Wednesday, April 27, 2011

How the Economy Works

That's the title of a book I just finished reading and I have mentioned it recently in my macro classes. Here is the link to the Amazon page: How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies. It is by Roger Farmer, who is the chairman of the UCLA economics department.

If you have taken principles of macroeconomics and want to learn more, this book might be a good place to start. Here is the summary from Amazon:

"Farmer explains the differences between classical and Keynesian economics and shows how they influenced the policy debate that developed after the 2007 world financial crisis began and exploded into a global disaster, with the collapse in the U.S. of Lehman Brothers in the fall of 2008. Along with a history of economic thought from 1776 to the present (noting it is incomplete), the author offers his suggestions for preventing future financial crises. “The correct response to the crisis is to set in place, in every country in the world, an institution to control the value of national stock market wealth by targeting the rate of growth of an index fund.” “Central banks should use changes in the size of their balance sheets to prevent inflation from rising too high or too low. They should use changes in the composition of their balance sheets to prevent bubbles and crashes.” This challenging book will appeal to the academic community but not to a broad range of readers."

Sunday, April 24, 2011

There's A New Book On The Economics Of College Sports

It is called Big-Time Sports in American Universities, by Charles T. Clotfelter. It was just reviewed in The Wall Street Journal. See Calculating the Score.

Here are some excerpts from that review:

"Pity the poor presidents of colleges with major athletic programs. Football coaches are not just better known than the administrators, the coaches also tend to make a lot more money. And professors lag even further behind. In 1986, the presidents at 44 public universities with teams in the five most established athletic conferences actually made, on average, a little more than their coaches: $294,000 for the presidents, $273,000 for the coaches; full professors earned about $107,000. By 2010, the professors' income, adjusted for inflation, had climbed 32%. University presidents' pay had gone up 90%. The football coaches' pay jumped to more than $2 million—it had "increased by an astounding seven and a half times," Charles T. Clotfelter writes in "Big-Time Sports in American Universities.""

"The book's central theme is that the time has come to end the strange dichotomy on college campuses, where athletic and educational departments exist in parallel universes and regard each other warily. University leaders "typically ignore" athletics "when putting together a formal statement listing their institution's essential functions and objectives."

The unwillingness to acknowledge the centrality of major sports on many campuses makes no sense. Football and basketball teams are, for starters, a huge physical presence, with their gigantic stadiums (Bryant-Denny Stadium at Alabama seats 102,000) and large arenas (the Dean Dome at the University of North Carolina holds nearly 22,000). "Whether or not universities like to admit it," Mr. Clotfelter says, "big-time athletics must be counted as one of their significant activities.""

"And one of their significant economic centers. The author notes that critics complain "how few big-time programs break even or make a profit." Sounds scandalous, right? Despite millions that pour in from TV contracts, merchandise and ticket sales, and other sources, athletic departments barely make ends meet. But as Mr. Clotfelter observes, "arbitrary administrative decisions"—like billing the athletic department for students' phys-ed classes—muddle any net-profit analysis. And there's no way to measure the role that a high-profile team might play in attracting better students and alumni donations."

"At 58 universities with major athletic programs in 2010, 72% of students graduated, but only 56% of football players and 42% of basketball players received a diploma."

Friday, April 22, 2011

Can The Fed Prevent Inflation By Paying Banks Interest On Their Excess Reserves?

This week in my macro classes we covered the Federal Reserve (Fed) policy tools that are used to control the money supply in the economy. Ceteris paribus, the more money in the economy the more aggregatge demand (AD) we have. To see how this affects the economy, go to this post from back in 2009 Fed Officials Disagree On Threat Of Inflation. It shows a graph that explains how AD affects the economy.

The Fed sets the "required reserve ratio." This tells banks what percentage of their deposits they must keep on reserve. If they keep more on reserve than they have to, the extra amount is called excess reserves. The Fed now pays banks interest on these excess reserves.

