Saturday, September 27, 2008

Policy Implications of the Credit Crisis

I have been working on a way to conceptualize where our economy is and how we got here. I am trying to avoid all of the finger pointing that is currently going on (including my own finger pointing) in an attempt to remain somewhat objective, and I do not pretend to include all of the elements of our current economic system. What I am trying to present is a basic model that helps explain the relationships between our economic system and the need for tax, trade, energy, and education policies. I want something that can work for students, and I appreciate any suggestions that would improve the model and/or the presentation.

I have developed a framework that I think makes sense and it is represented by the two diagrams below. The first diagram, "The Way It Was", illustrates the basic wealth creation model of a country with balanced internal flows and net exports. This is the USA in the past. Note that there are net positive flows to investors from within the USA and from abroad (represented by blue items), while at the same time there are positive flows to the USA box, representing domestic wages and consumption (the red lines) from domestic investment and net flows from abroad. The INVESTMENTS box is subdivided into investments in productive assets and investments for consumption. I have labeled the consumption investments FINANCIAL to represent purchases of financial assets supporting consumption such as consumer loans, mortgage backed securities and so forth.

The next diagram represents "The Way It Is". Note the change in flows of investment in production from the USA to Non-USA recipients of investment represented by the red line. This creates a shift in the net wage gains and net consumption flows as we begin to import more from overseas production and invest less domestically than we otherwise would. Initially this model works well for investors as profits increase due to cost reductions. Adding tax cuts into the mix provides a dramatic increase in wealth to investors and a larger pool of investment capital. Adding to that profits from the gains made by NON-USA investors investing back into the USA and you have a gigantic pool of liquidity looking for profitable investments. Unfortunately, at the same time this massive liquidity pool is building, the reversal of flows to wage earners begins to put pressure on consumption. This should have caused a reduction in consumption in the USA that would have been a normal response to these changes in flows, but it did not. Rather than adjusting production down to a new level of consumption the massive liquidity pool was directed into financial instrument supporting consumption. This created the base for a large explosion in debt as USA consumers continued to consume financing this over-consumption through debt. Now, however, consumption is above the wage earners' means of supporting ownership and the debt underlying the financial instruments invested in by investors begins to go bad (defaults on home mortgages, for example).

Combining all of these factors we get both a debt bubble (represented by the green lines) and a wealth bubble (represented by the blue lines). This is where we are today, and the bubbles are unwinding. Wealth is falling as asset values decline and the debt bubble burst last year. We are currently on life support from the Federal Reserve and other government sources. At this time we should see a reversal of consumption flows as USA consumers pull back. This would help to slow the imbalance of international flows through a normal adjustment process (including a falling dollar as USA interest rates fall and the economy weakens). Unfortunately this is where energy policy (or lack thereof) comes in. As investors try to protect their asset values they are moving from financial investments to hard assets such as gold and energy products. Energy products are also priced globally in dollars, so as the dollar declines in value the dollar price of energy goes up. These factors are keeping energy prices high, and since the USA is a massive importer of energy the trade flows remain strongly negative.

So, what does all of this tell us with respect to our national policies? I believe it has implications for tax policy as tax incentives to the investor class may have over stimulated the economy during globalization. I pose the unanswerable question – would real interest rates have been negative for so long in 2003 if tax cuts flowed to consumers rather than investors (thereby stimulating consumption rather than "investment")? Would the size of the debt bubble have grown so large if there were less investment chasing return? Questions that merit empirical study, I think. Perhaps tax cuts for wage earners would be better policy considering all of the money flows.

It also has implications for trade policy as sustaining the structural trade flows we currently have is a recipe for massive wealth transfer from the USA to energy producing countries (this massive transfer is currently under way). That brings us to energy policy. Perhaps we should direct future investment into energy independence. This is not a new idea, but this model helps to illustrate the need and the interdependence of energy, trade, and tax policies. Developing new sources of energy could certainly help reverse the flows back to what they were in the first diagram. I'm not suggesting we adopt an isolationist stance. What I am suggesting is that we very quickly direct our investment capacity in a massive way into energy independence and additional efficiency technologies to help offset the advantages of investing outside the USA (rather than simply driving USA wages down). You can bet that other countries are doing exactly that and we are in direct competition with them. This, then, gets us to education. Should it be a national priority that we educate the population to the maximum of our capacity? I believe it is.

What has been missing, in my humble opinion, is leadership to help guide the country through appropriate policy incentives to achieving these necessary goals. This void has left us scarred and my hope is that the current crisis will point us in the correct direction for the long term. (OK, I couldn't help just a bit of politics).

Sphere: Related Content


Gerald Harris said...

I posted a comment after yours on the WSJ blog. But I think the big long term question looking at your model is can the US ever pay back the debt burden that we are building up. How will this be handled--through inflation or tax increases (and thus slower growth)?Or is there a third alternative called war? Or, possibly something new we haven't even imagined>

Palermo's Blog said...

I think this is truly the question of our generation - how do we reinvent our economy to provide jobs and profits for everyone willing to work for them? I think energy policy is critical to dealing with the trade imbalances and education is critical to keep us on the forefront of innovation - an area where competition is coming on strong. I also think we need to redirect a good portion of our national income to our infrastructure, energy, and education and unfortunately that means higher taxes for a while. BTW - the studies that determined higher taxes reduce economic growth also say that this is not the case when tax increases are for reduction of prior deficits - see Romer & Romer here:

Higher taxes on the higher incomes would also reduce the pool of excess capital that will continue to seek return, and not necessarily through productive investment (as we have just seen). For these reasons I am in favor of drastically higher tax rates on very high incomes - perhaps several additional brackets up the income scale.

The bottom line is that we are in a mess and whatever policy we use to go forward will have costs. We have already incurred the costs - so the real issue is how do we try to minimize the damage going forward. Monetizing the debt is scary, and even now the interest rate policies are placing the burden on savers while benefiting borrowers (and the intermediaries). If you pull back the stimulus and increase taxes now you risk more recession, and the more the economy sinks the more tax revenues sink, so you end up with a big deficit anyway. If deficits are here for a while I figure we may as well limit the suffering. Paying it back will require some really big productivity/innovation gains such as in energy/health/water. I think we should be driving toward these goals at full speed ahead.

Thanks for the comment.