a SS program at all?-

We have a DB, pay-as-you-go system. How does it work? Etc. – talk about on Friday-

4/3/09

Ec 1420 Page 86

4/3/09Social Security ReformToday: how social security works in the US-Pay as you go, DB program-

Tax part: (How it is financed)

On all wage a salary income (up to $102,000)o

6.2% tax paid by individuals, 6.2% tax on employerso

Who actually pays the tax is irrelevant – it’s a total 12.4% taxo

Includes a Medicare component of 2.9%, 1.45% by employers and 1.45% by employeeso

Total: 15.3% taxo

Financed by a payroll tax-

No deductions, very different from income tax (where you have deductions for number of people in family, etc.)

-

Since there are no deductions, for more American households, this payroll tax is the largest tax they have to pay (has really grown into a huge tax)

-

Benefit part:Depends on your wages and how much you worked-

sum of Wit/Wt over 35 years of your highest earningso

AIME = 1/420 sum (from 1 to 420) Wit/Wto

Average index monthly earnings (AIME) –take inverse of person’s wage in month t, multiply by average wage of that month

-

Primary Insurance amount (PIA) –amount of benefit that a retiree would get (without a spouse) if they retired at a normal age

-

As you get older, you get more benefit, but at a decreasing rateo

Graph of PIA versus AIME – looks like four line segments that start out really steep and levels out at the top

-

Rule used to be that you can get your benefit at 65, now the rule is that if you were born after 1938, you have to wait longer (2 months more per year—creeps up to age 67 max)

-

This formula looks quite re-distributive –everyone pays the same amount of tax, but benefits are decreasing returns over time

-

Someone with median earnings ($40,307) would get benefits of $16846 per year or 42% of their immediate, pre-retirement income

o

Someone with maximum earnings ($90,737) would get benefits of $26220 per year or 29% of their immediate, pre-retirement income

o

Someone with lower incomes ($18,138) would get benefits of $10224 per year, or 56% of their immediate, pre-retirement income

o

How does this look?-

This makes it look like this is a very redistributed program by percentages-

People in higher incomes start working later, so they pay for less years than the poorer people who generally start working at age 18 (everyone only gets benefits for 35 years of their work, even if they worked much longer)

o

Life expectancy depends on earnings – if you are a high income person, you are much more likely to reach age 65 and get benefits, and you are much more likely to last longer than 65 and receive benefits every year

o

2-earner households. Social security was made for a single-worker home. If there is a spouse, they have the choice of getting 50% of the primary earner’s PIA or they have the choice of getting their own PIA. Women generally drop out of labor force for many years so they get more if they earn 50% of husband’s PIAs. It’s a strange system, where a woman can pay in for many years and get no benefits because of it (because they get money because of husband’s earnings.) If one spouse dies, surviving spouse gets 100% of higher PIA.

o

However, statistics say there is not redistribution for 3 reasons:-

Marginal tax rate is the PIA minus the actuary expected value of future benefits-

Ec 1420 Page 87

Marginal tax rate is the PIA minus the actuary expected value of future benefits-For people who are working not in their top 35 years, they get nothing back for what they put in-For woman who are going to collect on behalf of their husband, they get nothing for what they put in-

Many people are choosing this routeo

If you choose to retire early (within 36 months of retirement age), you get a lower benefit based on how early you retire (FRA –36 months)

-

If you choose to delay retirement, there is an actuarial adjustment. Benefits rise by 7% per year.-

Historically, SS began as a much smaller program. When it began in the 1930/1940s, it began as a 2% tax. By 1960, it was a 6% tax. By 1980, it was a 12% tax including Medicare. Since 1990, it is a 15.3% tax including Medicare.

-

Bt+1/Tt = (thetat+1/thetat) (Wt+1 Nt+1 / W2 N2)-If you were lucky enough to be working in the 40s and then getting benefits in 80s, you paid only 2% while workers in 80s were paying 12%…get a much higher rate of return

-

In lifetime, taxes paid by both him and his employers were total: $68000o

In less than 6 years, he would get everything he paid in plus interestp.Benefits that he gets in 1989 for himself/spouse are: $15000 (CPI indexed)o

His life expectancy was 16 years, so he expected to get $255,000 total before he diedo

Example: Joe was born in 1923, works from 1948 to 1988, has max salary-

This good deal was there because of the growing population and growing tax rate-Our generation will be hurt by the demographic shift –more retired people and not a growing tax rate. We will get a negative rate of return because we are at the higher end of the spectrum.

-

Social Security Trust FundIs just an accounting device – taxed money goes in, all benefits must be paid from trust fund-Once the trust fund benefits are used up, then there’s no money to pay benefits.-What happens in future when taxes aren’t enough to fund benefits? Government is going to issue bonds from trust fund.

-

Something has to change when this happens.-

How does Social Security affect the economy?Has enormous effects of labor supply, savings behavior, etc.-

Effect on Labor Supply:-

Guy earns $40,000 pre-tax. Pays: income tax of 4000, Payroll tax of 3000. Net pay is $33000o

If he chooses to retire, his benefits would be $17000. So his net reward for work = $16000.o

He’s facing a 60% effective tax rate in his marginal decision to decide whether to work –very big distortion here.

o

Effect of SS on retirement age people:-

Middle income person whose tax rate is 25%, Massachusetts tax of 5%, and payroll tax of 15% -- total tax of 45%. Should subtract present actuarial value of benefits (PAVB) which is 8% (since they’re working in top 35 years and will get benefits based on what they pay in payroll tax). Thus, total tax is 37%.

o

Tax DWL is really high.o

Effect of SS on pre-retirement years:-

Effect on Saving:-Replacement rate –how much of income you get back through SS-Replacement rates for pre-tax income: 41%, 60+% if individual has spouse-Replacement rates for after-tax income: 70%-(will be indexed for inflation, so will keep pace with inflation)-An old couple, has a house that’s paid for, has medical bills paid by Medicaid, medicare would cover them if they needed to go to a nursing home. So they have little incentive to save at this point.

-

2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to -

Ec 1420 Page 88

Savings w/o SS – enough for 70% of pre-retirement incomeo

Savings w/0 SS – enough for 20% of pre-retirement incomeo

2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to survive after retirement, so they calculate how much they need to save to get 70% of pre-retirement income.

-

Because of social security, savings when people are young is about 2/7 of savings if there were no SS-

4/6/09Social Security ReformQuestion: since SS reduces saving during working years but also reduces dis-saving during retirement years, what is the net impact on aggregate saving for the economy as a whole?

-

Why don’t they just cancel out? They would cancel out in an economy that wouldn’t grow. If each generation of savers were the same size and had the same growth as the previous economy. But in reality, the economy grows –more young people, higher average incomes

-

Thus, for economy as a whole, we see a positive savings rate-

Over the past few decades, savers started saving less. And retirees started consuming more –dissaving of dissavers increased. Thus aggregate savings rate in economy came down from 10% in early 1980s to essentially 0 currently.

-

Now with collapse of wealth, household savings rate has returned to 5%...estimated to increase as wages rise –so people can gradually increase their consumption and their saving.

-

SS increases saving and dissaving, but in a growing economy has the same net effect-If each individual reduces his or her saving by 5/7th, then aggregate saving will decrease by 5/7th-

Creates a smaller savings rateo

--o

Lower productivity, lower growth in productivityo

Net impact of SS:-

Currently, we have 3 workers per retiree. By 2020, there will be only 2 workers per retiree.o

Because of the retirement of the baby boom generation – this is accelerating the trend of rising number of retirees per worker

o

What is forcing politicians to take this problem seriously? The aging population. In the future, there will be more retirees for workers.

-

We must have a 50% increase in the tax rateo

However, with the smaller tax base –we need an even higher tax rate to get same revenue

q.

Personal tax rate/payroll tax would probably actually have to rise to 22%r.

Right now, we have 3 workers paying 12.4%, then we must have 2 workers paying 19% (50% higher)

o

Implication of this?-

Today we have combined marginal tax rate of 0.25 + .05 + .15 = .45, it will go up to .55o

DWL of tax will increase by 50% (is proportional to square of tax rate)o

Net impact: 10% increase in personal tax rates. This has an enormous impact on DWL.-

Cut benefits: could scale back benefits by a thirdo

Change retirement ageo

Change inflation index –so benefits don’t automatically increase with inflationo

What is the alternative?-

All of these changes impact different groups of people in different ways, all of these would be hard to pass

-

This is the way our private pensions worko

There is a better way – partially or fully finance benefits in an investment based way-

Advantages to this plan:-

Ec 1420 Page 89

Has higher rate of return. Don’t have to save as much during working yearso

Advantages to this plan:-

Paygo system rate of return of 3%, IB system of 7%o

Person works from age 25 to 65 and gets benefits from 65 to 85. So simplify by saying person does ALL of saving at age 45 (right in the middle) and ALL of their dissaving at age 75 – this model fits actual numbers very well

o

with 3% rate of return gets $2427 in benefits laters.with 7% rate of return gets $7612 in benefits latert.

Person saves $1000 over 30 yearso

implication: 19% payroll tax could go down to 6% tax in IB plano

Lets compare a paygo system and IB system-

Transition generation might have to make a huge sacrifice, paying double taxes to support retirees and to support new program

o

Answer: yes, we can – if we do this gradually we can shift systems. We can gradually shifto

Question: can we get from a paygo system to an IB system?-

Answer: it would be quite risky. If we went to a pure investment-based system –would impose risks which most people would say are too high.

o

Second question: How risky would this be?-

At age 67, median annuity that could be paid out would be 1.41 x “benchmark”o

Lets look at the 30th percentile of retirees –0.92 x “benchmark”o

At 10th percentile of retirees – its only 0.52 x “benchmark”o

At 1st percentile – its only 0.26 x “benchmark”o

This is too high of a risk for individual retireeso

Let’s think about an IB system with savings rate of 4%, where we invest 60% in stocks, 40% in bonds-

Guarantees would add into national debtu.We could have an IB system where government provided guaranteeso

Mixed system where we use paygo and IBo

What should we do then?-

Use IB to provide high returns, use paygo to provide less risky baseo

Mixed System:-

Feldstein’s research projecto

Strategy: mixture of paygo system and personal retirement accounts (PRA) that would generate IB annuity

o

we wouldn’t actually reduce benefits, they would just grow more slowlyv.idea is to gradually reduce paygo benefits relative to current lawo

while substituting PRA annuities for missing paygo benefitso

if we combine these two, could we maintain retirement income? YES.o

Is it possible to 1) retain the current retirement income of retirees, 2) not raise the payroll tax rate from 12.4%, 3) not use general revenue funds/not run a deficit further than what is allocated for this, 4) achieve a permanent solution (a lot of plans only achieve temporary solutions), and 5) to avoid serious risk?

-

Paygo accounts would continueo

Everyone would get a PRA account – should it be mandatory or voluntary, if its voluntary should it be automatic enrollment? (automatic enrollment has a very high impact on participation rates)

o

The amount that has to be paid is very small (1.5%) in the transition periodw.

Each individual, in order to participate, must put in 1.5% of covered wages from out of pocket (referred to as an “add-on”)

o

If the individual does that, then the government will match by taking 1.5% of covered wages from the payroll revenue (referred to as a “carve-out” system)

o

Funds are invested in diversified portfolio –60% stocks, 40% bonds (diversified, no strong

How this scheme would operate?-

Ec 1420 Page 90

Funds are invested in diversified portfolio –60% stocks, 40% bonds (diversified, no strong bets on one thing)

o

Main reason: to avoid potential government interference in investment practices. These accounts grow really rapidly—funds that accumulate in this way add up to 50% of GDP. Thus, Congress would pass rules saying that you couldn’t invest in companies that outsource jobs/bad industries/etc. There would also be pressure to invest in social investments, housing etc. This would be bad, would cause smaller rate of returns for peoples’ accounts. It would also cause a huge interference in markets.

x.Why individual accounts? Why PRA way?o

Feldstein has analyzed this based on personal retirement accounts. Has found a real rate of return of about 7%. Calculations reduce this number to 5% (to have a margin for uncertainty, for accounting purposes). At retirement, persons would receive an annuity based on same combination of stocks/bonds. If individuals die early, before they reach annuity stage, this would trigger bequest benefit –all of these funds would go to heirs.

o

Someone who has been in this system for 15 years would get paygo benefits equal to 91% of benchmark

o

Someone who has been in this system for 20 years would get paygo benefits equal to 85% of benchmark

o

Someone who has been in this system for 40+ years would get paygo benefits of 60% of benchmark

o

We can’t afford to continue paygo system, so we will gradually decrease paygo benefits-

Replace lost income from paygo benefits with personal account annuities-

Benefits of 150%o

2050: benefits of 120%o

2070+: benefits of 130%o

We don’t need benefits so much higher than benchmark so could scale back tooo

Combined amount:-

Transition people will have to pay double. To meet demands of current retirees and to pay for your own in the future. However, this plan minimizes transition costs

a.

Variant on this objection: won’t this deplete the trust fund? Yes, but we are also reducing the benefits that come out of the trust fund. Calculations show that trust fund never goes negative.

b.

What about the transition costs?1)

SS is very effective in that there are very low administrative costsa.PRA systems’ administrative costs seem relatively large…b.

Administrative costs2)

Objections to this plan:-

*will finish this on Wednesday

4/8/09Finishing Social Security ReformFrom last time, we talked about how the transition to a mixed system would be feasible-What’s wrong with this new system?-

Transition costs (look above)o

People say that we get rid of a lot of administrative costs in current system. They point to Chile/Mexico as examples of countries with high administrative costs. However, this is due to the way Chile/Mexico set up their SS program.

y.Administrative Costso

Objections to the Plan:-

Ec 1420 Page 91

this is due to the way Chile/Mexico set up their SS program.These countries gave their people a lot of choices, with a lot of different systems to choose from. This caused administrative costs to rise. They didn’t give the people incentives to pick from the most cost-efficient programs.

z.

Ways to avoid administrative costs: Best alternative is to have funds collected by payroll. Limit frequency by which people can change plans. Investments must be in broad indices so you don’t pay fancy management fees. Estimated that costs would be less than 30 basis points (30 hundredths of a percent).

aa.

Current system is not very redistributive. We could make new system redistributive by adjusting payroll tax to make it more redistributive or adjusting benefits.

bb.Redistribution (check this?)o

Pure IB plans are risky. In a mixed system, risks are much much lower.cc.

What does this mean? In 40 years from now, if stock market literally goes to zero, you’ll only have 60% of what you put in. (Stock markets don’t go to zero, though.)

15 years from now: the only risk you would have are between 91% to 100% of amt you put in, in 20 years: 85%, 40 years: 60%

dd.

