Finance 361 Business Conditions Analysis. Macroeconomic Controversies and Policy Debates

Finance 361

Business Conditions Analysis

Macroeconomic Controversies and Policy Debates

Macroeconomic Controversies and Policy Debates

• Rising inequality in income and wealth: Is it happening and Why?

US Income Distribution

Median = $42,500

Mean = $57,500

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$2,500 $12,500 $22,500 $32,500 $42,500 $52,500 $62,500 $72,500 $82,500 $92,500

Average vs. Median Income (1979 = 100)

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MeanMedian

US Income Quintiles

$10,136

$42,629

$66,839

$145,970

$25,468

$0

$20,000

$40,000

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$80,000

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$120,000

$140,000

$160,000

Lowest 5th 2nd Fifth 3rd Fifth 4th Fifth Top 5th0

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Average Income% of Total

The Lorenz Curve

0 3.512.2

26.8

49.9

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% of Households

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USPerfect Equality

The Gini Coefficient

• The Gini Coefficient attempts to quantify income inequality

The Gini Coefficient

• The Gini Coefficient attempts to quantify income inequality

• Gini = A/(A+B)

The Gini Coefficient

• The Gini Coefficient attempts to quantify income inequality

• Gini = A/(A+B)• The Gini coefficient

will always be between 0 (perfect equality) and 1 (perfect inequality)

Are the rich getting richer while the poor get poorer?

• The Gini Coefficient has been steadily rising in the US from a low of .35 to a current level of .44

Are the rich getting richer while the poor get poorer?

• The Gini Coefficient has been steadily rising in the US from a low of .35 to a current level of .44

• The increase in the Gini coefficient has accelerated in recent years.

• The after tax/transfer Gini coefficient is around .4

Economic Growth: 1947-1973

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Bottomfifth

2nd Fifth 3rd Fifth 4th Fifth Top Fifth Top 5%

Economic Growth: 1977-1989

-1

-0.5

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2.5

Bottomfifth

2nd Fifth 3rd Fifth 4th Fifth Top Fifth Top 5%

Why is income inequality increasing?

Why is income inequality increasing?

• New technologies favor skilled labor (an increase in the “skill premium”)

The US Industrial Revolution

The New Economy

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1950s 1960's 1970's 1980's 1990's

Productivity Using a Base Year

Labor ProductivityTotal Productivity

The New Economy: A fluke?

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3.5

1950s 1960's 1970's 1980's 1990's

Productivity Using Chain Weighting

Labor ProductivityTotal Productivity

Why is income inequality increasing?

• New technologies favor skilled labor (an increase in the “skill premium”)

• Increasing importance of international trade

International Trade:1960-2000(% of GDP)

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1960 1965 1970 1975 1980 1985 1990 1995 2000

ImportsExports

Macroeconomic Controversies and Policy Debates

• Should we be worried about deflation?

Japan: 1981-2000

• During the 1980’s Japan experienced remarkable economic growth. However, the Japanese economy experienced a meltdown starting in 1991

Japanese Inflation Rates• It is commonly

believed that the root of the Japanese problem was a “deflationary spiral”

Japanese Inflation Rates

• It is commonly believed that the root of the Japanese problem was a “deflationary spiral”

• Deflation is particularly noticeable in Japanese producer prices.

Why is Deflation a Problem?

Why is Deflation a Problem?

• Lower prices raises the real cost of labor.

Why is Deflation a Problem?

• Lower prices raises the real cost of labor.

• Falling prices increases the real cost of borrowing for firms.

Why is Deflation a Problem?

• Lower prices raises the real cost of labor.• Falling prices increases the real cost of

borrowing for firms.• A contracting manufacturing sector lowers

employment and income. This lowers consumer demand for goods and services which creates another round of price decreases….a deflationary spiral!

Is The US heading for a for a Japanese Style Meltdown?

• The US experienced a mild recession in 2001, but many are concerned about a “double dip”

US Prices

• Inflation in the US looks quite similar to that experienced in Japan.

US Inflation Rates

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7

Average 1960's 1970's 1980's 1990's 2000's

Federal Reserve Statements

The probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level.

• June 25, 2003: Fed Funds Target Cut by 25 basis points to 1%.

