Tuesday, March 12, 2013

Econ 101

With looming cuts I thought it might be helpful to explain some of the ways that our economy functions in a rambling and probably far from comprehensive way.

The Rational Actor Model or Rational Choice Theory
The basic Adam Smith style of economics established the Rational Actor Model--RAM.  The basic concept can be broken into four components:
  1. People are always trying to be happier (utility)
  2. People make their choices based on complete information (perfect information)
  3. People have enough time to make decisions (time)
  4. People make the decision that maximizes their happiness (maximization)

You don't have to be a genius with a Ph.D. in economics to realize that the Rational Actor Model doesn't work too well on a case by case basis.  This concept is, however, fundamental to the basic capitalist model of supply and demand that we encounter in the most condescending debates about what to do with the economy.  And why would such a fundamentally wrong model persist--even squirming into many modern economic papers that are valid?

The simple answer is that it's simple.  When analyzing large groups together, the RAM acts like a statistical curve.  Individual anomalies are counter-balanced by a large number of 'regular' nearly-rational people who tend to make nearly-rational decisions as a population.  The forest appears from the trees--sort of.

The RAM has come under severe criticism and seems to work in select situations.  As a complete theory, it falls short, often deteriorating when pitting two goals against each other.  An excellent example is the Tragedy of the Commons where the long-term and community benefits diminish short-term and individual benefits.  I've written about this in other places, so I'll stop there.  The point is that often we can't fully account for outcomes using the RAM.

Supply and Demand
Most people are familiar with the Supply and Demand curves.  These two intersecting lines represent how markets function in a very basic context.  It is, more or less, pure Capitalism.  The fundamental assumptions:
  1. RAM
  2. Infinite vendors and buyers
  3. No barriers between vendors and buyers
  4. Homogenous product

Obviously, this model is insufficient to properly explain our modern, complex financial systems.  In fact, in America instead of many small vendors selling the same goods to a geographically small area of rational Americans, we have a few vendors selling specialized goods to nearly a continent of irrational 'mericns.  Then there is the added bonus of tariffs, government regulations, and product specialization within a category of goods (Audi R8, Ford Focus, and Toyota Sequoia are all cars but are drastically different).  For more on specialization, it would be instructive to read about Paul Krugman's work--which incidentally won him the Nobel Prize.

The supply and demand graph is good for establishing a basic sense of economics.  It also can be modified to add in some factors like monopolies, government regulations, and geographic barriers.  However, it fails to fully account for unknown qualitative impacts.  That is, as long as all variables can be directly quantified, the model holds pretty well.

How this works in the real world?  Well, politicians and pundits--often with an axe to grind and with little by way of formal economic education--are apt to frame economics in black and white language.  Economics, as with all sciences, is an on-going and evolving debate that rarely makes discoveries that nullify previous ones.  As such, it is far better to think of splits in economic philosophy as part of a continuing refinement rather than an "at-odds" crossfire style debate.

And this reflects in how economists present themselves.  Despite being from a wide array of political persuasions and cultural backgrounds, they generally agree on many basics.  And they tend to be right.

Modifying the dream - Keynes
John Maynard Keynes is the Macro-Economics guy.  He basically came up with a philosophy that works pretty well for governments, "in the long-run, we are all dead."  As a caution, this is a gross oversimplification.  What he was getting at is that a government's function is to ensure the prosperity of its citizens now, and in so doing, the long-term tends to work itself out.

The case study is the Great Depression.  Hoover restricted spending and tried to cut the deficit in anticipation of lowered revenue due to the downturn.  When he lost--partly because FDR was so charismatic--the New Deal Democrats set up national programs that boosted spending in local economies.  The idea was that by creating fiscal policies that encouraged private companies to grow and thrive there would be a cushion while the private sector recovered its capital and eventually prospered without government intervention.  Keynesian theory tries to reduce unemployment by creating job demand when private enterprise cannot (again, major oversimplification).  Of course, FDR's policies didn't pass without opposition, and so he was forced to create measures that were inadequate to fully address 1/3 of workers being unemployed.

