Thursday, March 19, 2015

Why did rich-world deficits start exploding around 1980?



The U.S. federal deficit, which had been decreasing since the end of WW2, began to trend upward beginning around 1980:


Why? Well, the proximate cause was big tax cuts, without any offsetting spending cuts. The beast was not starved, and tax cuts did not pay for themselves.

But what was the political-economic cause? I have a theory.

Economists have studied mechanisms by which a government might pay for public goods (i.e., things that the market won't provide enough of on its own). All the mechanisms basically boil down to either a Vickrey-Groves-Clarke mechanism or an AGV mechanism (AGV stands for some French names). These are ways of determining how much each taxpayer pays for the public goods.

The VCG mechanism, which is similar to what Google uses to sell ads, can't balance the budget. Deficits grow and grow. The AGV mechanism, on the other hand, balances the budget on average. It does this by taxing rich people a lot. However, the AGV mechanism doesn't satisfy something called "individual rationality" - it taxes the rich people so much that they'd like to leave entirely.

If the rich people can't leave, you can tax your captive rich people a lot and balanced the budget. But once they get the ability to leave, you have to cut taxes, and then you can't provide public goods without big deficits.

So one story of the explosion in U.S. government debt is that around 1980, globalization (i.e., European and Asian catch-up growth) progressed to the point where rich people - or companies, which are not explicitly dealt with in the VCG or AGV mechanisms - could threaten to leave unless we cut their taxes. So we did cut the taxes - we switched from AGV to VCG, and could no longer balance the budget.

Now a big caveat is that lots of the things our government pays for aren't public goods, they're transfers. Their level is set not by some consideration of economic efficiency, but by some more complicated political mechanism. So this mechanism-design-based story doesn't fully explain why we failed to cut government spending. It also leaves out the distinction between corporations - whose taxes were cut mostly by loopholes rather than tax rate reductions - and individuals. And it doesn't explain why U.S. deficits stopped expanding as a percentage of GDP in the 1990s, and again since 2011.

So the story isn't entirely satisfying. But it's really striking that deficits started trending upward all over the rich world around the same time. And, via Marginal Revolution, here's some evidence that rich people do sometimes move around to take advantage of lower tax rates - probably a lot more in Europe and Asia than in the U.S.

Anyway, I think the mechanism design story could an overlooked part of the explanation for why rich-world governments have borrowed so much money since the 1980s.

46 comments:

  1. Even if the people didn't leave, their money could (and did). Isn't that the point?

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  2. Anonymous4:18 AM

    Great theory! Not true, but great theory!

    Here is Steve Benan being liberal, and gettingiti right, but not being honest:

    http://www.washingtonmonthly.com/political-animal/2011_08/a_timeline_of_events031362.php

    So let's get it honest:

    USG had a VCG mechanism from 1787 until 1913. Rich could bounce from state, states ran balance budgets - just had no real safety nets (not good enough for your side).

    In 1913, suddenly we trap the rich with 16th amendment and simultaneously give banks / bankers control over Fed. Fed operates as a 2nd tool of hegemony to keep first tool of hegemony, USG, from getting too big for britches.

    THEN FROM 1913-1980 (tho Nixon started it), GOP got very tired of not winning elections. So instead of trying to be the fiscal scold, they decided to short-circuit the Dem trade with voters (vote for me, get free stuff).

    In 1981, Reagan says OUT LOUD "I didn't come here to balance the budget," and David Stockman came to realize massive deficit spending was on purpose and hated it.

    And this strategy to GOP seemed UNBEATABLE, think about it:

    After running in 91-92 where after the word "change" his 2nd most used word was "invest" Clinton sat down with Greenspan very early in1993, and came out and said he wouldn't be “investing” in anything, he’d be balancing the budget, put Greenspan on the dias at his first SOTU next to Hillary, and bought himself 8 years.

    Clinton first act as POTUS? Don't ask, don't tell. Why? Only free thing he could give his voters. Everything Hillary did on health care was wrapped around this brutal no new deficit spending rule. Failed.

