The Gap Again Widens

 The September trade numbers are out and America’s Trade deficit increased significantly since August. Not only did it increase, but it made the largest percentage increase since February of 1999. Of course, part of that dramatic note is due to the contraction that resulted as part of the economic down-turn.

An AP article (see: http://www.google.com/hostednews/ap/article/ALeqM5gNiyJ905Ho0Ur96V2TQhsBX19lGwD9BUNGF80) sites authorities who suggest that the increase in energy prices is outstripping the benefit gained in the export sector by a falling dollar.

As President Obama travels through Asia this will no doubt be a subject of discussion. A Chinese Yuan that is kept artificially low is credited with a not insignificant portion of the problem. The Chinese have indicated a willingness to let the Yuan adjust a little, but are, not unexpectedly, quite concerned about the state of the dollar (being holders of vast quantities of dollar assets.)

Is Iran on the verge of a revolution? Can Kim Jong Un maintain power if his father transfers it to him in the near future? Are we seeing the leading indicators of America’s decline in conditions like debt that is completely out of control, failing business giants, the crippling costs of persistent asymmetric warfare, and looming unaddressed crises such as the mathematically infeasible pay-go social security system? What will the rise of massive high-growth emerging economies mean for world affairs? What will the world look like politically, economically, and diplomatically 3 months from now?; 6 months?; 1 year?; 2 years?  

We are living in interesting times. We could be on the precipice of some very major changes to the international system. Sometimes change is slow and evolutionary; sometimes it is faster and more revolutionary; and, rarely but occasionally, the conditions evolve to converge to the point where it is catastrophically instantaneous. There is a vigorous tug of war in progress between inertia and the winds of change.

I would love to be able to make some definitive predictions about what the world will look like next year. Like the vast majority of people, I am motivated by discomfort with uncertainty to want to think that I can have a grasp on how events will unfold. However, the lesson (an unintended lesson to be sure) that has most stuck with me in completing graduate degrees in International Relations and Economics  is that anyone who thinks they can predict the future unfolding of large-scale political and economic events is full of crap. This will no doubt be considered heresy to many who have made lucrative livings because we (as a species) would rather pay millions to someone who makes an incorrect prediction than to accept that we have no idea what will transpire. One can read papers that misapply probabilistic and statistical models in some of the most elite scholarly journals because even the most educated of our society are addicted to thinking that the future can be known in a system whose level of complexity remains beyond our capacity to unravel.

My advice to those trying to get a handle on the future, save your soothsayer money, hedge your bets, and enjoy the ride.

With respect to government culpability for the financial crisis, the primary lesson that people have taken away seems to be that the executive and legislative branches were just negligent and did not regulate businesses enough. That is, while business was actively at fault, the government was merely too passive.

It is true that there were certainly specific areas in which the existing incentives created an economically unstable condition, and regulation (and 20/20 hindsight) might have negated the problem. For example, the recently proposed legislation to require loan originators to keep five percent of the loans they make on their books is probably a good idea for new regulation. After all, a major part of the problem was that those who madeloans had no incentive to ensure they were good loans because they were selling them off in securitized form as the ink was still drying on the paperwork. This meant that their only incentive as to make more loans, not good loans.

However, I don’t think we should be quite so quick to conclude that the government’s only role was in failures of omission. The government has long supported the notion that virtually everyone should be homeowners. They supported and implemented policies that facilitated a move toward a greater proportion of home-ownership, and, in doing so, they too are culpable for a condition in which there were way too many people without the incomes to be homeowners who were buying homes.  Until a year ago or so, many people would have thought this a laudable policy, but seeing the effects of having so many people owning homes they cannot afford, we must recognize that the government should not have been supporting housing ownership in the manner it did.

Why is this distinction between active and passive culpability important? My worry is that we seem to be in a period in which people just want government to get off their duffs and be active, and we may not be conscientious enough about whether they are actively doing the right things. No one can say the Obama Administration hasn’t been bold in its policies, but whether it turns out to have been smart in them remains to be seen.

To be frank, I am a little terrified about the idea of a $1.8 trillion deficit for the year. A budget deficit of well over 10% of the entire Gross Domestic Product (GDP) is nothing to take lightly. I certainly hope President Obama will be true to his words to engage in deficit reduction at some point, but I am afraid that like the Republicans, without facing legislative opposition, he will go just as hog-wild as they did. The President certainly has lofty goals, but they all come with price-tags attached.

