By William Dupor, Assistant Vice President and Economist
The most recent U.S. expansion, however lackluster, entered its eighth year in June.1 In anticipation of the possibility (or perhaps inevitability) of another recession, observers have remarked on how and whether countercyclical fiscal policy should be used to combat an economic downturn….
Gauging Effects through Military Spending
Research Analyst Rodrigo Guerrero and I took up the issue of the efficacy of government spending at increasing employment. We looked specifically at over 120 years of U.S. military spending, which provides a kind of “natural experiment” for our analysis.
Looking at government spending more generally suffers from the problem that the spending may be correlated with economic activity: The government may spend more during a recession (as with ARRA) or more during an expansion (when tax revenues are high). This might bias the results, which economists call “an endogeneity bias.”
Military spending, on the other hand, is likely to be determined primarily by international geopolitical factors rather than the nation’s business cycle.
….We used a similar methodology and found that military spending shocks had a small effect on civilian employment. Following a policy change that began when the unemployment rate was high, if government spending increased by 1 percent of GDP, then total employment increased by between 0 percent and 0.15 percent. Following a policy change that began when the unemployment rate was low, the effect on employment was even smaller.
In the event of another recession, policymakers have a number of stabilization tools at their disposal, including quantitative easing, negative interest rates and tax relief. The research discussed above suggests that one other device, namely countercyclical government spending, may not be very effective, even when the economy is slack.
I think the authors of this research come to the wrong conclusion. Instead they should have concluded that military spending is not very effective in creating jobs.
Military spending provides no lasting benefit to the economy in terms of tax revenue or saleable assets, leaving future taxpayers with public debt and no means of repayment. Other than an austerity budget which would risk another recession.
Whereas infrastructure projects can be selected on their ability to generate market-related returns on investment, providing revenue to service the public debt incurred…..and saleable assets that can be used to repay debt.
But there are two caveats.
First, project selection must not be a political decision. Else projects likely to win votes will be selected ahead of those that generate decent financial returns.
Second, the private sector must have skin in the game to ensure that #1 is adhered to. Also to reduce cost blowouts. Private companies are not immune to blowouts but government projects are in a league of their own.
The added benefit of infrastructure spending is the free lunch government gets from reduced unemployment benefits. Money they would have spent anyway is now put to a more productive use.
During the Federal Election campaign, Labor’s shadow treasurer, Chris Bowen, confirmed that the overall tax burden would hit 24.8% GDP by 2026-27 under Labor, up from 23.5% in 2019-20:
Mr Bowen told The Australian Financial Review that his number was lower than the 25.7 per cent of GDP that Treasurer Scott Morrison claimed Labor would deliver, but higher than the Coalition’s ceiling of 23.9 per cent.
Mr Bowen said the alternative would be spending cuts to essential services.
“Let me be clear: tax-to-GDP will be higher over the medium term under both the Coalition and Labor government. Either that, or the Coalition will continue to deliver more savage cuts to Medicare and education,” he said.
The admission was immediately seized upon by Treasurer Scott Morrison, who claimed that a higher tax burden would damage the Australian economy’s growth:
“Labor might want to think you can have a tax-to-GDP ratio approaching 26 per cent and that will have no impact on the Australian economy. They are kidding themselves…”
The Coalition’s 23.9% of GDP ceiling on tax is based on the National Commission of Audit’s recommendation that taxation revenue as a share of GDP should be capped at 24%.
The assumption that higher tax equals less economic growth is a popular one among conservatives, not just in Australia.
However, four American academics have published an important new book, entitled “How Big Should our Government Be?”, which examines in detail the vexed issue of government size and growth.
According to the Washington Post, which provides a good summary of the book, there is actually a positive correlation between the size of government and economic growth per capita:
Using data on 12 advanced economies from 1870, the authors of the book conclude with the following:
“In the century and a half since then, government expenditures as a share of GDP have risen sharply in these countries. Yet they didn’t experience a slowdown in their long-run economic growth rates. The fact that economic growth has been so stable over this lengthy period, despite huge increases in the size of government, suggests that government size probably has had little or no impact on growth.”
The authors also note that “A national instinct that small government is always better than large government is grounded not in facts but rather in ideology and politics,” and that the evidence “shows that more government can lead to greater security, enhanced opportunity and a fairer sharing of national wealth.”
In particularly, the authors call for more investment in infrastructure, education, as well as proper safety nets for the unemployed and those that get sick.
The Turnbull Government should take note as it considers taking an axe to Australia’s public services.
MY REBUTTAL:
Let me start by saying that I am not in favor of austerity as a response to a major economic slow-down. If anything that will exacerbate unemployment and prolong the contraction. Instead I advocate major infrastructure programs to stimulate the economy. But with two caveats: (1) investments must generate a market-related return on investment; and (2) there must be strong involvement from the private sector. Investment in assets that do not generate direct revenue leaves future taxpayers with a pile of debt and no income (or saleable assets) that can service (or repay) it. Involvement of the private sector should be structured to ensure that the benchmark of market-related returns is not superseded by projects selected to win the most votes. Also, the private sector should have skin in the game to restrict cost blowouts. They are not immune to cost blowouts but are not in the same league as big government.
