A historical note on Brexit

Brexit has become a mess. Yet some Britons, mostly supporters of the conservative party, remain adamant about leaving the EU. In social media, they often object to the prospect of the UK having to constrain some of its domestic policies according to the will of other European nations and especially Germany, which they feel they defeated in WWII. In light of this attitude, it is important to note that the first European politician to speak about a United States of Europe was British, and not just any Brit. It was the man who led not only the conservative party from 1940 to 1955 but also the UK in its resilient fight against Nazi Germany. If you guessed that his name was Winston Churchill, you would be correct.

Below is a short clip from Churchill's speech delivered on September 19, 1946 at the University of Zurich in Switzerland. In it, Churchill urges Europeans to pursue the creation of a federal political entity even if this means leaving behind countries that may not be ready to follow. It is ironic that decades later, one of the few European countries that would turn down membership to a United Europe and the party that would opt against it would both be his own. But maybe it is not ironic after all. Churchill witnessed the horrors of two world wars. He led his country during one of them, and spent a good chunk of it fighting Nazism nearly single-handedly. He could never be a nationalist isolationist. Unfortunately, the current generations may remember the victory, but it seems that they have forgotten the hardship, sacrifices, and alliances that forged it.

Trump's views on monetary policy and the elephant in the room

It is not the first time that President Trump's rhetoric seems convoluted when discussing economic issues. So far, his confusion has been mainly on trade. I have pointed here the mistakes in his reasoning.  And after beginning to experience the negative consequences of his trade war, Americans are once again shifting towards favoring free trade. According to a recent NBC/WSJ poll, the share of Americans who believe that free trade is good has risen from a little over 50% in 2015 to an all-time high of 64% in August 2019, while the share of those who hold negative views has fallen from a little over 40% to 27%. By unwillingly illustrating the perils of defying economic theory, Trump may be the most effective ally that mainstream economists have. A slow-down in economic activity would be bad for reelection however, so Trump seems to be looking for someone to throw under the bus if the negative consequences of his trade policies intensify. In today's press conference, he asserted that our economic growth will continue unless the Fed kills it. The growth is, of course, the President's doing, but a recession would be the Fed's doing. How convenient! What is the Fed's sin? That they raised interest rates too fast, are keeping them too high, and are normalizing. The President wants the Fed to gradually lower the targeted interest rate by "a minimum"  of 100 basis points (one percentage point). He believes that if the Fed did that, we would experience a "burst of growth that we have never seen before". What is wrong with his assertions? Well, there are factual problems and theoretical ones.

Let's start with whether monetary policy is "too tight". There is an excellent and more detailed analysis by Stephen Williamson here, so I will only mention a few facts. Below is a graph showing the Federal Funds Rate (FFR) since January 1990. The FFR is the rate at which banks borrow reserves from each other overnight, and is the rate that the Fed has traditionally targeted. The graph extends to July 2019, when the FFR stood at 2.40%. As you can see, by historical standards this is remarkably low, especially given that the economy is experiencing reasonable growth and a tight labor market; the unemployment rate is at 3.7% and the rate of job vacancies relative to the rate of unemployment is quite high. As well, keep in mind that the Fed recently lowered the targeted range further, to between 2% and 2.25%. Lowering the FFR by 100 basis points below the current range would bring it below the rate of inflation, which is currently 1.8%, and lead to a negative real rate unless inflation also declines. There is no justification for such a dramatic move. Moreover, as Williamson shows, the Fed's balance sheet remains much larger than it was before the financial crisis. So no, we are not even close to normalization.

As far as economic theory goes, obviously the President is unaware of the concept of monetary neutrality. While economists disagree on whether money is neutral in the short run, the consensus is that money is neutral in the long run, and that sustained growth can only come from real factors like improvements in productivity. In other words, most economists believe that even if a positive monetary shock does stimulate economic activity temporarily, once everything plays out economic activity will return to its previous level and only prices will rise permanently. By then, of course, Trump may have been reelected. But this is precisely why we have given our central bank relative independence; to prevent politicians who are up for reelection from manipulating monetary policy for political gain at the expense of everybody else. If the President wants sustained improvement in economic activity, he should rethink his trade policies. But I am afraid there is something even worse happening here.

In the press conference, Trump laid out a plan for further cuts in payroll and capital gains taxes. The announcement came just in time for the 2020 elections. Isn't a tax cut a good thing? Well, not if it is not followed by curbing spending and is accompanied by a historically high debt and large budget deficits about to make the debt grow further. As the graph below shows, the Federal government debt as a percent of GDP is currently at 104.5%, the highest it has been since the end of WWII.

Making matters worse, as shown below, the federal government is running the highest budget deficit as a percent of GDP during a boom since WWII. The budget deficit was larger during the early 1980s and during the Great Recession, but this is to be expected following an economic downturn (the shaded eras). If the deficit is so large when the economy is booming, what would happen if we entered a recession?

