Texas Trouble

Paul Krugman recently wrote about a “Texas Tragedy” in relation to the budget cuts that are going to have to be made in the upcoming legislative session in Austin. Certainly this last election in Texas was a farce as the true extent of the budget problems were kept from the voters (in my cynical mind) to ensure a Republican victory and of course the re-election of Governor Rick Perry. And now the alarm bells are certainly ringing loud and clear in all state-funded institutions (including my own), with virtually all planning on hold now until the extent of the cuts is made a little clearer.

But for those like Krugman who live outside of the State, I should start off by saying that there is really one group that is going to be drastically effected in Texas – the poor. For those who “have” and who are educated, the Texas budget crisis is not as bad as might be expected. Certainly at the University level, with several Universities now running early retirement programs, with some programs being abandoned and plans to combine existing programs between Universities in the same geographical proximity, this should yield some savings and so ease the pain. In general educated workers tend to be more mobile as well, so they are likely to head for other states if they are laid off in the private sector. Plus the housing market downtown hasn’t nearly been as bad in Texas as say Florida or Arizona, so there is still considerable mobility.

No, the tragedy of the cuts lies with the poorer segments of the population and the economically dislocated. But more about that in a moment. I first want to explain the way in which budgets are formulated in Texas, which is unusual, to say the least.

In Texas the legislature meets every 2 years for a short period of time in the spring and hammers out the budget as well as any new legislation. This saves money on one front, as paying annual salaries for legislators is not required as it is in most states or Canadian provinces with standing legislatives. But it leads to all sorts of problems on other fronts. First, a budget is not enacted and revised every year ( - the legislature in Texas is in essence currently making 2 budgets – one for 2011 and one for 2012). So when there is an economic downturn, the budget isn’t adjusted gradually, but on a two year basis – hence much larger cuts are likely this year in the state budget given the deficit last year, and this won’t be revised for another 2 years even though the economy could rebound In the second half of 2011, giving the State a surplus in 2012. Second, it also leads to suboptimal lawmaking as well, as laws are made during the legislative session, and then cannot be revised until 2 years later. While I support the idea of a part-time legislature as a cost-saving measure, I do think the legislature should meet at least once a year, perhaps for a short session just to revise budgets and amend existing laws, if needed.

The other thing that I think is a little crazy in Texas is that the State only has a sales tax for general tax collection purposes. Particularly during recessions like the most recent downturn, US consumers retrenched, leading to an increase in the US savings rate, which I (like most other economists) think was a good thing, as the US savings rate has been chronically low for some years and was a source of international economic imbalances. But of course, a higher savings rate really clobbers state revenues, and causes a disproportionate decline in revenues. To make things worse, the state even has a “tax free” weekend in September at the beginning of school year which caused an absolute shopping blitz in 2010 as cash-strapped parents, among others, avoided paying taxes on all clothes and school items.

Texas, like most states, has Balanced Budget legislation, and while this is all well and good, it really has a terrible impact if the recession occurs immediately after the legislature meets, as any overrun during the subsequent nearly 2 years has to be corrected with a surplus as soon as the legislature meets again two years later. That is the situation that we now find ourselves in. Here, in my opinion, Texas should really learn from Europe. The one part of the Stability and Growth pact that is, in my opinion, very sensible, is the part relating to budgetary measures during periods of recessions. The pact states that member states are exempt from abiding by the 3% of GDP limit on budget deficits in severe recessions. Of course that means that Texas would have to be able to issue bonds to cover the deficit, and that could lead to a build up of state debt that was unsustainable. I would argue that there are other options – one would be to have a temporary increase in tax (what might be called a “solidarity tax”) – another would be to build up an even bigger fund than the current “rainy day fund” ( - perhaps calling it a “recession fund”) which could be spent to offset a decline in state revenues during bad times.  Another approach would be to calculate a cyclically adjusted budget  metric that would automatically yield a surplus in the expansionary phase of the business cycle and a deficit in

the contractionary phase.