But lately, banks have been keeping alot of excess reserves. This is because of the recession and the financial crisis. Banks want to make sure they have enough on reserve and are leary of lending too much money. The borrowers might not be able to pay it back. And businesses and consumers have been reluctant to borrow since they too fear they might not be able to pay it back.

To see a good chart on excess reserves, go to Why Are Banks Holding So Many Excess Reserves And Will Those Reserves Fuel Future Inflation? (from the blog "Carpe Diem" by economist Mark Perry). The chart shows that until about the middle of 2008, excess reserves were about zero. Now they are over $1 trillion.

But what might happen if the economy starts to improve and everyone gains confidence. Then banks start lending alot more money and spending increases rapidly. Could this cause inflation? One view is that the Fed just has to raise the interest rate it pays banks on excess reserves to keep them from lending too much. The banks will prefer to keep the excess reserves and earn income from the interest rate rather than lend it out. This would keep AD from increasing past the full-employment GDP into the steep part of the short-run aggregate supply curve (see the post I mention above).

Wednesday, April 20, 2011

The Possible Impact Of A Lower Credit Rating For The U.S. Government

Last week I talked about problems the national debt might cause. Now this week Standard & Poors says that the government has a one in three chance of seeing it lose its AAA rating (the best rating).


U.S. debt finally draws serious warning by Terry Savage, a financial columnist for The Chicago Sun-Times


Debt worries turn up heat on Congress to act by Jim Spencer of Minneapolis Star Tribune.

Here is an excerpt from Spencer:

"For financial experts and political combatants here and in Minnesota, Monday's double dose of fiscal foreboding carried an unmistakable warning: Do something about the nation's debt.

The day began with news of a possible downgrade in the nation's credit rating and quickly turned into the stock market's worst day in a month as traders reacted to growing doubts that leaders in Washington could find a way out of the debt crisis.

"This was people on Wall Street [speaking] who are agnostic on politics," said U.S. Rep. Tim Walz, D-Minn. "Either we listen to what they said [Monday] or we pay a horrific price."

When Standard & Poor's switched its outlook on the nation's AAA credit rating from stable to negative, it raised the possibility that Americans could find more of their taxes spent on interest instead of public services. The cost of loans to consumers, government and businesses would go up, as well, suppressing an already fragile economic recovery.

"It's kind of scary," said Murray Frank, a University of Minnesota finance professor, adding that the announcement "is taking one of the central pillars of the world's economy and saying it is not grounded.""

Now one from Savage:

"Interest on the national debt is the third-largest federal spending category. In the last 12 months, the Treasury has paid more than $400 billion in interest — and rates are currently at historically low levels. A ratings drop could cost the taxpayers billions in extra interest payments every year. Worse, the higher rates needed to entice borrowers also would negatively affect our economy.

The United States still maintains its “triple A” bond rating, but the downgrade warning signifies concern that Congress will not act prudently to rein in deficit spending.

In its statement, S&P emphasized “the importance of timely bipartisan cooperation and action on fiscal reform.”"

The Wall Street Journal has an article with a chart showing how annual interest payments on the debt will change in the near future. They also say that it was $200 billion this past year. See As Budget Battle Rages On, a Quiet Cancer Grows

Sunday, April 17, 2011

What Do Men In China Need To Get A Bride?

See For Many Chinese Men, No Deed Means No Dates from the NY Times. Excerpts:

"Although there are few concrete ways to measure the scope of involuntary bachelorhood, more than 70 percent of single women in a recent survey said they would tie the knot only with a prospective husband who owned a home.

Among the qualities they seek in a mate, 50 percent said that financial considerations ranked above all else, with good morals and personality falling beneath the top three requirements. (Not surprisingly, 54 percent of single men ranked beauty first, according to the report, which surveyed 32,000 people and was jointly issued by the Chinese Research Association of Marriage and Family and the All-China Women’s Federation.)

