The Becker-Posner Blog

Is the Federal Government Broke? Posner

A company or other organization, or an individual, is insolvent when its liabilities (what it owes) exceed the market value of its assets. Bankruptcy is a legal mechanism for liquidating or reorganizing an insolvent entity in a way that maximizes value for the creditors. When a firm is insolvent, each of its creditors is eager to be repaid what he is owed, out of the firm’s assets. By definition those assets are insufficient to satisfy all the creditors’ claims, so the creditors race to obtain judgments, which are then satisfied by sale of the firm’s assets, perhaps at fire-sale prices because of the race. Even if the firm could be saved as a going concern by eliminating some of its debt burden (its liabilities), transaction costs will make it difficult for the creditors to agree on how far their respective claims will be written down—how in short to share the grief. In a bankruptcy proceeding, the creditors are barred from suit and the judge supervises an orderly disposition of assets (whether by liquidation or by placing them in a reorganized entity) designed to maximize their value and hence the creditors’ ultimate return.

 

Bankruptcy is not limited to individuals and business firms; under U.S. law, even a city can be declared bankrupt; and this happens occasionally. In one Illinois town, the bankruptcy judge ordered the sale of city hall to satisfy creditors’ claims. U.S. states cannot be subjected to bankruptcy proceedings, and neither can the federal government, or the governments of other nations. But that doesn’t mean that a state or nation can’t be insolvent. Insolvency is the condition; bankruptcy is a method of treating the condition.

 

A nation has creditors in both a narrow and a broad sense. In the case of our federal government, they are of four types: owners of federal securities (Treasury bonds and short-term bonds called Treasury bills or Treasury notes); other persons or firms that have contracts with the federal government, for example for sale of goods or services to it; holders of federal entitlements, such as social security, Medicare, Medicaid, and the pensions of retired federal employees; and beneficiaries of government services (as distinct from transfer payments), such as drivers on interstate highways and visitors to national parks, as well as the population at large, which is protected from crime and foreign aggression by federal police and military forces.

 

The first two categories of holders of government “debt” in a broad sense—owners of government bonds and holders of government contractors—correspond closely to the creditors of private companies. The third does not because federal entitlements can always be cut with impunity, from a legal standpoint; and the fourth are not entitlements, but services that are funded by annual congressional appropriations and so can be altered without being thought to disrupt settled expectations; they are the domain of “discretionary” government spending, though in a legal sense entitlements are discretionary also rather than being fixed and legally enforceable obligations.

 

But remember that insolvency is the condition, bankruptcy merely a treatment for the condition; and a condition is not less grave just because the best treatment for it is unavailable—in fact the condition is more serious in that case.

 

These reflections are suggested by the first issue (August 25) of a new publication by Morgan Stanley called Sovereign Subjects. The first issue is captioned “Ask Not Whether Governments Will Default, but How.” It is a criticism of the conventional method of evaluating a nation’s economic condition, which is to compare public debt (government bonds) to Gross Domestic Product. In the case of the United States, that ratio in percentage terms is 53 percent, which is high by historical standards but lower than that of a number of European nations, which are listed in the report (France, Germany, Greece, Ireland, Italy, Portugal, Spain, and the U.K.). But as the report points out, this is not a proper way to determine solvency. The proper way is to compare assets and liabilities. The major asset of any government is its taxing power, which of course cannot be equated to the entire GDP, or the entire value of the nation’s human and physical capital; for both economic and political reasons, the taxing power is limited to a percentage of GDP well below 100 percent. And, realistically, the liability side of the national ledger includes not only government bonds but also other contractual obligations, entitlements, and at least strongly anchored expectations concerning government services (we’re not about to eliminate our armed forces). In addition, as especially emphasized in the Morgan Stanley report, the national balance sheet must be reckoned in dynamic terms, with due regard for likely increases both in GDP and in liabilities, especially increases in entitlement spending that are likely to result from the continued ageing of the population.

 

Because American tax rates are low by international standards and resistance to increasing them is fierce, Morgan Stanley’s report estimates that the ratio of current U.S. public debt to realistically realizable tax revenues is 3.58 to 1, which is the highest by a large margin of the countries in the report’s list; only Greece comes close (3.12 to 1). But America has certain advantages, such as a younger population and a more rapid rate of economic growth, and as a result its ratio of net worth to GDP is in the middle of Morgan Stanley’s list of countries—but it is strongly negative, as are the ratios of all the countries in the list (Italy, surprisingly, being at the top, and Greece, unsurprisingly, at the bottom). According to Morgan Stanley’s calculation (which obviously is merely suggestive, as the report emphasizes, because of the uncertainty of the future), America’s net worth is negative, and this negative net worth is eight times larger than our GDP. This means that the net present value of the government’s liabilities, minus assets, is approximately $120 trillion.

 

What does a firm or an individual do when it is broke and there is no bankruptcy regime? It defaults. Nations do occasionally default on their bonds or other contractual obligations; or, if the bonds or other obligations are denominated in the local currency, they inflate the currency and so repay their obligations in cheaper money, which is the equivalent of a partial default. The U.S. government is unlikely to do either of these things and therefore, in conventional parlance, is not insolvent. But as the Morgan Stanley report insightfully emphasizes, the government has other “stakeholders,” and they are creditors in a loose but illuminating sense. A cut in social security, Medicare, or other entitlements amounts to breaking the government’s promises to the holders of these entitlements, promises on which the holders have relied. So does reducing government services (highways, police, etc.) or increasing taxes, which reduces the net value of those services.

 

The deeper the financial hole that the government has dug for itself by incompetent economic management—and our government has dug itself a very deep hole, largely because of the mismanagement of monetary policy and financial regulation by the Federal Reserve under Greenspan and Bernanke and by other government agencies—the more difficult it is to climb out of the hole on the backs of holders of entitlements and recipients of government services. The political resistance is too intense. It’s at that point that the bondholders, and holders of other contractual rights against the government, have to start worrying about the prospects for outright default or default through inflation. These are possibilities in our future, just as in the future of Greece.

