Fiscal Policy: Structural/Cyclical. Size of government Questions And Business Cycle Smoothing Issues

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1 Fiscal Policy: Structural/Cyclical Size of government Questions And Business Cycle Smoothing Issues

2 When is government a preferred provider of goods? What is a PURE PUBLIC GOOD? My consumption of the good does not reduce its availability to you. Government takes over banana market I eat the banana, it is gone, for you. Government provides national defense. My benefit does not reduce the benefit to you.

3 Paul Samuelson on Pure Public Goods: Each individual s consumption of such a good leads to no subtractions from any other individual s consumption of that good. It is impossible to exclude any individuals from consuming the good.

4 A Police force, A standard public good Police work to make your town safer. The fact that I benefit from being safer, does not reduce your benefit from being safer. Police make things safer, in an area, not for an individual.

5 Why have a governmental agency provide a police service? An Answer: The Free Rider Problem Suppose you privatize the police force. How would you charge for it? Volunteer funds, and the sum pays for the policing. But I can contribute ZERO and I get exactly the same protection BECAUSE THE P0LICE CAN T EXCLUDE ME FROM THEIR EFFORTS.

6 NATIONAL DEFENSE, ANOTHER CLASSIC PURE PUBLIC GOOD The U.S. spends around $600 billion per year. That is close to $2,000 per person per year. I benefit from that defense, but it does not diminish your benefit. If you refused to pay for a privatized military, we could not prevent you from benefiting from its efforts.

7 The Top 10 Military spenders as share of GDP* *source: Index Mundi Rank Country Military expenditures - percent of GDP 1 Oman Qatar Saudi Arabia Iraq Jordan Israel Yemen Eritrea Macedonia Syria 5.9

8 Global defense spending: An international free rider problem? MILITARY SPENDING DOLLARS PERCENT POPULATION DOLLARS (BILLIONS) OF GDP (MILLIONS) PER CAPITA USA ,925 CHINA , RUSSIA SAUDI ARABIA ,036 U.K JAPAN INDIA , GERMANY FRANCE ITALY

9 How big are Washington outlays, as a share of GDP? Source: Nate Silver blog

10 So what does the federal government spend money on? Federal purchases consist of defense spending and everything else, like salaries of FBI agents, operating national parks, and funding scientific research. Figure 16.3 Federal Government Expenditures, 2010 Around half of federal expenditures are spent on transfer payments, like Social Security, Medicare, and unemployment insurance. The rest is spent on grants to state and local governments to support their activities, like crime prevention and education; and on paying interest on the federal debt Pearson Education, Inc. Publishing as Prentice Hall 10 of 64

11 Total government outlays must include state and local.

12 Where does Federal revenue come from? Figure 16.4 Federal Government Revenue, Pearson Education, Inc. Publishing as Prentice Hall 12 of 64

13 Taxation can adversely affect effort. Once cannot ignore effects on incentives.

14 Along such lines Early 1980s Reagan tax cuts. Along similar lines: Early 2000s Bush tax cuts. Where are we today, on the Laffer Curve?

15 Size of government: international comparisons Total outlays total ex-defense France 56% 53% U.K. 48% 45% Germany 45% 44% Japan 42% 41% U.S.A. 42% 38% Brazil 39% 37% India 27% 24% China 24% 20%

16 U.S. Health Care Costs: A Major Contributor to the Size of U.S. Government outlays

17 Sadly, we spend more but don t seem to get much for it.

18 Is there a looming fiscal crisis in the US? What will happen to U.S. Government outlays as the Baby Boomers Retire?

19 In 2011, estimates suggested a radical increase in U.S. government debt

20 Is there precedent for a GIANT budget forecast error? Yes, in 2001, forecasters ignored this picture and projected a cumulative $5 trillion U.S. surplus by (INDIVIDUAL INCOME TAX RECEIPTS AS A SHARE OF GDP)

21 CBO on Labor Productivity in 2001: A dream of 2.6%, following 5 years of 2.8%

22 The 2001 vision. How do we accumulate $5 trillion? (Everything that can go right will go right) Individual tax receipts stay at 10% of GDP (They had been there for 5 years) Labor productivity rises at 2.6% per year. (It had risen at that rate for 5 years) We fight no Wars. (None fought in 10 years) We have no recessions. (No recession had occurred in 10 years)

23 The 2010 retrospective. How do we end up with a $ 1 trillion 2009 deficit? (Everything that could go wrong did go wrong) Individual tax receipts swooned as a share of GDP (falling stocks squeezed receipts from the equity market) We fight no Wars? No, we fought two wars. We also had two recessions: A small recession in The Great Recession in

24 The vision today? A fiscal crisis looms. (But take a look at this picture)

25 The Reality? Job growth was strong and bond yields fell! job job 10-Year 10-Year growth growth (CBO) (actual) (CBO) (actual) % 2.35% % 2.35% % 2.20%

26 To repeat a slide: In 2011, estimates suggested a radical increase in U.S. government debt

27 But the news on the primary balance radically improved from 2011 to CBO Primary balance Estimates: 2011 vs 2013 (share of GDP)

28 Estimates in 2014 are wildly better than in Why do they still envision a surge in borrowing? Retiring baby boomers swell payments on Medicare and social security. Retiring baby boomer stunt growth in the labor force. Labor productivity growth will be weak. Despite weak real GDP, real U.S. borrowing costs will rise to pre-crisis levels.