The marriage competition is fierce, and statistically, women hold the cards. Given the nation’s gender imbalance, an outgrowth of a cultural preference for boys and China’s stringent family-planning policies, as many as 24 million men could be perpetual bachelors by 2020, according to the report.

Zhang Yanhong, a matchmaking consultant at Baihe, one of the country’s most popular dating sites, said many disheartened men had simply dropped out of the marriage market.

“This fixation on real estate has twisted the popular notion of love and marriage,” she said. “Women are putting economic factors above everything else when looking for a mate, and this is not a good thing for relationships or for society.”"

"Many women are unapologetic about their priorities, citing the age-old tradition in which men provided a home for their brides, even if that home came with a mother-in-law."

"With such women on the prowl, even men who do have their own homes have come up with techniques to weed out the covetous and the inordinately materialistic."

Friday, April 15, 2011

Do We Need To Raise Taxes On The Wealthy?

I submitted an op-ed article to the San Antonio Express-News about this issue. It looks like it will not get printed. In it, I disagreed with the idea that we need to raise taxes on the wealthy and upper income groups. The article that I responded to was Millionaires and their tax request.

What I submitted is below. One thing I should add is that economist Veronique de Rugy wrote at the Reason magazine site the federal government has never been able to collect 21 percent of GDP in tax revenues. Even in the 1950s when the highest tax rate was over 90%.

"I disagree with investment banker John Kortenhaus who wants to increase taxes on the wealthy (“Millionaires and their tax request,” April 2).

For one, he says “trickle-down” economics doesn’t work, that the spending of the rich won’t create jobs. But we would have to compare this to how well government spending creates jobs and some economists are skeptical of that, too. There is no guarantee that the federal government will spend the money wisely.

Then he says “the wealthy ought to pay progressively higher percentages of their incomes in taxes because they benefit more” from government. It might be true the rich get more from government, but that does not necessarily prove progressive taxes are a good idea.

Let’s look at a flat-rate tax system. With a tax rate of 20%, someone earning $100,000 pays $20,000 in taxes, ten times what someone who earns $10,000 pays.

That seems equitable: You make ten times as much, so you benefit ten times as much from government. Paying ten times as much in taxes covers your benefits.

I am not aware of any scientific study that proves the rich receive disproportionate benefits from government.

He also says “many inherited their wealth.” But according to the book The Economics of Macro Issues, “current living standards are chiefly determined by the incomes people have earned for themselves” and not inheritance.

He then also says some inventors are lucky and don’t deserve their high incomes. But how would the government figure out who was lucky and should have to pay progressive taxes and who was not lucky?

I don’t think they could and making all high-income people pay progressive tax rates and punishing some who don’t deserve it seems like using guilt by association.

Maybe someone like Bill Gates could not have gotten so rich one-hundred years ago since there were no computers.

This only shows that all of us are much better off than people once were. It does not tell us that the rich have disproportionately benefited from progress. The typical low-income person is also much better off now, too.

Where does all this progress come from? Partly from entrepreneurs, some of the people Mr. Kortenhaus wants to tax so much.

Recently the eminent economic historian Deirdre McCloskey said around the year 1800 economic growth took off because societies started to treat entrepreneurs, their innovations and their drive to earn high incomes with dignity.

High taxes on the rich might hurt the innovation that benefits us all. Is punishing them a good vision for America?

We have income mobility, too. From 2001-2007, 44% of the top income earners fell out of the top bracket (top fifth). High incomes may be fleeting. Why punish some for having a good year with extra-high taxes?

Relying too much on the rich for tax revenue can hurt budgets in a recession. The Wall Street Journal recently reported that high income earners saw even bigger losses than everyone else in the recession. That partly explains the big deficits in many states.

In 2007, 37% of federal income tax revenue came from the top 1% of income earners. If we tried to get even more revenue from them, when the next recession hits and they see larger than average income drops, the federal deficit will grow even more.