Of course the type of taxation we have in Texas is also, in my view, a problem. What Texas really needs is an income tax, and democrats have long recognized that this is also the fairest way of taxing the population given the extremely wide distribution of income in the state. But of course Democrats these days never get a majority so have never been able to enact such a change, and many Republicans don’t like the idea as it would mean greater taxes for their constituency – the rich. But apart from the politics, this tax system is a problem, as it means that the extreme poor still get taxed when they spend, even if they hardly have any income. With an income tax you could exempt all the extreme poor from paying the tax and at the same time get rid of the sales tax completely like New Hampshire has done.  I think most Texans are afraid that introducing an income tax would leave 2 taxes in place ( - that is, they don't trust their State government to repeal the sales tax), so doing this would have to be entirely contingent on removing the sales tax. 

So these are my proposals for Texas. First, set up a revenue commission at the state level to explore the implications of changing the tax system in Texas and then present this to the State politicians to start a debate on moving to a fairer tax structure. Second, get rid of the “tax free” weekend as it is a ridiculous gesture ( - why should I not pay tax just because of when I’m available to shop?). Third readjust the budget every year with a short session of the legislature. Lastly, establish a “recession fund” into which the state has to put a certain percentage of revenues during good times so as to offset any drop in revenues.

"Double-dips" on each side of the Atlantic?

It's rare in macroeconomics that we get a chance to experiment with economies, but at the moment we have the prospects of exactly that happening over the next 12 months.  And the results of this experiment will, no doubt, be picked over by economists for decades to come. 

In the US there is no sign of tightening on either the fiscal or monetary fronts, and it transpired that this is justified by the miserable jobs data for July which appeared last Friday with 131,000 jobs lost and the unemployment rate stubbornly stuck at 9.5%.  Even stripping out the temporary census worker layoffs, the private sector only managed to add an anemic 71,000 jobs, hardly the post-recession "bounce" that economists would like to have seen (see http://www.bls.gov/news.release/empsit.nr0.htm).  This was also underlined by the fact that the change for June was also revised from a loss of 125,000 to a loss of 221,000 jobs.  Despite the fact that public debt levels in the US are headed towards 80% of GDP there is no suggestion that expenditure cuts or tax increases should be foisted upon the general public, until the economic is truly underway.  Of course once this does occur as Clive Crook of the FT pointed out recently (http://www.ft.com/cms/s/0/1b4c44d8-a32e-11df-8cf4-00144feabdc0.html) fiscal tightening is inevitable.

In the UK, the new Conservative/Lib Dem coalition government has taken exactly the opposite position.  Underscored by an apparent "bounce" in the economy in the last quarter (GDP grew by 1.1% in Q2 alone), and up until recently a resumption in house price inflation, the government has already increased the sales tax (or VAT as it's called in Europe) from 15% to 20% and looks to embark upon draconian cuts in public spending (£6.2bn immediately, to be followed by much more swingeing cuts from the fall/autumn onwards) to try to balance the budget from it's current £156bn deficit or in a matter of just a few years (see http://news.bbc.co.uk/1/hi/uk_politics/8700342.stm and http://www.ft.com/cms/s/0/bdf7380a-7e0d-11df-8478-00144feabdc0,dwp_uuid=716ef204-6808-11df-af6c-00144feab49a.html)

As readers of the FT will no doubt know, the contrast between these two positions prompted Martin Wolf's "austerity vs stimulus" debate (see http://www.ft.com/cms/s/0/f3eb2596-9296-11df-9142-00144feab49a.html) which really caused a stir in the economics world, but of course no real conclusion as economists are largely divided on the issue. 

The main points that I would like to make though regarding this comparison (and apparent "transatlantic divide" in macroeconomic policy) are as follows:

i) the global recession started in the US, so any recovery has to address the underlying problem that caused the downturn in the first place. Despite some attempts from Congress, this is really not happening, with no withdrawal of the government from the housing market and an excess of housing.  New building now is cheaper in many parts of the US than is buying a "second hand" house.  So excess supply and falling prices look to continue now for an extended period of time.

ii) although both countries possess similar levels of labor mobility, the UK and US housing markets couldn't be more different.  The UK tends to have interest-sensitive mortgages while the US tends to have interest-insensitive mortgages.  That means that for the UK cutting public expenditure will tend to keep interest rates lower than they would otherwise have been (the opposite of "crowding out") which will tend to boost the housing market.  Now the other factor with housing is that in the US there is an abundant supply of land, whereas in the UK there is not.  This means that the UK housing market should recover well ahead of the US housing market.  It also means in the longer term the UK economy should also grow ahead of the US economy as well.

iii) the Conservative/Lib Dem coaltion government in the UK is completely dependent on Lib Dem support for the public expenditure cuts, and it is clear that below the surface the Lib Dems are extremely uncomfortable with what is going on right now.  I would predict that once the Electoral reform referendum is done next May, the current government may collapse in which case some of the public sector cuts might not actually be implemented.  Certainly with spending cuts of up to 25% of government services likely, the employment consequences are likely to be quite severe and the effect on consumer sentiment marked. 