On a recent trip to Budapest, I snapped this picture on Margit Circle not far up the road from the the Margit Island Bridge. This is a popular thoroughfare on the Buda side of the Danube that leads to a massive multi-level shopping mall and to the  Moscow Square transit hub that is of modern design, yet, at once, appearing out-dated. At the time, I thought the picture conveyed an interesting theme or moral, but I was not certain what it was. Two buildings with structurally identical facades – ornate moldings,  faux columns, and window arches – but conveying completely different images. One is the color of cow dung from grass-fed cattle, is marred by chipped and peeling paint, and has a coating of grime and soot clinging to the paint that dares remain. The other is a clean white and light blue pattern with gray trim that has not yet been darkened and discolored by car exhaust and industrial plant emissions. It takes a sustained glance to realize that they are the same building.

For Ferenc Gyurcsany, Hungary’s soon to be erstwhile Prime Minister, the moral should be that one can only dress up an economy if the fundamentals underneath are sound. Hungary’s economic problems far precede the recent global recession, which is part of the reason why the Hungarians have been one of the worst hit nations in the region, and the first European nation to require outside assistance in the form of International Monetary Fund (IMF) loans last fall.

Gyurcsany resigned yesterday in the face of an economic melt-down. The outright resignation was foreshadowed over the weekend by an offer to step aside if a vote-of-no-confidence that would be held in April rejected the Hungarian Premier. Subsequently, the voice of the Hungarian people was clear in indicating that they had lost confidence in the presiding government.

Amongst the first things that one notices in examining the Hungarian economic fundamentals is that the Central Bank just decided to keep their interest rate steady at a rather high 9.5%. Hungary is so hard hit because it faces a catch-22 as a result of its recent history of excessive spending. For a country in recession, and estimates project a 3.5%  to 5% drop in GDP this year, the monetary prescription is to increase the money supply, and this is done by reducing the cost of money (i.e.  lowering interest rates.) However, Hungary has run such high deficits that it needs to maintain high interest rates in order to attract capital, and because lowering rates will lead to capital outflow and further depreciation of the Forint (Hungary’s national currency). Currency depreciation, while it may benefit exporters (but, of course, people are almost universally buying less these days), means that prices on imported goods are higher. As a globally integrated and relatively small country like Hungary relies heavily upon imports in some sectors, overall consumption is decreased, and consumption is the engine of an economy.

So if monetary policy cannot help, what is left? Unfortunately, fiscal policy prescriptions are out of the question as well. The fiscal policy prescription for a recession is to increase government spending and decrease taxation (i.e. further deficit spend.) However, because Hungary was deficit spending its heart out in the good times, it now faces conditions in which it cannot afford to continue on this path. It can’t exacerbate its deficit spending spree without serious consequences that are already being seen with Fitch’s early March downward revision of Hungary’s creditworthiness, and recent statements that the rating agency may down-rate Hungary further in the near future. Of course, the IMF would frown upon increasing government spending.

This puts Hungary in the unenviable position of having no economic policy to right its course, and it must ride it out and hope that it doesn’t go over the falls.

One of the most damaging mistakes made in policy-making is ignoring feedback loops. There is a tendency to see and act upon simple solutions without investigating whether unanticipated effects are likely to result. This is particularly true of economic decision making. Perhaps this is reflective of a general lack of economic literacy that develops between the time people (politicians included) take that obligatory sophomore microeconomics class and when they enter get into their unrelated careers.

The low income are having trouble living off the wages they earn? Just mandate a higher minimum wage. Of course, in most cases this will increase unemployment (particularly among those the law is attempting to help), and while a given person may end up benefiting from higher wages they may also be one of the unfortunate that end up with no wages. There is a shortage of affordable housing? Just put a cap on rental rates. Of course, this leads property owners to shift to alternate uses of land where possible, and possibly even to abandoning property if they can neither earn a profit on it nor, due to zoning laws, convert the property to another use. The simple solution, therefore, eventually leads to fewer housing units being available and possibly urban blight as well.

What does this have to do with the recent decision by Bank of America to pull job offers that it had made to foreign graduate students? Bank of America’s decision was the result of legislation that prohibited hiring foreign workers if a firm is accepting Federal funds and is laying off American workers. Because the bank had to lay off lesser skilled employees as a part of a reorganization, it could not hire the foreigners. I put both this legislation and many of  executive compensation cap plans in the category of ignoring the unintended consequences.

Readers of the Economist will recognize the dearth of executive talent as a reoccurring theme with regard to the  problems facing the business world today. Lately there has been an assumption that we could not have a more incompetent group of executives running American businesses. However, by limiting the pool of executive talent to which we have access to US citizens, we have a smaller base available and greater chances of having a less competent set of executives in the future.

