Finance

Janet Yellen before the Senate Banking Committee

/ Edward Thater / Leave a comment

If you happen to follow the Federal Reserve, then you are aware that Ben Bernanke’s tenure at chair of the Fed will be up soon. President Obama has nominated Janet Yellen to the post, making her the first woman nominee. There doesn’t appear to be too much push back from the Senate, and in all likelihood she will be confirmed as the first woman chair of the Fed. You can read a good description of the hearing, including Yellen’s articulation to her intention to continue QE3 into the future, here.

It’s worth noting that, despite the obscurity of the position, the chair of the Federal Reserve is probably the most influential person in the U.S. economy, in many ways much more influential than the President or Congress. In that regard, I think you could classify this breaking of a glass ceiling on par with Nancy Pelosi becoming the first woman Speaker of the House.

What do you, dear readers, think of Yellen as a pick? A victory for modern feminism? Smart/ disastrous continuation of the Bernanke policies? Sound off in the comments.

Fed Continues QE3

/ Edward Thater / Leave a comment

When the Open Market Committee of the Federal Reserve met earlier this week, it decided to continue its third round of quantitative easing, known as QE3, until at least its next meeting in six weeks.

Quantitative easing is a technique of monetary policy where a central bank, in our case the Federal Reserve, will purchase financial assets for freshly “printed” money, thereby increasing the money supply and stimulating the economy. The basic idea is this: all macroeconomic slow downs, recessions and depressions included, are ultimately caused by a reduction in the overall spending by economic actors. This reduction is aggregate spending has a multiplier effect, because my spending is someone else’s income, which ripples across the economy and causes a bigger drop in gross domestic product than the actual reduction in spending. (For a more detailed discussion of the multiplier effect, you can read my earlier SLACE post about the shutdown and its economic effects.) With more money in circulation, economic actors can build up savings in weaker economic times and yet still have enough money left over to go and spend at their old levels. Of course, this can lead to inflationary pressures, with too many dollars chasing too few goods, so the Open Market Committee has to walk a fine line.

QE3 is already the the largest round of quantitative easing since the 2007-2008 recession, and it is on pace to be the largest round of quantitative easing ever. Critics of quantitative easing policies are asking the legitimate question of whether we will see a crash of asset prices, in particular in the stock and real estate markets, after the Fed decides to scale back QE3 since it has been pumping $85 billion into the economy every month since last fall. However, with GDP growth still relatively anemic and no signs of inflation on the horizon, most Fed watchers predict the Open Market Committee won’t begin scaling back until sometime well into 2014, at the earliest.

As an aside, dear readers, we here at SLACE would love for you to leave us some comments and let us know what you think about our posts. In particular, if you have economic topics you’d like to see blogged on in the future, let us know and we will try to accommodate.

Why No Hate for Job-Killing Advertising?

/ Edward Thater / Leave a comment

As the various branches of the federal government continue to struggle to find ways to put the nation’s fiscal house in better order, a key component of these discussions is whether and how to make tax reforms. If you spend more than five minutes watching Sunday morning news, you know that some policymakers are pretty insistent that taxes cannot be raised because taxes “kill jobs.” My response to this is, “So what?” A lot of economic actions “kill jobs,” many to a larger degree than taxes do, but no policymakers are looking to ban those actions as bad for the economy.

Now, don’t misconstrue me here, dear readers. I am all in favor of tax reform. I think our federal taxation system is too complicated, has far too high a level of compliance costs, and is otherwise a pretty bad way to go about raising government revenue. However, unless and until there is a political consensus about where and how much to cut government spending, there is a legitimate case to be made (one that you don’t necessarily need to agree with) for increasing our current tax revenue to cover more of the costs of government so that we can borrow less. (As an aside, the debate around government spending is usually off base as well. The question should almost never be “how much should we spend?” but rather “are we spending the correct amount of money on the correct things?” But that is a topic for a different blog post.)