How Dismal is the Fiscal Future For America and Europe? Becker

Posner lays out clearly many of the present and future solvency and default risks to the United States federal government. He bases some of the analysis on a valuable recent Morgan Stanley report with the provocative title “Ask Not Whether Governments Will Default, but How”. Default on some of their debt by countries like Greece and Italy are real possibilities, and default by leading countries like the US and Germany is surely possible. But I do not believe their default is at all inevitable.

The report first presents the usual measure of default risk- the ratio of government debt (not held by other government agencies) to GDP in 2009- for the federal government of the US and for eight European nations: France, Germany, Greece, Ireland, Italy, Portugal, Spain and the United Kingdom. On this criterion, Greece and Italy look in trouble, with ratios of about 1.15, and the US looks in reasonable good shape, with a ratio of about ½, which is much lower than that for most of the other nations in their comparison set. For example, Germany’s debt/GDP ratio is 0.73, while the United Kingdom’s ratio is 0. 68. 

Morgan Stanley’s report argues debt/GDP is not a good measure of default risk, and suggests instead the ratio of debt to government revenues. On this measure, the US looks terrible, with a ratio of 3.58. This ratio is much higher than that of the eight European nations because they tax a much larger fraction of GDP than the federal government of the US does.  Yet it is not obvious to me that using tax revenue rather than GDP in the denominator is a better measure of solvency risk. Countries that already collect a sizeable fraction of GDP as tax revenue have less room to raise taxes than do countries like the US that tax a much smaller fraction. This argument suggests that the high GDP/tax revenue ratio for the US makes its solvency risk lower rather than higher compared to Europe. On the other hand, that the American federal government raises so much less may be a sign of greater resistance to higher taxes in the United States than in Europe.

On balance I believe it is better to use the debt/GDP measure, although the discussion that follows would be the same with either measure. Two main factors will determine the size of the default risk for the US as well as Europe. As both Posner and the report emphasize, a frightening prospect is the expected growth in entitlements over time, especially the growth in medical care spending. This is partly due to the continuing aging of populations in developed countries since older persons take a greatly disproportionate share of spending on medical care. Even more important than aging itself is that spending on each older age group has risen at a fast rate over time with the development of expensive new drugs and surgeries.

In the Affordable Care Act that became law in March of 2010, Congress and the president tried to address the high and growing spending by the US on healthcare. The US ratio of spending to GDP is approaching 17%, which is essentially the highest ratio in the world. Unfortunately, in many ways this law worsens America’s approach to health care rather than improves it. One main defect is the failure of this Act to increase the quite small ratio of out of pocket spending by older sick individuals on their own healthcare compared to their spending out of tax dollars. Obviously, individuals have much less incentive to economize on unnecessary health spending, such as the removal of the prostate for 85 year old men with prostate cancer, when the great majority of their spending comes from tax dollars rather than from their own income and wealth. Another serious defect of the law is that it extends rather than contracts the American reliance on employer provided health care. My post on the new law on March 28^th discusses other defects.

The Morgan Stanley report does not give much weight to the potential of faster economic growth to reduce the likelihood of sovereign default risk. If the rate of growth in GDP were speeded up, the debt/GDP ratio might be kept under control even without governments collecting a much larger share of GDP in tax revenue, as long as the growth in government spending did not adjust upward to the faster growth in the economy. For example, if the economy grew in the long run by 2% per capita per year rather than 1.5% per capita per year, GDP per capita would double in about 36 years rather than in 48 years. This difference in the level of GDP achieved over time would greatly improve the ability of governments to handle their debt.

 In recent months I have argued in several posts on this blog that governments should be concentrating on trying to speed up longer-term economic growth rather than promoting further stimulus packages and other short run palliatives. Faster long term growth in per capita incomes and real reform in the looming health and retirement entitlement are the only truly effective and efficient ways to greatly reduce the risk of eventual default on sovereign debt by the US, Europe, and other nations.

 

 

Will the Next Generation be Better off Than Their Parents’ Generation? Becker

The great majority of parents would like to see their children become better off economically than they are, and that hope would be even more common among the children. Yet, polls for a while have suggested that neither the majority of children nor parents in the United States are confident that this progress will happen. Despite frequent recent commentary on these polls, little systematic analysis has been presented of what determines whether the average child will be better off than the average parent, and why pessimism about such progress has apparently grown in the US.

The relation in particular families between say the earnings of adult children and those of their parents at comparable ages depends on many factors unique to any family. The abilities and health of the children relative to that of their parents, the luck of both children and parents in occupational and other choices, how concerned are the parents about ensuring that their children will become better off than they are, and many other considerations special to that family. I will not deal with individual family idiosyncratic factors, and instead focus my analysis on how well average persons in one generation fare compared to average persons in their parents’ generation.

The rate of growth in per capita income is by far the most important single variable in determining whether children will be better off than their parents. If per capita income is stagnating over time-the lot of the world throughout the vast majority of history- the average person in one generation will tend to be about as well off as the average person in his parent’s generation. Expectation during this long history of time that children will be better off then their parents would have been atypical.

During the past couple of centuries, much of the world has experienced systematic growth in per capita incomes that has radically changed such expectations. For example, if income per capita were growing only at 1 percent per year, the average individual in the next generation would have about a 30% higher income than the average individual in the present generation- I assume that generations differ by about 25 years. From about the middle of the 19^th century to the beginning of the 21^st century, per capita incomes in the US grew on average close to 2% per year. This implies that over this period of more than 150 years, or about 6 generations, the average income in one generation would have been about 60% higher than the average income in the prior generation.