    So after a truly winning strategy won big for 20 years, Bush II wanted to spend all the money on anything that didn't reward Dem voters. We got Iraq War, tax cuts for rich, Part D, all the way to the last $700B in bank bailout... spend it all on GOP voters before Dems can!!!

    Obama KNEW the money had all been spent on purpose, and instead of being Clinton he was able to fight it.

    The problem it turns out with GOP strategy is that in the throes of massive economic crisis, GOP can't Clinton a Obama. Sad but true, crisis in capitalism kills conservatives.

    Which is why Sumner's NGDPLT is such an interesting conservative concept, bc in theory it would keep us from having financial crises....

    Under a 5% NGDPLT, basically any new govt spending (without productivity gains) almost is just counted as inflation - it crowds out private Real GDP.


    mw

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    1. Economists scoffed at the rabble resisting globalism. They knew best, right? How come tariffs are so bad but its perfectly acceptable for currency exchange rates to significantly deviate and dramatically effect the feasibility of trade? Common sense is no longer at the table. Policy is decided by the high priests of economics who speak a exclusive babble all their own.

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  3. My first thought was immediately "Great Stagnation thesis" and think about the denominator (NGDP). The nominal value of Federal debt grew much more smoothly (with an acceleration in the Reagan era still being apparent), but the real value of Federal debt shows pretty much the same trend as in Noah's graph. This suggests inflation targeting combined with the Great Stagnation is a big part of the problem. Much of the short-run Federal deficit can be explained by looking at the unemployment rate.
    http://research.stlouisfed.org/fred2/graph/?g=14FX

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    1. "... the real value of Federal debt shows pretty much the same trend as in Noah's graph."

      It depends how the real value is figured.

      http://newarthurianeconomics.blogspot.com/2015/03/living-in-nominal-world.html

      Nice graph, 14FX

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  4. Look at my above graph as a scatter plot to see what I'm talking about. Reagan was a frickin' tightwad compared to Bushama, 2008-Fiscal Cliff.
    http://research.stlouisfed.org/fred2/graph/?g=14G9

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  5. There probably was a mentality change shortly before 1980 which was then allowed to run free under Reagan and Thatcher. At some point, the global elites decided that the time had come to grab a bigger share of the world's productivity. At the same time, Keynesian economics was facing a frontal assault, so the intellectual power of countercyclical policy was weakened. With r>g, the waning of countercyclical policy, triggered a self-sustaining inequality spiral.
    Private business became more powerful than the political sphere. Private citizens with higher wealth were able to influence policy more. And yes, the threat to simply leave a country which, during the Cold War, might have been considered unpatriotic, also strengthened the power of rich individuals. Then the collapse of communism ideologically supported these trends of the late 70s and 80s, so that the 90s continued these trends.
    In this decade, two new factors began to play a role, tax competition and the establishment of a global capitalist elite. Tax competition made, for example, Ireland a tax haven, and made central Europe compete with Eastern Europe. NAFTA and the age of free trade enforced tax competition because the fallling away of duties leveled the playing field. The establishment of a global capitalist élite brought rich people closer together, as exemplified by the Davos meetings, by forming a global class of US-trained businessmen and politicians, by increased freedom of movement, so that Russian billionaires moved ot London. In this context, it would be interesting to try to determine when tax havens like the Cayman Islands started to become important. In Europe, there were Switzerland and Luxembourg playing the same role.
    The 00s continued these trends, but they probably crossed into the realm of diminishing returns. The growth promises of supply-side theory didn't turn out to work, so much available private wealth only led to bubbles while public infrastructure crumbles away. But the trend continues until today, fueled by the now excessive power of private individuals.

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  6. It would be awesome if you could take the 10 question Satt test (economic coherence test) and share/explain/defend your answers! It's kinda like those Cosmopolitan sex quizzes... but for economists.

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  7. You are making this way too difficult. Kleinbard's, "We Deserve Better than This: How the Government Should Spend our Money" details this in spades. Deficits are caused when spending > income. Pretty simple, but then I'm just a humble chemist and not an economist.

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    1. No, not making it too complicated. Just the right level of causal explanation. Deficit is are arithmetic driven by political economy. Ignoring the politics is like "explaining" the chemistry of the earth while ignoring the sun. Where is all the energy in this far from equilibrium system actually coming from?