Federal Reserve Statements

The committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

• August 12, 2003: Fed Funds Target remains 1%.

Federal Reserve Statements Increases in core consumer prices are muted and expected to remain

low. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the committee believes that policy accommodation can be maintained for a considerable period

• December 9, 2003: Fed Funds Target remains 1%.

Federal Reserve Statements

Increases in core consumer prices are muted and expected to remain low. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the committee believes that it can be patient in removing its policy accommodation.

• March 16, 2004: Fed Funds Target remains 1%.

Federal Reserve Statements

Although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained…At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured

• May 4, 2004: Fed Funds Target remains 1%.

Federal Reserve Statements

Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors…. With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured

• June 29, 2004: Fed Funds increased to 1.25%.

Federal Reserve Statements

Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors…. With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured

• August 10, 2004: Fed Funds increased to 1.5%.

Reasons for Deflation

• The New Economy?

Reasons for Deflation

• The New Economy?

• International Trade/Developing Economies?

Reasons for Deflation

• The New Economy?

• International Trade/Developing Economies?

• Liquidity trap?

Macroeconomic Controversies and Policy Debates

• Do tax cuts increase economic growth, revenues and reduce deficits, or is it voodoo economics?

The Bush Tax Cuts (2001&2003)

• The centerpiece of the 2001 Bush tax cut was a restructuring of the tax code from 5 brackets (15, 28, 31, 36, 39.6) to four brackets (10, 15, 25, 33)

• The 2001 tax cut also included a gradual repeal of the estate tax, an increase in the child tax credit, and a reduction of the “marriage penalty”

• The 2003 tax cut accelerated the rate reduction schedule, and added a cut in the dividend tax rate

• The first year cost of the tax cuts are $73B and $30B respectively.

The Bush Tax Cut in Historical Perspective

Tax Bill Cost in Current Dollars (Billions)

Kennedy Tax Cut (1964) $11.5

Reagan Tax Cut (1981) $38.3

Bush Tax Cut (2001) $73.8

Bush Tax Cut (2003) $30.4

The Bush Tax Cut in Historical Perspective

Tax Bill Cost in Current Dollars (Billions)

Cost in 2003 Dollars (Billions)

Kennedy Tax Cut (1964) $11.5 $54.9

Reagan Tax Cut (1981) $38.3 $68.7

Bush Tax Cut (2001) $73.8 $75.8

Bush Tax Cut (2003) $30.4 $30.4

The Bush Tax Cut in Historical Perspective

Tax Bill Cost in Current Dollars (Billions)

Cost in 2003 Dollars (Billions)

Cost as a % of GDP

Kennedy Tax Cut (1964) $11.5 $54.9 1.9%

Reagan Tax Cut (1981) $38.3 $68.7 1.4%

Bush Tax Cut (2001) $73.8 $75.8 .8%

Bush Tax Cut (2003) $30.4 $30.4 .3%

What do we mean by the “cost” of a tax cut, anyways?

What do we mean by the “cost” of a tax cut, anyways?

• To estimate the “cost” of a tax cut, we need to forecast not just total income, but the distribution of income for the upcoming years.

What do we mean by the “cost” of a tax cut, anyways?

• To estimate the “cost” of a tax cut, we need to forecast not just total income, but the distribution of income for the upcoming years.

• Once we have our estimates for future income, we apply the tax code to that distribution to calculate projected tax receipts

What do we mean by the “cost” of a tax cut, anyways?

• To estimate the “cost” of a tax cut, we need to forecast not just total income, but the distribution of income for the upcoming years.

• Once we have our estimates for future income, we apply the tax code to that distribution to calculate projected tax receipts

• The difference in tax receipts is the “cost” of the tax cut.

What do we mean by the “cost” of a tax cut, anyways?

• To estimate the “cost” of a tax cut, we need to forecast not just total income, but the distribution of income for the upcoming years.

• Once we have our estimates for future income, we apply the tax code to that distribution to calculate projected tax receipts

• The difference in tax receipts is the “cost” of the tax cut.

• Is it possible for tax cuts to have a net benefit rather than a net cost? That is, can a tax cut actually raise revenues?

The Laffer Curve: Voodoo Economics?

