Tag Archives: Veronique de Rugy

A Muni Debt Crisis, and the Alternative

In May the financial advisory firm Alex Partners LLP reported that 90 percent of the restructuring experts it polled believed a major U.S. municipality would default on its debt in 2010…But even in the best-case scenario, a municipal debt crisis looms in the near future.

The parallels with the housing bubble are worrisome. Prior to the meltdown, mortgages were perceived as very low-risk investments. Banks were encouraged through government policies to lend large amounts to people, whether they could afford it or not, and borrowers were encouraged to spend more than they should. Both lenders and borrowers had faith that nothing would go wrong—and that if anything did go wrong, Washington would save the day. 

That is my colleague, Veronique de Rugy, writing about the muni bond market over at Reason.

Meredith Whitney, a well-respected banking analyst, was recently on 60 Minutes talking about the high probability of a “spate of municipal bond market defaults.”

Felix Salmon, a financial journalist at Reuters, largely disagrees with her. His bottom line:

So my feeling is that Whitney is probably wrong, and that we won’t see a lot of municipal defaults next year. But at the same time, the tail risk here is significant. If it gets bad, it could get very bad.

Here is one thing to keep in mind: Though a muni debt crisis — whatever its odds — would undoubtedly be terrible, the alternative isn’t so pleasant either. Though Orange County didn’t default in 1994, its bankruptcy forced painful tax increases and service cuts. So far, Illinois hasn’t defaulted and its fiscal woes have already forced similarly painful actions. Throughout the U.S., in fact, state and local governments are grappling with extremely painful choices.  

As with the housing bubble, it would have been far better to have restrained spending in the first place than to have ever let it grow so fast.

U.K. Austerity Measures Unveiled

Chancellor of the Exchequer George Osbourne, detailed his four-year fiscal plan for the United Kingdom yesterday estimated to reduce spending by £81 billion ($127 billion). They are described as the biggest cuts to spending since World War II.  Welfare payments will be reduced, including the removal of a child tax credit for couples earning more than £44,000 ($64,449) per year. Government departments face budget cuts and the retirement age for public sector workers will rise to 66 by the year 2020. In addition, Mr. Osbourne is recommending a permanent bank levy. The full details are here.

The U.K. is also facing huge levels of sovereign debt described very memorably by MEP Daniel Hannan. According to Nick Record of the IEA, the U.K.’s public pension obligations are £1 trillion ($1.58 trillion).

Meanwhile as Britain tightens its belt, The Wall Street Journal reports French workers are protesting President Sarkozy’s proposal to raise the retirement age from 60 to 62.

Are such cuts possible here? Veronique de Rugy considers why The Washington Post’s David Wessel doesn’t think it can be done in America.

Is Boosting Teacher Pay a Legitimate Use of the Stimulus?

That is the question raised by a recent headline from Fairfax County:

“Fairfax Teachers Fight for Raises Funded by Stimulus”

Now I don’t know whether teachers in Fairfax are underpaid or overpaid. And there may very well be good reason to boost their salaries (or at least to boost those of the top performers). But it makes little sense to argue that a salary boost right now would serve the original purpose of the stimulus (which was intended to stimulate the economy, for those who are still paying attention). 

Let’s try to look at this the way a Keynesian would. As Brian Caplan explained a few months back, an important element in the Keynesian model is the notion of wage rigidity. Here, according to Keynesians, is how it works:

  1. Trouble begins when aggregate demand falls (usually because animal spirits have caused a sharp decrease in investment).
  2. As this happens, firms have less revenue with which to pay salaries. They might be able to maintain employment, however, if they could convince their employees to take a real wage cut. 
  3. The problem, however, is that nominal wages are “sticky.” Employees do not want to accept lower wages and even if they did, employers would rather fire some people than lower everyone’s wage and have a disgruntled workforce.

