Econosseur

from Today's Deseret News:

The U.S. job market is showing signs of improvement if the latest data are accurate.  On Friday the U.S. Bureau of Labor Statistics reported that the unemployment rate has fallen to a three-year low of 8.5%.  Of particular note is that private sector employment was up more than expected in December.  Tall of this could just be a one-month data fluke, but it is also encouraging that the number of new jobless claims has been declining recently as well.

Jobs are important to the economy for a number of reasons.  One of the most important reasons is that jobs are by far the primary source of income for U.S. households.  The Bureau of Economic Analysis estimates that for the 3^rd quarter of 2011 the total of all income earned in the U.S. was 13.4 trillion dollars (seasonally adjusted at annual rates).  Of that total, 8.3 trillion dollars or just shy of two-thirds was paid in the form of wages and salaries.

Most of us think of unemployment as a bad thing for exactly this reason; jobless people earn no wages and, as a result, suffer from a whole host of associated problems.  The reason we have programs like unemployment insurance and other jobless benefits is to help alleviate these problems to some degree.

But another very important reason that jobs are important is that jobless people who want to work are a valuable resource that goes unused.

Of course not everyone who is without a job represents a wasted resource.  Retired people and children are two obvious groups of people who generally do not work for money.  For retired people the benefits of working are outweighed by the benefits of leisure time.  In addition, retired people generally have a stock of savings to draw upon and are not so heavily dependent on wages for their income.  For children, the benefits of working when young are outweighed by the benefits of enjoying a happy childhood and also of increasing their education to be more productive when older.

Many people between these two extremes in age also choose not to work.  This is particularly true for married couples with children where often only one person works for wages.  In these cases the benefits from working are outweighed by the benefit of having one parent at home. 

However, when qualified workers seek for jobs and are unable to find them, we can legitimately view this as an aggregate waste.

In this context, however, not all jobs are equal.  Some jobs add value in the aggregate, some do not, and some may even lead to a decrease in total economic well-being.  For example, if your shiftless brother-in-law who is currently jobless begins working as a jewelry-store thief, the economy as a whole would be worse off due to all the broken windows he creates in the course of doing his job despite the fact that he is now employed and has a source of income.

Politicians and policy makers often talk about the challenge of creating jobs, but there is no challenge at all if the objective is simply turning idle workers into paid employees.  All that is required is the ability to tax or create money and one can pay workers to do all sorts of things.  Milton Friedman once suggested that two jobs could be created by hiring one person to dig holes and simultaneously hiring a second to fill the hole up again.

What is challenging is to foster the creation of meaningful jobs that add net value to society.  Much well-meaning public policy is counterproductive in this regard.  For example, income taxes can act as a power disincentive to work.  It is often argued that these disincentives are very powerful for the wealthy because they face higher taxes on each additional dollar earned.  However, the burden at the other end of the income distribution is often heavier.  Going back to that shiftless brother-in-law of yours; suppose he has a knack for fixing cars and wants to work as a mechanic.  If values his current leisure time at $14 per hour and an auto shop were willing to shell out $16 per hour for his effort, he would likely turn the job down.  Right now the combined burden of Social Security and Medicare taxes alone would amount to $2.13 per hour, meaning if he took the job he would net $13.87 per hour.  Loss of jobless benefits and welfare payments when wages are earned can make the effective "tax" on earned income much higher than this.

This is only one example of the many ways public policy distorts employment.  The challenge our policy makers face is not in creating jobs, but rather in fostering an environment where meaningful jobs can be created and sustained for the long-run.

This article appeared in the Deseret News on December 27th.

This article, by Rick, came out in the Deseret News on December 20th.

Eyebrows raise when you hear about any interest rate on credit more than 30 percent. If you're discussing payday or title lending, the implied interest rates (in annual percentage rate) can be above 500 percent. Put in those terms, short-term consumer lending markets sound immoral and predatory.

With a first impression like that, it is no surprise that the short-term consumer lending industry is often the target of restrictive regulation proposals and public ire.

However, looking more closely suggests that these loans are smaller in both total market size and individual interest expense than the APR interest rate would suggest. And these markets receive fewer complaints from their users than any other lending industry.

In a new dataset collected during summer 2011, I surveyed all of the Utah payday and title lending firms, as well as some pawn lenders. The data include average interest rates (in APR), average loan amounts, average duration of loan, default rate and total principle lent for more than 50 percent of all the payday and title lending store locations in Utah.

A response rate of more than 50 percent makes this survey one of the most representative of its kind. The dataset also contains a level of detail that no other source in the state has available.

The first gems that emerge from these data are the respective sizes of the Utah payday- and title-lending markets. Payday lenders in Utah issued an estimated total of $280 million in payday loans in 2010, and Utah title lenders issued about $35 million of title loans. Compare these to the size of Utah's more traditional revolving and non-revolving credit markets of $6.4 billion and $10.8 billion, respectively, as reported in a 2009 Utah Foundation publication.

In addition to the fact that the Utah payday and title lending markets are small potatoes compared to the more traditional credit markets, they also differ in duration of loan and potential interest that can be charged.

The average Utah title loan in 2010 was $920 for 6 months with a 268 percent APR. In contrast, the average Utah household in 2007 had $13,000 of non-revolving credit and $7,700 of revolving credit, both with average interest rates of less than 25 percent. One reason for the high title loan interest rate is that 17 percent of title loan borrowers defaulted to some degree on their loan.

Utah's payday lending market is even more distinct. The average Utah payday loan in 2010 was about $410 for 17 days with a 490 percent APR. In the case of a payday loan, quoting the interest rate in an annual percentage rate can be particularly misleading. This is a two-week loan. The APR of 490 percent amounts to about a $15 fee every $100 borrowed. That $15 fee barely covers the hourly wage paid to an employee to process each loan, not to mention any increased administration costs from the 14 percent of payday borrowers who went into default to some degree on their loan.

In addition, the 490 percent payday APR represents the interest rate that would result if the payday loan were compounded for a year rather than the average of just over two weeks. Utah law prohibits payday lenders to charge interest on loans beyond 10 weeks (2.5 months). This makes the 490 percent APR a significant overstatement of interest expense charged to payday borrowers. To my knowledge, no other credit market in the country has that type of restriction.

Lastly, consumers who borrow from Utah payday or title lenders file the fewest complaints to the Department of Financial Institutions of any type of borrower. In 2010, DFI received less than 10 complaints regarding Utah payday lenders. That is likely the lowest number of consumer complaints for any Utah credit industry. This is not evidence of a population of borrowers who are being preyed upon.

