Econosseur

Economic recovery is inevitable, but better policies influence it

2012-05-14T23:54:43Z

This article comes out in the Deseret News tomorrow morning.

The U.S. economy has been through several rough years, beginning with a severe recession in 2008 and an anemic recovery since. The economy has actually been growing since June of 2009, but it hasn't felt like it to many Americans. Jobs have been slow to recover compared to most postwar recessions. Despite the weakness of the recovery, things are not as bleak as they seem. The longer the recovery remains weak, the greater the potential for future economic growth.

The U.S. economy is characterized by two important features. First, the number of goods and services produced per person (GDP per capita) grows over time with a fairly reliable trend of around two percent per year. Second, GDP per capital does not grow smoothly over time, but proceeds with periods rapid growth and other periods where the size of the economy actually shrinks. We call these downturns recessions and the upswings are called booms or recoveries.

The processes that drive these two features (growth and fluctuations) are distinct, but related. For example, oil price shocks can send the economy into a recession, but are unlikely to have long-run effects on the overall growth rate of the economy. For the most part economic growth is driven by a complex set of processes. Some of these cause implemented technology to rise over time. Others influence the desired savings and consumption of households. Still others are random shocks to supplies of key goods and services and could result from political turmoil or natural disasters. Economic fluctuations are driven largely by these unanticipated an uncontrollable shocks to the economy. One important source of shocks that is controllable, however, is government policy.

The most obvious source of government policy shocks is changes in taxation. An increase in productivity will increase number and value of goods any given worker can produce. This causes an increased demand for workers (more jobs) and an increase in wages (higher incomes) along with an increase in goods and services produced (higher GDP). A decrease in tax rates on firms will have the same effect. From the firms perspective it doesn't matter if the increase in goods comes from being able to produce more or from the government taking less.

Another example of policy shocks is the imposition and removal of regulations on how goods are produced. Safety and environmental regulations add to the costs of producing goods and services and, in effect, force firms to adopt technologies that are less efficient. If there are externalities (i.e. costs born by people other than the producers or consumers of the goods) and the regulation is appropriately chosen, then overall people will be better off. However, if the externalities are small or the regulation is inappropriately restrictive, people could end up worse off. In either case, however, when regulations change often and unexpectedly this can lead to fluctuations in economic activity.

Taxation and regulation also effect economic growth because the effect the returns from investing in technology. Lower after tax returns on innovation lead to less innovation and slower growth. Heavily regulating the way R&D is conducted will induce less expenditure on R&D.

The slow recovery we have been experiencing is likely due in no small part to the effects of expected taxation, regulation, and the uncertainty associated with how they are likely to change in the near future. For example, how burdensome will the costs of Obamacare be on the typical firm? The answer to this depends a great deal on what the Supreme Court says on the subject this summer. And right now the outcome of the court's decision is very uncertain.

Despite these dampening effects, growth in the application of technology has not slowed appreciably. This means that labor productivity in terms of output per hour worked has been rising. Eventually this will translate into a greater demand for labor and an increase in productions of goods and services. Detrimental policies in the short run can delay this inevitable recovery, but cannot stop it. In fact, the longer the recovery stalls, the stronger output is likely to surge when it occurs.

All this assumes, of course, that the growth in applying technology does not slow down appreciably. As we noted above, high tax and regulatory burdens can dampen innovation if they remain in place permanently. If this happens, then the economy will have fewer new technologies to implement. In that case, recovery in still inevitable in the sense of wages, jobs and GDP per capita returning to and surpassing their previous highs. But long-run growth rates will be lower resulting in incomes rising more slowly than has been the case in the past.

Hence, recovery is inevitable if we wait long enough, but better policies are likely to bring about a more rapid recovery and return the economy to a higher long-run growth path.

Utah State Pension Reform

2012-05-08T23:09:45Z

This article by Rick Evans and Kerk Phillips, appeared in the Deseret News last week.The working paper on which this op-ed is based can be accessed at the BYU Macroeconomics and Computational Lab website.

2008 was a bad year for anyone investing in the stock market. The Dow Jones Industrial Average lost almost 34 percent, and the S&P 500 lost 37 percent. Among those hit with big negative returns was the Utah Retirement Systems (URS), the agency that manages the state pension system. They reported a slightly less devastating loss of just under 25 percent on the pension portfolio.