Any plan that limits total compensation to executives runs the same risk. If compensation is not competitive with alternative employment, the most talented will go elsewhere, leaving those who cannot find alternative employment (either abroad or in other fields) to run American firms. This is not to say that capping salaries and then tying other earnings to performance wouldn’t be reasonable. This has a positive feedback effect in that it gives the executive incentive to increase a firm’s performance. There must be a value-added to executives to justify such high incomes. If they don’t enhance productivity by anywhere near their earnings, they obviously should not be earning such high wages.

I fear that there is a lot of simplified solutions going into the restoring the economy, and that we won’t know all of the adverse impacts for some time to come.

Inspired by David Letterman’s “Will it Float?”game, and, with the fiscal stimulus at the forefront of the national consciousness, I thought I would put forth my predictions for what parts of the  “American Recovery and Reinvestment Act of 2009″ will be likely to stimulate the economy. Though, in reality, it will be more of a look at which are “good” stimulus given the criteria discussed below.

The criteria for good stimulus is fairly simple, and these days the alliterative prescription is well known to just about everyone. It must be ”timely, targeted, and temporary.” I don’t know which economist first suggested these criteria, though at least part of it follows from the prescriptions of Keynes. I do know that it was not Nancy Pelosi, Harry Reid, or any of the other politicians that economically-illiterate journalists have given attribution for the concept.  Likely, the economist who suggested was not the same one who put it in it’s easily remembered alliterative form.  

The criteria of timeliness is probably the most difficult to make predictions about. Contrary to popular misconception, one will not necessarily get positive results from raining  money from the skies like manna from heaven. Even if the objective is more to spur consumption than to achieve the project goals (ala paying some crews to dig holes and others to fill them in), if there is no mechanism set up to allocate and distribute funds than it may become like trying to pass a moose through a garden-hose.  Getting legislation passed happened fast by Washington standards, but there is still the issue of getting the money into consumer’s hands.

The “target” in ”targeted” is job creation and the installation of dollars into the pockets of those who are most likely to spend them. The prevailing belief among economists is that this means those at relatively lower incomes rather than higher incomes. Higher income individuals tend to save more of the dollars that they earn. Preferably the disbursement will not take the form of a one-shot disbursement that many are likely to use to pay down debt or put into savings (laudable but not stimulatory.) Now one may be lured into the false reasoning that any government service that keeps people from having to spend their hard earned money on a given “necessity” would mean more money to spend. While there may be a marginal truth to this, because such service provision would be something that a given person may or may not provide for themselves if given their own choice in the matter, it would be, at best, a particularly inefficient form of stimulus and would get an “F” on the criteria of being targeted. Furthermore, most such programs would likely show a negative result on the “temporary” criteria.

The “temporary” criteria results from the fact that the goal is not to build permanently higher levels of government spending that will ultimately crowd out private sector growth. Politicians seem to understand the economic prescription to deficit spend (i.e. reduce taxes and increase government spending) during dire times like these. What they fail to grasp is that the rest of the time one should not be deficit spending. Instead, in good times, they should be cutting government spending. Of course, one may not put much stock in these Keynesian notions (they had fallen into disfavor until recently), but you can’t pick and choose the parts of the theory that are valid based upon the political benefits of doing so.

It should be noted that a “yes” vote assumes that it is done correctly, but in practice it may not work out that way. A “No” doesn’t necessarily mean that the government shouldn’t spend money on said item, but, rather, that it is not a good stimulus measure by the aforementioned criteria, and should probably not be in the recovery package. It should be noted that there is a great deal of room for debate as there is little by way of description of many of the programs, and, furthermore, timely, targeted, and temporary all involve a subjective element. However, some programs are clearly better than others in meeting these criteria. Those wanting to read through the Act itself to make their own judgements will find the link at the bottom.

And so, without further ado:

Department of Agriculture (DoA): Agriculture Department building repair and construction: Yes

DoA Office of the Inspector General: No, but you will have some necessary oversight and administration costs and so these expenditures are probably advisable, and will be referred to as the OIG Proviso in subsequent sections.

Agriculture Research Service (ARS) building maintenance: Yes

Farm Service Agency (FSA) Information Technology: Yes, if timely and temporary

Natural Resources Conservation Service (NRCS) Watershed and Flood Prevention Operations: Yes in part at least

Rural Housing Service (RHS) Rural Housing Insurance Fund Program Account: No

RHS Rural Communities Facilities Program Account: No.

Rural Business (RB) Program Account: No

Rural Utilities (RU) Rural Water and Waste Disposal Program: Yes

RU Distance Learning, Tele-medicine, and Broadband: No (Loan guarantees may not build a market where non exists presently)

Food and Nutrition Service Child Nutrition Programs: No (Temporary? try yanking this away)

Economic Development Assistance: Yes

Periodic Censuses and Programs: Not likely

Broadband Technology Opportunities Program: No

Digital-to-Analog Converter Box Program: No

Scientific and Technical Research Services: No (not much detail provided)

Construction of research facilities: Yes

National Oceanic and Atmospheric Administration (NOAA) Operations, Research, and Facilities: Not unless used in more well-defined manner.