In summary, this new dataset of Utah payday and title lenders provides a view of the Utah short-term consumer lending market that has not been seen before. When deciding whether government regulation of any industry is justified, a policymaker should answer the following three questions. 1) What is the market failure that the regulation addresses? 2) Do the benefits of the regulation outweigh the costs? 3) How is this industry different from other related industries that don't have the proposed regulation? This new dataset will provide more answers to the questions above regarding Utah's short-term consumer lending industry.

This article appears in print tomorrow, November 29th, 2011 in the Deseret News.

This article is from the Deseret News on Nov. 14th

This article appeared on Tuesday, November 1st in the Deseret News.

In February of 2009 congress passed and President Obama signed the American Recovery and Reinvestment Act.  At the time it carried an estimated price tag of $787 billion.  Commonly referred to as "the stimulus bill," it was intended to reinvigorate an economy battered by the subprime mortgage financial crisis.  In September of this year, President proposed the American Jobs Act, which is also intended to invigorate the economy and spur jobs creation.  Under this act an additional $447 billion will be spent, leading some people to refer to it as "Stimulus Jr."

How exactly is increased government spending supposed to stimulate the economy.  The basis for this prescription lies in a particular school of macroeconomic thought known as Keynesianism.  The name comes from the famous British economist, John Maynard Keynes.  When he came up with his theories Keynes had in mind an economy mired in recession or depression, as was the case around the world during the 1930s.  In this environment Keynes claimed that workers and firms stood ready and willing to produce goods at the prevailing prices, if only someone would buy them.  This is the description of a market surplus, which occurs in individual markets occasionally for a variety of reasons.  Keynes argued there was an economy-wide surplus of goods, not just a surplus in a few scattered markets.

Normally with surpluses markets respond by lowering prices to clear the market, so that all goods offered for sale are purchased.  Think of sales on day-old bread or DVDs in the discount rack and you get the right idea.  However, Keynesian theory postulates that prices are slow to adjust, particularly downward.  This is referred to as price "stickiness" and it implies that markets will remain in surplus for long periods of time.  In the long run prices will eventually fall and markets will clear, but as Keynes famously quipped once, "In the long run we are all dead."  Hence, we may be quite concerned about what happens in the short run while prices are not adjusting.

In this scenario the problem with the economy is coming from consumers on the demand side.  They are not spending enough to purchase all the goods offered for sale.  A Keynesian prescription is to let the government purchase goods and services instead.  In theory this increases the demand for goods.  Firms sell goods that would otherwise remain unsold or not even produced in the first place.  And workers go back to work producing those goods.

There are complications, however.  The government needs to get the money to pay for these purchases somehow.  If it raises taxes, and uses the increased revenue to buy goods, it is also lowering the income of the households and businesses it taxes.  As a result, they spend less even as the government spends more.  Whether this leads to a net increase in the demand for goods depends on whether those taxes reduce their consumption of goods by more or less than the government increases its consumption.  Economists call this the marginal propensity to consume or MPC and argue that the MPC of the government is close to 100% (at least for stimulus spending) while the MPC of consumers in less than that.   Hence, a stimulus increases government spending more than it depresses private spending and yields a net increase in demand.

If, however, the government pays for spending by running a deficit, private spending need not fall, because households are not taxed and need not reduce spending.  This reasoning is why the traditional Keynesian policy prescription is to stimulate via deficit spending in a recession.

Since Keynes, macroeconomic theorists have run across flaws in this reasoning, however.  For example, when the government runs a deficit, it borrows more money from the general public.  When domestic households lend to the government, they voluntarily reduce spending and buy government bonds instead.  Hence, deficit-financed stimulus looks very similar to tax-financed stimulus in its overall effects.

Another reason why stimulus spending may be less effective than Keynesian theory suggests is that the effects depend crucially on how the money is spent.  For example, older and younger people may have different MPCs.  The old have less of a savings motive than the young.  Indeed most retired workers are dissavers, withdrawing funds on net from savings accounts and pensions.  If a stimulus package reroutes money from the old to the young it can actually reduce demand.

Recent studies suggest that much of the money from the 2009 stimulus was transferred to state and local governments for local spending projects.  However, many of these governments had quite low MPCs and used these stimulus funds directly or indirectly to pay off or avoid debt.  In other words they saved the money rather than spent it.  This may be one reason the stimulus was so much less effective that its proponents believed it would be.

Additional problems with stimulus spending include the effect it has in the long-run on burdens of taxation and expectations of future taxes.  More on those issues will be forthcoming in a later column.

This article came out in the Deseret News on Tuesday, October 18th.

Last Monday the Nobel prize in economics was awarded to Tom Sargent and Chris Sims.  Both are well-known macroeconomists and both have worked on economic issues relevant to the 2008 recession and recovery.

Forecasting the future of the economy is tricky business.  For one thing it is very complicated, with millions of goods and services changing hands.  Another reason is that it is subject to changes in the economic environment that are not economic in nature; weather and politics being two good examples.  Forecasting how the economy will behave requires simplifying models that capture most of its features without adding too much complexity.  Over the years, economists have developed increasingly sophisticated ways of doing this.

By way of analogy consider the portion of U.S. Highway 6 that runs between Spanish Fork and Price.  I drive this stretch of road on occasion on my way to the San Rafael Swell.  The road goes up Spanish Fork Canyon, over Soldier Summit, and down Price Canyon.  It is necessarily winding and steep in many places.  Suppose you were tasked with forecasting the fate of a convoy of vehicles traveling over this road.

A simple first stab at the problem might involve using elementary physics.  The vehicles have given weights, they travel at certain speeds over different portions of the road, the road's gradient and curvature are known.  Based on this information you could, with some effort, derive a forecast for the progress of the convoy.

However, to improve your forecast, you might also consider the weather.  Unfortunately, the weather is changeable.  You have a general idea of conditions, but the specifics at each point on the road are not known.  Furthermore, these conditions can change unexpectedly.  You need to make a best guess and factor this into your forecast.  You will also need to update it as the convoy progresses and available information changes.  The same principle applies to other factors like the mechanical condition of the vehicles, and the mental condition of the drivers.

When you make your forecast you realize that it is only a best guess.  It is subject to change due to factors that are difficult to predict.