Median: In 40 years, a person putting in 3% of wages, has a 50% chance of getting 1.06 + 0.60 = 166% of benchmark

ee.

30th percentile: in 40 years… combined benefit will be 1.29% of benchmarkff.10th percentile: in 40 years…combined benefit will be 100% of benchmarkgg.Thus, there’s a 90% chance that you’ll do just as well in this system as what you put in!hh.Looking further, at 1th percentile combined benefit would be 80%, this is a low risk, 1 in 100 people

ii.

Risko

So far, it has almost happenedo

President Clinton presented a really detailed plan for transition to retirement-based accounts. Clinton was about to implement this when he was impeached

o

Republicans and Democrats never got to sit down at table and figure this out.o

In speech to congress recently, he said one of the major long-term problems we face is SS and how we are going to finance the benefits for future seniors.

jj.

In that context, he said, “we need a universal investment based account”kk.This wouldn’t be part of SS. The idea is that everyone would have an account, so when trust fund goes to zero…we wouldn’t have to raise taxes as much and can ask people to rely on the universal investment based account.

ll.

He said that all employers must automatically enroll employees in an IRA.mm.Feldstein thinks that if this happens, it is the first step to moving towards a mixed system.

nn.

What about Obama?o

Will this mixed system happen?-

Ec 1420 Page 92

Social Security Lecture 2In reality, the economy grows so the saving of the savers exceeds the dissaving of the dissevers.

-

What happened recently has been quite unusual: we used to have a savings rate of approximately 10 percent. As people became wealthier, people saved less during their working years and the retirees consumed more. The savings of the savers was less and the dissaving of the dissevers was more. The savings rate declined to nearly 0 in the past several decades. In the recent recession in abruptly climbed to 5 percent.

-

Even though Social Security discourages savings and encourages dissaving, it has the same net effect in a growing economy. The net impact of Social Security is to create a lower national savings rate, a lower increase in the Capital Stock, and hence lower productivity.

-

The action-forcing event: The aging of the population. Going forward, we can predict with certainty that there will be more retirees relative to the number of workers. By 2020, there will be only 2 workers per retiree. The reason that this transition will happen very fast is the retirement of the baby boom generation. The baby boom accelerates a trend that is the rising number of retirees per worker.

-

If we want to retain the same formula that we do today, if we go from three workers per retiree to two workers per retiree, we are going to have to increase taxes per worker by 50 percent. The higher marginal tax rate shrinks the tax base, implies higher tax rate to get same amount of revenue, the personal income tax revenue will go down as a result of the shrinking of taxable labor income. We may need to go up to about a 22 percent payroll tax. Net effect of increase of 10 percent in marginal tax rates.

-

We have a combined a marginal tax rate today of about 45 percent. This would go up to 55 percent. Deadweight losses are proportional to the square of the marginal tax rate – There is about a 50 percent increase in the deadweight loss of the tax.

-

What is the alternative? 1. To cut benefits – We would need to scale benefits back by one third. 2. Change the retirement age. Push the retirement age forward by four or five years then the cost of the program will be cut by one third. 3. Change the inflation indexing so that it doesn‘t already increase with inflation. These different ways of dealing with it affect different group in the population differently. None of this is politically easy to image passing.

-

There is a better way: partially of fully finance benefits on an investment-based way. Employers take some of salary and invests it and continues to pay paychecks when workers retire.

-

Advantages of investment based program: 1. Higher rate of return so that you don‘t have to set aside as much during working years.

-

Compare Paygo and Investment Based system: Someone who works from 25, retires at 65, and passes away at 85. Think of all saving at 45 and all of retirement consumption at 75 because these lie in the middle of the working and retirement spans. Saves $1,000 at 45 and gets $2427 with a 3 percent rate of return. With a 7 percent rate of return, they will receive $7,612. The implication is that you need only one third as much saving with a seven percent return than with a 3 percent return.

-

If you do it gradually, it is possible to get from a pure Paygo system to a pure Investment Based system in which the tax rate would come down to just 6 percent. How risky would this be? Quite risky – A pure Investment Based system would pose huge risks for the average retiree.

-

Say we have Investment Based system in which savings rate is 4 percent versus 12 percent. We invest in a portfolio where stocks are 60 percent and bonds are 40 percent. The median benefit per median retiree would be 1.41*Benefits that Median retiree would expect to get under current law. The median worker would be ok but let‘s look at the 30th percentile. They would receive 92 percent of the benchmark, at the 10th percentile, it is only 52 percent

-

Lecture 19?Monday, April 06, 2009

10:05 PM

Ec 1420 Page 93

They would receive 92 percent of the benchmark, at the 10th percentile, it is only 52 percent of the current benefits. At the first percentile, the benefits would be only 26 percent. If we did this at 77 rather than retirement age, we would find even lower annuities relative to the benchmark. We could go to a pure Investment Based system where the government provided guarantees of topping off benefits.

-

Marty wants to consider a compromise of a mixed Paygo and Investment Based system. He wants a system that can do the following: 1. Not use general revenue funds, 2. Not raise payroll tax rate, 3. Keep benefits of current retirees, 4. Achieve a permanent solution, and 5. Avoid too much risk. Mixture of current system and current retirement accounts that generate an annual annuity. Reduce Paygo benefits relative to current law and substitute PRA annuity for missing Paygo benefits. If we combine these two, we can maintain retirement income.

-

How would it work? 1. Paygo accounts continue, 2. Everyone would get a personal retirement account (do we make voluntary or mandatory or automatic enrollment), 3. In order to participate, each individual must put in 1.5 percent of covered wages from out of pocket – the amount that needs to be paid is very small in transition (carve out) and government will match by taking 1.5 percent of the payroll tax from the payroll revenue (add-on because we add more money to the current system), 4. these funds invested in a diversified portfolio – the same 60-40 mix of stocks and bonds, 5. You can only change once a year. We will limit tax rate to 12.4 percent. Gradually reduced Paygo benefits.

-

Why individual accounts rather than a single central account? 1. Avoid potential government interference in investment decisions. Personal accounts grow very rapidly. The funds accumulated in this way would grow to 50 percent of GDP. The Social Security administration would have a lot of say in how the economy operates. The temptation to allocate funds away from a variety of things would be bad and there would be the pressure to do things like social investing in housing, schools, healthcare, etc., and a great interference in the economy, and a system of private accounts with managers would protect it from government expropriation.

-

For past 60 years, a 60-40 portfolio produced a real rate of return of 7 percent but administrative reasons reduced this to 5.5 percent. At retirement, individuals would get an annuity based on stocks and bonds. If individuals die early, all of the funds accumulated before started annuity would go to people that I designate as my heirs. People often opt for ten year certain – promise that individual will get benefits for at least 10 years and if individual dies during those years, benefits go towards heirs.

-

Ec 1420 Page 94

Destabilize economieso

Global economic downturn

Economics of National Security

We raised the military stakes and their economy could not keep up with theirs

o

Russia could not keep hold of the empireo

Cold war

Russia still has nuclear technologyo

Nuclear material to be stolen/purchased

Russia is dangerously unprotectedo

Russia has energy policy that threatens European allies

Russia has gas reserves that control gas pipelineso

Russia’s triple threat.

Russia

Chinese conflict with Taiwan

Use it to justify confrontation with Taiwan o

Resources in China is low as is GDP per capita but growing very fasto

China will likely eventually spend more on military than America

Military strength depends on aggregate GDP and % spending on defense

o

Chinese military buildup

China

Major powerso

Small and poor

Demonstrated nuclear capabilities

Japanese worry that NK will attack them

Could raise money by selling nuclear material to another country or extremists

North Korea

Enriching uraniumo

Delivery mechanismo

Developing nuclear weapon

Dangerous to their neighbors

Nuclear capabilities allows them to be aggressive in a non nuclear way

Iranians

Entire government unstable

Pakistan

Small nuclear powerso

Organized international force

Train terrorists

Organized terrorism greater threat in Britain because of large Pakistani population

Will America face alienated population that will damage this country?

Al qaeda

Stateless terroristso

Military threats

Why would countrys stop shipping to the USOil

Threats

Lecture 22Monday, April 13, 2009

10:19 PM

Ec 1420 Page 95

This would require more than one country to cooperate in not shipping

If cooperation/intimidation of rich states, then those states (UAE) could bankroll others into financing their activities

Stateless terrorist actors can disrupt flow of oil

Why would countrys stop shipping to the USo

Sensitive to global price of oil

Risks to trade with other countries dependent on countries who need oil

Dependence on oil has grown over timeo

Cyberespionageo

Foreign power to shut down our utilities

Risk of extortion/terrorism

Cyber attackso

Cyberterrorism

Mutually assured destruction between US and USSR was stable outcomeo

Mitigate this risk by having second strike capability

Advised that we teach the Russians this to arrive at nash equilibrium

USSR used to worry that US could strike first, neutralize their capacity and win the waro

Game theory to stateless actorso

Studying strategy of warfare by Tom Schelling

More educated and more affluent are more in favor of suicide bombing

Reducing poverty through economic growth would take decades to make a difference

Poverty causes terrorism seems to be a mytho

Understanding sources of terrorism

Sanctions on Iran and North Korea

Need access to cash for luxury goods

NK leader agreed to restart six party talks

Sanction cut off access to banks for NK

Economic weapons

Outside of US state companies control oil and major source of budgeto

Since demand is quite inelastic we can increase supply which should lead to significant reduction in price

o

Oil

Take it out of economic growth (although fiscal deficits)o

Tax expenditures can be diverted to national securityo

Optimizing defense spending

Ec 1420 Page 96

Lectures 23 and 24Wednesday, April 15, 2009

10:33 PM

Ec 1420 Page 97

Health Care Policy Lecture 1

o

Need to construct effective health care policy

Insurance is valuable for risk averse people because health care is highly variable and Role of insurance in driving care

Lecture 25Monday, April 20, 200910:09 PM

Ec 1420 Page 98

Insurance is valuable for risk averse people because health care is highly variable and potentially very expensive

o

Role of insurance in driving care

When price is lower consume moreo

Health insurance lowers price of marginal consumptiono

Moral hazard drives higher consumption

Purpose of insurance is to insulate from costs in bad state of the worldo

Both extremes skew incentives of physicians and patientso

Try to provide risk protection but all imperfecto

Pay based on outcome or pay based on symptoms?

Physicians bears a lot of risk and does not want to treat for someone with bad health conditions

Patients and physicians affected

Contracting problem –capitation, pay for performance, cost plus

Any way around it?

Fundamental tradeoff between risk protection and moral hazardo

Moral Hazard vs. Risk protection

Buyers: potential enrollees with different propensities to use serviceso

Sellers: Health plans competing for enrolleeso

Young healthy people know that have de facto social insurance as hospitals cannot deny them care

Individuals have an incentive to wait to get an insurance until sick

Insurers have an incentive to attract healthier enrollees

Premium spiral where unhealthy people buy into insurance plan causing insurance company to raise premium and the cycle repeats

Ideally want health people to buy into insurance and lock in at low premium

Asymmetric information: enrollees know more about health status than insurerso

Adverse Selection in Health Insurance Markets

Choices among plans foster competition, but facilitate adverse selectiono

Employer sponsored market

Non-group market

One of reasons group market is appealing –ready – made risk poolso

Avoiding Adverse Selection

If workers fully value benefits and wages are unconstrained, workers pay for benefits in form of lower non benefit compensation

o

Mandated benefits may not be fully valued

May not be in tha worldo

Note that employer mandates and individual mandates likely to have quite different effectso

Who bears burden of Employee Sponsored Insurance

Because workers risk losing insurance when change jobs, less likely to move if sick

Job locko

Individuals underwriting in non-group market; health status affects premium

Hinges on difference in underwriting between group and non-group marketso

Additional Consequences of Tying Insurance to Employment

Less costly to adminster

Bargaining clout

Economies of scaleo

Can be undermined by choice among plans- more on this below

Adverse selection limitedo

If pay care out of pocket, paying with after tax dollars

Tax favored treatment of health insuranceo

Why is ESI preferred to non group market

Premiums paid through employer not subject to taxationCurrent Tax Treatment of Health Insurance

Ec 1420 Page 99

History rooted in WWII price controls

Makes a big difference on margin

Premiums paid through employer not subject to taxationo

“tax expenditure” on ESI larger than federal share of Medicaid spending

Huge but hidden public expenditureo

Current Tax Treatment of Health Insurance

Against those who obtain insurance on non group market

Against out of pocket spending

Two bviaseso

Regressive

Higher income

Who benefits the most from current treatmento

Unlevel Playing Field

Next week will discuss health reform proposals that include changing tax treatment of ESIo

Associated with dip in cost growth in mid 90s

Recent movement towards lighter managed care

On private side, movement towards managed careo

Choice among plans can promote competitiono

Improving Efficiency of ESI

Case Study: Harvard University

Balance of risk protection and moral hazard

Insuance likely to promote higher spendingo

Promoted by tax code

Fosters risk pooling

Favors inefficiently high spendin

Most private HI in US through employerso

Summary

Ec 1420 Page 100

Health Care Policy Lecture 2

Review

Private health insurance dominated by employer sponsored insurance (ESI)Review

Lecture 26Wednesday, April 22, 2009

10:12 PM

Ec 1420 Page 101

Private health insurance dominated by employer sponsored insurance (ESI)o

Facilitates risk pooling

Disproportionally consume extra medical goodso

Minimal cost sharing

Covers first medical cost (unlike other insurance)

Strong tax bias in favor of getting health care that way

Promoted first dollar coverage

Has labor market implications

Employer system rooted in tax treatmento

In 1960, government responsible for only ¼ of US health spendingo

Public check to private providero

Pay for private services with public dollars

Start with hospital only to appease AMA

Compromise when national health insurance unlikely

By 1970 government share of spending incrased ot 38%

Now almost half –more if consider implicit tax subsidies

Adoption of Medicare and Medicaid in 1965 resulted in significant expansiono

Rising role of public spending

Covers 45 million including elderly and uninsured. $431 billion in 2007o

Medicare has substantial effect on private health careo

Rising health care costs

Unfunded liability of medicare is 5 times greater than social security

Medicare spending growing more rapidly than social security not because of retirement of baby boomers but rather extra spending per person.

o

Part A: Hospital care, automatic enrollment

Part B: physician and outpatient care, voluntary enrollment

Coverageo

Covers only half of health spending on elderly

Elderly spend more than 20% of income on health care

Significant gaps in coverageo

Medicare

As major consumer of health care, Medicare prices and coverage patterns drive overall utilization

o

Introduction of medicare responsible for major ramp up in spendingo

Medicare Major Driver of Patterns of Care

Initially a retrospective cost plus reimbursement systemo

Introduction of prospective payment systemo

Interest now in pay for performanceo

Aimed to introduce care managemento

Cost containment in Medicare

More than 16% of Medicare beneficiaries enrolled in managed care plans

Since 1985 beneficiaries have had option of choosing an approved managed care plano