29 CBO looks for disappointing, 1.8%, labor productivity growth Lower than 1.8%? Only 18% of the time Higher than 1.8%? Occurred 69% of the time (The distribution of 25-year average labor productivity performances: ) x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x

30 Historically, strong labor travels with limited labor productivity. CBO forecast to 2038? HOURS = 0.5% PRODUCTIVITY = 1.8% (Rolling 25 year averages for labor productivity and labor hours) 3.0 labor hours versus labor productivity Labor Prod

31 But if real GDP is destined to be low, history suggests a lower average for the real interest rate

32 Financial market expectations for future real rates vs. Economists estimates of potential real GDP growth

33 History vs 2013 CBO forecast CBO forecast 50 year historical average( ) Real borrowing cost (r) 2.7% 2.7% Real GDP growth (g) 2.1% 3.4% r-g 0.6% -0.7% CBO looks for high real U.S. interest rates alongside A low real U.S. economic growth: Either is possible, but both together?

34 Size of Government summary Some items need to be provided by government. High tax rates do stifle growth and can, paradoxically, reduce tax receipts. Nations have different levels of government. Some argue, today, that the U.S. faces a fiscal crisis. Maybe so, but a lot depends on assumptions about productivity and real interest rates. And there is ample precedent for forecasters to mistakenly believe that the past few years are a good gauge for the next 25 years.

35 Fiscal policy Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. (State taxes and spending are not generally aimed at affecting nationallevel objectives.) Some forms of government spending and taxes automatically increase or decrease along with the business cycle; these are automatic stabilizers. Example: Unemployment insurance payments are larger during a recession. Discretionary fiscal policy, on the other hand, refers to intentional actions the government takes to change spending or taxes Pearson Education, Inc. Publishing as Prentice Hall 35 of 64

36 Does government spending create jobs? Government spending is a component of real GDP: Y = C + I + G + NX This makes it appear as though increases in government spending increase output and hence other relevant economic variables like employment. However some economists argue that government spending simply shifts employment from one group to another it does not increase total employment. This debate was particularly important after the recession: can the government use discretionary fiscal policy to increase employment? 2013 Pearson Education, Inc. Publishing as Prentice Hall 36 of 64

37 Fears of Crowding Out, in Disastrous Recessions, Makes No sense We expanded our loanable funds model and saw that collapsing risk appetites radically reduced government s borrowing costs during the Great Recession. So the Debate appears STUPID! But it was waged by very smart people??? Perhaps another motive exists for pretending to believe that government spending could crowd out in ? (Size of government)

38 Expansionary fiscal policy in the static AD-AS model Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Increasing government purchases directly increases aggregate demand. Decreasing taxes indirectly affects aggregate demand by increasing disposable income, and hence consumption spending. Figure 16.5a If the government believes real GDP will be below potential GDP, it can enact expansionary fiscal policy in an attempt to restore long-run equilibrium decreasing unemployment Pearson Education, Inc. Publishing as Prentice Hall 38 of 64

39 Contractionary fiscal policy in the static AD-AS model Contractionary fiscal policy involves decreasing government purchases or increasing taxes. This works just like expansionary fiscal policy, only in reverse. Figure 16.5b If the government believes real GDP will be above potential GDP, it can enact contractionary fiscal policy in an attempt to restore long-run equilibrium decreasing inflation Pearson Education, Inc. Publishing as Prentice Hall 39 of 64

40 FISCAL POLICY VS MONETARY POLICY Monetary policy, each and every day, works toward delivering desired macroeconomic objectives: We want low inflation We want low unemployment We want strong real GDP growth We want a secure financial system Monetary Policy is on the Job, 24/7

41 Discretionary Fiscal Policy? Only in the worst of Times Monetary Policy is more nimble, and so better suited to steer the bus. Fiscal Policy is a product of Congress and the White House: therefore it is always highly politicized. And it takes TOO MUCH TIME! Fiscal Stimulus: Policies that give money away, are very easy to enact, but very hard to take back.

42 Fiscal policy? Especially when monetary policy is hampered When federal funds are at ZERO, the Fed has fired all of its traditional ammunition. At such times fiscal policy seems like a reasonable alternative to hoping things get better.

43 The Loanable Funds Model: Crowding Out, when the economy is near full employment.

44 The Great Recession: the government borrowing rate, r g, plunged: no crowding out occurred

45 CBO estimates of the effects of the stimulus package The Congressional Budget Office (CBO) is a non-partisan organization that estimates the effects of government policies. The table shows CBO estimates of the effect of the stimulus package on economic variables, relative to what would have happened without the stimulus package: Table 16.2 Year Change in Real GDP Change in the Unemployment Rate Change in Employment (millions of people) % to 1.9% 0.3% to 0.5% 0.5 to % to 4.2% 0.7% to 1.8% 1.3 to % to 2.3% 0.5% to 1.4% 0.9 to % to 0.8% 0.2% to 0.6% 0.4 to 1.1 The CBO s conclusion: the stimulus package reduced the severity of the recession, but did not come close to bringing the economy back to full employment Pearson Education, Inc. Publishing as Prentice Hall 45 of 64

46 Those warning of crowding out, spoke of rising borrowing costs for companies: we got the opposite Q4:2006 Q4:2008 Q4:2010 U.S. 10-YEAR CORPORATE BOND SPREAD

47 Fiscal policy: Automatic Stabilizers versus Active Changes? Jobless benefits immediately put money into the pockets of the unemployed a good thing. Similarly, monetary policy is enacted, the moment it appears a change is needed its effects take time, but the policy change requires only a vote among 12 people. But how long does it take to get a fiscal stimulus deal?

48 Think of our Political system 435 Congress people must pass a bill 100 Senators must pass a bill A House/Senate Conference must agree upon a compromise bill. Both the senate and the house must approve the compromise bill. The President must sign the bill. Then the changes can begin to be implemented.

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