To finance his new tax cuts, Trump needs the Fed to keep interest rates low and to keep buying Treasuries, which means maintaining a large balance sheet. So long as the Federal government can keep borrowing at extremely low interest rates, the government debt can remain sustainable even if it grows further. If interest rates rise however, well, let's just say that nightmares of Greece haunt me. Of course, unlike Greece, the US has a central bank with an unlimited supply of money that it can use to keep buying government debt that nobody else wants to buy at high prices. But then, it is a matter of time before inflation starts creeping up. Trump may be reelected and gone by then, but the rest of us will still be here trying to clean up the mess.

The Earned Income Tax Credit is not a subsidy to employers!

In this follow-up to my previous post, which links to a thoughtful piece by Professor Jonathan Meer on the hidden costs of minimum-wage laws, I debunk the myth that the Earned Income Tax Credit is a subsidy to employers. Addressing this issue is important to the debate because most economists who oppose the minimum wage are not motivated by a desire to eliminate support for the working poor. On the contrary, they oppose minimum wage laws because they believe that such laws often hurt the same people they purport to protect, whereas policies like the Earned Income Tax Credit (EITC) are much more effective. Defenders of the minimum wage often respond by claiming that the EITC is a subsidy to employers that drives wages down, thereby making the establishment of a minimum wage even more necessary. Unfortunately, this claim shows a poor understanding of economics. Sadly it is often made by people who have advanced training in economics, and should therefore know better. Bellow I explain why the EITC is not a subsidy to employers as well as why it likely raises, not lowers, wages for low-skilled workers.

First, let's look at how the EITC works. The IRS offers an explanation here, but briefly, the EITC is a payment made to people who are earning an income, but that income is "too low". The IRS describes the EITC as "a benefit for working people with low to moderate income". The credit is more generous for people with children, declines gradually as someone's income rises, and disappears once a person's income has reached a threshold.

Second, let's look at how subsidies work. A subsidy is in essence a negative tax. It is a payment made to one or both trading parties each time a transaction takes place. As an example, let's look at how a subsidy to orange farmers could work. Such subsidies were popular in Greece, where I grew up, in the 1980s so I have an eye-witness account of their impact. Under one scenario, the government could pay a farmer some amount, say 50 cents, each time the farmer sold a pound of oranges. The impact of the subsidy is therefore to reduce the marginal cost of production. For example, suppose that to produce an extra pound of oranges, the farmer had to spend $2. By getting 50 cents back from the government, her cost effectively drops  to $1.50. It doesn't take much economic training to conclude that the decrease in cost motivates farmers to produce and sell more oranges. The problem is, however, that to sell more oranges, farmers have to lower their price to entice consumers to buy the added production. Hence, the subsidy becomes self-defeating to some extent. Farmers receive a payment from the government for each pound of oranges they sell but because they now want to produce and sell more they must charge less. Some of the benefit is lost and captured by the buyers. To prevent the price from falling, the Greek government first engaged in an advertising campaign to convince consumers that they should eat at least three oranges per day, and when that failed it was forced to buy and bury in dump yards large portions of the production so that it wouldn't reach the market. What a waste! Today, to avoid this problem, most subsidies to farmers impose production quotas that limit the amount that farmers can produce. Still a waste, this time of land.

Applying this concept to the labor market would involve the government paying workers some amount for every hour they work. This would motivate employees to work more hours, and in the absence of a minimum wage it would indeed drive wages down as workers would have to accept lower wages to convince employers to hire the added labor. The employers would reap some of the rewards of the subsidy, just like the buyers of oranges did even though the subsidy was directed at the farmers. But the EITC works the opposite way. An employee that worked more hours and earned a higher income would get less money from the government, not more. Therefore, the EITC recipients are discouraged from working since any increase in income is offset to some extent by a loss in government assistance. To convince workers who receive the EITC to work more hours despite that loss, employers would  have to pay not a lower but a higher wage. This is the exact opposite of what defenders of the minimum wage suggest. In economic jargon, if leisure (the time spent not working) is a normal good, then any increase in non-labor income should make people consume more leisure by working less. The decrease in the supply of labor should then raise the equilibrium wage.

In conclusion, the EITC is not a subsidy to labor. The credit is more generous to those who have lower income, and typically these are people who work fewer hours, not more. Because the EITC benefits more those who work less, it reduces the willingness of its recipients to work. To make them overcome their hesitation,  employers would have to pay them higher wages, not lower. Given that the minimum wage is a blunt instrument with several harmful unintended consequences, there is no reason why we should keep it, let alone raise it. We should focus instead on reforming the EITC or, even better, instituting a national dividend. But more on the national dividend in the future. 

The unintended dismal consequences of the minimum wage

David Henderson hosted recently at the Library of Economics and Liberty a guest blog post written by Professor Jonathan Meer of Texas A&M University of the hidden costs of the minimum wage. The article is particularly relevant given an increasing number of voices among congresspeople calling for an unprecedented increase in the Federal minimum wage. But what makes Meer's piece even more interesting is that unlike many of the op-eds we see in newspapers these says, his opinions are backed by making reference to recent scholarly papers and articles written by academic researchers as well as his own work. It is very much worth a read because, as he concludes at the end,

We should never minimize the struggles of low-income families to get ahead. But good intentions are no substitute for good policy. Minimum wage proponents mean well, but the unintended consequences hurt the worst-off the most.

You can find the rest of it here.