Add to this that health improved rapidly during the 20^th century as mortality of mothers during childbirth and that of children during their first 3 years were virtually eliminated, and that the huge number of immigrants to America did vastly better than their parents did in their home countries. No wonder that optimism abounded in the United States about how children would fare compared to that of their parents. The decline in this optimism is mainly related to declines in expectations about whether the US will continue to grow at similar rates as in the past.

The difference between generations is even more dramatic in rapidly developing nations. Consider, for example, China with a per capita income that has been growing at around 8% per year since about 1980.  In such a growth environment, the average income in the next generation would be more than six times larger than that in the present generation. No wonder most Chinese families are happy with what is happening in their country and with their government’s policies, despite various restrictions on freedom of speech and writing.

Comparisons among the income and health of the average person in different generations are not the only determinant of wellbeing and optimism about the future. Changes over generations in the degree of economic inequality also have important effects. Inequality has increased considerably since 1980 in the United States, and many other countries, developing as well as developed. When inequality is growing between generations, even if per capita income were stagnant, families at the higher end of the income distribution in their generation would be optimistic about their children’s prospects relative to their own, as long as they expect their children to also be at the higher end of the income distribution in the children’s generation. Conversely, under the same conditions, parents at the lower end of the income distribution would be pessimistic about their children’s opportunities if they expect their children also to be at the lower end of their generation’s income distribution.

A third factor determining the relation between childrens’ and parents’ economic position is called the degree of intergenerational income mobility. That is, the degree to which richer parents are likely to have richer children relative to the income of the children’s generation, and the degree to which poorer parents are likely to have poorer children relative to the children’s generation. When the degree of intergenerational mobility is lower, rich parents will tend to be more optimistic about their children’s prospects, and poorer parents will tend to be more pessimistic. Some evidence suggests that intergenerational mobility in the US has fallen some over time, which would lead to greater pessimism among poorer families about their children’s prospects.

Despite the inequality that has grown by a lot since 1980, and intergenerational mobility that has apparently fallen, I believe that fears about economic growth are the main reason for the growing pessimism in the US about the long-term economic future. As I have argued on many occasions in posts on this blog, faster economic growth by the US can compensate for growing government debt, growing inequality, and other factors that create pessimism about the economic future.

I will not repeat much of what I have said previously on improving long-term economic growth in the United States and other rich countries (for example, see my most recent post on August 15th for some discussion of how to improve growth). I summarize these discussions by stressing three factors. Of greatest importance are improvements in the American K-12 school system available to students from poorer families, so that many more of these students graduate high school, and those who graduate are better prepared for college-the recent report on the results of scores on the ACT test is depressing reading since it shows that far more than half of all students taking the test are unprepared for college courses.

Second, it is important to have low marginal tax rates on personal and corporate incomes, and on capital gains, in order to stimulate greater investments and innovations. Finally, entitlement need to be brought under greater control by shifting much more of medical costs to patients through greater out of pocket payments, and by converting public and other pension systems to defined contribution systems rather than defined benefit systems.

America has always been optimistic about its future. The decline in such optimism during the past couple of decades is understandable, but highly regrettable. The best way to restore this optimism is to promote faster economic growth. That is feasible with the right policies, but will not happen automatically. Even America has no destiny to be optimistic about the future without important redirection of various public priorities.

The Decline in American Optimism—Posner

I don’t put much weight on public opinion polls that show a drop in Americans’ optimism about the economic future of the country. Optimism and pessimism are personality traits that condition people’s reaction to uncertainty, but they are also influenced by uncertainty. This was one of Keynes’s insights. When a sharp economic downturn creates the kind of uncertainty about economic prospects that we’re now observing, people’s “animal spirits” (his term for optimism) droop; hoarding increases and entrepreneurship flags. These are rational responses to uncertainty, but they do not predict a nation’s future economic performance.

 

There are, however, objective reasons to worry that the nation’s economic growth may be stunted for years to come. One reason is the high level of international political instability threatening to U.S. interests (think of Pakistan, Iran, Afghanistan, Iraq, Lebanon, Yemen, and North Korea, and of potentially tense relations between the United States on the one hand and Russian and especially China, on the other hand), which will require the United States to continue to spend disproportionately on national security. A second reason for concern is looming fiscal crisis in the United States, as a result of a diminished tax receipts, huge and growing federal public debt, uncontrolled entitlement spending, and deterioration in state and local government finances. And third is our government’s inability to address in a serious fashion, let alone solve, a host of serious structural problems. We badly need tax reform, education reform, health reform, immigration reform, environmental reform (with emphasis on climate control and preserving biodiversity), repeal of the drug laws, a reduction in economic inequality (with particular emphasis on improving the lot of the black underclass), a better transportation network, and a slimmed-down public sector. Our political system seems incapable of achieving improvements in any of these areas. So we need reform of the political system, but that is blocked by a combination of incumbent self-interest and a constitutional structure optimized for eighteenth-century conditions.

 

In assessing the likely impact of these factors on our economic future, we need to distinguish between per capita income and a more inclusive measure of social welfare—call it happiness or utility (though, depending on how “happiness” is defined, it might better be regarded as a component of utility; see Becker’s comment on a well-known paper by Stevenson and Wolfers, which together with the paper can be found at http://bpp.wharton.upenn.edu/jwolfers/Papers/EasterlinParadox.pdf, analyzing the correlation across countries of happiness with income). Per capita income is a proxy for and input into happiness, but it is not a synonym for it. If there is diminishing marginal utility from increased income, then an increase in income inequality, which we have been experiencing of late and which may continue, may offset the effect of an increase in average income on utility. So also an increase in the average age of retirement as a result of increasing the age of eligibility for full social security benefits (one reform that is at least conceivable), or other increase in hours worked, are offsets to increased per capita income. But against this is the seemingly continuous increase in the quality and variety of most products and services. (Not all: airline service has deteriorated markedly since the 1990s and traffic congestion has increased.) Increased longevity, and the greater youthfulness of most middle-aged and elderly people, are only the most dramatic signs of impovements in welfare that are related to but not adequately proxied by increases in average personal income.

