Syllabus

Monday, March 09, 2009 5:24 PM

Economics 1420/ API 126 Spring 2009

Martin Feldstein Katherine Baicker mfeldstein@harvard.edu, kbaicker@hsph.harvard.edu 868 3905 492-5209 Robert Stavins Robert Lawrence Robert_Stavins@harvard.edu Robert_Lawrence@harvard.edu 495-1820 495-1118 Teaching Fellows Jeffrey Clemens (Clemens@fas.harvard.edu) Stephen Miran (Miran@fas.harvard.edu) David Seif (dgseif@gmail.com)

AMERICAN ECONOMIC POLICY Classes will be held in Emerson Hall 210 every Monday, Wednesday, and Friday, except February 16, March 6, 13 and 20 and April 24 Sections will be held once a week, at times to be arranged. • Prerequisite: Economics 1010a or 1011a, API-101, or permission of one of the instructors. Grades will be determined as follows: • a midterm exam given in class on March 11-- 25 percent • two four-page memos due at the beginning of class on March 16 and April 27 -- 25 percent • a final exam given on may xx -- 50 percent • Paper Option: Students have the option of writing a 20-25 page research paper (due on May 5) in lieu of the two four-page memos. The paper will count for 25 percent of the grade. Students who choose this option can count Economics 1420 as one of the courses that fulfill the economics department writing requirement. READINGS 1. Introduction: Where are we? How did we get here? (January 28) Martin Feldstein, "Housing, Credit Markets and the Business Cycle," in the 2007 Kansas City Federal Reserve Annual Conference Volume , Housing Finance and Monetary Policy, 2008. http://www.nber.org/papers/w13471.pdf?new_window=1

National Bureau of Economic Research, ―Business Cycle Expansions and Contractions.‖ http://www.nber.org/cycles.html 2. Business Cycles, Inflation and Monetary Policy (January 30, February 2 and 4)

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Christina Romer and David Romer, ―What Ends Recessions?‖ NBER 1994 Macroeconomics Annual, pp. 13-57. http://www.nber.org/papers/w4765.pdf?new_window=1

John Taylor ―An Historical Analysis of Monetary Policy Rules,‖ in John B. Taylor (ed.) Monetary Policy Rules, University of Chicago Press, 1999. http://www.nber.org/papers/w6768.pdf?new_window=1 Martin Feldstein "The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy," Journal of Political Economy, Vol. 87, No. 4, 1979, pp 749-768. http://www.nber.org/papers/w0201.pdf?new_window=1 Ben S. Bernanke, ―A Perspective on Inflation Targeting, Remarks at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C. March 25, 2003. (A pdf will be e-mailed out the week of this lecture.) Martin Feldstein ―Liquidity Now!‖ Wall Street Journal, September 12, 2007 http://www.nber.org/feldstein/wsj091207.html Martin Feldstein ―Enough with the Interest Rate Cuts,‖ Wall Street Journal, April 15, 2008 http://www.nber.org/feldstein/wsj41508.html

3. National Saving, Growth and Income Distribution (February 6) Edward Gramlich ―The Importance of Raising National Saving,‖ Benjamin Rush Lecture, Dickinson College, March 2, 2005. http://www.federalreserve.gov/boarddocs/speeches/2005/20050302/default.htm Lusardi, Annamaria, Jonathan Skinner, Steven Venti. ―Savings puzzles and savings policies in the US.‖ https://depot.erudit.org/retrieve/687/000036pp.pdf Parker, Jonathan. ―Spendthrift in America: two decades of decline in the US saving rate.‖ http://www.nber.org/papers/w7238.pdf?new_window=1 Martin Feldstein "The Return of US Saving", Foreign Affairs, May/June 2006, pp 87-93. http://www.nber.org/feldstein/returnofsaving.pdf Martin Feldstein and Charles Horioka, ―Domestic Saving and International Capital Flows,‖ Economic Journal, June 1980, pp. 314-329. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w0310.pdf? new_window=1 Martin Feldstein “Did Wages Reflect Growth in Productivity,” Journal of Policy Modeling, 30 (2008) pp 591-94. http://www.nber.org/feldstein/WAGESandPRODUCTIVITY.meetings2008.pdf 4 . Budget Deficits and the National Debt (February 9) Laurence Ball and N. Gregory Mankiw, ―What Do Budget Deficits Do?‖ Budget Deficits and Debt: Issues and Options, Federal Reserve Bank of Kansas City, 1995, pp. 95-119. https://www.kc.frb.org/Publicat/sympos/1995/pdf/s95manki.pdf Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp. 0-24 & 63-80 (the remaining pages are assigned for a later class). (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w8488.pdf?new_window=1

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Office of Management and Budget, Budget of the United States Government: Analytical Perspectives, Fiscal Year 2008, pp. 183-187. Note: Page numbers refer to the page numbers of the document itself, not the page number of the pdf. http://www.whitehouse.gov/omb/budget/fy2008/pdf/spec.pdf Congressional Budget Office, The Long-Term Budget Outlook, December 2007, pp 1-17. http://www.cbo.gov/ftpdocs/88xx/doc8877/12-13-LTBO.pdf

Congressional Budget Office, Economic and Budget Outlook 2009 -2019. http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outlook_Testimony.pdf http://www.cbo.gov/ftpdocs/99xx/doc9957/01-07-Outlook.pdf 5. Housing and Financial Markets (February 11) Martin Feldstein, ―How to Stop the Mortgage Crisis,‖ The Wall Street Journal, March 7, 2008. http://www.nber.org/feldstein/wsj03072008.html Martin Feldstein, ―How to Help People Whose Home Values Are Underwater,‖ The Wall Street Journal, November 18, 2008. http://www.nber.org/feldstein/wsj100408.html Martin Feldstein, ―The Problem Is Still Falling House Prices,‖ The Wall Street Journal, October 4, 2008. http://www.nber.org/feldstein/wsj100408.html Edward L. Glaeser, ―Why We Should Let Housing Prices Keep Falling,‖ New York Times, October 7, 2008. http://economix.blogs.nytimes.com/2008/10/07/why-we-should- let- housingprices-keep-falling/ ―Popping Sounds: House prices are falling just about everywhere,‖ The Economist, December 4, 2008. http://www.economist.com/finance/displaystory.cfm?story_id=12725898 Doug Diamond and Anil Kashyap. ―Everything you need to know about the financial crisis.‖ http://freakonomics.blogs.nytimes.com/2008/10/15/everything- you-need-to-know-about-thefinancial-crisis-a-guest-post-by-diamond-and-kashyap/ 6. Keynesian Economics: Retreat and Return (February 13, 18, 20) Martin Feldstein, ―The Retreat from Keynesian Economics,‖ The Public Interest, 1981. Martin Feldstein, ―Rethinking the Role of Fiscal Policy,‖ forthcoming in the American Economic Review, May 2009 (Available on American Economic Association website for January 2009 annual meeting) John Taylor, ―The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy,‖ forthcoming in the American Economic Review, May 2009 http://www.aeaweb.org/annual_mtg_papers/2009/retrieve.php?pdfid=387 Alan Auerbach, ―Implementing the New Fiscal Activism,‖ forthcoming in the American Economic Review, May 2009. http://www.aeaweb.org/assa/2009/retrieve.php?pdfid=324 Martin Feldstein, ―How to Avoid a Recession,‖ Wall Street Journal, Dec 5, 2007. http://www.nber.org/feldstein/wsj120507.html Lawrence Summers, ―Why America Must Have a Fiscal Stimulus,‖ Financial Times, January 6, 2008. http://belfercenter.ksg.harvard.edu/publication/17845/why_america_must_have_a_fiscal_stimulu s.html Douglas Elmendorf and Jason Furman, ―If, When, How: A Primer on Fiscal Stimulus,‖ Brookings Institution Hamilton Project Strategy Paper, January 2008. http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx
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http://www.brookings.edu/papers/2008/0110_fiscal_stimulus_elmendorf_furman.aspx Gregory Mankiw, ―What Would Keynes Have Done?‖ New York Times, November 28, 2008. http://www.nytimes.com/2008/11/30/business/economy/30view.html?_r=5&adxnnl=1 &partner=permalink&exprod=permalink&adxnnlx=1228241156- T3%2bMqzQf Broda, Christian and Jonathan Parker. ―The impact of the 2008 tax rebates on consumer spending: a first look at the evidence.‖ http://faculty.chicagogsb.edu/christian.broda/website/research/unrestricted/Stimulus% 20Payments%20and%20Spending.pdf Martin Feldstein, ―The Tax Rebate Was a Flop. Obama's Stimulus Plan Won't Work Either,‖ The Wall Street Journal, August 6, 2008. http://www.nber.org/feldstein/wsj080708.html Congressional Budget Office, Options for Responding to Short-term Economic Weakness, January 2008. http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf

7. Fluctuations Of The Dollar and the Trade Balance (February 23, 25) Richard E. Caves, Jeffrey A. Frankel, and Ronald W. Jones, ―Expectations, Money, and the Determination of the Exchange Rate,‖ World Trade and Payments, pp. 581-589. (We may need to scan the book directly to create a pdf of this one.) Martin Feldstein, ―Resolving the Global Imbalance: The Dollar and the US Saving Rate,‖ Journal of Economic Perspectives, Summer 2008. http://www.nber.org/feldstein/ResolvingtheGlobalImbalance.pdf Martin Feldstein, ―The Dollar at Home – and Abroad,‖ The Wall Street Journal, April 28, 2006. http://www.nber.org/feldstein/wsj042806.html Martin Feldstein, ―A More Competitive Dollar is Good for America,‖ The Financial Times, October 15, 2007. http://www.nber.org/feldstein/ft101507.html 8. Environment Policy (February 27, March 2, 4 , 9 ) Professor Robert Stavins a. Basic Analytics of Environmental Policy (February 27) Don Fullerton and Robert Stavins. "How Economists See the Environment." Nature, volume 395, pp. 433-434, October 1, 1998. Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and Robert Stavins. "Is There a Role for Benefit-Cost Analysis in Environmental, Health, and Safety Regulation?" Science, April 12, 1996. Lawrence Goulder and Robert Stavins. "An Eye on the Future: How Economists' Controversial Practice of Discounting Really Affects the Evaluation of Environmental Policies." Nature, Volume 419, October 17, 2002, pp. 673-674. Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam: Elsevier Science, 2007. b. More Analytics and an Application to Acid Rain (March 2)

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Richard Schmalensee, Paul Joskow, Denny Ellerman, Juan Pablo Montero, and Elizabeth Bailey. ―An Interim Evaluation of Sulfur Dioxide Emissions Trading.‖ Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 53-68.

Robert Stavins. ―What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.‖ Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 69-88. Robert Hahn, Sheila Olmstead, and Robert Stavins. "Environmental Regulation During the 1990s: A Retrospective Analysis." Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415. With R.W. Hahn and S.M. Olmstead. Robert Stavins. "Regulating by Vintage: Put a Cork in It." The Environmental Forum, Volume 22, Number 3, May/June 2005, p. 12. ___________. "What Baseball Can Teach Policymakers." The Environmental Forum, Volume 22, Number 5, September/October 2005, p. 14. c. U.S. Climate Policy (March 4) Gilbert Metcalf. ―A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate Change.‖ The Hamilton Project, Discussion Paper 2007-12. Washington, D.C.: The Brookings Institution, October 2007. Robert Stavins. A U.S. Cap-and-Trade System to Address Global Climate Change. The Hamilton Project, Discussion Paper 2007-13. Washington, D.C.: The Brookings Institution, October 2007. William Nordhaus. ―To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming.‖ Review of Environmental Economics and Policy, Volume 1, Issue 1, Winter 2007, pp. 26-44. Robert Stavins. "A Tale of Two Taxes, A Challenge to Hill." The Environmental Forum, Volume 21, Number 6, November/December, 2004, p. 12. __________. "A Sensible Way to Cut CO2 Emissions." The Environmental Forum, Volume 24, Number 6, November/December, 2007, p. 18. __________. "Cap-and-Trade or a Carbon Tax?" The Environmental Forum, Volume 25, Number 1, January/February, 2008, p. 16. __________. ―Inspiration for Climate Change.‖ The Boston Globe, Op-Ed, November 12, 2008. d. International Climate Policy (March 9) Robert Stavins. "Beyond Kyoto: Getting Serious About Climate Change." The Milken Institute Review, volume 7, number 1, 2005, pp. 28-37. Joseph Aldy and Robert Stavins. Designing the Post-Kyoto Climate Regime: Lessons from the Harvard Project on International Climate Agreements. An Interim Progress Report for the 14th Conference of the Parties, Framework Convention on Climate Change, Poznan, Poland, December 2008. Cambridge, Mass.: Harvard Project on International Climate Agreements, November 24, 2008.
Robert Stavins. "Linking Tradable Permit Systems." The Environmental Forum, Volume 25,

