Some general descriptive statistics 9/26/2013. The Institutions of a Market Economy: The Case of the United States

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1 The Institutions of a Market Economy: The Case of the United States Factors Affecting Development Business Structure Labor Markets International Trade Financial markets Legal System Government s Role and Size The Great Recession First, Some Statistics: How does the U.S. Compare to Other Major Developed Economies? United States United Kingdom France Germany Population (millions) GDP (billion $) $ 15,040 $ 2,250 $ 2,214 $ 3,085 PPP Per Capita $ 48,100 $ 35,900 $ 35,000 $ 37,900 PPP Adjustment Avg. Growth % 1.5% 1.0% 1.3% Standard Deviation Annual Recession Depth -5.5% -6.1% -3.9% -4.9% Per-Cap Growth % 0.4% 1.1% 3.1% Some general descriptive statistics United States United Kingdom France Germany Median Age Infant Mortality (per thousand) Life Expectancy Obesity 34% 23% 17% 13% Health Spending/GDP 16.2% 9.3% 3.5% 8.1% Area (thousand sq. km.) 9, Average Pop. Density Arable Land 18% 23% 34% 33% Urban Population 82% 80% 85% 74% Oil Consumption (barrels per person)

2 Inequality and Unemployment United States United Kingdom France Germany Income Share Bottom 10% 2.0% 2.1% 3.0% 3.6% Top 10% 30.0% 28.5% 24.8% 24.0% 10/10 Ratio GINI Coefficient Inflation Rate 3.0% 4.5% 2.0% 2.2% Current Unemployment 9% 8% 9% 6% Youth Unemployment 18% 19% 23% 11% Industry and Trade United States United Kingdom France Germany Agricultural Labor 1% 1% 4% 2% Industrial Labor 20% 18% 24% 25% Labor in Services 79% 80% 72% 74% 2011 Investment Rate 12.4% 14.3% 19.8% 18.2% External Debt/GDP 98% 437% 254% 182% Trade Ratio 25% 51% 57% 84% Trade Balance/GDP -5% -7% -5% 7% United States United Kingdom France Germany Heritage Index of Economic Freedom Transparency Index Top Personal Tax 46%* 50% 75% 45% Top Corporate Tax 50%* 24% 33% 30% 2011 M2/GDP Ratio 81% 157% 118% 144% 2011 Stock Market Capitalization 114% 138% 87% 46% 2011 Forex Reserves 1% 4% 7% 7% 2011 Public Debt Ratio 69% 80% 86% 82% * Includes Federal, State, and Local Government. 2

3 Be careful with ratios Ratios put things in perspective, but be careful. A ratio can change because either the numerator or denominator changes. In a recession, for example, GDP falls. Any numerator divided by GDP will look bigger. For example: 20% / 95% is a little over 21% -a jump of 1%. 33% / 90% is almost 37% -a jump of 4%. Don t read too much into short-term fluctuations. Factors Affecting U.S. Development Natural Environment: Rich in natural resources. Cultural Factors: Strong protestant ethic of Calvinism, Lutheranism; Horatio Alger mythology. Philosophy of individualism, anti-government attitudes. Immigration, slavery, and expansion led to melting pot issues problems of discrimination, attitudes towards redistribution, now a growing tolerance of diversity. Historical Factors: The Frontier free natural resources, rural wage parity, opportunity for wealth. North vs. South tensions over trade vs. protectionism, role of federal government, industry vs. slavery. Civil War decided in favor of federal power, protectionism, and industry. 3