The Keynesian solution to this dilemma is to somehow boost aggregate demand to get people spending again. As Brian has more-recently pointed out, an alternative solution that is completely consistent with the Keynesian diagnosis of the problem would be to make sure that all prices—including wages—are as fluid as possible. If we could reduce nominal wage stickiness and get people to accept lower wages during a recession, then we could lower the unemployment rate.

Somehow in practice, however, Keynesian policy usually ends up increasing nominal wage stickiness and the Fairfax teacher story is a case in point.

Addendum: My colleague, Veronique de Rugy, weighs in at NRO, noting that the Administration changed the rules in February to permit stimulus funds to be used for such a purpose.

Unemployment Insurance, Take II

In response to my post earlier this week about unemployment insurance being stimulative, Harry Moroz over at Huffington Post, makes a good point

I had cited evidence showing that—contrary to conventional Keynesian expectations—those with lower net wealth and those with lower incomes actually have lower marginal propensities to consume compared with high-wealth, high-income people.

According to Moroz, I “wholly conflated ‘the poor’ with ‘the unemployed.’ ” Fair enough. Unemployment and low income are not the same. But research by the Center for Labor Market Studies at Northeastern University shows that the correlation is extremely strong (in fact, as Veronique de Rugy has pointed out, the blogosphere has lit up lately with posts about the high unemployment rates among low-income people):


So: low income people are more likely to be unemployed; and according to the Sahm, Shapiro, and Slemrod study, low-income workers seem not to have high marginal propensity to consume. Putting these two facts together, I would be surprised if unemployment insurance were particularly stimulative.   

In my mind, the central argument comes down to three points:

  1. Keynesians will argue that transfer payments to the unemployed will—through the magic of the multiplier—lead to a boost in aggregate demand. I tend not to put a ton of stock in this because many estimates of the multiplier are relatively low and the latest estimates of the multiplier are even lower. Also, as I argued in my last post, I don’t see a lot of evidence to indicate that the unemployed or the poor have really high marginal propensities to consume (and probably no higher than those from whom the revenue is obtained through taxation or borrowing). The bottom line: We can quibble about which estimate is right but it seems that many proponents of stimulus are over-confident in their assessment that fiscal stimulus works. Given the ambiguities in both the theoretical and empirical research, I’d say a little humility is in order.    
  2. Even if we take the Keynesian multiplier arguments at face value, we must acknowledge that there are other forces at work. In the most basic economic model, if you tax work and subsidize non-work, then on the margin you should expect less work. And, indeed, numerous studies have found that increasing the length of potential unemployment benefit duration increases the average length of the unemployment spell. We may not like this result, but as Alan Blinder notes, we have to acknowledge what this is what the research shows. This must be weighed against the Keynesian result in #1 above. 
  3. The final point is a long-term one. Compared with other countries, the U.S. has significantly lower long-term unemployment rates. Moreover, the unemployed in the U.S. tend to remain so for shorter periods than in other countries. At the same time, U.S. unemployment insurance replaces a much smaller fraction of income and does not last as long (see charts below). Numerous studies have found this is no coincidence: the difference in European and U.S. unemployment experiences seems to be due to the relative dynamism of the U.S. labor market. Compared with Europe, we have relatively low taxes on labor, limited regulation of employment, and limited duration of unemployment benefits. I believe that if we really want to decrease the likelihood of unemployment and the length of the average person’s unemployment spell, then the best thing we can do is ensure that ours continues to be a dynamic labor market.  Ironically, extending unemployment benefits may very well make that more difficult. 


The Government (Un)employment Effect

A few hours ago, the Obama Administration released a new report estimating that Stimulus II saved or created about 3 million jobs. Shortly thereafter, my colleague, Veronique de Rugy, testified before Congress on the impact of the stimulus. She argued, among other things, that more realistic estimates show that fiscal stimulus tends to do more harm than good.

