That is to say, is Post-Modernist Macroeconomic Policy over?
” ….Postmodernism is largely a reaction to the assumed certainty of scientific, or objective, efforts to explain reality. In essence, it stems from a recognition that reality is not simply mirrored in human understanding of it, but rather, is constructed as the mind tries to understand its own particular and personal reality. For this reason, postmodernism is highly skeptical of explanations which claim to be valid for all groups, cultures, traditions, or races, and instead focuses on the relative truths of each person. In the postmodern understanding, interpretation is everything; reality only comes into being through our interpretations of what the world means to us individually. Postmodernism relies on concrete experience over abstract principles, knowing always that the outcome of one’s own experience will necessarily be fallible and relative, rather than certain and universal.
Postmodernism is “post” because it is denies the existence of any ultimate principles, and it lacks the optimism of there being a scientific, philosophical, or religious truth which will explain everything for everybody – a characteristic of the so-called “modern” mind. …”
‘The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality.” I nodded and murmured something about enlightenment principles and empiricism. He cut me off. “That’s not the way the world really works anymore,” he continued. “We’re an empire now, and when we act, we create our own reality. And while you’re studying that reality — judiciously, as you will — we’ll act again, creating other new realities, which you can study too, and that’s how things will sort out. We’re history’s actors . . . and you, all of you, will be left to just study what we do.”‘
I’m not the first person to comment on the PostModernist tendencies of this Presidency — see in particular Josh Marshall’s 2003 Washington Monthly article, “The Post-Modern President”. However, I think this might be among the first to systematically dissect the post-modernist aspects of this Administration’s macroeconomic policies. I’ll tackle these points in turn.
- Do tax cuts increase tax revenues?
- Is more financial deregulation always better?
- Macroeconomic aspects of energy policy.
- Do budget deficits have an effect on current account deficits?
Do tax cuts increase tax revenues? This topic has recently been in the news, with Bruce Bartlett’s recent op-ed recounting the success of supply side economics, while disavowing the view that tax revenues would rise in response to a tax rate decrease (see the debate at Economists View , , , Brad Delong , and Angry Bear ). It is nonetheless important to recall that some people — including the Vice President — still believe that the response of tax revenue to decreases in marginal tax rates is very substantial. This in turn leads to there fervent belief that dynamic scoring would lead to big changes in how “good” tax cuts would look from a fiscal perspective. Yet, the CBO’s recent analysis of the President’s budget request has a little remarked-upon section (Table 2-1) which examines how CBO’s baseline, and models accounting for supply side effects, would differ from the OMB forecast.
Table 2-1 from CBO, An Analysis of the President’s Budgetary
Proposals for Fiscal Year 2008, March 2008. [pdf]
What is remarkable is how little the textbook supply side model response, with high responsiveness to tax changes, differs from the CBO’s baseline. The open economy change is -$496 billion cumulative change (2008-2012), versus the CBO’s standard model estimate of -$507 billion. In other words, it’s a cumulative difference of $11 billion, or roughly $2.2 billion in a projected 2012 economy of $17.2 trillion (i.e., 0.01% of GDP in 2012).
Some might object, saying these are “just models”. Let’s look to the surging tax revenues in FY’06 and FY’07. I’ll ignore the declining state tax revenues (see NYT on this), and re-iterate the fact that the surge in revenues is well within the two standard error bands (see here). In any case, the CBO’s estimate of standardized/cyclically adjusted Federal tax revenues in FY’07 is still 1.4 percentage points of GDP lower than it was in FY’00.
Figure 1: Standardized Federal government revenues as a proportion of GDP, fiscal years. Source: CBO, Cyclically Adjusted and Standardized Budget Measures, February 2007. [pdf]
By the way, there is even doubt whether tax cuts increase GDP in the long run, a separate issue from whether tax receipts increase. The answer depends critically upon how the tax cuts are financed. This is discussed in the Treasury’s report, even though — as recounted in my post on the subject — this fact is often omitted from arguments of the proponents of dynamic scoring.
Is more financial deregulation always better?
Figure 2: Enron share prices. Source: 
Figure 3: Annual growth rate in OFHEO Housing Price Index and in index of transactions prices. Source: OFHEO March 1st release.
Most economists would agree that when markets are competitive (in the textbook sense) and information is perfect (so that agents on both sides of the transaction have the same information set), regulation is usually counterproductive. However, when information is asymmetric — so that for instance lenders and borrowers have access to different information sets regarding motives, assets and liabilities — then regulation may be a second best way of managing what would otherwise be disappearing markets, or situations where the government is forced to enter in to bail-out systemically important sectors. This was the subject of my recent post on the subprime collapse.
What was the role of the Bush Administration’s ideology in this lack of regulatory fervor? Apparently, it was to some extent important (from the WSJ):
“What is really frustrating about this is [federal regulators] don’t have enforcement authority to do anything with these state-licensed, stand-alone mortgage lenders,” says Fed Reserve Governor Susan Bies.
Yet even where federal regulators have jurisdiction, they sometimes have been slow to grapple with the explosive growth in especially risky practices and quick to shield federally regulated banks from states and private litigants. The underlying belief, shared by the Bush Administration, is that too much regulation would stifle credit for low-income families, and that capital markets and well-educated consumers are the best way to curb unscrupulous lending.