If you had some control over the highway or the vehicles you might be able to reduce the chances of a serious slowdown or pileup.  Suppose you had a radio controller that could uniformly boost or reduce the amount of fuel all the vehicles consume.  If conditions looked dangerous you could dial down consumption of gas, slow the convoy down, and reduce the chances of something bad happening. 

 

This type of forecasting and policy recommendation corresponds roughly to state-of-the-art economic forecasting prior to the introduction of Rational Expectations theory thirty to forty years ago.  Tom Sargent was an important contributor to that literature.  Chris Sims' contribution was to develop statistical techniques that identify how economic variables influence each other as time progresses.

When you cut back gas consumption you assumed this would make the cars go slower.  However, drivers are not automatons and they adjust their driving behavior based on the conditions they observe.  They do this by gathering all the relevant information they can: direct observation of the road through the windows, listening to the radio, talking with other drivers on cell phones, etc.  When things look dangerous, they slow down on their own.  If you dial down the gasoline flow, drivers will simply push harder on the accelerator to compensate and will maintain the speed they think is best.  .  Ignoring the responses of the drivers (decision makers) in the convoy (economy) to your manipulation of the gas flow (economic policy) gives bad forecasts.  Good forecasts will incorporate these rational responses.

The 2008 financial crisis and recession have been held up by some people as evidence that Rational Expectations is incorrect.  If decision makers are gathering information and processing it effectively, how could they have missed the subprime meltdown?  Why did they ignore the warnings of those who were warning against just such a meltdown at the time?

Go back to the convoy.  Suppose you have a fellow forecaster who believes the brakes on a large semi-truck are about to fail.  As the convoy makes each turn along the route he announces over the radio to all concerned that the semi is about to run out of control, tip over, and cause a massive pileup.  However, for the first several turns the brakes hold and the convoy continues on unharmed.  Eventually, everyone discounts his predictions of doom.  If the brakes finally do fail, it comes as big surprise to almost everyone.  Why did drivers not foresee the crash?  Why did they ignore the voice on the radio?  Because the problem was small, subtle, not readily apparent to anyone but an expert, and the exact moment of failure was largely random.

The problem is not that the forecasting methodology is wrong.  Rather, it is that unexpected or difficult to predict events can in some circumstances have huge consequences.  They are easy to see in hindsight, but not so easy to see before they happen.  One message the Nobel committee sent was that rational expectations is still an important piece of economic theory.

This article appeared in the Deseret News on Tuesday, October 4th.

According to the National Bureau of Economic Research (NBER) our most recent U.S. recession began in December 2007 and ended 18 months later in June 2009.  There are no precise criteria for deciding when recessions begin and end.  Instead, the NBER uses a variety of economic data to reach a consensus on the dates.  The general idea is to look for turning points in economic activity.  A peak, when economic activity begins a sustained fall is the beginning of a recession.  A trough, when the economy stops shrinking and begins to expand again is the end.  One commonly used rule of thumb is that a recession is at least two quarters of falling inflation-adjusted gross domestic product (GDP), while a recovery is two quarters of rising GDP.

Not all recessions and recoveries are equal, however.  A downturn can be mild as the one from July 1990 to March 1991 was, when GDP fell by 1.3%.  Or it can be severe like the most recent one where GDP fell by 5.1% from peak to trough.  In addition, recoveries can be anemic or robust.  For example GDP grew almost 14% in the two years following the 1981-82 recession, while it has only grown 5% in the two years since the end of the last recession.

What exactly causes a recession is a matter of intense debate amongst macroeconomists.  It is likely that there are many causes.

Keynesian theories focus on the role that consumer confidence plays in recessions.  When consumers begin to feel pessimistic about the future, they will save more and spend less.  This leads to a decrease in demand for goods and services.  If the prices of goods are slow to adjust, this will, in turn, lead to a surplus of production and firms will begin to lay off workers.

New classical economic theories point to the role of technology.  When there is a drop in productivity, firms will be unable to produce as many goods as they could previously.  The drop in worker productivity leads firms to lay off workers and leads to a recession.  It also causes capital to be less productive and this leads to large drops in purchases of investment goods.  New classical economists realize that technology rarely decreases, but they point out that energy price increases and increases in taxes are often identical in terms of their effects on firms.

Financial crises can also cause recession if they have a major impact on the banking sector.  When banks are in financial trouble they are reluctant to lend to businesses, and many sectors of the economy rely on bank lending to cover up front costs.  Residential construction and shipbuilding are two good examples.  A loss of lending forces these firms to lay off workers since they cannot borrow the money to pay their wages.

Our most recent recession was caused primarily by the subprime mortgage financial crisis.  The resulting drop in consumer confidence was likely an important contributing factor.  The anemic recovery, however, is likely due to other causes.  One facet of recent recoveries has been the slow rebound in employment.  This is especially true of the past two years.  A great deal of this is due to government policy.  Increases in personal and corporate income taxes are very similar to drops in technology from the point of view of firms hiring workers.  It makes no difference to the firm if revenue is lost because the firm is less efficient than before or because the government takes more in taxes.  Expectations of increased taxes act as a powerful disincentive to businesses.  Since most business operators dislike dealing with uncertainty concerning the future business environment, even uncertainty about whether taxes will go up or not, can act as a drag on the economy.  The expectation of increased government regulation can also mimic a productivity drop.  When particular methods of production are banned or made more costly, this forces firms to adopt different production techniques that are likely less efficient (else the firm would already be using them).

Are we headed toward another recession soon?  It is difficult or impossible to say for certain.  Unpredictable future events will have bigger effects than anything foreseeable right now.  The unfolding sovereign debt crisis in Europe has the potential to stress the banking sector.  But a banking meltdown is not a foregone conclusion.  Increased taxes are a possibility, particularly with the increased attention the public and policymakers are placing on reigning in government deficits.  However, budgets can be balanced by cutting spending rather as well, so it is entirely possible that tax rates will not be raised.  The implementation of Obamacare has the potential to impose costly regulation on firms that would lead to a drop in productivity.

One thing that is certain is that there will be another recession sometime.  It may begin this year or we may be lucky enough to go a decade or more without one.  When making financial plans for the future it is always a good idea to remember that recessions are a recurring feature of the economy.

This article was published in the Deseret News on Tuesday, September 20th.

The Greek financial system is in big trouble right now.  The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros.  It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt.  Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.