One of the consequences of this loss is that it made the pension system substantially underfunded. The degree to which a pension system is funded is most commonly measured by what is known as the funded or funding ratio. This is more or less the expected present value of future contributions and earnings on the pension fund divided by the expected present value of future benefits to be paid out. A fully funded pension system has a funded ratio of one, meaning the expected future receipts are equal to the expected future payments. In 2008, the URS funding ratio fell from 95 percent to 87 percent. Many state pension funds around the country found themselves in even worse fiscal condition.

The Utah legislature responded to this shortfall by passing Senate Bill 63 (SB 63) during the 2010 legislative session. The law closed the current pension plan to new employees and gave them the option of enrolling in a hybrid pension plan or a defined contribution plan like the 401(k) retirement plans many private firms offer.

As a natural extension of our joint research on the U.S. Social Security System and the inherent instabilities of defined benefit pension programs, we developed an economic forecasting model for state pension systems. Using the publicly available data and actuarial assumptions from URS, we forecast the effect of the 2010 Utah pension reform on the balance of the Utah pension fund as compared to what would have happened if the reform had not passed. See the figure nearby for an illustration. We focus our analysis on the largest portion of state employees and retirees, the Noncontributory (employer pays premiums) System, which accounts for more than 85 percent of Utah workers and retirees.

Our best estimates show that, without the 2010 pension reform, the Utah retirement fund would have had a 50-percent chance of becoming insolvent (hitting a zero balance) by 2028, with a 10-percent chance of insolvency by 2022. In contrast, the 2010 pension reform rendered the expected balance of the fund to be solvent over the foreseeable future. However, it is important to note that we still find a 10-percent chance that the fund becomes insolvent by 2024, even with the reform. This is because there is always the chance that the Utah economy will be hit with a few bad economic years in a row.

Our results are only estimates, and our analysis is based on our best reconstruction of the characteristics of current state employees and retirees from publicly available data. More precise information on the age and job tenure distribution of employees and retirees would give more precise forecasts about the future of the pension fund. But our finding that the fund had a high probability of insolvency before the reform of 2010 is undisputed. What is less widely understood is that, even with reform, defined benefit pension programs will always pose a risk of insolvency and some type of painful policy change. Utah's 2010 reform of its pension system was commendable and rare when compared to other state pension funds and the U.S. Social Security System. The reform reduced the probability of insolvency but did not eliminate it.

In the end, it is a policy question rather than an economic question as to how much risk should be borne by the state, taxpayers, and employers for employee retirement benefits and how much risk should be borne by employees. But economics can help us understand how big those risks are.

Shattering the American dream: The US government's Ponzi scheme

2012-05-08T22:53:19Z

An op-ed piece that appeared at www.voxeu.org on May 4th, by Rick Evans, Larry Kotlikoff and Kerk Phillips and based on this paper.

Alex Tabarrok blogs about the piece at Marginal Revolution.

What Causes Economic Growth?

2012-04-03T19:09:33Z

Today's column from the Deseret News

This semester I have been teaching a class at BYU on economic growth. One of the anticlimactic moments in the class comes near the end when I try to summarize the various theories and models of growth we have covered. We try to determine by an appeal to the evidence which of these is the best explanation of observed growth patterns. The bottom line is that we don't really know.

Growth is one of the most important issues economist study. As Bob Lucas, a Nobel Prize winner from the University of Chicago has said, the consequences for human welfare from correctly understand the mechanisms that drive economic growth are simply profound. So profound, in fact, that when one begins to think seriously about growth, it is difficult to concentrate on other topics.

The modern experience with economic growth is unique in history. Prior to the 17^th century standards of living changed very slowly over time, if at all. Something happened in the 18^th century that changed that dynamic dramatically. Standards of living now rise rapidly from one generation to the next. And this is true even for some of the poorest places on the earth. That is, even the typical citizens of poor countries like Mali or Bangladesh are better off today than their parents were a generation ago.

As economists, we now understand growth a great deal better than we did even twenty years ago, but the root causes are still elusive. Back in the 1950's Nobel Laureate Robert Solow of M.I.T. showed that growth in per capita income cannot be driven in the long-run by simple mechanisms such as the accumulation of physical capital. Such mechanisms can cause growth spurts as economies build up their capital to some long-run optimal level, but they cannot explain sustained episodes of rising per capita income over very long periods of time. The Japanese post-war growth spurt is a prime example. Growth was very rapid for several decades, but once the Japanese economy reached a level of capital and output per capita similar to the rest of developed world, growth rates fell to more common rates. Today the Chinese economy is booming in a similar way and it will likely continue to do so for quite a while. But eventually growth rates in China will also fall to rates closer to the rest of the world. By then, of course, incomes in China will be very similar to levels in other developed economies.