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Number 2, March/April, 2008, p. 16. 9. Tax Policy (March 16, 18 and 30) Martin Feldstein, ―The Effect of Taxes on Efficiency and Growth,‖ Tax Notes, May 8, 2006. http://www.nber.org/feldstein/taxanalysis.pdf Council of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President, Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf Martin Feldstein, ―The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,‖ Journal of Political Economy, 1995, pp. 551-572. (A pdf will be provided.) Joel Slemrod, ―Methodological Issues in Measuring and Interpreting Taxable Income Elasticities,‖ National Tax Journal, 51: 773-788, 1998. (A pdf will be provided.) Robert E. Hall, ―Guidelines for Tax Reform: The Simple, Progressive Value-Added Consumption Tax, in Alan Auerbach and Kevin Hasset, eds, Toward Fundamental Tax Reform, (Washington, DC, AEI Press), 2005, pp. 70-80. (A pdf will be provided.) Martin Feldstein, "How Big Should Government Be?," National Tax Journal, Vol. 50, 1997, pp. 197-213. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w5868.pdf?new_window=1 10. Social Security Reform (April 1, 3 and 6): Martin Feldstein, ―Rethinking Social Insurance,‖ 2005 Presidential Address to the American Economic Association, American Economic Review, March 2005. (A pdf will be provided.) Martin Feldstein and Andrew Samwick, ―Potential Paths of Social Security Reform,‖ Tax Policy and the Economy, 2002, Vol. 16, Issue 1, pp. 181-224. http://www.nber.org/papers/w8592.pdf?new_window=1 Martin Feldstein, ―Structural Reform of Social Security,‖ Journal of Economic Perspectives, 2005. http://www.nber.org/feldstein/streformofss.pdf Alicia Munnell, ―Social Security: It Ain‘t Broken,‖ Social Security Reform, Federal Reserve Bank of Boston, June 1997, pp. 297-303. http://www.bos.frb.org/economic/conf/conf41/con41_ 24.pdf Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, ―Fiscal Policy and Social Security Policy During the 1990s,‖ in American Economic Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp 80-106 and 121-125. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w8488.pdf?new_window=1 Jeffrey Liebman, ―Redistribution in the Current U.S. Social Security System,‖ in Distributional Aspects of Social Security and Social Security Reform, Editors Martin Feldstein and Jeffrey Liebman, 2002, pp. 11-41. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w8625.pdf?new_window=1 Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, ―Nonpartisan Social Security Reform Plan.‖ http://www.newamerica.net/files/archive/Doc_File_2757_1.pdf 11. Unemployment Insurance (April 8)
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11. Unemployment Insurance (April 8) Martin Feldstein , ―Rethinking Social Insurance,‖ American Economic Review, March 2005, pp 13-15. (A pdf will be provided.) Martin Feldstein and Daniel Altman, "Unemployment Insurance Savings Accounts," Tax Policy and the Economy, Vol. 21, 2006. (A pdf will be provided for those who do not have access to the NBER‘s working paper series.) http://www.nber.org/papers/w6860.pdf?new_window=1 12. Oil (April 10) Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html John Deutch, James Schlesinger and David Victor National Security Consequences of US Oil Dependency Council on Foreign Relations, 2006 http://www.cfr.org/content/publications/attachments/EnergyTFR.pdf Martin Feldstein and Henry Kissinger “The Power of Oil Consumers”, Washington Post, September 18, 2008 http://www.nber.org/feldstein/washpost_091808.html Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July 2008 http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf Martin Feldstein ―Tradable Gasoline Rights,‖ Wall Street Journal, June 5, 2006 http://www.nber.org/feldstein/wsj060506.html 11. The Economics of National Security (April 13) Martin Feldstein, ―The Underfunded Pentagon,‖ Foreign Affairs, March/April 2007. http://www.nber.org/feldstein/the- underfunded-pentagon.pdf Martin Feldstein, ―Defense Spending Would Be Great Stimulus,‖ Wall Street Journal, December 24, 2008 http://www.nber.org/feldstein/wsj12242008.html Optional: Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary Update for Fiscal Year 2008, December 2007. http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm 12. Trade Policy (April 15, 17) Professor Robert Lawrence
13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker

14. Final Lecture (May 1

Schedule American Economic Policy Spring 2009
W Jan. 28 F Jan. 30 Introduction (Feldstein) Demand Management and Monetary Policy (Feldstein)
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F Jan. 30 M Feb. 2 W Feb. 4 F Feb. 6

Demand Management and Monetary Policy (Feldstein) Demand Management and Monetary Policy (Feldstein) Demand Management and Monetary Policy (Feldstein) National Saving, Productivity and Growth (Feldstein)

M Feb. 9 Budget Deficits and National Debt (Feldstein) W Feb. 11 Housing Crisis and Financial Markets (Feldstein) F Feb. 13 Keynesian Economics: Retreat and Return (Feldstein) M Feb. 16 President‘s Day, University Holiday (No Class) W Feb. 18 Keynesian Economics: Retreat and Return (Feldstein) F Feb. 20 Keynesian Economics: Retreat and Return (Feldstein) M Feb. 23 Fluctuations of the Dollar and the Trade Balance (Feldstein) W Feb. 25 Fluctuations of the Dollar and the Trade Balance (Feldstein) F Feb. 27 Environment Policy (Stavins) M Mar. 2 W Mar. 4 F Mar. 6 Environment Policy (Stavins) Environment Policy (Stavins) No Class

M Mar. 9 Environment Policy (Stavins) W Mar. 11 Midterm Exam F Mar. 13 No Class

M Mar. 16 Tax Policy (Feldstein) W Maar 18 Tax Policy (Feldstein) F Mar. 20 No Class M Mar. 23 Spring Break W Mar. 25 Spring Break F Mar. 27 Spring Break M Mar. 30 W Apr. 1 F Apr. 3
M Apr. 6 W Apr. 8 F Apr. 10

Tax Policy (Feldstein) Social Security Reform (Feldstein) Social Security Reform (Feldstein)
Social Security Reform (Feldstein) Unemployment Insurance (Feldstein) Oil (Feldstein)

M Apr. 13 Economics of National Security (Feldstein) W Apr. 15 Trade Policy (Lawrence) F Apr. 17 Trade Policy (Lawrence) M Apr. 20 Health Care Policy (Baicker) W Apr. 22 Health Care Policy (Baicker) F Apr. 24 No Class M April 27 Health Care Policy (Baicker) W April 29 Health Care Policy (Baicker) F May 1 Final Lecture Reading Period: May 2 - May 13
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Reading Period: May 2 - May 13 Final Exam: May 20 (?)

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Lecture 1
Wednesday, January 28, 2009 1:37 PM

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Monetary policy, inflation, unemployment, exchange rates, etc. Taxes, budget deficits, medicare, social security Cover a wide range of economic policy W 12, 3pm; Tues 7pm, Thurs 2pm for section mfeldsten@ Worst recession we have ever seen Financial crisis Decline in aggregate demand These circumstances require a different kind of policy than other recessions o Very different intellectual approach o Different from other downturns we have experienced o Exciting and worrying time for economists o Will spend time contrasting traditional recession policies vs. those in the future The longer term performance of the US economy—has been very good o Its like a patient who is very sick, but who is actually healthy  Like a disease Before recession in fall 2007, we had best development o 3.1% growth in GDP for 5 years until it peaked in 2007 o better than US perfornamnce in previous years and in europe o 4.6 % unemployment  now its over 7% o Inflation now is very low: 0 or negative  That‘s not a good thing  But we had succeed in bringing inflation down to 4.5% in 2007  Better than 12% in 1980 o Fiscal deficit is exploding now  In 2007: 1.5% deficit o Economy that was doing really well up until 2007  But now has contracted a really bad bug Are we going to be able to return to that? Or will we suffer for rest of lives? o Marty thinks we wil return to it, it‘s a reflection of economic policies, not coincidence Massive trade deficit, about 5% of GDP-$17Bn o Part of that reflects price of oil o Other part going forward: fiscal deficit: cost of social security and medicare and Medicaid Strong growth, low unemployment, low inflation, low fiscal deficit—remarkably better than 20 years ago o Good performance was not an accident o Reflected good monetary and tax policies o But also some policies got us in trouble recently o Will talk about the analytic issues  Current debates depend on and reflect on decisions made at analytical level Focus on all of this is on applications While we don‘t approach this as a historical course, we will from time to time look
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o While we don‘t approach this as a historical course, we will from time to time look back over the past few decades Reading list available online Schedule: Shows you the schedule of classes; pretty good approximation Do the readings! Not substitutes for lectures What else might you want to read? o The Economist magazine o WSJ o Financial Times Macroeconomic issues: there are lots of data, o One easy place: at the NBER‘s website  Look for economic indicators 2 short memos Public finance at 9am: government, and taxation o Essentially a microfinance course This term‘s first lecture: Where we are and how did we get there Worst economic downturn in history o Unemployment went from 4.6% to 7.2%  People are worried that it will be up to 9% at next announcement  Increase in about 7 million unemployed What is a recession and why is it different than others? o A recession is a time when the economy is contracting o See diagram  Even in expansion, high unemployment  Economists take a while to say its actually a recession  Stay in expansion until get to next peak Recession: dated by NBER o National Bureau of economic research o NBER looks at a variety of monthly indicators and asks if we are in a broad sustained and deep decline in economic activity, and then makes guess about next peak o Last peak was December 2007  Look at cycles on NBER‘s homepage  The typical recession from peak to trough was 10 mos  Relatively short and mild  Not that many people got laid off and turned around quite quickly  Now: we‘re already in 12 mos, could last to 2010—probably over 24 mos  Contrast economic policies in this recession vs. typical policies used in past and which we will probably still use in future Federal Reserve o Inflation o It would raise Short Term interest rates until it slowed economy and brought down inflationary pressures  This was true throughout the post-war period  But this time, the fed did not create the recession o The fed would lower ST interest rates  This time, the traditional remedy is not working because the fed did not push us into this recession by raising ST interest rates, so it cannot cure it that way  We can see they‘ve been lowering to no avail  Asterisks: except has affect on exchange rate Overnight interst rate: 0-.25%-->has little effect Since fed did not cause this recession, what did??
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 Since fed did not cause this recession, what did?? o Two things that are the fundamental causes of this  1.) Higher prices of risky assets  risk was underpriced  Treasury Bond: 4%; Corporate bond: 8%  Prices were too high meant that corporate bond had 6%  So the extra risk that you took, that company might default, was only worth 2%, not 4% o The interest rates on these risky securities might go back up from 6% to 8% o The price of a bond varies inversely with interest rate o So the individual who holds that bind will take a significant loss o Underpricing of risk was not just corporate bonds, but also mortgages, emerging market bonds, and the stock market o Yield on stocks: was about 6% o So there was this underpricing of risk by investors  Why would they be willing to do this? Why were they willing to hold risky assest when the extra yield held with risky assest was not very much? And these were professional investors! o The short answer: competitive pressure o They would say yes, we are getting little return  But we‘re paid to take those extra risks!  But if I don‘t take that risk and get that extra 2% yield, client will take money to another money manager  Also, the money was not their money  Pension fund, hedge fund  It wasn‘t your money!  You can get paid in the short run for taking the extra risk, maybe you‘ll be gone before it goes down  Its like selling earthquake insurance o Someday the earthquake will happen, and your company will get hit bigtime o But in meantime, you‘re making a profit, and you‘re getting rewarded for it o Why don‘t companies understand this idea of tail risk? We have to experience with this risk  Also 25% fall in home pricestail risk  Very low probability of it happening o Also, this idea that they can get their finger on the button faster and get out sooner than everyone else  2.) high leverage, borrowing  because the risk seemed low, there was a temptation to want to borrow more in order to lever up in order to get a higher rate of return  they too were caught in this world  Investment banks: for every dollar of capital, they had $30 of investments$29 of contributed funds o But if it fell by 4%, then that $30 became $28.50, but they owe $29 By early 2007, characterized by this underpricing of risk and high leverage
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o By early 2007, characterized by this underpricing of risk and high leverage  Indicator of this came from the subprime mortgage crisis o Subprime loan: loan to creditor with high risk  Poor credit history, bad record of paying back in past  Policy Required to increase their lending to this group  GNMA, FRMC  If we only lent to people with good credit records, then minorities and poor people couldn‘t get homes  Community reinvestment act  If banks took money from certain areas, they also had to give back to those areas o ALT-A:  High risk borrowers because couldn‘t prove their credit history o Low probability that these people would default came from examining the experience over the past few years  In 2005, 2007, there was an explosion of lending to these peeps  These were wonderful years, rising house prices, so it was a bad basis on which to make judgment about how risky these loans were  In 2007 there were suddenly many more defaults on subprime loans  Repricing of risk: on all financial instruments, saw stock market come down by 40%  House prices come down by 12 trillion  Enormous decline in wealth and in value of mortgage backed securities

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Lecture 2
Friday, January 30, 2009 1:41 PM

