The Economists’ Hour (part 3)

May 28, 2021

Previous | Next

Binyamin Appelbaum calls the period from 1969 to 2008 the “Economists’ Hour” because of the unprecedented influence professional economists had over public policy during those years. At the same time, within the economics profession and in public policy discussions, the government activism of Keynesian economics was giving way to the free-market conservatism advocated by Milton Friedman and the Chicago school.

The “Great Moderation”

The latter part of this era, beginning around 1985, goes by another name in economics, the “Great Moderation.” That was a time when both inflation and unemployment were at lower rates than during the stagflation of the 1970s. Unemployment did rise during the recessions of 1990-1991 and 2001, but not as severely as during the recession of 1981-1982, when the Federal Reserve was putting the brakes on the economy to tame inflation.

Not surprisingly, free-market economists attributed the Great Moderation to the success of their recommended policies—lower taxes, less market regulation, and both fiscal and monetary restraint on the part of government. Appelbaum is skeptical, suggesting that other forces were at work. “The ‘peace dividend’ from the end of the Cold War made it easier to reduce federal spending; globalization weighed on wages and prices [that is, global competition made wage and price hikes harder]; new technologies drove a surge in productivity and prosperity.” He also points out what wasn’t so great about those years—relatively slow economic growth, increasing inequality of wealth and income, and reduced public investment in future growth.

The financial crisis

In his assessment, Appelbaum has the benefit of hindsight, since he knows that this period of economic history ended in disaster, the greatest financial collapse since 1929 and the deepest recession since the depression of the 1930s. “The Economists’ Hour did not survive the Great Recession…. In the depths of the Great Recession, only the most foolhardy purists continued to insist that markets should be left to their own devices.”

Appelbaum’s account of what went wrong focuses on developments in the expanding financial services industry. The bank failures of the 1930s had led government to impose stricter regulations, including limits on the interest rates banks could pay depositors or charge borrowers. When other interest rates spiked after the Federal Reserve started tightening the money supply in 1979, pressure from both consumer groups and bankers led Congress to deregulate bank rates. In the previous year, the Supreme Court ruled that credit card companies could charge whatever interest rate was allowed in the state in which they were headquartered, even if they did business nationwide. Financial institutions rushed to locate in states with the most permissive rules, and states competed for their business on that basis.

In addition to relaxing old regulations, governments failed to develop new regulations to keep up with financial innovation. The prevailing view that financial markets were efficient and self-regulating encouraged policymakers to leave them alone. The riskiest innovations were new forms of derivatives—securities whose value depended in some complex way on the fluctuating value of an underlying asset. Instead of buying and selling real estate, investors could buy and sell packages of mortgage loans. They could even invest in a derivative that represented a bet that such packaged loans would either gain or lose value. The gains and losses from derivative investments could be many times the gains and losses from trading in the assets on which they were based.

When Brooksley Born was appointed head of the Commodity Futures Trading Commission by President Clinton, she began to advocate for the regulation of derivatives. She was opposed, however, by Fed Chair Alan Greenspan, Treasury Secretary Robert Rubin, and SEC chair Arthur Levitt. In 2000, Senator Phil Gramm quietly inserted a provision to prohibit such regulation into a broader bill, which passed without much notice.

Signs of the financial trouble ahead appeared early in this period of financial deregulation—or non-regulation. Many Savings & Loans failed between 1986 and 1995 after being bought by financial speculators and swindlers. (The failures cost the taxpayers over $100 billion, since the deposits were federally insured.) Risky investments in derivatives led to bankruptcies like Orange County, California in 1994 and Long-Term Capital Management in 1998. But it was the housing boom of 2003-2006 that encouraged the most dangerous behavior. In their zeal to profit from the boom, financial institutions engaged in subprime lending on a massive scale, lending to borrowers who didn’t qualify for traditional fixed-rate mortgages but could be sold more complicated loans with the potential for spiking monthly payments. Lenders could disguise the shakiness of the individual loans by selling them off in packages that were assumed to minimize risk, just like a diversified stock portfolio. The packages were then overrated and even insured by companies willing to bet on their continuing value. When the bubble of inflated asset prices finally burst and the 2007-2009 recession began, borrowers who owed more than their houses were now worth defaulted in large numbers, causing massive losses to investors and financial institutions.

The financial crisis and deepening recession forced the federal government to act, both to keep huge financial institutions from failing and to stimulate aggregate economic demand with federal spending. Suddenly, Keynesian ideas were dusted off and given a new look.