Later work by Solow showed that much of the growth we observe is attributable to increases in technology. Discovery of new knowledge and application of that knowledge to the production of goods and services allows us to produce more goods and services with the same amount of labor and capital. This discovery only pushes the question back a stage. If growth in standards of living is driven by growth in technology, what causes the rise in technology?

Modern growth theory has no shortage of plausible explanations. For example, some economists argue that economic growth is driven by increasing returns-to-scale. In other words, doubling the capital and labor and all other factors in an economy, more than doubles the number of goods and services that are produced. Others point to learning-by-doing arguments. As firms produce more they discover, as a byproduct of production, more efficient ways to produce and these production methods can be adopted by other firms, expanding overall technology. Still others believe that growth is driven primarily by R&D firms that are attempting to corral monopolies on new goods. The lure of these monopoly profits induces the firms to hire researchers to work on developing a new and improved product that will allow them to drive existing producers out of the market. Many researchers focus on the role of government and public policy in generating improvements in technology and human capital. Each of these mechanisms implies a mostly unique set of economic indicators should be highly correlated with economic growth.

Empirical evidence able to distinguish these various hypotheses is difficult to come by. The main reason is that while any of these theories in isolation implies a particular set of data should explain growth, when taken together all the data tell much the same thing. For example, some theories suggest that higher rates of primary or secondary education should cause faster growth. Other theories suggest that an increase in legal enforcement of property rights should cause more rapid growth. In reality we observe all three of these rising simultaneously. Is rising education causing more rapid growth and better enforcement of property rights? Or are property rights causing rising growth and, hence, a better educations system. Or are all three being driven by some other factor.

An appeal to the data does not allow us to resolve the issue. In one sense this is good as it may imply that the sources of growth are various and if one source disappears growth can be sustained by the others. This is not very satisfying to students or professors hoping to learn the ultimate cause of economic growth, however.

Pensions and Social Security

2012-03-20T04:15:05Z

This article is from Tuesday's Deseret News

Social Security is in trouble. While the system is currently generating tax revenue that is approximately equal to the benefits payouts, this will not be the case in the near future. Many state and local pension funds are in a similar situation.

Retirement plans in the U.S. can be classified into two broad categories: defined benefits programs and defined contributions program. The former include traditional pension funds where retirees receive a fixed monthly benefit upon retirement; this is often a fixed percentage of the salary they earned in the year just before they retire. The latter include familiar 401(k) plans that many private employers offer. Under these plans a defined percentage of the worker's salary is deposited in an investment fund earmarked specifically for that worker and the worker receives the market value of that personal fund upon retirement.

Defined benefits programs place plan riskiness on the employer or the pension fund manager with whom the employer has contracted. Since benefits are fixed according to a predefined formula, extraordinary losses or gains in the value of the pension fund's assets accrue to the fund itself and do not affect the worker's retirement benefits. Defined contributions plans, on the other hand, place all of the risk on the employee. As many of us discovered a few years ago, losses in the value of investments have big effects on a worker's expected retirement income.

Richard W. Evans, a colleague of mine at BYU, and I have been working over the past few years on a series of papers dealing with the financial viability of the U.S. Social Security system, social security in general, and (most recently) state and local pension stability. One recurring theme in our research is the fundamental instability of defined benefits programs.

Social Security and government pensions are defined benefits programs where the system's income is determined by a set contribution (or tax) rate; i.e. the percentage of each worker's salary that must be paid into the pension system with each paycheck. Sometimes this is paid by the employer, as with most state and local pensions. And sometimes this is paid directly by the worker, as with Social Security taxes. At the same time, the benefits paid out are also set according to a well-defined set of rules.

To see how this generates instability consider the case where the system has been perfectly calibrated so that the contribution inflow exactly matched the benefits outflow. If the pension fund starts off with no assets, then the amount of assets over time will remain zero as long as contributions exactly match benefits. However, if the pension fund starts off with a positive asset balance, it will accrue interest over time that sends the pension fund balance off to infinity in the long-run due to compounding of interest. If the fund starts off in debt, the same compounding drives it off to negative infinity over time.

Of course in the real world, inflows and outflows rarely match up exactly. Unexpected fluctuations in either of these can tip the fund from an unstable upward path to an unstable downward path or vice versa. Pension fund managers are constantly monitoring the balance of their fund's assets along with actuarial projections of future contributions and benefits to ascertain as accurately as possible on which path the fund is headed in the long-run.