I do agree with him on eliminating some deductions and loopholes that allow the rich to pay less in taxes, but let’s be careful before we make the system even more progressive.

Finally, full disclosure: I am not a millionaire even though the one car I own is a Honda Civic."

Wednesday, April 13, 2011

Why is college so hard?

This was a guest column I wrote that appeared on The Ranger website (that is the school paper for San Antonio College). Here is the link:

Why is college so hard?

Sunday, April 10, 2011

Smokers and the obese cheaper to care for, study shows

See Smokers and the obese cheaper to care for, study shows from the New York Times. The idea is that the healthy live longer and that tips the scales to make them more costly. Excerpt:

"The researchers found that from age 20 to 56, obese people racked up the most expensive health costs. But because both the smokers and the obese people died sooner than the healthy group, it cost less to treat them in the long run.

On average, healthy people lived 84 years. Smokers lived about 77 years and obese people lived about 80 years. Smokers and obese people tended to have more heart disease than the healthy people.

Cancer incidence, except for lung cancer, was the same in all three groups. Obese people had the most diabetes, and healthy people had the most strokes. Ultimately, the thin and healthy group cost the most, about $417,000, from age 20 on.

The cost of care for obese people was $371,000, and for smokers, about $326,000.

The results counter the common perception that preventing obesity will save health systems worldwide millions of dollars."

Friday, April 08, 2011

Why High Taxes To Pay Back The Debt Might Be A Problem For Economic Efficiency And Future Economic Growth

This is a continuation of Wednesday's topic.

Suppose that you buy a new shirt every month for $20. But now there is a high tax on shirts to help pay back the debt so that the price is $35. You might not buy that new shirt. Many other people might not, either. Then some stores go out of business and some t-shirt makers lay off workers. This will slow down economic growth in the future.

Also, if taxes are especially high, businesses will have less incentive to invest (build new factories, stores, restaurants, buy new capital, etc.). Less capital means less economic growth. The problem with taxes is that each incremental tax increase causes more harm to economic efficiency than the previous increase (and probably harms economic growth more). I will explain more of this below.

But also remember that just a small drop in the growth rate hurts us in the long run. For example, in the last 30 years or so, the annual growth rate in the real GDP in the U.S.has been about 2.8%. If per capita GDP goes up 1 percentage point less than that to take population growth into account, we would have a per capita growth rate per year of 1.8%.

If 30 years ago per capita GDP was $27,500 then today it would be about $46,900 (actually close to what it really was last year). But what if we had only grown 1.3% per year? The per capita GDP would be only $40,500. That would be $6,000 less, which is big and that kind of difference just keeps getting bigger over time and that is only a .5% lower growth. This big difference is due to compound interest.

Below is a letter to the editor of the WSJ I wrote a few years ago. It helps explain the exponentially growing damage that taxes cause:

"Stephen Moore did a great job explaining how complicated our tax code is and how high taxes have gotten relative to what was originally promised in 1913. One other way to see the insidiousness of taxes is to realize that they are just as much the "noise" in the economy as prices are the "signals." The income you get paid is the price for your services and therefore signals the value of those services. But taxes reduce the clarity of that signal (hence, they are noise) by reducing how much of your pay you actually get to keep. As taxes increase, the noise-to-signal ratio in the economy increases even more, meaning distortions, and the misallocation of resources they cause increases disproportionately. For example, if the income tax rate is 10%, you keep 90% of your income. The noise-to-signal ratio is .111 (or .1/.9). But if the tax rate goes up by .10, or to 20%, the noise-to-signal ratio goes up even more, by .15 to .25 since you keep 80% of your income. The .25 comes from .20/.80 equaling .25. Another .10 increase in the tax rate increases the noise-to-signal ratio by .179 from .25 to .429. Then going from a 30% tax rate to a 40% tax rate makes it go up by .238, from .429 to .667. Every tax increase causes increasing damage to the economy's ability to efficiently allocate resources."