 

Innovation is costly, so if the rate at which per capita income rises declines, the rate of improvement in the quality and variety of goods and services will slow. Nevertheless that improvement will continue even if per capital incomes stagnate.

 

While, as Becker points out, per capita income has been growing in the United States for a long time at an average annual rate of about 2 percent, happiness has been growing at a much lower rate, if at all. People in 1810 were not sad at the thought of how much better people would be living in 2010; and people in 2010 take for granted improvements in product quality before they were born. One has to be a certain age to appreciate these improvements; the first car I drove was a 1953 Pontiac.

 

The issue of increased per capita income over time is often discussed in terms of parental preferences: parents want their children to be better off than they. Here I think the distinction between income and welfare is critical. I believe that most parents want their children to be happy, though some want them to be successful even at some (modest) cost in happiness, rather than to be financially better off than they (than the parents). The farther down one goes in the income distribution, however, the closer the correlation between income and happiness; this is an implication of diminishing marginal utility of income. So poor people, or people who are not poor but are beset by anxieties, do want their children to be better off financially than themselves; but I do not think people who are well off do, or at least should, want their children to have higher incomes than they. Parental altruism implies concern for children’s welfare, rather than for children’s incomes per se; and the higher a family’s standard of living, the less likely an increase in that standard in the next generation is to increase happiness.

Our Limping Economic Recovery—Posner

In my first book on the economic crisis (A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression), which was completed in February 2009, I argued that the crisis should be called a depression rather than a recession, in part because of the enormous debts that the government was assuming in an effort to overcome the crisis. In my second book (The Crisis of Capitalist Democracy), completed in January of this year, I further emphasized the potential long-term adverse consequences of the crisis, and argued that a depression or recession should not be considered over until GDP rejoins its growth path. GDP in real terms is essentially unchanged from what it was two and a half years ago (2007), which means it’s roughly 7.5 percent below the growth path (which assumes 3 percent real growth annually), and suggests that it will be years before the economy gets back on it.

 

I continue to insist that this is the proper way to evaluate an economic crisis. Most journalists and many economists believe that the “recession” as they like to call it (or “Great Recession”—indicative of a mindless proliferation of labels) ended in the third quarter of 2009, when GDP began to increase, after having been flat in 2008 (though falling sharply in the last quarter) and falling in the first half of 2009. But the current performance of the economy, and the likely political and long-term economic consequences, convince me that we are in the midst of a depression, much as we were in 1936 (before a sharp drop in 1937–1938), even though the economy had grown rapidly since the bottom of the depression in 1933.

 

Why is the economy so sluggish at present? The basic reasons are, I think, first, the reduction in household wealth, due to the fall in housing and common stock values (with the fall in housing values precipitating many foreclosures); second, the high rate of unemployment, underemployment, and reductions in wages and benefits; and third the continued weakness of the banks.

 

The reduction in household wealth increased the amount of leverage (debt-equity ratio) in consumers’ personal finances, and consumers have been deleveraging by increasing their personal savings rate (which has increased from 1.7 percent three years ago to 6.4 percent today), leaving them with less money for consumption. One might think that today’s very low interest rates would discourage savings, but the other side of this coin is that savers must increase the amount of their savings in order to obtain the interest income they obtained when interest rates were higher.

 

With less consumption, there is less production and hence less private investment. These effects are being compounded by the weakness of the labor market from the perspective of workers, which reduces incomes and, by increasing insecurity, increases the propensity to save. And while banks are making good profits because of the very low interest rates at which they can borrow, they continue to hold many sick assets (mainly investments in home and commercial mortgages) on their books, making them reluctant to lend. And anyway loan demand is way down. Most borrowers from banks are either small business or consumers (large businesses tend to borrow by issuing bonds or commercial paper rather than by taking out banks loans), and neither group is in the mood for increasing its indebtedness.

 

One spur to recovery from a depression is the need to rebuild inventories and replace durable goods that have worn out. This need may explain, along with the stimulus program enacted in February 2009, the growth in GDP that began in the third quarter of 2009 and seems now to be fading. As long as demand for consumption goods is weak, sales will slow after inventories are restocked and worn-out durable goods are replaced. Modern products tend to be highly durable and inventories tend to be much smaller than they used to be, so one cannot expect these standard spurs to economic recovery to have much staying power.

 

The uncertainties and long-term debt created by the Obama Administration excessively ambitious domestic programs (notably health care and financial regulatory reform) on top of the deficit spending of the Bush years, the plunge in federal tax revenues resulting from the depression-induced decline in taxable income, and uncertainty about which Bush tax cuts will be allowed to expire in the coming year, have impeded private investment. They have done this by exacerbating concerns about what the economic picture will look like both in general and for individual businesses and consumers in the next several years, and perhaps much longer.

 

A further worry is the volatility of the stock market. The tendency is to view the market’s gyrations as reflections of changing estimates of future corporate earnings and of efforts by investors in the market to guess what other investors are likely to do. But when as at present a large fraction of the population has a significant part of its savings invested in the stock market, market volatility increases economic anxieties and thus dampens spending.

 

As long as private investment and interest rates remain very low, there is a case for further stimulus (deficit spending), especially since federal stimulus spending has been offset to a degree by reductions in state and local government spending. Cautious or fearful consumers save in safe forms, such as insured bank deposits, Treasury bills, or cash. Such savings are inert; under present conditions they do not get translated into productive investment, since banks are reluctant to lend but instead keep most of the deposits they receive in either cash or government securities. The government, to whom no one is afraid to lend, could put all these inert savings to work on infrastructure and other projects that would employ the unemployed.