I also believe that weak government will harm an economy. We need strong regulators, rule of law, police and military to ensure stability. Also spending on education and science to foster growth.
But the article by Jared Bernstein in the Washington Post typifies the kind of rubbish pedaled to voters around election time. And seems to have been swallowed hook-line-and-sinker by the author of the MB article.
Where do I start?
First, the fact that a book by four unnamed academics is cited as proof in itself should tell us how much credibility to attach to their claims.
Second, the author mentions that there is “a positive correlation between the size of government and economic growth per capita…”. A positive correlation is any correlation coefficient greater than zero. The highest correlation is a value of 1.0 which represents a perfect fit. No correlation coefficient is provided in either article and judging from the graph I would assume it is closer to zero than 1, meaning there is only a vague correlation. If you ignore the line drawn on graph, the data looks randomly scattered with no clear trend.
Also the author overlooks that he is only dealing with a sample of 12 countries, which again would give a low level of confidence in any result.
Further, in the WP article the author concedes that correlation is not equal to causation: “That positive slope in the figure on the left above could easily be a function of reverse causality: As economies grow, their citizens demand more from them.” This is omitted in the MB report.
Then the study of data for the 12 economies from 1870 up top the present is used to argue that growth in government expenditures does not hinder GDP growth. I would be surprised if the data didn’t show growth in government across all countries as it spans the era from horse-drawn carts up to the area of modern jets and space travel. From the country GP with a stethoscope to modern nuclear medicine and MRIs. From slate and chalk to super-computers and digital technology. Of course the demand for infrastructure has grown exponentially over that time. To argue otherwise would be stupid.
But that is not an argument in favor of a welfare state or increased government expenditure. In fact, most of those advances in technology were driven by private individuals and not by government.
Finally, I will use another graph from “How big should our government be,” Bakija et al in the same Washington Post article to argue the case for lean government (as opposed to small government circa 1870):
The graph shows that tax revenues as a percentage of GDP have steadily declined, since the late 1990s, for every country except France. Why has this occurred in even model welfare states like Sweden and, to a lesser extent, Canada? Simply because they reached “peak welfare” in the 1990s and realized that the only way to revive GDP growth was to reduce the role of government in the economy.
The only one who hasn’t accepted the evidence is France. Which may well be contributing to their poor economic performance.
The ASIC review of investments banks found that not only do the heavyweights of Australia’s financial system have difficulty in managing their conflicts of interest they also financially reward staff for potentially conflicted behaviour.
…..So ugly is the result the Australian Securities and Investments Commission has warned the people often known as the smartest men and women in the room it will take action against the culprits if the poor behaviour continues.
……Managing conflicts of interest are crucial for investment banks because often one part of the bank is advising on an asset sale or an initial public offering while the bank’s research arm is producing research for the investment banks’ investor clients about the quality of the assets or the IPO.
….ASIC said it had also found “instances of remuneration structures where research remuneration decisions, including discretionary bonuses, took into account research analyst involvement in marketing corporate transactions”.
The review also found “instances with mid-sized firms where research reports on a company were authored by the corporate advisory team that advised the company on a capital-raising transaction or had an ongoing corporate advisory mandate”.
Results of the review come as no surprise. When there is a conflict between profits with multi-million dollar bonuses and independence the outcome should be obvious.
Having worked in the industry, I believe that the only way to achieve independence is to separate investment banks from research houses, with no financial linkage. A professional body for research houses would ensure independence in much the same way as the auditing profession. There is no better way of enforcing good behavior than the threat of censure from a professional body that has the power to prevent its members from practicing.
Long-term interest rates surged on strong jobs numbers, well above the estimate of 180,000. From the WSJ:
Nonfarm payrolls rose by a seasonally adjusted 255,000 last month, the Labor Department said Friday. Revisions showed U.S. employers added 18,000 more jobs in May and June than previously estimated.
10-Year Treasury yields strengthened to 1.58 percent in response, from a record low of 1.33 percent four weeks ago. Expect a test of the descending trendline at 1.66 percent.
Gold fell to $1335/ounce on expectations of higher interest rates. Penetration of the rising trendline would suggest a correction to test primary support at $1200/ounce. Follow-through below $1300 would confirm.
At present I don’t see much threat to support between $1300 and $1310. Especially with safe-haven demand for gold enhanced by European uncertainty over Brexit, the dilemma of US November elections (a choice between two equally undesirable alternatives), and a declining Yuan encouraging capital flight from China.
June US Light Vehicle Sales came in at a disappointing seasonally adjusted annual rate of 16.689 million vehicles. Light vehicle sales, an important barometer of consumer confidence, have been trending lower since November 2015. Further falls would be cause for concern.
Want to know the real cause of low GDP growth? Look no further than Private Investment.
Private Investment ran with peaks around 10 percent of GDP and troughs around 4 percent throughout the 1960s, 70s and most of the 80s. Since then Private Investment has declined to the point that the latest peak is close to 4 percent.
