Agenda Lectures 4 and 5

Transcription

1 Agenda Lectures 4 and 5 What is Money? The Federal Reserve System A Primer on the Control of the Money Supply Intro to Monetary Policy The Target Inflation Rate Quantitative Easing Why the Recovery was so Weak Stagnation Hypothesis and Why Interest Rates are Still So Low The Republican Tax Plan 1 Page 1

2 What is Money? Money is a financial asset that serves three functions: The unit of account: A store of value: Money is how values in the economy are measured and indicates the price of all goods and services in the economy. Money is a means of preserving purchasing power. Other assets can also serve as a store of value but not as the medium of exchange. Money is the most liquid of all assets. The medium of exchange: Money is the accepted method for payment for goods and services and repayments of debts 2 Page 2

3 What isn t Money? Money is not the same as: Wealth: the total collection of property and financial assets, net of liabilities, that serves as a store of value Income: a flow of earnings per unit of time (money is a stock) 3

4 The Money Pyramid M2 Note: M2=M1+other stuff M1 The Monetary Base 4 Page 4

5 Monetary Aggregates: M1 & M2 In the real world there are many forms of money besides cash. So they must be defined. The two most discussed in the monetary literature are M1 and M2. The M1 is a very liquid measure of the money supply, as it contains primarily cash, checking and NOW accounts that can quickly be converted to currency. M2 is M1 + Savings Accounts, small CDs, and retail money market accounts 5 Page 5

6 How Much M1 and M2 is in Circulation? Trillions of $ 6 Page 6

7 Why Do Economists Care? Index 1959Q1 =1 7 Imagine you re a monetarist economist and its M2 and GDP are highly correlated. So, one might interpret that as causal and predictive. Page 7

8 Why Do Economists Care? Index 1959Q1 =1 8 Problem: whatever relationship there was, it broke down beginning in 1990 Page 8

9 The Federal Reserve System The U.S. central bank was created by an Act of Congress on December 23, Responsibilities: Functions as the government s bank. Regulates and supervises banks Acts as lender of last resort. Implements monetary policy. For those with Netflix accounts, check out the documentary: Money for Nothing 9 Page 9

10 The Federal Reserve System Key Governance Structure Board of Governors 7 members appointed by President with overlapping 14 yr. terms., Confirmed by U.S. Senate. Chair and Vice-chair have 4 year terms. 12 regional Federal Reserve Banks, with Presidents appointed by BODs of the FRBs, subject to BOG approval Federal Open Market Committee (FOMC): FRBOG + FRB presidents on rotating basis Note: Not a single elected official sits on these Boards or governance committees. 10 Page 10

11 The Federal Reserve System 11 Page 11

12 Federal Reserve - Independence Independence Appointment of Governors by President Appointment of Bank Presidents by FRB Boards approved by Fed Board of Governors Reserve Bank Directors elected by bank members and BOG Financed from its own resources Surplus from interest paid on bonds held in vault returned to U.S. Treasury Oversight by Congressional Committees 12 Page 12

13 Federal Reserve: How is it Budgeted? Release Date: January 11, 2016 The Federal Reserve Board on Monday announced preliminary results indicating that the Reserve Banks provided for payments of approximately $97.7 billion of their estimated 2015 net income to the U.S. Treasury. Release Date: January 10, 2017 he Federal Reserve Board on Tuesday announced preliminary results indicating that the Reserve Banks provided for payments of approximately $92.0 billion of their estimated 2016 net income to the U.S. Treasury. The 2016 audited Reserve Bank financial statements are expected to be published in March and may include adjustments to these preliminary unaudited results. 13 Page 13

14 Federal Open Market Committee (FOMC) Created by an Act of Congress on March 1, The primary monetary policy decision-making body in the US government Consists of 12 voting members: 7 members of the Board of Governors. President of the New York Fed. 4 other regional Federal Reserve Presidents that serve on an annually rotating basis. 7 non-voting members: The other regional Federal Reserve Presidents off rotation. 14 Page 14

15 Federal Open Market Committee (FOMC) Transparency Chairman of the Board of Governors presides as the FOMC chairman Meeting Records: Minutes released 3 weeks after the meeting. Monetary Policy Report released semi-annually. Meeting transcripts released after 5 years. 15 Page 15

16 The Money Supply Process: A Primer on How the Fed Manages the Money Supply 16 Page 16

17 The Money Supply Players The Fed conducts monetary policy. Depository institutions (i.e., banks) accept deposits and make loans. The public (i.e., people and firms) holds money as currency and deposits. 17 Page 17