 GDP figures for the 4th quarter: Surprised the forecasters, who said that this was going to be an absolutely awful 4th quarter, thought it was going to fall by 5.5% o Its not what's happening now, or whats happening in the 4 th quarter, its what happened between the 3rd (JAS) and 4th (OND)  -3.8%  does this mean in much better shape? No—a lot of it was because of inventory  didn‘t sell stuff in inventory because consumers didn‘t come o so less of a decline in output o so they‘re probably going to sell even less in 1st quarter because they ended on such large inventories  Reasons for the economic crisis  Let‘s focus on decline in housing sector o Central to problem o Drove down household wealth o Restricted the assets, capital, earnings of financial system and led to paralysis of financial institutions  4 trilllion  3 things happened in this past decade which never came together like this before o I.) Decline in House Prices (Ph) o II.) Increase in leverage (loan/value ratios) o III.) Securitization  In beginning of this decade, house pries increased at a much faster rate o So we had an unsustainable bubble, rate of increase in house prices  2000broke out of historic pattern  60% increase in total  had been increasing 10-15% per year  now, they‘ve come down about 25% o eroded o they have been falling rapidly o Schiller measure of house prices—down 18% in past year, but still another 15% to go to original trend  Will it go back to equilibrium, or will it overshoot?  Maybe: now its become a risky asset  Now we know that you might get wiped out  People who bought house at peak got wiped out  So equilibrium price might be lower, like in stock market  Causes of I? House Prices Decline o 1.) What the federal reserve did  back at the beginning of the decade, it was very concerned about deflation  at beginning of decade, there were a flurry of months when prices were falling  why is deflation a worry? If the fed wants to cut interest rates to stimulate the economy, it wants to cut the real insterest rate  r=i-  real interest rate= nominal interest rate - inflation
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real interest rate= nominal interest rate - inflation .04=.06-.02 .01=.03-.02 But what if there is deflation? .04=.02 – (-.02) o there is the zero bound: the fed has driven the federal funds interest rate to zero o so .02=0+.02 o but say that deflation gets worse, that would drive the real rate up o may cause the real rate to be high and continue to rise as deflation gets worse  and there's nothing the fed can do about it  2.) When there is deflation, in real terms, companies that are in debt owe more money and will have a harder time dealing with that debt o deflation makes the value of debt greater in real terms  Fed didn‘t want this, so pre-emptively cut interest rates and said they would keep it low  Drove down interest rates on mortgages  Mortgage borrowing became cheaper o Led to increase in borrowing because cost of carrying that mortgage was lower  So the primary cause of low interest rates was federal reserve  2.) Housing Policy: Government policy encouraging buying homes o relatively low income individuals o tried to bring low income individuals o if you draw money from a certain area, you must lend back to that area in form of mortgages  so banks were forced to go out and find people and make loans to them  affordability products in the mortgage market  we‘d love to give you a mortgage, but we know you'll have a hard time paying 6% o so well give you a 2% rate for 2 years o but don‘t worry about it, because housing prices are rising, so in 2 years you can get a new mortgage to pay 6% rate o These were ways of trying to make houses more affordable  shifted demand curve to the right o and it succeed for a while, but now not anymore… o 3.) Market Psychology  why am I renting when my friends are getting returns on their homes  fed the demand  at the time, there was short-sighted rationality (there is no such thing but lets call it that)  houses going up at 10-15% per year, can borrow at 6% tax deductable o not taking into account that 10% wont continue: in a bubble  like any bubble, when you get far enough away from a feasible equilibrium, prices will start to go down  Causes of II? - Leverage o Sometimes you could get 2 mortgages at once, so you didn‘t have to put anything down
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o down o High volume of 90+% loan to value ratios  Why would they do this (the banks)?  While its more prudent to do 70-80%, the 90% would eventually come down to 70-80% because of rising housing prices o And that did work o But it stopped working when we got to the peak of the curve o What happened as a result of that is that we went from 90% to LTV ratios, to >100% LTV  Loan is greater than underlying property  12 million individuals, 2.5 trillion mortgages are underwater, individual owes more than house is worth  average underwater home is 120%  Law of mortgages: if you default, they can take mortgage, and take away house and sell it and that’s ALL they can do in US  You borrowed 200,000 for 250,000 house, but now its only worth 180,000 o Still owe 20,000  But they are non recourse mortgages, so creditor cant resource to other assets or income  De facto: non recourse  When creditor sells house at low price, drives prices down in that area, and increase LTV of everyone else  So we can easily overshoot as result of this decline  So house prices will continue to fall as result of this o If housing prices fall another 15%, the average underwater home will go to 140% o Negative equity of 40% o Danger is an avalanche of selling o Rate of foreclosure doubled this year  Some people defaults because teaser rate over, lose job o But really it‘s the high LTV of the loan o What does this mean for the bank that holds them  Don‘t know what those mortgages are worth  Don‘t know who will pay them  People with negative equity like homes, neighbors, hope things will turn around  Why are we paying these rates, when we can rent across street for much less  Financial institutions don‘t know what loans on balance sheet are worth  Causes III? Securitization o Years ago, you went to the bank, told the bank I don‘t want to default, you don‘t want me to default, lets work something out o Now, most of loans are securitized  Sell loans to pension funds, other banks  So you get in trouble as homeowners, because there is no one to turn to  You send local banks monthly check, but they already sold loan o If you make local loans, and a big employer in town goes out of business, a lot of people will default
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o people will default o But if you pool mortgages from all over country, there is much less of this risk  Even though homeowner has no one to go to o Bankers could generate a lot more leverage to generate more risk in o Mortgage Backed securities  A bunch of subprime loans pooled together to create a AAA security  Tranche A: risk lovers, the ones who want a high yield and who are prepared to take the most risk o The first hundred mortgages to default, they are stuck with it o First hundred losses are theirs o Chance that 100 mortgages will default is low—only maybe 20 will o B security  Tranche B guys get losses 101-200 o More than 100 mortgages have to default before it gets to me o So I go to a rating agency, Moodys, S&P, lets call this a AA security  Tranch C: Losses 201-300 o AAA  Tranche D: Super senior, safer than gov‘t bonds  But the history of defaults of subprime mortgages was during rising housing prices, great era o So the rating agencies, stupidly, judging on an atypical part of history, put these ratings on it o Might as well buy 10 bonds and lever up  Suddenly discovered that there was much more risk than anyone imagined o Subprime mortgages defaulted much more than expected o Don‘t really know what they're worth  Thought there was no chance of default, but we don‘t know how many will actually default  So where does this put the financial institutions  Can I raise $ from anyone else? o No one wants to lend to them, because they don‘t know how many losses lie ahead  Keep seeing billions of dollars of losses incurred by financial institutions  Don‘t know what counterparty risk is  Don‘t know if they can repay them next week o For every dollar they lend, don‘t know how much capital they have  Don‘t know what their losses are  So they‘ll make a loan to a high quality borrower for a short period of time  But wont commit for long period of time  Total gridlock  Dysfunctional credit market  Financial institutions don‘t know what they're worth, cant raise money, don‘t know how much they can lend if they could raise money  Even if government's lending rate is low, the financial institutions aren‘t there to do any lending because they don‘t know what they're balance sheets are  Dysfunctional credit markets and major collapse of demand Household wealth fell 8 trillion because of fall of stock market
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o Household wealth fell 8 trillion because of fall of stock market o And 4 trillion for loss of Housing values o Historically, if lost $100, consumer spending down $.04  Now might be more  Now, pensions more affected by fall in market  So consumer saving up o Like it was years ago o So enormous decline in consumer spending 4-5% of 12 trillion: 500 billion o Housing starts-200 billion per year o So 200+500=700bn fall of GDP o Declines in consumer spending  Normally would say leave it to fed, they‘ll drive down interest rates and take care of it o But that wont help now, huge hole o Need to go back to regime which uses a lot of fiscal policy

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Lecture 3
Monday, February 02, 2009 1:43 PM

 In previous downturns, we could rely on fed‘s monetary policy to fix it (in part because fed had caused it) o But this one is massive, dysfunctional credit markets o Fed not enough now  Big question: what to do? o Increase taxes? Increase gov‘t spending?  Let‘s look at the traditional role in economic policy in managing aggregate demand  How the federal reserve has dealt with downturns in the past and will in the future  Govt announce today that saving rate was negative a year today, now 6.8% o Real consumer spending slid 1%  Traditional Role of Monetary Policy in Managing recession o In dealing with inflation o We can see against that background how the intellectual climate has changed  National Saving and growth  Budget deficits and national debt directly o Then return to credit policy  First, Fiscal and Monetary Policy o If you go back before John Maynard Kaynes, before 30's, there was no fiscal policy  The norm was a balanced budget  The gov‘t was very small  1929=federal gov‘t was 3% of GDP  now, its 20% o During the economic downturn of 20's, 30's  There were welfare jobs  But what about monetary policy?  There has always been an intellectual idea about what should be done for monetary policy o On achieving low inflation, so link between increase in money and infation (increase in price level) o Worry about avoiding or correcting financial crisis  Protecting stock of gold  Raise interest rates depending on inflow or ourflow of gold  Did not expect gov‘t to be able to control GDP o Saw it like the weather  Didn‘t expect them to fix it  Treat hardship by providing jobs for unemployed and monetary policy  Until this past year, monetary policy was virtually the only policy used in US and other o Compared to fiscal policy (Changes in tax rates or gov‘t spending) o what were advantages of monetary policy?  Short timeline for decisions and implementation  Federal reserve can take small steps while its learning  Fed began lowering interest rates in 2007 and continued lowering them for years  As opposed to gov‘t which took huge multibillion dollar bite  Also, fed can reverse quickly  Can raise rates back up again  Monetary policy relative to fiscal policy  The fed is MUCH more politically independent  Chairman, fed independent agency
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 Chairman, fed independent agency o Can report to congress  But the fed is de facto quite independent o Unfortunately, these days it has been brought into the administration's policy process more o But it is much less of a political process than congress o So for all of these reasons, monetary policy looks more attractive than fiscal policy o How does monetary policy operate?  Should really be talking in past tense  Today, it has rates down to 0  Affecting credit market  So when we talk about fed, we‘re talking up to 2008, and how we expect the Fed to act in the future o So the Fed makes monetary policy by open market operation  Buys and sells treasury bills  When buy From the banks increases their reserves  Banks don‘t want to sit there looking at their reserves  And then banks want to lend that out  To do that, they lower their rates  These days, the fed has started paying interest rates on reserve, so banks will just let them sit there and accumulate o What does this lowering of interest rates do? o When the fed lowers short term interest rates in the market?  This then affects lowering of long term interest rates, which affect mortgage rates  Why? Because anyone who holds bond has cost of doing so  So it lowers the cost of carry for these bonds o When cost of carry decreases, demand goes up, and so does price, which is inversely related to long term rate o Fed funds rate  This is the rate that the fed targets  The governor plus the chairmen meet to make a decision about the fed funds rate and announce it to world  Now its between 0-.25%  Haven‘t always made fed policy by focusing on fed funds  Also looked at monetary aggregates, M1, M2  But now focusing on fed funds rate  What does this change? o 1.) Inventory investment  inventories are financed by short term borrowing  CP!  GDP:= C+I+G+ (Ex-Im) o 2.) Investment: Fixed investment (structures, equipment, housing), o 3.) software  Also affects fixed investment  Housing: when interest rates down, more people qualified for homes, more people could afford o 4.) Consumer Durables  when interest rates up, interest rates at which auto companies, ect provide credit affect auto demand o 5.) Consumer nondurables  perhaps more surprising
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 perhaps more surprising  like going to McDonalds  1/3 of mortgages are Adjustable rate mortgages  reset every year  so as interest rates go up and down, monthly payments fluctuate o so I have more or less to spend on everything else o cash availability affect o 6.) Stock market  Reduces future value of dividends  people concerned business profits will go down because businesses pay interest on their loans  lower stock market has 2 affects on economy: has less real wealth for households less consumer spending  and higher cost of equity for firms o taking into account what they raised through new equity o can afford to do more investing, etc. o 7.) The dollar  increase in rates leads to an increase in value of dollar relative to other countries  increase in imports, decrease in exports o 8.) Changes in Inflation expectation  even before it affects demand, it affects expectations  as fed eases rates  maybe I should buy now vs. later? o 9.) Increases in mortgage financing  can refinance without penalty  I have 6% loan, IR drop to 5%  Do you want me to do it with you or go to another bank?  So now I have lower mortgage o If mortgage rates come down I can refinance These are the 9 channels which changes in IR can affect aggregate demand and level of output and inflation So what is the goal of the fed? o What are they trying to accomplish? o Primary goal of fed: LOW INFLATION  True of bank of England, European banks as well  Aim for 2%  Ben Bernanke was very interested in the idea of achieving an inflation target before crisis  Dual mandate: low inflation and low unemployment  Inflation zone between 1-2%  Well, that‘s the least of his problems now…. Why this focus on inflation? o Summarized by saying the Fed's goal is price stability  But their not saying that the CPI shouldn‘t change from year to year  When CPI increases at about 2% rate corresponds to no increase in the price level  The price level is constant and the dollar income is constant  Where does bias come in? CPI doesn‘t capture new products and quality changes  Really means no increase in maintaining same standard in terms of CPI So why is low inflation focus? 1.) Econometric evidence that high inflation (over 10%) lowers economic growth
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 o 1.) Econometric evidence that high inflation (over 10%) lowers economic growth  Argentina, mexico  Instead of running ordinary business, you spent all of your time trying to figure out how to speculate, how to collect money sooner, delay payments o 2.) The public dislikes inflation because they see it as eroding the value of their earnings  economists don‘t like this public…  joe gets 9% bonus; inflation 7%, angry cuz he only gets 2%  If everyone gets extra 7% in pay, then it would just wash thru  If no inflation, have to fess up and cut joes pay  But when 7% inflation; can just give him 3% pay increase  Individuals know this  In early 1980s: in shelf life of soup price levels increase  Shops with narrow margins had to increase prices  14% inflation o 3.) Even if we got down to moderate rates of inflation, makes long term planning very difficult o 4.) Erodes the value of financial assets  sophisticated folks should manage their money such that if inflation goes up, don‘t leave money in checking or savings account o 5.)even smart guys get adversely affected by tax system, which uses nominal not real rate  For pi=0, (1-.3)*.04=.028  For pi=6, (1-.3)*.1=.07-.06=.01  Wow! You just went from a real rate of 2.8% to 1%  If pi=10, (1-3)  Real return in economy stayed same, but higher inflation leads to higher affected tax rates  Also capital gains ec  So how do we reduce inflation? What are costs and are they bad? o Increase rates to produce significant real rates, Higher unemployment, and that turns around economy  That produced reduction in inflation o Is high unemployment worth it to bring inflation down?  Consensus: Yes, it is worth paying that price if inflation is getting higher than minimal level  That wasn‘t always true  Used to think they should stop it from going higher but don‘t pay price for going down o Increase in unemployment is a TEMPORARY unemployment  Temporary loss of GDP  Once inflation is down, it is permanently lower o How do I know this?  Depends on how much of increase of unemployment I need to bring down inflation rate  Estimate is that it takes about  An increase in the rate of unemployment by 1-1.5% ( for one year) leads to a reduction in inflation rate of 1% (permanent)  So to bring It down to 2%, need unemployment up to 2-3%  This unemployment has a cost in terms of loss of GDP  Low inflation has benefit of increase in real income o In cyclical terms, 1% increase in unemployment rate causes GDP to fall between 2-2.25%  Oken‘s law: A cyclical rise of unemployment by 1% leads to a decline in GDP of 2-2.25% in the same year (concurrent fall)  Not at all clear why its called a law
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 Not at all clear why its called a law  No particular reason why it should hold, remarkably  If we are facing inflation o If Pi=4%, to go to pi=2%  Change in real unemployment = -2%  Change in GDP:4-4.5&  600bn lost Gdp? (check that #)  is it worth it? o Bringing down inflation from .04 to .02 leads to reduced distortion o Inflation causes real interest rates to fall  Intertermporal allocation of consumption  Causes more money to go into houing, and other things  Tax systemt  1% increase in gdp permanently o So you can give up 4-4.5% one time, but it pays off in 4-5 years o Basic point: you get a substantial annual increase in GDP for one time cost associated with doing it  This is a 1x cost that should be avoided  But if you find yourself here, slow the economy down to get back to square 1