This is consistent with the fact that deadweight loss also grows exponentially with tax increases. There will be some links to deadweight loss at the end of this post (my students can simply look at the appendix to chapter 3 in their textbooks). But the idea is that a tax on a good causes the problem mentioned above when the price of a shirt increases.

In supply and demand, if an excise tax has to be collected by the seller, the supply line shifts up by the amount of the tax. In the graphs below, the green triangle shows the deadweight loss or the total economic harm from the tax.

In the first graph, the tax on the good is $2 per unit, so the supply curve shifts up by $2 (the red line represents the new supply line). The area of the green deadweight loss triangle is 1 (one-half times the base times the height (I turn it sideways to make a base of 2)).

But in the second graph, the tax is doubled. It is $4 per unit, so the supply curve shifts up by $4. Now the area of the deadweight loss triangle is 4. So we doubled the tax but the damage caused has quadrupled. This shows that tax increases cause exponential damage to economic efficiency, which harms economic growth in the future.

If the supply line gets shifted up by $20 (if taxes were that high), then there would be no market left at all.

Links on deadweight loss:

Deadweight loss

Deadweight loss

Wednesday, April 06, 2011

Gross public debt exceeding about 90% of annual economic output can slow growth

See Reinhart and Rogoff: Higher Debt May Stunt Economic Growth from the WSJ blog last year.

"To all the reasons to worry about the rapid rise in government debt in the wake of the financial crisis, add another: It’ll stunt our growth.

In a new paper presented Monday at the annual meeting of the American Economic Association, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard study the link between different levels of debt and countries’ economic growth over the last two centuries. One finding: Countries with a gross public debt debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections. The U.K.’s gross government debt stood at 69% of GDP in 2009 and is expected to reach 98% of GDP by 2013.

“If history is any guide,” the rising government debt “is very troubling for the U.S. and other advanced economies,” says Ms. Reinhart.

The relationship between government debt burdens and growth is even stronger for emerging-market economies, Ms. Reinhart and Mr. Rogoff find. For countries above the 90% threshold, average annual growth was about three percentage points lower than for countries with public debt of less than 30% of GDP. The countries above the threshold also experienced much higher inflation: prices rose more than twice as fast as in countries with small debt burdens."

I will post more about this on Friday. But the big issue for me is that taxes might have to rise so much that they hurt economic growth. The loss of economic efficiency or deadweight loss grows faster than taxes. That is, every one percentage point increase in the tax rate causes more than a one percentage point increase in deadweight loss.

In the long run, that slows down growth in the economy. Even if the economy only grows 0.1% less or 0.2% less than otherwise, those losses compound every year and after 30 years we start to see big losses in our incomes (or they don't grow to as much as they could have).

Sunday, April 03, 2011

North Dakota Is Number One!

See Why North Dakota May Be the Best State in the Country to Live In. The state has the lowest unemployment rate (3.8%), in 2009 had the third highest GDP growth rate, the fourth lowest crime rate and the state government has a budget surplus. Why?
"North Dakota's economic good fortune is pretty much a function of being a major producer of two very in-demand commodities: wheat and oil, both of which have seen huge global price increases. The state is the country's #1 producer of durum wheat -- that's what pasta is made from -- and is also a major grower of other crops including barley, pinto beans, and flaxseed."
But if people really believe that North Dakota is the best state and many of them go there, things won't be very fun due to the crowds (which reminds me of something that Yogi Berra said about a restaurant: "nobody goes there anymore, it's too crowded").

Prices of everything will be bid up. This also illustrates what economist Steven Landsburg calls the "Indifference Principle." "Except when people have unusual tastes or unusual talents, all activities must be equally desirable."

This applies to North Dakota. Once everyone sees it as a good deal, they start going there. Only people with unusual tastes will really enjoy it. That is, you will have to like what that North Dakota has to offer alot more than the average person or the crowds and congestion will erode your enjoyment. It won't be any better than anywhere else to live. Other places will be just as desirable.