Two posts on the sales tax and work incentives

If you want to measure the incentive for working, the sales tax needs special consideration.

(A)  Arithmetic.  Think of it this way:

(Disposable income) = (Total income) - (income taxes) - (sales taxes)

Sales taxes are levied as a percentage s of one's disposable income: namely, when you buy a dollar's worth of items at the store you get an extra sales tax charge of s dollars. Income taxes are, for simplicity, a fraction t of income. We have:

(Disposable income) = (Total income) - t*(Total income) - s*(Disposable income)

Equivalently:

(Disposable income) = [(1-t)/(1+s)]*(Total income)

(B) Labor supply behavior.  In order to understand how labor supply behavior changes in response to tax rate changes, to a first approximation all we need to know is the percentage change in [(1-t)/(1+s)]. Over the past 10 years, U.S. sales taxes (levied at the state and local levels) have hardly changed, which means that the time series for t, which is what I showed in my WSJ article, is all we need to calculate the percentage change in [(1-t)/(1+s)].

John Cochrane explains this further on his blog. Today I gave an example, from the U.K., where sales tax rates were NOT constant.

The U.K. example also reminds us how the sales tax is included in the CPI so that, if you do have a marginal tax rate measure inclusive of the sales tax, you should NOT multiply it by a real wage deflated by the CPI because that would double-count the sales taxes. The MTR series that I showed in my WSJ article (and available here in excel format) does not include sales taxes, and therefore can be multiplied by wages deflated by the CPI.

Indeed, economists researching wages should make this multiplication more often than they do (which is hardly ever), because taxes are part of the functioning of prices in the labor market.

(C) Welfare analysis.  If you want to calculate the new deadweight losses from new income taxes, you have to consider the sales tax and any other other wedge between total income and disposable income, even if the sales tax were constant over time, because the behavioral changes avoiding the new income taxes have the side effect of reducing sales tax revenues.  That's what I do in the small section of my book (Appendix 4.3) that quantifies labor market deadweight losses.

Chicago v. Harvard on Obamacare: link repaired

I posted this yesterday and the Mulligan link was to an older piece on part-time employment. The correct link directly addresses Cutler's testimony.

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Mulligan: Somebody should have told Congress that the ACA's labor-contracting provisions far outweigh its labor-expanding provisions.

Harvard's David Cutler replies.

Chicago v. Harvard on Obamacare

Mulligan: Somebody should have told Congress that the ACA's labor-contracting provisions far outweigh its labor-expanding provisions.

Harvard's David Cutler replies.

update: the Mulligan link has the correct URL now

Health Care Inflation and the Arithmetic of Labor Taxes

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A modest reduction in health care inflation by itself might increase employment or number of hours worked, but the effect will be overwhelmed by new taxes coming into effect in the next two years.

Health care and the labor market are connected because so much of the non-elderly population obtains health insurance through an employer or the employer of a family member. As the decades have gone by, Americans have been spending more and more on health care, largely through their health insurance premiums, to the point that many families cannot afford the kinds of health insurance plans in which middle- and upper-income families take part.

So it’s reasonable to wonder whether the health expenditure trends affect the amount of employment in the economy, and thereby whether policy reforms that reduce the rate of health expenditure growth might reverse some of those employment effects.

The direction of the employment effects of health care inflation is unclear, because it depends on the reasons for rising health care costs. To the degree that rising costs derive from new, valuable (but expensive) pharmaceuticals and medical procedures, rising costs may make people more attached to jobs with health benefits in order to have better access to medical innovations and to pay for them with pretax dollars.

But health economists have also pointed to less benign sources of health care inflation, including excessive malpractice penalties and a number of other health industry inefficiencies that raise employer health insurance costs without creating commensurate value for employees.

The economists Katherine Baicker and Amitabh Chandra looked at evidence suggesting that malpracticelike sources of health care inflation are economically equivalent to an implicit tax on employers (see Page 612 of their paper). Economists call it an “implicit tax” because it has many economic characteristics of a tax, even though it is not legally a tax; it reduces employee cash wages by the amount of the implicit tax, and incentive-sensitive employees respond by working less.

As the House of Representatives began to consider whether to repeal the Affordable Care Act, David Cutler of Harvard testified about the Baicker-Chandra results and asserted that the Affordable Care Act would reduce average health care costs by about 5 percent by 2015, reduce the health care cost implicit tax on employers and thereby increase nationwide employment more than it would have grown had the Affordable Care Act not been enacted.

He also organized and signed an economists’ letter to Congress asserting that “repealing the Affordable Care Act would produce job reductions of 250,000 to 400,000 annually.” The Affordable Care Act was cutting employer costs and Congress needn’t worry that it would contract the labor market, they wrote.

Neither Professor Cutler’s testimony nor the economists’ letter mentioned that the Affordable Care Act also creates explicit taxes on employers, subsidies for layoffs and various implicit taxes on employees with many of the same economic characteristics as taxes on employers.

Other advocates of the Affordable Care Act dismiss the act’s work disincentives as negligible, because incentives supposedly have little effect on employment and hours worked. At first glance, it might seem that we have a case of dueling experts, and that we’ll never know which effect dominates. But that first impression would be incorrect, because each effect cited above – like the employer mandate or the health care cost reduction – is a tax effect, and simple arithmetic is all that is needed to determine the direction of the combined effect of all of the tax-like provisions.