NOAA Procurement, Acquisition, and Construction: Yes

NOAA Office of the Inspector General: OIG Proviso Applies

Department of Justice (DoJ) OIG: OIG Proviso Applies.

DoJ Violence Against Women Program: No

State and Local Law Enforcement Assistance:  No

Community Oriented Policing: No

NASA: As there is no explanation of these funds, I will have to go with No.

National Science Foundation (NSF) Research Activities: Yes, potentially. NSF is set up to distribute funds (timely), and can distribute these until they run out (temporary), but whether this puts money in the right wallets will be seen.

NSF Educational and Human Resources: No

NSF Research Equipment and Facilities: Yes

NSF OIG: OIG Proviso Applies

Department of Defense (DoD) Operations and Maintenance:  Yes ( they installed a timeline to incentivize timeliness)

DoD Research, Development, Test and Evaluation: Yes

DoD Defense Health Program: Yes (specifically for repair and modernization)

DoD OIG: OIG Proviso Applies

Corps of Engineers (CoE) Investigations: No

CoE Construction: Yes

CoE Mississippi River and Tributaries: Yes

CoE Operation and Maintenance: No

CoE Regulatory System: No

CoE Formerly Utilized Sites Remedial Action: Yes

Department of Interior Water and Related Resources: Part Yes and part No

Department of Energy (DoE) Efficiency and Renewable Energy: Yes, but timeliness criteria is a concern. It depends upon block grants operating effectively, and also  funds develop technologies that may not be mature enough.

DoE Electricity Delivery and Reliability: Yes. Again, timeliness is a concern. However, improving the grid is both overdue and may yield substantial benefits in addition to temporary employment gains.

DoE Fossil Energy R&D: No

DoE Non-Defense Environmental Cleanup: Yes

DoE Uranium Enrichment Decontamination  and Decommissioning Fund: No

DoE Science: Probably No (Not defined in the Act)

DoE Innovative Technology Loan Guarantee: No. Not a good stimulus, though, perhaps, laudable.

DoE OIG: OIG Proviso Applies

Defense Environmental Cleanup: Yes

Construction, Rehabilitation, Operation and Maintenance Western Area Power Administration: Yes in part

Department of the Treasury (DoT) Salaries & Expenses: No, but like OIG expenses, may be necessary

DoT Community Development Financial Institutions Fund: No

Internal Revenue Service (IRS) Health Insurance Tax Credit Administration: No, but like OIG necessary for conduct of the program

General Services Administration (GSA) Federal Buildings Fund: Yes

GSA Energy-Efficient Federal Motor Vehicle Fleet Procurement: Yes

GSA OIG: OIG Proviso Applies

Recovery Act Accountability and Transparency Board: No, but necessary administration

Small Business Administration (SBA) Salaries and Expenses: No mostly

SBA OIG:  OIG Proviso Applies

SBA Surety Bond Guarantees Fund: No

Business Loans Program: Perhaps, depending on loan use

Department of Homeland Security (DHS) Office of Secretary for Management: Yes

DHS OIG : OIG Proviso Applies

Customs & Border Patrol (CBP) Inspection and Communication Systems Installation: Yes

CBP Fencing, Infrastructure & Technology: Yes (although whether it is a good idea is a different question entirely)

CBP Construction: Yes

Immigrations Automation Modernization: Yes

Transportation Security Administration (TSA) Aviation Security: Yes (equipment purchase and installation)

Coast Guard (CG) Acquisition, Construction, and Improvements: Yes

CG Alteration of Bridges: Yes

Federal Emergency Management Agency (FEMA) State and Local Programs: Yes if grants are used in ways that are timely and create temporary employment

FEMA Firefighter Assistance Grants: Yes, They are for modifications and upgrades.