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  8. Do you have any citations on this topic? Would love to read more. Thanks!

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  9. When some institutions limit services markets with arbitrary definitions for service formation and participation, they also stand between governments and the people who need services. That's why people - especially lower income levels - need to be able to define important services on their own recognizable terms, i.e. those that don't have to add to government budgets. Government budgets are also strained by providing transfers for the ones who can already take care of themselves.
    http://monetaryequivalence.blogspot.com/2015/03/how-much-austerity-is-illusory.html

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  10. 1. You are not showing the deficit, you are showing the accumulated debt.
    2. Accumulating debt is a choice (you could choose to print money instead)
    3. It might be interesting in this context to look also at the trade deficit and private debt. I realize they are related, but it is not at all clear in which direction the relationship runs. Hint - when did Bretton-Woods come to an end?

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  11. @Alexander Sebastian Schulz
    -Your comment has nothing to do with the topic of the post and is ridiculous. First, as shown in my first chart here, Keynesian countercyclical policy was strengthened after 1990. Secondly, why would an increase in inequality have any impact on the course of Federal debt at all?

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    1. The higher the share of the wealthy of total wealth, the more they can buy the politics they want, and that means tax cuts. I don't think your first chart shows what you think it does.

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    2. And sorry, maybe I should explain something else. Private wealth increases especially strongly when Public debt increases. Public debt is a safe asset to store value and to facilitate the existence as a rentier. Rentiers can have a disproportionate influence on the policy of a country if the politie allows such, and recent studies confirm that the USA is now more an oligarchy than a democracy. It's in the interest of the rentiers to decrease taxes, especially capital gains and estate taxes. It is also in their interest to find safe returns on their investments, and government debt seems to fit the bill. It can be seen right now that even negative nominal interest rates do not kill the demand for government debt. So rentiers have both an interest in low taxes as well as in more government debt. It's a self-sustaining process.

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    3. Which is why world interest rates are at historic lows.
      Still, the fact you can imagine it happened does not mean it actually did.

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  12. Government dissaving (fiscal deficits) funds non-government saving (domestic private surplus + external surplus) in aggregate net financial assets. Since non-government cannot save in net financial assets in aggregate with funds created endogenously (assets = liabilities) for non-government to increase net financial assets, government must increase net financial liabilities. When government increases its net liabilities wrt to non-government then non-government increases its net income and net financial assets.

    Decomposing non-government, the domestic private sector can further decomposed into household and firms, and the external sector can be decomposed into a countries trade partners. The questions then become who is net saving, does this make economic sense in terms of efficiency and effectiveness, and what are the underlying politics in terms of application of power.

    This brings up the questions of distribution and inequality of income and wealth that countries running chronic deficits and accumulating public debt are facing. Given the Kelecki profit equation, one might expect that the net gain is flowing to profit.

    Furthermore, net imports are a benefit in real terms of trade, whereas net exports are a financial benefit at the cost of the country working for and supplying resources to other countries to accumulate the currency of the net importers.

    Finally, the financial situation of nations that are sovereign in their currency and do not net borrow in other currencies is different from countries that are not currency sovereigns like US states, the members of the EZ, and countries that don't float their currencies. Currency sovereigns cannot become insolvent, as Alan Greenspan pointed out to Paul Ryan, whereas countries that have abandoned currency sovereignty can. The financial constraint on currency sovereigns is inflation, which is a matter of available real resources. As long as a country's economy is able to expand to meet increasing demand, there is no problem with inflation.

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    1. "Currency sovereigns cannot become insolvent"
      -I know, man. Just ask Russia, 1998. Can you make your carefully-transcribed MMT chanting relevant, for once?

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  13. Having nothing of real substance, I'd just answer: Thatcher and Reagan.

    Combine a political ideology with outcomes that are good for powerful stakeholders (lower taxes for the rich, bonds for the finance industry, defense spending for contractors, transfers for retirees) and you've got something powerful.

    I also think think its worthwhile to consider whether budgets should be fully balanced.

