September 2009 – Donald Marron

Still Broad Weakness in Q2 GDP

Earlier today, the Bureau of Economic Analysis released updated GDP figures, estimating that the economy contracted at a 0.7% pace in the second quarter. The BEA’s well-named “third estimate” thus indicated that the decline in the second quarter was somewhat slower than the 1.0% BEA had previously estimated.

As I mentioned a couple of months ago, whenever the GDP data come out, the first thing I look at is Table 2, which shows how much different sectors of the economy contributed to the growth (or, in this case, the decline). Even with the small upward revision, the most striking thing about Q2 continues to be how broad the weakness was:

Broad Weakness in Q2 GDP (Third)

As the chart shows, Q2 witnessed declines in every major category of private demand: consumer spending, residential investment, business investment in equipment and software (E&S), business investment in structures, and exports. Wow. To find the last time that happened, you have to go all the way back to … the fourth quarter of last year, when it was even more severe. But before that, you have to go back five decades to the sharp downturn of the late 1950s.

Not surprisingly, government spending helped offset the declines in private spending. Most of the boost came from defense spending (a contribution of 0.7 percentage points), but state and local investment also helped (adding 0.48 percentage points, presumably at least in part due to stimulus spending).

A sharp decline in imports, finally, was the biggest contributor to growth in Q2, at least in an accounting sense. As I’ve noted before, it’s important to choose your words carefully here, since declining imports are clearly not the path to prosperity. In a GDP accounting sense, however, import declines do boost measured growth. Why? Well consider the fall in consumer spending. That decline affected both domestic production and imports. GDP measures domestic production, so we need a way to net out the decline in consumer spending that was attributable to imports. That’s one of the factors being captured in the imports figure.

Note: If the idea of contributions to GDP growth is new to you, here’s a quick primer on how to understand these figures. Consumer spending makes up about 70% of the economy. Consumer spending fell at a 0.9% pace in the second quarter. Putting those figures together, we say that consumer spending contributed about -0.6 percentage points (70% x -0.9%, allowing for some rounding) to second quarter growth.

More TIPS to Finance Our Growing Debt?

As you may noticed, the U.S. needs to borrow vast amounts of money. Which raises an interesting question: how should we finance that debt?

The Government Accountability Office (GAO) has taken note of this question and has begun a series of reports on debt management. In its first report, released today, the GAO provides a ringing endorsement of inflation-indexed bonds, aka TIPS (Treasury Inflation Protected Securities). The title of the report pretty much summarizes its conclusions: “Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges.”

The report provides a nice history of the TIPS program, which dates back to 1997, and the challenges it has faced. The number one challenge? Liquidity. Regular Treasury securities are the most liquid in the world and, as a result, investors are willing to pay a premium to own them. U.S. taxpayers thus benefit from the low interest rates our government has to pay on its debt. Unfortunately, TIPS are much less liquid and thus don’t enjoy the same benefit. GAO thus suggests that actions to improve liquidity (e.g., more frequent auctions) could help bring down interest costs.

GAO also recommends that longer-dated TIPS be issued as the U.S. moves to lengthen the maturity of its debt. As noted in the following chart, the current maturity structure of U.S. debt is heavily skewed to short maturities:

GAO - Debt Issuance

More than $3 trillion of U.S. debt will come due by the end of 2010 alone.

The reliance on short-term debt makes sense when near-term interest rates are incredibly low, as they have been lately. But interest rates will rise again one day (perhaps sooner than many anticipate according to a recent op-ed by Fed Governor Kevin Warsh), and the government should therefore be evaluating how it will lengthen maturities. GAO believes that TIPS should be part of that.

Netflix Avoids the Sunk Cost Fallacy

The highlight of this month’s Wired magazine is a profile of Netflix and its CEO, Reed Hastings. The theme is Netflix’s strategy to thrive even as their business model changes (e.g., as on-line streaming replaces DVDs by mail).