4 Business Structure Agriculture/GDP >50% until 1870, largest sector until Services became largest sector in 1950s. Not the birthplace of the industrial revolution, but economy characterized by increasing innovation, especially interchangeable parts, mass production, and retail. Legal development of the limited liability corporation, and innovation of new corporate structures (e.g., the U-form and M-form of large conglomerates). Most firms are sole proprietorships, but most output comes from corporations. Majority of labor force still works in firms smaller than 100 employees. Corporations are state-chartered, with limited liability and legal personhood; controlled by stockholders through board of directors. Business Structure During the Gilded Age industrial and retail expansion, age of monopolies, trusts, and Robber Barons The Public be Damned! Antitrust Movement Sherman Antitrust Act (1890), Clayton Act (1914), Dept., Case Law and Rule of Reason. Regulation of Natural Monopolies (ICC, FCC, PUCs, etc.). Slowing concentration ratios for manufacturing , rising competitiveness through 1980s, but after 1980 greater tolerance of mergers, less antitrust enforcement. Relatively market-based labor market, but some regulation: low minimum wage (relative to history, other developed countries), payroll taxes, overtime regulation, easy layoffs, state unemployment insurance, worker safety. Labor Markets and Unions Rise of Unions: In 1880s, unions radical and unsuccessful 8-hour movement, Knights of Labor, Haymarket riots. AFL (1886) founded on Gompers pure and simple unionism. CIO split in 1935, later rejoined. Norris-LaGuardia Act (1932) full freedom of association, selforganization, et cetera. Wagner Act (1935) NLRB, union of workers choice, collective bargaining, banned unfair labor practices. Taft-Hartley Act (1947) passed over Truman s veto cooling-off period, Federal mediation, no right to strike for government employees. Unions pushed for other labor market regulation minimum 4

5 International Trade Conflict between North and South over trade policy: North Hamilton s infant industry argument. South Plantation exports at low cost. After Civil War, policy became increasingly protectionist, ending with Smoot-Hawley Tariffs. Roosevelt, Cordell Hull, and the move to Free Trade: Reciprocal Trade Agreements Act, Bretton Woods, Havana Charter, GATT. Kennedy Round and exceptions to agriculture, multifibres: Distributional vs. Encompassing interests. Strategic trade policy goals changed from before and after Cold War. Rising trade, increasing globalization, and competitive checks on monopoly power of large corporations. Factor price equalization and the backlash against trade. 20% Exports and Imports 15% 10% 5% Exports Imports 0%

6 Savings and Investment Trade Balance plus Net Income and Transfers from Abroad equals Current Account Balance. Current Account Deficit equal net borrowingfrom foreigners. Every dollar lent to us (via bond, stock, or other capital markets, either public or private) is a dollar not spent on our goods or services. Net Investment by Private Sector = Net Government Budget Surplus + Net Savings by Households + Corporate Savings + Current Account Deficit. By 2008, U.S. Net Private Savings by Households fell to zero, while corporate savings was roughly equal to depreciation on capital. Federal budget was in deficit, while Current Account Deficit reached a record. After financial crisis, extensive deleveraging by private households and firms, with federal government becoming borrower of last resort. In Summer 2008, and again in early 2012, the USD had reached an all-time low against other major currencies. Appreciation Depreciation Appreciation Depreciation U.S. Financial Markets Anglo-American model of separating debt and equity. Banks and borrowers are relatively independent. Banking sector relatively deregulated, very consumeroriented, relatively high consumer debt: mortgages, credit cards, other loans; low personal savings rate. Higher money velocity (i.e., relatively less money demand) than Japan, France, or Germany. High financial ratio: much higher stock market capitalization, large public and private bonds market, etc. 6

7 U.S. Financial Markets U.S. Federal Reserve System created in 1913: quasiindependent monetary policy, lenderof last resort, lead regulator over lending practices. Explicit deposit guarantees through FDIC, FSLIC. Financial Policy based on: Prudential regulation: bankers are lending other people s money Contagion problems, financial crises Central bank is chief regulator, lender of last resort in U.S. Legal System Longest-lived constitutional democracy: 1787 Constitution with federal system, three-branched government, bicameral legislature, and system of political checks and balances. Experiment in individual rights and self-government. Legal system derived from British common law Precedent, legal equality, independent judges Different standards for criminal and civil law Property rights formal rights follow actual use Accounting and financial disclosure, bankruptcy and contract enforcement. Eminent Domain public use of private property, with compensation. Government Institutions Role in Allocation and Production: Military Federal government tends to be sole purchaser. Highways Federal government provides grants to states. State production limited to education, post, administration. State ownership limited to public lands, military bases, government buildings. Police, fire protection, education, etc. mostly provided by states. Health care largely private (except for Medicare, Medicaid as single payers, V.A. as provider). Product Market Regulation pricing (e.g., utilities), consumer safety. Environmental Policy natural resource use, endangered species, air and water quality. 7