FEMA Disaster Assistance Direct Loan Program: No

FEMA Emergency Food and Shelter: No

DoI Management of Lands and Resources: Yes, if used for rehab and restoration

DoI Construction: Yes

DoI Wildland Fire Management: No, not likely

Fish and Wildlife (US F&W) Construction and Improvements: Yes

National Park Service (NPS) Deferred Maintenance: Yes

NPS Historic Preservation: Yes

NPS Construction: Yes

US Geological Survey (USGS): Yes

Bureau of Indian Affairs (BIA): Part No and Part Yes

BIA Construction: Yes

BIA – Indian Guaranteed Loan Program: No

BIA – OIG : OIG Proviso Applies

Environmental Protection Agency (EPA) – OIG: OIG Proviso Applies

EPA Superfund: Mostly Yes

EPA Leaking Underground Storage Tank Cleanup: Yes

EPA State and Tribal Assistance Grants: Perhaps, depends upon use

EPA Administration: No

Department of Agriculture (DoA) Forest Service Capital Improvements: Yes

DoA Wildland Fire Management (DoA): Yes

Department of Health and Human Services (DHHS) Indian Health Services: No (ambiguous description)

DHHS Indian Health Facilities: Yes

Smithsonian Facilities Capital: Yes

National Endowments for the Arts Grants and Administration: No

Department of Labor (DoL) Employment and Training: No, fails on timeliness (hopefully anyway, one would hate to think we will still be in a recession in the time that it takes not only for these funds to be disbursed productively, but for the workers to complete training programs and then find work.)

DoL Community Service Employment for Older Americans: Yes

DoL State Unemployment Insurance: Yes

DoL Departmental Management: No, but administrative

DoL Office of Jobs Corps: Yes

DoL OIG:  OIG Proviso Applies

DHHS Health Resources and Services: Yes, if spent properly

National Institutes of Health (NIH) National Center for Research Resources: Yes

NIH Office of Director: Probably not

NIH Buildings and Facilities: Yes

Agency for Health-care Research and Quality (AHRQ): Part Yes and Part No

Administration for Children and Families (ACF) Block Grants to States: No

ACF Children and Families Service Programs: No

Administration on Aging (AA) Aging Service Programs: No

AA Office of the National Coordinator for Health Information Technology: No

AA OIG: OIG Proviso Applies

AA Public Health and Social Services Emergency Fund: Yes

AA Prevention and Wellness Fund: No

Department of Education (DoEd) Education for the Disadvantaged: Mostly No, partially Yes

DoEd Impact Aid: No

DoEd School Improvement Programs: No

DoEd Innovation and Improvement: No

DoEd Special Education: No

DoEd Rehabilitation Services and Disability Research: No

DoEd Student Financial Assistance: No

DoEd Student Aid Administration: No

DoEd Higher Education: No

DoEd Institute of Education Sciences: No

DoEd OIG : OIG Proviso Applies

Corporation for National and Community Service (CNCS) Operating Expenses: No

CNCS OIG: OIG Proviso Applies

National Service Trust: Presumably No

Social Security Administration (SSA): Yes, in large part (funds replacement of IT)

SSA – OIG: OIG Proviso Applies

Government Accountability Office (GAO) Salaries and Expenses: Yes. While I normally would put ”Salaries and Expenses” a “No”, this provision has a time limit that would seem to make it a temporary rather than permanent expansion of the Federal government.

Military Construction (all branches): Yes (One can only hope that they won’t build up the bases that will subsequently be BRACed out of existence.)

Family Housing Construction and Maintenance: Yes

Homeowners’ Assistance Fund: Perhaps

Veterans Affairs (VA) Medical Facilities: Yes

VA National Cemetery Administration: Yes

VA General Operating Expenses: No

VA Information Technology Systems: Yes

VA OIG: OIG Proviso Applies

VA Grants for Construction of State Extended Care Facilities: Yes

VA Administrative Provision: No

Department of State (DoS) Diplomatic and Consular Programs: No

DoS Capital Investment Fund: Yes, if used in a timely manner.

DoS OIG: OIG Proviso Applies

International Boundary and Water Commission (IBWC)  Construction: Yes

Department of Transportation (DoTrns) Grants for National Surface Transportation System: Yes

Federal Aviation Administration (FAA) Facilities and Equipment: Yes

FAA Grants-in-Aid for Airports: Yes

Federal Highway Administration (FHwyA) Highway Infrastructure Investment: Yes

Federal Railroad Administration (FRA) Capital Assistance: Yes

FRA Capital Grants to Amtrak: Yes (time limits imposed)

Federal Transit Administration (FTA) Transit Capital Assistance: Yes

FTA Fixed Guideway Infrastructure Investment: Yes

FTA Capital Investment Grants: Yes

Maritime Administration (MA) Grants to Small Shipyards: No (ostensibly there is a lack of business for such yards, and nothing in this Act changes that.)