The opening paragraphs document an impressive willingness to change course:

It had taken the better part of a decade, but Reed Hastings was finally ready to unveil the device he thought would upend the entertainment industry. The gadget looked as unassuming as the original iPod—a sleek black box, about the size of a paperback novel, with a few jacks in back—and Hastings, CEO of Netflix, believed its impact would be just as massive. Called the Netflix Player, it would allow most of his company’s regular DVD-by-mail subscribers to stream unlimited movies and TV shows from Netflix’s library directly to their television—at no extra charge.

The potential was enormous: Although Netflix initially could offer only about 10,000 titles, Hastings planned to one day deliver the entire recorded output of Hollywood, instantly and in high definition, to any screen, anywhere. Like many tech romantics, he had harbored visions of using the Internet to route around cable companies and network programmers for years. Even back when he formed Netflix in 1997, Hastings predicted a day when he would deliver video over the Net rather than through the mail. (There was a reason he called the company Netflix and not, say, DVDs by Mail.) Now, in mid-December 2007, the launch of the player was just weeks away. Promotional ads were being shot, and internal beta testers were thrilled.

But Hastings wasn’t celebrating. Instead, he felt queasy. For weeks, he had tried to ignore the nagging doubts he had about the Netflix Player. Consumers’ living rooms were already full of gadgets—from DVD players to set-top boxes. Was a dedicated Netflix device really the best way to bring about his video-on-demand revolution? So on a Friday morning, he asked the six members of his senior management team to meet him in the amphitheater in Netflix’s Los Gatos offices, near San Jose. He leaned up against the stage and asked the unthinkable: Should he kill the player?

Three days later, at an all-company meeting in the same amphitheater, Hastings announced that there would be no Netflix Player.

In short, Reed Hastings is not a man who gets locked in by sunk costs: he’s willing to kill projects (or, in this case, spin them off) even if he’s got years invested in them. A good example for my students when we discusses costs in a few weeks. And just another example of the strengths of Netflix’s culture.

Human Organs, Behavioral Economics, and Insurance Mandates

Like the minimum wage and rent control, the market for human organs is a classic topic when teaching the basics of supply and demand. Organ markets are largely outlawed and, as a result, the demand for organs greatly outstrips the supply. For example, according to some estimates, as many as 4,000 people in the United States die each year while waiting for donor kidneys (some of which could, in principle, come from healthy donors).

As Dick Thaler notes in the New York Times today, the usual economist solution to this problem – allowing the buying and selling of human organs – is a political non-starter. Many people find the idea “repugnant,” as economist Alvin Roth has put it.

One solution, which Roth helped pioneer, is to create organ swaps rather than sales. Suppose, for example, that my wife needs a kidney and that I am willing to donate, but am not a match. And at the same time, a woman wants to donate a kidney to her sick brother, but also isn’t a match. That seems like a dead end (so to speak), but if I am a match for her brother, and she is a match for my wife, then we can arrange a swap – my kidney for hers. Two lives get saved, and there’s nothing repugnant about it.

Over time, this basic idea has expanded to include “daisy chains” of donations involving numerous donors and recipients (for a nice description see this recent article in Wall Street Journal).

Thaler considers another way to address the problem of organ supply (from individuals who become brain dead, not those who are healthy) using the insights of behavioral economics:

Continue reading “Human Organs, Behavioral Economics, and Insurance Mandates”

IMF: The Lasting Effects of Financial Crises

Earlier this week, the IMF released a key chapter from the upcoming World Economic Outlook: Chapter 4: What’s the Damage? Medium-Term Output Dynamics After Financial Crises. As noted in the much pithier summary, the report concludes that:

The global financial crisis is likely to leave long-lasting scars on the world economy, but governments can act to stimulate a quicker revival and counter output losses … . The study finds that banking crises typically have a long-lasting impact on the level of output, although growth eventually recovers. Lower employment, investment, and productivity all contribute to sustained output losses.