It is quite well established that taxes reduce production and reduce jobs. Let’s say the government imposes a $10 tax on widgets. Let’s also say that for the purpose of this example, the market conditions are such that the price of widgets rises by $5. This means that consumers bear half of the cost of the tax through higher prices, while producers bear half the cost of the tax through a hit to their bottom lines. (A fuller discussion of tax incidence and why producers can’t simply pass on 100% of the tax’s cost to their consumers is beyond the scope of this particular post.) However, this means some consumers will be priced out of the widget market, as they will be unwilling and/or unable to pay the new, higher price. Likewise, facing diminished demand and the hit to their bottom lines, producers will scale back production or leave the widget business entirely. That means fewer people employed making widgets. Economists call this loss of economic activity (fewer people buying widgets and fewer producers making widgets) deadweight loss, and it does translate to fewer jobs on an economy-wide scale.

However, lots of other things cause deadweight loss besides taxes. Take, for example, monopolies. The reason monopolies are generally considered bad is because they maximize their profits by creating artificial shortages. This in turn creates a rise in the price per unit (shortage of supply drives prices up), which increases the monopoly’s profits. The monopoly could create more units and sell them at a lower price to people who want the units while still turning a profit, but it wouldn’t be as big of a profit as the one it gets from its artificial shortage. Thus, unchecked market power, which is the ability to control the market price by controlling the quantity produced, creates deadweight loss.

While monopoly is one extreme example of market power, millions of firms in the U.S. economy enjoy some level of market power that allows them to withhold production in order to increase profits. And what causes these firms to have this market power they exercise? For most of them, it is simple advertising.

Companies advertise to build their “market share” by attracting new customers and by building brand loyalty. This, in turn, leads to those businesses commanding a portion of their markets, which allows them to withhold production and make more money. If you’ve ever known someone who rushed to the store to buy the latest Disney DVD release before it goes “back into the vault,” you’ve seen this technique in action. But it’s not just Disney. Firms of all sizes use similar techniques to make more money.

So why aren’t any politicians railing against job-killing advertising? After all, given the millions of firms with some level of market power, the number of lost jobs to advertising is at least as big, if not bigger, than the number of jobs lost to taxes. The obvious political answers are that (a) few policymakers in D.C. have had any sort of economics training, and (b) business hate taxes, which hurts their balance sheets, but love advertising, which pads their balance sheets at the expense of their competitors, so they tend to lobby against the one and not the other.

There are many good reasons to support a smarter tax system with lower rates and a broader base. Such a system would cause less deadweight loss and be better for the economy in the long run. But unless you’re willing to go the extra step to crusade against any economic activity that causes deadweight loss, you should find a better argument to lower taxes.

Calculating the Economic Cost of the Federal Shutdown

/ Edward Thater / Leave a comment

Let’s set aside for a moment the politics of the shutdown.  Regardless of political views, we can all generally agree that the shutdown costs the economy something.  The bigger question is what that number is.  The national media have more or less universally been reporting a number calculated by IHS Global Insight, a Massachusetts-based economic forecasting firm, of $12.5 million per hour.  For you non-mathematically inclined readers, that works out to $300 million a day. The problem with that number is that it represents only the dollars that the federal government spends on goods and services each day.  It does not represent the actual economic costs of the shutdown.

The main reason for this is something called the multiplier effect.  One dollar of spending by any economic actor does not just raise GDP by that same dollar.  Instead, my spending is someone else’s income that the next person can spend.  If I buy a hot dog and a soda from the vendor down the street, I spend $3.  The hot dog vendor, in turn, uses those $3 in income to purchase buns for tomorrow’s sales.  (Yes, I know, the buns cost more than $3.  The idea is that part of the money to buy the buns is my $3.)  The grocery store uses those same $3 to pay the employee who put the buns on the shelf.  And so on. Thus, my initial $3 ends up creating an increase of more than $3 in GDP.

Obviously, the real word is more complicated.  Some of the $3 is taken out at each transaction in taxes, some of it is saved by various economic actors instead of spent, etc.  However, you can measure this effect.  The Congressional Budget Office generally calculates the multiplier for federal spending as a range between 0.5 and 2.5.  (Here is sample source,  but there are lots of CBO reports using the same numbers.) So this means that, in reality, the shutdown is costing the US economy anywhere between $150 million to $750 million a day in lost GDP.  In any event, the costs are almost certainly more than $300 million per day number that is being widely reported in the media.

Of course, this calculation doesn’t include the medium- and long-term savings we get for not borrowing nearly a third of that money to cover the deficit, but that is a different blog post entirely.