All of this talk about jobs reminds me of one of Veronique’s recent posts:

Since the beginning of the recession (roughly January 2008), some 7.9 million jobs were lost in the private sector while 590,000 jobs were gained in the public one. And since the passage of the stimulus bill (February 2009), over 2.6 million private jobs were lost, but the government workforce grew by 400,000.

I will leave it up to you to draw conclusions.

In the spirit of drawing conclusions: one body of research suggests that the conclusions are not happy ones. A number of studies have examined the relationship between government employment and private employment, concluding that the former crowds out the latter. Using data from 19 countries over 17 years, Horst Feldmann (2006), for example, examined the relationship between a large government sector and unemployment. He found:

[A] large government sector is likely to increase unemployment. It appears to have a particularly detrimental effect on women and the low skilled and to substantially increase long-term unemployment.

What is more, Feldmann is not the only one to come to this conclusion. As he reports in his literature review:

Several empirical studies suggest that an increase in government expenditure impairs labor market performance. For example, Karras (1993) observed negative employment effects of government spending in eight countries in his sample of 18 countries. Yuan and Li (2000) came up with the same result for the US. In a cross-country study of 15 major industrial countries, Abrams (1999) found that the government expenditure ratio was positively related to the unemployment rate. Christopoulos and Tsionas (2002) examined the relationship between the government expenditure ratio and the unemployment rate for 10 European countries over the period 1961 to 1999 and found that there was unidirectional causality from government size to unemployment rate.

The magnitude of the government (un)employment effect is not trivial. Looking at a sample of OECD countries for 40 years, Algan, Cahuc, and Zylberberg (2002) found that the “creation of 100 public jobs may have eliminated about 150 private sector jobs”

Economic “Experiments”

After my last post, some friends stopped by my office with a few questions: “If, as you say, we are conducting a big experiment in spending, will the experiment produce evidence that finally answers the question of whether or not fiscal stimulus works? Why can’t we just compare the economy’s performance during periods of stimulus with its performance during normal times?  Why mess with military spending as Barro and Redlick do, when what we want to know is whether stimulus spending works, not military spending?” (This latter question gets at Harry Moroz’s point too).   

Here is my attempt at an answer:

Let’s start by imagining the ideal conditions to test for the effect of a stimulus. Suppose the distribution of stimulus money were determined not by the political process, but by a scientist. This scientist would probably randomly assign units of observation two groups: a “treatment” and a “control” group. He would use a coin or some other random process to select some regions to receive money and some regions to receive none. Ideally, he would do this over the course of several years, distributing money both during boom and bust periods to see if the economy responded differently. Then, he would compare various measure of well-being (growth rates, unemployment rates, etc.) in times and places that received stimulus (the treatment group) with comparable measures in times and places that did not receive stimulus (the control group). 

Unfortunately for the scientist (fortunately for the citizen), stimulus money isn’t doled out this way. Instead, politicians make some attempt to target the expenditure of stimulus money to hit times and places that are in need (as my colleague, Veronique de Rugy has shown, they aren’t always very good at hitting their target). But this means that it becomes very difficult for the economist to assess, empirically, the impact of fiscal stimulus.

Why? Because economies in times and places that are in need tend not to grow at the same pace as more normal economies. As standard economic theory teaches us, market-based economies have natural recuperative properties. For example, if aggregate demand suddenly falls, causing a contraction, a chain of events is set in motion that helps sow the seeds of recovery. Spending will fall, lowering prices and increasing savings. The lower prices cushion some of the blow, allowing consumers’ dollars to go farther than before and allowing them to spend more than they otherwise would. As saving increases, interest rates fall and business investment picks up. As these processes work their way through the system, the economy begins to heal. Economists famously argue about how effective this process is, but few would deny that there is some truth to this story.

