Understanding Our Economy and Our

Current Government Policies

Oral Capps, Jr.Executive Professor and Regents ProfessorTexas A&M University March 4, 2013Email: ocapps@tamu.edu

Things should be made as simple as possible, but not any simpler.

---- Albert Einstein

Overview• Gross Domestic Product• Measurement• Key Points• Components

• Understanding Determinants of Private Sector Components of GDP (Consumers, Business)• Interest Rates• Taxes

• Monetary Policy• Fiscal Policy

Overview• Deficit/Surplus/Balanced Budget• Public Debt• Fiscal Policy Tools• Recent Situation• 2007-2009 Financial Crisis• Dodd-Frank Act• Quantitative Easing• Passage of Obama Care

• Where Should We Go from Here?

Gross Domestic ProductDefinition

A measure of the total amount of goods and services produced by the economy during a particular period of time.

Simon Kuznets – National Income Accounts – Department of Commerce – first made estimates in 1932.

Gross Domestic Product Measurement

Money – a common denominator ; add up the value of money in terms of the total output of goods and services during a certain time period, normally a year.

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

50 55 60 65 70 75 80 85 90 95 00 05 10

GDP

Year

Gross Domestic Product (GDP)

GDP at the beginning of 2013 was $15.8 Trillion

Gross Domestic Product Key Points

1. GDP only includes the value of final goods and services produced.

2. Some final goods and services included in GDP are not bought in the market place, so they are valued at what they cost.

3. Some non-marketed goods and services are excluded from GDP.

4. Purely financial transactions are excluded from GDP.

5. Sale of second-hand goods are excluded from GDP.

6. Illegal activities are excluded from GDP.

Year to Year Change in GDP

-6

-4

-2

0

2

4

6

8

10

55 60 65 70 75 80 85 90 95 00 05 10

YTOY_CHANGE_GDP

Year

GDP Componentsa) Personal Consumption Expenditure (C)b) Gross Private Domestic Investment (I)c) Government Expenditure (G)d) Net Exports (NE) = Exports – Imports

GDP = C + I + G + NE

Work of John Maynard Keynes – Represents the Aggregate Demand for any Economy

Components of GDP, 1947 to 2012

0

2,000

4,000

6,000

8,000

10,000

12,000

50 55 60 65 70 75 80 85 90 95 00 05 10

PCE

0

400

800

1,200

1,600

2,000

2,400

50 55 60 65 70 75 80 85 90 95 00 05 10

GPDI

0

1,000

2,000

3,000

4,000

50 55 60 65 70 75 80 85 90 95 00 05 10

GOVT_EXP

-1,000

-800

-600

-400

-200

0

200

50 55 60 65 70 75 80 85 90 95 00 05 10

NET_EXPORTS

YearYear

YearYear

Share of GDP by Component, 1947 to 2012

-10

0

10

20

30

40

50

60

70

80

50 55 60 65 70 75 80 85 90 95 00 05 10

GOVT_EXP_SHARE GPDI_SHARENET_EXPORTS_SHARE PCE_SHARE

Year

Average over the period: PCE – 65%; GDPI – 16%; GOVTEXP – 20%; NETEXPORTS – 1% (negative)

Understanding Determinants of Personal

Consumption Expenditures and Gross

Private Domestic Investment

Drivers of Personal Consumption Expenditures

• Changes in the level of disposable personal income (the Keynesian consumption function); disposable personal income (DPI) is income after taxes

• Increase/decrease in wealth of nation’s household sector

• Interest rates

Drivers of Gross Private Domestic Investment

Profit expectations

Interest rates

Technological change

Taxes

Keys to making changes to GDP – interest rates and taxes

Key Question: How do we affect interest rates and taxes?

Monetary Policy Actions by the Federal

Reserve System (The “Fed”)

Changes in the money supply bring about changes in interest

rates

Consequences of FED Actions

• Contractionary monetary policies that drive up interest rates will depress personal consumption expenditures and investment expenditures by businesses and households

• Expansionary monetary policies that lower interest rates will stimulate personal consumption and investment expenditures

Fiscal PolicyTaxation by federal,

state and local governments

Government spending by federal state and local governments

Budget deficit and the public debt

Requires explicit actions by the President or Congress

Consider the Difference Between Government Expenditures (G) and Tax Revenues (T):

T – GT – G < 0 → DeficitT – G > 0 → Surplus

T – G = 0 → Balanced Budget

Deficit

• Record high deficits during the Obama Administration

• 1998-2001 surplus years in recent times

-1,600,000

-1,200,000

-800,000

-400,000

0

400,000

30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10

DEFICIT

Year

“There are 1011 stars in the galaxy. That used to be a huge number. But it’s only a hundred billion. It’s much less than the national deficit. We used to call them astronomical numbers. Now we should call them economical numbers.”

- Richard Feynman

Debt and the Deficit

Public debtT = Public debtT-1 + DeficitT

Total Public Debt, 1966-2012

0

4,000,000

8,000,000

12,000,000

16,000,000

20,000,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

PUBLIC_DEBT

Year

Public debt currently $16.6 trillion as of 2-27-2013.