Larry Summers, who was installed as head of the National Economic Council [in 2009, in the Obama administration] had said in 2001 that government stimulus spending during an economic downturn was “passé” because its merits had been “disproven.” In 2009 he changed his mind. When a reporter asked Summers to describe the government’s plans, he responded with one word: “Keynes.”

The federal stimulus plan passed by Congress in 2009 was controversial, supported by Democrats but opposed by almost every Republican. Obama himself wavered in his support for stimulus, calling for more “belt-tightening” the following year. Support for government austerity remained strong for several more years, but many economists began to believe that budget restraint was prolonging the recession. Paul Krugman and Robin Wells say in their macroeconomics text, “By 2014, the intellectual debate seemed to have gone mostly against the advocates of austerity.”

The Federal Reserve also became more activist, broadening its focus on fighting inflation to include the goal of creating jobs. Not only did the Fed bring short-term interest rates down to near zero, but it tried to reduce long-term rates as well by buying up Treasury and mortgage bonds. (That has the effect of raising prices on bonds and lowering their rates, since bond prices and rates move in opposite directions.)

Appelbaum wrote this book before the 2020 pandemic and associated recession. That new crisis led both the Trump and Biden administrations to propose additional stimulus spending, further undermining the free-market position. The leading advocate of free-market economics, Milton Friedman, did not live to see either the 2008 financial crisis or the pandemic. He died in 2006.

Economies, people, and imagined futures

I will finish by citing two of the grander themes of The Economists’ Hour. In his conclusion, Appelbaum says, “If you have taken anything from this book, I hope it is the knowledge markets are constructed by people, for purposes chosen by people—and they can be changed and rebuilt by people.” We invented the market economy as an awesome wealth-producing machine, but it remains our invention. When we start to think of it as an autonomous machine requiring no creative human intervention, I think we reduce ourselves to cogs within the machine.

A related idea is that we must always keep one eye on whatever future we desire. Appelbaum complains that “the emphasis on growth, now, has come at the expense of the future: tax cuts delivered small bursts of sugar-high prosperity at the expense of spending on education and infrastructure.”

Jonathan Levy adopts a similar perspective in his new economic history, Ages of American Capitalism, which I am currently reading. “Because a capitalist financial system is a perpetual leap of faith, over and over again, confidence becomes the emotional and psychological mainspring of economic activity.” Where do we place our confidence? In the stock market, or a bank, or a technology company, or in world trade? In a country with both a capitalist economy and democratic government, are we wise to put all our confidence in markets and none in our government? Or vice versa? If the economic machine keeps breaking down, or serves the few better than the many, or seems to be pushing us towards environmental disaster, must a democratic people be precluded from trying to actualize a better future through honest political debate and collective decision-making? If a loss of faith in government gave us the “Economists’ Hour,” maybe some recovery of that faith can give us a wiser and more balanced approach to public policy.


The Economists’ Hour (part 2)

May 26, 2021

Previous | Next

During the period Binyamin Appelbaum calls “the economists’ hour” (1969-2008), free-market reformers focused their efforts on a number of policy areas. Here I will discuss five of them: monetary policy, taxation, antitrust enforcement, deregulation, and free trade.

Monetary policy

In 1979, new Federal Reserve chair Paul Volcker adopted Milton Friedman’s recommendation to fight inflation by restricting the growth of the money supply. Limitations on the supply of money made interest rates—the price of money—rise precipitously. That in turn discouraged borrowing for business expansion and consumer spending, bringing on the 1981-82 recession. The rate of inflation did drop dramatically, from 13.5% in 1980 to 3.2% in 1983. The next Fed chair, Alan Greenspan, continued to make fighting inflation the priority even after inflation fell below 3% in the 1990s.

By then the economy was doing better, but still not growing at a very rapid pace. President Clinton wanted to increase government spending to stimulate growth, but was advised by economists to take the path of austerity and progress toward a balanced budget. Appelbaum observes that at this time, “there…was little remaining difference between the two political parties in the United States.” Clinton agreed with Republicans that “the era of Big Government is over.”

Americans benefited from lower inflation as consumers, but were hurt as workers by relatively high unemployment and stagnating wages. The biggest winners from tight monetary policy were wealthy lenders, who could lend money at high interest rates and be repaid with dollars that had not lost any purchasing power.