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Lecture 4 - Review
Wednesday, February 04, 2009 1:47 PM

 Focusing on price stability do it by changing interest rates o Affect the cost of funds more generally o By affecting aggregate demand o Phillips curve lower inflation  Tindbergine o Distinguish between instruments, policy, targets of policy, and intermediate targets o Instrument: something that policy makers can control o Target: something that the gov‘t and policy cares about, but can‘t directly control o Intermediate target: ex. Fed doesn‘t literally set the federal funds interest rate  It affects that number by buying and selling T-bills  Announces targets  Meaning that they will buy or sell t-bills until they achieve that  Inject funds into banks, so then banks will want to lend to one another  Feds don‘t actually control it  Cant set how citi lends to jpmorgan  The most important conclusion that tingenberg taught us: o The number of targets that can be achieved is equal to or less than number of instruments they can control o Examples o Change in monetary aggregate= a+b*Treasury bill  Decrease T-bills, decrease money supply because take funds from bank  Look on sheet for 2 equations for change in I and change in M  Can only set target for one of them, though  Instrument that fed has o Buying and selling t-bills o Ultimately there is a relationship between buying t-bills and unemployment rate o So the fed can decide on one or other : unemployment rate implies necessary change on t-bills which in turn affects inflation  If it decides to focus on inflation (usual), then unemployment will react because gov‘t can only control that  Now, lets assume a gov‘t has 2 instruments o Tax credits, and OMO o two targets: inflation, investment o More investment means more productivity, more growth, etc. o Now, the policy makers can set two goals: figure out the combination of the two instruments which will get you there o Tight money would reduce the inflationary pressure even though upset by large income tax credit this example tells us this, but its not the pt o Two targets, two instruments, we can achieve those 2 goals  Nowadays, the fed has been using credit market tools o In the past, when the fed sticks to its standard procedures, it only has 1 instrument really o Well, the US has 2 targets by law  Dual mandate  Unlike European central bank, which has a single de facto mandate
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 Unlike European central bank, which has a single de facto mandate  How does it deal? Has to balance between the two  As in everything in economics, there's a tradeoff and have to balance those two things  Often, central banks hide behind rhetoric  Oh , Within 2 years, labor markets will adjust, and unmeployment will adjust So what does the fed do in practice o Makes a decision about the federal funds interest rate o And communicates that to the NY federal reserve  Which operates in T-bill market to bring about desired level in fed funds interest rate  How would you go about doing it?  Look at inflation, unemployment, inflation expectations (via survey data) o Treasury inflation protected security—gives real interest rate  Compare its interest rate to ordinary bond The dollar: how do you combine them? John Taylor: looked at what Allan Greenspan had been doing o Can we find a rule? o I bet what he‘s doing is looking at inflation in terms of real interest rate and unemployment o How he has set it as a function of unemployment rate  From 1987-1997  Taylor rule: Lets pick a desired level of inflation  We want it to be low, but not 0 (then we might have real > nominal interest rate) When the actual inflation rate is greater than this target rate, it will increase Iff o If inflation is low, it will reduce I ff (federal funds rate) o About 2% You want to pick a sustainable long term unemployment rate so that inflation NAIRU: Non-accelerating inflation rate of unemployment o Target rate of enemployment  Reasonable assumption = 5.5% Taylor said who knows what that rate is! o I‘ll look at nominal level of GDP relative to trend at a given time, divided by GDP  Yt-Ytrend/Ytrend  If output GDP is greter than trend, then we‘ve probably gone to far--?will be inflationary, so probably want to go lower Simplified version of Taylors law: o Iff,t=+1/2[t-*t] +1/2[Yt-Yt,trend/Ytrend]+.02 o ○ =*, Yt=Ytrendiff-t=.02=rff=.02 o Federal funds rate is consistent  No upward or downward pressure ∆iff= ∆t+.05∆t o ∆i(iff=)= ½ ∆t Seems like common sense o But greenspans predecessors did NOT do this o Got bad inflation 1960-1979
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o 1960-1979  ∆i/∆=.81  nominal rate went up by .81  so ∆rff/∆=-.19 o how could they do that?  They dealt with inflation by raising interest rates  They only raise nominal interest rates, not real  Its hard to believe they didn‘t get that right, but they didn‘t In some of these earlier year, great confusion about inflation o Caused by demand, or unionsdoes not produce ongoing inflation  Unions produce higher level o What causes inflation is higher demand sustained by increases in money supply  Always and everywhere a monetary phenomenon This relationship is one which links inflation and unemployment to the nominal fed funds rate o Has the fed continued to do it? o How does it correspond to this o ∆(Yt-Ytrend, t/Yt)=-/2/25∆RU  until this crisis, the fed followed this rule remarkably closely i*ff,t=1.5t-0.5[.02]-0.5(2.25)[RU-NAIRU]+.02 o NAIRU=5.5 i*ff,T=1.5T-1.125RU+.07 Jan 2000 o ○ =.022 o RU=.04 o I*=.058 o I=.054  Pretty good! Jan 2001 o Stock market starting to fall o ○ =.024 o RU=.042 o I*=.059 o I=.06  Still pretty good But by July 2001, recession had been gone o ○ =.023 o RU=.046 o I*=.063 o I=.038 o Why so dramatically different? The economy is sliding into a recession? Its only a matter of time before unemployment slides more and inflation comes down o Very short recession: 8 mos! Nov 2002 o =.019
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o RU=.06 o I*=.031 o I=.0125 Dece 2004 o ○ =.019 o RU=.054 o I*=.039 o I=.02 o But still keeping rates low, bringing down long term rates  Start of housing bubble December 2005 o ○ =.018 o RU=.049 o I*=.042 o I=.042 Dec 2006 o ○ =.025 o RU=.049 o I*=.055 o I=.0525 December 2007 o ○ =.041 o RU=.050 o I*=.076 o I=.0425 Today: o ○ =-.019 o RU=.072 o I*=0 o I=0 With a few exceptions back in Nove 2002, 2003 the fed has followed the Taylor rule o wanted to do something much more forceful to balance the economy o big one in July 2001, accepted a much lower rate What was the logic of doing this? o For these much lower than you might have expected o What greenspan called risk based policy

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Lecture 5
Monday, February 09, 2009 1:50 PM

 The stimulus package does not deal with market disfunctionality, and treasury defaults o Treasury is working hard on that  Publications from Congressional Budget officego to cbo.gov o Put out reports about the nature of the problem, what the gov‘t is doing, how they see the nature of the recovery o Very optimistic—see impact of fiscal policies as much greater  Finish up discussion about demand management o Talked about two targets: inflation and NAIRU o Fed has only one instrument: OMO  Has to balace these 2 in the short run  By following something like the Taylor rule, the economy will naturally go back to NAIRU and gov‘t will have succeeded in bringing inflation down to the low level that it wants o While the Taylor rule is not really a rule, it is a way to guide where to set the fed funds interest rate  Achieves it thru OMO  Is a kind of backward looking rule  Not using forecasts of unemployment, using backwards #  Taylor says: its safe to use numbers that everyone can check  We saw that the fed basically followed the taylor rule which was based on estimates of behavior of alan greenspanapplied it to fed‘s behavior years later o Has come to be more or less right on to applied interest rate according to Taylor rule  Between summer 2001 and 2004, the fed was much easier than the taylor rule implied o Though taylor rule said 4%, fed kept it at 21.2% why?  Fear of deflation  If the inflation rate had gotten to what it was at the time:1%, what if it got to 0%  If economy starts to slide into deflation, the real interest rate goes up and there is nothing the fed can do  If interest rates are below zero, get deflationary spiral, and interest rates would be stuck  Greenspan departed from what would be expected of their behavior from what he saw would be the risk of their current outcome o How bad could it be? o And what would be the consequences of different actions o Useful concept and how did it play out in early part of this decade?  Statistical decision theory o Characterize the problem by thinking about possible  Actions  I=i* (from taylor rule)  I= very low (.01)  States of Nature  Large # of these states of nature  Represent the uncertain outcomes with different actions 1.) Severe recession if i=i*
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o 1.) Severe recession if i=i* o 2.) No recession if i=.01, but there will be an increase in inflation  think about the world in these terms  choose 4% or 1% interest rate  Loss function  o Fed was thinking in a narrow rage of functions o Actions Top: Action; Left: State of Nature
A. Recession if I = i*

I=i*
-20

I=.01
-5

b. No Recesion if I = .04; pi, i=.01 0 -3 o That‘s the loss function: how do you choose? Which is more likely A or B? o What are the probabilities (in the absence of policy)  A=.4  B=.6  More likely that we would have no in inflation  But that would be a mistake to focus on the most likely thing o How about minimize worst outcome?  Clear what the terrible outcome is  Only to avoid would be to use i=.01  Would it be worth taking on if it only has 1% of happening? o Wants to have lowest expected loss.  Expected loss of I = i*: 8  Expected loss of I= .01: 3.8  Don‘t just go with most likely or worse possible to be avoided?  But take minimal expected loss  Did Greenspan do the right thing? o In terms of the tradeoffs between RU and inflation, he was doing the right thing  He could have turned to his friends in the administration and said that he needed a fiscal package because he couldn't do it using only fiscal policy  He was doing the right thing as long as he limited his risks to inflation and unemployment o What happened as the result of 2 years of very low interest rates  Soaring house, share prices  Pursuit of greater risk to offset the fact that interest rates were so low  So this strategy led to excessive risk-taking and  We have to think beyond inflation and RU, have to think about asset prices and stability of financial markets  Now lets talk about LT growth and relation to savings; also fiscal deficits  Focus on LT: don‘t think about cyclical fluctuations and demand management o Time: fundamental potential growth o Chart of Real GDP per capital vs. time  Steady incline  $2000  1960: 2.5023 trillion  2003: 11.049 trillion 
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  growth @ 3.4%  if we ask relative to the population what was actually happening  Population o 1960: 181mm o 2003: 297mm o 1%  GDP/POP  $13846$37252  @2.3% growth rate169%  @1%-->56%  @3.05278%  What is it that determines economic growth, real GDP? o Not thinking about it in demand terms  Thinking about potential  Sometimes fall short of it  So don‘t want to think about adding up components of demand  Think about production function of how GDP is produced o Y is a function of labor inputs and technology o Y=f(K,L,tech)  L=labor  Human capital, people are geographically and socially mobile  Good economy in terms of allocation of labor  These attributes are important for rates of GDP rather than growth o Small change through time in recent decades relative to what it would have been o All educated o Role of eduction is to make labor force more capable  Increases in GDP relect increases in K and L o But if it were just increases in K & L we would fall short of capturing growth in GDP  Increases in Productivity  Gov‘t publishes a productivity # every quarter  Defined as real output divided by man hours o Labor Productivity= real output/employee hours o Things that cause it to rise secularly o Recently, it went up a lot o Over the long term, labor productivity rises  Equality goes up because of more human capital  Labor productivity= f(quality of labor, K/L, technology) o Total Factor productivity  Get increase in labor productivity  Get increase in CAPITAL  Employee hours adjusted for education  Y=a(t)*K^alpha*L^1-alpha  A(T) is the TFP o Does drive GDP  But we are going to focus on K
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 But we are going to focus on K  Basic relationship o Y=f(K,L,technology)  What happens if we increase K at a given amount of L ?  Delta Y=MPK*delta K=rho*delta k  Rho=Marginal productivity of K o =.10 in real terms for nonfinancial sector o Delta k = net investment = gross investment- depreciation  putting in place equipment and structures  want to link that idea to savings  net investment in the economy  have to advance  inventory, software, equipment  has to be matched by savings: resources being produced not consumed  Net investment= net national savings plus the inflow of capital for the rest of the world o Net I= Net national savings + net capital inflow+ ROW

