Wednesday, 30 May 2012

Good hunches

As opposed to Samuelson’s faulty predictions of the Soviet Union overcoming the US in the late 1990s, another economist with a popular introductory economics textbook provides much better and more precise predictions.

I recently read an article by Greg Mankiw from 2006, written as a prelude to Paulson replacing Snow as the US Treasury Secretary. Mankiw issues a lot of warnings on the sustainability of the US budget back then. 

He emphasizes the importance of consolidating the public finances in the long run as a key challenge for Paulson. Even in 2006, where everything was going so well, it was obvious to Mankiw (and many others) that the demographic pressure was placing a huge challenge on the Social Security, Medicare and Medicaid systems. But somehow there was no credible pledge on either sides of the political spectrum to address this concern. This is the problem with short-termist politicians: if things are going good, don’t try to implement potentially painful reforms that will endanger your chances of re-election. And this is exactly why I’m against short-term solutions like currency devaluation or large stimuli (both fiscal and monetary) that would restore growth temporarily and then allegedly make room for reforms. That’s nonsense and as I mentioned before, no such thing will happen in the foreseeable future for any nation facing fiscal problems of global proportions, since no politician will ever have the strength, power or the courage to do that. 

The article carries on to identify the main divergence between economists on which is the right way – more taxes to fund all the promises accompanied by a further expansion of entitlements, or on the other hand a reform of the entitlements system accompanied with closing of the fiscal gap with reduced spending and Pigou taxes (this is the approach Makniw strongly supports, today more than ever I think). 

In fact, he had this to say on raising taxes at the time: 
“One of Mr. Paulson's first briefings from the Treasury staff should be about what high taxes have done to the economies of Europe. According to research by Nobel laureate Edward Prescott and by economists Steven Davis and Magnus Henrekson, the high tax rates in Europe have reduced work effort and distorted the industrial mix. The Davis-Henrekson study reports that a tax increase of 12.8 percentage points (a change of one standard deviation) reduces work for an average adult by 122 hours per year. It also reduces the employment-population ratio by 4.9 percentage points and increases underground economy by 3.8% of GDP. As Mr. Paulson works to resolve the fiscal imbalance, he should keep the European experience firmly in mind.” 
I think I read that last sentence about a thousand times in the past year. Also, this is probably why the tax raising part of the austerity agenda is failing so miserably. 

And finally, how’s this for a good hunch: 
"The federal tax system now tilts the playing field toward residential capital at the expense of corporate capital, which in turn reduces productivity and real wages. Even if one believes that policy should promote homeownership over renting (a debatable claim), there is no reason to encourage people to buy ever larger homes. Let's lower the cap on subsidized mortgages well below its present $1 million level."
If only Paulson had listened.


  1. In regards to Pigovian taxes on fossil fuels. I would not be opposed to them IF, and only IF, they were used to reduce and REPLACE, both regressive taxes like the FICA, and idiotic environmental fiats such as CAFE standards.

    In regards to lowering the mortgage tax preference. It would have to be done very carefully as not to further destroy the already ailing housing market. While I agree that it is a market distortion, it is also something which has become an important crutch in the domestic economy.

    1. The Pigouvian taxes can be debatable, although they do offer some interesting advantages.

      As for the final quote on the housing market, this is the qoute from the same text from 2006, so it was a solution offered back then, not now.

  2. Even though now these look as bold predictions, I'm sure that any well trained economist back then (particularly if they were the chief economic advisor to the President as Mankiw was from 2003 to 2005), could have foreseen that the US social security system was unsustainable and needed drastic reform. It was nice of Mankiw to point that out back then, but too bad that no one listened. Perhaps you're right, short-term oriented politicians don't bother with reforms if everything is going well, and particularly if they are running wars (hint: Bush).

    1. oh, btw, regarding Mankiw's 'predictive power', he wasn't always spot on. I recall this paper he and David Weil wrote in 1990 on the US housing market and the baby boom vs baby bust generation. They predicted that "real housing prices would fall substantially in the next two decades."

    2. I know of that paper, however in the abstract they do say that "if the historical relationship between housing demand and housing prices continue", then they predict that the prices would fall. So basically, if all else stays equal, the lesser demand for housing would decrease the prices. But, all things didn't stay equal.

      At the time they couldn't take into account any of the low interest rate policies, the community reinvestment act, the effects of Fanny and Freddie following HUD's housing goals or the effect of the recourse rule on the financial market leading to an increased demand for mortgages. I covered these in my paper on the crisis; summary available on the blog.