Not until America entered World War II, did the government have the political capital to spend whatever it needed to address the economy.  If the war effort were to be looked at as a stimulus to the economy, it was the single most effective in American history.  Post-war, the GI Bill, aimed at returning veterans, provided low-cost access to education, housing, and middle-class lifestyles; creating the boom in the 50s.

Then Eisenhower pushed for his drastically improved interstate road system.  After that, Johnson had his great society.  All this during the Vietnam Era and the Cold War.  Spending for public and military programs really didn't contract too drastically until the recession in the 1970s.

The 1970s were interesting because high unemployment coincided with high inflation, a phenomenon known as stagflation.  Classical, Neo-classical, and Keynesian theories (schools of economic thought) at the time failed to fully account for stagflation and an appropriate response.

Basically, a major change in supply or demand causes a shock to markets, resulting in steep price increases, while the unemployment rate also rises causing high unemployment and high inflation.

This change brought about the Neo-Keynesian theory of the economy.  Traditional monetary and fiscal policies assumed that reactions to certain policies remained constant when in fact, the effectiveness of monetary stimulus changes over time because markets adjust expectations.

The response by Central Banks at the time was to lower interest rates and make it easier to borrow money; a well-tested policy that works in a non-stagflation scenario.  However, businesses and consumers reacted differently--because inflation remained high* and actual availability of goods remained low.  Instead of companies producing more, they simply raised prices.  This could be caused by several factors, and during the 1970s was attributed mainly to price controls imposed by Nixon--and price fixing by OPEC nations

Eventually, many price controls were lifted, and during the late 1970s and early 1980s, the government made a concerted effort to increase productivity, reduce the effect of price shocks, and create cushions for goods.  Things like the National Oil Reserve, deregulation of the airline industry, and reducing or eliminating tariffs for goods.

These all, of course, came with their own drawbacks, but generally the trade-off was seen to be good.

The Great Recession has been an interesting case study in effective macro-economic policies.  With the world economy largely driven by four major players--the EU, the US, China, and Japan--we can see four different policy approaches in place.  China, being a rapidly developing nation with its communist style of government, is hard for a comparative analysis, but the other three have relatively similar economies and governments.

The EU's response, largely due to its weak centralized government, has been to increase taxes, restrict spending, and prevent the free flow of goods and capital.  While the EU was originally conceived as an economic coalition, during the Great Recession, it has proven itself to be inefficient at addressing crises quickly.  The PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain) have all experienced high unemployment while their governments have been unable to provide needed stimulus.  This has also been exacerbated by the ECB (European Central Bank) responding with similar lethargy until recently.  The simple fact is that the countries that can provide cash flows, refuse to.  It is politically suicidal for Germany, France, and Britain to hand over money to nations they see as less developed, less responsible, and less able to spend effectively.  Meanwhile, PIIGS see their more prosperous counterparts as stingy and deaf to the needs of their people.  The union built on trust and international goodwill has been strained enormously. 

Japan, on the other hand, has recovered well.  Their strong central bank with a firmly mainstream approach to monetary policy has moved largely in lock-step with the fiscal policies of their government.  While not fully recovered and certainly still prone to shocks--as they recently experienced for a brief moment--Japan hasn't experienced massive turmoil despite the tsunami, an aging workforce, and losing its number two economic spot to China.

The United States, being the primary driver of economic activity in the world, had to respond quickly to the crisis.  In addition to passing a stimulus package and providing huge bailouts, the government has been fairly responsive to the diverse economic needs of local jurisdictions.  The Federal Reserve has been similarly adept at responding, steadily drawing down interest rates to .01% (from about 5%) and providing several rounds of quantitative easing (lots of money).  The initiatives have been tempered: first the stimulus package was far below what economists recommended and the money didn't go straight to shovel ready projects as hoped; second political gridlock and a wave of deficit hawks in 2010 sparked a backlash against government spending, causing many capital flows to slow or stop, and hindering the recovery.

In the pursuit of smaller government, the US has shed nearly 500,000 government jobs, a sizable chunk of the nation's overall unemployment.  The problem isn't necessarily that government is getting smaller per se but that the private sector during this time did not have the willingness or resources to absorb those jobs, let alone the many that were in the private labor force pool already.