Imperfect but operational

Separate issue of average payment level

Risk adjustment ot mitigate adverse selectiono

Some systematic level of overpayment

Needs further adjustment

Medicare managed patients will drive more efficiency for the rest of patients

Effects on efficiency of careo

Medicare Managed Care Part C

Before 2006, prescription drug coverage was not included in medicareo

By 2006 90% had rx coverageMost significant medicare benefit expansion in almost 40 yeraeso

Medicare Rx Coverage Part D

Ec 1420 Page 102

By 2006 90% had rx coverage

Dually eligibly automatic enrolled

Administered by private D plans for fee for service enrollees

Plans bid to provide coverage in given region

Donut hole of spending for Medicare Part D paying for patientso

Enrollee premium about 25% cost average of $37 montth in 2006

Subsidies for premiums and cost sharing for low income

Enrollee cost structure o

Enrollees must have choice of at least two competing plans

Plans differ based on deductible, premium, copayments and formularies

Plan competitiono

Enrollees choose lower cost plans

Most have “donut hole” coverage

Early evidenceo

Cost for Part D

Medicaid joint federal state program for some low income populations

SCHIP joint federal state program for low income children

Subsidize low income states

Federal government reimburses states relative to their income

Medicaid spending is crippling states at the moment

Programs based on categorical elibigibilityo

More than 46 million non elderly uninsuredo

Coverage for non-elderly

Balance health care benefits with DWL

Needs to raise revenues to cover costs DWLo

Some people switched their private insurance for public insurance

Potential to affect private health insurance coverageo

Effects of Publicly Financed Low Income Insurance Coverage

47 million uninsuredo

People move in and out of insurance and eligibility

Around of those uninsured at a point in time are uninsured for a whole year

Dynamic processo

So who is unsinured

Disproportionately but not exclusively low incomeo

Smaller firms are less likely to offer ESI

Mostly in working familitieso

Non white populations at higher risk of uninsuranceo

Some people are eligible for public insuranceo

Uninsured are heterogeneous

Income –health care is expensiveo

Samaritan’s dilemma – free rider problemo

Cross subsidies mean low risks often paying more than expected costs

Exacerbated by different premium restrictions in large group, small groups, and non group markets

Pricing problems – insurance is a bad deal for someo

Why are people uninsured

Health externalitieso

Care about well being of low income people

Value some kind of consumption more than others

Primary care more cost effective than emergency care

Adds particular interest in efficiency of care consumption

Paternalism/redistributiono

Why should we care about uninsured

Ec 1420 Page 103

Primary care more cost effective than emergency care

Ec 1420 Page 104

Health Care Policy 3

Less likely to use preventative care

More likely to report postponing needed care, being unable to fill prescriptions

Uninsured report worse access and outcomeso

Insurance Status Related to Care and outcomes

Lecture 27Monday, April 27, 2009

10:14 PM

Ec 1420 Page 105

More likely to report postponing needed care, being unable to fill prescriptions

But: causal effects hard to nail down from observational studieso

Don’t be misled: uninsured spend less than insured, so extending coverage unlikely to be cost saving

We care because of paternalism, but may also suggest potential ties between covering uninsured and cost growth

o

Increase insurance overage – increase access

Stem rising health care costs – make system more “affordable”

Two common goalso

Who bears burden of consumption. Individual payments/risk pooling among people with similar risk/general revenues

Reducing inequities in financing

Additional related goalo

Rising costs may have put reform at top of domestic agenda –but is minimizing costs right goal

o

Reform goals

Health care dollars not allocated to highest value useso

Consequences of inefficient Spending

Attempts at broad implementation of national health insurance schemes largely unsuccessful

o

But: Crowd-out, public costs, diminishing effectivenesso

Expansion of Medicaid SCHIP

Incremental federal reforms

But: limited toolkid, heterogeneityo

Income tax reform

Federal government has policy levers that states do noto

Mandates, state programs, purchasing collectives

State reforms

Narrower reforms more successfulo

Reform Strategies

Need insurance because of RISK and COST

Insurance is about Risko

Principles for Evaluating Reform

Uninsured sick people need health care not health insuranceo

Insured people whose expected costs go up

Uninsured people whose expected costs are high

Perhaps not most efficient way to pool risko

Subsidy that pushes people of disparate risks in same pool is social insurance

When people start with different expected costs that are hard to distinguish without some socialized insurance

Two separate problemso

Redistribution from low-risk to high-risk is hard to do through private markets alone

Social insurance need not be socialized

Key distinction between social insurance and private insuranceo

Uninsured Sick People need Health Care

Insured people consume more –but get much more health

Offsetting reductions in efficient utilization –but not total

Will need to devote resources –but can be money well spento

A few procedures that are cost –saving

Many more that are cost-effective

Lots left that are wildly cost-ineffective

Corollary: preventative care doesn’t pay for itself eithero

Covering the uninsured unlikely to pay for itself

Employees Bear Burden of ESI

Ec 1420 Page 106

Employers mandates does not equal individual mandates

Not instantaneous or 1 for 1 though

Ultimately comes out of wages

Retiree benefits are more complicated

Corollary: health care costs for current workers not primarily an issue about competitiveness

Empoyers don’t pay for health benefits –workers doo

Has negative effects on labor markets; reduces efficiency of health spending is regressive

Has advantages for risk pooling so wouldn’t want to eliminate without good alternative in place and transition strategy

Employer-based system promoted by tax codeo

Employees Bear Burden of ESI

Strong evidence of price sensitivity and moral hazard, but

premise is that individual payments don’t make best choiceso

higher marginal payments to regulate consumption

Evidence that some copayments may reduce efficiency of utilization

First dollar coverage generates a lot of inefficiency, but nothing magic about HDHP/HAS structure

o

Proposals such as risk adjusted vouchers

Insurer competition may lead to innovation –but need to eliminate incentive to shed sick enrollees

o

Slow to innovate, not particularly efficient

Single payer system not magic bullet eithero

High deductible Plans not magic bullet

Different effects on cost growth

Subsidy of marginal additional care

Subsidy of particular insurance forms

Payment for quality v quantity

Results driven by price and income effectso

Magnitude of incentive for coverage

Size of low income subsidy

Risk poling and subsidy of insuance for chronically ill

Income

Health risk

Different effects o ndistribution of burden

Different effects on insurance overageo

Evaluating Reforms:

Anyone whos taxes go up or whose insurance group changes, feel like losers and therefore form more effective political lobbies

o

Uninsured are not voters, but insured may soon become uninsured so they are an important voice

o

Problem if winners are more diffuse, harder to measure

Winners and losers

Problem if policy is hard to explain

Simplicity

Problem if effects unfold over years

Immediacy

Problem of does not have natural allies and advocates

Problem if leaves no room for negotiation and compromise

Strategy

Politics affects both goals and metrics of successo

Politics of Reform: Economics not only factor

Increasing information availabilityClasses of Reforms

Ec 1420 Page 107

This information is hard to evaluate

Prices, quality

Purchasing collective (with or without public option)

Increasing information availabilityo

Pay for performance

Provider and insurer competition

Public insuranceo

Anyone with private policy gets same deduction

ESI contributions reported as taxable income (for individuals not employers)

Value would not vary based on premium, source of insurance

Flat deductiono

A

Flat Credito

Capo

Proposals for Reforming tax Code

Uninsuredo

Insuredo

Moving people away from employer program would create high transition costs

Nongroup –vs employero

How would different grups fare

Provider payment formso

Promoting insurer competitiono

Introduction of comparative effectivenesso

Public Insurance Reforms

Some pareto reforms but quickly exhausted

Few cost saving, quality imporiving interventions

Evaluate trade-offs: Insurance coverage and financial protection(short and long run

Tough choices will be necessaryo

Focus on promoting high value insuranceo

Conclusions

Ec 1420 Page 108

Lecture 28Wednesday, April 29, 2009

10:14 PM

Ec 1420 Page 109

Prior recessions caused by Federal Reserve

Rating agencieso

Financial institutionso

How risky these securities areo

Culprits

Couldn’t use monetary policy because credit marks were dysfunctioningo

Traditional channels of lower interest rates resulting in greater lending and mortgage borrowing did not happen when home prices were falling at double digit rates

Focus from reliance on monetary policy to fiscal policy

1/3 of househould wealth lost

Decline in stock prices and real estate

Fall in residential construction

Fixed investment fell 50% from Q408 to Q109

No supply or demand for business investment

Focus over 1-2 years

Significant portion of one time reduction

Multiplier / accelerator effectso

Annual Gap of GDP of $750 billion with annual stimulus of $250 billion

$800 billion stimulus

Counter sharp fall in aggregate demando

o

Dysfunctioning credit marketso

30% of loans are underwater

Half of all homesales in California were foreclosures

Plan to deal with affordability problem rather than correct high LTV (they can get political support for people who are struggling to stay in their homes. Much harder to

Housing market stabilizationo

Administration goals

$60 billion a quarter from stimulus, one time increase in levelo

Annualized rate (1.5% 6%)o

In Q109 DI rose by 9% because of tax rebates and transfers (1% increase in GDP) and that gives you 5% at an annualized rate. Some of that increase in disposable income will carry over to second quarter but it is based on one time increases in tax rebates

o

We are going to see temporary strong second quarter

Fed buying mortgages, assets backing credit cards, buying commercial real estate,

Shut them down or infuse additional capital

Not adequate because only looking ahead 18 months

Stress testso

Real estate loans

Gov provide credit from FDIC or Fed of $6 for every $1 from investors

o

Goal is to buy $500 billion in toxic assets aim to cleanse balance sheets

o

Private investors will bid for them in auction and government will invest in parallel (50% contribution of government)

Banks will offer toxic assets for sale

PEPIPo

Treasury fixing banking system

American Economic Policy Final Lecture

Lecture 29Friday, May 01, 2009

10:14 PM

Ec 1420 Page 110

sheets

Keeps toxic assets in private hands

Don’t have to go to congress

Not enough. $2 trillion of toxic assets

Will shareholders like this because of dilution of equity?

Treasury should tell them they will provide them additional capital from the hole that will develop from selling toxic assets

o

Banks are going to be reluctant to put forward securities because of prices to affect mark to market

Criticisms

Explosion of reserves for banks as they hoard cash and deposit it at the Fed

$700 billion excess reserves that can create inflationary

Problem is excess reserves not created by buying treasury bonds

Usually Open Market operations to sell bonds to take cash back from banks

Will banks want to buy back assets they got rid of.

Fed buying wide range of unsecure assetso

Top marginal tax rate will be over 50%

If cap and trade plan goes through as they tighten Co2 limits, the value of these permits will go up. Price of permits will go up to substantial numbers.

Budgeto

Long term concerns

Ec 1420 Page 111

8. Environment Policy (February 27, March 2, 4 , 9 ) Professor Robert Stavins

a. Basic Analytics of Environmental Policy (February 27)

Don Fullerton and Robert Stavins. "How Economists See the Environment." Nature, volume 395, pp. 433-434, October 1, 1998.

-In fact, markets are only perfectly efficient if there are no public goods, no monopolies, perfect information, no externalities, etc.

-Economists consider how the government can correct these factorsby limiting access to open-access resources or restricting emissions, for example

-Universal markets – idea that universal markets can solve any problem

-This can be a solution (maybe in the case of an emissions cap-and-trade system), but it still has to address issues with monopolies, information, etc.

-Market solutions – idea that economists always recommend market solutions

-Economists understand that benefits extend far beyond the monetary-Costs/benefits are just expressed in monetary terms to use a common yardstick

-Market prices – myth that economists try to figure out prices for everything

-Economists think about both -Efficiency – economists only concerned with efficiency, not distribution

-Various myths exist about how economists think about the environment

Benefit-Costs Analysis: a tool for comparing the desirable and undesirable impacts of proposed policies

Benefits: value of cleaner environment, etc.o

Costs: direct costs of meeting regulation + indirect costs such as time spent waiting in line for vehicle inspection

o

Difficult to measure marginal benefit and costs though

Also question of equity, even when aggregate benefits exceed aggregate costs, there are winners and losers with regulation

B-C Analysis can help determine how much regulation is ―enough‖o

In regards to environmental, health and safety regulation

help decision makers understand implications of decisions although hard to draw conclusions because of uncertainty in quantifying effects

1. Useful for comparing favorable and unfavorable effects of policyo

2. Decision-Makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Agencies should be allowed to use economic analysis to help set regulatory priorities.

o

3. B-C A should be required for all major regulatory decisions. o

4. Despite number 3 agencies should not be required to follow strictly the B-C testso

these estimates should take into account actual trade off decisions that

5. Best estimates for B and C should be presented along with the uncertainties that come with those estimates

o

Eight Principals to follow when using B-C Analysis to inform regulatory decisions

Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul

Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and Robert Stavins. "Is There a

Role for Benefit-Cost Analysis in Environmental, Health, and Safety

Regulation?" Science, April 12, 1996.

Article Summaries After MidtermWednesday, May 13, 2009

9:44 PM

Ec 1420 Page 112

these estimates should take into account actual trade off decisions that individuals would make

6. The more external review regulation receives the better it will beo

This will help in comparing results across analysis

7. A core set of economic assumptions should be used in calculating B and C. Key variables include: social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

o

8. B-C A should also identify important distributional consequenceso

Lawrence Goulder and Robert Stavins. "An Eye on the Future: How Economists' Controversial Practice of Discounting Really Affects the

Evaluation of Environmental Policies." Nature, Volume 419, October 17, 2002, pp. 673-674.

Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam: Elsevier Science, 2007.

b. More Analytics and an Application to Acid Rain (March 2)

Richard Schmalensee, Paul Joskow, Denny Ellerman, Juan Pablo Montero, and Elizabeth Bailey. “An Interim Evaluation of Sulfur

Dioxide Emissions Trading.” Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 53-68.Title IV of the1990 Clean Air Act established the first program to deal with sulfur dioxide pollution (acid rain) by relying on tradable emissions permits. This article summarizes the results to date of the ongoing empirical analysis of compliance costs and allowance market performance under the U.S. acid rain program.

- Came in 2 phases. Phase I, 1995 through 1999, aggregate annual emissions from the 263 dirtiest large generating units-the so-called "Table A units" -must be below a fixed cap. In Phase II, 2000 and beyond, virtually all existing and new fossil- fueled electric generating units in the continental United States become subject to a tighter cap on aggregate annual emissions.- Allowances can be bought or sold without restriction to cover emissions any- where in the continental United States.