18 The Fed s Balance Sheet A central bank creates money when: It acquires real assets from the public. The liabilities it issues are called money. These liabilities are called: M2 The monetary base or High-powered money M1 The Monetary Base 18 Page 18

19 FOMC Open Market Operations Primary method for changing money supply FRB-NY buys and/or sells U.S. gov t securities in open market from the desk in NYC. Open Market Purchase: When the Fed buys U.S. government securities in the open market, it will: Increase banks deposits and reserves. Banks will now increase their lending. Households and firms deposit their borrowings in their checking accounts, which are part of the money supply. Open Market Sale: When the Fed sells U.S. government securities in the open market, it will: Decrease banks deposits and reserves. Banks will now decrease their lending. Households and firms checking accounts will decline, which are part of the money supply. 19 Page 19

20 Control over the Money Supply Fed Sells Treasury Securities to the Market Monetary Base Decreases Banks Reduce Lending Money Supply Decreases 20 Page 20

21 Control over the Money Supply Fed Buys Treasury Securities from Market Monetary Base Increases If Yes Banks Lend (or not) If No Money Supply Increases Banks Hold Excess Reserves and Money Supply stays relatively Unchanged 21 Page 21

22 September 2008: The Money Supply Game Changed and Has Remained Changed 22 Page 22

23 Monetary Base 1960-Aug 2008 Currency Required Reserves Excess Reserves Monetary Base ($B) 23 Can t see Excess Reserves because they re so tiny. Page 23

24 Monetary Base through Oct 2017 Monetary Base ($B) 24 Page 24 Now that s a Change in Bank Behavior

25 Monetary Base Dec 07 Oct 17 Monetary Base ($B) 25 Page 25 This is a picture of FRB Liabilities and the first look at the Fed s use of Quantitative Easing

26 Control over the Money Supply Fed Buys Treasury Securities from Market Monetary Base Increases If Yes Banks Lend (or not) If No Money Supply Increases Banks Hold Excess Reserves and Money Supply stays relatively Unchanged 26 Page 26

27 Control over the Money Supply Trillions of $ M1/MB 27 Page 27 Money Supply Relationships Changed the Day the Let Lehman Brothers Declare Bankruptcy

28 Fed s Holding of Assets Prior to Meltdown Trillions of $ Other Treasuries 28 This is what the Fed s holding of assets looked like to manage the country s money supply prior to Mar 08 Page 28

29 The Fed s Balance Sheet: Post Meltdown (Sep 08) Lehman Bros. Failure Fed s Use of its Balance Sheet changed dramatically after Lehman failure Trillions of $ Bear Stearns Failure QE1 QE2 QE3 Oct Page 29

30 Fed Announcement Sept. 26, 2017 In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee's Policy Normalization Principles and Plans. Trillions of $ 30 Page 30

31 Conclusions Lehman Failure and Financial Collapse has had material consequences on the core operations of the Federal Reserve: In order to stimulate economic growth the Fed has pumped trillions of dollars into the banking system Because the economy was performing so poorly, banks did not lend these funds and they became historically off the charts level of excess reserves This changed the behavioral relationship between the variable the Federal Reserve has close control over (the Monetary Base) and the one it has less control over (the Money Supply) 31 Page 31

32 Monetary Policy and Why It s Relevant to Personal Finance 32 Page 32

33 The Dual Mandate and Fed Policy In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. In setting monetary policy, the FOMC seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. 33

34 Aggregate Demand and Aggregate Supply Aggregate Demand Conservatives believe in this p Inflation Rate Region of Debate Aggregate Supply Liberals believe in this GDP Potential GDP 34 Page 34

35 Stabilization Policy in the AD/AS Framework In Normal (pre-2008)times: p Fiscal and Monetary policies work together Fiscal stimulus & Monetary are used to stimulate the economy GDP Potential GDP Both work to INCREASE AGGREGATE DEMAND When GDP<< Potential for increasing the inflation rate is not a major concern. In fact the inflation rate declining may be a concern. 35 Page 35

36 Unemployment vs. Inflation Here s What the Fed is Worried About Inflation Rate (%) 36 Page 36

37 Policy Diagram Core Inflation 3 2 Current core inflation = 1.8% Target Inflation Rate 1 Current Unemployment rate = 4.1% Unemployment Rate NAIRU (est) Page 37

38 An Example of Macroeconomic Policy Success Inflation Rate (%) 38 Page 38 Average Inflation Rate: = 5.0% = 2.3%

39 An Example of Macroeconomic Policy Challenges Unemployment Rate (%) 39 Page 39 Average Unemployment Rate: = 6.0% = 6.0%