 MA OIG: OIG Proviso Applies

Housing and Urban Development (HUD) Public Housing Capital Fund: Yes

HUD Native American Housing Block Grants: Yes

HUD Community Planning and Development: Yes (gives preference to those who can award contract within four months)

HUD Home Investment Partnerships Program: No

HUD Homelessness Prevention Fund: No

HUD Housing Stability and Energy Investments: Yes

HUD Lead Abatement: Yes

HUD OIG: OIG Proviso Applies

Health Information Technology: In part Yes

State Fiscal Stabilization Fund: No

A note on the ”Buy American” Clause: Many are rightfully distraught over provisions requiring that all iron, steel, and manufactured goods come from the US if they are to be used in carrying out the earlier provisions of the act. While the bulk of the outrage comes from abroad, there are also those from US firms who are likely to be injured by the ensuing trade disputes that find the provision objectionable. There is also an issue of what effect this will have on cost and timeliness. It should be noted that there are exception provisions for cases in which the needed material is not made in the US in sufficient quantities. It is recognized that costs will, in many cases, be higher because of this clause, and there is an exception provided the total cost is greater than 25% of what it would be if free trade ruled. Despite these exceptions, it is a near inevitability that inefficiencies will result because of these provisions. It will take time to determine what the effect will be on cost and there will be differences of opinion about whether US manufacturers can meet the needs, and, all the while, timeliness will take a hit or there will be a default position that leads to always using US suppliers even when there are radical delays or cost increases.

While the reasoning behind this provision may seem solid because it seems to produce a force-multiplier effect for employment, it is hard to determine the true effects because this analysis must take into account that some foreign companies will stop buying Boeings in favor of Airbus or Caterpillars in favor of  Komatsu in retaliation.

I will not go through the tax provisions in any detail. In general the tax provisions for individuals are likely to have some type of positive effect on consumer spending. Though with debt being what it is there will probably be a lot of cases in which the extra income is used to pay down debt. I’ve heard the idea of issuing as pre-loaded debit cards to make consumption easier and debt repayment more difficult. I don’t know what the administration costs and timeline are on such a plan (the government is geared up for sending out lots of checks now, but, to my knowledge, not for issuing debit cards) or whether it would succeed. Presumably, credit card companies would begin to take these debit card payments unless strictly prohibited. Of course, rebates (whether in check or debit card form) are not as useful as reduction in monthly deductions because “permanent” income increases are more likely to be spent.

There are many admirable tax credits for energy conservation and reduced pollution emissions in the Act. They may be worthwhile, but they are not necessarily good stimulus. In many cases, they distort consumer behavior without having much impact in causing increased consumption.  

 For those who would like to view the Act in order to develop their own opinions, it can be viewed at:

http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.pdf

Source: Library of Congress

A friend was telling me the other day that his salary was cut due to the economic downturn. He explained that his boss had put the “decision” in his hands, he could take the cut or he would have to be laid off. I found this interesting because it seems so anomalous, but the fact that it is an oddity is probably part of the reason we may be on the brink of a depression.

The story goes like this. Some prices rise and fall freely as demand and supply fluctuate (think of wheat, oil, pork bellies, and the like), but other prices are impeded from change. One kind of price that does not adjust easily, at least in one direction, is the price of labor (i.e. wages.) With respect to wages, we see what is commonly called a “ratchet effect”. This means that they can move up with minimal difficulty, but, in most cases, they cannot move down readily. There is often an expectation that a person’s wages will rise regardless of whether that individual’s  productivity or responsibilities have increased, just by virtue of their loyalty to the company. Firms readily accept this reality when sales and profits are increasing. (After all, replacing workers is costly.) In a few cases there are contractual obligations that prevent wages from dropping, but, even when there are not, wages often don’t move downward even when prices in general are in free fall.

This, I believe, is where psychology enters the picture. Cutting wages tends to be taken as a personal affront. There is an emotional reaction to it because people take it as a sign that others believe their personal value is diminished. Because of this, employers are reluctant to even suggest wage reductions, and, when costs must be cut, they engage in reducing their workforce. In other words, instead of cutting $50 from every employee’s paycheck, they fire ten workers and leave everyone else’s wages unchanged.  Granted there are some firms for which - due to their size and idiosyncratic situation – it wouldn’t make sense to keep every employee, but, rather, it is more feasible to reduce there labor pool by a few. However, this is not true in every case, and if some firms would benefit from retaining an experienced workforce (say for a day when the economy rebounds) they could reduce the problem at hand if they were able to change their decision-making. One will note that some employers with lots of hourly employees are able to cut hours and keep all of their employees working, because it is not an insult to ask someone to work less like it seems to be when one asks them to take less per hour of work. Some might point to this as a benefit of a universal health care system versus the current employer-based system. That is, if people could retain the benefit of health care under reduced hours, they might be more readily willing to accept such adjustments. However, if the move from 45 hours per week to 39 per week means forfeiting health care, the decision making is changed. (I don’t know if this is a true benefit on net because a universal system might also translate to reduced worker loyalty to a firm and an increase in labor costs associated with a migrating labor force.)

