Wednesday, February 24, 2010

Unsustainable Deficits and Growth

Just how much contraction can we expect to get the Federal budget deficit back under 3% of GDP on a trend basis if the private sector doesn't pick back up? Is the multiplier greater when cutting the deficit?  NorthGG
To answer this question, I start with the budget assumptions released by the CBO.  (In my last point, I used the much less realistic numbers published by the OMB.)  Under the CBO’s assumptions, the deficit dips under 3 percent in 2014 before unfavorable demographics push it back over 3 percent by 2020. 

We can’t adjust the deficit for growth assumptions until we pin down the relationship between revenue growth and GDP growth.  I copied the picture below from the CBOs website—ignore the scary outlays line, I only want to talk about revenues.  Between 1950 and 2007, revenues remained around 18 percent of GDP.  This implies that on average revenue growth has been the same as nominal GDP growth.  In the CBO projection (remember they are constrained by law), revenues are growing consistently faster than nominal GDP. 

So, first things first.  I adjust the CBO’s revenue line so that it matches its historical growth pattern.  This scenario, shown by the solid red line below, yields a deficit that stabilizes around 8 percent of GDP before trending negative in 2018.  If GDP growth stays low as NorthGG suggests, the deficit trends negative from 2012 forward, reaching almost 11 percent of GDP by 2020. 

Neither of these scenarios is sustainable.  Under the first scenario to reach a 3 percent deficit by 2020, total nominal spending growth can increase no more than 1 percent per year from 2012 forward.  To achieve the same goal by 2015, requires total nominal spending to fall by 2.3 percent per year beginning in 2011.  Under the slow-growth scenario, these numbers fall to zero and negative 4.5 percent.

Is the multiplier greater when cutting the deficit?

Good news.  In my view, government spending is for the most part a drag on growth.  The spending can be good or bad but it harms growth.  So, reducing the deficit by slowing the growth of outlays is positive for growth. 

Unfortunately, politicians love large government.  (Yes, this statement is true across ideologies.)  The deficit is much more likely to be attacked from the tax side rather than the spending side.  Higher taxes are the likely outcome.  This route is unambiguously bad for growth—both from distortionary taxes and distortionary spending. 

In my view, the budget doesn’t have to be balanced but spending has to be brought under control.  I don’t think it will happen, though.  At least not until, the pain of adjustment is far more difficult than mere 1 percent nominal growth of spending. 

Monday, February 22, 2010

Robert Barro on Fiscal Stimulus

Take a look at the wsj collumn by Robert Barro (here).  We are pretty much in agreement on the effects of fiscal stimulus, although I think his use of war spending provides a substantial upward bias to the spending multiplier. 

Sunday, February 21, 2010

The Economic Report of the President and Fiscal Stimulus: Romer Does it Again

Chapter 3 in this year’s ERP makes the case for the positive benefits of fiscal stimulus.  The chapter brings much evidence to bear in support of the case that fiscal multipliers are large and positive.  But perhaps the most convincing is chart 3-13.  In that graph, the ERP compares forecast errors against fiscal stimulus, measured as a percent of GDP. 

Here I have replicated the chart.  The vertical axis is the deviation in 2009Q2 growth (annual rate) from private sector forecasts in the third quarter of 2008.  The horizontal axis is the level of fiscal stimulus in 2009 as a percent of GDP.  I use data from table 3-1 in the chapter.  The dates are chosen carefully:  the first date is pre-stimulus for most economies; the second date maximizes the slope of the regression line. 

The results are impressive.  The slope is positive and highly statistically significant.  Indeed, since the time of the ERP was put to bed, data revisions—especially for the Czech Republic—have improved the relationship.  For every additional percentage point additional fiscal stimulus, the economies grew 2 percentage points faster.  Notice, because we are using annual rates that is not a multiplier of 2 but rather a multiplier of 0.25. 
But the chart is deceptive.  First, the result in the chart is specific to Q2.  If we chose any other quarter in 2009 (or the year as a whole), the result is no longer statically significant.  Second, the results as shown rely entirely on the data points for Japan and South Korea.  In the absence of these two countries, the regression line has a slope of zero and the R-squared is 0.002.  Of course, one might make the argument that it would be deceptive to exclude those two data points. 