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Lecture 6
Wednesday, February 11, 2009 1:51 PM

 Capital Stock o Affects saving o Net of depreciation o 2 sources of funds available for investment o ∆K=Net investment +Net savings + Capital from abroad o rho=net national saving on fraction of GDP =Marginal Product of capital  ∆K= rho Y+CAD (current account deficit) o ∆Y=rho*∆K=rho*sigma*Y+rho*CAD o ∆Y/Y=rho*sigma+rho*CAD/Y o what does it say about changes in savings rate on rate of economic growth?  If rho=.1  Sigma=.1  Cad/y=.05  ∆y/y=.01+.005=.015  HOLDING constant technology (which would add another percent) and labor (which would add another percent)  So about .035  Impact of capital accumulation, either domestic savings or inflow of capital from ROW, contributes to .015 o If we didn't have CAD/Y, it would drop by .005  If our savings rate goes up 5% (say from 5% to 10%) it add .05 to growth rate o Small changes in savings rate have a huge influence on capital accumulation and GDP  What is national saving? o Net National Savings  State and local government saving = 0  Because they are not allowed to run deficits o For current operations o They can use debt to finance projects tho  Current account deficit= .05 of GDP  Business savings= Returned Equity  Household savings = used to be 7 or 8% after taxes, but they were negative 2 or 3 years ago  Doesn‘t mean everyone is a negative saver o But that the savings of the savers is less than the dissaving of the dissavers o Why?  Because of boom in wealth in which retirees looked and saw that had so much more than they thought they did  Federal Government= -.02-.10  Deficits can be very large relative to savings o Can have important long run effects  Budget deficits and surpluses o Stimulus actions unprecedented since WWII o What is relationship to national debt  How does national debt affect the economy  Fiscal years= does not correspond to the calendar years
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 Fiscal years= does not correspond to the calendar years  Represent the year ending Sept 30th  Source of these numbers in the congressional budget office  Look at website!  When we talk about the national debt: value it at a point in time at end of fiscal year o Talk about deficits flows at end of fiscal year  Unified budget deficit  See why unified in a minute  The overall budget deficit o DEFt =Gt +iB_t -Tt  G=Government Spending  B=the end of fiscal year national debt  B _bar=average debt over the year  T=taxes  455=2730 Bn+249-2524 (for 2008)  455BN is an ENORMOUS numer  2009 estimates: estimate what it means to maintain current level of services: doesn‘t include anything about legislation that everyone things will pass  1186=3345+195-2357  corporate taxes, personal gains taxes  percentages of GDP  2007: the defict was 1.2% of GDP  1.2=18.2+1.7+18.8  2008: 3.2=19.2+1.7-17.7  2009:8.3=23.5+1.1-16.5  all these numbers ar e in percent  On Budget  Rev On budget Off Budget  11.8  1.1  Surplus  -9.4  -8.3    

 Bt=Bt-1+DEFt+ miscellaneous borrowing to finance acquisition of assets  AT THE END OF 2009, the nation debt as currently projected o 7193=5803+1186+204  its really all in this enormous increase in extra spending  extra puzzle of miscellaneous borrowing  The increase in gov‘t spending was 618Bn o There were 2 very unusual items in it o FreddieMac and FannieMae, which have an implicit gov‘t guarantee, which have about 5 trillion dollars worth of debt which they guarantee  Either issue mortgages,  They got into terrible trouble, and the government had to put them into a conservatorship  Bush: no they're not part of government they're just there  But CBO: said we‘re going to count this as a form of govt spending o Injected 18Bn into o Now the govt in one fell swoop took this thing which if it had gone belly up would have cost the bondholders, creditors all of this money o This implies future losses  Figured out the present expected value of those losses
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 losses  In effect, that is something we incurred this year when we took this on  Said its worth 220Bn o So FNMAE and FRMC are a big part of this 600Bn  220Bn non cash o Troubled Asset Recovery Program: TARP  700 bn to play with  COB said you guys are taking risks  You're putting preferred stock into troubled companies o But we have to take into account you have some risks that they wont recover it all  Of 700BN of TARP, 180bn was treated as non cash expected future losses plus some risk premium  So that 220+180=400  And 18bn for F+F  So 2/3 of it is in accounting, non cash items Mysterious miscellaneous borrowing o Where did this 204 bn come from? o TARP: borrowed 640 bn  But already counted as G 180 bn of that  So there was 460bn o They also bought Mortgage backed securities to drive down rates  Cost them 250bn of borrowing  250+460=710bn o FDIC=great guarantor didn‘t have enough money  Borrowed 300bn from gov‘t  So there will be a repayment of 300bn in future o And there will also be a repayment of FRMC and FNMA of 220bn o So: 460+250-300-220=190+14 misc=204 o What looked like enormous increase in deficit driven by increase in gov‘t spending  Most of increase in deficit comes from increase in gov‘t spending  Most of that is not actually real spending o Didn‘t add to aggregate demand o Yet was classified that way by CBO This increase of1390 bn in debt=Bt-Bt-1 B/gdp=40.8(debt held by public?) If B/X rises Bdot/b>Xdot/Xnon GDP Bdot/B=DEFG/X*(X/B) B/X will increase if DEFG/X>B/X * Xdot/X o WHAT IT TAKES FOR THE DEBT TO GDP to rise says that debt to GDP will increase if the deficit relative to GDP is greater than B/X times the growth rate (Xdot/X) o > .5 (.02) o the only way to makeB/X start going down again is to get DEF/X<(B/X)*(Xdot/X) .5(.05)

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Lecture 7
Friday, February 13, 2009 5:01 PM

 Last time, we still had a very large increase in national debt ~10% o Cyclically adjusted deficit o When the economy today is weak, personal and corporate tax revenues fall  There is a rise in the fiscal deficit which is inherently temporary representing the cyclical state of the economy  How big is it or how much stimulation is in system  What is cyclically adjusted deficit  2007 GDP: $13670 Bn o Pot‘ll GDP at NAIRU: 13790 o GDP GAP: DELTA=-126 o Deficit (2007): Observed deficit of 163 BN  But 31 Bn of that was due to cyclical  So C.A. GDP GAP: 163-31=$132 BN  ~.9% of GDP  Unemployment rate in 2009= ~8.3% o GDP Gap to cyclical deficit ratio about ¼  Defg (2009): 1186 BN  250 Bn cyclically adjusted deficit  so 936 bn is cyclically adjusted deficit  418 is accounting (from last lecture)  518 bn of ―financially adjusted deficit‖  3.6% of GDP!!!! o ENORMOUS BUDGET DEFICIT  What are the consequences of this? o What is that people used to think about budget deficits?  And what happened in the Keynesian revolution?  The view that prevailed before the 1930s  A country with a debt is poorer  We are passing out debt to our children, making them poorer  This generated a political aversion to debt o Except when used to finance assets : school, roads o Key feature of Keynsian: we need to use fiscal deficit to stimulate the economy  But this ran into opposition from these people about the making kids poorer thing  How did the Keynsian economists get around this? o As a country, we are poorer because of the debt  What about this debt?  Well, we only owe it to ourselves  1930swe didn’t have a lot of OPEC buyers, etc.  5.8 trillion dollars at end of 2008 o excludes the national debt held inside the federal reserve  and the national debt inside the SS national trust fund o Gross debt: 9bn :but doesn‘t matter as much because they owe
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o some to themselves  What we care about is what we owe to civilians and foreigners  Back to 1930s o Intellectual debate: we only owed it to ourselves  This is like keeping internal records inside housedoesn’t matter  Not like borrowing from a bank  If we buy a tank now, how can that be a burden on children and grandchildren  These arguments were fallacious  Where is the fallacy? o Internally held debt: had to be serviced in the future  Gov‘t has to raise taxes to pay interest on that debt  Ex 5000 Bn of debt *.02=100bn of taxes each year to pay interest o There is a burdendeadweight loss  Distortionary effect of the taxes to pay the interest  Even though we owe it to ourselves o Significant piece of overall gov‘t overlays  Even if all of that was just inside the economy o If they pay today, wont be future burden on future generation?  Crowds out future formation  Capital stock is lower because of borrowing  National saving rate is lower because gov‘t absorbs part of savings that would otherwise be available for capital stock  Burden: have to be servicedDW loss  And lowers capital stockfuture incomes  Now, lets think about what happens when economy is roughly at full unemployment o How does fiscal deficit compare to gov‘t borrowing o Some say that all that matters is gov‘t spending  Debt finance under general economic conditions  I want to make a case for fiscal deficits today  Under normal circumstances, whether we finance by taxes or borrowing is an important choice and that the burden of financing by borrowing is greater than the burden by taxes  Key idea: Tax finance (increase in income tax) will decrease consumption  Debt finance will decrease investment  Some gov‘t borrowing may increase interest rates and lead to higher savings o Think about extreme: Taxing = less consumption o Borrowing = less investment  Wedge between Marginal product of capital and return consumers receive o $1 is worth more at margin than $1 of consumption?  Gov‘ts options o 1.) tax now $100  reduces consumption by $100 o 2.) Borrow now $100  reduces investment today by $100  say Marginal product of capital= MPK= .085  so it reduces by $8.50 per year in future in cons_t  so lets look at the real net interest that individuals face  Discount future lost cons_n by real net interest rate faced by consumer o Government bond interest rate: 6.25% Tax 2.00%
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o Tax 2.00% o Net interest rate 4.25 o Inflation 2.00 o R_n 2.25 $377.78 We can reduce consumption today by 100 or we can reduce future consumption, which because of tax wedge, represents a higher return o That 8.5 dollar perpetuity is worth substantially more than that $100 o As long as MPK is substantially greater than real net rate of interest than taxes are going to have a smaller burden than the lost real incomes associated with borrowing Nevertheless there are circumstances where we may want to do it o We‘ve run fiscal deficits every year o Think about it in terms of full employment economy  Have to modify it for circumstances like today Now there is a kind of special case worth thinking about o Temporary increase in spending financed through borrowing or a tax increase  Ex military expenditures during a time at war  Need a quick military buildup  Better to have an increase in taxes or borrow? o Barro argues that it would be better to borrow and spread cost over long period of time o Taxes distort  10% tax rateto 20% tax rate  quadruples distortion  inversely with square o the deadweight loss will be less if do it in series of small increases in tax rate Ex 2% of national income o Tax finance: .02*Y o Debt finance: i= .05  Delta T=.05*.02*Y=.0010Y  Do we want to levy a one time tax or a perpetuity of taxes equal to 1/10 of a percent of GDP? DWL=12et^2wL o E= elasticity of labor supply o wL= Y (GDP) Tax=1/2E(.02)^2Wl=1/2ewL[.0004] DWL=1/2E[.001]^2wL(10^-6) each year o PV DWL=1/2EwL10^-6/4*^-2=1/4*10^-4 Use debt for one time event like war o Except borrowing displaces investment! o With reasonable assumptions about displacement of private investment If you have a 1 time financing need and don‘t have a large tax wedge distorting the consumption/investment decision o Then use borrowing: spread tax weight over long period of time But when you‘re at full employment, $ of tax o MPK> NET DISCOUNT RATE APPLIED TO individual consumption o Want to use tax finance instead of debt finance? Check this might be other way Large fiscal deficit Often monetized
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o Often monetized o Bt=Bt-1+DEFt  Pretty good for Us, where we have good bond market  Monetary policy independent of policy needs  Other countries (developing), when they run deficit, they increase the money supply  So an increase in money supply increase price level  NOT true for US  Mt=Mt-1+DEFt  M*V=P*Y  Not necessarily will lead to inflation in US  But could o Interest rates rise o Need to crowd out private investment o Might be pressure on fed to bring down interest rates  By temporarily lowering ST rates, can increase inflation o Always tempt to use inflation to reduce debt! o If we could have higher inflation, than that would erode the real value of the debt  Ability to service that debt would be eased  What stops you?  Extent to which market perceives this inflation, interest rates rise and gov‘t has to pay more  Guy who buys it takes the risk  Still get 3% interest  As inflation goes up, wont be able to erode the value of the debt  Finally, there will be a temptation o Weak recovery in which unemployment rate doesn‘t come down very fast o May be more attention to bringing down unemployment rate o