8 Government Institutions Role in Distribution: Welfare reform in 1990s limited most poverty subsidies. Redistribution in-kind: public housing, food stamps. Social Safety Net: Social Security, Medicare are pay-as-you-go. Limited unemployment insurance. Political preference for tax expenditures. Evolution of U.S. Government Federal government small, policies very laissez faire until Civil War. Import duties primary revenue. Lincoln: federal land grants to railroads, colleges. Populist movement ICC, free silver movement. Progressive Era trustbusting, FDA (The Jungle), Federal Reserve Bank, women s rights, and income tax during WWI. Great Depression Roosevelt s New Deal increased role and responsibility of government, including Social Security, CCC, TVA, FCC, SEC, FDIC, FHA, Fannie Mae, et cetera. Truman s Full Employment Act of 1946 gave federal government responsibility for managing growth, inflation, and unemployment. Evolution of U.S. Government World War II, Korean War, and Cold War more powers to federal government. Johnson s Great Society Programs Medicare, War on Poverty underfunded due to effort to hide costs of Vietnam War. Collapse of Bretton Woods System, rising inflation during 1970s. Nixon: environmental protection, We are all Keynesians now. Deregulation Era began with airlines (Carter, 1978), then expanded under Reagan and continued through Clinton. Welfare reform in mid-1990s reduced transfer payments. 8

9 Since 2010, government employment has declined relative to the labor force. Tax System Taxes are necessary to fund public goods, but taxes and subsidies create a deadweight loss. Pigouvian taxes may offset market failures. Progressive personal income tax accounts for half of federal revenues, maximum federal tax rate = 35% (was 40%), most states also have income taxes. Redistribution of income: prior to 1964, 1981, 1986, income tax was significantly progressive. Less so now. Payroll taxes 36% of federal revenues, capped for social security, effectively regressive. State and local governments rely on property taxes, sales taxes tend to be regressive. Capital gains and many dividends taxed at lower rate. Relatively high statutory corporate tax rate, but low average effective rate. 9

10 Progressivity of Federal Taxes has declined dramatically, while state and local taxes are generally regressive. Federal Taxes have risen with income (until 2001) Real Federal Receipts Per Capita $10,000 $8,000 $6,000 $4,000 $2,000 $0 $0 $10,000 $20,000 $30,000 $40,000 $50,000 Real GDP Per-Capita Stabilization Policy U.S. Full Employment Act makes federal gov t responsible for economic stability. Fiscal Policy: Increasing overall spending by increasing government expenditures, cutting taxes. Keynesian countercyclical demand management, should be balanced over business cycle. Budget deficits lead to more debt, which leads to more interest expenditures. Budget deficits may cause more foreign borrowing, trade deficits offset stimulus effect. Monetary Policy: Money supply affects willingness to spend, depends on private deposit and lending cycle. Central bank increase bank reserves by buying assets (government bonds), can also affect bank s willingness to lend. Seigniorage central banks lend government with new money, so small deficits can be paid for if people are willing to hold it. If central bank lends too much, of course, inflation results. 10