The article continues:
Public disciplinary actions by federal bank regulators are rare. In the past two years, the FDIC has issued four cease-and-desist orders against subprime lenders that required the companies to change their practices. The Fed has issued just one and the OTS none, the FDIC said. The OCC said it has sanctioned one subprime lender in that time. Federal regulators say they spot and correct problems quietly during the examination process before they reach the point where public enforcement action is needed.
Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.
He also early on announced plans to slash expenses to resolve the agency’s deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had “exercised increased diligence in its review of abusive consumer practices” while reducing thrifts’ regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran’s cuts. Citing “understaffing,” he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn’t available to comment. …
Now it would be irresponsible to place the entire blame for the subprime collapse at the feet of the Bush Administration. Financial innovation — partly to avoid regulation — is a recurring theme in American economic history (see for instance Mishkin’s money & banking textbook). In addition, divided responsibility between state and Federal authorities is part of the problem. But certainly the deregulatory zeal could not have been helpful. It is against this backdrop (and the ongoing discoveries of further financial irregularities in accounting and the granting of stock options) that I find the current attempt to “reform” Sarbanes-Oxley puzzling.
Were these financial sector issues restricted in effect to the financial sector, then my concerns would not have macroeconomic implications. But exactly because the financial sector plays a central role in allocating capital and monitoring projects, it’s not just another sector. Indeed, as one economist wrote in 1983:
“The present paper builds on the Friedman-Schwartz work by considering a third way in which the financial crises … may have affected output. The basic premise that, because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information-gathering services. The disruptions of 1930-33 … reduced the effectiveness of the financial sector as a whole in performing these services. … “
That economist was Ben Bernanke (“Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” American Economic Review 73(3)).
Macroeconomic aspects of energy policy. As noted previously, the President has recently argued for dealing with “oil addiction”. However, as was also highlighted, the President’s convictions extend only to devoting more resources to R&D and continuing subsidization of ethanol production. Strangely — for a President supposedly devoted to market-based approaches, gasoline — or energy taxes more generally — are nowhere to be seen.
Now, I do not argue that it is either feasible or desirable to hit zero energy imports. Indeed, even if we were to be net zero oil importers, upward shocks to oil prices would still put upward pressure on economy-wide prices, thereby exerting contractionary effects on output. But, it’s clear that our present dependence on imported oil adds another layer of vulnerability to oil price shocks, insofar as they redistribute income away from the US and to oil exporting nations. Were those nations to exhibit roughly the same marginal propensity to consume as do Americans, then the net effect on world output would be small (some will recognize this as the “transfer problem” discussed by Keynes and Ohlin in the context of the Treaty of Versailles). But they have not thus far (see Brad Setser‘s various posts on this subject), thus subjecting the world economy to various imbalances (see also here).
Let me lend a personal note to this discussion. As one of the professional staff of the CEA held over from the Clinton Administration, I had the opportunity to sit in on some of the meetings of the (staff level) working group of Vice President Cheney’s National Energy Policy Development (the Report is here). While we were admonished to “think outside the box”, one will find absolutely zero mentions of gasoline tax in that report, as well as the 2006 Economic Report of the President (by the way, this is why I’m wary of arguments of the sort that assert “the world is different now”). This is true despite the fact that when there are negative externalities, the standard (neoclassical) economists’ response to internalize the externality by way of taxes (see this post). As Jim Hamilton has argued, the way not to go, at least as a first resort, is via command-and-control means such as CAFE standards. And, to further critique the Administration’s approach to energy policy, it seems foolhardy to subsidize ethanol production when current oil prices make ethanol production profitable (see here and Jim Hamilton’s more recent post).
The impact of the budget deficit on the current account deficit. I’ve written a lot on this, so much will be redundant. But it must be said that the White House’s dogged determination that deficits don’t matter is indicative of a general disregard for empirics. Exhibit one in this regard is internal inconsistencies within a single chapter of the 2006 Economic Report of the President. As I noted slightly over a year ago on page 146, it states:
“The interdependence of the global financial system implies that no one country can reduce its external imbalance through policy action on its own. Instead, reducing external imbalances requires action by several countries. Specifically, at least four steps may help to reduce these imbalances.”
And yet in Box 6-3 assessing “the link between fiscal and trade deficits”, the ERP authors cite favorably the Fed’s estimate of an elasticity between fiscal and trade deficits of 0.20, directly contradicting the previous statement. I might further observe that the quote from the 2006 ERP does not jibe with the Treasury’s (more nuanced) Occasional Paper on the topic, entitled The Limits of Fiscal Policy in Current Account Adjustment. Then the question is how big is the effect; there reasonable people can differ. My empirical work suggests something between 0.15-0.44. For those skeptical of econometrics, well, between 2000 and 2005, there was approximately a 4.3 percentage point swing in the Federal budget balance, and a 2.2 percentage point swing in the current account balance. This outcome is consistent with a 0.5 coefficient. See also Figure 2 below.
Figure 4: Change in the consolidated government budget balance to GDP ratio, lagged two years (blue) and change in the current account to GDP ratio (red), on a NIPA basis. Sources: BEA, NIPA release, February 2007 and author’s calculations.
So, confronted with this evidence, will the reign of PoMo Macro be ended? It should, but there will always be those who will choose ideology over data. For them, they will continue to construct their own “reality”, and so, like in other dimensions, we have not yet seen the last throes.