I suspect that the consumer confidence calculus (i.e. whether people feel it is safe to spend their money versus saving it) is effected differently in a world of wage inflexibility with higher unemployment than it would be in a world with higher wage flexibility and lower unemployment. An employee that expects that there is a high probability of a marginal cut to his or her wages will probably reduce spending, but to a different degree than does someone who has a more dire fear that, albeit with a smaller probability, his or her job will go away altogether. Facing the paralyzing fear of being unemployed in an economy in which jobs are hard to come by, people may feel more compelled to restrain spending than if they think a loss is coming that is within a range that they can later absorb (e.g. packing a lunch as opposed to eating out and reducing discretionary leisure spending.) The reduction in consumer confidence is of course what keeps the economy on a downward trajectory.

I was thinking about how, should this line of thought be correct, one might go about increasing wage flexibility and, therefore, reducing unemployment and the corresponding contraction in consumer confidence. My astute wife pointed out that individuals given a choice between a wage cut and a workforce cut seem to choose the former. Also, as mentioned, the aforementioned friend explained how he was given a choice (that may not have really seemed like a choice) that he accepted. It seems that one way to circumvent the mode of thought that imposes a ratchet effect on wages is to move the decision making down the line. If an individual is given a choice, they cannot take the outcome as an insult, and, even if a majority of workforce peers decides to a wage cut when one disagrees, it is still not likely to be taken as a personal offense because the peers are making decisions based on themselves rather than the dissenter. So I think one mechanism to increase wage flexibility is by way of increased democracy.

Another means to increase labor flexibility would be to find a way to reduce the correlation between benefits and a forty hour work week. This may be economically challenging, but if hours could be cut without a major hit being taken on the benefit front, this could be useful to increasing labor flexibility in the non-salaried sector of the economy.

I saw “The Day the Earth Stood Still” this weekend. Those who haven’t seen it may have gathered from the trailer or the original that,… SPOILER WARNING… the essential premise is that an alien, Klaatu (played by Keanu Reeves), is tasked with making a determination about whether humanity can turn around its behavior before it destroys a rare planet capable of sustaining life. Among the major complaints of reviewers seemed to be that the film was high on preachiness and Computer Generated Imagery (CGI) and low on story and acting. This aside, I think an interesting question is raised about what it takes to change fundamental human behavior. (A more interesting critique might be why the producers / writers thought a  benevolent species that used energy so wastefully [giant orbs creating light that served no purpose] without apparently causing pollution would opt for destruction of humanity rather than sharing this high intensity – low waste energy source.)

While there is still a debate about whether climate disruption is real and the degree to which it is created by humanity (versus natural processes), the scales seems to have tipped in favor of those who think human activities must be changed in order to reduce a very high risk of catastrophic results. The question is whether anything can and will be done about it on a revolutionary time scale (we are of course already making changes on a more gradually paced time scale.)  President-elect Obama has stated his desire to create a green energy revolution that would create a jobs building energy capacity based on more environmentally friendly energy sources. However, there are difficulties that have historically prevented not only the US, but the world more generally, from moving full-speed ahead in this direction.

At its heart, the issue is that green energy technologies are, for the most part, not cost-effective at the current time. This means that the commercial world will not switch to them of there own volition. A firm cannot take on higher energy costs than its competitors without reducing its profit or, possibly, driving itself out of the market altogether, and, therefore, there is an incentive to let others change without doing so oneself. Using a more expensive energy technology translates to fewer dollars for spending on other goods and services. Our economy is based on the ability of people to perpetually buy more and better stuff and if people have to spend more of their incomes for a given amount of a staple like energy the less they have available for what passes for enhanced standard of living (more and better stuff.)

Nuclear is cost competitive (though it is hard-pressed to compete with coal in the absence of a carbon tax) and reduces carbon emissions for a given energy output, but it can’t meet all our green energy needs. First of all, nuclear plants are expensive to build and take about six years to build (and this length will grow much longer as the number of plants under construction increases because of limited suppliers of certain components and shortages of qualified /certified labor.) Second, in an era of tight credit, financing such huge capital costs may prove challenging. Third, there are just not enough qualified people to build and run these plants. Finally, no good policy has yet developed for dealing with spent fuel.

Coal is an incredibly inexpensive fuel if one doesn’t count the marginal social cost of carbon emissions. There are technologies such as carbon sequestration that may make coal more environmentally palatable, but it is not yet cost-effective in the absence of a carbon tax.

Unless it turns out that the time is ripe for various green technologies to become cost competitive, I have trouble imaging that there can be much success in developing such a revolution. In essence, it seems that the policies designed to create substantial numbers of jobs may have to follow the technology development rather than leading it. Of course, there are any number of  good policies to be enacted to motivate research and development, but developing jobs around these technologies before they are adequately mature may not be feasible. 