- Represented departure from previous command and control strategies which set efficiency standards but did not focus on total emissions.

What is the Acid Rain Program?

- They were reduced. The cap and trade system cut emissions in half by 1995/96.What Happened to Sulfur Dioxide Emissions?

- the implementation of SO2 scrubbers (mechanism which remove SO2 from gaseous and other emissions) and the substitution towards low-sulfer coal in electric power plants contributed to an overall reduction in Sulfer Dioxide emissions.

How Were Emissions Reduced?

- while allowance auction prices were initially very high ($150 to $200 range) a lower equilibrium price ($50 to $100) was reached after phase 2 of the acid rain program came in 1995.

What Happened in Allowance Markets?

Total costs of reducing emission by 3.9 million tons in 1995 was 726 million, a per ton cost of about $200 per ton.

-How Much Did It Cost?

Why Have Allowance Prices Been So Low?

Ec 1420 Page 113

High expectation about the price of allowances in during phase one (early 1990‘s) caused many infrastructure changes – mainly, investments in scrubbers which reduced the total amount of SO2 emissions for many firms without having to buy allowances. Demand for allowances in phase 2 was limited, so prices fell.

-Why Have Allowance Prices Been So Low?

- Tradable permit system is better than command-and-control.What Have We Learned?

Robert Stavins. “What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.” Journal of

Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 69-88.

Robert Hahn, Sheila Olmstead, and Robert Stavins. "Environmental Regulation During the 1990s: A Retrospective Analysis." Harvard

Environmental Law Review, volume 27, number 2, 2003, pp. 377-415. With R.W. Hahn and S.M. Olmstead.

Robert Stavins. "Regulating by Vintage: Put a Cork in It." The Environmental Forum, Volume 22, Number 3, May/June 2005, p. 12.

Like in baseball, uncertainty is an absolutely fundamental aspect of environmental problems and the policies employed to address those problems. Any study that fails to acknowledge and take this uncertainty into account, which historically has been most of the studies regarding environmental policy, is fundamentally flawed. Uncertainties in underlying inputs used by analysts are propagated through analyses, leading to uncertainty in ultimate benefit and cost estimates (the core of Regulatory Impact Analysis, which are required for all ―economically significant‖ proposed federal regulations). Due to the complexity of interactions among uncertainties in inputs to RIAs, an accurate assessment of uncertainty can be gained only through the use of formal quantitative methods, such as Monte Carlo analysis. OMB‘s new requirement for formal quantitative assessments of uncertainty marks a significant step forward in enhancing regulatory analysis under E.O. 12866. It has the potential to improve substantially our understanding of the impact of environmental regulations, and thereby to lead to more informed policymaking.

Robert Stavins. "What Baseball Can Teach Policymakers." The Environmental Forum, Volume 22, Number 5, September/October

2005, p. 14.

c. U.S. Climate Policy (March 4)

Gilbert Metcalf. “A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate Change.” The Hamilton Project,

Discussion Paper 2007-12. Washington, D.C.: The Brookings Institution, October 2007.

Robert Stavins. A U.S. Cap-and-Trade System to Address Global Climate Change. The Hamilton Project, Discussion Paper 2007-13.

Washington, D.C.: The Brookings Institution, October 2007.

Ec 1420 Page 114

Washington, D.C.: The Brookings Institution, October 2007.

William Nordhaus. “To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming.” Review of Environmental Economics and

Policy, Volume 1, Issue 1, Winter 2007, pp. 26-44.

Robert Stavins. "A Tale of Two Taxes, A Challenge to Hill." The Environmental Forum, Volume 21, Number 6, November/December,

2004, p. 12.

Whether they are called ―revenue enhancements‖ or ―user charges,‖ fear of the political consequences of taxes restricts debate on energy and environmental policy options in Washington. However, a gas tax increase — coupled with an offsetting reduction in other taxes, such as the Social Security tax on wages — could make most American households better off, while reducing oil imports, local pollution, urban congestion, road accidents, and global climate change. This proposal could be politically feasible since it would be revenue-neutral (the increase in revenue from the gas tax would be given back to the people in the form of tax cuts on the payroll tax) and exemplifies efficient, market-based approaches to environmental protection and resource management.

Getting serious about greenhouse gas emissions will not be cheap and it will not be easy. But if the current state-of-the-science predictions about the consequences of another few decades of inaction are correct, the time has arrived for a serious and sensible approach. Stavins proposes an up-stream, economy-wide CO2 cap-and-trade system that implements a gradual trajectory of emissions reductions over time (with selective inclusion of non-CO2 greenhouse gases), and includes mechanisms to reduce cost uncertainty. The cap-and-trade system reduces compliance costs by building on the scientific nature of the climate change problem, offering ―what, where, and when‖ flexibility. The system allows — indeed encourages — emission reductions through whatever measures are least costly, and it achieves reductions wherever they are least costly, adjusting automatically as control costs change over time. It provides temporal flexibility by permitting the banking and borrowing of allowances.

"A Sensible Way to Cut CO2 Emissions." The Environmental Forum, Volume 24, Number 6, November/December, 2007, p. 18.

Countries are moving toward cap-and-trade systems, many economists favor a carbon tax

Cap-and-Trade is the best option for the US in the short- to medium-termo

Measured in terms of environmental effectiveness, economic effectiveness, and distributional equity

o

Cap-and-Trade can provide cost effectiveness while achieving meaningful reductions in greenhouse gas emissions. Also offers easy means of compensating for unequal burdens imposed by climate policy. Harmonizes with other countries‘ climate policies. Not a tax, not likely to be degraded by political forces, and has history of success in past 2 decades.

o

Problem: political economy forces want less severe targets if carbon taxes

A tax is a straightforward tradeoff. Although it doesn‘t guarantee achievement of an emissions target, it provides greater certainty regarding costs.

o

Stavins feels that both are good systems, but is opposed to the weak arguments often thrown out against cap-and-trade

"Cap-and-Trade or a Carbon Tax?" The Environmental Forum, Volume 25, Number 1, January/February, 2008, p. 16.

Ec 1420 Page 115

Problem: political economy forces want less severe targets if carbon taxes are used

Political pressures on carbon tax system will lead to exemptions of sectors and firms, reducing environmental effectiveness and driving up costs.

Economists should look at policy that would be optimal in Washington, not just from perspective of Cambridge, New Haven, or Berkeley.

“Inspiration for Climate Change.” The Boston Globe, Op-Ed, November 12, 2008.

Written immediately after Barack Obama‘s election

Speculates whether Obama will respond effectively to tough environmental challenges, or let us down like Bush did 8 years ago

Ultimately, will Obama work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will he take on the difficult task of crafting meaningful climate legislation? Or will he make symbolic gestures to firm up his base while actually not enacting serious change?

Declining cap increases cost of polluting, discouraging use of most carbon-intensive fossil fuels

o

Gradual reduction avoids dead weight losso

Stavins suggests a comprehensive upstream cap-and-trade system to reduce CO2 emissions 50 to 80 percent below 1990 levels by 2050

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100 percent auction over 25 years.

Make program revenue neutral by returning all auction revenue to citizens

Still, costs will be high, reducing GDP by up to 1% per year. But waiting longer isn‘t going to make this action cost less. Bottom line: getting serious about global climate change will not be cheap or easy, but we cannot afford another few decades of inaction.

d. International Climate Policy (March 9)

Robert Stavins. "Beyond Kyoto: Getting Serious About Climate Change." The Milken Institute Review, volume 7, number 1, 2005, pp.

28-37.

Joseph Aldy and Robert Stavins. Designing the Post-Kyoto Climate Regime: Lessons from the Harvard Project on International Climate Agreements. An Interim Progress Report for the 14th Conference of the Parties, Framework Convention on Climate Change, Poznan, Poland, December 2008. Cambridge, Mass.: Harvard Project on International Climate Agreements, November 24, 2008.

Robert Stavins. "Linking Tradable Permit Systems." The Environmental Forum, Volume 25, Number 2, March/April, 2008, p.

16.

As more and more countries implement cap-and-trade systems, we should look into setting up a global trading system so permits can be traded between countries

CAT has a maximum level of allowed emissionso

Credit systems award credits to firms who voluntarily take on emissions-reducing projects, and can then sell the credits on the market

o

Tradable permit systems fall into two categories: cap and trade and emission reduction credits.

Ec 1420 Page 116

projects, and can then sell the credits on the marketo

Linking reduces costs of individual systems and also allows us to achieve a greater level of emission reductions

Also opens up all systems to advances made in emission reducing technology

Need international agreements governing aspects of the design of linked CAT systems

o

One-way and Two-way links both cause harmonization of cost-containment measureso

Some links may be harder to establish than others

9. Tax Policy (March 16, 18 and 30)

Martin Feldstein, “The Effect of Taxes on Efficiency and Growth,” Tax Notes, May 8, 2006 http://www.nber.org/feldstein/taxanalysis.pdf

Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf

Council of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President,

Martin Feldstein, “The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,” Journal of

Political Economy, 1995, pp. 551-572. (A pdf will be provided.)

High marginal tax rates create significant DWLes by inducing taxpayers to change their behavior.

o

This paper finds that there is a significant response of taxable income to changes in marginal tax rates, meaning that a change in income tax rates has substantially less impact on tax revenue than if there were no behavioral response to marginal tax rates.

affects females more than males

short run: change how hard you work

long run: change location and types of jobs

labor supplyo

untaxed compensation is preferred such as fringe benefits i.e. health insurance, corporate cars, in-house sports facilities, etc.

the form that employee compensation is takeno

high marginal tax rates encourage individuals to invest assets in ways that reduce the portion of return included in taxable income, i.e. bonds and high-dividend stocks are reduced in favor of untaxed municipal bonds

portfolio investmentso

itemized deductions and other expenditures that reduce taxable income and taxpayer compliance

o

Ways that changes in marginal income tax rates make individuals alter their taxable income. Changes in:

In sum, people change their behavior and taxable income in response to changes in the marginal tax rate. Taxable income can be changed by varying the labor supply and other forms of compensation, like investing and also the extent of spending on tax-deductible activities.

Joel Slemrod, “Methodological Issues in Measuring and Interpreting Taxable Income Elasticities,” National Tax Journal, 51: 773-788,

1998. (A pdf will be provided.)

Ec 1420 Page 117

Robert E. Hall, “Guidelines for Tax Reform: The Simple, Progressive Value-Added Consumption Tax, in Alan Auerbach and Kevin Hasset,

eds, Toward Fundamental Reform, (Washington, DC, AEI Press), 2005, pp. 70-80. (A pdf will be provided.)

Big Idea: Current US tax systems are inefficient, Euro-VAT is not progressive. A progressive VAT achieves all four goals of tax reform because it is: simple, provides incentives for capital formation, is progressive, and efficient. A progressive VAT is two parts: a business tax on everything but wages, and a personal consumption tax. The personal side can be made progressive but eliminating taxes for lowest level, and having scaling rates.

Goals of tax reform: simplification, incentives for capital formation, progressive distribution of tax burden, economic efficiency

Taxes are typically on consumption because taxing income creates too many distortions

Best structure: Value Added Tax (VAT): its simple provides right incentive for capital formation, rate is low so it is effective. Problem: lack of progressivity

VAT taxes all business receipts except export sales, business deducts all operating expenses

Another= personal consumption tax on all good purchased (like VAT except collected only from businesses that sell final product to consumers)

Cash flow consumption tax: businesses pay no tax, households file complex returns accounting for all inflows and outflows of cash (more complicated, not really considered much)

Reducing taxes on necessities (not quite enough)o

Offset VAT taxes with rebate for families earning subsistence level or less (cash rebates create administrative problems, people who are eligible might not know it and file for it)

o

Attempts to redistribute burden of VAT (make it more progressive)

Steps to a Progressive VAT

Split VAT into two coordinated taxes:

One; Tax on all businesses, just like European VAT except business tax gives a deduction for compensation, carry forward is granted at market interest rates for tax losses ( rapidly growing business will have a negative tax base since investment exceeds cash flow)

Two: personal consumption tax

Base is same as before (all consumption), but splitting gives option of exempting lower income people from the personal consumption tax

Refer to this design as a flat tax, but people believe flat taxes put too much burden on middle class (where taxation starts) and not enough on prosperous

Can fix this by having differing rates for different levels

Need to have business rate = to top consumption rate (otherwise rich people will find ways to label earnings as business)

Unlike Euro-VAT, a progressive VAT families would have to fill out personal consumption forms, BUT they would be very simply (post-card sized)

Simple: taxes fit on a post-cardo

Right incentives for capital formationo

Fair : exemptions and progressive rates in personal taxo

Efficient: top rate is no more than 30%o

Meets all four goals!

US Pursuit of Tax Reform

Attempts to correct current system by: Providing vehicles for tax deferrals (ie, retirement, college) and Lowering interest rates on return to capital

Detailed Summary:

Ec 1420 Page 118

college) and Lowering interest rates on return to capital

Issues with tax shelters

Advocates shift to progressive VAT away from cash-flow taxes, should eliminate personal taxation of capital dividends and business gains

Mortgage deductions are seen as sacrosanct, they can be preserved in progressive VAT

Have all plant equipment deducted in year of purchase, like under Euro-VAT

Should not: consider national sales tales, or Euro-VAT, or expanding savings incentives at personal level

Martin Feldstein, "How Big Should Government Be?," National Tax Journal, Vol. 50, 1997, pp. 197-213. (A pdf will be provided for those

who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w5868.pdf?new_window=1

Summary: Government simply represents a transfer of wealth from the private to the public sector through taxes. The economic burden caused by government depends on (1) the taxes required to raise incremental revenue and (2) the deadweight loss that results from those taxes. Both in turn depend on behavioral responses of taxpayers.

Introduction: Feldstein prefaces his argument by citing the inevitable increases in government expenditures that will result from the aging population (i.e. Medicare, Medicaid and Social Security). By 2030 Government expenditures will have to rise from 9% to 17% just to pay for these three. What about increases in education, research, and defense? Thus, economists can play an important role in estimating the total cost plus the dead weight loss of financing such a government program.

Section I: The official method used by the Treasury and Congress underestimates the amount of tax increase required to raise a certain amount of revenue. Because they do not take changes in GDP into account, they cannot use the observed responses of revenue to past changes in tax rates as a basis for estimating how future changes in tax rates would alter taxable income and tax revenue, thus they underestimate the substitution and income effects.