I agree, which brings me to my third and final point.  Why didn’t they include the rest of the countries included in table 3-1.  The hard part of this exercise is finding comparable measures of fiscal stimulus but they already took the trouble to include these numbers in the chapter.  With twenty minutes of effort, I tracked down both the comparable private-sector forecast for these countries and the realization of GDP growth in the third quarter. 

The results including the omitted countries are shown in the chart below.  By coincidence, the excluded economies yield a regression with almost exactly the opposite result to the included countries.  These countries yield a line with a slope of negative 2.2—every extra percentage point of stimulus lowers GDP growth by a little more than 2.  Combining all of the data into a single line yields an insignificant regression. 

Once again, the case for fiscal stimulus does not survive the microscope.  I wish, however, that the ones responsible for deciding on the level, type, and timing of stimulus were a little more honest in their presentation of the facts.

Friday, February 5, 2010

The Deficit: On an Unsustainable Path?

The Administration published its budget this week.  I will leave others to play with the details of the budget.  (For example, this post on EconomistMom does a good job of examining the key details).  I like to look at the macro assumptions embedded in the budget. 

This administration, following the grand and old tradition of budget forecasting, makes economic assumptions that are possible but on the extreme edge of possible.  In other words, the Administration sticks to the broad outlines of the macro models but whenever there is a choice it errs in the favorable direction:  growth is a little higher, inflation a little faster, spending a little slower.  In addition, the Administration likes to cut programs in its budget that it knows Congress will reinstate.  An old favorite is threatened military programs.  A new favorite is sun setting tax provisions. 

I like to take the budget and tweak each of these assumptions back into the reasonable range.  Sometimes the result is a little worse; sometimes it is a lot worse.  In the current case, things end up a lot worse, because the jumping off point for the budget is so bad. 

I recalculate the budget forecast assuming 10 percent (not percentage points) lower nominal GDP growth, 18 percent faster expenditure growth (still faster growth than any time since the early 1990s), and 15 percent slower revenue growth. 

My forecast for government outlays as a percent of GDP is shown as the red line below.  Outlays as a percent of GDP start at a record 26 percent and grow steadily thereafter. 

The next picture shows my forecast for the deficit, using the same adjustments.  Notice, the assumptions in the OMB budget are exactly those that stabilize the deficit as a percent of GDP by 2014.  Using more reasonable assumptions, the deficit improves in the near term but then begins to explode as Social Security and Medicare expenditures rise sharply with the coming surge in retirements. 

What I have not considered is the cost of higher interest rates.  The Administration assumes almost no increase in interest rates despite the robust recovery and relatively rapid inflation path.  In itself, this is not realistic.  But it is especially not realistic if the markets come to believe the path I have written down.  If my path becomes the standard, the market will begin to demand a premium to hold U.S. debt.  (Of course, the good news is that the spread between corporate debt and U.S. Treasuries will narrow.  Oh wait …)

Wednesday, February 3, 2010

How (Not) to Destroy American Jobs: Bad Analysis and Misleading Statistics

“The fundamental assumption behind [the Administration’s proposals to tax U.S. multinationals] is that U.S. multinationals expand abroad only to "export" jobs out of the country. Thus, taxing their foreign operations more would boost tax revenues here and create desperately needed U.S. jobs.
Academic research, including most recently by Harvard's Mihir Desai and Fritz Foley and University of Michigan's James Hines [here], has consistently found that expansion abroad by U.S. multinationals tends to support jobs based in the U.S. More investment and employment abroad is strongly associated with more investment and employment in American parent companies.”  Slaughter, WSJ 2010  
A group of international economists have been pushing two ideas for some time:  When multinational firms expand their overseas operations, jobs in the U.S. increase; when multinational firms increase their overseas investment, they also increase their investment in the United States.  Therefore, because these firms are also productive, taxing or inhibiting the growth of these firms harms the United States and slows domestic growth.  The seeds of the idea have merit: international trade should make the United States a wealthier country, at least when the driving force for the trade is not regulatory or tax avoidance.