President-elect Barack a has been presenting the details of an economic stimulus package that will consist of massive government expenditures on public works and attempts to incentivize businesses to employ more labor. (As an aside, the spending on public works may just help alleviate some of the risks resulting from our dilapidated infrastructure.) While the idea of increasing government spending, particularly direct spending such as public works, may be economically sound, it will likely face some daunting challenges because the general modus operandi of our government is not to be fiscally responsible. In other words, the proclivity to run up massive debt may well bite us in the ass. 

Lack of fiscal restraint is not a trait that solely characterizes the George W Bush Administration, but rather is much more widespread. While many will point to the Clinton years as an example of when the government shifted into surplus territory and began chipping away at the debt, it should be noted that much of the money that was overflowing the public coffers was earned in a speculative bubble on information technology. Firms that weren’t making a dime had stocks that were going through the roof. The 1990’s  may be seen as a time in which monetary discipline was lacking more than one in which fiscal discipline reigned. The Federal Reserve kept rates low, and the feeding frenzy continued.   

The question is how do we pay for the economic stimulus? Obviously, taxation is out of the question. The other half of fiscal policy for combating a recession (besides boosting government spending) is to reduce taxation. A government cannot raise more revenues in a recession because increasing tax rates means that disposable income is reduced by the amount of the tax hike, and the public, which is already being thrifty, reduces its spending yet further.

This leaves borrowing money, and, because our domestic propensity to save is low and many people have low or reduced incomes at the moment, this means borrowing from abroad. Under ordinary circumstances, this would not be a problem. After all, America’s current account deficits mean that there are a lot of US dollars in foreign hands, and, historically, the dollar has been seen as a low risk place to invest and a good place to weather financial storms (even ones centered in it.) However, because, even in economically good times, we don’t save or act with fiscal restraint, it may well be that confidence in dollar assets will erode. This could put the Federal Reserve in a very bad place. Foreign markets may not buy dollar assets at the low interest rates that have been put in place to fight the recession, and raising interest rates in a recession is an economy killer. While we are talking mostly about long-term borrowing, and so there may be expectations of better times ahead (no where to go but up?), I don’t think it is clear what a run up on interest rates will do.

Furthermore, even if foreigners would otherwise be willing to purchase US assets, they may be spending down their reserves in an attempt to boost their own domestic economies. Granted, China has a massive amount of reserves (about $2 trillion USD), and a fraction of that amount would go a long way in stimulating the Chinese economy. However, the combination of a need to spend these reserves and a “once bitten, twice shy” attitude toward dollar assets could spell doom for the president-elect’s plan.

I arrived in Budapest the other day, and was interested in seeing what effect the recent financial crisis might be having on the country. One may recall that Hungary accepted IMF loans of about $16 billion last month, and, more recently,  just passed a budget that will reduce the considerable government budget deficit.

As in the US, if one doesn’t watch the financial news, it is not easy to see the effect of the financial crisis. People are going about their business shopping at the Christmas market, going to work, and preparing for the holidays. As in the US, it has been reported that there is an expectation that holiday season consumer confidence might be unexpectedly high given the state of the economy.

However, Hungary faces real economic woes due to excessively high government budget deficits. Where the effects of the crisis are most notable to the common traveler are in the many strikes by government servants and contract workers who, having gotten used to the government spending freely, are upset about the austerity measures that include pay freezes, elimination of bonuses, and reduction of iron-clad job security. These are particularly prevalent in the transportation sector; with flights being cancelled, rail workers on strike, and bus drivers joining in as well. If it were not for transportation uncertainty, I would say this is an ideal time for Americans to travel to Hungary. With the dollar’s recent strengthening, visiting Hungary is much less expensive than it was in 2006 when I was last here. At that time, a weak dollar and high Hungarian inflation conspired to make Hungary more expensive than I had ever seen it.

It will be fascinating to see how this all plays out. Government civil servants and other workers relying on government expenditures have a strong lever on the economy because they are integral to an infrastructure that undergirds all economic activity. In other words, they can likely succeed in injuring the economy, but the more they do so the worse there situation becomes. If they succeed in making Hungary a less attractive place for business operations and tourism, they reduce the tax revenues that are the source of their income. It is clear that the government has to reduce expenditures, and, as labor costs are ostensibly the most substantial portion the costs of providing public services, this will involve reduction of wages, employment, or some combination thereof. This means that the government is between a rock and a hard place, and, if labor overplays their hand, they could end up in a far worse situation than they are currently facing. From a strategic perspective, an interesting lose-lose situation has been created, and such a situation creates a potential for a spiral into oblivion.