By itself this is not really a very interesting or important situation.  There are a large number of countries in the world and inevitably, some of them get into fiscal trouble.  Some sort of financial crisis of this sort happens on a fairly regular basis.  Greece is, however, a member of a monetary union.  And its financial health could have an effect on the financial health of other members of that union.

The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case.  The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries.  Control of the euro money was given to the European Central  Bank (ECB), which was created with the sole purpose of managing the euro.   When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily.  It was not clear, however, how unified these countries would be in fiscal terms, however.  There is no governmental equivalent to the ECB.  There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole.  Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government.  The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.

Suppose Greece decides it is going to default on its government bonds.  Does this necessarily mean that the euro as a currency is in trouble?  Not necessarily.  In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all.  Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default.  If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries.  The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.

However, a problem does arise with one the way that Greece might choose to default on its debt.  Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma.  They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma.  Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money.  The result would be a devaluation of the drachma.  Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided.  In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.

Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31^st 2011.  What should you do today?  You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued.  If you are a savvy investor you might take profits by short-selling Greek debt.  Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell.  When all or most investors do this, the result is a worsening of the financial crisis.

If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems.  These countries include Ireland, Spain, Portugal, and perhaps even Italy & France.  If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.

Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.

This article was published in the Deseret News on Tuesday, September 6th.

Money in most countries in the world is issued by a central bank that is granted the monopoly right to issue the nation's currency.  In the United States the central bank is actually a system of 12 regional banks that are controlled by the Federal Reserve Board of Governors in Washington, D.C.  The Federal Reserve System, or Fed, is legally a private enterprise and is owned by member commercial banks.  Effectively, however, the Fed is 4th branch of the government.

The members of the Fed's Board of Governors are all appointed by the President of the U.S.   One of these is selected every four years to serve as the Chairman of the Fed.  Currently the Chairman is Ben Bernanke, who served as a member of the Board under the previous Chairman, Alan Greenspan.  While the Fed is legally owned by the member commercial banks, these banks have little direct input into the governance of the Fed these days.  Member banks elect six of the nine members of each of the 12 regional Federal Reserve Banks board of directors.  This board of directors, in turn, selects a president to run the regional Fed.  In practice, the members of the board and the presidents are chosen in Washington by the Board of Governors.

The Federal Reserve has a great many duties.  It was created in 1914 primarily to serve as a lender of last resort and address a longstanding problem the U.S. had been experiencing with bank runs.  Prior to 1914 the U.S. had no central bank.  There was a brief period early in U.S. history where the First and Second Banks of the United States were chartered and then disbanded, but these banks served mainly as depository and lending institutions for the U.S. government and not as modern central banks.  During most of the 19th century and up through 1913, the U.S. had no central monetary authority that would step in and loan funds to banks that were hit with bank runs.  As a result the nation experienced periodic bank panics where runs would occur on several banks simultaneously and led to nationwide financial crises.  The Federal Reserve System was set up to help alleviate this problem.

The Fed has many other duties as well, including regulatory control over banking, facilitation of check clearing and interbank transfers, and maintaining accounts for many U.S. government agencies.  The most important role the Fed plays, however, is as a creator and controller of the U.S. money supply.

One of the reasons the Fed is structured as it is, is to insulate it from political pressure.  The Fed is largely independent of the Federal government.  Day-to-day operational control is in the hands of the Board of Governors and the governors are appointed to very long terms of 14 years.   If the Fed were more susceptible to political pressure from the president or congress they would be more likely to use monetary policy to finance government spending.

Over the years since 1914 there have been period calls by people to disband the Fed.  The main reason that this has never been done is because the alternative is undesirable.  If you are one of those who is not pleased with the way congress has handled the U.S. budget, imagine what things would be like if congress was also in charge of the money supply.  By insulating the Fed from political pressure, we are able to maintain a much lower rate of inflation than we would otherwise have.  If congress were to take direct control of the U.S. money supply you can be assured that they would quickly give in to the temptation of simply printing whatever money they needed for their desired level of spending.  Delegating control to a central bank that is insulated from political influence makes it difficult or impossible to give in to that temptation.

While having an independent central bank does alleviate some problems, it creates others.  One argument against a central bank is that it is undemocratic.  Monopoly control of the money supply is placed in the hands of officials who are not answerable directly to the public.  This often leads to the perception that the money supply is in the hands of special interests who do not have the best interests of the public in mind.  In some countries and in many historical cases this perception is justified.  It is not so justified in the case of the Fed.

There are alternatives to the Federal Reserve System that are democratic in nature but not prone to inflation.    For example, from 1716 to 1845 Scotland had a free banking system of sorts, where two competing central banks each issued currency.  More generally, free banking would allow commercial banks to issue whatever currency they desired and they could back this currency however they wished as long as the backing was truthfully disclosed. Competitive free banking would allow some banks to issue monies backed by gold or other commodities.  Consumers would be free to choose what type of money they wished to hold and sellers could choose what types of money they would accept as payment.  One interesting new technological option that has many of the aspects of free banking is BitCoin, an online payment system that settles payments on a peer-to-peer basis without using a bank or even a currency controlled by a central bank.

Free banking is unlikely to be adopted as official U.S. policy anytime in the near future.  In the meantime, the Fed will continue to control the supply of dollars.  Despite its shortcomings, the Fed is a much better arrangement that most of the alternatives.

Runway Inflation in Hong Kong: Miners could teach infrastructure planners a thing or two
from the Wall Street Journal, July 14th, 2011

Should the Hong Kong airport be expanded to include a new 3rd runway at a cost of $17.5 billion?  Why not let the market decide?

"...we must figure out how much ... is "enough" over the long term as we also tailor our demand to resource availability at any given moment. This is easy, relatively speaking, for miners and nearly impossible for airport planners because miners have something the planners don't: a market price for their product and for their capital.

"In the airport context, putting a price on capacity would mean fully liberalizing the air traffic market and then auctioning off take-off and landing slots. Hong Kong could adopt a unilateral open-skies policy to welcome any and all comers, and also remove the remaining restrictions on so-called fifth-freedom traffic rights that would allow a carrier from Country A to fly between Hong Kong and Country C. Meanwhile, auction take-off and landing slots to the highest bidders, each slot being valid for some reasonable number of years.

"Then, let the airport operator figure it out. Privatize the Airport Authority (currently a government body), and see if the bond market thinks its expected income from slot sales will be sufficient to cover the capital expense of new capacity. Just like a mining firm."

The price mechanism could be implemented in lots of places that currently it is not.  This is just one good example.