In a pension fund, the managers have the ability, and indeed the obligation, to adjust the contribution rate as needed to ensure the fund is fully-funded in the long run. With apologies to LDS Apostle Dieter F. Uchtdorf, an appropriate analogy might be an airplane. An airplane left to cruise without any pilot control will eventually crash. Its flight path is unstable in exactly the same way as the path of a pension fund balance. The altitude of the airplane corresponds to the value of the pension fund. Just as going to zero altitude is bad for airplanes, zero pension fund balances are also bad. If weather or other circumstances outside the plane push it toward the ground, the pilot must respond by adjusting the control surfaces to raise the plane's altitude back to the desired cruising level. Similarly, fund managers can and must adjust the contribution rate to bring the fund balance back up to an appropriate level. In this manner the fundamental instability is controlled by intelligent intervention.

One major difference between Social Security and pension funds is that currently there is no mechanism for adjusting the contribution rates. In the case of Social Security this is the payroll tax rate, which is set by the U.S. Congress. The managers of the Social Security Trust Fund cannot change this rate. In a disturbingly real sense then, the Social Security system is like an airplane without a pilot. Is it any wonder it is in trouble?

On Taxes

2012-03-09T13:18:38Z

Published this week in the Deseret News.

Taxes are in the news these days. Both Rick Santorum and Mitt Romney recently released tax plans as part of their campaigns for president. And the Obama administration released a new budget proposal for the coming fiscal year that alters some key tax rates.

Taxes are important for a variety of reasons. Few people enjoy paying them, but they are necessary if the government is going to, in the long run, pay for the goods and services it consumes along with the goods, services and transfer payments it provides to the public.

It is often instructive to think of the government as if it were a smaller entity like an individual or a household, but at times the comparison can be misleading. Just as households need to run balanced budgets in the long-run, governments also need to make sure they have the funds available to pay for the things they buy in the long-run. Failure to do so leads to problems like those we see in many places around the world today; Greece being one of the most prominent examples.

When governments face budgetary shortfalls they need to either cut spending or increase revenue or some combination of both. Households face the same stark choices. Household can raise their revenue by having some family members work longer hours or having additional family members enter the workforce as wage earners. They can also try to find higher earning jobs. To summarize, households usually increase their income by selling more of their available factors of production (like labor hours) or by earning more per each unit of factors provided.

Governments, on the other hand, do not really sell anything. Instead they increase revenue by raising tax rates on various kinds of assets and economic activity, or by closing legal loopholes and exemptions that previously made some types of assets and economic activity exempt from taxation. This is not the same as a household earning more income, since the government is not offering a voluntary trade of equally-valued things the way a worker does when he or she works more for a higher pay.

Governments - or more precisely government policy makers - often talk of raising tax revenue as if they were behaving in exactly the same way as a worker putting in more hours on the job. What they neglect to point out - or are oblivious to - is that this revenue is extracted involuntarily from households and is not the same as a market exchange. How this tax revenue is ultimately spent as compared to how the household would have spent the money is of key importance.

As University of Rochester economist and columnist, Steve Landsburg, has pointed out, wasteful government spending does not magically become less wasteful simply because the government pays for it with increased tax revenues rather than borrowing the money.

Taxes are also important for the incentive effects they provide, however. In fact, this may be the most important effect they have on the economy. Independent of any effects on the size of the budget, taxes can incentivize or de-incentivize people in very powerful ways.

Consider the effects of taxes on capital earnings. One way to make workers more productive is to increase the size and quality of the capital goods they have available when they work. Part of a firm's revenues are attributable to the capital it owns (roughly one-third in the U.S.) and the remainder is attributable to the workers it hires. Labor-generated revenue is returned to households in the form of wages and salaries. Capital-generated revenue is returned in the form of interest payments on loans & bonds and in the form of stock dividends. When governments increase taxes on capital, they reduce the net return to investors who finance the purchase of new capital via their purchases of corporate bonds or stocks. Investors respond by investing less and capital stocks either fall or fail to grow as rapidly as they would have.

Taxes on capital income are often touted as a way of achieving a more even distribution of income. Since all of us have an equal endowment of time most wealthy people do not earn the majority of their income in the form of wages. Instead, their income is primarily from investments in capital. On average, taxing capital is a way of placing a greater tax burden on the wealthy. Note however, that in the long-run this reduces the size of the capital stock and this, in turn, reduces labor productivity and wages.

In the end heavy taxation of capital hurts both workers and investors.