So pulling this all together, a "double dip" recession in the US is now pretty remote in my view.  A mini deep "double dip" in the UK is now a real possibility, depending on how quickly the proposed public expenditure cuts are implemented and whether the Lib Dems withdraw support from the coalition government half way through the fiscal year.  So likely the UK will go into reverse from October through to the middle of 2011, but then another "bounce back" in economic growth will occur, pushing it ahead of the US once again. I'm sure Keynes would favour the US approach, but for this economist, at least, this is going to be a fascinating experiment to watch!

The Greek Tragedy Unfolds

Greece is currently waiting to hear whether a rescue package will be forthcoming from the European Union or whether it needs to go cap in hand to the IMF. Many people living outside Europe will probably think “so what?”. Indeed there are lots of cases of countries in trouble with high levels of debt, where they have gone to the IMF for help so what’s different here? I would say that Greece is different because it is also a member of the euro area and the European Union, so a default potentially threatens other highly indebted euro area member states, notably Spain and Portugal, with a much more direct link than is usually the case.  The link being the fact that they all use the same money, the euro. As Paul Krugman has pointed out (see his blog at http://krugman.blogs.nytimes.com/2010/02/09/anatomy-of-a-euromess/), Greece is a relatively small country so it’s debt is small but Spain is not so small and would be next on the list if contagion occurs. It’s now got so serious that the ECB is meeting tonight (2/10)by teleconference to discuss what to do ( see http://www.bloomberg.com/apps/news?pid=newsarchive&sid=adO.ysWPeJyQ).

What is interesting to me though is how we got into this mess ( - some people are mentioning the Olympics [see the photo above] as one obvious culprit), as well as what could and what should be done about it.

First, the European side of things. Back in 1997, Germany was getting nervous about which countries might qualify to get into Economic and Monetary Union (EMU) which was due to adopt the euro in 1999. Who would get into this “elite” club was to be decided by economic criteria that were set up as part of the Maastricht Treaty. The Maastricht Treaty (Article 103, Section 1) of 1991 clearly states that:

The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

But Germany was afraid that the Maastricht criteria for joining the EMU was only applicable at a single point in time, and the so-called “no bailout” clause was too weak in the face of some kind of emergency in the financial markets that threatened fiscally profligate member states. So the Germans negotiated the so-called “Stability and Growth pact” (SGP) which was not incorporated into the Treaty in any subsequent revision, but was passed as a “directive” which could be revoked without having complete unanimity. In simple terms the SGP said that government budget deficits had to be below 3% of GDP unless there was a recession going on, in which case this level could be overrun on a temporary basis. If there was no recession, a long process kicks into action whereby the member state is given time to correct the situation after which non-refundable fines are levied and the proceeds shared out between the other member states. When France and Germany overran this 3% level back in 2004, a decision was made not to kick start the process, which looking back at what is now happening was a mistake, as it made the SGP completely toothless. For more on all this see my research on the SGP at http://faculty.tamucc.edu/pcrowley/Research/workingpapers.htm and go down to the SGP heading)

So, what’s happened with Greece? Well Greece has run up large debts, mostly through not having good tax collection systems in place and also through not having properly functioning public accounting mechanisms that accurately report the deficit, so that new administrations always seem to dramatically revise debt levels upwards. Only recently another €40 billion of debt was “discovered”, and to try and shrink the debt and deficit levels Greek GDP was revised upwards by including “black market” transactions into the GDP calculations. Of course the SGP doesn’t swing into action on deficit levels retroactively, only on prospective budget deficits, so Greece didn’t worry too much about sanctions under the SGP. But as my research points out, it’s a little crazy to put sanctions on a member state that has public finance problems as you’ll make things worse, not better!!

Second, what is interesting about the Greek case, is that Greece (and other highly indebted “olive” member states) have been benefitting from the low interest rates in the euro area as the area is still dominated by the big players who have lower levels of debt together with low inflation. Even with these low interest rates Greece has clearly not been able to get a grip on its public finances, so when the possibility of a creditworthiness downgrade was raised by the rating agencies, the markets sat up and took notice!