40 The Fed Funds Rate and Other Interest Rates and Why they Matter Interest rates that receive media attention are Prime rate Federal funds rate London Inter-Bank Offered Rate (LIBOR) Treasury bill rate Ten-year Treasury bond rate AAA, AA, A, BBB rates 30 Yr FRM (fixed rate mortgage), 15 Yr FRM Adjustable Rate Mortgages: Floating rate, hybrid, option ARM 40 If economic agents are transacting at these rates then they matter. Hence, they all matter. Page 40

41 Treasury Yield Curve 10Yr Treasury Bond Rate Nominal interest rate (%) 3M Treasury Bill Rate 3 Mths Maturity 10Yrs 41 Defined as the locus of points for the same issuer over different maturities. In this case, this is considered (as long as the US Gov t doesn t default) a riskless security. Page 41

42 Treasury Yield Curve and Other Rates Prime Rate 15 Yr Fixed Rate Mortgage 30 Yr Fixed Rate Mortgage Nominal interest rate (%) 3 Mths Maturity 10Yrs Other rates are priced off the Treasury curve. 42 Page 42

43 Long Term Rates vs. Short Term Rates Rate (%) 10 Yr Rate 3M Rate (%) Page 43

44 Federal funds: Wikipedia Federal funds are overnight borrowings by banks to maintain their reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the federal funds market enable depository institutions with reserve balances in excess of reserve requirements to lend reserves to institutions with reserve deficiencies. These loans are usually made for one day only, that is, "overnight". The interest rate at which these deals are done is called the federal funds rate. This the rate that all financial markets are paying attention to because it signals the Feds Plan 44 Page 44

45 The Fed and the Fed Funds Rate The Federal Reserve targets the Fed funds rate by the buying and selling of Treasury bills and bonds in the secondary (a.k.a., open market ) Supply of FF by Banks Fed funds nominal rate Upper Target Lower Target Demand for FF Fed funds balances 45 Page 45

46 Fed funds Targets vs. Fed funds Rate Upper Target 46 There are occasions when the market is so disrupted that the effective Fed funds rate is not close to the target. Page 46 Lower target has been zero since 9/2008

47 Key Issue: The Transmission Mechanism Open Market Operations Fed Sells Treasuries Intrabank Market Fed Funds Rate Increases All Financial Markets All other rates increase Economic Growth Slows Consumption and Investment Declines Borrowing Costs Rise 47 Page 47

48 Key Issue: The Transmission Mechanism Open Market Operations Fed Buys Treasuries Intrabank Market Fed Funds Rate Decreases All Financial Markets All other rates decrease Economic Growth Increases Consumption & Investment Increases Borrowing Costs Decline 48 Page 48

49 A Real Simple Model of the Fed s Reaction Function Prior to Dec 2008 Mike s Model FF t = FF t-1 + 1/3 * (p-2) + 2/3 (GDP Gap) The FOMC considers BOTH deviations from Target Inflation and Full Employment when determining the Fed Funds Rate 49 Page 49

50 Prior to 2008, How Did the Fed Do? Period Average Standard Deviation GDP Gap p U GDP p U 1949Q1-1959Q Q1-1969Q Q1-1979Q Q1-1989Q Q1-1999Q Q1-2008Q Q3-2015Q Standard Measure Average Deviation : GDP Worse Better U Worse Better 50 Page 50 p Far Better Far Better

51 Prior to 2008, How Did the Fed Do? Measure Average Standard Deviation GDP Worse Better U Worse Better p Far Better Far Better Inflation Targeting has made a material difference to meeting one of the mandates (stable prices), but not the other (lower unemployment). 51 Page 51

52 After 2008, How Did the Fed Do? Period Average Standard Deviation GDP Gap p U-NAIRU %DGDP p U-NAIRU 1949Q1-1959Q Q1-1969Q Q1-1979Q Q1-1989Q Q1-1999Q Q1-2008Q Q4-2016Q Page 52

53 After 2008, How Did the Fed Do? Inflation (%) Period Average Standard Deviation GDP Gap p U-NAIRU %DGDP p U-NAIRU 1949Q1-1959Q Q1-1969Q Q1-1979Q Q1-1989Q Q1-1999Q Q1-2008Q Page 2008Q4-2016Q

54 After 2008, How Did the Fed Do? Period Average Standard Deviation GDP Gap p U-NAIRU %DGDP p U-NAIRU 1949Q1-1959Q Q1-1969Q Q1-1979Q Q1-1989Q Q1-1999Q Q1-2008Q Q4-2016Q What happened? 54 Page 54