"Do Not Disturb" Sign for Economics Nerds

2012-03-03T21:40:17Z

Did the 2009 Stimulus Package Work?

2012-02-15T18:21:05Z

This article appeared in the Deseret News yesterday.

Congress passed the American Recovery and Reinvestment Act in February of 2009. If you will recall, at the time it was touted by its proponents as an economic treatment for the recession caused by the housing financial crisis that preceded it.

In trying to determine if the stimulus package worked, we first need to define what "worked" means in this context. What is success for a stimulus package? When the stimulus was being considered in 2009 the Council of Economic Advisors (CEA) released a report predicting what would happen to the US economy if the stimulus were passed and contrasted this with what would happen if it didn't pass. The unemployment rate was predicted to peak at just over 9% during 2010 and run between 8 and 8.5% in early 2011 if the stimulus package did not pass. With the stimulus, the unemployment rate was supposed to peak at just under 8% at the end of 2009 and would run between 6.5 and 7% for the first half of 2011.

In reality the unemployment rate peaked at 10.1% in October of 2009 and is currently inching down slowly to its most recently reported values 8.3%. Clearly by the standards of the CEA report the stimulus did not "work". If fact, one might argue it worked negatively, since the actual outcome was worse than what was predicted if congress did not act. The problem with such comparisons is that it is difficult or impossible to establish a counterfactual. What really would have happened if the stimulus had not passed?

Proponents argue that the stimulus helped because things would have been even worse without it. Unfortunately, the validity of that argument cannot be tested, since we can't rerun the economy starting in February 2009 without the stimulus. Over any lengthy span of time a great number of random, unpredictable events will occur that effect the economy. If we could rerun the economy a thousand times we would get a thousand different sets of random outcomes. If these events really are random and unpredictable before they happen, it is pointless to argue that something different should have been done. Rather than ask if a policy was appropriate given what we know now, a more important question is if the policy was appropriate given what was known when it was put in place.

The notion of fiscal stimulus is based on the work of John Maynard Keynes who wrote much of his most influential work based on his observations of the Great Depression. Keynes argued for government spending as a way to stimulate the economy because he observed firms and workers ready and willing to produce goods and services at the prevailing prices if only they could find someone willing to buy. If this is really the case, then government spending leads to purchases that would not otherwise occur. Traditional Keynesian theory argues that a $1 increase in government spending will lead to a much more that $1 increase in economic activity because the workers and firms that sell to the government will earn income which they will, in turn, spend on other goods. This is the notion behind a government spending "multiplier."

Suppose, however, that firms did not stand ready to produce any amount of goods at prevailing prices. Instead suppose that when the government buys goods it increases their demand and causes prices for the goods it buys to rise. In this case, the higher price will make private consumers and firms cut back on their purchases and the government ends up "crowding out" private purchases. In this case the government multiplier may be a number less than one, possibly even close to zero. That is, a $1 increase in government spending increases economic activity by less than $1 or perhaps by nothing at all.

Professor Robert Barro of Harvard University has estimated that unexpected increases in government military spending have multipliers of .8 or so. This is in sharp contrast to multipliers of 1.5, 2.0 or even 3.0 that are assumed in some traditional Keynesian models.

So did the 2009 stimulus package work? No, in the sense that it did not work as advertised. The actual performance of the economy has been much worse than the worst-case scenario envisioned in early 2009. On reason for this failure may be that fiscal stimulus is really not as effective in our modern economy as it might have been in the 1930's. There are, of course, other methods for stimulating economic activity. These would include reducing taxes on economic activity, particularly on investment in new capital goods.

Does the economy need another stimulus to avoid a "double-dip" recession? Given what I observe from the last stimulus package, I would say no.

What Exactly Do Financial Markets Accomplish?

2012-02-03T20:21:54Z

From the Deseret News this last Tuesday.

In terms of public opinion, the past couple of years have not been kind to people who work in financial markets. The subprime mortgage meltdown and recession have generated negative feelings among a substantial number of Americans toward financial markets and the people who profit from them. Recent rhetoric in the Republican presidential primaries concerning Mitt Romney's role at Bain Capital and Bain's role in the economy has revived the issue.

Are financial markets a net benefit to society? Or are they an instrument for exploitation of one group of people for the benefit of another? To answer these questions we need to understand what exactly it is that financial markets do.

