Naked Economics (28 page)

Recessions can spread quickly across international borders. If the U.S. economy weakens, then we buy fewer goods from abroad. Pretty soon Mexico, which sends more than 80 percent of its exports to the United States, is reeling. In business as in sports, your competitor’s misfortune is your gain. At the global level, the opposite is true.
If other powerful economies fall into recession, they stop buying our goods and services—and vice versa.
Think about it: If unemployment doubles in Japan or Germany, how exactly is that going to make you better off? During the financial crisis, the problems on Wall Street quickly spread to other countries. Americans—who are collectively the biggest consumers in the world—bought fewer imported goods, which harmed exporting economies around the globe. America’s GDP contracted at an annual rate of 5.4 percent in the fourth quarter of 2008. You thought we had it bad? Singapore’s economy fell in the same quarter at an annual rate of 16 percent, and Japan’s by 12 percent.
¹⁵

How do things get better? There are often underlying issues that need to work themselves out. In the case of the “tech wreck,” we massively overinvested in Internet businesses and related technology. Some firms went bust; other firms cut back their IT spending. Resources were reallocated, at which point there were more U-Hauls going out of Silicon Valley than in. Or, in the case of higher energy prices, we reorganize our economy to deal with a world in which oil is $100 a barrel instead of $10. In the run-up to the financial crisis, consumers and firms borrowed too much; speculators built houses that never should have been built; Wall Street grew fat dealing in products with limited economic value. These things are now (painfully) fixing themselves. Recessions may actually be good for long-term growth because they purge the economy of less productive ventures, just as a harsh winter may be good for the long-term health of a species (if not necessarily for those animals that freeze to death).

The business cycle takes a human toll, as the layoffs splashed across the headlines attest. Policymakers are increasingly expected to smooth this business cycle; economists are supposed to tell them how to do it. Government has two tools at its disposal: fiscal policy and monetary policy. The objective of each is the same: to encourage consumers and businesses to begin spending and investing again so that the economy’s capacity no longer sits idle.

Fiscal policy uses the government’s capacity to tax and spend as a lever for prying the economy from reverse into forward. If nervous consumers won’t spend, then the government will do it for them—and that can create a virtuous circle. While consumers are sitting at home with their wallets tucked firmly under the mattress, the government can start to build highways and bridges. Construction workers go back to work; their firms place orders for materials. Cement plants call idled workers back. As the world starts to look like a better place, we feel comfortable making major purchases again. The cycle we described earlier begins to work in reverse. This is the logic of the American Recovery and Reinvestment Act of 2009—the stimulus bill that was the first major piece of legislation under the Obama administration. The Act authorized more than $500 billion in federal spending on things ranging from expanded unemployment benefits to resurfacing the main highway near my house. (There is a big sign on the side of the road telling me that’s where the money came from.)

The government can also stimulate the economy by cutting taxes. The American Recovery and Reinvestment Act did that, too. The final bill had nearly $300 billion in assorted tax cuts and credits. The economic logic is that consumers, finding more money in their paychecks at the end of the month, will decide to spend some of it. Again, this spending can help to break the back of the recession. Purchases generated by the tax cut put workers back on the job, which inspires more spending and confidence, and so on.

The notion that the government can use fiscal policy—spending, tax cuts, or both—to “fine-tune” the economy was the central insight of John Maynard Keynes. There is nothing wrong with the idea. Most economists would concede that, in theory, government has the tools to smooth the business cycle. The problem is that fiscal policy is not made in theory; it’s made in Congress. For fiscal policy to be a successful antidote to recession, three things must happen: (1) Congress and the president must agree to a plan that contains an appropriate remedy; (2) they must pass their plan in a timely manner; and (3) the prescribed remedy must kick in fast. The likelihood of nailing all three of these requirements is slim.
Remarkably, in most postwar recessions, Congress did not pass legislation in response to the downturn until after it had ended.
In one particularly egregious example, Congress was still passing legislation in May 1977 to deal with the recession that ended in March 1975.
¹⁶
At the end of the relatively mild 2001–2002 recession, the
New York Times
ran the following headline: “Fed Chief Sees Decline Over; House Passes Recovery Bill.” I’m not making this stuff up.

What about the Obama stimulus? The American Recovery and Reinvestment Act was seemingly timely, but most of the money was not spent immediately (though there still can be a psychological benefit, and therefore an economic benefit, to simply announcing that lots of spending is coming). Critics of this huge economic intervention argue that it lavished borrowed government money on all kinds of unimaginable projects, some of them quite silly, and will add huge sums to the national debt. Proponents of the stimulus, such as Obama’s chair of the Council of Economic Advisers, Christina Romer, make the case that the $787 billion stimulus raised real GDP growth by 2 to 3 percentage points and saved a million jobs.
¹⁷
As far as I can tell, they’re both right. I was a congressional candidate at the time, so my views are a matter of public record (for the small number of people who paid attention to them). The economy was caught in dangerous negative feedback loops—foreclosures were causing banking problems which were causing layoffs which were causing foreclosures, and so on. I was fond of saying, “A bad stimulus is better than no stimulus, and a bad stimulus is what we got.” The government needed to do something to break the cycle (in part because monetary policy was not working, as will be explained in a moment). I would have preferred that the government target more of the spending toward infrastructure and human capital investments to improve the long-term productive capacity of the nation. I agree that rising government indebtedness is a problem, as will be discussed in Chapter 11. That said, given the financial panic described earlier in the chapter and the capacity for bad economic events to beget more bad economic events, there is a reasonable argument to be made that even paying people to dig holes and then fill them in would have been a better policy choice than doing nothing.