Those conclusions are based on their review of financial crises around the world since the early 1970s. As shown in the following graph, the key finding is that after a financial crisis economic output remains below trend for years:

IMF - Lasting Effects The blue line shows, for example, that in the average country, output seven years after the crisis was about 10% below what would it would have been if the pre-crisis growth rate had continued.

The dotted red lines, however, highlight the enormous range of outcomes. At least one-quarter of the countries eventually had output that was above the level implied by the earlier trend; while another quarter eventually fell at least 25% below the prior trend.

The study slices and dices this result in numerous ways, trying to identify the factors that lead to better or worse outcomes. Some are bad news for the United States.

Continue reading “IMF: The Lasting Effects of Financial Crises”

Answer: When It’s a Fine

Readers have provided many thoughtful comments on yesterday’s post about whether we should use the word “taxes” to characterize the financial penalties that would be used to enforce an individual health insurance mandate. Based on those comments, and some further reflection, I have several additional thoughts:

I discovered that some people think the individual mandate itself should be characterized as a tax. I don’t agree. As long as individuals are free to choose among private insurance plans in satisfying the mandate, there is no need for the President (or anyone else) to refer to the mandate as a tax. The distinction between regulation and taxation can sometimes be blurry, but it’s still a useful distinction. And an individual mandate is clearly a form of regulation. (However, I also won’t object if opponents characterize the mandate as a tax; that’s well within the norm of political economic rhetoric on both sides of the aisle. My point is simply that proponents of the mandate don’t need to use the “t” word in characterizing it.)

Note: The situation would be different if individuals were forced to purchase a specific government insurance plan. That would be a tax. (For a related discussion, see this brief from the Congressional Budget Office that discusses how it decides whether regulations are so intrusive that the regulated activities should be reflected in the budget; as I noted in one of my first posts, that was a key issue during the debate over the Clinton health proposals.)

My ruminations were focused on the question of what you should call the financial penalties that would be applied to individuals who didn’t satisfy the mandate. Following the CBO, I am firmly of the belief that the resulting cash inflow to the government should be characterized as revenues.

Most revenues are the result of taxes, but not all. And, on reflection, it seems rhetorically defensible to refer to the penalties as “fines” rather than “taxes” if their purpose is to enforce the individual mandate and not to generate revenue. (This is similar to, but somewhat different from, my earlier thoughts about the penalty acting like a Pigouvian tax, which is what I took the President to be saying on Sunday.)

So, here’s my revised suggestion for rhetoric that the President can use next time he’s interviewed by George Stephanopoulos: “If my plan is enacted, I believe that all responsible Americans should have health insurance. If they don’t they should face a penalty because they are imposing costs on others who may have to pick up the tab for their future health costs. And that penalty is a fine, George, not a tax.”

When is a Tax Not a Tax?

A critique–and, if you read far enough, a partial defense–of the President’s rhetoric about the definition of a tax.

Be sure to read my follow-up post: “Answer: When It’s a Fine“

President Obama has walked into a rhetorical box on taxes. On the one hand, he campaigned on a promise not to raise taxes on Americans who earn less than $250,000 per year. On the other hand, he has endorsed policies that look a lot like taxes on those people. They include:

A $0.62 per pack increase in the federal cigarette tax. President Obama signed this into law to help finance an expansion in health programs for children; the increase went into effect on April 1.

Proposals to tax insurers who offer “Cadillac health insurance plans.” As many commentators have noted – and as I taught my students on Monday – some of that tax (perhaps much of it) would ultimately be passed on to consumers in higher insurance premiums. So insurers may be the ones writing checks to the government, but, in reality, consumers will be paying higher taxes.

Penalties to enforce an individual mandate in the health bills now pending in Congress. For example, the draft Baucus bill (from a few days ago; it may have since changed) would impose a penalty of up to $3,800 per year for families that could afford health insurance but do not purchase it.

The President’s supporters have argued that the first two tax increases are consistent with his pledge. The increased cigarette tax, for example, isn’t an increase in income taxes. And the tax on insurance companies isn’t a direct tax on individuals and, even if it’s partially passed through, it would not increase individual income taxes.