After I sent Professor Cutler a draft of this post, he responded: “When I was giving my testimony, I was excluding the vast bulk of policies that will affect part-time work, job choice, etc., because I wanted to focus on the overall cost issue. I don’t think you can do this right unless you include all the effects.”

He agreed with me that readers of his testimony and letter might get the wrong impression that “repealing the Affordable Care Act would produce job reductions” refers to the act as a whole, when it fact it refers to the cost-reduction provisions by themselves. (He also said that neither his testimony nor my calculations quantify the effect of the health care law on job mobility and on the health of the work force, and that he believes these two employment effects to be large. I will return to those issues in a later post.)

Furthermore, Professor Cutler told me he left out explicit and implicit tax effects because he believed (and still believes) them to be less than the cost-reduction effects, and because he “didn’t have a way to add them all up,” referring to the various effects. Since Professor Cutler’s testimony, I have shown how most of the effects can be added together because cost reduction is a tax effect comparable to the tax effect of the employer mandate, the tax effect of the subsidy for layoffs and so on (see also the methodology in Chapter 3 of my book “The Redistribution Recession”).

Begin with Professor Cutler’s (probably optimistic) estimate that the act will reduce employer health costs by 5 percent as of 2015. Because of the special payroll and income tax treatment of employer health insurance, 1.5 of those five percentage points of savings will accrue to government treasuries, leaving 3.5 percentage points of health care savings for employers and employees. Americans spend about 18 percent of their gross income on health care and 82 percent on other things: saving 3.5 percent on health care is like saving 0.6 percent on their total budget.

(In principle, the government treasuries could use their savings to cut marginal tax rates or increase them less than they would have. But they could also use the savings to pay for additional assistance programs that erode work incentives, so I take the middle ground and assume that the government savings by itself has no effect on marginal tax rates.)

Some cost-reducing provisions in the Affordable Care Act, such as the tax on “Cadillac” health plans or the Independent Payment Advisory Board, may reduce value received by employees at the same time that they reduce employer costs, and therefore affect employment less than cutting implicit employer taxes does. The implicit tax cut effect associated with the act’s cost reductions (as estimated by Professor Cutler) is therefore somewhere in the range of 0.3 to 0.6 percentage points, with the 0.6 percentage point case representing the extreme where none of the cost-saving measures reduces employee value.

The Affordable Care Act’s explicit taxes on employers, subsidies for layoffs and implicit taxes on employees, together amount to a five or six percentage point addition to the average marginal tax rate on labor income (this includes the fact that many people will not take part in programs for which they are eligible, the tendency of the act to move people off means-tested uncompensated care and the fact that the act implicitly taxes unemployment benefits, as I noted in testimony before the Human Resources Subcommittee of the House Ways and Means Committee). By these calculations, the tax effects that Professor Cutler left out are about 10 times greater than, and in the opposite direction of, those he conveyed to Congress.

Professor Cutler projected that the Affordable Care Act’s cost reductions by themselves will increase employment in 2015 by about 400,000, or about 0.3 percent of total employment (see Figure 2 in his testimony). If his estimate of the cost-savings channel is accurate, and I am right that the overall labor market effect of the act is about 10 times larger (in the other direction) than the cost-savings channel, we might then expect the act to contract the 2015 labor market by about 3 percent rather than expand it.

As time goes by and additional research results become available, it increasingly appears that even the experts failed to fully appreciate the labor-market-depressing effects of the Affordable Care Act at the time it was passed.

Indexation Perils

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Indexing fiscal policy parameters to consumer price inflation was a nice improvement in the 1970s when both price and wage inflation took off, but the American economy is different now and may require different index approaches.

Economic policy often involves setting benefit amounts or thresholds for program eligibility or for new tax brackets. A few examples are the federal poverty line of $23,550 (for a family of four), the maximum food-stamp benefit of $668 a month and a $113,700 cap on income subject to taxation for Social Security.

Ideally, policy parameters are chosen to balance costs and benefits. The $110,100 threshold might have been pretty sensible for 2012, but we doubt that a $110,100 threshold would be equally sensible in 2017 or 2022. If nothing else, the existence of inflation means that a dollar will not have the same economic value in the future as it does now.

Costs and benefits could be re-evaluated every year, but it is sometimes easier to set a formula for automatic updating — guessing, in effect, how the optimal policy will change over time. Many fiscal policy parameters are now indexed to consumer price inflation, based on the assumption that they should remain in a fairly fixed ratio to consumer prices.

The income tax code was not always indexed, and the rapid inflation of the 1970s awakened many Americans to “bracket creep,” as inflation raised the dollar earnings of the poor and middle class and put them in tax brackets originally meant for higher-income taxpayers, without necessarily giving them any additional purchasing power.

However, many costs and benefits of fiscal policy, especially those related to incomes and jobs, depend on wages rather than consumer prices and arguably fiscal policy parameters should be indexed to wages rather than consumer prices. A few policy parameters are indexed to wages, such as parts of the benefit formulas for Social Security and unemployment insurance, but consumer price indexation is more common.

If wages and consumer prices always moved together, the distinction would be largely academic. But in reality, wages change differently than consumer prices do. There is a tendency for wages to increase more than consumer prices over long periods of time, thanks to labor productivity gains.

Indexing can play a role in political debates, as the parties that believe that a policy parameter is too low might want it indexed to wages rather than consumer prices in order that it increase more over time (for the same reason, they might want it indexed to the average wage rather than the median wage, because average wages have tended to increase more than median wages have). Parties on the other side might push for consumer price indexation, or no indexation at all.