 

That is in principle, but because the Obama Administration botched the design, execution, and public relations of the $862 billion stimulus program (President Obama, despite his undoubted eloquence and intelligence, has proved to be a poor explainer of his economic policies), and because of the soaring public debt (to which the stimulus contributed), there is no political stomach for a further stimulus of any consequence.

 

What is to be done? With Congress in recess and the mid-term elections looming, probably very little. The best hope may be that  the President’s bipartisan deficit commission (the National Commission on Fiscal Responsibility and Reform) will issue a first-rate report. (Its report is due December 1.) If the commission, chaired by President Clinton’s chief of staff, Erskine Bowles, and former Republican Senator Alan Simpson, produces an economically sound and politically palatable program for restoring the nation’s long-term fiscal soundness—a program to which far-reaching tax reform will be central—this may alleviate economic uncertainty and encourage more consumption and private investment in the near term.

The Slowdown in the Economic Recovery-Becker

After falling rather sharply in 2008 and early 2009, American GDP grew at a good pace in the fourth quarter of 2009, but has slowed down during the second quarter of 2010. Unemployment declined to 9.5% from its peak in November 2009 of 10.2%, but has been stuck around its current level for several months.  This has led to growing fears of a double dip recession, and to a call for still greater fiscal stimulus. I do not believe that either of these is correct, and that the federal government should be concentrating on providing a good economic environment to encourage businesses and entrepreneurs to invest, hire, improve productivity, and raise longer-term economic growth of the US.

More than 60 years ago, Arthur Burns- former head of the NBER and Chairman of the Fed- and Wesley Mitchell-founder of the NBER- together wrote a classic study of business cycles called “Measuring Business Cycles”. They divided business cycles into several stages, such as the economic peak, economic decline, trough, early recovery, late recovery, and then a peak again. They clearly show that business cycles are of uneven length, depth, and severity, and that recoveries do not always proceed smoothly. A recession ends after the trough is passed, but they recognized that during recoveries an economy takes a while before it reaches and then surpasses its earlier peak. So from this perspective, the troubles the American economy is experiencing are not unprecedented, or even unusual.

Nevertheless, I agree with Posner that something is rotten about this recovery from the so-called great recession. The Federal Reserve was slow to react to the financial crisis, but on the whole the Fed’s policies since then have been decent, given the many unknowns as it tried various old and new monetary approaches to stem the financial crisis. The financial picture was quite bleak as banks greatly increased their ratio of debt to assets during the boom years, and consumers rapidly expanded their debt to income ratios during these years. So even with the best of responses the recovery probably would have been slow and uneven.

But both the Congress and the administration of President George W. Bush, and especially the Congress and President Obama since his election in 2008 made the main mistakes after the crisis hit. Instead of concentrating mainly on fighting the recession and promoting faster economic growth, the Congress elected in 2008 believed they had a mandate to radically remake the American economy. Aside from repeated attacks on American business, especially banks-some of them deserved- they not only passed various stimulus packages (that did not stimulate much), but also tried to promote a vast legislative program that had nothing to do with fighting the recession. This program was aimed at reengineering the American economy. It included radical changes in the health care system, proposed taxes on carbon emissions by companies, much larger subsidies to alternative sources of energy, such as wind power, proposals to raise taxes on higher income individuals and on corporate profits, and to raise the taxes on capital gains and corporate dividends. It also includes a movement to make anti-trust laws less pro-consumer and more protective of competitors from aggressive and innovative companies. It has as its centerpiece a financial reform bill that was a complicated and a politically driven mixture of sensible reforms, and senseless changes that had little to do with stabilizing the financial architecture, or correcting what was defective in prior regulations.

In previous posts I have laid out some of the major defects in the financial reform act, the healthcare changes, and the unemployment extension bill (see my posts for 7/25 on unemployment, 7/11 on financial reform, and 3/28 on healthcare reforms). To single out a few points of these arguments, I criticized the financial reform bill for, among other things, neglecting to do anything about Fannie Mae and Freddie Mac, two major corporations that were important factors in causing the financial debacle, and for adding an excessive amount of discretion to financial regulators who did not use wisely the discretion they had prior to the crisis. I suggested that a proper unemployment bill would eliminate most unemployment benefits for persons during the first couple of months of their unemployment, and then use the savings from that to extend unemployment benefits during bad times to a year. The most desirable reform of health care should have been to increase the out of pocket share of medical expenses borne by older persons and other individuals with various illnesses- as in countries like Switzerland- but nothing much was done about this in the new law. My detailed criticisms are available in these posts.

Perhaps the new Congress elected after November will try to reverse some of these mistakes. I would like also to see a radical reform of the tax system that returns it to the income tax structure that resulted from the Tax Reform Act of 1986 promoted by President Reagan, and Democrats Senator Bill Bradley and Representative Richard Gephardt. This Act had a maximum personal income tax rate of 28%, except for a “bubble rate” for a few families that hit 33%.

To compensate for any loss in tax revenue from these changes, and to help face the growing debt problem of the US, I would support a value added tax, but only as part of such a comprehensive reform of the tax structure. Value added taxes have many attractive incidence features that can be a valuable way to raise tax revenue in a system with low personal and corporate income taxes. However, VAT taxes also have the potential to be rather easily increased over time without close controls over such increases (see my discussion of VATs in my post on 4/25).

Government spending rose a lot during the last year of the Bush administration, and rose even more so during the year and one half of the Obama administration. Instead of introducing additional stimulus packages and further raising the cost of doing business, Congress and the President should try to create an environment where companies, both large and small, and entrepreneurs are recognized as crucial forces in a dynamic economy. Their activities can help the American economy not only grow out of the economic slowdown, but also raise its economic growth in the future that will greatly improve the well being of future generations, and help meet a dangerous future debt burden.