The second tool at the government’s disposal is monetary policy, which has the potential to affect the economy faster than you can read this paragraph. The chairman of the Federal Reserve can raise or lower short-term interest rates with one phone call. No haggling with Congress; no waiting years for tax cuts. As a result, there is now a consensus among economists that normal business cycles are best managed with monetary policy. The whole next chapter is devoted to the mysterious workings of the Federal Reserve. For now, suffice it to say that cutting interest rates makes it cheaper for consumers to buy houses, cars, and other big-ticket items as well as for firms to invest in new plants and machinery. Cheap money from the Fed pries wallets open again.

During the depths of the “Great Recession” of 2007, however, the Fed couldn’t make money any cheaper. The Fed pushed short-term interest rates all the way down to zero, for all intents and purposes, but consumers and businesses still weren’t willing to borrow and spend (and unhealthy banks were in a poor position to lend). At that point, monetary policy can’t do anything more; it becomes like “pushing on a wet noodle,” as Keynes originally described it. This is the economic rationale for turning to a fiscal stimulus as well.

I conceded earlier in this chapter that GDP is not the only measure of economic progress. Our economy consists of hundreds of millions of people living in various states of happiness or unhappiness. Any president recovering from a horseshoe accident would demand a handful of other economic indicators, just as emergency room physicians ask for a patient’s vital signs (or at least that is what they do on
Grey’s Anatomy
). If you were to take the vital signs of any economy on the planet, here are the economic indicators, along with GDP, that policymakers would ask for first.

Unemployment.
My mother does not have a job, but she is not unemployed. How could that be? This is not one of those strange logic riddles. The unemployment rate is the fraction of workers who would like to work but cannot find jobs. (My mother is retired and has no interest in working.) America’s unemployment rate fell below 4 percent during the peak of the boom in the 1990s; it has since climbed over 10 percent. Even that may understate the number of people out of work. When Americans without jobs give up on finding one, they no longer count as unemployed and instead become “discouraged workers.”

Anyone who cares about unemployment should care about economic growth, too. The general rule of thumb, based on research done by economist Arthur Okun and known thereafter as Okun’s law, is that GDP growth of 3 percent a year will leave the unemployment rate unchanged. Faster or slower growth will move the unemployment rate up or down by one-half a percentage point for each percentage point change in GDP. Thus, GDP growth of 4 percent would lower unemployment by half a percentage point, and GDP growth of only 2 percent would cause unemployment to rise by half a percentage point. This relationship is not an iron law; rather, it describes the relationship in America between GDP growth and unemployment over the five-decade period studied by Mr. Okun, roughly 1930 to 1980.

Poverty.
Even in the best of times, a drive through Chicago’s housing projects is ample evidence that not everybody has been invited to the party. But how many Americans are poor? Indeed, what exactly constitutes “poor”? In the 1960s, the U.S. government created the poverty line as a (somewhat arbitrary) definition of the amount of income necessary to buy the basic necessities. Having been adjusted for inflation, the poverty level remains as the statistical threshold for who is poor in America and who is not. For example, the current poverty line for a single adult is $10,830; the poverty line for a family of two adults and two children is $22,050.

The poverty rate is simply the fraction of Americans whose incomes fall below the poverty line. Roughly 13 percent of Americans are poor, which is no better than we were doing in the 1970s. The poverty rate rose steadily throughout the 1980s and then drifted down in the 1990s. The overall poverty rate disguises some figures that would otherwise leap off the page: Roughly one in five American children is poor as are nearly 35 percent of black children. Our only resounding success is poverty among the elderly, which has fallen from 30 percent in the 1960s to below 10 percent, largely as the result of Social Security.

Income inequality.
We care about the size of the pie; we also care about how it is sliced. Economists have a tool that collapses income inequality into a single number, the Gini index.
^*
On this scale, a score of zero represents total equality—a state in which every worker earns exactly the same. At the other end, a score of 100 represents total inequality—a state in which all income is earned by one individual. The countries of the world can be arrayed along this continuum. In 2007, the United States had a Gini index of 45, compared to 28 for France, 23 for Sweden, and 57 for Brazil. By this measure, the United States has grown more unequal over the past several decades. America’s Gini coefficient was 36.5 in 1980 and 37.9 in 1950.

Size of government.
If we are going to complain about “big government,” we ought to at least know how big that government is. One relatively simple measure of the size of government is the ratio of all government spending (local, state, and federal) to GDP. Government spending in America has historically been around 30 percent of GDP, which is low by the standards of the developed world. It’s climbing right now, both because the stimulus is driving up government spending (the numerator) and because GDP has been shrinking (the denominator). Government spending in Britain is roughly 40 percent of GDP. In Japan, it is over 45 percent; in France and Sweden it is more than 50 percent. On the other hand, America is the only developed country in which the government does not pay for the bulk of health care services. Our government is smaller, but we get less, too.

Budget deficit/surplus.
The concept is simple enough; a budget deficit occurs when the government spends more than it collects in revenues and a surplus is the opposite. The more interesting question is whether either one of these things is good or bad. Unlike accountants, economists are not sticklers for balanced budgets. Rather, the prescription is more likely to be that governments should run modest surpluses in good times and modest deficits in tough times; the budget need only balance in the long run.

Here is why: If the economy slips into recession, then tax revenues will fall and spending on programs such as unemployment insurance will rise. This is likely to lead to a deficit; it is also likely to help the economy recover. Raising taxes or cutting spending during a recession will almost certainly make it worse. Herbert Hoover’s insistence on balancing the budget in the face of the Great Depression is considered to be one of the great fiscal follies of all time. In good times, the opposite is true: Tax revenues will rise and some kinds of spending will fall, leading to a surplus, as we saw in the late 1990s. (We also saw how quickly it disappeared when the economy turned south.) Anyway, there is nothing wrong with modest deficits and surpluses as long as they coincide with the business cycle.