For example, if you think that the poverty line is too high, you are glad that the line is not indexed to wage inflation and might wish that it were not indexed at all, so that more of the population might creep out of the poverty category.

But in these times, we may see political parties switching sides on the indexing question, because a number of forces may cause wages to increase less than consumer prices, if at all.

Rising health insurance costs tend to reduce cash wages or cause them to grow less than consumer prices, as employers cannot compete well when they are paying more in cash wages and more for employee health insurance. I noted in an earlier post that the least-skilled workers are seeing their wages fall over time, largely because they are out of work and failing to acquire the skills that come with working.

Employers are also facing new health care regulations expected to reduce cash wages as many employers of low-skill workers are hit with per-employee fines of about $3,000 per employee per year. Were a federal sales tax, such as the value-added tax used in many European countries, to be created, consumer prices would increase significantly more than wages do.

While we can be thankful we are not now experiencing the high inflation rates of the 1970s that urgently introduced inflation indexing into fiscal policies, we may want to reconsider policy thresholds and how they relate to the labor market fundamentals.

New Keynesian References

Today I wrote about "New Keynesian" models of the recession:

1. I clearly defined New Keynesian models as "… built on the assumption that employers charge too much for the products that their employees make and are too slow to cut their prices when demand falls" in which the recession originated with a surge in "the demand for safe assets."
   
   "Debt overhang" was absent from my definition.
   
   


2. I claimed that, according to those models, our labor market problems would be absent if only employers were charging less for the goods their employees make. "Price stickiness" stops them from doing so.
   


3. Assuming the New Keynesian models were correct, I offered a calculation of what the CPI would have been if prices had been fully flexible.
   


4. I claimed that, with the passage of time, prices and wages in the New Keynesian model would fall, thereby moving in the direction of what a fully flexible CPI would have done.
   

Professor Krugman would have his readers believe that, among other things, none of the above items are correct. My purpose here is to provide further evidence on items 1-4 so that readers might decide for themselves.

1. Definition. By "New Keynesian," I had in mind neoclassical growth models with flexible wages but augmented with Calvo-type staggered price setting (I have written separately about sticky wage models).
   
   
   

   According to Clarida, Gali, and Gertler's 1999 Journal of Economic Literature article, those setups are workhorses in the "New Keynesian" (their terminology, not mine) literature. More recently, Woodford (2010) used such a model to characterize the government expenditure multiplier and Eggertsson (2010) use such a model to describe the recent recession as a consequence of a time preference shock (and perhaps also in increase in the willingness to work).
   

   
   

   In case you are wondering whether Professor Woodford and Dr. Eggertsson have received Professor Krugman's seal of approval, click here and here.
   

   
   
   The Clarida, Gali, Gertler survey, the Woodford paper, the Eggertsson paper, and many other papers that call themselves "New Keynesian" feature sluggish price adjustment, and make no mention of "debt overhang."
   
   A number of economists, including myself, have written about debt overhang in FULLY FLEXIBLE price models, and did not describe their analysis as "New Keynesian." I think that debt overhang has a lot to do with this recession, but nothing to do with New Keynesian economics. So I see absolutely no reason to revise the accepted definition of New Keynesian.
   
   


2. If only prices were flexible. In order to see that my claim (2) is correct for the above defined models, take a look at Eggertsson (2010), p. 8. His equations (21) and (25) describe the impact of the time preference shock (embodied in his rs*) on output and labor.
   
   
   
   
   
   1. In each equation, the size of the impact depends on the speed of price adjustment as parameterized by k. The more flexible are prices, the larger is k. Think of fully flexible prices as k à¥.
      
   
   
   2. Equations (23) and (25) show that a time preference shock of a given size has no effect on labor in the fully flexible price limit k à ¥. In other words, the model blames the recession on the combination of sticky prices and the time preference shock: eliminate either of those, and there would have been no recession.
      


3. Fully flexible hypothetical. Assuming for the sake of argument that the recession is to be blamed on price stickiness (i.e., labor would have followed its previous trend but for price stickiness), I calculated the flexible price hypothetical by using a money demand function that relates the quantity of money to the price level, output (which is the same as labor in Eggertsson's model), and nominal interest rates. The percentage gap between actual and hypothetical CPI is equal to the percentage gap that labor has fallen short of trend (about 10) times the income elasticity of money demand (about one) times the elasticity of output with respect to labor (about ¾) plus an interest rate term (I assumed that money demand is insensitive to interest rates in the relevant range).
   


4. Deflation will continue as long as the recession does. I gave the intuition in my original article, but that's too much "bar talk" for Professor Krugman, so let's look at Eggertsson's equations again. His equations (23) and (25) say that the inflation rate has the same sign as the deviation of labor from its steady state. Since a recession is a negative deviation for labor, inflation must be negative.
   

For more of my critiques of New Keynesian models of recessions, see here and here.

New Keynesian Economics Misses the Point, for Now

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Our labor market has long-term problems that are not addressed by Keynesian economic theory. New Keynesian economics is built on the assumption that employers charge too much for the products that their employees make and are too slow to cut their prices when demand falls. With prices too high, customers are discouraged from buying, especially during recessions, and there is not enough demand to maintain employment.