What is Bitcoin? from CNBC, July 20, 2011

Currencies are normally issued by governments and are backed either by a commodity or by a legal mandate.  But Bitcoin is backed by neither.  In fact, it does away with a financial intermediary almost entirely.  Unlike Paypal or other online monies, Bitcoin is peer-to-peer exchange of "tokens."  The Bitcoin transfer protocol is the only intermediation that occurs.

"The process also lets people conduct transactions with virtual (but not complete) anonymity, perhaps the biggest key to its success so far. And as online transactions continue to grow and online data theft becomes a more common occurrence, bitcoin backers see an opening for the system."

This article appeared in the Deseret News on Aug. 23, 2011

Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.

The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.

For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.

As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.

This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.

Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.

Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.

Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.

Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.

This article was published on August 8, 2011 in the Deseret News under the title, "Debt deal didn't solve fiscal woes."

After months of wrangling and weeks of brinksmanship, the U.S. congress passed a bill raising the debt ceiling and President Obama signed it into law. The compromise calls for an immediate increase in the legal limit on federal borrowing by 2.4 trillion dollars and imposes reductions in federal spending by the same amount over the next 10 years.

It will be interesting to see how congress interprets the word "reduction." For most of us a reduction is an absolute drop. Congress, however, reduces spending by comparing the new forecast level of spending with the amount that was forecast before the agreement was reached, the so-called "baseline". There is no legal reason for using this baseline as opposed to some other measure. Some proponents of spending reform prefer a "zero baseline", where any change in policy is compared to a case where all future spending is assumed to remain at this year's levels. This latter baseline is a more accurate measure of how spending will actually change over time, but the former is a better reflection of the impact of a particular act of legislation.

If this was the only difference, baselines would not matter all that much. But when congress actually begins to implement the mandated spending cuts, the definition used will become very important. For example, if spending were forecast to rise by 10% per year over the next ten years, and we slowed that growth to only 5%, then (ignoring inflation) by the first definition we would have achieved a savings of just over 21%, but we would still have increased spending almost 26% from a zero baseline.

Credit agencies and financial markets are unimpressed by the debt-limit agreement. It is a good start; probably preferable to having the U.S. Treasury default on its debt payments. It may even be the best possible agreement one could hope for with a divided government. But it is only a start.
One of the more pithy, but accurate, descriptions of the deal came from Senator Rand Paul, who said, "The current deal to raise the debt ceiling doesn't stop us from going over the fiscal cliff. At best, it slows us from going over it at 80 m.p.h. to going over it at 60 m.p.h."
To the extent that the debt ceiling debate had focused the attention of the political class on the issue of spending it has done some good. But in a broader sense, the debt ceiling is a red herring. As I learned years ago from my college professor, Jim Kearl, the government has three fundamental ways of raising revenue: it can tax, borrow, or create money. And the effects of each of these, while not exactly identical, is roughly the same. In all cases the government extracts real resources from people in the economy which it then uses to buy goods and services and/or spend as transfer payments.

When it taxes the government uses the threat of force to extract resources. Failure to pay required taxes can result in imprisonment. When it borrows the government cajoles people into voluntarily surrendering resources by offering a sufficiently high repayment in the future. Of course, far enough in the future the government will be forced to raise taxes to pay for these interest payments, so the repayment is not as high as it may seem. Finally, when the government (via the Federal Reserve, in the case of the U.S.) creates money it taxes unilaterally without an explicit threat by reducing the real value of existing money holdings.
It is possible, by clever redefinition of terms to avoid a debt limit in the short run by turning debt into taxes. For example, suppose the government were to impose a surtax on households this year based upon estimated income from 2012. Tax revenue would rise, and the government debt would fall (or rise more slowly). But over time, everyone will end up paying the same amount as if the surtax had never been imposed.

The pressing problem with federal government finances is not the amount of money that is borrowed, but rather the size of the real resources the government extracts; in other words, the size of government. Right now there is no national consensus on how big the government should be. Until a consensus is reached and ultimately communicated to our political leaders, problems will continue to loom regardless what has happened or will happen to the debt limit.

A slightly edited version of this article was published July 25th, 2011,  in the Deseret News, under the title, "Term 'national debt' misleads country's finances."

On May 16th the US Treasury Department announced that the debt limit had been reached. Through accounting manipulations the federal government says it can manage to remain under that limit until early August. But what exactly is the national debt that is subject to this limit?

The statutory debt limit is a legal upper bound on the amount of debt the US government can issue through the Department of the Treasury. The actual amount of debt issued is often referred to as the "public debt" or the "national debt." The former term is more accurate, since this debt does not include amounts owed by private individuals or firms. Nonetheless, both terms are misleading.

So how much debt does the US government owe? The Treasury Bulletin reports that the outstanding US debt as of the end of September 2010 was $13,562 billion.

The national debt is held by a variety of individuals and institutions, and some of them really shouldn't count a part of the debt. For example, $5,656 billion was owed by one branch of the federal government to another. The US Federal Reserve System is included in this category because, while it is legally independent of the US government, it must refund its earnings on the US securities it holds to the Treasury. Subtracting this sum leaves a remaining balance that was privately held of $8,369 billion; still a substantial number, but more than a third smaller than the original.

This remainder was held as follows:
• $189 billion held by individuals in the form of savings bonds.
• $337 billion held by banks.
• $608 billion held by mutual funds.
• $1,030 billion held by pension funds and insurance companies
• $509 billion held by US state & local governments.
• $1,282 billion held by miscellaneous other investors.
• $4,257 billion held by foreign entities (firms, banks, governments, individuals, etc.)

It is not appropriate to think of the full amount as the debt of the nation. For one thing much of it is money owed by US citizens to US citizens. Just as I would not count $100 that I owe to my wife as part of our overall family debt, we should not count money owed by the government to its citizens as part of the overall national debt. It is in this sense that the term "national debt" is misleading.

Still that leaves over four billion dollars that the US government owes to foreigners. And if we include the net amount that private individuals and firms owe to foreigners the total is likely even greater. The national debt is only weakly related to the net amount of money we as residents of the US collectively owe to foreigners.

Another reason why the debt figures are misleading, however, is that they only show one side of the balance sheet. In addition to the debt it has issued the government also holds assets. These include some obvious things like the gold in Fort Knox, and money seized from criminals. But they also include physical goods (like the strategic petroleum reserve or stocks of grain bought to support farm prices), property (like the thousands of U.S. government buildings), machinery (like its fleet of automobiles, or its military hardware), and real estate (BLM lands, National Forests, and National Parks, for example).