Such hairsplitting has no economic content – some of both tax increases really would fall on families that earn less than $250,000 – but may provide enough political cover to defend what I presume the President actually meant on the campaign trail: “I will not raise income taxes directly on American families who earn less than $250,000.”

Unfortunately for the President, that hairsplitting apparently won’t work with the third proposal which involves a direct tax on individuals who don’t get qualifying health insurance. Those individuals would have to write a check to the government as a penalty for this lack of coverage.

There would seem to be no wiggle room to enable the President to call this anything but a tax (albeit not an income tax). Yet, when asked about this by George Stephanopoulos on Sunday, the President tried to deny that such penalties are taxes. Stephanopoulos and Merriam-Webster, however, were having none of it:

The President’s argument fails, on its face, if you take the view that a tax is any money that the government takes from you through exercise of its sovereign power. Purchasing a souvenir at a National Park? Not a tax since it’s a voluntary, market-like transaction. But paying a penalty because you haven’t purchased government-approved health insurance? That’s a tax. And, indeed, it is treated as such by the Congressional Budget Office in its evaluation of health proposals.

I think CBO is correct: for federal budget purposes, the penalty on the uninsured would indeed be a tax, since it reflects the exercise of the government’s sovereign power.

However, and this may surprise you, I also think the President has an important point which he tried, with only limited success, to articulate. I would describe it as follows: A well-meaning government levies taxes for two different reasons:

Continue reading “When is a Tax Not a Tax?”

Netflix Boosts Prize Economics

By at least one metric – the number of people who have mentioned it to me – my brief post about Netflix appears to be my most popular one so far.

The post linked to a remarkable slide deck about the corporate culture that Netflix has embraced in its quest for excellence. Most memorable line: “adequate performance gets a generous severance package.” If you haven’t seen it, I encourage you to click on over. It’s worth your time.

Yesterday’s award of the first Netflix prize highlights another strength of Netflix’s culture: it clearly does not suffer from “not-invented-here” syndrome. Indeed, quite the reverse. A few years ago, Netflix realized that it had reached its limit in trying to improve the accuracy of its movie recommendation system. Even though users may rate dozens (or more) movies, it turns out to be difficult to predict what other movies they will like.

So Netflix decided to outsource this problem in an ingenious way: it offered a $1 million prize to any person or team that could improve the recommendation algorithm by at least 10%. Stated that way, the problem seems deceptively easy. But it took nearly three years before the winner – a team led by AT&T Research engineers – took home the prize.

As recounted in Netflix’s press release, this marathon ended in a race to the wire:

“We had a bona fide race right to the very end,” said [CEO Reed] Hastings. “Teams that had previously battled it out independently joined forces to surpass the 10 percent barrier. New submissions arrived fast and furious in the closing hours and the competition had more twists and turns than ‘The Crying Game,’ ‘The Usual Suspects’ and all the ‘Bourne’ movies wrapped into one.”

…

Netflix said “BellKor’s Pragmatic Chaos” edged out a team called “The Ensemble,” another collaboration of former competitors, with the winning submission coming just 24 minutes before the conclusion of the nearly three-year-long contest. The competition was so close and the submissions so sophisticated that it took a team of external and internal judges several weeks to validate the winner after the contest closed on July 26.

Happily, the resulting algorithm won’t be exclusive to Netflix:

The contest’s rules require the winning team to publish its methods so that businesses in many fields can benefit from the work done. The winning submission and the previously hidden ratings used to score the contest will be published at the University of California Irvine Machine Learning Repository. The team licensed its work to Netflix and is free to license it to other companies.

On the first day of my microeconomics class, I told my students that economics is all about incentives. As an example, I used the famous prize for a way to measure longitude, which inspired the invention of the chronometer (i.e., a clock of sufficient precision to measure longitude). Next time around, I will mention the Netflix prize as well.

P.S. Not one to rest on its successes, Netflix has already announced plans for a second Netflix prize. This one aims to find a better way to recommend movies to people based on demographic data (e.g., where they live) rather than movie ratings.