When the financial crisis hit in 2008, the New Keynesian “sticky price” story had some plausibility because economic conditions were, in fact, deflationary (although I have my doubts about other aspects of their theory). That is, the demand for safe assets surged in 2008, which means that those assets had to become expensive or, equivalently, goods had to get cheaper in order to clear the market.

Normally the Federal Reserve could expand the money supply to satisfy the extra demand for safe assets, so consumer prices wouldn’t have to fall to maintain employment. But the financial crisis was severe enough that the Fed’s best efforts would not be enough.

At the time, New Keynesian fears seem to have been realized: consumer prices had to fall to maintain employment, but too few employers were willing or able to make the price cuts quickly enough. The result was going to be a severe recession that could be partly cured, in the short term, by fiscal stimulus or, in the longer term, as more companies had the time needed to cut their prices.

The red line in the chart below shows the consumer price index that, according to New Keynesian theory, was needed to maintain employment. I have rescaled the index to be based in December 2007, when the recession began: a value of 96 means consumer prices were 4 percent below what they were in December 2007.

In theory, the index of consumer prices had to fall eight percent below their peak (of almost 104) in the summer of 2008 to maintain employment. (I measure all consumer prices here, not merely the “core” price index that excludes fuel and many other items, because the excluded items provide jobs, too.)

The blue line shows actual consumer prices. We readily see the “downward pressure” on consumer prices at the end of 2008, because, in fact, prices stopped rising and actually fell a couple of percent.

But New Keynesians say that with the eight percent drop needed to maintain employment, the blue line needed to fall as much as the red, and a drop that large would take more time. In the meantime, employment would be low and employers would enjoy cheap labor for a while, as so many unemployed people were desperate to work.

But the availability of cheap labor would eventually give employers room to cut their prices – in theory the blue and red series would converge and employment would eventually return to previous levels.

Early on, I thought the New Keynesian theory was wrong because I didn’t see that employers perceived labor to be cheap. Federal law had increased minimum wages three times in and around the recession. A number of other public policies made labor more expensive. My fellow blogger Nancy Folbre has written that American labor looks increasingly expensive compared with potential workers abroad.

The price chart above shows little or no tendency for the blue series to converge with the red one, because, contrary to the theory, high unemployment rates have not caused employers to perceive labor as cheap.

The low employment rates we have today are too persistent to be blamed on price adjustment lags (I have similar reservations about another business-cycle theory: “job search” theory says that jobs are there to be found, but that unemployed people have not been lucky enough to look in the right places).

Our labor-market problems may not disappear by themselves and are not addressed by New Keynesian theory.

Who Cares About Inflation?

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Normally, inflation is one of the most harmful taxes, but these days inflation may do less harm than good.

During most of our lifetimes, the prices of things we buy have generally increased over time. We can name some exceptions, but most items (even houses) have prices that are higher now than they were 10, 20 or 30 years ago. This general increase in consumer prices is called inflation.

The Federal Reserve is charged with limiting the rate of inflation, which it can do over the long run by limiting the supply of money and similar assets in the hands of the public.

Inflation is widely disliked. A number of economists think that inflation’s bad reputation is undeserved, and that, while people complain that inflation makes things more expensive, they fail to recognize that inflation also raises their wages.

The net result of inflation could be to increase wages and prices in the same proportion, without harming consumer’s purchasing power.

A person on a fixed income, such as a pensioner receiving a specific number of dollars a month – a so-called “defined benefit” pension – does have less purchasing power when prices rise. However, Social Security benefits automatically increase with wages in the economy, and thereby automatically increase with inflation in the long run.

And these days defined-benefit pensions are less common than they used to be (and even many defined-benefit pensions were adjusted for inflation on an ad-hoc basis).

We also have to remember that for everyone receiving a payment specified in dollars, there’s someone else making those payments. For example, a worker with a fixed mortgage payment sees that payment decline as a share of his income as inflation pushes up his wages. For this reason, inflation is said to favor debtors and harm creditors.

The government is a major debtor, and some people suggest that sudden inflation would relieve the government’s debt burden and permit the government to spend more (prolonged inflation would just require the government to pay higher interest rates on its debt).

More government spending is bad news for those who want the government to spend less, and good news for those who want the government to spend more. In any case, my research suggests that inflation is not associated with more government spending.

Even if our government had no debt, inflation would increase tax revenue. Ronald Reagan famously complained about “bracket creep”: the personal income tax was not automatically indexed to inflation, so taxpayers moved into higher tax brackets as inflation raised their incomes, even though the extra income was barely enough to keep up with rising prices.

Much of the personal income tax is now indexed to inflation. But interest and capital gains are not indexed (neither are some provisions of the corporate income-tax code), so inflation increases the tax burden on saving and investment.

Consider, for example, a zero-inflation economy in which homes and business normally sell for what the seller paid when he originally purchased the property. According to our tax laws, those sellers would owe no capital gains tax.

In a 10 percent-inflation-rate economy, assets would appreciate in dollar terms at about 10 percent a year, even though their inflation-adjusted values were constant. When the assets were sold, their accumulated value, including that annual 10 percent gain, would be taxed.

With saving being less profitable thanks to inflation’s back-door income tax hike, people will save and invest less. Inflation’s harm to capital accumulation reduces productivity, and ultimately the inflation-adjusted wages workers receive. Martin Feldstein of Harvard has stressed that America’s capital accumulation was the major loser from 1970s inflation.