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  14. Whether or not you are right on the main mechanism, regarding transfers in the US, the largest ones have their own revenue sources that largely cover them, Social Security and Medicare, and pretty regressively as a matter of fact,.

    Barkley Rosser

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  15. This is conventional wisdom, no? It definitely is in Europe. Offshore capital and hedge funds boomed in the '70s after all. It's somewhat less obvious in the US vs Europe, since we tax globally.

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  16. Mike Toreno5:55 PM

    Hey, Noah, did you ever think of examining anything that actually happened? I never thought I would see anything as dumb as your civility-scold pose, in which you criticize those who call out idiots as being rude, but this post beats it.

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  17. I don't quite follow how a theory about public goods is supposed to explain deficits, where the main spending goes towards transfers. This is not some side issue. This is the issue.

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  18. While it may not disprove your general thesis, you may like to consider counter examples; for instance, Australia ran budget surpluses for 10 out of 11 years from 1997-98 to 2007-8 inclusive, and the only deficit in the period (0.1% of GDP, 2001-02) was smaller than the smallest of the 10 surpluses (0.2% of GDP, 1997-98). Why was Australia able to go against the trend that was occurring in the rest of the world? I'd be interested to hear any thoughts you have; hopefully more than "special case, dismiss it".

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    1. Canada ran surpluses from 1997 to 2007 as well. One of the things that happened in 1980 was that interest rates increased so government that had debt were facing higher interest expenses.

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  19. While it may not disprove your general thesis, you may like to consider counter examples; for instance, Australia ran budget surpluses for 10 out of 11 years from 1997-98 to 2007-8 inclusive, and the only deficit in the period (0.1% of GDP, 2001-02) was smaller than the smallest of the 10 surpluses (0.2% of GDP, 1997-98). Why was Australia able to go against the trend that was occurring in the rest of the world? I'd be interested to hear any thoughts you have; hopefully more than "special case, dismiss it".

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  20. C'mon man. The answer is Alan Greenspan, as inspired by Ayn Rand. As for tax cuts not paying for themselves, this is merely bug/feature confusion.

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  21. Anonymous11:48 PM

    Reason is the only guy that got it. Everybody else is just mumbling. In terms of real money expansion by the government itself, it stopped printing after the great inflation and started borrowing. Real Government spending when you factor in the printing was much higher in the post-war era than in 1980's onward when real government spending "declined" except for the borrowing. LBJ outright printed money to pay for guns and butter to create his 69 surplus which set the stage for the BW's showdown in the early 70's. There is a big reason Randians hate inflation more than just inflation as a monetary issue. Because it allows more government spending.

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  22. From where'd you get this idea?
    The natural log of
    http://research.stlouisfed.org/fred2/series/CURRCIR
    is consistent with your case, but there's no smoking gun.

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  23. US revenue collection went from 19.6% of GDP when Reagan took office to only 17.3% the year of his reelection.

    Outlays went over 20% peaking at 23.5% of GDP in 1983 and did not start falling until the Peace dividend began taking hold.

    Outlays fell to 18.4% in 2000 when revenue collection was 20.9%.

    The Fed would not let it stand and piled on the fiscal austerity with monetary tightening that cause a recession.

    The answer is political corruption and the wealthy winning the class war.
    The wealthy began waging a campaign against social spending by shifting the tax burden from the wealthy onto the middle class in an effort to build allies against social spending increases. This was done at the state as well as federal level. The answer is that wealthy people started investing substantial sums in federal and state politics to influence tax policy. Money talks, the politicians listen.
    -jonny bakho

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    1. @jonny bakho
      As I pointed out above, Reagan was unarguably a fiscal tightwad until his second term. Carter was a fiscal tightwad, too. Also, I have evidence that unadjusted deficits actually began exploding beginning with the 1970 recession, not the one of 1981-2. I note you referenced roughly zero evidence to back up your claim in your last paragraph.

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  24. Anonymous 11:48 PM (and Reason): The deficit would be the same, no matter how you finance it: whether by money or by public debt.
    The deficit, is the adjustment variable between a state that tries to give some transfers, public goods and positive externalities, and the taxes that the people pay (part of them supposedly countering some negative externalities).
    In this simple equation, there are two kinds of people: those who receive and those who pay in net terms. For different political and technological reasons, those who pay in net have decided (and achieved) that they are not interested in contributing to the game. End of story.
    Nuance: The fact that inequality has constantly been on the increase is the other piece of the puzzle, as the net receivers grew on necessities and number.