We might argue that some or most of these assets should not be sold (perhaps never) even if they could be. But when we think of our personal net worth we often include such just goods as assets in our calculations. If a family owns a million dollar home, but owes debts of $250,000 we would not think of them as being broke and in the hole by a quarter of a million dollars; even if they really loved the house and had no intention of ever selling it and moving out. Still, we would also not think it wise of them to continue running up debt. In the long run, if they want to keep their nice house they can't continue to spend more than they earn.

Similarly, the government should not continue to run up its debt or it too may be forced to sell off some of the valuable assets it holds. (The government has done this before; for example, when it sold land to citizens prior to the Homestead Act. However, the primary purpose of these sales was not to raise revenue.)

The national debt is misleading as a measure of our nation's total net worth or even as a measure of the government's net worth. But that doesn't mean it's not important to monitor it and hold our government responsible for how it is managed.

This article was published July 8th, 2011, at KSL.com and published in the Deseret News on July 12th.

Republicans in the House and Senate are preparing constitutional amendments that would require the government to run a balanced budget every year. Politically, the lines are already drawn, with Republicans generally in favor and Democrats generally opposed. But does balancing the federal budget each year make economic sense? Like many issues in economics, the answer is, "it depends." Specifically, it depends on the time horizon over which we balance.

One way to gain some insight into how the government should act is to imagine the parallel with your own household budget. The parallel is not perfect, because the government is big enough to affect the whole economy while your household (even if you are Bill Gates) is not. Nonetheless, the analogy is useful.

So, should you run a balanced budget as a household? The obvious answer is, of course you should. In fact, you really aren't given much of a choice in the matter, at least in the long run. If you spend more than you earn over a long period of time you will go into debt. And if you fail to pay that debt, your creditors will start seizing your assets. You might get out of paying back the full amount by declaring bankruptcy, but that's not a good choice when making a personal financial plan.

A more subtle question is, over what time horizon should you balance your budget? Should it be a year? Clearly you don't balance it over short periods of time, like a day. Most of us get paid relatively infrequently. If we adopted a strict balanced budget rule, we would spend our paycheck in full each payday. On days when we didn't get paid we would not be able to spend anything. Clearly a day-to-day balanced budget is silly for most of us. In practice, we set aside most of our paycheck on payday and gradually spend this balance down until the next one arrives.

Financial planners tell us to set some of our income aside each payday and save. One reason for saving is to be prepared for an unexpected expense. In many cases we can't really avoid running a household deficit. If the transmission goes out on the car, it is usually necessary to repair it or replace the car, even if this exceeds the planned budget for the month. We can dip into savings do to this or borrow money, but either way we are running a budget deficit.

Running this kind of deficit is not such a bad idea if we have the self-discipline to run surpluses later. That is, we either repay our loan or rebuild our savings account to its original level by spending less than our income.

When most of us manage our household expenses, we pay attention to the budget. We are aware of whether we have spent more or less than we intended and whether this is more or less than our income. However, we do not insist on a hard constraint that spending always be less than income. Instead, we keep an eye on our savings and borrowing. When savings falls or borrowing rises, we readjust our budget plans, realizing we need to spend less or do something to earn more.

Almost everyone in the U.S. realizes the government budget is seriously out of whack. We need major adjustments to spending if we are going to avoid bankruptcy. A balanced budget amendment is one way to force fiscal balance. Just as a financial planner might recommend a strict budget for a household that is heavily in debt, a balanced budget may be one part of a responsible plan to reform government spending and taxes. In this case, a strictly-enforced budget is a temporary tool that should be used to bring overall debt down. In fact, a good financial planner would recommend a budget surplus so that spending is significantly less than income and the large outstanding debt is reduced as quickly as is reasonably feasible. However, once the debt is reduced there is much to be gained from allowing borrowing in the face of unexpected events.

A balanced budget amendment is permanent and will bind all future congresses. Therefore, the short run gains in fiscal balance need to be weighed against the long-run losses in ability to respond to economic shocks. A better policy would be to impose spending restrictions until the level of debt reaches a much lower level. The best policy would be to elect a congress that is willing to spend within its means in the long run.

UPDATE July 25, 2011

Alex Tabarrok at Marginal Revolution has a proposal that brings together the good points of the balanced budget amendment, without the drawbacks I discuss above.  He calls it an "Unbalanced Budget Amendment," and it requires the government to run a surplus in good times, so that it has some savings to draw upon in bad times.

This article appeared in the Deseret News on June 28th, 2011.

In May, former Minnesota governor, Tim Pawlenty, declared his candidacy for the presidency of the United States. He also released a plan that is intended to lead to a revival of the US economy, which is in the middle of an anemic recovery. One of the key assumptions of this plan is that the economy can be coaxed and prodded into growing at an annual rate of five percent for a decade or more. As economist Donald Marron has pointed out, the US economy has grown at an average rate of 5% for ten years exactly once since the end of World War II. That was the period from mid-1958 to mid-1968. As he puts it, "Getting up to 5% over the next decade thus seems not merely ambitious, but almost unthinkable."

However, Stanford macroeconomist, John B. Taylor, argues that 5% is quite doable. One percent growth per year can come from growth of the population. Taylor argues another one percent can come from having a greater percentage of the population employed as workers. The remaining growth needs to come from increases in the productivity of capital and workers - what economists call total factor productivity or TFP for short. Since 1996 TFP has grown at an average rate of 2.7%, so the remaining three percent needed is not that hard to imagine.

When discussing growth it is important to distinguish between two different effects. The first is a levels effect. This occurs when something happens to permanently raise or lower the long-run productive capacity of the economy. For example, a one-time increase in the population due to a baby boom, or a relaxation of immigration constraints would give us a larger workforce and increase the amount of goods and services we could produce. Levels effects will cause the economy to grow in the short run as it adjusts slowly to incorporate these new resources. In the long run, however, the economy reaches a new higher level and then stays there without any further growth.

A second effect is a growth effect. This is a change that does not necessarily change the productive capacity of the economy immediately, but rather causes it to grow more rapidly over time. An increase in the rate at which new knowledge is discovered and turned into useful products would cause the economy to grow more rapidly over time, and these increases would continue for a long time without gradually petering out as level effects must necessarily do.