Without offsetting Congressional action to revise the tax laws, inflation today would increase the tax burden on capital, and that by itself would reduce investment. But what’s different today from the 1970s is how mortgage debtor troubles – foreclosures of underwater mortgages and the harmful economic activity surrounding them – have reduced gross domestic product and living standards.

At this point, an inflation that harmed banks and helped homeowners might be an overall improvement.

Why the Big Deal About Consumer Spending?

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Economic commentary makes a big deal out of consumer spending, but with little explanation. The many facets of consumer spending are confusing, and public policy often ends up treating the symptoms rather than curing the disease.

Both Republican and Democrat politicians tout their economic policies as ways to put money in the hands of consumers. Unemployment insurance, for example, helps people who are unemployed, of course, but it is also purported to benefit employed people because the unemployment benefits received are spent elsewhere in the economy.

Much of the debate about President Bush’s 2008 tax rebate centered on whether taxpayers would spend it, rather than invest or save it.

But a person receiving money from the government has to do something with the it. And policymakers like to tout investment as healthy for the economy, too. So isn’t investment just as good as spending? Don’t we admire the thrifty more than the spendthrifty?In order to answer these questions, we need to know whether consumer spending has a causal influence on the wider economy – as politicians often suggest – or whether it is a barometer of economic efficiency.

Journalists and commentators often note that consumer spending is more than 80 percent of private-sector spending and more than two-thirds of all spending. Thus, at first glance, it would seem that inducing a person to spend would have a larger impact on gross domestic product than inducing that person to invest.

However, the size of the consumption sector is not evidence of its potency, because any one dollar is necessarily a smaller share of consumer spending than it would be as a share of investment. One dollar either has a larger effect on the smaller investment sector or a smaller effect on the larger consumption sector – the effect on the total economy could well be the same by either route.

Regardless of whether consumer spending stimulates the wider economy, economists generally agree that it is an excellent barometer of the economy. Soviet-style economies sometimes achieved high levels of production but could never be considered successful without permitting high levels of consumer spending.

Consumers tend to spend more when they expect their futures to be successful and tend to tighten their belts when bad times are on the horizon. Consumers vary in terms of where they live, their occupations, their expectations and their spending patterns.

Aggregate consumer spending is a kind of referendum among many different people, and we can tell from the changes in the aggregate whether spending increases outweighed spending decreases.

In this view, a consumer spending drop is a symptom of problems ahead, even if it does not contribute further to the disease.

The distribution of wealth and saving is even more unequal than the distribution of consumer spending; more people are consumers than are investors. For politicians seeking voting majorities, this alone may be a reason why they want to see more money in the hands of consumers rather than in the hands of the relatively small group of investors. But this does not mean that consumer spending stimulates the economy, just that it stimulus incumbents’ re-election.

Nevertheless, Keynesian economists continue to insist that consumer spending is more than a barometer of the economy — that consumer spending is a driver of the economy, and that right now it is a problem for our country every time a person shifts spending away from consumer goods and toward saving.

Regardless of whether Keynesians are correct, they often do not explain themselves. In a way, they agree with me that consumer spending is not the root cause of recessions, because they believe that the real problem is deflation – the tendency for wages, the prices of consumer goods and the prices of investment goods to fall rather than rise – and that deflation is the result of consumers’ belt-tightening.

In the Keynesian view, large sectors of the economy accidentally fail to keep pace with deflation, so wages and prices there end up being too high, compared with wages and prices elsewhere in the economy (or compared with wages and prices expected in the future). The sectors with sticky prices have trouble selling their goods (customers view the goods as too expensive) and workers in sectors with sticky wages have trouble finding a job (potential employers view the workers as too expensive).

Wages and prices are measured in units of money – how many dollar bills or debits to one’s checking account it takes to buy something. So deflation is equivalently a rise in the relative value of money, checking accounts and other liquid guaranteed financial assets (hereafter, I refer to the three as money).

Assuming that deflation is the root problem, Keynesians emphasize consumer spending because they assume that a consumer who doesn’t spend is a consumer who tries to add to her or his holdings of money. With more demand for money, money becomes more valuable and nonfinancial goods and services become less valuable – deflation.

Conversely, when a person is willing to part with her or his money to purchase consumer goods, that reduces the value of money and raises the value of the consumer goods – inflation.

That’s why Keynesians like it when (during a recession) the government borrows money from investors to, say, give funds to the unemployed. They assume that the investors would have held on to money if they had not lent it to the government, and they assume that the unemployed will not hold on to the money they receive in the form of unemployment insurance.

Putting aside the fact that redistribution from investors to the unemployed is a rather indirect means of reducing the relative value of money (that is, creating inflation), Keynesians have assumed, rather than proved, that investors finance their lending to the government out of their money holdings rather than by reducing their purchases of investment goods.

If it were even partly the latter, then the borrow-to-finance-unemployment-benefits policy could itself create deflation as it puts downward pressure on the prices of investment goods.

Regardless of whether you agree with the Keynesian assumptions, the facts fail to confirm their emphasis on consumer spending as a driver of the economy. When the latest recession got under way, hiring fell much more than consumer spending.

More recently, we have seen real consumer spending reach all-time highs, while employment remains lower than it was 10 years ago. All of this is consistent with my view that consumer spending reacted to a bad labor market and rejects the assertion that a consumer spending recovery would bring back the labor market.

Public policy needs to help cure the labor market disease, not merely treat the consumer sector symptoms.