Total Public Debt on a Per Capita Basis, 1966-2012

Year

Debt per person as of 2-27-2013 was $52,632.

0

10,000

20,000

30,000

40,000

50,000

60,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

PUBLIC_DEBT_PC

Fiscal Policy ToolsExpansionary actions: Effects of action:Cut taxes Increase disposable incomeIncrease government spending Increase aggregate demand

Contractionary actions: Effects of action:Increase taxes Decrease disposable incomeCut government spending Decrease aggregate demand

Congress & Obama

A federal budget deficit requiresthe U.S. Treasury to issue moregovernment securities to balancesources and uses of funds…

A federal budget deficit requiresthe U.S. Treasury to issue moregovernment securities to balancesources and uses of funds…

An increase in the sale ofgovernment securitiesreduces the pool of privatecapital available to financeinvestment expenditures,raising interest rates…

An increase in the sale ofgovernment securitiesreduces the pool of privatecapital available to financeinvestment expenditures,raising interest rates…

Higher interest rates depresses gross private domestic investmentand personal consumption expenditures

Higher interest rates depresses gross private domestic investmentand personal consumption expenditures

Recent Situations:2007-2009 Financial CrisisDodd-Frank ActQuantitative EasingPassage of Obama Care

The 2007-2009 Financial Crisis• Subprime Mortgages, Housing Bubble• Between $10-20 trillion in costs:• Lost output, reduced wealth, extended

unemployment, and extraordinary government intervention programs

• Crippled confidence, lost opportunities, increased uncertainty

• Adverse impacts will likely endure for a long time• Reduced capacity to respond to the next crisis

Insurance “is a system whereby a person who can’t pay, gets another person who can’t pay, to guarantee that he can pay.”

- Charles Dickens, Little Dorritt

Dodd-Frank Act • Signed into law July 21, 2010; brought about

significant change to financial regulation in the U.S.• Long on process, short of results• Has not been simplified and codified quickly

• 849 pages; 8,800 pages of regulations; approx. 1/3 finalized!

• DFA contributes complexity and confusion to regulatory discipline; increases economic uncertainty

Quantitative Easing• The Fed has cut interest rates as far as they

can go and the economy is still struggling• Done by the Fed three times:• QE I – November 2008• QE II – August 2010• QE III – September 2012

• Unconventional monetary public tool used by the FED to stimulate the economy

• Buy up assets like long-term treasuries or mortgage-backed securities from commercial banks and other institutions, which drive long-term interest rates down

• Provides consumers/investors incentives to increase expenditures, thereby stimulating GDP (in theory)

Passage of Obama Care

• Creation of additional uncertainty

• Increases in costs of medical care

• Interference with the private sector

Commonalities• Government Intervention –

Socialism (Increase in Taxes; Increase in Government Expenditures)• Redistribution of Wealth,

Movement to Egalitarianism • Sizeable Increase in Uncertainty• Slow Economic Growth

Where Should We Go from Here?

(A Normative Question)

“The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest bankruptcy occurs. People must again learn to work, instead of living on public assistance.”

-- Cicero, 55 B.C.

Policies to Promote Growth• Lower Corporate Tax Rates • House Ways and Means Committee Chairman

Dave Camp, (R-MI) would lower the top corporate tax rate to 25%.

• America’s corporate tax rates are the highest in the industrial world, which has an average corporate rate of 23%.

• Canada, our largest trading partner, has a 15% rate, as does Germany.

• Make it easier for foreigners who want to work, the highly skilled and those with modest skills, to come to America legally

Policies to Promote Growth• Reduce the regulatory burden• 2013 will see a deluge of new regulations,

ranging from EPA standards for hydraulic fracturing to new Dodd-Frank Act regulations

• We must pass something akin to Representative Lamar Smith’s Regulatory Accountability Act of 2011 to make agencies demonstrate that regulations are cost effective

• Institute the Fair Tax• Balance the Budget – Gramm (TX),

Hollings (SC), Rudman (NH)

The Bottom Line“We need to stimulate production and savings. Everything the

government is doing is going to suppress that.”Peter Schiff, CEO of Euro Pacific Capital, Inc.Outspoken opponent to Keynes and Bernanke

•Create incentives to work, to save, and to invest – Reagan Playbook (supply-side economics)•Public debt, both marketable debt and promises to citizens, crowds out capital investment.•The almost unprecedented increase in the ability of the population to move resources to the future using debt rather than capital could result in a significant reduction in the rate of economic growth in the coming decades•Need to balance the budget•Seriously explore the institution of the Fair Tax

“Capitalism is the only system that can make freedom, individuality, and the pursuit of values possible in practice.”

Ayn Rand, The Romantic Manifesto

“When the people find they can vote themselves money, that will herald the end of the republic.”

Benjamin Franklin

Reading Assignments• What Everyone Should Know About Economics

and Prosperity – James Gwartney and Richard Stroup (119 pages)

• Economics in One Lesson – Henry Hazlitt (218 pages)

• The Fatal Conceit – Friedrich Hayak (180 pages)

• How an Economy Grows and Why it Crashes – Peter Schiff