Further, by restricting spending and forcing private enterprise to absorb labor--something they are unable to do if there is no demand for goods (which is driven by employment (do you see the catch-22?)) then the economic recovery will be as slow as the capital that goes into it.  Similarly, the housing recovery has been extraordinarily slow to come back, dragging down growth.  That is also due mostly to the failure of large private institutions or the government to step in and stimulate the recovery directly.  It would be unheard of for private lenders to take on that kind of task, so government is the remaining actor.  With constrained spending, a housing recovery program is mostly absent.

The Deficit, the Sequester, and the Debt Ceiling.
First the debt ceiling.  America incurs debt for its programs.  The debt ceiling is a limit on what the government can spend to pay back those debts.  The problem is that the debts have already been incurred.  Raising the ceiling does not affect spending, it just affects how trustworthy the US is when it comes to paying off our debts.  It's dumb to call oneself fiscally responsible yet refuse to pay off debts.  That it is a political football makes no sense to me; if someone can explain it in rational, non-ideological terms, please do so.

Second, the Federal Deficit is the revenue produced by a government (mostly through taxes) less its debt.  With the exception of a very few years in the history of the United States, we have run a deficit in our budget.  Budgets can be balanced via two methods, increasing revenue or decreasing expenditures.  Increasing revenue means increasing taxes, decreasing expenditures means cutting government programs.  Simple stuff.  Currently, the United States Federal Deficit exceeds $1 trillion per year, a number that has been decreasing steadily, but according to many, not fast enough.  The huge annual deficit is a product of the Iraq and Afghanistan wars, the Great Recession, and its subsequent stimulus.  Contrary to what some believe, the Affordable Care Act does not contribute to the deficit significantly, if at all (the CBO has estimated that it actually reduces the deficit). 

Programs for unemployment and poverty (the proverbial social safety net) have increased their expenditures due to an increased need, but are symptomatic of a sluggish economy and not the reverse.  It is expected that with an adequate recovery, many social programs will shrink accordingly.

So, what are the adverse effects of the deficit?  Actually, there kind of aren't any.  A large deficit might be worrisome to a household but as long as the nation is stable, there really isn't much bad that can happen--especially to the US.  This is sort of counter-intuitive, but because countries don't die, debts are being constantly paid off.  We can incur debt as long as we can pay it off in the medium and long term.  That means, raising the debt ceiling in the US and allowing the Treasury to sell bonds.

We'll have to detour briefly to explain how the Treasury and the Federal Reserve interact.  The US Treasury is empowered to buy and sell bonds.  Bonds are basically loans the government takes out that accrue their full value over time.  So, the US Treasury sells off bonds to private and public bidders. Anyone can buy a government bond, and the more demand for bonds, the lower the rate the treasury can sell them for.  The Federal Reserve is the bank of banks. They issue Federal Reserve notes to the Treasury in the form of a loan.  It's…um…weird.  Basically the Fed sets the money supply, and makes a loan to the Treasury which it uses to sell at auction.  Sometimes (often times) the Fed buys some of those.  The government does owe itself money.  Just look up US Treasury Securities on Wikipedia for a slightly more insightful look.

But this isn't nearly as worrisome as some might speculate.  The Fed is a highly regulated institution with a mandate to maintain moderate inflation, maximize employment, and keep the money supply stable.  These three elements are meant to be the cushion (from a monetary policy perspective) in case of a crash.  They insure against bank runs and stabilize out of control markets.  The Fed chairman is intentionally a conservative (as in reserved (no pun intended)) figure.

Right now interest rates are historically low.  This means that the government--when it sells or loans money to non-Federal institutions--is actually getting paid to do so.  Also kind of weird.  America is seen as such a safe investment that people are willing to lose money.  Remember how I started with the RAM?  Yeah, a little proof it has some limits.

