Chaffetz: Wrong on Stimulus

Our 3rd District Congressman Jason Chaffetz voted against the stimulus package and recounts his reasoning on cnn.com.

Most economists, myself included, think he's wrong on this issue.

The big immediate problem we face in the economy --- the problem that's leading to the half-million jobs lost each month --- is a kind of coordination problem.

To understand it, think about a firm making decisions about how much output to produce over the next six months and, by extension, how many people to employ. If our firm expects demand for its product to be strong, then it will plan to produce a lot. It will plan to employ a lot of people. If it expects demand to be weak, our firm will cut back on output, and we'll have to lay some of our workers off.

Now, what determines demand for our firm's product? One factor that determines demand is whether our firm's customers are likely to have jobs. So, if our firm expects other firms to have layoffs, then our firm will expect demand for its product to be weak. Expectations of other firms layoffs can trigger layoffs at our firm.

The reason I refer to this as a "coordination problem" is that our firm's best strategy --- layoff or no layoff --- depends on what other firms are doing. One outcome of this game is for no one to have a layoff. Another outcome is for everyone to have a layoff. We're on the "everyone" track as of now.

So how can we stop this cycle?

Well, this isn't the sort of thing that any single firm can undo. One firm deciding not to lay off its employees won't have a big enough impact. A group of firms --- a very large group --- could undo this by all simultaneously deciding to maintain or increase employment. But think of the problems of getting all those CEOs on board.

A final possibility is to take the single biggest player in the US economy --- the federal government --- and have them spend money. And this is what the stimulus package is for. The idea is that the government puts people directly to work --- and this will support demand and induce the firm we considered a few paragraphs above to not do layoffs. This will then support demand at other firms, and we can limit the spiraling job loss we are currently seeing.

This is what the president means when he says that only the federal government is large enough to have an impact on this crisis.

Don't take my support for the stimulus bill to be support for each and every provision in it. My view is that it would be better if we saw more immediate spending and less in the way of tax cuts for anyone with high earnings (unless those cuts are in rates that could somehow be made permanent, which I don't think is feasible.)

But when Congressman Chaffetz votes no because he "spoke with a guy who employs 12 people in his small trucking company, (who) sees a trillion dollars in new deficit spending and yet nothing that will help him," I just have to respond.

Ask the trucking company owner whether his business has been affected by the general economic slowdown. Ask him whether he'd prefer Utah's unemployment rate to rise to 6-7 percent (which it is likely to do even with the stimulus package), or whether he'd prefer Utah's unemployment rate to hit 8-9-10 percent. Most economists think the stimulus bill will mean lower unemployment. And this is likely to be good for the demand faced by local trucking companies.

And since I'm criticizing a Republican here, let me praise some as well. How should governments manage their fiscal policy, if they want to limit the impact of the business cycle on residents? They should do pretty much exactly what I'm guessing the State of Utah will do. Run surpluses and eliminate debt in good times. Bond --- that is, borrow --- and use the Rainy Day fund to support spending in bad times. This allows the state to work against the business-cycle coordination problem outlined above, without running massive long-term deficits.

The Middle Class

Article in the D-News yesterday on "The Middle Class".

Reporter Lois Collins did a nice job summarizing the facts, so I won't repeat them here. But I will add a little about some theories on why this might be happening.

The leading theory among economists is something called "skill-biased technical change." The idea is that production technologies --- that is, the way we make good and services --- have changed. And they've changed in such a way as to make the skills of very educated people (think of college graduates and those with graduate degrees) more valuable relative to the skills of somewhat educated people (think high school grads).

If your skills become more valuable, then employers will be willing to pay higher wages to try to hire you. If your skills become less valuable, then employers won't be as eager to hire you, so your wages won't grow.

Why might this have happened? Computerization is one possible answer. A computer isn't a good substitute for a truck driver. But a good piece of accounting software is a good substitute for a bookkeeper. So, maybe in 1980, a CFO needed a staff of ten bookkeepers to track accounting numbers in a large firm. By 2005, though, a similar CFO could do the same work with only five bookkeepers. Computers substitute for bookkeepers, and therefore make bookkeeping skills less valuable.

At the same time, the computers are allowing the CFO to do more with less. This might make it more important to have a really good CFO. If computers complement CFO skills, then good CFOs will be even more highly sought after, and their wages will rise.

David Autor is an MIT economist and a friend who works on these issues. He's written recently on the polarization of the labor market.

I want to emphasize that skill-biased technical change isn't the only potential explanation for what's been happening in our labor market. This is not a settled question in our field --- others think globalization or tax policy might be driving changes in the labor market.

Present Value Math, Mitt Romney, and Tax Cuts

Mitt Romney says he wants permanent tax cuts rather than direct government spending.

One problem with tax cuts in the current environment is that it's hard to commit to making them permanent. Even John McCain's economists think that overall tax rates have to go up --- due to the large entitlement spending that our government has to do over the next 30-40 years. And if businesses expect tax rates to go back up after the current crisis is over, then they won't respond (as much) to a current tax cut.

Here's some present value math on that:

Businesses decide whether to invest by following the net present value rule. Consider a project that costs $7.5 this year, but will pay $1 in revenue annually starting next year. If the tax rate on those revenues is zero and the interest rate is 10%, then this project has a positive net present value.

The present value of a $1 perpetuity is $10, and so the present value of $10 exceeds the present cost of $7.5.

If the tax rate is 30%, then this is a negative NPV investment --- the after-tax NPV is $7, which is less than the cost.

If we permanently cut the tax rate 20%, then the the after-tax NPV rises to $8, and the project is positive NPV. The firm will invest today, which will create jobs and stimulate the economy.

But what if the owner of the firm doesn't think the tax cut will be permanent? In particular, what if the business owner thinks the tax rate will be 20% next year and the year after, but will return to 30% after that?

Then the after-tax NPV of the investment is $7.17. So no investment!

What this means is that expectations of future tax rates matter a lot for the stimulative effect of tax cuts.