1. reduces the supply of labor and in the long run the amount of capital and thus a loss in revenue results from the loss in taxable income from labor and capital

2. induces a substitution towards untaxed fringe benefits and more pleasant working conditions from taxable income.

3. induces spending on tax deductible items like debt financed spending secured by real estate, charitable gifts, and healthcare

4. changes intertemporal allocation of consumption

Section II: Behavioral Effects of a Tax – Dead Weight Loss:

1. Deadweight losses needed to be better understood by public officials so the desirability of incremental government spending can be better analyzed – it depends on the total cost (reduction income, disposable income, consumption, and thus GDP) as well as the deadweight loss, which includes the income, labor and substitution effects described above.2. Better estimates of the changes in taxes rates and the resulting chages in revenue are needed – this scan be achieved by included effects that alter GDP and looking at past experiences.3. Deadweight loss includes not only labor supply effects, but all changes in taxable income. Past experience estimates a cost of 2 dollars for every 1 dollar of incremental government spending.

Conclusion:

10. Social Security Reform (April 1, 3 and 6):

Ec 1420 Page 119

10. Social Security Reform (April 1, 3 and 6):

Martin Feldstein, “Rethinking Social Insurance,” 2005 Presidential Address to the American Economic Association, American Economic

Review, March 2005. (A pdf will be provided.)

See summary under unemployment insurance

Martin Feldstein and Andrew Samwick, “Potential Paths of Social Security Reform,” Tax Policy

and the Economy, 2002, Vol. 16, Issue 1, pp. 181-224. http://www.nber.org/papers/w8592.pdf?new_window=1

Martin Feldstein, “Structural Reform of Social Security,” Journal of Economic Perspectives, 2005.

http://www.nber.org/feldstein/streformofss.pdf

Social Security can be adjusted over timeI.

Alicia Munnell, “Social Security: It Ain’t Broken,” Social Security Reform, Federal Reserve Bank of Boston, June 1997, pp.

297-303. http://www.bos.frb.org/economic/conf/conf41/con41_24.pdf

-adjustments made through amount of benefits and types of accounts-article examines the state of SS for next 75 years starting with a surplus and moving to a deficit

S.S. has enough to pay benefits to 20291.-In 2029, revenues exhausted-Revenues would still pay for ¾ of costs-Between 1997-2012 SS will make profit (receipts and payroll taxes >outlays)-As there is an increased ratio of retirees to workers, expenditures>revenues-Misconception- In 2029, SS is going to implode-In reality, payrolls taxes and benefit taxation would cover 75% of benefits in 2040 and 70% in 2075

Actions required to eliminate shortfall are within the bounds of previous change.2.-the deficit amounts to 2.23 percent of taxable payrolls-thought experiment: fund 75 year deficit by increasing employee-employer tax from 12.4 to 14.6% immediately, a large but not unprecedented increase

-Medicare program costs are also rapidly growing-system should not be left until 76th year then try to figure it out

Economic and demographic assumptions made for 75-year projection are reasonable. 3.demographic assumptions- fertility and mortality ( AKA people in labor force and how long people receive benefits)

-

economic assumptions- CPI and tax rates, also, growth in wages (real wage differential)

-

miscalculating real wage differential by .6 percent would be equivalent of increasing deficit by .6 percent of taxable payroll ( a relatively modest amount during 75 years)

-

1997 ―low cost‖ 75 yr projection is a surplus of .21 percent of taxable payroll-1997 ―high cost‖ 75 yr projection is a deficit by 5.54 percent of taxable payroll-LONG TERM UNCERTAIN -

Ec 1420 Page 120

1997 ―high cost‖ 75 yr projection is a deficit by 5.54 percent of taxable payroll-LONG TERM UNCERTAIN -

Deficits reemerged in 1983 due to upsurge of disability case load and technical problems (not Greenspan commission recommendations)

4.

- Factors for costs increasing- increase years with deficit as time passes, increased disability caseload, and rising disability costs.

- lower costs through improved CPI and increased immigration

5. Unhelpful to lump together SS and Medicare as out-of-control spending.-similarities: provide defined benefit (one cash and other insurance for medical services), same population, benefits haven‘t changed in past 15 yrs.

-differences: Medicare‘s issues are more complex with a higher predicted deficit, driven by different forces

Take away message: Social Security needs modest repair if action is taken today (written in 1997). It is not fundamentally broken.

Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, “Fiscal Policy and Social Security Policy During the 1990s,” in American Economic

Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp 80-106 and 121-125. (A pdf will be provided for those who do not have

access to the NBER’s working paper series.)

http://www.nber.org/papers/w8488.pdf?new_window=1

In the 1990s, there was a huge budget surplus, which were expected to continue

Surpluses came from tax increases and fiscal discipline, which were reversed under next administration

Committing to short run reductions in deficit lower future short term interest rates and current long term interest rates, stimulating the economy in the present

In the 1990s there was a huge increase in investment, in part because the deficit reduction freed resources for saving, helping to lead to expansion of economy

Projected need for entitlement reform with aging population and rising healthcare costs

There was debate about changing social security policy, with an emphasis placed on investing in equities (through the trust fund or personal accounts), Clinton supported lockbox, but no new system was adopted

Preserving budget surpluses would help solve the entitlement problem

Reeeeally long article

Jeffrey Liebman, “Redistribution in the Current U.S. Social Security System,” in Distributional Aspects of Social Security and Social Security

Reform, Editors Martin Feldstein and Jeffrey Liebman, 2002, pp. 11-41. (A pdf will be provided for those who do not have access to the

NBER’s working paper series.) http://www.nber.org/papers/w8625.pdf?

new_window=1

Proposed Individual-Account based system: some think this would

Social Security: progressive because lower earners get a high fraction of

lifetime earnings

Ec 1420 Page 121

Proposed Individual-Account based system: some think this would

decrease the redistribution of SS

lifetime earnings

From people with low life expectancy to those with high life expectancy

From single workers and married couples with a substantial secondary

earner to married one-earner couples

From those who work more than 35 years to those work 35 or less

SS Transfers

all of these other transfers partially offsets the progressiveness of SS•

Individuals under 18 receive 2x the benefits as they pay in taxes since

few children have labor income while some receive benefits for their parents that are disabled or deceased

Individuals 30-49 receive benefits= 8% of taxes paid

Over 65 receive benefits 30x what they pay

46% of SS goes to families whose non-SS income is below the poverty

line

annual benefits for males are 68% of taxes paid, for women are 120%

of taxes paid

benefits/taxes ratio is highest in the south with high number of retirees,

lowest in the west with young working population

low education levels get higher ratio of benefits/taxes, reverse is true

for highly educated (primarily reflecting the increase in education over time thus correlated to age)

Annual Redistribution

Payroll taxes are proportional up to a cap, the benefit formula replaces a

higher fraction of lifetime earning for lower earners than for higher earners

Higher earners tend to live longero

Spousal benefits in which spouses of higher earners get more than

spouses of lower earners, even if the spouses themselves earned equal amounts

o

This is altered by two factors

Intracohort Lifetime Redistribution

Part of this can be attributed to spousal benefits, wives receive

higher transfers because they have longer life expectancy

o

This is not the full difference though. Among males variation is due

to life expectancy, marital status, earnings of secondary earners, share of earnings earned in years outside the highest 35 years, and

timing of earnings

o

A substantial number of high income individuals receive greater

transfers than the typical low-income individual does

Differences in transfer across race and education groups are not

statistically significant

Significant amount of redistribution based on income and a significant

amount that is not income related

**Variation in transfers at a given level of income is due to different

mortality rates for people in different demographic groups, variation in earnings levels by secondary earners, and to marital status differences.

Findings

Ec 1420 Page 122

earnings levels by secondary earners, and to marital status differences.** Income-based redistribution is fairly modest compared to the total

benefits paid. It is important to note though, that some of the benefit of SS is inflation protection and absence of market risk which may be

particularly valuable to low income families. Therefore, when examining alternative systems it is important to ask if it will provide a comparable

level of income security.

Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, “Nonpartisan Social Security Reform

Plan.” http://www.newamerica.net/files/archive/Doc_File_2757_1.pdf

The three authors come up with a plan, LMS Plan (their last names), full of compromises to aid in politicians coming to an agreement about Social Security changes.

4 Elements of LMS Plan

1.Benefit Cuts-reduction in PIA factors and an increase in retirement age-reduces aggregate spending by 35% relative to current benefit formulas-benefit cut for retirement is larger by 43% for typical worker because not reduced for disables and young survivors

-cuts implemented by changing PIA and increasing full benefit agei. Changing PIA Formula-benefits reduced for higher earnersii. Increasing Retirement age-FBA of 68 and EEA of 65iii. Protecting Disabled and Child Beneficiaries from Benefit cuts

2. New Revenue

-end practice of government using SS Surplus to fund general operations.

-Mandatory Account Contribution of additional 1.5% mandatory account contribution in Personal Retirement account (PRA)

-Raising Taxable Maximum by gradual increase in payroll tax cap to 90% of earnings

3. Mandatory PRAs-3% of earnings, funded half by new contributions and half directed from SS trust fund, with full annuitization required upon retirement

-all payments paid as annuities, fixed and inflation-adjusted

4. Updates to traditional system–minimum benefit for low-wage worker–increase widows benefits-decrease spousal benefits-possible progressive matches

MAJOR COMPROMISESRevenue Increases Vs. Spending Reductions-benefit cuts 2.7 percent of payroll and revenue increases equal 2.5 percent

Level of traditional benefits-keep traditional benefits at 12.4 percent of payroll tax, keeping them from crowding out

Ec 1420 Page 123

Level of traditional benefits-keep traditional benefits at 12.4 percent of payroll tax, keeping them from crowding out spending on other programs

-minimizes distortionary tax and Gov borrowing

Level of Benefits Vs. Length of Time of collecting benefits-traditional benefits and PRA produce replacement rates (ratio of retirement income to pre-retirement income)

-increase in age eligible for benefits

Sources of PRA Financing-mandatory worker contributions (1/2)-SS Trust Funds (1/2)

Storage for Saving-new revenue stored in PRA-increasing the likelihood that would contribute to Nat‘l Savings-decrease distortionary effects by workers receiving money back

Size of Accounts-3%, PRAs large enough to accumulate wealth but not overshadow traditional benefits

Level of Progressivity-Revenue and Tradition benefits more progressive but not to undermine support for universal social insurance

ADVANTAGES OF THE PLAN

Sustainable Solvency AchievedI.-actuarial balance would improve by 2.14 percent of 75-year projection, leading to .22 surplus

II. Fiscally Responsible Plan-does not rely on general fund transfers, instead uses changes in benefits and revenues-In years benefits exceed Revenues, Gov. must make it up by the general funds of the government either through reductions in other government spending, increases in taxes, or issuing additional debt

III.Many Practical Reforms are included–annuitization making sure don‘t spend savings too quickly

IV.Economically Beneficial-future SS surpluses and revenues are invested in PRAs-raising national Savings

V. Good for future Generations-phasing in changes quickly, decreasing burden

VI.Balanced Compromise-political compromise-compromises on solvency, adequacy, and funding-amounts of taxes, amount of choice

11. Unemployment Insurance (April 8)

Ec 1420 Page 124

11. Unemployment Insurance (April 8)

Martin Feldstein , “Rethinking Social Insurance,” American Economic Review, March 2005, pp 13-15. (A pdf will be provided.)

Martin Feldstein and Daniel Altman, "Unemployment Insurance Savings Accounts," Tax Policy and the Economy, Vol. 21, 2006. (A pdf will be

provided for those who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w6860.pdf?new_window=1Big Picture: Look at system of Unemployment Insurance Saving Accounts (UISAs) where ind save 4% of wages in special accounts and draw from them for unemployment. Gov‘t lends money if account runs out, positive accounts earn balances, which is then paid out on retirement. Analysis finds that almost all ind will have positive accounts, even at end of unemployment spell. With UISA, incentives to be unemployed more frequently/for longer spells are removed. Cost to taxpayers is less. Minimal gain for top 25% of income, minimal loss for bottom.

Unemployment insurance distorts benefits, this program aims to fix that

Unemployed ind receive the same cash amounts during unemployment as now

Person with positive UISA can completely internalize cost of unemployment, and wouldn‘t have incentive to inefficiently increase frequency or duration of unemployment

Feasibility of account depends on extent to which unemployment is concentrated in subgroup of ind

Use Panel Study of Income Dynamics (PSID) to see that 5% of employees would retire or die with negative account balances, and that about half of all benefits from UISAs would go to such ind

Therefore, cost to gov‘t with UISA is less than current system, which permits a reduction in payroll tax and distortionary effects of existing benefit system

Current system: ind gets about 50% of previous gross wage (1997 ave weekly benefits = $193), benefits are subject to income tax, but not SS payroll tax, benefits are levied on firms by state gov‘t

Current system reduces costs of being unemployed, and can increase frequency or duration of spells (people search excessively for job)

UISA removes the incentives- costs are internalized, people search for right length of time

Feldstein runs through a variety of ways to design the UISA program, (like limited amount in fund to 3 times average wage, just above average wage, or making people more likely to be unemployed have a higher fund) but I don‘t think we‘d need to run through this in detail (Pages 8-12 if you‘re curious)

Analysis with/ PSID data shows that individuals are 95% sensitive to cost of unemployment benefits; about 7% would ever go into negative funds; UISA gives people stronger incentives to avoid unemployment,

Distributional effects: someone who never taken unemployment insurance gains because they don‘t have to pay the taxes and get to keep the funds from their UISA, someone who ends with a negative balance- the gov‘t contribution must come from a tax, but the tax is smaller than under previous system

Lowest quintile would lose $95 over 25 years, largest gains $468

Reduction of about 60% of taxpayer burden

Detailed Summary:

12. Oil (April 10)

Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html

Ec 1420 Page 125

Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html

· In the short run, the supply of corn cannot change much in response to a global increase in demand.

· Since demand for corn is very price insensitive, it takes a very large price increase to bring global demand in line with global supply.

· In the past year, global demand of corn rose by 10% à It took a 100% increase in the price of corn to offset this rise in demand.

In order to explain the source of the price rises in food and energy, Feldstein first looks at perishable agricultural commodities, specifically corn:

· Unlike perishable agricultural products, oil can be stored in the ground. Thus, owners of oil will keep their oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money from selling the oil. Thus, their decision to sell is based on the expected price rise and any considerations of risk. Any expected change in the future price of oil will have an immediate impact on the current price of oil.· Thus, when oil producers concluded that demand for oil in China and other countries would grow more rapidly in future years, they inferred that the future price of oil would be higher than previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its original rate.· By understanding this, we can see how news stories, rumors and industry reports can cause substantial fluctuations in current oil prices – all without anything happening to actual current demand and supply.