But knowing that this process happens to at least some degree, we can’t simply compare economic growth in times and places that receive stimulus with that of times and places that don’t. Otherwise, instead of picking up the effect of stimulus, we may just end up measuring the natural recuperative abilities of the market economy. Nor, more generally, can we compare economic growth in times and places where governments spend a great deal of money with economic growth in times and places where governments spend little. This is because there is strong reason to believe that causation runs the other way too: when the economy is humming, state and federal coffers are flush with cash and tend to spend more and when times are lean, states have no choice but to cut back spending.

The problem is analogous to that of understanding the impact of police patrols on crime. We would like to measure crime rates in times and places where patrols are sent with crime rates in times and places where patrols are not sent. But, like politicians distributing stimulus funds, police captains don’t randomly pick the areas where they send their patrols. Instead, they try to target patrols to the places and times where they are needed. Thus, a naïve look at the data shows that places with more police patrols tend to have more crime! This clearly doesn’t make sense, but it is what the data show.    

Which gets us to the question: why study military spending when we are interested in stimulus spending? The answer is that it helps solve the statistical problems I mention above. I won’t get into the technical details of two-stage least squares regression techniques (I’d prefer you finish reading the post), but here is the basic gist of the strategy: start by finding some phenomenon that is correlated with the treatment (the treatment here being cops or government spending) but uncorrelated with the outcome of interest (in this case, crime rates or economic growth). If you can find such a phenomenon, you can use it to study the pure, unbiased effect of the treatment on the outcome.

In the case of police and crime ­­­­­­­­­Steven Levitt came up with an ingenious phenomenon to help unravel the real relationship. He accurately surmised that elections might induce elected officials to increase the number of patrols on the street. And since elections are not directly related to the underlying crime rate, this allowed him to obtain an unbiased estimate of the effect of patrols on crime. As you probably guessed, this unbiased estimate showed that, indeed, more police patrols actually lead to less crime.

So what about stimulus? As I mentioned in my previous post, Robert Barro and Charles Redlick use military spending to assess the impact of stimulus spending on economic growth. Military spending is positively related to overall government spending. But it turns out that it isn’t related (positively or negatively) with economic downturns. Thus, it makes an ideal phenomenon to assess the impact of stimulus. As I mentioned, Barro and Redlick found that stimulus spending isn’t stimulative.

Similarly, Lauren Cohen, Joshua Coval, and Christopher Malloy, make clever use of another phenomenon to assess the impact of government spending on economic activity. They rely on the fact that government spends more in Congressional districts whose members are chairs of powerful committees than in districts whose members are just rank and file. Like Barro and Redlick, they find that government spending isn’t stimulative.   

I suspect that right now some clever economist is working on a study of the current stimulus that relies on a technique similar to these. I sincerely hope that it will bring us closer to a consensus on the effect of stimulus. If Barro and the others are correct, we can’t afford to keep throwing good money after bad.

The Bottom Falls Out

Ezra Klein conjured up a fanciful reason why the stimulus spending hasn’t stimulated… anything. Matt and Eileen broke it down pretty thoroughly. Today, Mercatus Senior Research Fellow Veronique de Rugy has some visual evidence to rebut Ezra’s Keynsian dreams.

Klein is exactly wrong when he writes:

Uncertain about the future, [consumers] spend less now. The role of the government is to step up and keep the economy moving until consumer confidence returns.

Uncertainty isn’t a side-effect of a downturn, it’s a primary cause. In the recent bust, asset values were drastically skewed. If the government “keep[s] the economy moving,” confidence can’t ever return; everyone knows the old status quo was horribly flawed. Ezra, like Krugman, believes that government spending can drive an economy. Veronique’s chart neatly dispels the illusion that public spending can effectively supplement (or supplant) the private sector.

Things That Should Make Us Very Nervous

Nicole Gelinas at City Journal asks an excellent question, “Is it not daft to lend New York and California one more dime?” In the past two years tax revenues have plummeted. Overall state and local governments face an operating gap equal to 15 percent of their budgets.