It is highly unlikely that the US will be able to sustain GDP growth if the rate of investment continues to decline. GDP growth is a factor of population growth and productivity growth. Productivity growth is not primarily caused by people working harder but by working more efficiently, with better tools and equipment. Using an earthmover rather than a wheelbarrow and shovel for example. Falling investment means fewer new tools and efficiencies.
The second graph plots the annual increase in private debt against GDP. You would think that this figure would fall — in line with falling rates of investment. Quite the opposite. Private debt growth is rising. While annual debt growth is nowhere near the red flag of 5 percent of GDP, if it crosses above the rate of private investment — as in 2006 to 2009 — I would consider that a harbinger of another crash.
Good point made by R.A. in The Economist as to why the Fed should target nominal GDP rather than inflation:
One of the strongest points in favour of NGDP targeting, in my view, is that it implied a need for far more action from the Fed far earlier in this business cycle. People remember how aggressively the Fed intervened to prop up the financial system in the fall of 2008, but they forget how slow the central bank was to react to what was obviously a precipitous decline in the macroeconomy. The fed funds rate stayed at 2% from April until October of 2008. The Fed didn’t ramp up its initial asset purchase programme above $1 trillion until March of 2009, at which point the economy had already lost some 6m jobs. Why the delay? One data point worth noting: the monthly core inflation rate was positive throughout 2008 and 2009. NGDP growth, by contrast, was already negative in the third quarter of 2008, and was sharply negative in the fourth quarter of that year, when total spending in the economy shrank at an 8.4% annual pace. A central bank with an explicit NGDP level target would have faced (appropriately) intense pressure to do much more much sooner than one with the Fed’s present, vague focus on an inflation target as a means to broader macroeconomic stability.
If we look at the graph below, it is likely the Fed would have cut the funds rate to near zero by May 2008, when Q1 GDP results were available — possibly earlier if they were using surrogates to give more up-to-date measures of GDP — rather than waiting until November 2008.
But that misses the key point. The Fed would have intervened far earlier with tighter monetary policy — in late 2003 when GDP growth jumped to 6.4 percent — and prevented the bubble from forming.
In a blistering attack on decades of common government practice, Australian Competition and Consumer Commission chairman Rod Sims said the sale of ports and electricity infrastructure and the opening of vocational education to private companies had caused him and the public to lose faith in privatisation and deregulation.
“I’ve been a very strong advocate of privatisation for probably 30 years; I believe it enhances economic efficiency,” Mr Sims told the Melbourne Economic Forum on Tuesday. “I’m now almost at the point of opposing privatisation because it’s been done to boost proceeds, it’s been done to boost asset sales and I think it’s severely damaging our economy.”
Mr Sims said privatising ports, including Port Botany and Port Kembla in NSW, which were privatised together, and the Port of Melbourne, which came with conditions restricting competition from other ports, were examples where monopolies had been created without suitable regulation to control how much they could then charge users……
Deregulating the electricity market and selling poles and wires in Queensland and NSW, meanwhile, had seen power prices almost double there over five years, he said.
I have also been a strong advocate of privatising state assets, but Rod Sims raises some important concerns that need to be addressed.
There is a strong trend in capitalist economies away from free enterprise and towards privatised “monopolies”. Investors place a great deal of emphasis when evaluating stocks on a company’s “economic moat” or competitive advantage. Both of which imply the ability to restrict competition. While this may maximize revenue for the individual economic unit, it is harmful for the economy as a whole.
Which brings me back to Mr Sims’ point. Higher prices paid for infrastructure services destroy the competitiveness of the economy as a whole, with profound implications for exports and productivity.
On secular stagnation: “I don’t see growth picking up until you either redistribute income downwards — which is politically quite difficult and slow — or developed countries which are credible borrowers engage in massive infrastructure spending — which would be a great idea but politically difficult — so I’m afraid secular stagnation is going to last several more years.”
On BREXIT: “I’m not to optimistic that the Euro will be around in 10 years…BREXIT could speed up the process if England does well.”
On future crises: “It’s always the same thing: a huge switch from New York to Washington (in American terms) where policy begins to dominate the whole process…because the solutions to the problems are political solutions, not really economic or financial solutions…”
Steve Keen has a number of detractors who knock him for his incorrect forecast of collapse of the Australian housing bubble. But he was wrong for the right reasons…. the Australian financial system, based on highly-levered mortgages, is a house of cards. It was only rescued post-GFC by massive stimulus in China, resulting in a mini-boom in the Australian Resources industry.
Steve is at the cutting edge of economic theory. He and Richard Koo (The Holy Grail of Macroecomomics) were at the forefront of identifying the role that debt plays in the Aggregate Demand equation. We should take heed of his warnings.
“Our models predicted it [the GFC] couldn’t happen. It did happen. We therefore shouldn’t trust our models.”
“…What drives house prices is acceleration in mortgage debt…..Australians avoided collapse of the bubble by continuing to lend but mortgage debt is now 1.1 times GDP which is outrageous.”