The benefits of low inflation…were concentrated in the hands of the elite. In the United States in 2007, the top 10 percent of households owned 71.6 percent of the nation’s wealth. By punishing workers and rewarding lenders, monetary policy was contributing to the rise of economic inequality.

Appelbaum quotes John Kenneth Galbraith, “What is called sound economics is very often what mirrors the needs of the respectably affluent.”

Taxation

Some of the free-market economists believed they had a way to reduce inflation and unemployment at the same time. University of Chicago economists Robert Mundell and Arthur Laffer made sweeping claims for the benefits of tax cuts, especially tax cuts for the wealthy. The purpose would not be to stimulate consumer demand, as with the Kennedy-Johnson tax cut, but to expand the economy from the supply side by giving the owners of capital the means and the motivation to work harder and expand their businesses. The benefits would then “trickle down” to everyone. The tax cuts could even pay for themselves as the growing economy generated more income and more tax revenue.

This “supply-side economics” was never very well supported by evidence or fully embraced by mainstream economists, but it became a popular party line for Republican politicians. Under Presidents Ronald Reagan and George H. W. Bush, the top tax rate was reduced first from 70% to 50%, and then to 28%. From there it fluctuated as political control shifted from one party to the other, ending up at 37% after the Trump tax cut in 2017. (The effective tax rate for high-income taxpayers is lower than these numbers suggest, since they pay the top rate only on the portion of income that exceeds the top bracket threshold.)

Milton Friedman did not believe in using tax cuts or government spending as a tool for growing the economy, and he did not expect tax cuts to pay for themselves, as their most enthusiastic supporters claimed. He supported them anyway, however, for a different reason. He “wanted to blow a hole in the federal budget, and then close it with spending cuts.” That would reduce the role of the federal government in the economy, leaving the free-market to work its magic.

Ronald Reagan claimed that he could cut taxes, increase military spending, and still balance the federal budget. Instead, when the optimistic predictions of the supply-siders didn’t pan out, the loss of tax revenue left the country with a growing federal deficit. That experience would be repeated when George W. Bush and Donald Trump cut taxes. After Reagan’s 1981 tax cut, private investment spending as a percentage of GDP increased only briefly, and was generally no higher in the 1980s than it had been in the 1970s. The rate of economic growth was actually a little slower. Tax rates were flatter and less progressive, shifting the tax burden a little more from the rich to the middle class and creating more after-tax inequality. The United States became more dependent on China to finance the deficit. The Chinese earned dollars by selling their manufactured goods to American consumers, then lent those dollars back to us by buying treasury bonds.

Appelbaum is not surprised by these results, saying that economic growth depends mainly on productivity growth, which depends on innovation. Low taxes and government austerity may not help; and they can mean reduced investment in future growth if they require spending reductions in such areas as infrastructure or research and development. He characterizes the tax cuts as a “political triumph and an economic failure.”

Antitrust enforcement

Antitrust laws were supposed to keep business monopolies or oligarchies from overcharging consumers, suppressing competition from smaller firms, and undermining democracy with excessive political influence. By the 1960s, many economists were questioning those alleged benefits.

One problem was that an important method for keeping companies small—blocking mergers and acquisitions—wasn’t working very well. Even without mergers, many companies grew big enough to dominate their industries anyway. Economists also observed that big companies were often efficient enough to deliver goods and services at low prices, so that no apparent harm to consumers occurred. Some argued that “economic efficiency should be the sole standard of antitrust policy, which…meant the government mostly should let corporations do as they pleased.”

During the 1970s and 80s, federal judges began to embrace these views. Antitrust laws were not so much repealed as permissively interpreted. President Nixon’s appointment of four conservative justices to the Supreme Court helped. Large corporations financed university seminars that paid judges to learn the new economic views. By 1990, 40 percent of federal judges had attended programs of this kind organized by Henry Manne, a founder of the discipline economics and law. (Another book I have reviewed, Nancy MacLean’s Democracy in Chains, tells that story in more detail.)

At the same time that economists were taking a more benign view of corporate power, they were taking a dimmer view of union power. They often argued that union wage demands discourage hiring by raising the price of labor. (One could also argue that corporate power discourages labor force participation by holding down wages.) Appelbaum reports that consolidation in the meatpacking industry didn’t appear to hurt consumers or the ranchers who raised the cattle. But real wages declined by 35 percent “as companies shuttered unionized plants and used the threat of closure to squeeze concessions from workers.” He concludes that the “concentration of the corporate sector is tilting the balance of power between employers and workers, allowing companies to demand more and pay less.”