Financial markets exist to do a variety of things. One role they serve is to move wealth around over time. Very rarely is it best for a person to consume all of his income as soon as it is received. Financial markets facilitate delayed (or accelerated) consumption by allowing consumers to purchase financial assets today when they have a lot of income, and sell them later when their income level is low. In economics this is referred to as the consumption-smoothing motive, since it is driven by a desire to keep consumption constant over time, or at least to have it change gradually if it does change.

Middle-aged workers generally want to save because they realize they will have much lower income after they retire. Young and old consumers, on the other hand, often want to dissave. Young people may borrow when young to finance an education, for example. Retirees want to draw down their savings so they can continue to consume at a level close to what they did while working. This type of trade can be supported by relatively simple financial assets, like bank loans, or bonds.

Another role that these markets serve requires more sophisticated financial assets, however. That is the buying and selling of riskiness.

Some types of risk can be completely eliminated by appropriately diversifying. Auto insurance is a good example. The insurance company collects premiums from all its customers and makes payments equal to damages for those who have accidents. With a large number of customers the payouts over a given period of time can be predicted quite accurately. In the end all the customers end up mostly the same when it comes to their cars. They have all paid the premium and they all have a working car.

Some other types of risk cannot be eliminated by diversification. This type of risk is called aggregate risk. Even though it can't be eliminated, it can be transferred. This is perhaps the most important role that financial markets serve. Some people, like myself, are very averse to risk. They are often referred to as "hedgers". They buy relatively large amounts of insurance and they take safe jobs at places like universities. Other people, like my next-door neighbor, Brent, are less averse to risk. We call these people "speculators". They tend to buy less insurance, or buy policies with larger deductibles, and they are more willing to take jobs that have greater income risk, like being self-employed.

Suppose I unexpectedly inherit an old abandoned gold mine from a rich relative. No one knows if the mine still has any gold in it. Suppose the mine has a 50% chance of being worthless and a 50% chance of generating a million dollars in profit. This is a risky asset. I don't like risk. My neighbor, Brent, doesn't really like it either, but is more tolerant of risk. I could offer to sell the mine to Brent for $450,000. I would prefer have $450,000 for sure than the risky mine. Brent will end up with a net profit of $550,000 if the mine is viable and a net loss of $450,000 if it is not. As a result I end up with a much safer portfolio but lose an average of $50,000. Brent ends up with an average of $50,000 more than before, but his income is really risky.

In terms of dollars this is a zero sum game. It appears Brent gained $50,000 at my expense. Before anyone starts occupying his front yard, note that in terms of overall well-being, we both end up better off. I am happy to take my loss in order to avoid risk and Brent is happy to accept that risk in exchange for $50,000.

One of the things financial markets do in general is transfer both risk and wealth to people who are less risk averse from people who are more risk averse. As a result some people end up quite wealthy (Brent nets more than half a million dollars if the mine pans out), but they offered something of real value in exchange. They took on risk that other people did not want to face.

As with any group there are a few dishonest and immoral people dealing in financial markets. But generally speaking high payoffs are a payment for willingness to take on risk. Financial markets, rather than being arenas for fraud and theft, are efficient ways of reallocating risk to for the benefit of all participants.

Why Jobs are Important

2012-01-10T11:27:22Z

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.

What Lies Ahead for North Korea?

2012-01-05T16:58:35Z

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

Kim Jung-il, the ruler of North Korea, died last week, reportedly of a massive stroke. Other than a few deluded souls who might have been sincerely crying their eyes out on North Korean television, he will be missed by no one.

His death does, however, open up the possibility of changes in that reclusive country's policies, both domestically and internationally. In terms of politics and policy, North Korea is probably the hardest country in the world to reliably understand. We can observe the final results of whatever process determines policy, but very few people outside North Korea have any clue how that process actually proceeds. So it is entirely possible that nothing will change in practical terms as a result of Kim Jung-il's death. Still, if you are a bit of a gambler, the odds are higher now than they have been in a long time.

North Korea by almost any economic standard is a real basket case today. This wasn't always the case. Korea was occupied by Japan from 1910 until the end of World War II. By agreement of the allied powers at the Yalta conference the Russians occupied the peninsula north of the 38^th parallel and the U.S. occupied the south. At that time the south was largely agrarian and what industry the Japanese had allowed to be built was mostly in the north, closer to natural resources from Manchuria, which Japan also occupied. Up until the 1970's, standards of living in North Korea were actually higher than those in South Korea.

The real slide in standards of living came with the fall of the U.S.S.R. Up until that time the North Koreans had skillfully played off of the antagonism between it and China. When the Soviet Union ceased to exist, both China and Russia felt less of a need to compete for North Korean loyalty and the subsidies virtually ceased.