Credit ratings agencies such as Moody’s do not expect municipal governments to default, because they will do anything to avoid it, they have the power to tax (i.e. they will find the money), and states can’t declare bankruptcy. Of course it is also expected that Washington D.C. will bail out an insolvent state.

But, those state and municipal bailouts need to be added to the most frightening tab of all.

In the next year, our economy will enter a ‘debt super cycle’. the United States’ $13 trillion in federal debt will overtake GDP in 2012. By that time several states will need to contribute increasingly large amounts to pay pension obligations with Illionis leading the way to insolvency sometime in the next few years.

We are, as my colleague Veronique de Rugy puts it, on the verge of a financial disaster. Simply, this level of indebtedness is unsustainable. The next question is how will it end?

Finding another way to weather unemployment

The Bureau of Labor Statistics recently released its latest unemployment figures. The Atlantic Online notes, it isn’t pretty. The national unemployment rate remains at 10 percent. However, for many states, December brought deeper unemployment. Mercatus Center economist Veronique de Rugy shows how “unstimulated” our economy remains with a mass exodus of 600,000 workers from the economy since December.

It may seem like obvious policy for the federal government to extend unemployment benefits for a record fifth-time. It’s something they’re considering. But, as Emily Washington and I discuss in our recent Mercatus On Policy, expanding the current Unemployment Insurance (UI) program isn’t the best medicine for the economy or for the unemployed. UI has become an poor safety net. At worst the program actually helps to extend unemployment.

Now may be the time to start discussing another approach to helping workers weather recessions: Unemployment Insurance Savings Accounts. Chile did it in 2003. Rather than dedicating employer payroll taxes to a state-administered fund, states should let workers set up individual savings accounts. With contributions from both the employer and the employee, UISA’s are available to individuals when unemployment occurs, or can be converted into savings upon retirement.

New Jersey’s “Stretched” Jobs Numbers from Another Dimension

The New York Post reports that New Jersey Governor Corzine’s office suggested Cabinet members find him speaking events that show job creation or economic development in the private sector, writing in an email, “I know that it might be a stretch for some of you, but please be creative.”

Rather than find fault with political actors acting (unsurprisingly) in their own self-interest, it’s bad policy resting on weak theory that lends itself to creativity in economic calculation.

My Mercatus colleague Veronique de Rugy explains what this fuzzy stimulus-math has to do with the job creation multiplier, a Keynesian-inspired calculation that sits on shaky theory.

First the theory. Keynes asserted that during downturns consumers hoard money. Thus, less is spent in the economy. The policy solution was for government to spend to spur economic activity. In 1930, Richard Kahn built on idea, creating the “Keynesian multiplier,” demonstrating how a government dollar stimulates more spending in the private economy.

Simply put, when the government spends $100 million on workers to pave a road, the workers spend that money in different businesses, which now have more money to spend — i.e., hire more people, who will now have income to spend. Sounds simple. But the theoretical problems are many:

  1. In his model, Keynes separated saving from investment, a fatal flaw. Saving is not necessarily money hoarded, it is money put in the bank and lent out; that is, invested.
  2. Keynes’ model is based on an “aggregate consumer” which abstracts away from the reality of an economy comprised of individuals all facing their own unique circumstances.
  3. The government cannot create wealth, it can only redistribute it from the private sector. At the other end of government stimulus are taxes.

Then there is the problem of calculating the effects of government spending on the economy. When wading into multiplier territory, it can get technical fast. Here’s a discussion of different approaches.

Carl Bialik of the the Wall Street Journal notes that jobs measures differ between states and the CBO due to wildly different assumptions and huge counterfactual leaps:

In every method used, economists are forced to imagine an alternate reality — one built on assumptions that are easily challenged. For example, to compare present unemployment rates to past rates may be straightforward but it fails to account for other economic forces that were going to affect unemployment with or without the stimulus.

Given the “alternative reality” problem, is there really much difference between jobs figures stretched for political effect, and those generated via sophisticated models? Depends on what parallel universe you like to live in.