55 The Zero Bound and Monetary Policy Since Dec 2008 Dec 2015 the Fed Funds rate was essentially zero Additional open market operations were constructed to NOT reduce the Fed Funds rate further. Other longer term interest rates have not been at zero Transmission mechanism of stimulating the economy through lower Fed Funds rate due to a ZLB policy was not possible after December So, How Could the Fed meet its DUAL MANDATE? 55 Page 55

56 The Zero Bound and Monetary Policy Quantitative Easing: Designed to address the DUAL MANDATE given the policy preventing the Fed from a negative Fed Funds Rate. Hypothesis: buying long term bonds and mortgage backed securities will lower longer term rates and the rate on 30 year fixed rate mortgages 56 Page 56

57 The Evidence $1.75 T in MBS Trillions of $ $2.5 T in Treasuries (~.8T is normal) QE1 QE2 QE3 Oct Page 57

58 Oct 2014: What the Fed Said The Committee (FOMC) continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction That last sentence is why the holdings of Treasuries and MBS have not declined since Oct Page 58

59 Purpose of Quantitative Easing QE1 QE2 QE3 QE Purpose: Pushing Down Long Term Rates! Rates and Spreads (%) 59 Page 59

60 How Well Did QE Work? Fed Holdings of Treasuries & MBS ($T) Mort Rate Holdings ~5% ~4% Hypothesis: $3.0 trillion of additional purchases may have lowered mortgage rates 1 percentage pt from ~5% to ~4%! 60 Real question: what would the mortgage rate be without QE? Page 60

61 Monetary Policy Does Not Occur in a Vacuum Monetary Policy Can t Be Evaluated on a Stand-Alone Basis. The position of the economy AND what the federal government was doing has to be considered. 61 Page 61

62 Government Purchases of Goods and Services since the 2009 Fiscal Stimulus Total Government Purchases are Constraining Economic Growth Trillions of $2009 State and Local Government Purchases are Constraining Economic Growth Federal Purchases Peak GDP = C+I + G + NX 62 Page 62

63 Deconstruction of FOMC Announcement Sept. 17, 2015 Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Dual Mandate Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. Inflation Target Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Aggregate Demand/ Supply The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. 63 Page 63 QE

64 Prior to the Great Recession Recession Peak Trough D Def/GDP D Real FF 57Q3 58Q Q2 61Q Q4 70Q Q4 75Q Fiscal and Monetary policies work together to simulate Aggregate Demand (with one minor exception) 81Q3 82Q Q3 91Q Q1 01Q Average Q4 09Q Page 64

65 The Great Recession Changed the Macroeconomic Response Recession Peak Trough Average D Def/GDP D Real FF Q4 09Q Constrained by Zero Bound 2009 Stimulus Fiscal stimulus as large as it was wasn t sufficient to stimulate faster economic growth and Fed s ability was constrained by the zero boundary on nominal interest rates 65 Page 65

66 A Critical Assumption in December 2008 Larry Summer s Briefing Memo to Obama Dec. 15, 2008 Here s what really happened Fiscal stimulus weakened in Page 66

67 Fiscal Stimulus in 2009 Worked D Jobs (000) D Non-Farm Payroll It is not a coincidence. The fiscal stimulus stopped the decline in employment. The recession was over in June Page 67

68 This Recovery Compared with Others The weak recovery was because of the COMBINATION of weakening fiscal stimulus AND the zero bound on interest rates The Fed turned to Quantitative Easing policies but these have only weak effects on stimulating aggregate demand and economic growth 68 Page 68

69 Federal, State and Local Government Purchases of Goods and Services: this Recovery vs. Others Gov t Purchases Relative to the Trough (%) Avg. of Prior 10 Recoveries This recovery Just when the economy needed additional fiscal stimulus it didn t get it. 69 Page 69

70 Conclusions about the Great Recession The economy needed additional fiscal stimulus in and didn t get it. Quantitative Easing Policies Worked a Little. There was nothing else the Fed could do because of the zero bound on nominal interest rates. Politics and ideology trumped implementation of good macroeconomic policy and imposed significant economic costs on the economy, individuals, and families. 70 Page 70

71 What about Now? What is the Fed Looking at? And What Does this Have to Do with Your Personal Finances? 71 Page 71

72 Aggregate Demand and Aggregate Supply Aggregate Demand Conservatives believe in this p Inflation Rate Region of Debate Aggregate Supply Liberals believe in this GDP Potential GDP 72 Page 72

73 Unemployment vs. Inflation Here s What the Fed is Worried About Inflation Rate (%) 73 Page 73

74 Policy Diagram Core Inflation 3 2 Current core inflation = 1.8% Target Inflation Rate 1 Current Unemployment rate = 4.1% Unemployment Rate NAIRU (est) Page 74