Deregulation

In some industries, consumer protection had taken the form of regulating monopolies or oligopolies rather than antitrust measures. Sometimes, an industry consisting of many small firms wasn’t very practical.

Even as the United States sought to increase competition across much of the economy in the mid-twentieth century through invigorated enforcement of antitrust laws, it was widely accepted that some industries were “natural monopolies”—sectors in which healthy competition was impossible. Electric companies, for example, could compete only by running multiple lines into the same homes, and all but one of those lines would be wasted. The result would be either too much competition, which was bad for the companies, or too little competition, which was bad for consumers. So governments intervened.

Besides public utilities, transportation was another area in which a small number of large but highly regulated companies was considered an acceptable arrangement. For example, in 1938, the new Civil Aeronautics Authority “issued licenses to sixteen airlines and then refused to let anyone else enter the business for the next four decades.” But was that really good for consumers, or just for the favored companies?

Another example:

In 1977, the eight largest trucking companies were twice as profitable as the average Fortune 500 company. It helped that trucking firms, unlike airlines, got to set their own prices. The industry’s milquetoast regulator, the Interstate Commerce Commission (ICC), allowed ten regional bureaus controlled by trucking firms to hold secret hearings and then issue binding prices. This system was also lucrative for the industry’s employees, represented by the belligerent Teamsters union….

By the 1970s, free-market economists were arguing that publicly regulated industries were worse for consumers than unregulated industries. Even consumer advocate Ralph Nader campaigned for less regulation. Some economists went so far as to argue that regulation in general was a waste of effort, since the regulators so often ended up serving the industries they were supposed to regulate.

The deregulation of the airline and trucking industries began with President Carter and continued under Reagan. The Civil Aeronautics Board closed down at the end of 1984. Consumers benefited, at least initially. Companies like Southwest Airlines and UPS lowered the cost of transporting people and goods. On the other hand, wages for truck drivers and flight attendants fell, while executive compensation skyrocketed. After eight airlines consolidated into four in the early 2000s, the price of airline tickets stopped falling.

Currency exchange and free trade

In 1944, the Bretton Woods conference set up a system of international monetary exchange rates based on the dollar. The American dollar anchored the system by having a constant value in gold, while other national currencies were valued in dollars. The American commitment to redeeming dollars in gold upon demand made the dollar the strongest and most desired currency in the world.

There was a downside for us, however. Suppose that another economy, say Japan, recovers from World War II and grows faster than the US economy. To be more specific, suppose their auto industry goes into high gear while ours is—well—stalling out. In a system of floating exchange rates, we might expect the Japanese yen to gain in value against the dollar, because people need yen to buy those great Japanese cars. But fixed exchange rates don’t allow that. So the dollar remains stronger than it deserves to be, allowing Americans to buy Japanese goods at a kind of discount. But the Japanese may be reluctant to use their dollars to buy American cars or other goods, which sell at a kind of premium. They would rather exchange their dollars for gold, producing a run on gold.

Friedman always took the position that free financial markets, not international agreements, should govern currency exchange rates. By the end of the 1960s, most economists agreed. In 1971, President Nixon announced that the United States would no longer guarantee the value of the dollar in gold. The Bretton Woods system fell apart, and floating exchange rates emerged.

Friedman expected that the floating rates would be relatively stable, since they would reflect slow changes in the relative strength of national economies. Others feared that floating rates would be so chaotic as to trigger a collapse in global trade. Neither side got it right. Exchange rates turned out to be more volatile than Friedman had expected, but global trade grew anyway. The new potential for currency trading and speculation did create new risks, however. Some banks failed because they lost their investors’ money in currency trading, and others were caught trying to manipulate exchange rates for their own advantage.

The dollar, which might have been expected to fall when the US left the gold standard, instead continued to rise. Because of the size and strength of the American economy, foreigners saw the dollar as a safe refuge in a world of volatile currencies. High US interest rates during the period of inflation-fighting also encouraged foreigners to invest in dollar-denominated assets. Treasury bonds were valued because the US government had never defaulted on an obligation. And China’s willingness to finance our deficit by holding treasury bonds—as opposed to converting dollars to Chinese yuan—kept their currency cheaper than ours, hurting their own consumers but helping their export-oriented, manufacturing economy. Our economy went in the opposite direction, shifting toward consumption and foreign debt at the expense of manufacturing production and exports. The areas in which jobs were created were those most sheltered from foreign competition, such as health care and retail sales.