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  25. Why do some states (e.g., California) have much higher taxes than others (e.g., South Dakota)? One reason is that rich people want to live in California regardless of the policies in place (e.g., because of the nice weather), while rich people only want to live in South Dakota as long as the policies are favorable (e.g., low taxes). If you tax people a lot in California, they won't leave to the same extent as they would in South Dakota.

    Prior to the TFP slowdown, and during the post-WW2 catchup phase, the US was the bomb diggity economically, while most other places kinda sucked (as they rebuilt from war). By the late 70s, the developed world was largely in a similar place, and the TFP slowdown meant the US, despite being at the frontier, was not much more successful than other places. So we went from California to South Dakota, and taxes came down.

    I think this is similar to your story but I'd put more emphasis on a Tiebout equilibrium type story.

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    1. What if I told you Federal revenue as a percentage of GDP peaked in two years: 1945 and 2000? I.e., it did not go down?

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  26. And it doesn't explain why U.S. deficits stopped expanding as a percentage of GDP in the 1990s, and again since 2011.

    The explanation in the United States is political. The Republicans learned that the only way to get elected was to promise voters magic ponies and free lunches. Dick Cheney famously said that "deficits don't matter." They nominated Mitt Romney as their flag bearer - a man who seems to have personally moved a few hundred million dollars of income off shore through various, no doubt perfectly legal, tax dodges. The current Republican budget proposal is more of the same.

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    1. And your statements have zero to do with the quote you pasted..

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    2. And your statements have zero to do with the quote you pasted..

      Rhetorical questions: Which political party held the presidency for most of the 1990s? Which political party held the presidency from 2011 to present?

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  27. Sorry - an after thought - the whole "starve the beast" strategy, which was endorsed by George W. Bush, was explicitly about running deficits to effectively bankrupt the Federal government so it would have to cut social spending for ideological reasons. There is no mystery here.

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    1. Two words: Medicare Part D. That ain't a spending cut.

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    2. Bush said in 2001 "so we have the tax relief plan [...] that now provides a new kind—a fiscal straightjacket [sic] for Congress. "

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  28. G.A. Pakela3:06 PM

    The reduction in the deficit as a percentage of GDP in the 1970s portion of the graph can be attributed to two factors: 1) sustained rates of inflation from the late 1960s until the early 1980s which caused GDP to rise faster than the accumulated post-war debt and 2) annual tax increases on all income levels due to the fact that the U.S. had a very progressive tax system with a myriad of rates that were not indexed for inflation. Thus, in spite of the stagnating economic growth and a brutal 1973-74 recession, taxes as a percentage of GDP held up quite well. The massive increase in the 1980s was due to the aftermath of the double dip recessions, the second of which was just as bad if not worse than the so-called Great Recession. The most recent run-up in the deficit is the same as the 1980s the aftermath of a brutal recession combined with increased government spending. If tax cuts were a significant factor, the stabilization of debt in the 1990s wouldn't have occurred as the top tax rate was lower than the previous post-war decades (40% compared to 90%, 70% and 50%) and tax revenues as a percentage of GDP were the highest of the post-war era.

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  29. rich people do sometimes move around to take advantage of lower tax rates - probably a lot more in Europe and Asia than in the U.S.

    American wealthy seem to prefer to just move their money rather than where they sleep at night. First world amenities, third world tax rates.

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  30. Anonymous10:18 AM

    have you ever heard of occam's razor ?
    Rich people bought congress, and got the law changed
    it aint' that hard
    the reason you don't go their is a parasitic meme - economics math that denys class as the basis for our lives - has infected your brain

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  31. You are making this way too difficult. Kleinbard's, "We Deserve Better than This: How the Government Should Spend our Money" details this in spades. Deficits are caused when spending > income. Pretty simple, but then I'm just a humble chemist and not an economist. http://bit.ly/1Kci1Ez

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