Pawlenty's plan calls for reductions in tax rates, balancing the federal budget, easing government regulation, and encouraging sound monetary policy. All of these are laudable goals, but they are also examples of levels effects. Eliminating burdensome regulation, for example, would allow firms to produce more efficiently and lead to increased production. It would also cause firms to hire more workers and invest in greater amounts of capital and machinery. However, once the firms have fully adjusted, there will be no additional economic growth.

If economic policies focus solely on these types of levels effects, then it might be possible to generate a decade's worth of growth in the neighborhood of five percent, but growth would not be sustainable at that level for much longer than that. To have long-lasting high growth rates, policy makers will need to focus on growth effects.

MIT economist Robert Solow won the Nobel Prize in 1987 for his pioneering work in economic growth. One his most important contributions was to show that much observable growth comes from increases in hard-to-measure intangibles that economists lump together and term "technology." Technological progress is now regarded as the primary engine of long-run, sustained growth. To raise the long-run growth of the economy, policy will need to focus on encouraging the expansion of technology.

Some countries, particularly developing ones, try to increase technology by government industrial policy. While this may be somewhat effective for economies that are catching up with the world technology leaders, it does not work well with economies that are already technologically advanced.

For countries like the US a much better approach is to put incentives into place that encourage the production of new ideas and technologies. Tax deductions or tax credits for research and development are one way to do this. Better enforcement of patents and other intellectual property would encourage firms and entrepreneurs to engage in more research and development as well.

Five percent growth for a decade is not an impossible goal for the US economy, but if it is to come about it will require careful consideration and implementation of policies that encourage investment in new ideas and technologies. A focus on policies like balancing the budget and reducing government inefficiency will make us better off, but by themselves are unlikely to yield the five percent growth that Mr. Pawlenty has in mind.

This article appeared in the Deseret News on June 14th, 2011

Last month the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, was arrested in New York. The extensive coverage of that case has led to increased scrutiny of the IMF as an institution. The IMF is an important institution in international banking and finance, but few people realize what the IMF does and why it matters.

The IMF was created near the end of World War II. In July 1944, delegates from the Allied nations met at the Mount Washington Hotel near Bretton Woods, N.H.. The conference was called to set up an international financial system that would stabilize the world economy once the war was over. The need for stability had been clear as early as World War I, when most major nations abandoned the gold standard. The successive turmoils of the Great Depression and World War II made reestablishment of a gold-based system impossible. The Bretton Woods agreement put the world back on an international gold standard.

Three major international institutions were created as a result of the Bretton Woods Agreement. The World Bank was established to aid in the reconstruction of countries in Europe and Asia that were severely damaged by the war. The General Agreement on Tariffs and Trade (GATT), now known as the World Trade Organization (WTO), was set up to negotiate reductions in high tariff barriers that had been erected during the 1930s. Finally, the IMF was established to help maintain the stability of the fixed exchange rate system.

Most fixed exchange rate systems are subject to speculative instability that is very similar to a bank run. When a run occurs on a bank it is because of widespread beliefs on the part of depositors that the bank lacks sufficient cash on hand to pay out the small number of depositors who would normally withdraw their money in the short-run. As George Bailey explained so well in "It's a Wonderful Life," the deposits in a bank are backed mostly by loans and only a small amount of cash is kept on hand. When depositors fear the cash is going to run out, they all run to the bank and withdraw. This quickly depletes the cash on hand and the bank can become insolvent. Historically, to reduce the likelihood of bank runs, we have instituted deposit insurance and created lenders of last resort, i.e. central banks. They provide cash that the bank does not have on hand during a run and allow depositors to be paid off if they wish. Knowing that the lender of last resort exists and will act if needed is often sufficient to stop a bank run from happening in the first place.

Similarly, when countries fix the value of their currencies they can be subject to speculative attacks. Central banks that fix their exchange rates must constantly buy or sell foreign currency reserves to smooth out fluctuations in the supply and demand for their own currency. Suppose holders of Thai baht believe the Thai central bank will soon run out of U.S. dollars. They also realize the value of the baht will fall. To avoid this loss they attempt to convert their baht to dollars now -- just like a run on bank deposits. The IMF was created to be an international lender of last resort; a sort of central bank for central bankers. When a speculative attack occurred the IMF was supposed to step in and provide needed foreign reserves from its fund (hence the name).

The fixed exchange regime set up at Bretton Woods was abandoned in the early 1970s. And the main purpose for the IMF's existence disappeared at the same time. With floating exchange rates, central banks need never run out of foreign currencies, because they don't really need to buy or sell them.

So what does the IMF do under our current international system? Despite abandoning fixed exchange rates in general, many countries still fix the value of their domestic currencies to others. Sometimes this pegging is formal -- as in the case of Hong Kong -- and sometimes it is informal. The IMF played an important role in supplying needed foreign reserves to Asian countries in 1997, for example. Sometimes countries experience financial turmoil unrelated to exchange rates, and the IMF is increasingly involved in restructuring sovereign debt. The most recent example of this is the crisis in Greece, and looming crises in Spain, Ireland, Portugal and elsewhere.

While these services are useful, they could be provided by other international institutions or governments, even by private parties in some cases. The IMF's main purpose for existing vanished 35 years ago, but the IMF is likely to remain an important international institution for the foreseeable future.

This article appeared in the Deseret News on May 31st, 2011.

In mid-May the trustees of the U.S. Social Security system issued their annual report. The conclusion of the report is stated clearly and succinctly: "Projected long-run program costs for both Medicare and Social Security are not sustainable under currently scheduled financing and will require legislative corrections if disruptive consequences for beneficiaries and taxpayers are to be avoided."

One bit of information from the report that got some attention was that the total payouts in benefits have finally surpassed the collection of revenue from payroll taxes. This was not unexpected; we have known for a long time that the retirement of the baby boomers would eventually cause this to happen. What was surprising is that it happened this year and that it is projected to remain this way for the foreseeable future. Last year's report projected this flipping point would occur in 2015.

The Social Security system is a pay-as-you-go system. Revenue collected from workers is used primarily to pay for the benefits of retirees. Only a small fraction of revenue (about 8.5 percent this year) goes into the trust fund. This is in contrast to most other retirement plans, where most or all of the revenue collected goes into holdings of financial assets earmarked specifically for future benefits.

Social Security is still generating net surpluses today because it earns interest on the $2.7 trillion held in the trust fund. The system is expected to start generating net deficits starting in 2022. From that point on, the balance in the trust fund will begin to fall until it drops to zero in the year 2035.