Again, there were winners and losers. Consumers used their strong dollars to buy inexpensive foreign goods, and many workers were able to move into the industries that were sheltered from foreign competition. But many others became disenchanted with globalization:

The Georgetown economist Pietra Rivoli argues that opposition to trade is stronger in the United States, in comparison to other developed countries with higher levels of trade, because the social safety net is much weaker. The United States, for example, is the only developed nation that does not provide universal health care. If the people who lose jobs when a factory closes still have health insurance, if training is affordable, if they can find housing in the areas with new jobs and pay for child care, then transitions are manageable. If not, those people are likely to be angrier about globalization—and with ample justification.

These dynamics and their results are the legacy of “the economist’s hour,” and they provide the background for understanding the Great Recession that began in 2007.

Continued


The Economists’ Hour

May 24, 2021

Previous | Next

Binyamin Appelbaum. The Economists’ Hour: False Prophets, Free Markets, and the Fracture of Society. New York: Little, Brown and Company, 2019.

Economic journalist Binyamin Appelbaum reports on the prominent role of free-market economists in shaping national policy during the four decades from 1969 to 2008. The period began with the Nixon administration and ended with the financial crisis in the last year of the George W. Bush administration.

Free-market economists like Milton Friedman were influential voices during those years. They were not alone, however. Appelbaum says, “The economists provided ideas and the corporations provided money: underwriting research, endowing university chairs, and funding think tanks like the National Bureau of Economic Research, the American Enterprise Institute, and the Hoover Institution at Stanford University.” In addition, economic conservatives joined with social conservatives to move the Republican Party to the right. They formed a “coalition of the powerful, defending the status quo against threats real and imagined.” For economic conservatives, the threat might be environmental regulations or high taxes. For social conservatives, it might be gay rights or affirmative action. Republican leaders rallied the support of both groups in order to dominate politics during those years. Mainstream economists and moderate Democrats like Bill Clinton went along with much of the new thinking as well.

Appelbaum acknowledges the many economic benefits that resulted as “economists played a leading role in curbing taxation and public spending, deregulating large sectors of the economy, and clearing the way for globalization.” The runaway inflation of the 1970s was tamed; competition increased in some industries; free trade raised incomes in developing countries and brought inexpensive manufactured goods to American consumers. But he also believes that the “market revolution went too far.” Decade by decade, economic growth slowed down, and the benefits of growth went increasingly to the wealthy. Real wages for low-income workers stagnated or declined. The pursuit of short-term benefits put long-term prosperity at risk, as public policy failed to address environmental problems, deteriorating infrastructure, and human capital needs.

The brief era of “activist economics”

When the Great Depression hit in 1929, few economists had the ear of political leaders. Only in 1946 did Congress create the White House Council of Economic Advisers. Four years into the Depression, the British economist John Maynard Keynes published a letter in the New York Times encouraging the recently elected Franklin Roosevelt to stimulate the economy with massive federal spending. Roosevelt met Keynes the following year, but he was reluctant to create very large deficits. New Deal social programs helped reduce unemployment, but wartime spending after 1941 is usually credited with ending the Depression.

Looking back on that experience, economists and policymakers generally accepted the idea that government could steer the economy on a productive path toward full employment and low inflation. The main Keynesian tool would be fiscal policy, which called for spending in excess of tax revenues to stimulate a lagging economy, but curbing spending to cool down an inflationary economy. The prime example of deliberately Keynesian intervention was the tax cut proposed by President Kennedy and signed by President Johnson in 1964. It seemed to work, as unemployment fell from 5.6% in 1964 to 3.5% in 1968.

Opponents of government activism were already having their say, however. “Milton Friedman…wanted to restore the pre-Keynesian consensus that governments could not stimulate economic growth and should not try.” In Capitalism and Freedom in 1962 and A Monetary History of the United States, 1867-1960 (with Anna Jacobson Schwartz in 1963), he argued that the only useful macroeconomic policy was to insure a slow and steady growth of the money supply. The Federal Reserve Bank’s failure to accomplish this was the main reason for either recession or inflation.