11 Growth and Inflation by Period Annualized Rates Real Std. Real GDP Std. GDP Dev. Per Capita Inflation Dev % 4.9% 1.5% 0.1% 6.6% % 6.5% 1.1% 8.0% 7.7% % 6.2% 1.1% -2.1% 4.8% % 8.6% 1.2% -1.6% 5.8% % 9.6% 3.3% 5.4% 4.0% % 3.1% 1.7% 2.4% 1.8% % 2.1% 2.9% 2.7% 1.6% % 2.6% 2.1% 7.0% 1.9% % 3.3% 2.3% 3.4% 2.6% % 0.8% 2.3% 2.7% 0.7% % 1.4% 1.2% 1.8% 0.6% % 0.7% 2.9% 1.3% 0.4% % 1.3% 1.5% 1.8% 0.4% U.S. Government Spending over Time Average Share Total Net State of GDP Federal and Local Total Govt Total Govt Surplus Spending Spending Spending % 7.2% 11.2% 0.4% % 7.2% 15.2% 0.0% % 4.2% 27.8% -6.2% % 4.9% 21.1% 0.7% % 5.6% 22.2% 1.7% % 7.7% 25.4% 0.9% % 9.3% 29.2% -1.3% % 9.7% 32.2% -3.5% % 10.4% 32.1% -2.7% % 10.9% 33.0% -3.6% % 10.4% 30.4% 0.7% % 10.7% 30.9% -2.4% What is the relationship between government and growth? The relationship between government and growth is probably shaped like an inverted U. Too much or too little government is bad for growth. It is not clear that the U.S. is on the downward-sloping portion. 11

12 THE FINANCIAL CRISIS Housing bubble led to excessive construction, then housing crash led to financial crisis and big drop in residential investment and construction. Drop in residential investment spending not likely to bounce back quickly, but housing prices have turned around in hardest-hit states, and population growth means there is latent demand. Dramatic fall in home equity halted growth in consumption spending. Consumption is growing again, helping with recovery. EP1 12

13 Slide 36 EP1 Mortgages and the stock market are comparable to our annual GDP. Elliott Parker, 7/6/2009

14 EP4 The Ownership Society Between : Est. 15 million new homes owned, 9 million at trend, plus 6 million more (5% rise). California and Nevada started catching up to rest of the country. Mortgage debt grew MUCH faster than either income or home ownership First Wave (1950s) commercial banks Second Wave (1980s) GSE-guaranteed securities Third Wave (>2002) other mortgage-backed securities What Caused all this Lending? Speculative bubble: basing purchase decisions on past price behavior, not information about future. New homebuyers, existing homeowners, and speculators all participated: not just poor and sub-prime borrowers, but also middle-class buyers taking on too much debt. Mortgage brokers and predatory lenders profited. Investment banks, rating agencies, and hedge funds all had principalagent problems. Firms competing for highest returns, with short-term incentives for financial managers. Financial market consolidation made these firms too big to fail as Lehman Brothers demonstrated. 13

15 Slide 37 EP4 How ownership rates began to climb in the mid-1990s, but the numbers are not enough to explain the bubble. Elliott Parker, 7/6/2009

16 What are Derivatives? A derivative is a financial asset whose value is derived from other financial assets (e.g., futures, options, swaps). A derivative is financial insurance against price changes: a risk-averse person pays another party to take their risk from them. The most common type of derivative is an interest rate swap, but there are more types of derivatives than bets in a casino. 40 Why are Derivatives a Problem? Insurance markets are regulated to make sure the insurer has adequate capital. Derivative markets are not. Derivative markets can be complex, and traders on both sides may not realize what they are doing. Derivatives are not transparent, often off-book, and huge. You don t have to own the asset to buy insurance on it. This can leads to pyramiding of side bets. There are also often multiple generations far removed from the asset. All insurance markets have problems of moral hazard. 41 Role of Federal Government in the Crisis Removed regulations on lending practices and on derivative markets, and negligent in enforcing existing regulations. Pressure to turn a blind eye to emerging problems. Encouraged more people to buy homes, and pushed lenders to devote some portion of their lending for those who would normally not get loans. A small share of overall market. Allowed financial mergers that made these firms too big to fail. 14

17 Role of Federal Government in the Crisis Fannie Mae (FNMA) and Freddie Mac (FHLMC): Privately-owned, government-sponsored enterprises responsible for the mortgage-backed securities market for conforming loans. Latecomers to the debacle, but large. Federal Reserve Bank: Monetary policy made cheap credit available, creating incentive for combining short-run borrowing and longterm lending. Twelve FRBs are controlled by member banks, and failed to regulate bank involvement in the derivatives markets. Great Recession! Recession Recession Recession Recession! Recessions Recessions Great Recession! 15