For several years I have been working with my BYU colleague, Scott Bradford, to try and predict what would happen if economic policy in North Korea were to change. In a recently published paper with a former student, Dan Kim, now at Cambridge University, we examined what would happen if the government there were to open to market reforms, much like China did in the 1970's and 80's. We found that simply implementing a market pricing mechanism is insufficient to bring North Korea out of a downward spiral.

North Korea has two major economic problems that need to be corrected. First, it needs to more efficiently allocate the goods it produced across various industries. Second, it needs to use a much greater proportion of its GDP for investment in capital equipment. Partial reforms which are more likely to be enacted by a government intent on gradual change could solve the first problem, but leave the second in place. For example, suppose the government continued to mandate the amount of production at state-run firms, but let those firms compete in a market with each other to purchase materials and equipment. This would go a long way toward reducing inefficiency, but would still leave the country as a whole woefully short of capital.

Increasing investment in capital and infrastructure would correct the second problem, but is very difficult to do if North Korea is intent on remaining isolated from the rest of the world. If they do not open up to trade, then the only way to allocate more toward capital goods is to either lower government spending on the military (unlikely) or lower consumption by households (difficult given chronic problems with starvation).

The best solution would be to import capital from other countries. China, South Korea, Japan, and many other countries have capital available and firms that would be ecstatic to invest in North Korea under the right circumstances.

Meaningful reform in North Korea, if it happens, must involve changing the way they view outsiders. Right now South Koreans enjoy a standard of living that is well over ten times higher than their North Korean neighbors. This difference is due almost entirely to economic policy; the South is open to the world with free flows of capital, goods, and even workers. The North is closed to even its closest ally, China, and exports little (almost all of its imports are in the form of humanitarian aid).

North Korea has a long, long road ahead if it is ever to catch up with South Korea and the path looks daunting. However, remember that fifty years ago the same things were said about South Korea. It may take time, but recovery is possible.

Data show short-term lending not predatory

2012-01-05T16:52:59Z

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.

Is it Really that Bad to be Irrational?

2011-11-29T04:38:49Z

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

Several years ago I heard a joke about two macroeconomists who went hunting with a non-economist colleague. As they tracked a deer up a slope and over the crest of a hill, they noticed it edge into a clearing, making a perfect silhouette on the horizon. Within heartbeats of each other the two economists fired. One missed by ten feet to the right and the other missed by ten feet to the left. The deer ran off immediately, unharmed and the two men yelled in joy and began to hive five and slap each other on the back. Their colleague asked how they could be so excited when they had both missed by a substantial margin. They replied. "Yes, we missed. But on average we hit him right between the eyes!"

Modern macroeconomic thinking incorporates the concept of rational expectations. Rational expectations is the notion that while individuals in the economy may not always be able to accurately predict the future, they at least do not consistently underestimate or overestimate. On average people hit their forecast targets right on.

To continue with the hunting analogy, suppose you have a gun with a bad sight. When you fire it into a target you consistently hit it too low and to the right. If you could not adjust the sight and were forced to take the gun hunting, you would mentally adjust by aiming a bit high and to the left of the intended target, in an attempt to correct the bias. Households and firms do something similar when they forecast the future of the economy. Household savings decisions, for example, are based on expectations about what interest rates will be earned in the future and what wages the household can expect in future years. Often household rely on analysis from professional financial planners and/or economy-watchers, but they make the same kinds of adjustments.

Rational expectations as an economic theory says that agents in the economy will take all relevant information into account when forming a forecast or expectation of the future. Failure to do so leads to mistakes that the agents will regret later. Just as failure to adjust for the bad sight on a gun leads failure in hunting, failure to adequately process all relevant information leads to bad economic outcomes. Incorporating this insight into economic models has led to a vast improvement in the quality of macroeconomic models over the past several decades.

But are people really rational? Not all economic researchers are convinced that rational expectations is a good approximation of actual behavior. Behavioral economists often prefer an alternative model of behavior that stresses time-inconsistency. Agents that behave this way make plans for the future with the intent of following those plans, but when the future rolls around they often change their mind. A time-inconsistent planner might eat burger and fries for lunch today with the intent of starting a healthy diet of salad and fruit tomorrow. However, when lunch time rolls around again the next day, he eats the burger again and the salad gets postponed . The end result is someone who is heavier and less healthy than he initially planned.