Friedman’s ideas were slow to gain traction. Barry Goldwater endorsed them, and Friedman in turn supported him for President, but he lost to Lyndon Johnson in a landslide in 1964. The following president, Richard Nixon, was ideologically sympathetic, saying in his 1968 inaugural address, “Let each of us ask—not just what government will do for me, but what can I do for myself?” Nixon also signed into law one of Friedman’s proposals, the all-volunteer army, in 1971. But when he faced a troubled economy, Nixon also relied on activist policies like deficit spending to fight unemployment and wage-and-price controls to curb inflation.

The stagflation crisis

What really turned the tide in Friedman’s favor was the combination of persistent inflation and unemployment in the 1970s. The rate of inflation hit 5.8% in 1970, 11.1% in 1974, and 13.5% in 1980. Some of the possible reasons were Vietnam War spending with insufficient taxes to pay for it, shortages of foreign oil, and a slump in productivity growth. Friedman blamed the Federal Reserve for allowing the money supply to expand too rapidly. Meanwhile, the rate of unemployment was over 5% for almost the entire decade, with higher spikes during recessions.

Keynesian economics had no good answer for simultaneously high inflation and unemployment. Inflation was supposed to indicate an overheated economy with high aggregate demand pushing up prices. Unemployment was supposed to indicate a sluggish economy with low aggregate demand discouraging production. Appelbaum describes the resulting loss of confidence in Keynesian solutions:

Nixon and his successors, Gerald Ford and Jimmy Carter, kept trying the interventionist prescriptions of the Keynesians until even some of the Keynesians threw up their hands. Juanita Kreps, an economist who served as Carter’s commerce secretary, told the Washington Post when she stepped down in 1979 that her confidence in Keynesian economics was so badly shaken that she did not plan to return to her position as a tenured professor at Duke University. “I don’t know what I would teach,” she said.

The stage was now set for a massive political and policy shift, one that would embrace the free market unencumbered by much interference from government. As President Ronald Reagan announced in his 1981 inaugural address, “Government is not the solution to our problem; government is the problem.”

Continued


Republicans Reject Biden Economic Plans

May 5, 2021

Previous | Next

Senate Republican leader Mitch McConnell has announced that no senators of his party will vote for President Biden’s American Jobs Plan or American Families Plan. He is not waiting for actual legislation to be negotiated or debated. He may be hoping to discourage public debate altogether by not taking the proposals seriously. The plans are not dead, since Democrats can pass them under reconciliation rules if all fifty Democratic senators can agree on them.

McConnell did say that Republicans could still support something like the $568 billion they proposed for a much narrower bill focused on “hard infrastructure,” especially roads and bridges. However, that is only about one-seventh of the $4.1 trillion Biden proposes for his two plans. Much of that smaller sum wouldn’t even be new money, but rather taken from existing allocations, including coronavirus aid to the states that has not yet been spent. That way, Republicans would avoid raising any taxes, but they would also create few additional jobs.

Republicans have made their priorities clear. They place a higher value on preserving the Trump tax cuts for corporations and the wealthy than on addressing broader infrastructure needs such as the transition to new energy sources. Also left out would be the needs of families for more affordable housing, education or child care. Bear in mind that the Biden plans would raise taxes only on incomes over $400,000 a year. To the extent that they make economic arguments at all, Republicans continue to insist, contrary to the economic evidence, that tax cuts for the wealthy create jobs and expand the economy more than increases in government domestic spending. Meanwhile, their primary preoccupation is spreading the lie that Biden won the election only because of fraudulent voting, and working at the state level to suppress the Democratic vote in future elections.

The Biden plans are not perfect, but they deserve honest analysis and fair debate, not rejection out of hand on ideological grounds. Since most people have been dissatisfied with the direction of the country, we would all benefit from such a debate over the future role of government in the economy. Having failed to govern very well while they were in office, Republicans should get over the election and try to restore their tattered reputation as a responsible participant in a two-party democracy.


An Economic Case for Building Back Better

May 3, 2021

Previous | Next

Last week, in his first address to Congress, President Joe Biden defended the three legislative initiatives in his “Build Back Better” program. So far at least, the response from the public has been mostly positive. Yet Congressional Republicans seem united in their opposition, leaving the fate of two of the proposals in some doubt. Here I will give a brief overview of the plans, describe how the President intends to pay for them, and discuss some of the pros and cons of implementing them. On balance, I think that the proposals would help rather than hurt the economy.

The Biden plans

The American Rescue Plan is the $1.9 trillion COVID relief and stimulus package that President Biden has already signed into law. It passed Congress very narrowly, without Republican support. Senate opponents could not filibuster the bill because it qualified for passage under budget reconciliation rules.