Deflation: 1931 vs. Today

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Deflation has returned this summer, but it’s still nothing like what happened in the Great Depression years of 1929-33.

During most of our lifetimes, the prices of things we buy have generally increased over time. We can name some exceptions, but otherwise most items (even houses) carry prices that are higher now than they were 10, 20 or 30 years ago.

This general increase in consumer prices — often called inflation — has become familiar. Employees expect regular pay raises, and employers can normally afford them because they are increasing the prices of the products they sell.

On rare occasions, consumer price trends suddenly change directions.

One occasion was 1929. Consumer prices were pretty constant during the 1920s. The chart below picks up the story in January 1929 with the red line. That line measures the seasonally unadjusted consumer price index in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 97.9 in April 1929 means that prices then were 2.1 percent lower than they would be in October).

Prices were heading up in the spring and summer of 1929, during which time lenders might have expected that the typical homeowner would obtain a pay raise and the typical farmer would someday fetch more for his crops — in both cases making it easy for them to pay their respective mortgages.

In the fall of 1929, the inflation stopped and prices headed down (incidentally, that’s when the Great Depression began), falling almost every month for nearly four years. By the summer of 1931, when the Depression was about two years old, this deflation had brought prices down almost 13 percent from their 1929 peak. It was difficult for homeowners and farmers to make mortgage payments as their income fell sharply.

The blue line in the chart shows the consumer price index for 2008-10. Like the 1929 series, the 2008 series is normalized so that October is 100.

The chart shows that consumer prices also rose in the spring and early summer of 2008. Inflation had stopped by the fall, and consumer prices headed down. Unlike the deflation of 1929, the deflation of 2008 lasted only a couple of months, after which time consumer prices increased for more than a year.

On Friday, the Bureau of Labor Statistics reported that consumer prices had fallen three months in a row since March 2010. That’s not good news, because our economy could benefit from some inflation. But the silver lining is that the latest deflation is mild, and so far short-lived.

Don't Fear the Next Inflation, If It Comes

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Economists disagree about the prospects for inflation. But inflation may be something to welcome, not fear.

Prices in the economy ultimately depend on the demand for goods relative to the demand for dollars and related assets (such as Treasury securities) whose values are specified in dollars. Prices in the economy increase – that is, there is inflation – when demand for goods increases more than demand for dollars and related assets.

Economists agree that the deflation of 2008-9 – when prices fell in the economy – resulted from a “flight to quality,” a rather sudden reduction in demand for goods and increase in demand for dollars. They agree that, in principle, inflation will occur in the future if demand suddenly shifts in the opposite direction.

But there is a lot of debate as to what will happen to the relative demand for goods, and therefore disagreement about the future of inflation. Some economists say investors over the next several years will continue to demand dollars, so future deflation is the more likely danger. Continued glimpses of deflation – such as the fall in the consumer price index from April to May 2010 – give some support to that view.



Other economists, including John Cochrane of the University of Chicago in this recent paper, say our government budget is on an unsustainable path, with lots of public spending promised and elected officials who lack the political will to raise taxes. The Treasury, they say, will make ends meet by flooding the market with Treasury securities, thereby causing inflation.

Clearly our government has promised a lot of public medical care, as well as much spending on pensions both for future Social Security recipients and for retired public employees. Few elected officials want to crusade for higher taxes. But our aging population and public medical spending that grows faster than the rest of the economy are nothing new to 2010.

History certainly has examples of high inflation that resulted from dire fiscal situations. But there are also many examples of governments that fueled new spending programs by raising taxes or by cutting other spending. Our government may well raise taxes, cut military spending or cut spending on certain types of health care.

So the real question is whether the economic damage from inflation is more or less than the economic damage of raising payroll taxes, implementing a national sales tax or paring some of the government’s spending promises.

The answer is that inflation is less costly now than it usually is. Inflation would alleviate some damage done by the housing market to the wider economy. Specifically, inflation would raise prices of homes, among other things. Higher housing prices would pull a number of mortgages out from under water – the case when more is owed on a mortgage than the market value of the house that collateralizes it – and thereby reduce the number of foreclosures.

So even if our government had its fiscal house in order, the reason to expect inflation is that inflation wouldn’t be so bad right now.

TIPS expected inflation

Often I see bloggers say that expected inflation is low, because treasury securities have similar yields regardless of whether they are indexed for inflation (inflation adjusted Treasury securities are called "TIPS").

The logic to the calculation makes a lot of sense, and the Cleveland Fed appreciated the logic so much that they sponsored an expected inflation estimate. But here's what the Cleveland fed says now:

"TIPS Expected Inflation Estimates
October 31, 2008
We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates."

Gullible New Keynesians? Or Tax Collector Windfall?

Incentives Matter, Period
Long before Adam Smith, people learned that incentives matter. If a person cannot keep enough of the fruits of his efforts, he will not put forth the effort in the first place.

Kings, emperors, sharecropper landlords, treasury secretaries, slave owners, and many others over the ages understood that they maximize their tax collections by limiting their tax rate to something less than 100 percent. Even the so-called Communist Chinese government appreciates this. An economy with excessive tax rates will necessarily be an economy that produces far less than its potential, and ultimately produces little revenue for its tax collectors.

This impeccable logic, supported by centuries of experience around the world, includes nothing about “interest rates,” nothing about the “Federal Reserve,” and nothing about the “zero lower bound.” In the grand scope of human experience, the Federal Reserve (a U.S. institution that was absent for most of its history) is at most a minor footnote.