75 Economic Capacity = Potential GDP Trillions of Real 2009 $ 75 The Economy is at or close to it s Potential Output Growth will be determined by supply side rather than demand side factors Too much demand will translate into higher inflation The Fed will raise interest rates if it believes there is too much demand Page 75

76 The Bond Market s Expected Inflation Rate Relative to the Target Inflation Rate Inflation Rate (%) 2% Target 76 The current inflation rate is now = to the target rate of 2%. But, it has been under the target for a long period. What is the proclivity for the inflation rate to go higher? The Fed will raise interest rates if it believes there is too much demand. Page 76

77 The Expected Inflation Rate Relative to the Target Inflation Rate Inflation Rate (%) 2% Target 77 The bond market expected inflation rate is consistent with Fed s stated policy goals. The market believes the Fed that it intends to pursue this target and will continue to get close to achieving it. When the red line exceeds the target, the Fed becomes more likely to raise rates Page 77

78 The Unemployment Rate Relative to NAIRU Unemployment Rate (%) U6 includes discouraged an part-time workers 78 Data provides a separate source on how close the economy is to full employment How the above is interpreted will determine whether the Fed raises rates? Note: the Fed does not ignore discouraged workers. Page 78

79 Jobs are Being Created but the Rate of Growth is Slowing D Jobs (000) Despite What You May Read or Hear, Jobs have grown every month since Oct 2010, averaging 196,000 per month 79 Page 79

80 It s the Real Rate of Interest that Matters Rate (%) Rate (%) 80 Page 80

81 It s the Real Rate of Interest that Matters Rate (%) The real rate of interest is negative (<0%). How the above is interpreted will determine whether the Fed raises rates? Note: the Fed does not ignore discouraged workers. 81 Page 81

82 The Real Rate of Interest vs. the U Gap Real Fed Funds Rate (%) There is only one observation in the last 27 years (2005Q3) in which U NAIRU and the real rate of interest was < 0, EXCEPT FOR THIS Recovery. Real interest rate is negatively related to the unemployment rate Based on that measure, current real rate is accommodative 82 Page 82

83 Rates the Fed Doesn t Control: Treasury Yield Curve and Other Rates Prime Rate 15 Yr Fixed Rate Mortgage 30 Yr Fixed Rate Mortgage Nominal interest rate (%) 3 Mths Maturity 10Yrs It controls the Fed Funds Rate but not any of the others. 83 Page 83

84 Negative Interest Rates in Non US Advanced Economies The interest rate policies of other countries influence what happens in the US 84 Page 84

85 Negative Interest Rates in Non US Advanced Economies Interest Rates in Local Currencies (%) When US rates increase relative to other country s rates, it reduced inflation rate and employment growth in the U.S. 85 Page 85

86 What Did the Fed Do? Dec. 13 FOMC Statement In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1-1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. 86 Page 86

87 What was the Response of the Bond Market? Rate % 87 Page 87

88 The Secular Stagnation Hypothesis: Why You Should Care and How It Affects the Evaluation of the Republican Tax Plan 88 Page 88

89 The Stagnation Hypothesis The advanced economies are growing far too slowly and have been for some time. Inflation is too low Central banks have been managing this slow growth by keeping interest rates extraordinarily low Zero Lower Bound Policy has constrained the ability of monetary policy in the U.S. to have provided sufficient stimulus in the post meltdown recovery. If the zero lower bound on the nominal interest rate is an important constraint on policy, then there is a real risk of protracted stagnation. In the U.S. the current Fed funds rate is negative in real terms and long term interest rates are at historical lows At the same time the returns on stocks are extra-normal 89 Page 89

90 Real GDP Growth % Real GDP Growth % Among Advanced Economies USA CAN GER FRA AUS UK SPA JAP ITA SWE SWI What do you see? There has been significant decline in economic growth rates across the most advanced economies. 90 Page 90

91 Recent OECD Real GDP Real GDP Relative to 2007Q4 USA ITA GER UK FR EUR (16) JAP SP POR GRE 91 Page 91

92 Recent OECD Unemployment Rates Unemployment Rate (%) 92 Page 92 Current Population of 18 OECD Countries = 1.2 B people

93 Japan Unemployment Rate (%) Full Employment in Japan Japanese Full Employment 2% The Lost Decade is the time after the Japan asset price bubble collapse, where unemployment >> full employment. It originally referred to , but now includes hence decades. 93 Page 93

94 Low Inflation in U.S., Europe & Japan Inflation Rate (%) Central Banks in Advanced Economies have adopted low inflation targets and succeeded in achieving them. Page 94