Is It Possible to Tame the Deficit? Yes.

The fiscal outlook for the United States is grim. This year’s deficit will be around $1.4 trillion, about 10% of GDP, and the Obama Administration projects that deficits in the next ten years will total about $9 billion. Under those projections, the ratio of publicly held debt to GDP will be approaching 77% by the end of 2019, up from 41% just a year ago.

Those figures are daunting. We are in a deep fiscal hole. But we shouldn’t give up hope just yet.

As the Committee for a Responsible Federal Budget notes in a new report, numerous countries have faced gigantic deficits and found the political will to change course. A few examples:

Finland (1992–2000): Following a major banking crisis, Finland faced large deficits (around 8 percent of GDP) and a rapidly rising debt (58 percent of GDP). Prior to the crisis, Finland was running surpluses of around 6 percent of GDP. Motivated by strong political support to get its house in order to qualify for eurozone participation and by the need to address external financing concerns, the government pursued a fiscal consolidation program. A medium-term budget framework, entitlement reforms, spending cuts and tax reform were part of the program. By 2000, the debt/GDP ratio was under 45 percent. The cyclically adjusted primary fiscal balance improved cumulatively by 10 percent of GDP from 1992.

Spain (1993–97): Spain’s fiscal position had been deteriorating since the late 1980s. By 1995, its fiscal deficit exceeded 7 percent of GDP. Its public debt exceeded 70 percent of GDP. Facing external financing concerns and strong public support to adopt fiscal disciplinary measures to prepare for euro area membership, the government adopted a fiscal consolidation plan that emphasized spending (including cuts in social transfers, government wages and health care spending) but also included tax reform. Fiscal balances improved, cumulatively by around 4 percent of GDP since 1993.

Sweden (1994–2000): Sweden’s fiscal situation deteriorated severely in the early 1990s as a result of a banking and economic crisis. In the midst of a recession, the government adopted a fiscal consolidation program to achieve fiscal balance through a tightening up on household transfer payments and an increase in various taxes. As a result of its fiscal consolidation efforts, the fiscal position shifted from a deficit of over 11 percent of GDP to a surplus of 5 percent of GDP and the debt/GDP ratio was reduced from 72 percent to 55 percent in 2000.

The CRFB report draws some interesting lessons from these episodes (e.g., Lesson 6: “It is preferable to make fiscal adjustments on your own terms before they are forced upon you by creditors.”)

But my point today is much simpler: Just as we were hardly the first developed economy to face a major financial crisis, we also are not the first to face a looming fiscal crisis. Indeed, as the examples of Finland and Sweden show, we aren’t even the first developed economy to face a potential fiscal crisis in the aftermath of a financial crisis.

As we prepare (I hope) to address our looming deficits, we can take heart from the fact that some other nations have successfully faced similar challenges.

Talking Health on CNBC

When I worked for the White House, I discovered that you could learn a lot about your co-workers — or, at least, their portfolios — by their TV habits. Some people watched CNBC, some Fox, and some CNN. And some even managed to get through the work day without turning their TVs on.

I have always been firmly in the CNBC contingent, so I was particularly happy to appear on Squawk Box this morning. Here’s a link to a video of the interview (sorry, I still haven’t mastered the embedding of videos from news sites.)

Going in, my main talking points on the health debate were:

From a budget perspective, the Baucus bill is much better than the House bill. As Chairman Baucus has said, his bill would increase spending by more than $800 billion over the next ten years. On a comparable basis, the House bill would increase spending by more than $1.5 trillion. That’s a huge difference.

My biggest budget concern about the Baucus bill involves the offsets he proposes to pay for those increased costs. Some of those offsets presume that we can make substantial future cuts to payment rates for various Medicare providers. The trillion-dollar question is whether we will actually have the backbone to make those cuts when the time comes. Our recent experiences with doctor payments in Medicare should give us all pause on that front. In addition, there’s the hard question of whether we should be using the “easy” offsets to address our existing fiscal crisis instead.