Most Popular ArticlesAugust 4, 2009
As you mentioned, our huge spending will need to be financed to a large degree by higher taxes. A study prepared a while back by Christina Romer, Director of the President’s Council of Economic Advisors, suggested that for every $1 increase in taxes, private investment is reduced by $3. Your thoughts?
This is an old paper of hers in which she tried to identify clean historical examples of changes in taxes and investment, which were the direct result of government fiscal policy, not simply a reaction to what was going on in the economy. The only significant examples she could find in the post-WWII record in terms of changing tax policy that affected private investment, however, were tax cuts. In these cases, what happened to the economy thereafter seems to have suggested that the effect of these tax cuts on private sector spending was much larger than it actually was.
The raw empirical correlation she found suggests that fiscal policy does have significant effects on investment. But it wasn’t about tax cuts versus spending increases, because she didn’t actually have any examples of spending increases to consider. So there is a lot of misrepresentation of what her findings were all about.
Accordingly, I don’t think you want to read too much into any of this. She found some interesting correlations in the historical data. But her report was not the same as policy analysis.
So let’s talk about the impact of tax increases on private spending.
Nobody is seriously talking about raising taxes any time soon. Doing this in the middle of a recession is not a good idea. But we will not always be in a recession. We are talking about raising taxes several years out when the existing slump will hopefully be over and when we will definitely need more revenue and when the private sector will be able to manage this additional expense.
But what about letting Bush’s temporary tax cuts expire, resulting in higher taxes by the end of 2010?
It’s possible that the slump might still be on at that time. And if it is, we certainly could consider delaying their expiration or providing some alternative temporary tax relief. I would prefer the latter because the former are primarily benefiting very high-income taxpayers.
What are your thoughts regarding the study by Barro and Perotti suggests that for each dollar increase in government spending, private investment is reduced by the same amount.
If the economy is at full employment, then increases in government spending would almost certainly crowd out spending by the private sector because the economy can’t produce more. But we are far from that scenario.
Barro and Perotti were looking at WWII, when there was a big increase in public spending while there was a decline in private spending. This was supposedly demonstrating their point. But I found myself scratching my head, because during WWII there was rationing and people weren’t allowed to increase consumer spending. You needed permits to engage in construction. So private investment declined as a result of force majeure. So in using this example, they concluded that surges in government spending crowded out private spending. This is completely ignoring the historical context.
The $787 billion stimulus legislation was a massive document. How did you become familiar with it?
I relied on many people who know how to read legislative language, especially people from the Center of Budget and Policy Priorities, who did go through it and summarized the key elements.
Did the bill make sense to you?
I had problems with substantial pieces of it. I felt that about one-quarter of it was not really stimulus, but simply extending the patch on the Alternative Minimum Tax. Even if you treat that as new stimulus, it’s not likely to be effective because the people who are benefiting from it are not likely to spend much of the money, and because this move was something the markets expected anyway. So I didn’t think it would improve overall sentiment and actual stimulus.
Another sizable chunk of the plan with which I don’t agree is the tax cut for middle-income families. I understand the politics that made it important for Obama and congressmen to pledge these tax cuts. But I don’t think they’ll have much impact on growth because most of that money will be saved or used to pay down debt.
The real stimulus elements that made sense to me--infrastructure spending, aid to state and local governments, and temporary expansion of aid to social security recipients—were not an overwhelming majority of the bill. The latter two points are the quickest ways to stimulate the economy.
What are your thoughts on regulating financial institutions going forward?
In a nutshell, anyone who borrows short and lends long and who offers safe assets for savers but invests in riskier products is a bank and needs to be regulated like a bank. Otherwise, our system remains prone to the catastrophic meltdown that we’re experiencing.
What made this crisis possible was that the banking system expanded beyond traditional banking, which was covered by the safety net built in the 1930s. The system of deposit insurance and regulated lending was undermined as banking activities expanded beyond regulatory control. So I believe we ought to be expanding old fashioned banking regulations to a much wider range of institutions and activities.
The ideal solution is to subject all such institutions to bank-type capital requirements. They should have a well-defined set of government guarantees that apply to a wide range of assets, financed through an equally well-defined set of premiums like those that banks currently pay into the FDIC, to help finance rescues when necessary. If you are a hedge fund, for example, you should be subject to the same kind of regulation and oversight as any other financial institution.
Depending on how it’s applied, an administration proposal which would allow the Fed to identify systemically important institutions and subject them to regulations, would pretty much do what I’m proposing. Take a business that sells auction-rate securities, something that technically does not involve bank deposits, but sure as hell functions like one. We’ll say that you will have capital and reserve requirements like an ordinary commercial bank because for all practical purposes, you’re doing the same thing.
Key to all of this is codifying principles-based, not rules-based, policy. This would more likely inhibit the financial industry, with their very good lawyers, to find ways to evade legislative intent.
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