Anyways, there is a sort of fear that the house of cards may fall.  That by the Fed printing so much money, it will eventually cause rapid inflation or some sort of economic collapse.  Given the discussion of the 1970s there is a real possibility that under the right conditions employment could take a nosedive, prices could skyrocket, and stagflation could ensue.  It comes down to a question of how fast money can move to goods.  The answer is pretty damn fast.  Currently markets are not only absorbing the capital that is flowing from the government, but it is having a measurable impact.  Employment is slowly but surely rising, indicating that supply is meeting demand.  When there is a bump in inflation across the board; an unpredictable one, the Fed's policies could be called into question a bit more.

Then again, I'm no fan of easy money policies.  They were how we got ourselves into the housing crisis.  But there is a time and place for everything.  The biggest problem is that a good macroeconomic policy reflects both monetary and fiscal controls.  These days, our fiscal policy is sluggish and mismatched to our situation.  Listen a bit to Ben Bernanke berating Congress.

And now back to the deficit.  At an annual rate of over $1 trillion, the deficit is pretty freakin' big.  The ways to reduce the deficit come in a couple of basic packages: the sequester, revenue, cuts, or a mix of revenue and cuts.  The sequester sucks.  Anyone who gives a god damned about who started it is missing that it was passed in a bi-partisan manner specifically as a stick to get congress to come to an agreement about the budget.  Spoiler alert: they haven't.

Of course the reasonable solution would be to have Congress and the Executive come to an agreement.  The two houses, being divided, haven't gotten it together to even put something before the president.  Hell, no offense to Boehner, but he can't even get his majority in-line enough to get a bill to the floor.

But theoretically the house would pass a bill that reduces the deficit while avoiding the two major adverse impacts: increased unemployment and/or inflation.  Frankly speaking, 100% cuts not offset by revenue in any way results in essential services being cut.  The government, although far from being perfect, isn't full of as much pork as people tend to think.  The examples of welfare queens and lazy recipients of government services don't hold up to the Poli-Sci microscope.  There are few people--if any--living off the largesse of the government without putting back into the system.

What is known are the adverse impacts of cutting essential government programs.  The first programs that have taken hits are community service programs--things like bus services to rural areas, grants for essential infrastructure, housing and food to underprivileged communities, and many more.  And now with the sequester, our national security.  These cuts can cost America billions--and if they last long enough trillions--in lost productivity, increased household/national insecurity, and reduced opportunities.  The cuts disproportionately affect underserved and underprivileged communities (those most vulnerable already) and far exceed their savings.  The cuts that would shave down the deficit would almost certainly increase unemployment and inflation by cutting off labor demand from its qualified supply.  And it won't be temporary.  By making these cuts--cuts no private institution or group of institutions can adequately fill--we will increase our institutional unemployment.  The kind of unemployment that doesn't just go away when the economy recovers.  The kind of unemployment that persists because the jobs aren't there.  If the primary way to stabilize an economy is to prevent shocks, the sequester is an antithetical push away from that course of action.  Economies recover as industry slowly replaces government spending with private sector growth, but a precipitous drop in government not countered by private investment in goods, services, or employment can easily reverse growth trends.

Oh, and also, Hanford.  That is scary stuff.  Because of federal cuts the government is unable to clean up leaking tanks at this time. there is nuclear waste just leaking with no way to stop it because we don't have the money.  We aren't a third world country and we deserve better public health.

There are ways to manage a budget. You can shave programs down, but that is a long-term conversation.  A lean, mean government doesn't come from the hack job that we've just done on it.

Realistically, a package with some amount of revenue is essential.  Revenue comes almost exclusively in one form. Tax increases.  It doesn't sound very palatable, but it is reasonable.  Tax raises come in two (three) flavors: reduced loopholes, and increased rates.  Currently there are about $1 trillion (over a decade) in loopholes that can be closed without much of a change.  These could immediately start generating revenue.  Political will for this has been hard to come by on this because the Republicans are split on whether this is reasonable.  Small government and tea party Republicans have mostly resisted while establishment and moderate Republicans tentatively support it with an eye on HW Bush's famous last words, "read my lips, no new taxes."