Now, looking at oil:

· Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. Thus, it is possible to bring down today‘s price of oil with policies such as increases in government subsidies to develop technology that will make future cars more efficient, tighter standards that gradually improve the gas mileage of the stock of cars, etc.· In addition, an increase in the expected future supply of oil would also reduce today‘s price. The fall in the current price would induce an immediate rise in oil consumption that would be matched by an increase in supply from OPEC producers that have inventories of oil.

Good news:

In summary, any steps that can be taken to increase the future supply of oil or to reduce the future demand for oil in the US or elsewhere can lead to both lower prices and increased consumption today.

John Deutch, James Schlesinger and David Victor National Security Consequences of US Oil Dependency Council on Foreign Relations,

2006 http://www.cfr.org/content/publications/attachments/EnergyTFR.pdf

Lack of sustained attention to energy issues is undercutting U.S. foreign policy and national security

Other nations (Russia, Iran, Venezuela) have used their energy resources to pursue their strategic and political objectives.

Also put in competition with other importing countries (China and India), creating

Energy consumers, like the U.S., are increasingly dependent on imported energy. This increases strategic vulnerability and constrains ability to pursue broad range of foreign policy and national security objectives.

Ec 1420 Page 126

Also put in competition with other importing countries (China and India), creating further foreign policy challenges.

o

Reliable and affordable supply of energy is a prominent feature in international political landscape, and it affects U.S. foreign policy.

Although energy policy and foreign policy are distinctly different policies, they are still closely connected.

This paper says that in the next 20 years, it is impossible to eliminate U.S.‘s dependence on foreign energy sources. The main focus should be to manage the consequences of energy dependence, not to act like we can get rid of it.

This has been a problem for a long time, but growing global demand for oil has made the issue more pertinent.

Tax on gasoline

Stricter and broader mandated Corporate Average Fuel Economy standards

The use of tradable gasoline permits that would cap the total level of gasoline consumed in the economy

Three measures to slow and eventually reverse growth in consumption of petroleum products. These measures would also encourage higher-efficiency vehicles, introduction of alternative fuels, and use of public transportation.

1. While the U.S. has limited leverage to achieve energy security objectives through foreign policy, it can manage its energy future through domestic policies that complement short- and long-term international strategy.

o

2. Task Force recommends that the U.S. take initiatives to encourage the efficient, transparent, and fair operation of world oil and gas markets. This means encouraging all countries to reduce subsidies and deregulate prices of oil and gas.

o

3. U.S. must work closely with major oil suppliers to detect and deter attacks on their infrastructure. Producing and consuming countries have a common interest in reducing infrastructure vulnerability, from terrorist attacks, natural disasters, etc.

o

This is in U.S.‘s interest because stably governed countries are better able to attract the investment needed to maintain and increase hydrocarbon production. And because it supports the long-standing American goal of encouraging progress toward democracy and good governance.

4. Many countries exploit oil and natural gas resources but fail to manage their revenues in a way that improves the social and economic prospects of their people. U.S. should play a stronger role in promoting better management of revenues.

o

This is difficult because of the range of other issues that demand attention. The Task Force recommends a small energy security directorate is established to give adequate attention to energy policy issues.

5. The U.S. needs to mobilize government resources to focus more on the integration of political, economic, technical and security perspectives needed for energy policy-making.

o

Policy Strategy proposed by Task Force

Martin Feldstein and Henry Kissinger “The Power of Oil Consumers”, Washington Post, September 18,

2008 http://www.nber.org/feldstein/washpost_091808.html

· When oil tripled in price from $30 a barrel in 2001 to around $100 today, we saw a huge transfer in wealth from the world‘s most powerful nations to some of the world‘s weakest. Yet, the world‘s powerful nations stand by impotently as if the price of oil were some natural event that cannot be influenced by political forces.· The price of oil is not determined by a traditional competitive market—major producers can raise or lower the price of lower by reducing or increasing their rate of

Ec 1420 Page 127

producers can raise or lower the price of lower by reducing or increasing their rate of production. The monopoly suppliers have very large market share and will continue to have this until the consuming nations 1) sharply reduce their dependence on imported oil and 2) develop a political strategy to counter political manipulation of the oil market.· The Group of Seven, along with India, China and Brazil should establish a coordinating group to shift the long-term trends of supply and demand in their favor. Their efforts could reduce the price of oil by reducing future demand and by establishing an effort to increase oil supply in all of these countries. While these efforts would take years to play out, the expected changes in oil supply/demand would reduce the price of oil today.· A cooperative policy should also include emergency sharing arrangements to counter selective boycotts or supply interruptions.

· Overall, while the US can make many of these changes, a coordinated international effort would be much more effective to increase supply and reduce demand in the global energy market.

· In the past year, the price of oil rose by 85%, from $65/barrel to $120· During the same period, the dollar fell by 15% relative to the euro, and 12% relative to the yen

· Link between the two?

Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July 2008 http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf

· Oil market is global, so the price reflects total world demand and total world supply· The increasing demand for oil from all countries, but particularly from the rapidly growing emergent-market countries like China and India, has been a huge force in pushing up the price of oil· The currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into any currency – market equilibrium is the same when translated into all currencies

Would the price of oil have increased less if oil were priced in euros instead of dollars?

· This is only true to the extent that we think about the price of oil in dollars, since the dollar has fallen relative to other major currencies.

· But if the dollar-euro exchange rate had remained at the same level as it was last May, the dollar price of oil would have increased less – in this case, the euro price of oil would be the same as it is today, but the dollar price of oil would have only risen by 56% (the amount that the euro price of oil actually did increase)· The only effect of the dollar‘s decline is to change the price in dollars relative to the price in euros/other countries

Did the dollar‘s fall cause the price of oil to rise?

· However, the rising price of oil does contribute to the decline of the dollar. The increasing cost of oil imports widens the US trade deficit. The dollar has declined in order to be more competitive and thus shrink the trade deficit to a sustainable level.· Thus, as oil prices keep rising, it will be more difficult to shrink the US trade deficit and the dollar will depreciate even more rapidly.

Martin Feldstein “Tradable Gasoline Rights,” Wall Street Journal, June 5, 2006 http://www.nber.org/feldstein/wsj060506.html

11. The Economics of National Security (April 13)

Ec 1420 Page 128

11. The Economics of National Security (April 13)

Martin Feldstein, “The Underfunded Pentagon,” Foreign Affairs, March/April 2007. http://www.nber.org/feldstein/the-underfunded-

pentagon.pdf

-Threats fall into three categories-Major states (Russia, China), rogue states (NK, Pakistan, terrorists)-Our defense budget is not enough to secure us against 21st century threats -Need to grow army, marine corps-Military is the quintessential public good-We should not raise income taxes to finance military – this would require extremely high marginal tax rates

-Instead, take advantage of the fact that tax revenue growth exceeds GDP growth -Or eliminate tax expenditure categories

Martin Feldstein, “Defense Spending Would Be Great Stimulus,” Wall Street Journal, December 24, 2008

http://www.nber.org/feldstein/wsj12242008.html

Optional:Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary Update for Fiscal Year 2008, December 2007. http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm

12. Trade Policy (April 15, 17) Professor Robert Lawrence

Where we stand:

United States Trade Representative 2009 Trade Policy Agenda.

http://ustr.gov/Document_Library/Reports_Publications/2008/2008_Trade_Policy_Agenda/Section_Index.html

Big Picture: Managing trade policy in face of crisis is a great challenge. Trade is very important for the US, it brings in $1tril/year and accounted for all economic growth in 2008. Am. People are nervous about globalization because they see that it ―takes jobs‖ US Policy needs to reassure Am. People (through improving education, fixing unemployment insurance, creating training prog for people who lose jobs). US cannot withdraw from trade, because countries we trade with can find new partners, putting the US at a serious disadvantage.

Needs:

Protectionist policies can aggravate the recession (it happened in the 1930‘s)

Post 9/11: G-20 summit led to a pledge to avoid new restrictions for 1 year

Need to reverse the erosion of US foreign policy/global standing

Initiative on global warming: has HUGE impact on global standing

Must restore confidence on American people: trade balance has provided all US econ growth over past year, but people view globalization as source of job insecurity, stagnant real ways, and growing income disparity

Will address these need with:a new narrative, a competitiveness agenda, and an adjustment policy

Detailed Summary:

Ec 1420 Page 129

policy

A New Narrative:

Need to re-explain benefits of trade to Am. People

Issues: China has emerged as low-cost manufacturing giant; people who have worked hard feel that they aren‘t sharing in benefits,

Retreating from globalization isn‘t good idea (it makes us $1 trillion richer, can‘t give up the internet)

All Am can benefit from growth is: tackle budget deficit, modernizing financial regulations to assure security of international mkts, investing in people and tech to drive innovation, expanding trade

Resrore faith that gov‘t : understands challenges, can equip country to face challenges, can provide adequate support for workers facing career changes/job dislocation due to global econ changes

Strengthen ability to compete and innovate: improving telecommunications and rail, road, and air transport

Upgrade educ level and quality- educ reform, more careers in science, raising high-skill immigration

Address main causes of anxiety: portability of health care, pension security, social insurance

Refocus trade policy to target largest markets and emerging sectors

Restoring US Competitiveness:

Private investment in plant equip is 2% of GDP lower than at start of decande=> loss of $1.7 Trillion in potential investment

Gov‘t investment in physical ifrastructure, R&D, and educ has not kept pace with GDP growth

Lack much physical infrastructue (roads, bridges, dams are crumbling)

Need to invest more in new tech: high-speed wireless, energy/environ tech to meet

Must encourage more private/public invest in R&D,

human capital is important: have all US achieve a high school degree, better worker training

Budget deficit hurts competitiveness through exchange rate rising deficits raise interest rates, attracting inflows that push dollar to be overvalued (overvalue= MAJOR negative for US competitiveness)

Designing Strategy for Promoting Econ Adjustment

US labor market is very flexible; the programs supporting it (health care, social security) are in significant need of update

Little uptake of program (people don‘t know about it and must go through lots of red tape to qualify)

o

Trade Adjustment Assistance= newish program designed to help workers by providing extended unemployment insurance to people getting job training

Federal spending on training programs is at lowest rate in 45 years

Should: update unemployment insurance; make service workers eligible for TAA, provide assistance to communities facing severe job loss (ie plant closing), encourage employers to provide their own assistance to laid-off workers

Trade Policy

Most recent round (Doha Round) of multilateral trade negations in WTO= has little enthusiasm, must finish it or else countries will look elsewhere to make deals

Need to reassess approach to trade negotiations

Trade deficit is too large; good trade deals reinforce broader obj of US foreign policy (creates alliances to work with partners closely, we benefit when partners prosper)

US engagement in trade ensures that US interests will not be disadvantage as other trading powers pursuer trade pacts with each other (if Pan-Asian bloc makes deal with EU, US is in trouble)

WTO must adapt to increased number of members, address link between security (vias) and trade, clarify rules on taxes and subsidies, meet new challenges of climate change

Ec 1420 Page 130

and trade, clarify rules on taxes and subsidies, meet new challenges of climate change initiatives

US should refocus Free Trade Areas, particularly with Asia or the middle East

Relationship with China is key: esp exchange rate (which China undervalues)

The Trade Policy Study Group Report to the President Elect and the 111th Congress , available at

http://iie.com/publications/papers/20081217presidentmemo.pdfYear: 2008

Thesis: The United States needs a comprehensive new trade policy to increase its competitive stance and maintain domestic support in the context of a rapidly globalizing world economy.

Summary:

Trade is an important part of the policy response to the global financial/economic crisis. Protectionism will only worsen the current situation (as occurred during the Great Depression).

o

Cooperative trade policy is essential for reversing the erosion of US foreign policy and global standing in recent years.

o

Planned initiatives on global warming will necessarily include a trade component.o

Trade and America‘s role in the global economy will need to be addressed as part of an effort to restore American confidence/optimism.

o

Trade will need to be addressed by the new Administration/Congress for four reasons:

A new narrative: new policies that allow Americans to succeed in a globalizing world, including policies that (a) strengthen our ability to compete/innovate, (b) upgrade the educational level and quality of our workforce, (c) increase the portability of health care, etc and (d) refocus trade policy to target the markets that will be central to our economy in the future.

o

A competitiveness agenda: increased private and public investment in activities that promote productivity gains and the creation of high-skill, high-wage jobs; this includes investment in infrastructure, R&D, education, training, new technologies, etc. We also must reduce the federal deficit, which harms our competitiveness by crowding out private investment and causing the overvaluation of the dollar.

o

A new adjustment policy: much stronger and effective national program of safety nets and empowerment initiatives, including reforms of health care, unemployment insurance, etc.

o

A new approach to trade policy: US should lead international trade negotiations (in the Doha Round, NAFTA, other FTAs, etc) for three reasons – (a) international trade supports US ec growth, (b) good trade deals reinforce US foreign policy, and (c) US trade negotiations ensure that US interests won‘t be disadvantaged as other major trading partners form trade agreements with each other.

o

The proposed new strategy includes four components

Challenges:

(1) Summers, Lawrence “America needs to make a new case for trade”Financial Times, April 27 2008http://www.ft.com/cms/s/0/0c185e3a-1478-11dd-a741-0000779fd2ac.html

Thesis: The traditional economic arguments for supporting trade policy, while valid, are no longer sufficient. Instead, policymakers have to convince the American citizenry that global success is in their best interest, which is not immediately obvious for several reasons.

Ec 1420 Page 131

success is in their best interest, which is not immediately obvious for several reasons.

o Trade has many benefits via comparative advantage (for exporters, consumers, and the economy as a whole).

o Trade agreements are good mercantilism for the US, for two reasons. First, the US already has low trade barriers and thus will not need to reduce as much as trading powers. Second, not having trade agreements with countries with whom our competitors do will put us at a competitive disadvantage.o Increased income inequality in US is due to technology, not trade.o Acknowledged that not everyone wins out, but that trade agreements should be accompanied with polices to reduce income inequality/insecurity.

- American economic policy has traditionally supported globalization, but the recession likely will put this in question. This support is based on four valid economic arguments:

o American producers benefit from having larger markets to sell into, but also have to face more competition.

o Developing countries increasingly export goods that were traditionally produced by the US, which puts downward pressure on US wages.

o Growth of developing countries puts pressure on energy and environmental resources, thus raising their prices.

o Global growth encourages the development of stateless elites who are loyal to global economic success and their own prosperity, rather than the interests of their home nation. (i.e., rich CEOs who dislike regulation, taxation, etc)

- However, just because trade barriers harm our economy, it is not immediately obvious that the US is helped by the success of its trading partners. There are several reasons why global success may harm us:

- Therefore, these arguments above must be addressed in order to convince Americans that global economic success is actually in our best interest.