Included in the plan are direct stimulus payments to households, extended unemployment benefits, a continued moratorium on home evictions and foreclosures, an increased child tax credit (fully refundable for families too poor to pay income taxes), assistance to state and local governments, assistance to schools trying to reopen, and subsidies for COVID vaccination and testing.

The American Jobs Plan is a $2.3 trillion plan to improve infrastructure and create jobs. Some of it relates to infrastructure in the traditional form of roads, bridges, airports, railroads and waterways. It also addresses “community infrastructure”—such things as new schools, VA hospitals, affordable housing, clean drinking water, broadband access for all communities, power grid modernization, and support for energy efficient homes and new sources of energy like wind turbines and charging stations for electric vehicles.

The plan also addresses manufacturing and workforce development, including government investments in research and development, which Biden noted has declined from 2% of GDP to less than 1%. It would also support new jobs in the area of home and community-based care for the elderly and disabled.

Biden defended the plan as an exercise in “public investment,” doing things that only government can do. Private firms will do what is profitable, but they don’t do as good a job providing goods and services that benefit the entire society without regard to ability to pay, such as public education or clean water. The low wages and shortages of eldercare workers suggest a public need greater than the private market can meet.

The American Families Plan is a $1.8 trillion plan to address the health, education and wellbeing of families. It includes $800 billion in tax cuts, especially an extension of the rescue plan’s child tax credit for four additional years. This is intended to cut child poverty in half.

The plan also enables each child to obtain four more years of free public education, two in the form of free preschool and two in the form of free community college. It subsidizes high-quality affordable child care, with payment caps for parents adjusted for income level. It finally does what other industrial countries do, moving from unpaid to paid family and medical leave. The plan makes changes to the Affordable Care Act, lowering deductibles and prescription drug costs, and allows Medicare to negotiate lower prescription drug prices with pharmaceutical companies. As it is, American often pay more than people in other countries for the same drugs, at least partly because the power of large drug companies is not challenged by the countervailing power of government.

Whether they pass Congress this year or not, these plans represent a fundamental reversal of the trend to disparage and reduce the role of government in the economy and society. Although the current national situation is not as dire as the Great Depression, the proposals are already being compared to those of Franklin Roosevelt and the New Deal.

Economic costs and benefits

The goals of these plans are fairly popular. Most of the debate over them concerns their economic implications. Democrats say they will help the economy, while Republicans claim they will hurt the economy. Who has the better argument?

The American Recovery Plan is very different from the other two plans because of its obvious benefits and costs. It is responding to a national emergency, but since it is not paid for with new taxes, it does add to the federal deficit, a potential burden on future taxpayers. Last year’s deficit was already $3.1 trillion, or 15.2% of GDP, the largest percentage since 1945.

However, I am not losing too much sleep over that, for two reasons. By its very nature, emergency spending is mostly temporary. But also, deficits and debt normally rise during economic contractions and fall during economic expansions. At the end of World War II, the deficit was 21% of GDP, and the accumulated public debt was 106% of GDP. By the early 1960s, the deficit was down to zero—the budget was balanced—and by 1974 the public debt had fallen to 23% of GDP. The postwar economic boom had boosted GDP and tax revenues, and made the debt relatively smaller and more manageable. Similarly if less dramatically, economic growth in the 1990s eliminated what had been a 5% deficit and brought public debt down from 48% to 32% of GDP. Deficits and debt do matter, but so do economic stimulus and economic growth.

The Jobs Plan and the Families Plan are in a different category, because the President proposes to pay for them by undoing some of the Trump tax cuts on corporations and the wealthy. To the extent that we do that, the plans have the potential to stimulate growth without adding to deficits and debt. Biden would increase the corporate tax rate from 21% to 28%, which is still lower than the 35% rate before the 2017 tax cut. He would also impose a 15% minimum rate to stop corporations that have been using tax loopholes to avoid taxes altogether. The Biden plan would go back to taxing personal income over $400,000 at 39.6%, the top-bracket rate before Trump reduced it to 37%. That would affect only the richest 1% of taxpayers. Finally, the plan includes a higher capital gains tax for millionaires. The tax cuts of 2017 did not turn out to be very popular, and a majority of Americans support these increases.