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Lecture 8
Wednesday, February 18, 2009 8:02 PM

No class this Friday! What was the Keynesian revolution? Why did economists eventually reject it? Why is there a new interest in fiscal policy, and how should it be applied? Keynes wrote the General Theory in 1936, which was about the economics necessary to deal with depressions, through using fiscal policy to manipulate aggregate demand. The basic policy prescription of Keynes was to use budget deficits to reduce national savings in order to stimulate aggregate demand. Richard Kahn wrote an article in 1931 explaining fiscal multipliers, how if the government increased government spending by change in G, then GDP would increased by Change in G / MPC. This idea became central to Keynes‘s thinking. For Keynes‘s disciples, the idea could be applied not just in depressions, but to smooth out the business cycle, to fine tune the economy, to eliminate fluctuations in GDP. Unfortunately, this didn‘t work out so well. Keynesian fiscal policy failed to deliver low unemployment and low inflation, which is what we were looking for. From the 1960s to the 1970s, unemployment and inflation both went up significantly. Four reasons why economists rejected fiscal policy to deal with business cycle: 1) We realized the fiscal multiplier was much, much smaller than early textbooks suggested. Instead of a multiplier of something like 5, we saw that changes in government spending had a multiplier of about 1.5, and tax cuts had a multiplier of about .8. 2) Investors would know that interest rates would rise in the future when the government has to compete with private investors to have money to spend. When those in the bond market know that interest rates will go up in the future, they‘ll wait to buy bonds until the price falls, and then the price will fall immediately and interest rates will rise immediately. When the government raises the fiscal deficit in the short run, it had the direct effect which increases GDP, but it also has the interest rate effect of increasing real long term interest rates. This depresses housing and business investments which reduces GDP. 3) We realized that there were long lags when implementing fiscal policy. There are recognition lags, as it takes some time to realize you‘re going into a recession. There are also legislative lags, as it takes time to get fiscal policy through the Congress. There are implementation lags. Finally, there are impact lags between the time when the money starts to flow and when it changes aggregate demand. 4) There was also uncertainty about the state of the economy about how to know if we were in a recession, what exactly the multipliers were, etc. So, economists became much more cautious about implementing fiscal policy. All of this led to a sense that we should rely much more on monetary policy and less on fiscal policy, because there is no long term debt or interest rate problem by using monetary policy. There are also much shorter lags when using monetary policy. Also, with monetary policy you can move in small steps, only cutting the interest rate a little bit. Or, if you realize you‘ve gone too far, you can bring the interest rate back up a little. Monetary policy is just much more flexible. Conceptually, some economists began to question Keynesian policies in the 1960s and 1970s. However, the policies were still very much Keynesian, and they pushed unemployment so low that it stimulated inflation to sky rocket.

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Keynes thought the great depression was caused by too much savings. Thus, the USA literally implemented policies to disincentivize savings, like social security, taxing return to savings much more heavily than return to labor, etc.

Keynes also had a lot of faith in government activism. Keynes was also very focused on the short run. He said that ―In the long run, we‘ll all be dead‖ in response to the idea that we don‘t need fiscal policy because eventually the economy will get back on track by itself. By the 1970s and 1980s, people realized that these policies weren‘t working, and that savings was important, faith in government activism fell, etc. Now, why is there renewed interest in fiscal policy? Monetary policy is currently ineffective, because our credit markets are broken and not providing credit. We‘re looking at an unprecedentedly large fall in wealth. All the issues that Prof. Feldstein brought up in lecture are still valid, but most economists still think we need a fiscal stimulus. We ought to ask of each project when designing the stimulus, what‘s the change in GDP from this project (how much bang are we going to get from increased aggregate demand?), and how valuable is this activity to society?

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Lecture 9
Monday, February 23, 2009 8:03 PM

Capital $100 In addition to that bank put out sign and said I‘m a bank come and make deposits People make deposits and deposited $800 Those are the liabilities of bank = $900, what it owes to depositors and equity holders Then it loans out money so say $900 So total assets = $900 Note that for every dollar of capital they have 8 dollars of deposits so that why did they need to have capital there Let‘s say that what we see is that some loans go sour, don‘t repay so that the value of the loans falls to 850 So assets are only $850, not that they‘ve been paid off, they went sour, defaulted on those loans So what‘s happening? Still owe 800 to depositors, so what‘s changed is capital, capital that's left only $50 So bank regulator says you‘re living too dangerously, if you lose another 50 you would have no capital and another 50 you wouldn‘t be able to repay depositors So regulators can say you can‘t live that way, have to raise more capital or you have to shrink the number of loans you make, which means you don‘t want as many deposits so you‘ll shrink that as well since you pay interest on the deposits and having them sit there is not good Govt comes and looks at bank and says you‘ve got a lot of bad loans there, no one really knows how many bad loans you have, so nobody wants to invest in you and give you more capital, you‘re not earning new profits to build up capital, so either shrink a lot (meaning less credit in economy and economy shrinking) or we the govt will infuse some capital in, as part of the TARP plan, the govt went in and dropped $10 billion here or there So in addition to private 50 capital, put in govt 50 capital then you will have your original 900 and not only that, you could actually go and do more lending and expand But bank isn‘t really sure that it really has 850 of good loans, maybe only 750, so afraid to do additional lending so banks hold back on that, and that‘s what‘s happening now

Variety of proposals One is to inject more capital, another is for govt to buy up some of these loans, now talk about govt taking over entire bank and restructuring But too much to discuss, basically are two kinds of bad assets 1. Residential mortgages, 1 out of every 4 mortgages is underwater – loan exceeds value of house – 2. commercial mortgage – corporate loans, credit card debt, auto loans, so more complex problem than people are confident to solve Feldstein thinks diff solutions for mortgage part and non-mortgage part Hard to value b/c don‘t know what kind of defaults are coming along as house prices continue to fall Really are two separate problems in the mortgage area, president announced program which deals with one and not other 1. affordability – people took out mortgages with low interest rates that have gone up (teaser rates) or someone in the household lost income b/c of loss of job or other reason so ability to afford monthly payments has gone down so mr. banker why don‘t you lower the monthly payments to 38% of disposable income of that household and if you do that, says the govt, then if you want to lower it further to 31% (why that‘s the magic number, I don‘t know) then we in Washington will share the burden with you, the govt will subsidize that reduction in interest rate in no doubt will help some people stay in their homes; what we know from mortgages that have been fixed in this way, still a large number of them default b/c of 2nd problem 2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house
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2. high loan-to-value ratio (rational default) meaning someone says I owe 30% more than house is worth, why shouldn‘t I throw in the keys rent for a few years, come back and buy a similar house at a lower price, govt hasn‘t dealt with this dollar and the trade deficit US has massive trade deficit, 5% of US GDP That puts us in a precarious position b/c we have to finance trade deficit with foreign capital, someone has to loan to us to afford to buy more goods from rest of world than we sell Exports were 1.1 trillion dollars But imported nearly 2 trillion dollars So managed to have trade deficit of 800 billion So we‘re good at services but not as good as our appetite for goods from the world Trade surplus on services, trade deficit on goods, on net, trade deficit Foreigners have investments in the u.s.; tend to be overwhelmingly done by foreign govts investing in bonds, particularly govt bonds Our receipts on our investments abroad are817 billion Our payments on investments to foreigners is 736 billion So we have a small positive income surplus In addition to that, have so-called unilateral transfers, they can be foreign aid, whatever they are, they are payments for which you get back a thank you note, but not a sale in the sense that shipment of goods or services or receipt, -110 billion So end up with a shortfall of 731 billion dollar? Means the amount we need to finance b/c we sell less to the world than buy and even allowing for extra income b/c of investments abroad, that total amount is 731 billion about 5% of GDP In 1998, the balance on goods and services was 166 billion By 2007, it was 700 billion In most recent qtr, running at slightly higher number Why? S-INV=EX-IMP Why? If we save more than we invest, Saving is household, business, govt combined, if we save more than invest, we have excess resources, what do we do with them? We can export them to rest of world On other hand, if we invest more than we save, then we have to get physical resources from some place—rest of the world This is not some powerful theorem of economics, not some empirical finding, this is an accounting identity known and loved since beginning of economics GDP or Y = C + I + G + NX What is Y – C – G = national saving So national saving = I+(Exp-Imp) Or S-I = Exp-Imp What makes it hold? What is the market process? The answer: exchange rate, the price that makes this work When savings rate goes up, that leads to a fall in the dollar, which makes U.S. Makes interest rates lower, lower the dollar, increase exports and decrease imports Let‘s start with nominal exchange rate Nominal exchange rate is by definition is number of foreign currency units per dollar The people who do the exchange rate statistics sometimes do it in reverse but we will always mean the number of foreign currency units per dollar You can imagine For example 115 japanese yen would be exchange rate b/n yen and dollar But saying all other things equal, means prices haven‘t changed, so think of a measure that takes prices into account and that‘s the real exchange rate What matters for trade purposes is the real exchange rate Japanese yen and think that initially the exchange rate was 110 yen per dollar
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Japanese yen and think that initially the exchange rate was 110 yen per dollar Let‘s imagine what happens if the prices in u.s. unchanged, and prices in japan are unchanged, but what happens if the yen goes from 110 to 100 yen per dollar, so dollar declines in value Only get 100 yen now Think about buying something, a camera, the camera costs $22,000 yen So at 110 yen per dollar, that‘s equal to $200 But now at 100 yen per dollar, that‘s equal to $220 Now let‘s consider a slightly diff scenario in which the yen now is going to stay at 110 yen per dollar but instead is that prices in japan are going to increase by 10%, so the camera that used to cost 22,000 is now going to cost 24,200 yen so $220 So we can get the same impact on the American consumer either by keeping prices in two countries the same and have exchange rate move by 10% or we can keep the exchange rate the same, and prices in japan go up 10% and cause price in dollars to change Summarize that by saying real exchange rate = nominal exchange rate x (price in u.s./price in other country) Put a star/asterisk on something to refer to other country Real exchange rate = e x (P/P*) You can add them all up and compare to all exchange rates by weighing depending on amount goods sent abroad Try to understand why it is the exchange rate moves, what causes the movements of the exchange rate The exchange rate is a single variable in complex general equilibrium system You can‘t say X moves the exchange rate, but helpful to identify some of factors 1. changes in price levels at home and abroad if the price level goes up in mexico, what‘s going to go up, the nominal exchange rate should go up to keep the real exchange rate the same this theory is called the purchasing power parity does it work? Sort of, it works in the long run, if you imagine that price level of mexico doubled, obviously something would happen to peso to dollar exchange rate, b/c otherwise no one would buy when there are big moves associated with high inflation rates, the purchasing power parity works pretty quickly, when there are small differences in inflation there‘s a long run tendency for purchasing power parity to hold, but it is something that links price levels 2. balancing trade the u.s. is fortunate in sense that it‘s able to borrow from rest of the world if there is a trade surplus, then the currency appreciates, if deficit, currency depreciates now come to something that isn‘t just a long run tendency but something that happens in real time, a condition that has to hold in financial markets 3. balancing the supply and demand for currencies in financial markets investors don‘t want currencies per se, they want to have those currencies and invest them typically in some short-term interest bearing security have to ask themselves what is going to happen next to the exchange rate something called the equilibrium condition in the financial market is called the interest parity condition if you invest in u.s. two-year govt bonds you will get an interest rate today of roughly 3 percent, if you invest in german two-year bonds you will get interest rate of 3.5 percent but while getting extra half percent could lose value if german currency depreciates so when do you decide when you‘re indifferent b/n the two start with simple view = interest rate available on foreign deposit (i*) and that has to be equal to u.s. comparable risk rate (i) + (percentage change in exchange rate) hypothetical example: you‘re an investor with 1 year horizon, here‘s question, you could buy u.s. treasury bill with 3
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you‘re an investor with 1 year horizon, here‘s question, you could buy u.s. treasury bill with 3 percent yield i for u.s. is 3% or buy a german one, i*=4% yield the exchange rate is .8 euros per dollar but if everyone agreed no change in exchange rate then everyone would invest in german currency, causing it to be bid up, so that would change exchange rate when would it stop? When the condition is held when .04=.03+.01 i*=i+E(change in e/value of e) going to get 3% here, but if I expect dollar going to become 1% more valuable then I‘m indifferent here‘s a picture difference b/n foreign interest rate and u.s. interest rate at the beginning of year has to be expected that dollar come down if look halfway thru the year, still getting higher interest rate but now only for 6 months so at end of 6 months euro has to work it‘s way half way back so next six month has only half of a percent to fall so when go away and think about this, make sure that you are firm in understanding in diff b/n change in exchange rate and the expected change in the exchange rate in the coming period

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Lecture 10
Wednesday, February 25, 2009 8:04 PM