95 Why It Matters: the Debate Is the slow growth the result of a shortage of demand or a shortage of supply? What the Fed does with interest rates depends on how it interprets the data If it s interpretation that the economy s growth is constrained by the supply side interest rates will rise more and stock prices less If it s interpretation is that the economy s growth has only been constrained due to a lack of stimulus, then interest rates will rise less and stock prices relatively more 95 Page 95

96 The Supply Side When the economy is at or near full employment, how the capacity of the economy grows starts to become more important in terms of evaluating the potential impact of a tax cut The potential growth of an economy s capacity at full employment depends on three factors Growth of labor hours Growth of capital services Rate of Technological change % D Real Potential GDP = w % D L + (1- w)% D K + % D Tech w = weight in total production 2/3 96 Page 96

97 The Supply Side View Avg Annual Growth Rates (%) Tech D Capital LABOR 97 CBO Est: Page 97 Period L K Tech D GDP

98 Which View of the Future is Correct? Trillions $ 98 Page 98

99 Labor Growth Potential When the economy is at or near full employment, how the capacity of the economy grows is a critical factor in policy making. Labor Force Participation Rates (%) Labor Force Participation Rates = Labor Force/Population 99 Page 99

100 Labor Growth Potential Annual Growth Rate of Labor (%) 100 Page 100 %D Labor % D Working Age Population + % D LFPR Period %D Pop %DLFPR %DL

101 Capital Growth Potential Measurement of Capital Requires Many Estimates Regarding Depreciation. But the estimates show significant declines in the growth rate of capital services 101 Page 101

102 Which View of the Future is Correct? Trillions $ 102 Page 102

103 An Evaluation of the Republican Tax Bill 103 Page 103

104 Criteria Triangle Economic Growth Fairness or Distributional Effects Unintended (or Intended) Consequences Page 104

105 General Criteria for a Macroeconomist 1. Do the changes impact economic growth? If the answer is NO, then the impact of the tax is distributional (by definition, there are winners and losers) Note: identification of winners and losers can be very tricky when various exemptions are eliminated or enlarged. Page 105

106 General Criteria for a Macroeconomist 2. What is the level of unemployment in the economy when the bill becomes law? To assess whether the bill impacts economic growth, one of the key issues is what is the economy s capability of growing faster than its potential? In other words, if the economy is at potential GDP (or NAIRU), how could it stimulate growth? If stimulus is required, will this restructuring provide that stimulus? 3. Do the changes in taxes generate a deficit? If it doesn t stimulate economic growth AND increases the deficit then there are potential international consequences to consider. Page 106

107 More Initial Comments The Republican Tax Plan is extraordinarily complicated because of the many details that will affect economic behavior and outcomes. There is never going to be tax simplification. Sounds appealing. It doesn t exist in reality. In a complicated economy tax laws have been and will be written to favor or disfavor one economic activity over another. Big examples: Mortgage interest deduction State and local income tax deductions Municipal bond interest is tax free Deductions for charitable contributions Capital gains preferential tax treatment 107 Page 107

108 Changes Affecting Individuals and Families Income Taxes & Exemptions Issue Current Law New Law Notes Tax Brackets 7 7 Some changes Top rate 39.6% 37% Benefits those with very high incomes Alternative Minimum Tax Complex calculation that Keeps but increases Upper middle class to impacts higher income exemption high income taxpayers Standard Deduction $6,500/$13,000 $12,000/$24,000 May help lower middle Personal Exemptions $4,150 per taxpayer and incomes depending on Eliminates dependent # of dependents Child tax credit $1,000 $2,000 Refundable portion 15% of earnings over $3,000 Up to $1,400 Benefits lower income Credit for other dependents None $500 Family tax credits phase out $75,000/$110,000 $200,000/$400,000 Upper income families benefit Education Related Student Loan Interest Can deduct up to $2,500 Graduate student tuition waivers Tuition waivers exempt Deduction for class room $250 deduction No Change Page 108

109 Changes Affecting Individuals and Families Itemized Deductions Other Issue State & Local Tax Mortgage Interest Moving Expense Medical Expenses Current Law New Law Notes Income or sales tax and property tax are deductible Interest up to $1MM Mortgage All personal moving expemses. Employer reimbursements excluded Can deduct in excess of 10% of AGI Limited to $10,000 Limted to payment of $750,000 mortgage Elminates except for military Expands by reducing threshold to 7.5% Overall Limit $266,700/$320,000 No Change Individual Mandate Required under ACCA Repealed Estate Tax 40% above $5.6MM/$11.2MM Thresholds doubed Pass-through Income Taxed at Individual Rates 20% deduction Harms upper middle income in high tax states with high home prices Makes moving more costly Only applies to 2017 and 2018 Huge benefit to small # of wealthy families Benefit to highest income earners who can change status Page 109