Once this milestone is reached, the system faces a conundrum. Since the Social Security trustees do not have the legal authority on their own to raise taxes or lower promised benefits and cannot issue debt obligations, they will have no choice but to pay only some portion of promised benefits. That will initially be about 80 percent.

The scenario laid out above is true as far as it goes, but it also misrepresents how our fiscal system actually works.

The Social Security trust fund holds all its assets in the form of U.S. Treasury securities. Since these are normally very safe assets, this might actually be prudent, but it also means that the trust fund is effectively a fiction. The trust fund is a set of government assets that is backed by the same government's debt. This means the public debt is not as big as reported, and it also means there is no nest egg tucked away in a secure vault somewhere. In truth, the trust fund is backed by the government's ability to tax its citizens in the future. Workers today who are interested in receiving their promised benefits when they retire should therefore be very concerned about the size of the public debt and the U.S. budget deficit.

The trustees' report assumes that in 2035 they will need to reduce benefits so that total benefits outflows equal the total inflow of tax revenues. Politically, this seems highly unlikely. Rather, Congress would likely borrow more money to pay the full promised amounts to retirees. This accumulation of debt could conceivably go on for a very long time, but eventually the government would be unable to issue any more debt. No one knows for certain what the limit is, but we do know there is one. In fact, the limit may appear unexpectedly -- just ask the Greek government.

To avoid long-run bankruptcy, we need to realign the mismatch between promised benefits and expected tax revenues. The Social Security Administration is well aware of this problem. There are many viable options that would move us in the right direction. For example, there is talk of changing the way Social Security benefits are calculated so that future benefits are not so large a proportion of lifetime earnings. But change cannot occur unless Congress enacts it.

Since Social Security is pay-as-you-go, and workers pay the benefits of retirees, one way to make the system more sound is to increase the ratio of workers to retirees. In the past a high ratio was maintained by a high birthrate. But birthrates have fallen dramatically in the U.S. in the past few decades, and life expectancy has risen at the same time. We are transitioning from a retirement age of 65 to 67 in an attempt to adjust this ratio, but it is unlikely to be sufficient. Increases in legal immigration are one way to correct the imbalance. For fiscal purposes it doesn't matter if the birthrate rises and we have more young workers, or if they immigrate from other countries. More workers supporting the existing retirees reduces the tendency to draw down the trust fund balance.

Still, the fundamental problem with the system is that the benefits levels are too high relative to the taxes. Lawrence Kotlikoff of Boston University recently calculated the gap between the net present value of promised benefits from all government programs (which are dominated by Social Security and Medicare in the long run) and the net present value of all taxes likely to be collected. He calls this figure the "fiscal gap" and comes up with a number of $202 trillion! This means that in order to meet the promised obligations from our current fiscal system, we need to find the equivalent of more than a decade's production of all the goods and services in the entire U.S. economy.

Clearly, unless we can reduce promised benefits relative to taxes imposed, the system will go bankrupt. It is not too late to fix the Social Security system, but the longer we wait, the more difficult the fix will be.

A new Google product I just became aware of- Google's public data explorer.  The number of datasets is still limited, but it's a great place to get a graphical depiction of data.  Here are minimum wages around Europe from 1999 to present:



It'd be neat to overlay this with the unemployment data...

From the archives of Conan O’Brien:

The US Dollar has done well against the Euro with the impending bankruptcy of the PIIGS.  It's also holding up against the Blizzard of 2010:

 

Russ Robert's masterpiece:

Note the cameo by Mike Munger.

The Man in Black channels Schumpeter:

Jason sent me the great interactive graphic below from the folks at the New York Times (April 7, 2009). It shows the amount and countries of origin of foreign-born workers in the United States. Note that the top five sources of immigrant employment in the U.S., in descending order, are Mexico, Philippines, India, China, and El Salvador. We have over 5 million workers from Mexico, but the second-place country--the Philippines--was the source of only about 850,000. U.S. Immigration is truly only about Mexico.

The data come from the most recent survey of the Census Bureau's American Community Survey via the Minnesota Population Center. For a link to other great graphics see, "Perfecting the visual presentation of information."

It was one year ago today, back on October 14, 2008, when Jason Debacker and I started this blog. The first post on Econosseur.com was entitled, "Who is to blame for the crisis? Supply and demand approach". As of the writing of this post today, we have had 39,069 visitors. Jason and I wanted to thank all of you who have read our commentary, suggested ideas, or given constructive criticism in the comments. We love the forum.

Below are some of the highlights from the last year.

The Nobel Prize in Economics was awarded today to Elinor Ostrom and Oliver Williamson for their contributions to our understanding of the economics of institutions and their governance. It is noteworthy that Ostrom is the first woman to win the Nobel Prize in Economics. Women in economics should be bursting with gratitude (or envy) that Prof. Ostrom has broken the "separating hyperplane" ceiling that has existed for the profession's highest award until today.

You must read Greg Mankiw's post from today entitled, "First-year Grad Student Wins Nobel Prize in Economics!" And please do it in the following order. First read what Mankiw wrote about young Quintus Pfuffnick winning the Nobel Prize in Economics (not really). Then click on the link to the AP story about the Nobel Peace Prize award. Well played, Greg.

Here is a fun little video parody from Reason.tv. (Thanks to Jason for the link.)

After getting a B.A. in economics from BYU in 1998, I went to work for Thredgold Economic Associates for two-and-a-half years. Jeff Thredgold took an unconventional route to becoming a Chief Economist for major banks. He came up as a bond portfolio manager. As such, I always felt like he had very good intuition for what was happening in markets on a day-to-day basis.

One of Jeff's most insightful arguments is one that he has been making for as long as I've known him. In this week's issue of his weekly economic newsletter, The TEA Leaf, Jeff drives the point home, yet again, in compelling fashion.

"What [Ron] Paul and other Fed critics don't understand is that the Federal Reserve has an overseer...something or someone IT has to answer to. That something is the American bond market."

Jason and I have always been fans of the great presentation of data and it is an important skill in communicating economics. Good examples that we have discussed on this blog include the Democrats health plan diagram, the averages from the American Time Use Dataset, and the breakdown of the Federal Reserve balance sheet. Jason sent me this link to one of the coolest blogs I have ever seen: InformationIsBeautiful.net. This is an entire blog dedicated to the artful and effective visual presentation of data. Below is a graphic from a post about disease case fatality rates if you wash your hands.