The second approach is raising rates.  Overall, tax collection has poor oversight, rates are at historical lows, and the code is incredibly imbalanced.  There is a reasonable case to be made for many revenue generating taxes that would cause little headache and could conceivably stabilize our financial markets as well.  Read Winner Take All Politics for more information.  The gist is that we could very realistically raise rates for some and reap huge benefits for all. As a real what world example we could look at the raised rates on the wealthiest americans via the expiration of the payroll tax holiday.  The economy hasn't flinched, dire warnings about a second recession haven't come true and that's because taxes are poorly correlated with a successful economy.

This holds especially true for rates on the wealthiest Americans, which have all but decoupled from the rest of the economy.  That presents a real challenge--the wealthiest Americans have seen exponential gains in their income while the rest of the population has experienced only moderate or negative growth.

That's not to say we need 100%tax rates, just that they may be raised moderately without incurring an employment or a growth penalty.

The third tax option is changing the code.  Things like the VAT (value added tax) are a great example.  Alternately, we could add a .01 cent tax on short sales of stock, generating billions without measurably hurting financial markets.  Seriously.  That's a little longer term.  When government can actually pass more than a few bills in a year.

Raising taxes does risk businesses not wanting to hire people though right?  Or raising prices to cover their costs?  Maybe in the statistical outlier, but again, the Poli-Sci/econ fields find little evidence to show that reasonably raising taxes causes slow downs in hiring or price shocks.  What they do find is little direct linkage at all between tax rates and economic prosperity.  That means trickle-down doesn't work, and tax cuts don't spur growth.  Sorry.  I really don't mean to be a hard ass about this but the data sort of kind of pretty definitely shows that.

But again, the deficit isn't our most pressing issue.  And here is why http://www.nytimes.com/2013/03/11/opinion/krugman-dwindling-deficit-disorder.html?ref=paulkrugman&_r=0.

Democracy and Capitalism (aka Political Economy)
Recovery comes from investment.  The deficit shouldn't be our first priority.  Ultimately, we need to readjust how we think about our economy in terms of long-term stability, short-term responsiveness, and focus on who benefits (and who doesn't).  Despite our best intentions, our 'capitalist' economy is neither free nor tied down, and we'd want neither.  It is a highly regulated instrument with laws that benefit some and hurt others.  Some of these cushions make some sense. Some do not. 

If economics can be seen as part of our societal construct--a distinct manifestation of our values, culture, and flaws--then many of our misconceptions about wealth acquisition and management melt away.  What is left are models for understanding behavior and transactions in a complex equation where governments interact in the economy not just as regulatory bodies but also as participants.  This participation cannot be eliminated and during periods of uncertainty must be increased temporarily to offset less powerful actors.  Most of the time the government is steering the ship and in rough waters they must press forward harder and with a steady hand.

One may draw down spending over time and during prosperous eras but it must be offset equally by businesses and consumers willing to helm the economy together.

But again, our current economic situation has a surprising dissonance.  Wall street is posting record gains while unemployment remains fairly high.  Growth in most sectors is not being matched with employment. Quality of life is being overshadowed by a drive for higher productivity.  Employment is not keeping parity with liquid assets.

If economic recovery for all Americans is the goal, then policies that transfer money into jobs is the path to that goal.  Simply put, it is the responsibility of a government to oversee the prosperity of all its people, not in an authoritarian or communist sense but rather in knowing that the most unstable periods in our history have sprung from disproportionate allocations of wealth and power to a very few individuals.

The budget deficit does not pose a threat to the fabric of our society. It is the waving screaming distraction to the real bread and butter issues of the economy.  Jobs, jobs, jobs.

Conclusion (Sort of)
Basically, looking at the fundamentals of economics and understanding its evolution is instructive for noting how people tackle modern economics problems.  While many things may seem complex or obscure--economists still have a ton of research to do--there is plenty that is known.  These known elements make up the core of economic thought, a substantial field that has robust results and can be quite helpful in forming policy.

If there is a lesson here it is to listen to economists and fund their research so that we may all enjoy the benefits of a more stable economy with low unemployment.  Or something equally (hopefully more) profound.

*High inflation is pretty relative: in America, high inflation can be 4% annually, but in other countries inflation can exceed 1000% (known as hyper-inflation). Low inflation is 'good' because it keeps prices stable and ensures that people can expect what to earn, and how to spend the money that they earn.