 

 

Germany vs. US: Two Different Approaches to the Recession-Becker

In many past commentaries I attacked labor markets in Western Europe as being too rigid regarding layoffs and hires, and for providing too generous unemployment compensation often for very extended periods. That rigidity explained why unemployment rates in the 1990s and the first 6-7 years of this decade were much higher there than in the United States. Responding to the facts of high unemployment and long durations of unemployment, and to criticisms of their labor market policies voiced by economists, many countries of Western Europe began to reform their labor market policies to make them more flexible, and to limit the duration of government support of unemployed workers.

The case of Germany is one of the most interesting, only partly because Germany is the largest economy of Europe. Under the long reign by the conservative Christian Democratic Union, little was done to reform the German labor market. In a reminder again of the “Nixon going to China” doctrine, the socialistic Social Democrats, led by Gerhard Schroder, introduced various labor market reforms in 2003 after being elected to power in 1998. He cut the length of the period of eligibility for unemployment compensation, extended the age of retirement and reduced retirement pensions, and made it a little easier for companies to layoff workers. In good part as a result of these policies, while Germany unemployment had been close to 10%, it fell to 7.5% prior to the onset of the recession, perhaps mainly due to these reforms.

Germany was hit hard by the worldwide great recession as world GDP took a nosedive, mainly because Germany is the world’s second largest exporter after China. Its GDP fell by over 5 percentage points in 2009, and is expected to rise by about 2% this year as world GDP recovers, and because the euro has fallen by about 10% relative to the dollar since the euro peaked at about $1.5 per euro. The German economy as measured by GDP was during the first quarter of 2010 still somewhat below comparable numbers for the first quarter of 2008.

What happened to German employment and unemployment is even more interesting. Employment fell only slightly, but part time work increased sharply as jobs were spread. Unemployment rates increased only a little. Unemployment is now down to its 7.5% pre crisis level, and employment is back at its earlier peak, and part time work is declining, as the German economy continues to recover.

Contrast this with the American economy. On the one hand, the US financial system was hit much harder than the German system. On the other hand, the German economy is far more dependent on exports than is the American economy. The net effect of these differences is not completely clear, although US GDP fell by a lot during the first year after the recession hit, but then began to recover at a moderate rate. Whereas Germany’s unemployment rate grew by very little during the recession, the US unemployment rate grew by over 5 percentage points.

This difference in employment and unemployment behavior between Germany and the US may be mainly the result of the fact that the American labor market is still far more flexible in most respects than the German labor market. However, if that were the main explanation, then the jobs recovery in Germany should have been slower than in the US, but that has not been the case. Total jobs in Germany are about at their pre-crisis level, whereas the number of Americans employed is still several million below its peak in 2008.

Germany was criticized because it did not have a big enough stimulus and did not run large enough fiscal deficits to stimulate the economy.  In early 2009, Germany introduced a 50 billion euro stimulus package after much urging from intellectuals and some economists. That is about 1.6% of its GDP, with about one-third earmarked for infrastructure improvements, and the other two thirds going to tax cuts, child allowances, and social benefits. Even more important from the traditional “stimulus” analysis, Germany’s fiscal deficit is expected to hit between 5-6% in 2010, smaller than the fiscal deficits in many euro-zone countries.

Contrast these numbers with those for the United States. The American stimulus package of about $800 billion-by no means as yet all spent- is 6% of American GDP, about four times as large relative to GDP as the German stimulus. Even more telling is that the fiscal deficit during 2009 and expected during 2010 amount to about 12% of American GDP, far larger than the fiscal deficits Germany has been running. Germany has recently taken actions to cut spending and raise some taxes, while the US government continues to think of ways to increase government spending, as if the huge fiscal deficit is not enough.

Let it be clear that I am not claiming that US employment and unemployment has been very sluggish in recovering to pre crisis levels mainly because the US has had a large stimulus package and large fiscal deficits. They probably have been factors, but the evidence is still too uncertain to reach such a judgment. But it is clear that the stimulus package completely failed relative to the explicit predictions of the Obama administration and its Council of Economic Advisers about what would happen to unemployment. They predicted unemployment would decline by about 1.5 percentage points from a much lower peak, whereas so far the total decline from the higher unemployment peak of 10.2% is only 0.7 percentage points.

I continue to believe that the biggest factor in the sluggish employment recovery of the US is that many of the actual new and proposed anti-business legislation, as well as the large fiscal deficits, made businessmen and investors cautious about taking on new workers. These proposals and laws include the health care bill, the pro-union bias and anti-business rhetoric of Congress and the president, suggested increased taxes on higher earners, changes in anti-trust laws to be less pro-consumer, and the endlessly complicated and largely misplaced financial “reform” law. Germany, by contrast, has continued with the same coalition government headed by the mainly pro-investment, pro trade Christian Democrats. Germany surely made various mistakes during this recession, but the US has made many more.

 

German Employment—Posner

I am distrustful of international economic comparisons, especially when only two countries are compared, in this instance the United States and Germany. Countries differ in a large number of respects that bear on economic performance; in a large sample, many of those differences may cancel, but a sample of two is tiny.

 

Becker provides a plausible explanation of Germany’s lower unemployment rate, but is it correct? According to the Bureau of Labor Statistics, Germany’s unemployment rate is not the lowest current unemployment rate of ten major countries that the BLS has compared after adjusting the unemployment rates in those countries to correspond to U.S. concepts of unemployment. France has the highest unemployment rate—9.6 percent—followed by the United States at 9.5 percent. The German rate is 7.5 percent. Australia, Canada, Japan, and the Netherlands have substantially lower unemployment rates. The U.K. unemployment rate, surprisingly, is only slightly above the German rate. Sweden and Italy complete the picture, with unemployment rates roughly halfway between the German and the American. Given European labor laws, it is surprising that the unemployment rate in France is only trivially higher than the U.S. rate and that the unemployment rates in Italy, the Netherlands, and Sweden are significantly below the U.S. rate, though Swedish labor laws, at least, are fairly loose, and the Italian unemployment rate is believed to be underestimated. But why should Canada and Japan have unemployment rates substantially below the U.S. level?