Summary:

Free Trade's Great, but Offshoring Rattles MeBy Alan S. Blinder Washington Post Sunday, May 6, 2007;Robert Z Lawrence. Comments on Alan Blinder: Off-shoring: Big Deal or Business as Usual? Given at Alvin Hansen Symposium on Public

Policy, Harvard University, May 2007.

THE TROUBLE WITH TRADE; Paul Krugman Pittsburgh Post-Gazette (Pennsylvania) December 29, 2007 Saturday

US now imports more manufactured goods from third world than advanced economies

Trade improves lives of third world workers, but at the expense of real wages of many or most American workers, this problem is getting worse

Highly educated workers (a minority) benefit from trade

Should not lead to increased protectionism, but strengthened social safety net

Income inequality in the US grew because the wages of the rich have surged, not because of trade decreasing the wages of less skilled workers.

Despite huge increases in trade and immigration, these changes have not increased

Robert Z Lawrence The Globalization Paradox: More Trade Less Inequality. Vox EU 4 September 2007. http://voxeu.org/index.php?

q=node/524

Ec 1420 Page 132

Despite huge increases in trade and immigration, these changes have not increased conventional wage inequality, even though there is increasing competition from third world countries

One potential explanation is that goods manufactured in US might be more sophisticated and made by more skilled workers when compared to third world countries. Therefore, competition won‘t lower American wages

Another expectation is that the goods America imports are no longer produced in America. Therefore, the decreasing prices of imports will not lower wages in the United States or lead to job losses. This specialization will in fact decrease inequality.

World Trade Organization: 10 benefits of the WTO trading System. http://www.wto.org/english/res_e/doload_e/10b_e.pdf

Top 10 Reasons to Oppose the WTO Global Exchange.

Griswold, Dan NAFTA at Ten: An Economic and Foreign Policy Success. Center for Trade Policy Studies: Free Trade Bulletin, No1.

December 2002 http://cato.org/pub_display.php?pub_id=4074

NAFTA delivered more trade

Trade with Mexico has tripled from $81 billion to $232 billion

Canada and Mexico are now the largest trading partners of the US

The potential affect on the labor market was overestimated by both sides

In reality, the agreement was never really going to have a huge effect on the US economy

It is much larger than Mexico‘s economy and tariffs were already very low before

Biggest impact has been in foreign policy

Enticed a move from centralized protectionism to democratic capitalism in Mexico

Also encouraged more political competition in Mexico

There was no loss of jobs, in fact there has been an increase in employment from 120 million to 135 million and a decrease in the unemployment rate

There was an increase in manufacturing investment in Mexico, but too small compared to domestic investment to have a real impact

Manufacturing output has actually grown in the US since NAFTA was passed

Faux, Jeff NAFTA at 10, The Nation February 2, 2002 http://www.epi.org/publications/entry/webfeatures_viewpoints_nafta_le

gacy_at10/

13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker

Moral Hazard and Adverse Selection

Cutler, David M. and Richard J. Zeckhauser. "Adverse Selection In Health Insurance," Forum for Health Economics and Policy, 1998, v1,

Article 2· INTRODUCTION: Adverse selection exists in healthcare because people at higher risk differentially prefer more generous and expensive plans.

Ec 1420 Page 133

Prices to participants do not reflect marginal costs individuals select the wrong health plans on a cost-benefit analysis

Desirable risk spreading is lost: sicker people pay more

Health plans manipulate their offerings to deter the sick and attract the healthy

Three classes of inefficiencies:o

Medicare reform

Changes in employment-based health insurance

Efficiency of individual insurance markets

Healthcare reform tries to deal with adverse selection very present in employer-offered policies, government-sponsored insurance, or individuals purchasing their own

o

differentially prefer more generous and expensive plans.

Occurs because individuals are not charged marginal cost adverse selection

Employers offer multiple offerings: high-risk individuals differentially choose some plans and low-risk others differential selection

o

Insurers set premiums on the riskiness of people

Employers pay some portion of premium

Employees choose a health care plan based on cost-benefit calculation and preferences

Three parties play a role in differential selection:o

Employers pay equal contribution to chosen plan: inefficient b/c employee pays the difference based on the average cost of other people in the plan

Employers pay a fixed percentage of plan‘s costs: distorts prices more

Two examples of inefficient plans:o

THEORY OF ADVERSE SELECTION

Group similarities: costly, generous plan & several HMOso

Healthy people departed from PPO raised risk premium more for PPO

Adverse selection death spiral: PPO became untenable in 3 years and was dropped

Harvard: changed to an equal contribution plan in 1995; negotiated lower prices for HMO while PPO (more generous plan) price rose

o

Mixed HMOs into a PPO people enrolled, risk spreading was good, costs fell down to almost HMO levels

But ppl have been dropping out of the PPO plan and costs are rising while HMO prices have stayed the same

Adverse selection: working through lower risk people dropping out rather than high risk selecting themselves in

GIC: employees paid an equal share (from 10% to 15% in 1995)o

EMPIRICAL IMPORTANCE: Harvard University and the Group Insurance Commission (GIC) of MA

Individual‘s characteristics: assign them appropriate plans goes against the norm of great choice

o

Debate on particulars of the plan to standardize

May impede valuable competition on program design plans need to negotiate, so what is right for one plan might not be for another

Standardizing plans: requiring same coverage in all plans could help no particular selection for certain plans that are generous for mental health, diabetes, etc.

Premium subsidizes: subsidize the premium of the most generous policy

Disparate pricing: adjust prices to account for the risk mix; 4 strategies for risk adjustment

Decentralized choices: individuals choose from a menu of optionso

REFORM STRATEGIES: How can we encourage individuals to select the plans that they would choose if they faced the true posts of choosing one over another?

Ec 1420 Page 134

Pays little attention to actual composition of populations w/in health plans; assumes that higher price is due to worse mix of enrollees

o

Eliminates many incentives for plans to operate efficiently or price competitively

o

Premium subsidizes: subsidize the premium of the most generous policy so that it is more affordable than risk differences alone would indicatehistorically most popular, but maybe not most effective

If the high-cost group were primarily responsible for the high costs of the more generous plans, would reduce adverse selection

o

Danger: once the expenses of high-cost users are pooled, the plan loses the incentive to monitor their utilization

o

Doesn‘t make sense in that ppl want insurance to cover very expensive things, not routine small things

o

Reinsurance: mandatory reinsurance for high-cost people to adjust premiums by risk; remove all spending above a certain amount—carve-out approach

Incomplete b/c distribution of risk-spending is highly skewedo

Severely hindered if insurers can alter their coding practices in light of the risk adjustment system

o

Prospective (ex ante) & Retrospective (ex post) risk adjustment based on the population composition of ppl in the plan

Manning, W., et al., Health Insurance and the Demand for Medical Care: Evidence from a Randomized Experiment, American Economic

Review, Vol. 77, No. 3, June 1987.

Fee-for-service plan had different levels of cost sharing: coinsurance rate and upper limit on annual out-of-pocket expenses

Enrolled families in 6 cities from 1974 to 1977; assigned to 1/14 fee-for-service insurance plans or to a prepaid group practice

o

Dependent variable: health care services (not dental or psychotherapy)o

Independent variables: health care plan coverage + controlso

Statistical methods: ANOVA and estimates based on a four-equation modelo

Design of the Rand Health Insurance Experiment:

differences in expenditures across plans reflect variation in the number of contacts (visits) rather than the intensity

No significant differences among the family coinsurance plans in the use of inpatient services, probably due to the upper limit on out-of-pocket expenses b/c 70% exceeded their upper limit

Main effects of the insurance plan: o

Income groups: probability of use of any outpatient medical service increases with income with larger increases for family pay and individual deductible plans than the free plan; probability of use of inpatient services declines with income for the family pay plans net result is shallow U-shaped

Age groups: adults have significantly lower use of inpatient services on family-pay plans than they do on the free plan

Health status: no differential response btw healthy and sickly—unusual b/c of the cap on out-of-pocket expenses

Sites: least access to doctors had the second highest probability of any use

Period of Enrollment: duration of plan (3 or 5 years) did not matter for

Use by subgroups:o

Empirical results:

Ec 1420 Page 135

Period of Enrollment: duration of plan (3 or 5 years) did not matter for expenditure

Elasticities for a constant coinsurance policy are in the -0.1 to -0.2 rangeo

Change in insurance can only explain a small part in the huge change in health care spending since WWII

o

Nontrivial welfare loss from first-dollar health insurance coverageo

Conclusions: demand elasticities for medical care are nonzero and the response to cost-sharing is non-trivial

Newhouse, J., Medical Care Costs: How Much Welfare Loss?, Journal of Economic Perspectives, Vol. 6, No. 3, Summer 1992

Real medical care expenses per capital have grown at 4%/year for 50 years (more rapid in 1960s)

o

Growth in medical costs is different b/c of moral hazard and tax treatment of health insurance excessive insurance b/c costs are misaligned

o

But the moral hazard/risk sharing story is in a one-period model; distinguish between one-period from multiple period

o

· Magnitude of health expenditure increase

Aging: only accounts for a tiny fraction in the increase based on how their spending changed if just measuring the population age increases

o

Largest single component of increase in real medical expenditure has been in the hospital sector, but the coninsurance for hospital visits has been about the same while expenditure has risen 50%

Increased insurance: factor-of-five increase in real expenditure per person from 1950-1980 is perhaps 8x as large as one could account for solely from the effect of increased insurance on demand in the one-period model.

o

Increased income: medicare is a normal good so increased income could account for increase in expenditure; elasticity measured around 0.2 – 0.4

o

Supplier-induced demand: if physicians have considerable discretion in treating ignorant consumers, to what degree might they have induced more and more demand? As supply of doctors increases, they demand higher costs to protect their incomes hypothesis not supported by the evidence.

o

Factor productivity in a service industry: medicare is a service so if productivity gains are lower for medical care, then the relative medical prices would rise over time, and b/c demand is inelastic, expenditures would also rise. Very difficult to measure—many reasons for why there‘s no empirical basis for decomposing the medical care expenditure increase into increase in price vs. quantity

o

Accounting for the medical expenditure increase: method is to identify a series of factors, determine how much of the change they might account for, and account the residual to technological change

Other factors probably account for 50% of rise in expenditure; rest due to technologyo

Highest increase in cost come from hospitals—where the newest technology iso

Technological change in medical care

Fallacious argument that insurance makes things more affordable and therefore more expensive technologies was the result and is a welfare loss

o

Was technological change induced by insurance?

Initial cost sharing by patients has increased—probably will not change the long-term rate of cost increases

o

Increased enrollment in health maintenance organizations: rate of growth in HMO spending appears similar over an entire sector

o

Adoption of prospective payment systems: paying a lump sum per type of admission rather than the additional cost of a procedure length of hospital stay decreased, but bottomed out soon

o

What has been done about medical costs?

Ec 1420 Page 136

bottomed out soon

Real rate of increase in costs is similar across countrieso

Rate of increase in HMO costs in the US has been similar to the overall medical care sector

o

The willingness to pay for new technology: welfare loss from additional spending on technology may be less than some of the rhetoric surrounding the need for cost containment would imply

A note on the terminally ill: data offer little support for the notion that society is wasting an ever-larger share of resources in a fruitless attempt to save those who are about to die—spending on the last year of life has not contributed disproportionately to the increase in medical care costs

However, there would probably be deadweight loss associated with financing an increase in medical care costs

o

The uninsured: probably about average in risk on the whole; covering the uninsured would probably increase demand for medical care by less than 10% universal insurance would add costs but would not wreak havoc on the nation‘s medical care economy

Concluding thoughts: conventional wisdom that the tax subsidy increase demand for medical care; however, it‘s not apparent that ending the tax subsidy would address the increasing costs nor be an unambiguously good policy

Health Insurance Markets and Labor Markets

Summers, L, Some Simple Economics of Mandated Benefits, American Economic Review, Vol. 79, No. 2, May 1989.

Mandated benefits are one way governments can ensure universal access to a good

The other is public provision

Today the issue is whether it is good to provide mandated health insurance, so those who are not normally covered will be

Economists standard view is of mandated benefits as a tax

Employee provided benefits can be efficient if they can be provided at a lower cost then their value to employees then it can be cost effective compensation

The paternalism argument supports the idea that mandated benefits will correct an undervaluing of a good in the market

There is a positive externality associated with health insurance

Prevention of contagious diseases spreading

Also, there is an unwillingness to refuse care to those who can‘t afford it

These creates an even larger externality

Also, it is more efficient to mandate health insurance because the market outcome does not provide universal insurance

The adverse selection will cause employees to set a high price so only sick people will pay for insurance and everyone loses money

Mandated benefits are a more efficient way to provide benefits than public provision

Allows employers to tailor policies to individuals and avoids government provision trap –those willing to pay for high quality care will settle for provided middle quality care

Also avoids deadweight loss of tax

The deadweight loss associated with mandated benefits is lower than that of a tax

Also, effects on employment are much less than with a tax

For health insurance a lump sum tax might be an efficient form of government provision, but this is not politically feasible

Since all get same benefits a payroll tax is largely more inefficient than employer provision

Major problem with mandated benefits is only help those with jobs

In those cases public provision is necessary

Wage rigidities also hurt this program by not allowing wages to fall in exchange for

Ec 1420 Page 137

Wage rigidities also hurt this program by not allowing wages to fall in exchange for benefits

Madrian, Brigitte, Employment-Based Health Insurance and Job Mobility: Is there Evidence of Job-Lock?, Quarterly Journal of

Economics, Feb, 1994.