Determinants of exchange rate ($) 1. PPP and nominal rate 2. balancing trade 3. ‗‘ S+D currencies 4. speculation 5. govts

interest parity condition i*=i + E((change in e)/(value of e)) we were talking about minute by minute determination of exchange rate – the supply and demand of currencies fundamental to that is interest parity condition, that the foreign interest rate must be equal to the domestic interest rate plus the expected percentage change in value of exchange rate look at graph, euro becomes suddenly more valuable (if interest rate increase is 1%, the exchange rate drop is 1% and then gradually appreciates) be sure you clearly understand the diff in statement ―the expected change in the exchange rate at that point‖ the distinction b/n that and the instantaneous change of the exchange rate when interest rate jumps by 1%, the immediate effect is that value of dollar falls by 1%, but expected to increase at 1% annual rate going forward this is a riskless picture of the world more realistic would be i*=i+(expected change in exchange rate)+risk premium for foreign currency let‘s say you think that dollars are much much safer than even euro currencies, b/c you read in newspaper that Greece may go bankrupt so have i*=.04 i=.03 risk premium=.005 so expected increase in dollar is only .005 have to bear in mind risks may change done all this in nominal terms, but what about real? The same relationship holds for real interest rates and real exchange rates and won‘t take the time to do it but If did real interest rate = real interest rate in U.S. + change in the real exchange rate i*-pi*=(i-pi)+E(change in nominal rate times fraction of prices/initial value)+risk if you have a temporary surge in interest rates, then the ten year rate wouldn‘t move, but saw back then, a sustained increase in the long term interest rates let‘s look at that calculation, w/ help of friendly diagram with respect to trade it was overvalued, but perfect equilibrium for trades b/c interest rate is higher in US than abroad so other set has to be compensated by form of appreciation of euro vs. dollar for interest differentiation this shows you how relatively small movements in interest rates can have powerful effects on exchange rate budget deficit may cause a substantial increase in interest rates, which lead to a move in the exchange rate, making large swings in the trade balance

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so far we‘ve left out speculation people anticipate where the dollar has to end up look at the interest differential and they make investments based on that

but we also know that in any financial market, speculators react to rumors, the govt may be doing this or some foreign govt doing that, and they react many of the investors – guys looking at screen – ―the trend is my friend‖ ―momentum traders‖ – look at what‘s happening at market, don‘t have underlying philosophy, and they bet on the trend, they mean from now until lunchtime so when you actually try to look at the numbers, there are anomalies, people who made bets based on rumors, all we can do is say that there are these speculative things, so shouldn‘t expect equations to hold perfectly great deal of uncertainty associated with it still the fundamental forces of trade balance, purchasing power parity and interest parity condition continue to provide basic driving force what about govt intervention? Traditionally govts whose currencies came under attack (latin American currencies in 80s, asian currencies in late 90s), often those countries tried to preserve value of currency by entering the market, govt would buy currency Thailand – the govt would come in and buy the thai currency, buy the thai bat, so speculators How did they do that? They had reserves in central bank, but they ran out, so bhat just collapsed That‘s the story of countries around the world that have tried to preserve value of currency when under attack Counterspeculation by govt has not been successful The markets know how much the country has in reserves, and if they see trying to maintain exchange rate that‘s unsustainable in long run, they will keep speculating, and the govt has not been able to stop it Now if it‘s an unwarranted speculation, hedge funds thinking Thailand is pretty vulnerable, momentum traders will join us, we‘ll borrow bhat, sell it at high price, then buy it back at low price, purely speculative Thailand has enough reserves that they can fight back, so what we‘ve seen after the 1997-99 asian crisis is that asian countries that had relatively small reserves, built up large reserves so if there was a speculative attack, they could fight back, Taiwan $200 billion, china $1 trillion? Then there‘s a diff kind of intervention and that is purposely trying to keep their currencies low Japan did it for a long time China has been doing it, in order to make foreign goods less attractive domestically, they reduce the value of their currency Why does that speculation work? b/c if you‘re japan wanting to keep yen weak, you could do it; you could print yen and buy dollars and speculators say they‘ve pushed it artificially low, we‘ll buy, then govt can just print more yen in any case, govts have shown a willingness to do that, to spend vast amounts of resources to drive down their currencies in general, govts don‘t do that, the Chinese claim they‘re not doing that, they certainly were doing that for a while, doing it much less, and the Japanese were clearly doing it and stopped years ago
what‘s the situation now and what‘s going to happen going forward? We have an enormous current account deficit, foreign investment is exceeding u.s. investment in
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We have an enormous current account deficit, foreign investment is exceeding u.s. investment in rest of world, there is a capital inflow The result of that is that foreign investors in US have accumulated 15 trillion in u.s. assets We have foreign assets abroad, but they‘re in excess of 15 trillion which is equal to about our entire GDP so there has to be a point where people get nervous about holding too many dollars in their portfolios Do the Chinese really want to have 2 trillion in US bonds when there‘s a risk that dollar could fall by 10%? That would be $200 billion loss, $200 loss per person, a large loss for them Is there an incentive for investors to keep doing it? That depends on interest rates Right now, interest rate is slightly higher on euros than dollars, so unless you think there‘s a risk premium for holding euros, or that you believed dollar was going to appreciate to offset the interest differential – which is hard to believe as a long run proposition when we have 700 billion trade deficit, euro has 0? So dollar is going to have to come down Why have we recently seen dollar strengthen? History of the last ten years is that dollar starting coming down at beginning of this decade, came down 25% ,and why did it come down? b/c of market recognition that it was too high, ultimately it had to come down, so it had an expectation, also the fact that interest rates were slightly higher in Europe than in u.s. Than in 2007, dollar moved back up again, not b/c of big improvement in trade balance (oil prices complicated this process) but b/c of risk premium, desire for most liquid and safest currency in world (though germany isn‘t likely to default on debt) What happens when investors around the world want to hold more dollars? They can‘t hold more dollars b/c we have a current account deficit of 700 billion – how much money is going to come into US net rest of the world –but they can bid up dollar and bid up prices of short term treasury bonds, so dollar rose and interest on short term treasuries went down, quantities couldn‘t change, availability couldn‘t change, so had to show up in the price Going forward We have to move toward trade balance, various technical arguments, but basic is this: we have been enjoying receiving more goods and services from rest of world than we give back in form of goods and services For last decade, we‘ve been getting trillion dollars of extra goods from rest of the world and just handing them IOUs, at some point have to get back on path in which dollar is gradually coming down and make progress with shrinking deficit How would the imbalance actually end? One piece of that end would be a reduced demand for dollar bonds Foreign govts, foreign private investors might decide that they don‘t want to keep adding to their portfolios, they have too much risk, and are worrying about what‘s going in the US economy So they say enough is enough What happens then if the rest of the world says we don‘t want to do that anymore In short run nothing happens As long as producers want to send those goods, they can, just send it on credit As long as there is that trade deficit, we will continue to get those funds but the question is at what exchange rate, what interest rate If investors reluctant to buy US bonds at existing rates, then offer higher interest rates to attract them Higher interest rates, make it more attractive so funds continue to come in, also have damping effect on US economy S-I will go up, consistent with rise of exports-imports Change in foreign attitudes in their demand for US bonds and US currencies
Second thing that could happen would be a spontaneous rise in household saving rate It got down to low negative numbers, most recent reading is up to 3.6%
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It got down to low negative numbers, most recent reading is up to 3.6% So S-I will go up, so exports-imports go up Mechanism so make that happen is fall in the dollar If dollar doesn‘t fall what happens to the economy Should the US do anything about this? Try to accelerate this process? Maybe not trying to lean the other way The statement ―a strong dollar is good for the US economy‖ certain sense that is true – you can buy things from rest of the world more easily but that adds to trade deficit Strong dollar at home, competitive dollar abroad – new bumpersticker The dollar fall from 2002 to 2007 had no intervention by US, no attempt to slow it down But we do keep making this silly remark Implications Dollar is going to come down over next several years Shrink trade deficit – good for US manufacturers and service firms, restaurants and others, people will substitute towards US goods away from foreign goods As a whole 1. eliminating trade deficit means more GDP goes abroad, so that‘s a serious loss if we normally grow at 2.5% a year, and now giving up 4% of GDP And spread over 5 years, that‘s .8% each year subtracted 2. terms of trade effect – what we buy from rest of the world, what we exchange our stuff for, has become more expensive, so the cost of those goods reduces our standard of living what happens in the long run depends on what happens with our savings rate if it goes up, and if we can translate that higher savings into not a fall in GDP But an increase in net exports, yes there will be a transition period during which incomes will grow less quickly, if savings rate is higher, ability to grow domestic investment will be higher, and the potential GDP growth rate will be higher watching a race b/n offsetting factors, whether rate of capital accumulation is high enough to offset other slowdowns, tax laws and social security will help determine that

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Article Summaries Before Midterm
Tuesday, March 10, 2009 1:12 AM

Economics 1420 Final: Article Summaries 1. Introduction: Where are we? How did we get here? Martin Feldstein – “Housing, Credit Markets and the Business Cycle” (2007) Housing sector is at the root of 3 problems: 1) Falling house prices o Sharp surge in house prices after 2000, 3.4% decline in house prices (2006 to 2007) o Decline in housing construction – such declines precursed 8 of the last 10 recessions o Why did home prices surge over past 10 years?  Credit was cheap/easy to obtain  Fed cut interest rate to 1% in 2003, kept it low – caused promotion of mortgages with low temporary “teaser” rates, mortgage money was easier to obtain o If house prices now decline, there will be serious losses of household wealth, causing a decline in consumer spending 2) Widening credit spreads o Risk became underpriced – difference in interest rates between US treasury bonds and riskier assets were much smaller than before  Investors took comfort in apparent risk transfer to structured products  Less sophisticated investors were buying structured products without understanding level of risk involved  Hedge funds/PE firms substantially increased their leverage o Subprime mortgages – mortgages loans to high risk borrowers with low or uncertain incomes, high ratios of debt to income, and poor credit histories o Borrowers with subprime credit ratings took adjustable rate loans to get in on the house price boom o These loans were bundled into large pools of mortgages and sold – risk of these pools was definitely underestimated o Subprime problem unfolded with high default rates on subprime loans o Combination of subprime defaults and widening of credit spreads – triggered a widespread flight from risk o Investors and lenders also became concerned that they did not know how to value complex, risky assets 3) Declining mortgage credit for consumer spending o High potential for substantial decline in consumption in response to lower home equity withdrawals through home equity loans and mortgage refinancing  Starting in 2001, combination of lower mortgage rates and rapid rise in house prices led to widespread refinancing with equity withdrawals  A lot of the new borrowing was used to finance consumer spending  Decline in house prices/increase in mortgage interest rates shrinks the amount that people can spend, increasing household saving and decreasing aggregate demand o This effect is in addition to the reduced wealth caused by fall in home prices Possible Implications for Economic Policy - These problems point to a potentially serious decline in aggregate demand/economic activity - Fed has said its willing to lend against good collateral at a discount rate that exceeds fed funds rate - But much of credit market problem reflects more than lack of liquidity: lack of trust, inability to value securities, concern about risk - How should Fed balance goals of keeping inflation down and achieving full employment growth? o One view: focus on price stability, so don’t change current monetary policy Other view: look at both goals, thus decrease Fed funds rate for two reasons:
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o Other view: look at both goals, thus decrease Fed funds rate for two reasons:  Dramatic decline in residential construction is an early warning of a coming recession  Adopt a risk-based “decision theory” approach in responding to current economic environment – due to all of the causes above

National Bureau of Economic Research “Business Cycle Expansions and Contractions” http://www.nber.org/cycles.html

2. Business Cycles, Inflation and Monetary Policy Romer and Romer – “What Ends Recessions” (1994) Title: What Ends Recessions? Authors: Christina D. Romer and David H. Romer Year: 1994 Purpose: The authors analyze the role that monetary and fiscal policy have played in recovering from the 8 recessions in the US since 1950, in order to (1) determine if government action actually aids recovery and (2) make recommendations about what policies should be used in future recessions. Thesis: Monetary policy has been enacted shortly after the beginning of most recessions and has been the source of most postwar recoveries; fiscal policy hasn’t been enacted until the trough was reached and typically was too small to have much of an effect. Summary: - Record of Policy Actions Since 1950 o Monetary policy: nominal and real interest rates typically fell by several percentage points before most troughs o Fiscal policy: “high-employment surplus to trend GDP” (adjusts for the impact of economic activity on govt receipts and expenditures) only fell slightly around troughs and shows that discretionary fiscal policy only tended to become slightly expansionary late in recessions; on the other hand, automatic fiscal policy (i.e., the lower taxes and higher unemployment benefits that occur during recessions) was much more expansionary - Sources of Policy Changes o Nearly all monetary and most fiscal changes were anti-recessionary, but the largest fiscal expansions were taken to speed up growth - Lessons from Postwar Economic Policies o Monetary Policy:  Can respond quickly to changes in economic conditions  Most periods of high inflation are not the result of anti-recessionary monetary policy carried to far, as often asserted o Fiscal Policy  Limited fiscal stimulus can be undertaken rapidly, but is limited to actions that can be taken without Congressional approval  No examples of major anti-recessionary spending changes; most large fiscal actions were taken in response to slow recoveries - Effects of Policy Actions o estimate contributions of monetary and fiscal policy to recessions and recovery o results are varied, but suggest that monetary policy has been crucial in ending recessions while fiscal policy has not contributed much - Other Related Issues o There is little evidence that discretionary policy has had a consistent stabilizing influence, and there are actually several instances in which expansionary policy has
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influence, and there are actually several instances in which expansionary policy has actually exacerbated fluctuations o The component of fluctuations that is due to shifts in government policy is highly persistent and accounts for a large part of the persistence of overall output movements