Estimates from Desai et al. (2008) show that a 10 percent increase in foreign investment results in a 2.6 percent increase in domestic investment.  That is, for every dollar these multinational corporations spend abroad, they drop 25 cents in the United States.  They find similar results for sales, compensation, and employment.  They conclude, “These results do not support the popular notion that expansions abroad reduce a firm's domestic activity, instead suggesting the opposite.” 

First, and most important, their conclusion, as well as Slaughter’s in other work, is based on a flawed counterfactual.  Desai et al, in concluding the firms boost output in the United States, consider a counterfactual world in which the firms do not exist.  They do not consider a world in which the firms continue to exist but are prohibited, either through taxes or fiat, from expanding overseas.  The implicit assumption is that there growth would have been zero but for the expansion. 

I agree that their expansion would have been smaller had they not been able to take advantage of the cheaper, more lightly regulated, and lower tax foreign environment.  But do Desai, Foley, and Slaughter believe that Proctor & Gamble would not have grown at all between 1982 and 2004 if they had not been able to expand internationally.  So, to find direct evidence of the gains from outsourcing production, we need to compare the outcomes of the multinational firms with other U.S. firms.  I will do so in a moment.

Second, their statistical results rely on using the full sample.  Take a quick look at figure 1 in Desai et al (here  – scroll down to page 26).  The scatter plot shows foreign sales growth versus domestic sales growth over the sample period.  A positive relationship is easy to discern but is not particularly strong.  What the picture hides is the change in the relationship late (and early) in their sample.  Data post 1999 are very different than data before 1999, particularly the data between 1994 and 1999. 


The picture below uses aggregate data from the BEA (table 1 here).  The red bars show the annual average growth rate of employment in the foreign affiliates of U.S. multinationals (MNCs), the parents, and overall U.S. employment between 1982 and 2004.  Based on this aggregate data, the relationship between job creation at home and abroad is stronger than implied by the micro data, implying almost 80 jobs for every foreign job. 

However, job creation at multinationals in percentage terms pales in comparison to overall job creation in the United States.  Employment increased 1.8 percent per year on average between in 1982 and 2004 in the United States as a whole while growing a mere 0.6 percent at parent companies.  Indeed, the growth in employment of foreign affiliates is quite similar to the growth of overall U.S. employment. 

MCNs diminished net job creation in the United States.

But the picture is much worse for Slaughter’s argument if we simply examine the last 5 years of data.  Between 1999 and 2004, the growth rate of foreign affiliate employment was almost unchanged, near 1.8 percent, but the parents shed jobs.  Indeed, over this period, parents cut 2 jobs for every job created at a foreign affiliate.  Overall U.S. employment slowed over the period but remained positive.  Continuing the sample through 2007, does not change the picture.  U.S. and foreign affiliate employment remain positive while parent employment is still negative.  Although we do not have data beyond 2007, an increase in parent company employment during the recession is unimaginable, especially given the outsize decline in U.S. trade. 

What surprises most is that neither Desai et al. nor Slaughter acknowledge this point.  Nobody can work with the data as closely as these economists have and not notice such a basic fact.  In fact, the paper by Desai et al. never uses the words decline, slowing, reversal, or drop.  They have panel data and never include a time dummy.  They almost appear to be hiding the inconsistent fact in their data. 

Other Evidence

The two main other points brought up by Slaughter and Desai et al are the investments of MCNs and the value added (which leads to measured productivity).  The picture below shows gross value added for parents, foreign affiliates, and the nonfarm business sector in red and shows annual average growth rate of capital expenditures (gross investment for the non-farm business sector) in blue.

Parent’s growth is positive both in terms of investment and value added.  However, again the growth rates are well below that of both the foreign affiliates and the non-farm business sector. 

MCNs lowered investment and value added growth in the United States. 

By the way, the growth in value added combined with a decline in employment is what gives the parents their measured productivity edge. 


The expansion of international trade very likely has benefits for the United States.  But the expansion of trade has also had its costs.  The net benefit to the United State may be positive or negative (likely positive). 