A principal economic argument for these two plans is that the increased spending will stimulate the economy and create more jobs than the 2017 tax cuts did. Government purchases of goods and services boost GDP directly because they are a component of national spending. They also have a multiplier effect, where each dollar spent grows the economy by more than a dollar. Tax cuts, on the other hand, only increase the demand for goods and services to the extent that the increased disposable income is spent rather than saved. As Krugman and Wells say in their macroeconomics text, “In general,…a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP.” Furthermore, the tax cuts that are in Biden’s plans put money in the hands of ordinary families who are more likely to spend it, rather than wealthy families who are more likely to add it to savings. Increasing the child tax credit should boost GDP more than cutting capital-gains or inheritance taxes.

In addition to short-term economic stimulus, the Biden plans are investments in future growth. Addressing our neglected infrastructure, our research and development needs, and our transition to new sources of energy should be good for the economy in the longer run. So should the investments in human capital through wider access to preschool and college education. Addressing parental needs with paid leaves and subsidized child care makes it easier for people to combine parenting with paid employment, adding to the nation’s economic output and income.

Opponents of the plans are almost forced to argue for some form of “trickle-down” or “supply-side” economics. They must claim that low taxes on the wealthy are better for the economy than the proposed government spending. In theory, low taxes on corporations and the wealthy can stimulate the economy from the supply side by making more money available for private investment. Then the benefits trickle down to the rest of us. But that is a tough argument to support when the wealthy are already riding high and the interest rates on funds for investment are already at historic lows. There seems to be no shortage of funds to invest; what is lacking is business confidence because of sluggish growth and weak economic demand. That’s probably why trickle-down economics has not been working and the Trump tax cut was such a fizzle. The tax revenue that we lost by cutting taxes on the already-rich could be better spent “growing the economy from the middle out,” as President Biden said.

Another objection to the plans is that they could produce too much demand-side stimulus and runaway inflation. That is not impossible, and the day may come when we need to cool the economy by raising interest rates or cutting spending. But such policies seem premature when 6% of the workforce is unemployed, many others have dropped out of the labor force, and the economy is running below capacity. Turning from government stimulus to austerity prematurely was the mistake the US and many other countries made back around 2010, when we were still recovering from the last recession.

The Republican alternative

This section can be brief, since Republicans are proposing very little except to keep taxes low and avoid increases in domestic spending. In the official Republican response to the Biden address, Senator Tim Scott rejected all three of Biden’s initiatives, but based his position on worn-out slogans rather than economic arguments.

Senator Scott characterized the American Rescue Plan as a “partisan bill,” ignoring the fact that it is supported by about three out of four Americans. He suggested that it wasn’t needed because Biden had inherited an improving situation from his predecessor. America had already “rounded the bend” on the pandemic and the associated recession.

Scott described the American Jobs Plan as mostly “big government waste,” since only a small part of it involved traditional transportation infrastructure. Either Republicans believe that broader objectives like power-grid modernization and broadband access are a waste of money, or they think the private market will do the job alone. As for the taxes to pay for the plan, he called them “job-killing tax increases,” refusing to acknowledge that the additional tax revenue would be used to create jobs. Republicans want us to believe that tax cuts for the wealthy grow the economy more than spending to address majority needs, but the economic evidence does not support that. Basing policy proposals on facts is not something that Republican leaders have excelled at lately.

Scott dismissed the American Families Plan as an effort to put “Washington in your life from cradle to college.” I wonder how many of today’s struggling families would rather keep the government out of their lives than accept free preschool and community college, affordable child care and paid parental leave, not to mention more established programs like Social Security and unemployment compensation.

Having dispensed with Biden’s proposals with a few derogatory remarks, Senator Scott turned to pleasing the Republican base by arguing that America is not a racist society, and that Republicans really support making it easier to vote, just not to cheat. He didn’t explain why cheaters are so much harder to find than eligible voters standing in long lines in poor urban precincts.

For the last forty years, Republicans have been promoting the same one-size-fits-all economic policy. Always cut taxes, in good times and bad; and always call for domestic spending cuts, even if the actual cuts suggested are too unpopular to be passed. Blame the resulting deficits on “tax and spend” Democrats, not on “don’t tax but still spend” Republicans. Offer few constructive proposals for addressing national problems. Instead, deny the problems or blame them on vague conspiracies, trust the markets, and claim you are saving America from the tyranny of liberal elites and the Deep State. Our politics and policies have served the few better than the many, left the economy with sluggish and erratic growth and the worst inequality since the Gilded Age, and neglected many pressing national needs. The case for a new national direction is strong.