Yet now a few New Keynesian economists are telling us that hiking tax rates raises income and labor usage (sic). Their logic hinges critically on an esoteric theory of the Federal Reserve. Without evidence, they believe, and would have you believe, that the Federal Reserve’s situation can turn the impeccable logic of incentives on its head.

[Hereafter, for brevity I refer to those making this argument as “New Keynesians”, but please recognize that many New Keynesians such as Professor Mankiw are not so gullible as to conclude that incentives don’t matter. For now, I am not naming the gullible, in order to give them more time to pause and see the big picture].


Incentives from the (Usual) Macro Perspective
That incentives matter is not just a microeconomics point. If you have a large group of people (members of a kibbutz, citizens of the Soviet Union, etc.), each of whom has little incentive to work, the aggregate result for the group will be low output and low living standards.

The point that incentives matter in the aggregate seems so obvious, but the recent debate about them requires that we revisit each of the logical steps.

Suppose that something happens at the individual level to reduce the supply of labor. An increase in personal income tax rates, or an increase in unemployment benefits, are examples. New Keynesians agree with me that, say, an unemployed individual enjoying higher unemployment benefits will be less willing to accept a low paying job. Or that the substitution effect of a higher personal income tax rate is to cause people to put forth less of the effort that produces that income, unless the rate hike were offset by higher pre-tax pay.

As each individual supplies less labor, wages rise as employers compete for the smaller labor pool.

We usually say that the prices of the goods produced by those employers would rise with wages, or that employers would take other steps (suspending advertising, sales, discounts, reducing product quality, etc.) to reduce the volume of goods they deliver to customers (after all, the wage increase is reducing the profit they earn from delivering each unit). This process may not be exactly as in the undergrad textbook – that is, volume may react a bit less (or a bit more) than it would if prices increased one-for-one with wages – but the basic point is that higher costs ultimately and significantly reduce production and sales.

So the macro story, as most economists understand it, ends with less labor usage and output. And the basic conclusion that higher costs reduce production has been supported by decades of experience and economic measurement.

The New Keynesian Miracle
Nevertheless, the New Keynesians depart from me at this point. They say that, in response to higher wage costs, employers/producers will do essentially nothing in the short term to raise prices or otherwise reduce their production and sales. In the longer term, employers/producers will pass on their wage costs to costumers, and those costumers understand that they must buy now before the producers can adjust. This extra spending by the customers actually induces employers to produce more in the short run, and thereby employ more in the short run.

Thus we have quite a miracle. A greater tax on personal income increases aggregate income (even if the revenue from that tax is given back to taxpayers), because they have an individual incentive to earn less!

A tax rate cut would reduce income. The logic is the same: tax cut --> more labor supply --> lower costs and anticipation of lower prices --> less spending --> less production and labor usage.

Putting the Federal Reserve in the Picture
Like encounters with aliens, the New Keynesian miracle is said to occur in only specific situations when the skeptics happen to be looking elsewhere. Normally, they say, the Federal Reserve would respond to the labor supply shock by adjusting the nominal interest rate. When something reduced labor supply at the individual level, the Federal Reserve would normally raise the nominal interest rate to choke off the additional spending that would otherwise appear in the New Keynesian story.

When something increased labor supply at the individual level, the Federal Reserve would reduce the nominal interest rate to encourage the spending that (in the New Keynesian story) consumers would otherwise hold back until prices fell. That’s where the “zero lower bound” comes in – it supposedly prevents the Federal Reserve from reacting in this last step.

For this theory, it doesn’t matter whether the interest rate were stuck at zero, one, two, or ten. Nor is the “reason” for the interest rate’s being stuck relevant. The critical assumption is that nominal interest rates do not adjust in reaction to a shift in labor supply.


Tax Collectors’ Dream Come True
To recap, New Keynesians tell us that income and labor usage increase when something reduces labor supply at the individual level, as long as the nominal interest rate does not adjust upward.

This miracle is exactly what centuries of tax collectors have dreamed about. They could take a larger share of the economic pie and in doing so make the pie grow! All they have to do is make sure that the nominal interest rate cannot adjust upward.

That leaves us with the question. Is it a great misfortune of history that the New Keynesian miracle was not discovered until 2009?

Or have tax collectors over the years understood what New Keynesians do not: incentives matter, regardless of whether there’s a Federal Reserve, and regardless of the details of how nominal interest rates adjust?

Question About Deflation

Robert asks
"In our industry, the manufacturers claim to be holding prices, but are quietly making all kinds of deals to "help" us be more competitive.

Our competitors are taking those incentives and chasing prospects with what appears to the dealer to be lower prices across the board.

This is new behavior. For the past 8 years, no one really asked what the price was. Currently it's the prime topic.

Then I went online and ordered a pizza from pizzahut Friday. Suddenly every pizza is $10, half the price of the past few years. If that's a short term promotion were ok. If that's the new reality, are we in trouble?"

Let me rephrase Robert's post as three questions:

(1) Is deflation -- that is, a general decline of all prices (both the prices at which we buy, and those at which we sell) -- a problem? Theoretically, it is not a big problem, but just redistributes wealth from those with dollar-denominated liabilities to those with dollar denominated assets. However, this recession arguably got going because of the "underwater mortgages/foreclosure" problem -- a problem that get's better with inflation and worse with deflation. For more on this, see "Inflation, we need you!".