With true facts before us, we can discuss the taxation of multinationals.  Taxing these companies will slow their growth, reduce their investment, and lower total U.S. employment.  That’s what taxes do; they reduce the profit incentives of firms.  But taxing U.S. companies and U.S. households has exactly the same effect.  If we make a public policy decision to have a large government, we must also make a public policy decision to tax heavily – either now or in the future. 

There is no data (which I consider credible) to support the idea that taxing multinationals is any worse than taxing any other company or for that matter than taxing the household sector. 

In any event, the overall employment, value added, or investment of these companies or any other is not the metric by which we decide which sectors to tax most heavily.  Optimal tax theory relies on relative elasticities.  The least elastic sector should face the highest tax burden, thereby minimizing the overall tax distortion. 

So, I don’t know whether we should tax the multinationals.  But there is zero evidence for taking them off the table before the discussion is even begun. 

Tuesday, February 2, 2010

Real Estate Delinquencies, Mortgage Modification, and Two-Shock Foreclosures

Real estate delinquencies are continuing to grow.  The official delinquency rate on residential real estate at banks in the United States is nearly 10 percent.  But the official numbers, which do not include mortgages that have been modified, are currently understating the level of delinquencies by nearly 25 percent. 

Take a look at the picture below.  The black-dashed line is the official delinquency rate.  The red line uses OCC data (from the mortgage metrics report) to add modified mortgages back into the total.  As of the third quarter of 2009, there was a $41 billion gap between the two lines. 

I include modified mortgages in total delinquencies because almost all of these modifications are on track to fail.  To date, more than 60 percent of the loans modified in 2008Q3 have redefaulted.  That’s 6 times the default rate of a 2007-vintage subprime mortgage.  The modifications are doing nothing more than keeping a large set of non-performing loans off the books of banks (and the FHA). 

Why are mortgage modifications failing?

The following chart shows 12-month delinquency rates by payment modification.  The redefault rate moves from 40 percent when the monthly payments are reduced by 20 percent or more to almost 70 percent in cases where the monthly payment actually increases.
A shockingly high percentage of modifications result in higher payments to the household – who do the banks think they are kidding here?  The banks are not making a genuine effort to rework the loans.  In the third quarter of 2008, about 35 percent of modifications actually increased the monthly payment of the household.  Even in the latest data and after extreme (I am kidding) pressure from the OCC, 17 percent of modifications result in higher monthly payments.  One cannot construct an economic model in which the household has a lower incentive to default when their principal is not changed and their payments increase.  (If this fact does not make you angry, don’t forget you are subsidizing all of these modifications.)

However, even the modifications made in good faith and that substantially lower the household’s payments are seeing spectacularly high redefault rates, still four times the worst of the subprime mortgages.  And, remember that these modifications are only done in the cases where the bank believed (allegedly) that the household had a good chance of making the payments. 

Mortgage modifications are not working because the modifications are not hitting the key driver of foreclosures:  A household with negative equity has an increased incentive to default on their mortgage. 

Why do policy makers not believe this?

There have been several recent Fed studies that have shown that homeowners do not default simply because they are underwater; rather, homeowners only default when they suffer both income and price shocks.  This analysis however is flawed for two reasons.  First, their samples, per nature, consist of only historical data.  But in every past period, household’s expected their house to rise in value, giving them a positive value to waiting.  That is, if they could simply wait long enough (and if they could afford the payments in the meantime), the house would no longer be underwater.  Second, the house price declines in the data are small.  Households tend not to prefer default when they are barely underwater. 

The following picture shows the default lines for households taken from a simple model of housing.  In the model, households are given the simple choice between paying their mortgage or walking away from their mortgage and renting forever (again if you want details of the model email me).  When house prices fall slightly, the household prefers to keep paying their mortgage even when they are underwater. 

Take a look at the top line.  A homeowner who faces even a small fall in house prices prefers to default.  The more income the homeowner loses, the more they prefer to default.  Eventually, at an income loss greater than 60 percent they always prefer to walk away from their mortgage – if they are also underwater, they default. 

Two things made observing only one shock unlikely in historical data.  First, the average tenure was longer.  Notice the ten year line is well below the 2 or 5 year line.  Second, house price falls were all small.  Now, house price declines greater than 10 percent are not uncommon and, in large part because of the low interest rates in the last few years, the average tenure is much shorter than in historical data. 