So what could be done? I would say there are 3 options:

i) Nothing. Greek debt is not that high (120% of GDP) compared to say Japanese (over 200% of GDP) and is comparable with Italian debt levels (at around 115% of GDP), so as long as Greece doesn’t default on it’s payments, who cares?

ii) Deny an EU bailout and point Greece towards the IMF. As the Maastricht Treaty states, Greek debt is Greek debt, so the Greeks need to sort out their own house.

iii) Allow an EU bailout, but with stipulations. This is the option currently under discussion, and is probably the most interesting of the options, but most problematic in my view.

The danger in i) is that if the credit rating on Greek debt is lowered, this could create contagion with other member states being next in line. That might tarnish the appeal of the euro area significantly, eventually leading to some departures from the euro area. I doubt it would lead to a collapse of the euro area as some have predicted. The danger as well with i) is that nothing happens in Greece and they have no incentive to put their public finances in order.

The second option is perhaps the most attractive from a strict interpretation of the European rulebook. The “no-bailout” clause is there for a reason, and although Greece has largely escaped scrutiny under the SGP rules, it is basically Greece’s decision about what to do. The good thing about this option is that the “conditionality” that comes with IMF loans would make it essential that Greece clears up it’s public finance mess. The danger for the euro area is the same as under i) – contagion, and nasty effects on member states that may have transparent public finances and lower levels of debt than Greece. But in the financial markets, perception is everything, so contagion cannot be ruled out, but it can't be ruled out under any of these options.

The third option is the least attractive in my judgement. There is talk of arranging some kind of bailout under Article 100, section 2 of the Treaty on European Union:

Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned. The President of the Council shall inform the European Parliament of the decision taken.

But this would be a “generous interpretation” of the rule, as I don’t see any natural disasters or exceptional circumstances beyond the control of the Greek government. It would also set the stage for bailouts for other member states if and when there is any contagion. The “conditionality” just isn’t there either, so would not give the Greek government any incentive to clean up it’s public finances. So in my view the worst of all possible worlds, not just because it leads to so-called "moral hazard" in the future ( - who needs to worry about public finances when the SGP is toothless and you get bailed out in any case!!), but also because it obviously poses questions about the legitimacy of the European Treaty of Union if noone abides by the letter of the law.

Now there are those who are much closer to the action such as the authoritative Tony Barber of the FT (see http://blogs.ft.com/brusselsblog/2010/02/at-long-last-a-crisis-driven-big-leap-to-european-integration/) who think that this crisis will lead to the "leap forward" that European integration clearly requires if the monetary union is to be firmly entrenched within an integrated Europe, both from a fiscal point of view and a political union point of view. I doubt this. Unless the crisis becomes more widespread, and of course it might, I don't think the Greek crisis will prompt a re-think by the euro area members to press ahead with more integration in a "two-speed" set up and cede more powers to Brussels.

So in summary we got into this mess because we didn't set up a good SGP in the first place, and then secondly we didn't do the appropriate reforms to it and incorporate it into the Maastricht Treaty to give it some teeth.  What should be done now?  Tell Greece to go to the IMF and abide by the European Treaties otherwise what might be at risk is the entire euro area construct.

Obama's State of the Union Address

Like millions of others around the world, I settled down on Wednesday night last week to watch President Obama’s State of the Union address. And apart from being a little rambling, and way too long, with a rather quicker build up to the finale than we’re used to with Obama’s speeches, it was cogent, surprising in certain areas and yet conciliatory in others. A masterful speech I would say, but certainly it doesn't rank alongside his best to date.