18 Slowing Growth Variability Stabilizing over Time Deep Recession! Bank Bailouts Emergency Economic Stabilization Act: $700 billion authorized in October Only $550B used. TARP funds began with plan for purchase of troubled MBS, but changed to an equity purchases approach, with restrictions over executive pay. $270B went to AIG, GM, Wells Fargo, Citigroup, BoA, JPMorgan Chase, Morgan Stanley, and Goldman Sachs. $27B went to over 600 banks ($300K-$968M) Majority paid back, with interest. Fiscal Intervention Economic Stimulus Act of Feb. 2008: Tax rebates for 2008, estimated $150B cost (about 1% of GDP) in American Recovery and Reinvestment Act of 2009: Estimated $800B cost over several years, with less than $200B spent in FY 2009, and $400B in FY 2010 (about 3% of GDP). About 40% in tax credits, 30% in state fiscal support, and 30% in infrastructure investment (education, energy, health care), and some extended benefit support. How effective was this stimulus? 16

19 Monetary Intervention Federal Reserve authorized: Quantitative easing: purchase of government bonds, helped drive yield to zero. Purchase of private mortgage-backed securities. Central bank currency swaps. Target federal funds rate near zero. QE II Hail Mary pass to prevent deflationary expectations. Operation Twist to drive down long-run yields. Monetary Policy Intervention prevented collapse of the Money Supply. MB should not be confused with M2. Note where there are gaps 17

20 Balance Sheet Recession Financial institutions moved to cash & bonds, reducing lending in order to reduce portfolio risk. Many large producers facing damaged balance sheets and reduced consumer spending used their profits to reduce debt, not for hiring. Nonresidential investment has mostly recovered. Fiscal crisis in state & local governments due to long decline in tax revenues, led to continued decline in employment. A different kind of recession: recessions caused by financial crises are depressions, and are typically twice as deep, twice as long. There were many worse recessions (or depressions) before WWII, and this one was small compared to some of them. This was the worst recession since the Great Depression, though unemployment rate was actually higher during the recession of the 1980s. In this graph, I exclude government purchases to focus on the private sector. 18

21 Highest Peak Fastest Climb Normal Decline More Women Entering Workforce Relative to Noninstitutional Population 16 and Older Continued Decline in Workforce More is going on here The baby boom was born These people turn 65 from On average, those who make it to 65 can expect to live to

22 An Aging Population Explains the decline in the employment rate. Predicts continued declines for two decades. Fewer working people means slower growth. Net Profits are High As share of GDP, Corporate Profits after tax are the highest they have been in 60 years. Actual taxes paid are the lowest share. Stocks As high profits and low interest rates would predict, stock prices are high again even after adjusting for inflation. 20

23 Recovery? After falling by 35% since 2006 (62% in Las Vegas), housing prices have risen for 14 straight months: 16% nationwide, 27% in Las Vegas. Causes of the Federal Budget Deficit? Tax cuts in 2001, 2003 reduced federal revenue by roughly $300 billion per year. Wars in Iraq and Afghanistan increased debt by roughly $3T dollars, and obligated us to pay future VA and related costs. Slow economy in , and then the Great Recession, reduced tax collections. Personal federal income tax fell to 6.3% of GDP in FY2010, the lowest share since What Else Contributed? Pres. Bush s Spring ESA ($150B), October 2008 TARP ($700B). Pres. Obama s ARRA, payroll tax cuts added $1T more. A third of ARRA went to help states, a third went to tax cuts. States drained unemployment funds, borrowed from federal government. More retired early, went on disability, or became eligible for Medicare and social services. Rapid growth of healthcare costs over several decades, and an aging population that is living longer than originally predicted. 21

24 This depends on current law 22

25 Shrinking Deficits Federal budget deficit projected to fall to 2.8% by 2016, stabilizing the Debt/GDP ratio. 23