In summary, two shocks are not now nor have they ever been a necessary condition of default.  It’s just that two shocks make default more likely especially when house price declines are small. 


Because banks have become (probably correctly) convinced that they cannot fail, they will take no actions to correct their balance sheets and will continue to allow the loans to fester.  Markets then cannot work out the foreclosure problem and the current round of policy-forced mortgage modifications is not working (we can debate whether or not they should have worked).  It’s time for bank regulators to get off of the fence and force principal reductions.  Or it’s time for the administration to admit that it wants the foreclosures to proceed, in which case it needs to grease the wheels of the legal system and get the adjustment underway. 

(For the record, I think foreclosures are bad for the economy.  More importantly, underwater households are reducing the flexibility of the economy, creating long-term growth problems.  More on this when I next post on the labor market.)

Monday, February 1, 2010

Boomers, Bubbles, Debt, and Dust: A Guest Post by NorthGG

The following is a comment by NorthGG on this post.  As always, NorthGG makes an excellent point and I didn’t want it to get lost in the comments sections.  The comment is posted in its entirety:  Enjoy.

Greeting SE. As always thanks for the work, it’s greatly appreciated.

There are two effects of the housing bubble, economic and financial.  I would argue that the underlying demographic demand for housing (and the coming entitlement spending) is a natural bubble and that the Fed has no control over.

The boomer bubble has passed through C and I (as well as Net Imports) and now heads to G.

In my view, the Fed exacerbated the natural C, I and Net Import bubbles in the economy making their impact financial markets much bigger (i.e allowing too much leverage in the financial sector) leaving us all with huge problems once the boom turned to bust.

Lax regulation and deflationary fears pumped up the boomer economy in financial markets. This puts the Northeast section of the US at great risk given collateral prices (housing) and dependence on Wall Street Incomes; Incomes that depend on increasing leverage that is clearly mind numbingly ridiculous already.

Please note the following data table from 1961 forward, looking only at periods where growth was positive in every quarter. This is nominal Non-Financial Debt growth regressed on Real GDP growth.  Debt grew slower than GDP prior to 73 and then it was lights out.

Period              DtGrowth      Rsq
61to69             0.37x               .98
71to73             0.59x               .98
75to80             1.34x               .96
82to90             2.8x                 .98
91to00             2.07x               .998
01to07             6.02x               .984

Since the 2001 recession, nominal nonfinancial debt has grown at almost 10x the rate of GDP to current data! 10 times!

This debt laden economy now features (end 2008 data) nonfinancial debt per household in excess of $280,000 with a median household income of $69k (end 2008).

Every $1 trillion in incremental non financial debt is roughly $8,000 per household, well over 10% of median income. Does the Fed think it can raise the rate of inflation so that it will raise free (real) cash flow in the economy? This is crazy.

This debt to income ratio is likely even higher at the end of 2009.

What I question is the Fed's role in allowing the economy to become so levered. It allowed accelerating leverage. The Fed chose to allow the bubbles to inflate but had no game plan for when they naturally peaked and deflated. The economic volatility is natural but the decision to leverage is fostered by acceptance of regulators. What is going to be the impact on this country if (when) the government debt bubble deflates like the Nasdaq or housing? For this there is no backstop. Washington has exacerbated the 2 previous bubbles and currently does on the 3rd.

As we head into the government debt bubble, will the Fed speak out against excessive leverage already in the system as we see the government red ink explode before our eyes? Excess debt is deflationary. This is a liability crisis.

The zero bound is not stimulative (private credit continue to contract) nor is the fiscal policy. We are sowing the seeds of corrosive deflation with the Fiscal policies meant to offset it.

Debt must fall relative to GDP, there is much more pain to come on the balance sheets. What is good for the economy is bad for the banks. The Fed is simply watching the federal government do what the private sector did, lever up. That I do hold them responsible for. The Fed has favored the banks over the economy for a long period of time. Allowing debt to permeate the economy so deeply and to stand by and watch the reckless debt cycle now engulfing the public sector is outrageous.