 

I venture the following guess. All these countries except Australia had before the economic crisis a higher personal savings rate than the United States. And all without exception derived a much higher fraction of their national income from exports than the United States. Because of our very low personal savings rate, and the (related) fact that most savings were in the form of home equity and (directly or indirectly) common stock, the crash of 2008 ushered in a protracted period of stagnant consumption spending as frightened American consumers increased their personal savings rate from 1.7 percent three years ago to 6.4 percent today. Producers and distributors in the third quarter of 2008 and in 2009 could foresee a sustained period of subpar demand, and so laid off many workers and have been slow to rehire them, anticipating that demand for goods and services will not increase substantially for some time.

 

In other advanced economies, higher personal savings and greater reliance on export earnings created expectations of more rapid economic recovery. Consumers would have less incentive to increase their savings further and thus reduce consumption; so businessmen could expect demand to revive sooner than in the United States. They could also expect their export markets to rebound soon, knowing that major importers of technologically advanced manufactured goods, such as China, India, and Brazil and other Latin American countries, had been hit less hard by the economic crisis. The quicker a solid economic recovery is expected to occur, the less prone employers are to lay off workers, because laying off and rehiring are costly, and the costs may well exceed a short period in which employees are not busy because demand for the employer’s product is weak.

 

I agree with Becker that the Obama Administration’s overly ambitious legislative program and intermittent outbursts of hostility to business are hurting our economic recovery. But I would be inclined to give greater weight, in explaining our stubbornly high unemployment, to the other factors that I have mentioned.

Unionism and Economic Recovery—Posner

A frequent and I think sound criticism of the Obama Administration’s economic policy is that it supports programs that promote economic recovery from the severe recession that began in December 2007 and programs that retard that recovery, thus sending a mixed signal that by unsettling the business environment retards recovery. This mixed message is no surprise, however, because a President is a politician. Has there ever been a President who consistently pursued sound economic theory? Criticism of politicians must be tempered by recognition of political reality.

 

You don’t have to be a conservative to think it a bad idea to promote unionism in an economy struggling to climb out of a deep economic hole; you can be a Keynesian. A principal goal of unions of course is to raise wages, though in doing so it causes employment to fall by raising the cost of labor relative to the cost of capital. Keynes emphasized (though the point was not original with him) that workers strongly resist cuts in their nominal wages, where “nominal” means the dollar amount of the wages and is contrasted with “real,” which means the purchasing power of the wage. In an economic downturn, an employer who thinks it infeasible to reduce the nominal wages of his employees will have to lay off workers so that his costs of production are not excessive in relation to the diminished demand for his product. Therefore the higher the nominal wages of employees, the more unemployment will be generated by an economic downturn. Keynes thought moderate inflation should be part of a strategy of recovery from an economic downturn, because nominal wages tend to be sticky on the upside as well as on the downside (though less so), and so the employer’s real wage bill would fall in an inflation, though only initially—until the workers caught on to the fall in the purchasing power of their wages and demanded a raise. (This theory of “profit inflation” is no longer accepted by most economists.)

 

Against all this it might be argued that if employers cut wages rather than laying off workers, the reduction in wages would reduce the amount of money that the workers could spend on consumption; and economic recovery depends on increased spending on consumption (plus investment). But the stickiness of wages, which makes employers prefer layoffs (with the result in the Great Depression, which involved severe deflation, that many workers who retained their jobs experienced a substantial increase in their real wage), is not primarily a result of unionism, or even of worker pressures. Employers don’t like to make steep across-the-board wage reductions in an economic downturn, because the reductions frighten and distract the workers. Layoffs, in contrast, enable reductions in overhead as well as in wages and concentrate unhappiness on former workers (those who are laid off), whereas an across the board wage reduction demoralizes current workers.

 

Collective bargaining agreements, which are contracts between a union and an employer, usually forbid the employer to reduce wages during the contract’s term (usually three years). But the main reason why unions make it more difficult to recover from a recession or depression is that by raising an employer’s labor costs they cause the employer to lay off more workers in an economic downturn than if those costs were lower. Think of how the United Auto Workers had swollen the labor costs of the Detroit automakers, so that if the government had not stepped in and bailed out General Motors and Chrysler in the spring of 2009 the loss of employment as a result of the economic downturn would have been catastrophic. It is important to realize, moreover, that higher wages are often not the major source of higher labor costs in unionized firms. Benefits (such as health insurance) are very important—critically so in the collapse of GM and Chysler. And often the major source of higher labor costs in unionized firms is union-negotiated limitations on the employer’s control over his labor force: the employer’s freedom to assign tasks, to discipline unsatisfactory workers, and to determine the order of layoffs. Unions bureaucratize labor relations.

 

Almost at the bottom of the economic plunge—July 2009—the federal minimum wage rose, pursuant to legislation passed by the Democratic-controlled Congress in 2007, to $7.25 an hour. That is just the sort of thing one doesn’t want to happen in a recession. Unions strongly support the minimum wage in order to reduce competition from nonunion workers, but raising the wage retards recovery by increasing sellers’ labor costs.

 

Unions are weak in the private sector; only about 7 percent of private workers are unionized. But unions are powerful in the public sector—about 30 percent of public employees are unionized—and have contributed to the high wages of such employees. By swelling the labor costs of cities and states, these high wages have forced them to raise taxes and cut benefits in the midst of the most severe economic downturn since the Great Depression.

 

Even in the private sector, though unions are weak, employers are concerned that the pro-union policies of the Obama Administration will result in greater unionization and hence higher labor costs. This concern is a source of uncertainty, which slows economic activity. Under uncertainty consumers increase their savings (much of which may not get invested productively, at least without a considerable lag) and producers increase their cash balances.