(2) Is there deflation right now, or will there be in the near future? I think we have a bit of inflation right now, and expect more inflation in the next couple of years (see here). It's always a bit difficult to know the inflation/deflation rate precisely, because a lot of price changes can be pretty subtle, as with the promotional discounts indicated in Robert's post. But the Bureau of Economic Analysis and the Dept of Labor have enough serious ways of measuring it that, together with the recent commodity price inflation, I am confident that we do have inflation.

(3) If not general deflation, what is Robert supposed to make of his observations? It's no surprise that various manufacturing prices have been falling a bit over 2009, after falling significantly at the end of 2008. If he's seeing more drops than a "bit" then that's some bad news for his segment of manufacturing.

(4) The pizza bargains may indicate that his region's economy is tougher than the national average, or merely that Robert hasn't purchased a pizza for a year or two (maybe the case -- that's about the time frame he wedded his lovely bride!!).

PPI For Housing Construction

The housing PPI looks pretty flat over the last six months. That is one indicator that housing prices will be flat, which means that mortgages will not be going further underwater.



The bad news is that the housing PPI in the last six months has not participated in the moderate inflation seen in the wider economy over the last six months, which suggests that housing prices have not yet participated in that inflation.

Update of CPI comparison

Today we learned that the NSA (SA) CPI was down (up) a little in July, but still higher than it was in any month Nov - May.

Fed Independence Debate

For a long time, I thought the Federal Reserve was largely independent from the federal government, that it was heavily influenced by the banking industry, and that overall the public was better off from that arrangement, as compared to an arrangement where the Fed was an agency under the direction of the President, or under the direction of Congress.

This fall I saw the Fed chairman and Treasury secretary come arm-in-arm to steal $700 billion from the taxpayer, so I am wondering whether my long-time view was incorrect.

But assuming I was right in the first place, you might be interested in supporting this petition:

https://survey.chicagobooth.edu/ViewsFlash/servlet/viewsflash?cmd=showform&pollid=gfm!FedIndependence

That's Better!

Here's my 1930s comparison of NSA CPIs.



Seasonally adjusted, inflation is at a 2.7 percent annual rate over the period December 2008-June 2009.

PPI shows significant inflation

This morning the BLS released it's Producer Price index for June, which was 1.8 percent higher than in May. That's the largest monthly increase in quite a while.

The PPI for residential construction also increased modestly May-June, although it is still lower than it was in most of 2008 and early 2009. Higher residential construction prices (even if they are lower relative to the overall CPI or the overall PPI) likely mean that housing prices are higher. Maybe the biggest problem in our economy is that housing prices are low relative to the mortgage debt they collateralize.

Inflation is a good thing right now!

Inflation and Investor Sentiment

Copyright, The New York Times Company

The easy monetary policy at the end of 2008 has set up our economy for inflation, but the timing depends in part on how investors behave.

Last week I showed how the Federal Reserve dramatically expanded the monetary base (that is, the value of currency, coin and Federal Reserve deposits) at the end of 2008, and how nothing like this occurred during the onset of the Great Depression of the 1930s.

Still, even though monetary policy is so different in this recession as compared with the policies of the 1930s, inflation has not yet been very different.

During most of our lifetimes, there has been inflation: The prices of things we buy have generally increased over time. Only on rare occasions have consumer price trends suddenly changed directions.

One of those occasions was 1929.

Consumer prices were pretty constant in the 1920s. The chart below picks up the story in January 1929 with the red line. That line measures the (seasonally unadjusted) consumer price index in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 97.9 in April 1929 means that prices then were 2.1 percent lower than they would be in October).

In the fall of 1929, the inflation stopped (incidentally, the stock market crashed in late October of that year) and prices headed down, falling almost every month for almost four years.

For the first 15 months or so of this recession, consumer prices have followed a similar pattern. The blue series in the chart shows the consumer price index for 2008 and 2009. Like the 1929 series, the 2008 series is normalized so that October is 100.

The chart shows how consumer prices also rose in the spring and early summer of 2008. Inflation had stopped by the fall (there was a stock market crash in October 2008, too), and consumer prices headed down. In fact, the deflation at the end of 2008 brought prices down more than 4 percent in a couple of months, as compared with a 1 percent drop at the end of 1929.

The actions of the Federal Reserve and its chairman Ben S. Bernanke guarantee that we will not experience a four-year deflation like that of the Great Depression. But investor sentiment is an important reason why the short-run inflation patterns have been similar in 2008-’09 to what they were in 1929-’30.

During both episodes, investors had a sudden reduction in their willingness to hold private sector debt and equity and to purchase goods, and a sudden increase in their desire to hold “quality” assets like Treasury bills.

An increase in Treasury bill prices is one way markets adjust to this change in demand — and we saw this in September through December of last year — but another market adjustment is for the prices of goods, equities, and private sector debt to fall (or rise less than they would have) as investors pull their money out of these categories. Deflation is, by definition, a drop in goods prices.

Part of the next inflation may be the reverse of this process: Investors suddenly shift their demands from “quality” assets back to equities, private sector debt and goods. As some of the commenters explained last week, a sudden investor shift like this will be associated with a sharp reduction in the value of the dollar.

If I could predict exactly when investor demands will shift away from “quality” assets, both I and the readers of this blog might get as rich as the billionaire financier Warren E. Buffett. But recognizing the role of investor sentiment at least helps us appreciate why the timing of the next inflation is so uncertain.