110 Changes Affecting Corporations Issue Current Law New Law Notes Top rate 35% 21% Alternative Minimum Tax Alternative tax calculation impacting businesses Eliminated Upper middle class to high income Business Interest Deduction Fully deductible New Investment Complex rules 5 Years Net Operating Losses Can deduct losses from income in prior years Capped at 30% of Income Limited to 80% of Taxable Income R& D Expenses Immediately deductible Written off gradually Note: there could be many others. These are many other non-simplification elements that have yet to be fully stated Page 110

111 Non Debatable Impacts: I Multiple elements of the tax bill favor the most affluent Raising the Estate Tax exemption Reduction in top rate from 39.6% to 37% Reduction in Pass through tax rate on private businesses This creates a big tax cut for the most affluent workers to game the tax system by switching from one tax form to another. Reduction in Corporate Income Tax rate Corporations will pass through much of their gains to shareholders Elimination of the health insurance mandate Will raise premiums over time by healthy people electing to drop out of insurance pool Page 111

112 Non Debatable Impacts: II Some middle class taxpayers will benefit, some will pay more Outcome is specific to the circumstances of the individual taxpayer: Where the taxpayer lives (high property values) and whether they itemize or live in states with material state income tax rates. These are not permanent Impact of Individual Health Insurance Mandate will offset Inefficiencies in the Corporate Income Tax will be reduced Differential corporate income tax rates among countries generates gaming tax on international scale Reducing incentives for gaming generates a benefit. But this effect is limited to multi-nationals and doesn t account for response of other countries Page 112 Latest estimate is about 80% of middle income earners will see low taxes.

113 What the Tax Bill Would Look Like for 25,000 Middle-Class Families 113 Page 113 It s just an estimate, but it is a picture of a the complexity of revising tax rules

114 Page 114 MSNBC Analysis

115 Page 115 Rubio s Child Tax Credit

116 NY Times: What the Earlier Tax Bill Would Look Like for 25,000 Middle-Class Families Pay Less Pay More Page 116

117 What About? Impact on Debt? Pre- Reconciliation Page 117 Models vary significantly on the effects on economic growth

118 CBO Deficit Baseline + Tax Impact Billions of $ $10.1 T of Deficits w/o Bill Even without the changes in the tax structure, the deficit is projected to grow significantly over the next several years adding over $10 Trillion to the Debt Held by the Public Page 118

119 CBO Debt Baseline + Trillions of $ $10.1 T of Deficits w/o Bill % of GDP Page 119

120 Poll of Economists at University of Chicago Business School Question: If the US enacts a tax bill similar to those currently moving through the House and Senate and assuming no other changes in tax or spending policy the US debt-to-gdp ratio will be substantially higher a decade from now than under the status quo. Page 120

121 What s Missing from Debt Estimates? Factor #1: Likelihood of a recession and its impact on the debt CBO doesn t forecast recessions No one else is. Factor #2: Federal Reserve interest rate policies. Assumption embedded in forecasts is that it will make no difference to Fed policy response Higher rates slow economic growth and raise the cost of debt service. Page 121

122 Factor #1: Recession Stats Period Qtrs Recession Qtrs 1947Q1-2017Q % Longest Recovery (Qtrs) 1991Q1-2001Q1 We have been in a recovery since June 2009 or for 32 Qtrs. Thinking a recession won t occur for another 10 years is unrealistic. Size of deficits are highly sensitive to economic activity Page 122

123 Uncertainty: Fed Policy Responses There exists material uncertainty regarding how fast and how much the Fed will raise interest rates over the course of the next few years. If the Fed believes that the underlying potential growth is as the CBO currently estimates, then it is more likely to raise rates faster than what has been assumed in the CBO projections of the debt The deficit is sensitive to interest rate forecasts This would imply more debt being created and constraints on whatever stimulus is in the tax bill. If the Fed believes in the stagnation hypothesis AND empirically it continues to have difficulty keeping the inflation rate at 2% or higher then interest rates will be lower than assumed. Page 123

124 Tax Cuts and Impact on Economic Growth Economists know a lot about stimulating economic growth through tax reductions when we are in a recession However Cutting income taxes for the least affluent is usually the most effective Reducing income taxes for the most affluent is the least effective We aren t in a recession The amount of excess capacity is debatable Impact on growth is likely to be negligible 124 Page 124

125 Poll of Economists at University of Chicago Business School Tax Reform Question: If the US enacts a tax bill similar to those currently moving through the House and Senate and assuming no other changes in tax or spending policy US GDP will be substantially higher a decade from now than under the status quo. Page 125