 

The Administration is not uniformly pro-union. It rightly cares more about education than about unionism, and as a result has clashed with the teachers’ unions; this is one of the Administration’s most laudable endeavors. It has not pushed hard for (though it supports) enactment of the Employee Free Choice Act, which by abolishing the secret ballot in elections for collective bargaining representative and instituting compulsory arbitration of union-management disputes would significantly shift the balance of power from management to labor. It did condition the bailout of the Detroit automakers on preserving substantial, and completely unjustified, union benefits. The overall terms of the bailout weakened the union, but not as much as if the bankruptcy of the automakers had been allowed to proceed without government intervention.

 

The Administration has, however, under union pressure dragged on signing free-trade agreements that have been negotiated with South Korea and other countries. This would not retard our economic recovery if the net effect were to increase our exports relative to our imports, for exports increase domestic production and hence employment and imports tend to reduce it. But because of retaliation by foreign countries that want to increase their own exports and reduce imports, the effect of the Administration’s foot dragging is simply to reduce the efficiency of the U.S. economy. Also allegedly under union pressure, the Administration delayed suspending (as it is empowered to do in an emergency) the Jones Act, which protects the U.S. maritime industry from foreign competition, to enable foreign vessels to assist in combating the oil leak in the Gulf of Mexico.

 

Worse, the Administration has required that all projects funded by the $787 (now $862) billion stimulus enacted in February 2009 comply with the Davis-Bacon Act, which requires payment of union wages. Recently the President signed an executive order requesting all federal agencies to consider requiring all federal construction contractors to sign labor agreements. And he has said silly things like “labor is not part of the problem.  Labor is part of the solution.” These are just words, but they worry business by creating the impression that the President is hostile to it, and they increase the uncertainty of an already uncertain business environment. The pro-union policies of the Roosevelt Administration, notably the National Labor Relations Act (the Wagner Act), are generally believed to have made the Great Depression worse than it would have been without those policies. The Obama Administration’s pro-union policies will in all likelihood worsen our current economic situation.

Unions and the Obama Administration-Becker

Are the Democratic-controlled Congress and President Obama very much pro union? Unquestionably. Do the economic effects of unions on the welfare of workers as a whole justify that union bias? No. Has their pro-union orientation seriously retarded the recovery from the recession? Probably. The following discussion tries to justify these answers.

The pro-union orientation has been demonstrated in many ways. Posner gives a few examples, and I will add some more. The automobile industry would not have been bailed out so generously were it not for the political power of the United Auto Workers. The alternative would likely have been bankruptcy without a federal bailout, which I favored. Bankruptcy without government involvement would have cut health and other fringe benefits of autoworkers more sharply, and might have led to more plant closings in the industry. It would also, however, have led to a more robust recovery of the surviving American auto companies, and possibly even in the longer run raised employment in auto plants located not in the South because wages and fringe benefits would then have been lower at these plants.

An important example this past week offers another illustration of the pro union orientation. For the first time the US has cited for labor violations a country, Guatemala, that is a free trade partner with the US. That the American government has the presumption to interfere in the labor policies of another country is disturbing in itself. All commentators agree, however, that it was done at the urging of American unions. This was likely an attempt to reduce the competition of goods and services from Guatemala and especially from other free trade partners-such as Mexico-for goods made by unionized American companies.

Congress tried to pass, and President Obama supported, The Employee Free Choice Act to eliminate private elections for union certification. Fortunately, enough moderate Democrats and Republicans have been able to beat back these proposals, and they have been shelved, perhaps only temporarily.

Economists distinguish competitive from monopoly unions. A competitive union system, like Japan’s, has unions at companies when the employees of these companies prefer to bargain collectively. However, competitive unionism does not allow a single union to control the majority of companies in the same industry, which is monopoly unionism. The US typically has monopoly unions, such as the steelworkers union, autoworkers union, or service workers union, but a long time ago the Clayton Act of 1914 explicitly exempted unions from anti-trust laws under most circumstances.

Monopoly unions do tend to raise the earnings and fringe benefits of workers in the industries where they exist. This is seen from the ridiculously high fringe benefits that the United Auto Workers unions squeezed out of American auto companies during the days when they were profitable but not well managed. Higher union earnings come partly at the expense of the profits of the industries unionized, but also at the expense of lower employment than would have occurred with more competitive wages and other benefits. The prospective employees priced out of jobs in unionized sectors seek employment in other sectors, which lowers the earnings of workers in these latter sectors. The net effect is a misallocation of labor compared to an efficient allocation, and possibly even a reduction in the income received by workers as a whole, including workers in the non-union sectors.

During this recession, wages did fall for many workers, but mainly among non-union workers. A telling example is what happened at many state and local governments that are in serious fiscal difficulties. Since wages of their union workers have been set by contract, they were forced primarily to cut wages of administrative staff and other non-union employees. For example, the state of Illinois has the largest fiscal deficit as a percent of its budget of any state. It required many of its high level non-union employees to take 24 unpaid leave days, or about a 9% cut in their salaries, since the state government cannot touch the wages of their many unionized employees.

As Posner indicates, only about 7% of all non-government American workers are unionized, compared to over 35% of workers at federal, state, and local governments. During the past 40 years, the fraction of unionized civilian workers fell steeply-and not only in the United States- while the unionization of government workers fell only a little. It might seem unlikely that workers which comprise only about15% of the total labor force would have a major effect on the speed of the recovery from the recession. 

The real threat to a robust recovery on the labor side has come from employer and entrepreneurial fears that once the economic environment improves, a Democratic Congress and administration will pass pro-union and other pro-worker legislation that will raise the cost of doing business and cut profits. In this way the obvious pro-union-pro-worker bias of the present government has contributed to a slower recovery, especially in labor markets. This helps explain the depressingly slow decline in unemployment rates and in the number of workers who have given up looking for jobs.