From an economics perspective the surprises for me were: i) the lack of a proper analysis of why we need a new jobs package when the stimulus package hasn’t really started to show long-term results yet; ii) freezing of discretionary budgets along with a dropping of the “don’t ask don’t tell” military policy; iii) the emphasis on “full employment”; iv) the emphasis on export stimulus rather than protectionism; and v) the international comparisons that the President put into the speech relating to long-term growth. Let me elaborate…

First, the new jobs package. It is no mystery that some of the bigger long-term capital projects have been delayed – only late last week the high speed trains project was announced in various parts of the country – and clearly there are still others in the pipeline. So given that the economy is now growing, that the unemployment rate has stopped rising, that employment is at last showing signs that it might turn round soon ( - there was still a loss in jobs in December, 2009 – the latest figures), and that the financial system appears to have stabilized, it seems to me a little premature to do yet another stimulus. Surely some of the measures that the Obama administration wishes to pursue ( - including the $30bn fund for lending to small businesses) would do the trick rather than further increasing spending. This on top of the nervous situation about the rising deficit and mounting US debt. So from what I could gather from the speech the idea would be to set a date to quit increasing discretionary spending now, but in the meantime go for broke and increase spending now before the cap becomes law. The government spending multiplier needs some time to work – any student of macroeconomics would know that the fiscal lags inherent in any new spending take time to work their way through the economic system. [See http://www.cbo.gov/ftpdocs/99xx/doc9968/hr1.pdf - where this is a Jan 2009 estimate and many of the projects have taken longer than anticipated to come online.]

Second ( - and this is one reason I’m glad I didn’t post this blog immediately after the speech), military spending and “don’t ask, don’t tell”. I think it was a brilliant move on the part of the Obama administration to exempt the military from the discretionary spending freeze from next year, and announce the scrapping of “don’t ask, don’t tell” at the same time. The bad cops in the form of Pelosi and other democrats were immediately out there doing their jobs to make sure that the military understands that there are voices now on the left (see my previous post on this) favoring some trimming of military budgets. You can just imagine the conversation with the military top brass telling them that if they don’t want to scrap “don’t ask, don’t tell”, then it would be difficult to fend off the democratic calls for a military spending freeze ( - and this isn’t just a one year freeze…it goes on for 3 years). If I was top brass in the military I know what I would do!!

Third, as an economist, I was surprised to hear the term “full employment” once again being introduced into the political discourse. Most economists would use the term “natural rate of employment” given that this has become the level of employment that we use in our own academic work and one that makes a lot more sense than “full employment”. [For those of you not in the know on this see http://en.wikipedia.org/wiki/Natural_rate_of_unemployment] Psychologically what it means to me is a return to the “Keynesian” stimulus economics of the 1950s, when we were not worried about the effect of inflation and we were more worried about adjusting spending to an “optimal” level. We are not currently in this situation now, as we know that inflation can occur from these actions, particularly if interest rates rise which will automatically increase the burden of the debt on government finances. Potentially this is a vicious cycle – the more debt we incur, the more likely a sudden collapse in foreign confidence ( - look at what happened in Dubai if you don’t believe me on this), and the more likely interest rates will have to rise, making recovery less likely. It is clearly important to get this balance right ( - the balance between stimulating the economy and causing alarm among our foreign lenders), and in my opinion using terms like “full employment” implies that large budget deficits will continue into the future.

Fourth, the new and welcome emphasis on export spending. This was a high point in the speech that a lot of people missed. Why? Politically, because it placed new emphasis on developing new markets and boosting exports rather than resorting to protectionism. But what about the economics? First, it recognized that the U.S., because it started the current global economic downturn, can "hitch a ride" from other countries that get out of the recession faster, as other economies suffered a "shock" transmitted from the U.S. whereas the U.S. clearly had some major systemic problems that it needs to address.  Second, it implies that the exchange rate needs to stay low if the "doubling of exports in 5 years" and the "2 million more jobs" are to happen.  If for some reason the administration has it completely right (or some other country suffers a big shock which causes investors to seek the "safe haven" that the U.S. dollar traditionally affords) and so the dollar begins to rise again, this would derail their export objective. So the Obama administration must be betting on a low or even lower dollar than we have right now to make this happen. All food for thought.

Last, the international comparisons on long-term economic growth that the President mentioned in his speech. He specifically mentioned China and Germany and the stimulus measures that they have adopted that also enhance long-term growth prospects. It was refreshing to hear this use of “best practice” to justify new economic policy in the US. This was a hallmark of the UK Blair administration, who looked at what had been tried elsewhere to get the best ideas about policymaking, and it has clearly taken root in the current administration’s economic thinking. On a side note, although Fed Chairman Bernanke’s expertise is on the Great Depression, I would argue that we also need to understand what went wrong in Japan in the 1990s and 2000s to get it right in the U.S., as our situation much more closely mirrors what happened there. More on this next time…