126 The Biggest What About? The politics of the federal budget Will the rising debt provide more political power to those that want to cut future federal spending to reduce the forecast deficits: Medicare Social Security Medicaid/National Health Insurance If cuts in these programs occur because of the higher deficits, it ll diminish any supposed benefit to the middle class 126 Page 126

127 Notes on Corporate Income Taxes The Effects are the Least Measureable 127 Page 127

128 Federal Corporate Income Tax Revenues % of Federal Revenues Corporate Income Tax Revenues = $11.5 B / year 128 Page 128

129 Corporate Income Taxes It s Not What You May Think Q 1: Who Pays the Corporate Income Tax? Workers through lower wages? Owners of Capital (i.e., shareholders via lower stock prices and dividends)? Consumers (though higher prices)? Q 2: Does a Corporate Income Tax Lower Capital Investment in the U.S.? If so, then lowering the corporate income tax rate should raise investment in domestic capital. Yes, but by how much? Evaluation of Corporate Tax incidence is an unsettled area of economic research after decades of analysis. Page 129

130 Who Pays the Corporate Income Tax? Short Run vs. Long Run Closed vs. Open Economy If corporate income taxes lowers the K/L ratio over time, workers pay Owners of Capital, Shareholders Corporation Workers Consumers Page 130

131 International Corporate Tax Comparison 131 Page 131

132 International Corporate Taxes: What Other Countries have Done since 2003 Most other counties have lowered their statutory rates 132 Page 132

133 International Corporate Taxes: Who has the Highest Rate Depends on Definition Tax Rate (%) 133 Page 133

134 What Economists Say Different corporate income tax rates and rules among counties allow multi-national corporations to game these different structures This is a known inefficiency in the global corporate tax system But, it is not known, the materiality of the long-run benefits are Those benefits are very sensitive to precisely how it is set up This doesn t affect solely domestic institutions, who will benefit from the lower rate. 134 Page 134

135 What Economists Say In the mean time In the short run, owners of capital (shareholders) There isn t much evidence that reducing the corporate income tax will generate higher levels of investment The key factor is capacity utilization and this reduction doesn t have much impact on this factor There is a lot of evidence that it generates a significant cost to federal revenues 135 Page 135

136 What Debt Could Have Been Increased For Treasury rates are at or near historical lows Public infrastructure is deteriorating due to cuts in maintenance and revenues (e.g., real gas tax revenues) Higher real costs of post high-school public education are reducing investments and incentives for individuals to invest in human capital (i.e., post-secondary education) A clear case where benefits > costs over time The Tax Bill makes investment in infrastructure less likely 136 Page 136

137 My Conclusions - I The tax bill s timing is not good The economy is humming with low inflation and low unemployment Now is not the time to stimulate demand with various tax cuts The changes in taxes don t contain much stimulus, if any On a growth bang for the deficit buck measure it is structured very poorly Lots of components have zero (or negative) growth implications The tradeoff between economic growth and inflation remains to be determined These costs become much larger when the next recession hits because deficits increase materially when the economy shrinks 137 Page 137

138 My Conclusions - II The bill does contain substantial costs in terms of higher deficits and debt These costs become much larger when the next recession hits Based on history: there will be a recession within the time frame of the bill The benefits to individuals and families will expire in the bill It differentially impacts selected groups Example: Taxpayers in states with high state income and local property taxes are negatively impacted by the bill. It will pose significant challenges to social spending in the future when the real debt numbers begin to rise These challenges exist without the changes, but they are made more challenging by the loss of federal revenues 138 Page 138

139 My Conclusions - III Fixing the structural issues associated with corporate income tax isn t a bad objective Extraordinarily difficult transition to do properly in reality because of the complexity of the corporate tax code If the goal is to stimulate investment, there were many potential methods to address, but would have taken significant time to evaluate. While some less affluent families will get small tax cuts, the bill adds to the inequality of after-tax income and net worth Changes to the estate tax help only a small number of very wealthy families Changes to the tax treatment of pass-through income will differentially (positively) impact high income business owners. 139 Page 139

140 Some Questions and Predictions The impacts on the deficit will occur before any impacts on growth could possibly occur What will be the political response to those deficits? The economy may grow faster than economists expected having nothing to do with the bill Politically the bill supporters will claim credit if this occurs Impact on middle income families will only be understood over time Provisions in the bill are very complicated and how it plays out will vary by individual taxpayer Key variable to watch: the inflation rate If it crosses 2% by much, the Fed will raise interest rates to address Higher interest rates will reduce growth and contribute to even larger deficits 140 Page 140