From a macroeconomic perspective, this behavior is important only if it affects the aggregate behavior of the economy as a whole. One area where it does have an effect is in economic policy. Time-inconsistent households, for example, are argued to be less likely to save for the future. They will tend to put off savings and consume instead. Hence, they arrive at retirement with less savings than they need. This means there is a role for the government to play in saving for the household or forcing the household to save. One of the reasons - among many - that the US Social Security system was set up was to alleviate this problem.

In this light, a recent working paper by two macroeconomists at Utah State University's Huntsman School of Business is quite enlightening. Frank Caliendo and Scott Findley show that when one accounts for the age-of-retirement decision, things do not look so bad. They compare a model economy where all the agents are rational with one where all the agents have a time-inconsistency problem. In both models, agents retire at the same age and earn an exactly equal amount of income over their lifetimes. The rational individuals choose to retire at age 65, make a consistent savings plan, and stick to it over the course of their lifetime. The time-inconsistent individuals choose to retire earlier when making plans at young ages. But, they tend to over-consume and under-save and end up pushing their planned retirement age back each year. In the end, they too retire at age 65.

The interesting result is that both sets of agents end up retiring with roughly the same stock of wealth set aside. Time-inconsistent people under-save relative to their planned early retirement, but end up saving the appropriate amount for the age they actually retire.

The policy implication of this work is that the need for a government correction to the savings problem is not nearly as strong as previously thought. If Caliendo and Findley's work is representative of the actual economy, then even if all the households in the economy are poor savers, they still end up saving the right amount.

What does an Economic Stimulus Do in the Long Run?

2011-11-29T04:32:51Z

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

In the last article in this series, I talked about how economic stimulus is supposed to work. The basic premise is that when the government spends more money on goods & services, they more than replace the spending that households would've done without the stimulus. That is the marginal propensity to consume (MPC) of the government is higher than that of households.

Economist Robert Barro has argued for the past thirty years or so, that this simple story ignores important aspects of household reasoning. Imagine for example, that the government decides to run a budget deficit by lowering taxes. This should be stimulative, since it leaves more money in the hands of consumers, who will presumably spend at least some portion of it (based on their MPC). Barro argues, however, that rational households will realize that cutting taxes today and leaving spending unchanged does not mean taxes can stay permanently lower. Such a policy is unsustainable over a long period of time. Forward looking households will realize that lowering taxes today means raising them in the future (holding government spending constant over time in our example). As a result they have a lower tax burden today and higher taxes in the future. Since most consumers prefer consumption that is smoothed out over time, rather than high consumption now and low consumption later, the best behavior is to save. Barro showed that under certain circumstances households increase their savings by exactly the same amount as the government reduced their taxes. This leaves consumption unchanged and hence gives not stimulus at all.

Barro has termed this effect "Ricardian equivalence" based on work by David Ricardo in the 1800's. As mentioned, Ricardian equivalence holds only in certain circumstances. First, all consumers need to be rational and forward looking. If some consumers do not care about the future, they will view a drop in taxes today as an increase in spendable income and increase their consumption. If some consumers do not expect to be alive when the tax increase occurs they will also be likely to increase their consumption. In these cases, there will be a stimulative effect of cutting taxes, even when it must necessarily be a temporary cut.

Similarly, if the government increases spending and does so by borrowing money, rational households will realize that even though taxes don' t rise today, they must eventually rise at some future date. The further off into the future that date is expected to be, the greater the number of households that will expect to be dead when the increase hits. And, hence, the greater the stimulus will be.

A perfect example of this effect occurred in 1992 when Presidents Bush used an executive order to reduce federal withholding of taxes from people's paychecks. The order did not change their overall tax burden; the same amount of taxes was due on April 15^th. However because withholding was lower the expected payment (refund) in April was larger (smaller) than before the change. Since almost everyone in the economy expected to be around when the tax bill came due, this is an almost perfect implementation of a policy subject to Ricardian equivalence. The response was exactly what Barro predicted, consumers saved most of their withholding and the policy had virtually no effect on the macroeconomy.

Very few economists believe that Barro's strict version of Ricardian equivalence where stimulus spending has zero effect is correct. Nonetheless, his point is well taken. That is, the effects of a stimulus are likely to be much smaller than those predicted by standard Keynesian models. The effects are also likely to be larger when the future burden of paying for the stimulus is paid by future generations. Stimulus spending that is paid back in the near future is likely to have very small effects.

As citizens and voters we need to ask ourselves if the short-run gain from a meaningful economic stimulus is worth the cost it imposes on future citizens and voters.

How is economic stimulus supposed to work?

2011-11-04T10:11:37Z

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.