Katherine Baicker and Amitabh Chandra, Myths And Misconceptions About U.S. Health Insurance, Health Affairs 27, no. 6 (2008): w533-

w543Health Care Reform is Hindered by Confusion about how health insurance works

What is health insurance?- Insurance, in its simplest form, works by pooling risks: many pay a premium upfront, and then thosewho face a bad outcome (getting sick, being in a car accident,having their home burn down) get paid out of those collected premiums.- The premium for health insurance is the expected cost of treatment for everyone in thepool.-important for people to become insured when they are healthy

Myth 1: The Problem With The Health Insurance System IsThat Sick People Without Insurance Can‘t Find AffordablePolicies

i.Reality-Private health insurers will not charge uninsured sick people a premium lowerthan their expected costs. -Uninsured Americans need health care, not health insurance. Insurance is about reducing uncertainty in spending. It is impossible to ―insure‖ against an adverse event that has already happened, for there is no longer any uncertainty about this event.

ii. Social insurance versus private insurance-Social insurance; viewed as a right, redistribute money from the healthy to the (low-income) sick, in the same way that we redistribute money from the rich to the poor

- Private markets can pool risk among people startingout with similar health risks, and regulations can ensure that when some membersof those risk pools fall ill, insurers cannot deny them care or raise their premiums-providing subsidies for individuals to purchase private insurance or providing the insurance directly (as through Medicare) are both forms of social insurance.

iii. How to provide care for the sick and uninsured?-no private insurer wants to do this- we could force sick people and healthy people to pool their risks, such as through community rating coupled with insurance mandates- social insurance programs, including a nationalized health

care system, is that they can achieve redistribution that private markets alone cannot

Myth 2: Covering The Uninsured Pays For Itself By ReducingExpensive And Inefficient Emergency Room Care

i.Reality-empirical evidence does not support

Ec 1420 Page 138

i.Reality-empirical evidence does not support-maybe in the case of diabetes to prevent amputations

ii. Insurance and Use of Care-―Moral Hazard‖-*** The RAND Health Insurance Experiment(HIE), the largest experiment in social science, measured people‘s responsivenessto the price of health care: people who paid nothing for health care used 30 percent more care than did those with high deductibles

iii. Preventative Care and Health Costs-increases in preventative care do not pay for themselves-MOST preventative care goes along with greater spending and greater health outcomes-Example of cost-saving: Flu Vaccine-sometimes we should decide to spend money elsewhere

iv. Money Well Spent-insuring the uninsured would raise total spending, but it would be money well spent-receive great amount of increased health benefits in those that were uninsured

Myth 3: Lack Of Insurance Is The Principal Barrier To Getting High-Quality Care

i.Reality-having insurance my increase quality of care you get, but it is not a guarantee that you will get high quality care

-Americans receive less than 60% of recommended care- Yet the likelihood of getting high-quality care has more to do with geography than with insurance status or spending

-John Wennberg- in fact, in areas where the most is spent on Medicare beneficiaries, they are least likely to get high-quality care. Mammograms, flu shots, the use of beta-blockers and aspirin for heart attack patients, rapid antibiotics for pneumonia patients, and the use of simple lab tests to evaluate the management of diabetes are all lower in higher-spending areas. Higher spending is not even associated with lower mortality, which suggests that more generous insurance provision does not necessarily translate to better care or outcomes.

-SO…discard the simplified notion that more spending guarantees better care or even basic preventive care

ii. What do people in high spending areas get?-high spending areas get receive surgery, but they see more specialists more frequently, have more diagnostic and imaging services, and get more intensive care at the end of life—none of which has been shown through clinical trials to improve health

Myth 4: Employers Can Shoulder More Of The Burden Of Paying For Insurance

i.Reality-workers bear costs of benefits in the form of lower wages- Regardless of a firm‘s profits, valued benefits are paid for primarily out of workers‘ wages. Workers may not even be aware of how much their total health premium is; however, employers make hiring and salary decisions based on the total cost of employment, including both wages and benefits such as health insurance, maternityleave, disability insurance, and retirement benefits.- employers may respond in other ways: employment can be reduced for workers whose wages cannot be lowered, outsourcing and reliance on temp agencies may increase, and workers can be moved into part-time jobs where mandates do not apply

Ec 1420 Page 139

ii. Why an employer based system?- preference in the tax code for premiums paid by employers relative to premiums paid by individuals or direct payments for health care

- this tie between employment and insurance comes at a cost: workers who leave or lose a job risk losing their insurance or facing much higher premiums, sometimes forcing them to stay in a job to retain health insurance

iii. Advantages of the job-based system-including better pricing and risk pooling-the employer market is the primary mechanism for maintaining cross-subsidization from low-risk populations to high-risk ones

Myth 5: High-Deductible Health Plans And Competition, NotGovernment Action, Are The Keys To Lower Costs

i.reality- encourages the use of care with very Low marginal benefit and that greater cost sharing would help reduce the use of discretionary care of questionable value. But there is also evidence that patients under use drugs with very high value

-even $5–$10 increases in copayments for outpatient care can result in some patients‘being hospitalized as a result of cutting back too much- Capping total insurance benefits is also short-sighted and imprudent: not only does evidence suggest that such caps result in adverse clinical outcomes, worse adherence, and increased hospital and ER costs, but the presence of caps means that patients are not insured against catastrophic costs—exactly what insurance is supposed to protect against the most.

ii. A role for competition- Competition between insurers to offer plans that have the mix of benefits that enrollees find most valuable could drive the innovative plans described

False Conclusion: We Shouldn‘t Do Anything Until We Know What To Do

i.Reality- our health care system is not delivering the consistently high-quality, high-value care that we should expect

- we cannot afford to wait to act- without regulatory safeguards, even the insured sick will be at risk of losing the insurance protections to which they are entitled

- Private insurance fundamentally cannot provide the kind of redistribution based on underlying health risk or income that social insurance can

- Single-payer systems are also slow to innovate— as suggested by the fact that it took Medicare forty years to add a prescription drug benefit, long aftermost private insurers had done so.

- Reforms that promoted higher-value insurance could both extend coverage so that more people benefit from the protections that insurance affords and ensure that those protections are secure for those who fall ill

TAKE-AWAY: comprehensive reform proposal that aimed both to extend insurance protections to those who lack them and to improve the value of care received by those who are insured would be more likely to succeed at each goal than proposals that focused on just one

Public Health Insurance Programs

Ec 1420 Page 140

Public Health Insurance Programs

Iglehart, J., The American Health Care System: Medicaid, New England Journal of Medicine, Vol. 340, No. 5, 1999.

Largest health insurer in the US

Provides benefits to most of those that do not get employee-provided insurance

Has changed in the past decade to include a lot more people

Means higher expenditures and more forced managed-care programs

Many physicians still don‘t accept Medicaid because it provides so little payment to doctors

Medicaid is funded by both state and federal government

Funding to states for Medicaid is roughly 40% of all money provided to a state

States have significant influence over how to administer the payments

They can even decide who is covered under their policy

Result is almost 50 different Medicaids

Low income adults and children make up most of the people covered

But the elderly and disabled account for most of the spending

The insurance provided is much more extensive than Medicare, and there is very little cost-sharing involved

For elderly is effectively a form of supplemental insurance

In the Clinton years, the program has become much more state run

Also, Medicaid has cut ties with the welfare office

This was supposed to allow benefits for those who were not getting cash assistance

But has actually decreased the number of people applying for coverage

Most of these people don‘t have insurance of any kind now

Partly for this reason, the growth in Medicaid spending has decreased recently and is at its lowest level in years

Was rising due to increased coverage, increased spending per person and high payments to compensate hospitals for treating low-income patients

Now states are starting to limit their spending, even not accepting the full amount from the federal government

Managed care is a way to control the costs of health insurance

All states but Alaska now have mandated managed care programs

The savings have actually only been modest, because the compensation was already so low under the fee for service system

Iglehart, J., The American Health Care System: Medicare, New England Journal of Medicine, Vol. 340, No. 4, 1999.Started in 1965 for the elderly, meant to be a interim step toward the broader goal of universal health care coverage

Today covers 39 million people

Inpatient hospital services, continued treatment or rehabilitation, hospice care

Everyone is enrolled in Part A

Part A= Hospital Serviceso

Physician services and outpatient hospital services such as ER visits, ambulatory surgery, diagnostic tests, etc.

Medicare pays 80% of expenses over annual $100 deductible

Part B= Physicians‘ Serviceso

Spent on

Ec 1420 Page 141

Medicare pays 80% of expenses over annual $100 deductible

Voluntary enrollment

Money paid in today is spent today on current beneficiaries o

89% of revenue comes from people under 65, 11% from monthly premiumso

Money comes from: mandatory contributions by employers and employees, general tax revenue, premium paid by beneficiaries, deductibles and co-payments

Since 1977 Medicare spending has increased 10x and eligible population

has gone from 26 million to 38.6 million (Note: the article was written in 1999!)

A couple retiring in 1998 with one wage earner since 1966 would have

paid in $16,790 and would receive a PV of Part A benefits equal to $109,000

Financing Challenge

43 out of 347 plans announced their intention not to renew

with Medicare, citing financial losses

54 HMO’s announced plans to reduce number of

geographic regions

Enactment has been “fraught” with problemso

Bart of the 1997 Balanced Budget Act, expanded the array of insurance

plan choices

Medicare + Choice

Doctors are paid based on time, energy, and skill (physicians’ work),

practice expenses (like equipment), and premiums for malpractice insurance

The new payment schedule increased fees paid to generalists and

decreased fees paid to specialists

Generalists v. Specialists

May need to shift more risk to beneficiaries

Under this plan all beneficiaries would receive a predetermined

amount to be applied to the purchase of a health plan providing defined benefits: essentially a voucher with an amount determined

based on age, sex, geography, health risk, income, etc.

o

Replace Medicare’s commitment to provide a defined set of benefits to

all eligible beneficiaries with a “premium support” system

Future Directions

Cutler, D., and J. Gruber, The Effect of Medicaid Expansions on Public Insurance, Private Insurance, and Redistribution, American Economic Review, Vol. 86, No. 2, May 1996

Health Reform

Feldstein, Martin, Balancing The Goals Of Health Care Provision And Financing

Health Affairs, 25, no. 6 (2006): 1603-1611, 0.1377/hlthaff.25.6.1603

-Desirable healthcare system would achieve three goals -Provide healthcare to those who can‘t afford it -Mostly, it‘s only the very expensive bills that are problems for people. -People have different levels of interests in expensive treatments with low probabilities of success – need for choices

-Avoid wasteful spending

Ec 1420 Page 142

-Avoid wasteful spending -We need to be sure that value of improved health exceeds cost of additional healthcare

-Allow care to reflect choices made by patient – problem of one-size-fits-all care -Maybe we should have a high coinsurance rate up to a certain amount-Health insurance reduces deprivation of care, but increases wasteful spending-There are essentially three important issues with health insurance -Patients are insulated from true costs -What to do about uninsured -What about expensive, untested emerging technologies?-Health savings accounts could solve some of these problems -Individuals deposit amounts equivalent to current deductibles -Withdraw money when they need care-Current HAS structure flawed -We want to make required contributions smaller -Concern about nonpayments – could be solved by giving hospitals ability to draw from HSAs

Fuchs, Victor R. and Ezekiel J. Emanuel, Health Care Reform: Why? What? When?

Health Affairs, 24, no. 6 (2005): 1399-1414, 10.1377/hlthaff.24.6.1399

There are clear problems with U.S. healthcare system with many uninsured and high costs of care. Systematic problems include financing care and organizing delivery.

o

Employer-based insurance: fewer firms enjoy monopoly profits to draw on to subsidize health insurance for workers. Declines of unions also hurts this area.

o

Medicaid and Medicare together cover 30%. This kind of insurance requires costly determination of eligibility, imposes high marginal tax rates on recipients, encourages evasion of reported income, and generates discontinuities of coverage as recipients move into and out of eligibility.

Means-tested insurance: requires costly determination of eligibility, imposing a high marginal tax rate on recipients.

o

Organization and delivery of care: lack of information technology and quality control. o

Some experts advocate a complete overhaul of the financing of health care to give physicians the information, opportunity, and incentive to deliver cost-effective care.

Also problematic are cost-benefit trade-offs, as financial incentives are often misaligned. Doctors want to deliver the best care possible, despite cost, but what about the uninsured?

o

Why?

Should reform be incremental or comprehensive?

Should reform focus first on the financing of care or on the organization and delivery of care?

Fundamental questions:o

Most of these kinds of reforms focus on financing and reducing the numbers of uninsured people.

Attempt to eliminate ―free riders‖o

Negative effects: loss of employment especially for low-wage

Employer mandates: all employers above some size offer their workers health insurance (maybe accompanied with tax credits or subsidies).

Options

Incremental reformo

What?

Ec 1420 Page 143

Negative effects: loss of employment especially for low-wage workers; mid-size firms could be discouraged from expanding and entering into the mandate; when mandates are at the state level, firms could have incentive to move to a state with a different mandate.

o

Provided for the uninsured through tax credits. o

Advantage: increases freedom of choice; does not intrude directly on the labor market.

o

Indirect effects: could reduce the number of workers covered by employers; if subsidies are geared to income, additional disadvantages associated with determining eligibility and disincentives for those who might increase their income.

o

Subsidies

building on the Medicare/Medicaid programs

health savings accounts like consumer-directed healthcare focusing on cost-effectiveness

managed competition

quality incentives: paying for performance and subsidizing providers to install EMRs.

Other options

Goal is universal coverage.

Personal mandates and subsidies: everyone American has health insurance that meets some minimum standard, government provides income-related subsidies or tax credits to the poor.

Good on paper, bad in practice. Patients and physicians make own arrangements for care, with patients paying out of pocket or with private insurance.

o

Single-payer proposals: imagine Medicare extended to cover all age groups, covering dental services, long-term care, prescription drugs, and more comprehensive mental health care. Private health insurance would be sharply restricted or eliminated entirely.

Voucher system: universal health care vouchers, combining publicly funded social insurance for base care with important elements of choice and competition. Individuals and families have free choice of plans and freedom to purchase additional services with their own after-tax dollars.

Approaches

Comprehensive reformso

In order to reach organization, you need financial incentives.

Reform priorities: finance or organization?o

Political climate makes changes difficult (note: article written in 2005).o

Satisfaction with status quo: many are satisfied with the current status quo. Even if two-thirds were dissatisfied, that is still a large minority that does not want reform

Single- issue groups: this group wants a change in the system, but they want different changes. Some want better coverage for demographic groups, others want more attention and resources for those with certain diseases, others want preventative care, others more patient involvement, and the list goes on.

U.S. system of government: checks and balances make change difficult. Any comprehensive change in health care will result in winners and losers. Prospective losers are likely to be more involved and effective in blocking the change than prospective winners.

Differences of opinion: proposal must overcome resistance from those who

Obstacles to reformo

When?

Ec 1420 Page 144

Differences of opinion: proposal must overcome resistance from those who favor comprehensive reform but disagree on changes they want enacted.

A major war, a depression, or large-scale civil unrest could change the political climate and overpower the obstacles.

Other possibilities: widespread dissatisfaction of the business community with employer-based insurance; state governments‘ ability to sustain the growing fiscal drain of means-tested insurance; a financial crisis with Medicare.

There also might be a growing realization by average Americans that the risk of the current system to them personally and to the country as a whole outweigh the risks of a comprehensive reform.

What could set the stage for comprehensive health care reform?

Precipitators of reformo

Ec 1420 Page 145