• Tax revenues = (Tax Rate)(Tax Base)

The Laffer Curve: Voodoo Economics?

• Tax revenues = (Tax Rate)(Tax Base)

• Lowering tax rates alters individual decisions. Specifically, lower income taxes should raise the incentive to work. This should stimulate economic activity and raise income

The Laffer Curve: Voodoo Economics?

• Tax revenues = (Tax Rate)(Tax Base)• Lowering tax rates alters individual decisions.

Specifically, lower income taxes should raise the incentive to work. This should stimulate economic activity and raise income

• If the tax base increases by a larger percentage than the tax cut, revenues will actually increase.

Is there evidence of a Laffer Curve?

Annual Federal Receipts (Billions)

Year 0 Year 1 Year 2 Year 3 Year 4

Kennedy (1964) $110.2 $119.3 $136.3 $144.9 $168.5

Reagan (1981) $605.6 $599.5 $623.9 $688.1 $747.4

Bush (2001) $2,008.4 $1,875.6 ??? ??? ???

Warning: Trend vs. Cycle

• Tax cuts are generally passed during economic slowdowns. The question that needs to be asked is: How much of the economic recovery was due the the tax cut and how much would’ve happened anyway?

Warning: Trend vs. Cycle

• Tax cuts are generally passed during economic slowdowns. The question that needs to be asked is: How much of the economic recovery was due the the tax cut and how much would’ve happened anyway?

• That is, a tax cut should affect the underlying trend in economic activity, but not the cycle.

Macroeconomic Controversies and Policy Debates

• What should we do about the looming social security crisis? Should we privatize social security?

The impending social security crisis

• The Social Security System in the US is “pay as you go” system. That means that the benefits of those that are currently retired are paid for by the taxes collected on those currently working.

The impending social security crisis

• The Social Security System in the US is “pay as you go” system. That means that the benefits of those that are currently retired are paid for by the taxes collected on those currently working.

• When social security was created, there were approximately 9 workers for every retiree. Today, that ratio is down to 3.5. When the “baby boomers” retire, that number will be around 1.5.

The impending social security crisis

• The Social Security System in the US is “pay as you go” system. That means that the benefits of those that are currently retired are paid for by the taxes collected on those currently working.

• When social security was created, there were approximately 9 workers for every retiree. Today, that ratio is down to 3.5. When the “baby boomers” retire, that number will be around 1.5.

• Due to the increase in benefits paid, along with the decrease in taxes collected, the social security system is expected to go “bankrupt” 15-20 years.

Social Security Timeline

• 2014: Current benefits will exceed current Payroll taxes

• 2022: Current benefits will exceed payroll taxes plus interest earned on the social security trust fund

• 2034: Social security trust fund exhausted. Social security will only be able to cover 70% of promised benefits ($25T shortfall over the next 75 years)

What do we do?

• Current proposals to “fix” social security involve one or more of the following: – Lower benefits

– Increase payroll taxes

– Increase taxability of benefits

– Lower cost of living adjustments

• Problem: As taxes rise and benefits fall, the system itself becomes less desirable

Social Security vs. Private Investment

Social Security (12.4%) • Income = $7,000

• Annual payroll tax: $868

• Monthly Benefit upon retirement at 65: $532

Social Security vs. Private Investment

Social Security (12.4%) • Income = $7,000

• Annual payroll tax: $868

• Monthly Benefit upon retirement at 65: $532

Private Investment• Annual Contribution: $868

• Account balance at 65 (assuming a 4% annual yield): $66,487

• Monthly Interest: $221

• Monthly Annuity Income: $469

Social Security vs. Private Investment

Social Security (12.4%)• Income = $20,000

• Annual payroll tax: $2,480

• Monthly Benefit upon retirement at 65: $877

Private Investment• Annual Contribution: $2,480

• Account balance at 65 (assuming a 4% annual yield): $198,963

• Monthly Interest: $633

• Monthly Annuity Income: $1,496

Social Security vs. Private Investment

Social Security (12.4%)• Income = $84,900

• Annual payroll tax: $10,527

• Monthly Benefit upon retirement at 65: $1,684

Private Investment• Annual Contribution:

$10,527

• Account balance at 65 (assuming a 4% annual yield): $806,350

• Monthly Interest: $2,687

• Monthly Annuity Income: $6,351

Social Security vs. Private Investment

• (From the Testimony of Alan Greenspan: March 3, 1999)– The implicit average real rate of return on

social security for those born in 1905 was 10%– For those born in 1925: 6%– For those born in 1960: 2%– Under current tax system: 1.2%

Privatizing Social Security

• Recently, plans have been proposed to “privatize” social security. Under a privatized system, taxes would be put into individual accounts and invested (like a 401K)

Privatizing Social Security

• Recently, plans have been proposed to “privatize” social security. Under a privatized system, taxes would be put into individual accounts and invested (like a 401K)

• Problems: – Financial risk is passed on to households– How do we transition to the new system?

Macroeconomic Controversies and Policy Debates

• Should we be worried about government deficits?

US Government Deficits/Debt

• Currently, the total debt of the US government is approximately $7 Trillion ($25,000 per person). The interest payments alone ($250 B/yr) comprise 15% of the federal budget.

US Government Deficits/Debt

• Currently, the total debt of the US government is approximately $7 Trillion ($25,000 per person). The interest payments alone ($250 B/yr) comprise 15% of the federal budget.

• From 1998-2001, the federal government ran a “surplus” for the first time since 1970. However, in 2002, deficits returned (the 2003 deficit was around $400B and the 2004 deficit is projected to surpass $500B!)

US Government Deficits/Debt

• Currently, the total debt of the US government is approximately $7 Trillion ($25,000 per person). The interest payments alone ($250 B/yr) comprise 10% of the federal budget.

• From 1998-2001, the federal government ran a “surplus” for the first time since 1970. However, in 2002, deficits returned (the 2003 deficit was around $400B and the 2004 deficit is projected to surpass $500B!)

• Should we be concerned about this?

Could the US Government go Bankrupt?

• In 1992, Harry Figgie wrote a book entitled “Bankruptcy 1995: The Coming Collapse of America and How to Stop It”. In this book he predicted that by 1995, the national debt would be so large that the interest payments alone would take up the entire US Government budget. Could this happen?

Could the US Government go Bankrupt?

• In 1992, Harry Figgie wrote a book entitled “Bankruptcy 1995: The Coming Collapse of America and How to Stop It”. In this book he predicted that by 1995, the national debt would be so large that the interest payments alone would take up the entire US Government budget. Could this happen?

• It is true that the the debt is growing ( 5.5% per year since 1946 ). However, our ability to pay that debt is also growing ( 6.5% per year since 1946 )

Could the US Government go Bankrupt?

• In 1992, Harry Figgie wrote a book entitled “Bankruptcy 1995: The Coming Collapse of America and How to Stop It”. In this book he predicted that by 1995, the national debt would be so large that the interest payments alone would take up the entire US Government budget. Could this happen?

• It is true that the the debt is growing ( 5.5% per year since 1946 ). However, our ability to pay that debt is also growing ( 6.5% per year since 1946 )

• Debt/GDP has generally fallen since 1946

Debt in the US

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Debt/GDP in the US

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Interest as a percentage of the Federal Budget

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Does a large debt raise interest rates and lower economic growth?

• The traditional argument against large deficits is that government borrowing “crowds out” private investment by raising interest rates. Lower investment will result in lower economic growth

Does a large debt raise interest rates and lower economic growth?

• The traditional argument against large deficits is that government borrowing “crowds out” private investment by raising interest rates. Lower investment will result in lower economic growth

• While it is true that a government deficit increases the demand for credit, this argument assumes that the supply of credit is constant.

Does a large debt raise interest rates and lower economic growth?

• The traditional argument against large deficits is that government borrowing “crowds out” private investment by raising interest rates. Lower investment will result in lower economic growth

• While it is true that a government deficit increases the demand for credit, this argument assumes that the supply of credit is constant.

• If the supply of credit keeps pace with the demand, interest rates will not be affected (and, hence, neither should growth)

US Interest Rates

US Debt and GDP Growth

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Goals of the Course

• Create a unified framework to address these issues plus many others

Goals of the Course

• Create a unified framework to address these issues plus many others– Micro foundations– Exogenous vs. Endogenous– Causality vs. Correlation– Positive vs. Normative Analysis