Taylor – “An Historical Analysis of Monetary Policy Rules” (1999) Title: An Historical Analysis of Monetary Policy Rules Author: John Taylor Year: 1998 Thesis: A monetary policy rule in which the interest rate responds to inflation and real output aggressively is the best policy rule. The Fed has followed a policy similar to this since the late 1980s, and this policy likely contributed to the macroeconomic stability of the era. On the other hand, the Fed was much less responsive to inflation and real output deviations in the earlier gold standard era or the 1960s and 70s, which may have contributed to the suboptimal economic performance during these periods. Summary: - A monetary policy rule for the interest rate provides a useful framework for examining US monetary history, and can be derived from the quantity equation of money (MV = PY). o Specifically, Taylor uses the following functional form: r =  + gy + h( - *) + rf o r = short term interest rate,  = inflation rate, y = percent deviation of real output from trend, and g, h, *, and rf are constants o The two key response coefficients are g (= responsiveness to real output deviations) and 1+h (= responsiveness to inflation deviations); differences in these coefficients makes a big difference for the effects of policy (for example, if h < 0, then increase in inflation causes a rise in the nominal interest but a fall in the real interest rate, which actually puts further upward pressure on inflation) - A monetary policy that responds to inflation and real output is an implication of many different monetary systems, including constant money growth, the international gold standard, and ‘leaning against the wind’ (i.e., when the Fed sets short-term interest rates in response to events in the economy) - The monetary policy rule has evolved dramatically over time in the US, and these changes have been associated with equally dramatic changes in economic stability o The size of the coefficients g and (1+h) has increased over time, and are now close to the values suggested by the famous “Taylor Rule” o This evolution of monetary policy is best understood as a gradual process of the Federal Reserve learning how to conduct monetary policy; macroeconomic events, economic research, and policymakers at the Fed have gradually brought forth changes in the US’s monetary policy regime o Rules in significant time periods:  Gold standard era (1879-1914): short-term interest rates were very unresponsive to fluctations in inflation/real output (i.e., low g, h)  lowest degree of economic stability, once we adjust for the gold standard effects  1960 – 1979: slightly more responsive, but h still <1  1986 - 1997: interest rate much more responsive  greatest degree of economic stability - A monetary policy rule in which the interest rate responds to inflation and real output more aggressively than during the 1960s and 70s or than during the international gold standard era, and more like the late 1980s and 90s, is a good policy rule - “policy mistakes” (periods when the Fed deviated from the good policy rule described above) have occurred 3 times and have been associated with either high and prolonged inflation or drawn out

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periods of low capacity utilization o 1st episode: the early 1960s - too tight monetary policy, led to slow growth o 2nd episode: late 1960s-1970s – too easy monetary policy, led to the Great Inflation o 3rd episode: early 1980s –too tight monetary policy, which led to capacity underutilization

Martin Feldstein – “The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy” -Long-run unemployment independent of level of inflation—monetary policy temporary -Are short run benefits of monetary expansion greater than LR costs of inflation? -Feldstein believes that it’s almost always better to have low inflation -Inflation is an implicit tax on money balances -Inflation causes an immediate decrease in welfare dependent on the change in inflation, the elasticity of real money demand, and the size of the real money stock -If the economy is growing at its potential rate, inflation and elasticity should be constant -Money supply grows at same rate as real economy -So when we’re considering the costs of inflation, we need to calculate: -The size of future losses (which depends on growth rate of economy) -And the present value of those losses -Losses from inflation will theoretically be infinite if the growth rate of welfare losses exceeds the rate we use to discount future losses -It seems like many real-life situations fall into this category -Economic policy should focus on reducing inflation rather than increasing unemployment in the shortterm -Additionally, if deflation is the optimal solution, we should always embark on this policy immediately – more costly to wait -If the growth rate of the economy exceeds the social discount rate, inflation is never justified

Ben Bernanke – “A Perspective on Inflation Targeting” (2003) Bernanke supports inflation targeting and thinks the Federal Reserve should eventually adopt it. In this speech, he offers his view of inflation targeting and considers its benefits in what he considers to be its best-practice form. Best-Practice Inflation Targeting: One View Bernanke break down inflation targeting into two components: (1) a particular framework for making policy choices, and (2) a strategy for communicating the context and rationale of those policy choices to the broader public. (1) The Policy Framework of Inflation Targeting By policy framework, Bernanke means the principles by which the policy committee decides how to set its policy instruments, typically a short-term interest rate. He describes his view of best-practice inflation targeting as constrained discretion. Constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy (this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control (the "constrained" part of constrained discretion). The Communications Strategy of Inflation Targeting The second major element of inflation targeting is its communications strategy. The goal of a communications strategy is to focus inflation expectations and explain the policy framework to the public. Targeting inflation enhances central banks’ communications because an inflation target is a clear policy objective that can be reached by a relatively simple policy framework primarily based on one
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policy objective that can be reached by a relatively simple policy framework primarily based on one economic forecast. From the public's perspective, the central bank's commitment to a policy framework, including a long-run inflation target, imposes discipline and accountability on the central bank. This serves to anchor inflation expectations, making the private sector a partner in the policymaking process. Misconceptions about Inflation Targeting 1. Inflation targeting involves mechanical, rule-like policymaking Inflation targeting is a policy framework, not a rule. 2. Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. There are no "inflation nutters" heading major central banks. Inflation targeting central bankers’ dirty little secret is that they do care about output. 3. Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. Bernanke is nervous about the recent trend of separating central banking and financial supervision: “I have always taken it to be a bedrock principle that when the stability or very functioning of financial markets is threatened, as during the October 1987 stock market crash or the September 11 terrorist attacks, that the Federal Reserve would take a leadership role in protecting the integrity of the system. I see no conflict between that role and inflation targeting.” Inflation Targeting at the Federal Reserve Inflation targeting is a long-term goal for Bernanke’s Federal Reserve. The Fed has taken short-term steps in that direction by increasing transparency and enacting more forward-looking, proactive policies, most notably its publication of long-term forecasts for inflation, unemployment, and GDP. By publishing these forecasts, the Fed has effectively targeted inflation in a way that does not raise the same difficult political and communication issues that an explicit inflation target does.

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Martin Feldstein –“Liquidity Now!” (2007) Fed needs to cut Fed Funds rate substantially, starting at current 5.25% to 4.25% and possibly even less Three separate but related forces are threatening economic activity: credit market crisis, decline in house prices/home building, reduction in consumer spending Already weakening the economy – slowing employment growth and declining real spendable incomes Fed action to lower interest rates won’t solve credit market problems, but will help the economy: by stimulating demand for housing/autos/consumer durables, encouraging more competitive dollar to stimulate increased NX, raising share prices to increase both business investment and consumer spending, freeing up spendable cash for homeowners with adjustable-rate mortgages

Martin Feldstein –“Enough with Interest Rate Cuts” (2008) - Time for Fed to stop reducing fed funds rate – benefit is small compared to potential damage - Lower interest rates could raise already high prices of energy/food, will drive up commodity prices by making it less costly for commodity investors/speculators to hold larger inventories of oil and food grains - Also induces investors to add commodities to their portfolios -- will bid up prices of oil/commodities - Rising food and energy prices can contribute significantly to inflation rate and cost of living in US - Also, reducing fed funds interest rate from current 2.25% is not likely to do much to stimulate demand o Will have little effect on housing construction o Has not brought down mortgage interest rates o Will not stimulate demand for individuals/businesses trying to get credit

3. National Saving, Growth and Income Distribution Gramlich – “The Importance of Raising National Saving” (2005) -Low national savings rate is a huge concern – an issue that hasn’t gotten nearly enough attention National Saving = Private Savings – Budget Deficit = I – Borrowing
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National Saving = Private Savings – Budget Deficit = I – Borrowing -Keeping investment larger than savings implies a growing debt stock -High national savings leads to higher future living standards by either: -Financing investment directly -Reducing foreign borrowing -“Twin deficits” – budget deficits and current account deficits are often linked -National saving has dropped because household private saving has fallen AND because budget deficits have increased -Currently, the debt to GDP ratio is steadily climbing -It grew sharply in the 80s (tax cuts, increased spending) -And fell during the boom years of the 1990s -Budget deficits can be expected to increase further (Medicare, Social Security) if drastic changes aren’t made to these entitlement programs -Proposed reforms to Social Security should increase national savings -Increase in payroll taxes -Add-on, mandatory private savings accounts -Bush proposes carving individual savings accounts from existing payroll taxes -This would increase private savings -But decrease public savings -And so have no effect -Automatic enrollment in employer defined-contribution accounts -Individual Retirement Accounts w/ tax benefits -Would these actually increase the savings rate or just divert current savings -Would the increase in private savings offset the fall in public? -How long can we run budget deficits? -Few other countries have run trade deficits for more than five years -Maybe we have a case of co-dependency? -US unwilling to save -Rest of world keeps their currency weak, exports to US -Are other countries building stocks of assets to deal with aging populations? -Could explain huge investment in US capital -Home-bias eroding – open capital markets are weakening the link between domestic saving and investment -We don’t know which of these is the right answer -But raising national savings is certainly the safest option regardless -US would gradually cut budget deficit -Monetary policy could offset decreased expenditure

Lusardi Skinner and Venti – “Savings puzzles and savings policies in the US”  Savings rate has fallen from double digits to less than zero in the last 20 years o Half can be attributed to stock market gains expended by households  Stock market gains drive down the savings rate o 30% goes from savings into bonds o More wealth allows consumers to consume more  Savings rate measure by the NIPA (National Income and Product Accounts) o Very narrow and potentially defective way to measure savings rate  Despite this decline in savings, national saving and foreign capital flows have remained strong o Cannot measure if people are ready for retirement or recession  Study shows that about half of the population will keep enough for retirement, and the other half won’t o Still provides a measure of how much people are saving  Low income and low savings groups have stayed the same Households with little wealth in 1989 still have little in 1998
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o Households with little wealth in 1989 still have little in 1998 o Position has not changed and still do not appear to save anything o Saving is made difficult since low-income workers often aren’t offered/given pensions  Have no designated fund or habit that encourages saving S = rW + E – T – C o Savings = (rate of return)*Wealth + Earnings – Taxes – Consumption Savings = Contributions + Interest and Dividend Earnings – Benefits Paid Capital gains probably account for most of the decline in the savings rate o NIPA’s measure of the savings rate excludes capital gains, so it does not show how much people earn from investment  Half of Americans hold stocks  The top 1% of American households may keep up to 53% of household holdings in stocks  Those Americans that gained the most in the stock market also saw their savings rate decline Another contributing factor to long-term decline in savings rate: easier availability of debt Many households have gained significant wealth even though the savings rate slipped o A segment of the population remains that does not save enough

Parker – “Sprendthrift in America: two decades of decline in the US saving rate” Consumption is up 6 percentage points since 1980 This article refutes several mono-causal theories about why there has been such a boom in consumption In the past five years: Increases in consumption/income has stopped rising The decline in personal saving has been offset by government and business saving The focus of the paper is NOT on the past five years but the larger trend from 1980 that saw a boom of 6% in consumption/income Seven Conclusions: 1. Lower savings is not due purely to a rise in durable goods. That is, households increased consumption has not been on lasting purchases 2. Higher consumption cannot be explained by a “crowding-in” effect. That is, if higher household consumption was matched with decreases in government spending we might conclude that there was “crowding in” but government spending has also increased. 3. Changes in household wealth/income can explain, at most, 1/5 of the increase in consumption. The consumption boom began BEFORE wealth/income began to rise so we can’t say this is causal 4. During the period of high consumption, the growth rate of real consumption/capita was low and real interest rates were high. This is surprising, we would expect that higher r would cause an increase in savings. 5. Changes in the age distribution of the country were found to not be significant in explaining the consumption boom. 6. Relaxed liquidity constraints that make accessing credit easier can only explain about 1/3 of the increase in consumption. 7. Consumption/income ratio has gotten larger with each successive generation.

Possible explanations for the increase in consumption? Forward looking households may be anticipating high future incomes This is slightly questionable because over a 20 year period people would notice if these expectations did not come to fruition There has been a shift in household preferences towards consumption today Federal transfers (Social Security and Medicare) are increasing consumption of the elderly, while relaxed liquidity has allowed younger generations to access more credit
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relaxed liquidity has allowed younger generations to access more credit This is a combination of two theories but seems to be better than either theory alone Feldstein – “The Return of US Saving” (2006) - In 2003/2004 the combined net savings of households, businesses, and government were about one percent of Gross National Income, rate was at the lowest level in 50 years - Decrease in savings and corresponding increase in consumption has led to rise in imports - Savings: difference between what households receive in after-tax income and what they spend on goods and services - Net household savings turned to -1 percent in 2005 from 7 percent in mid-1990s (the level high enough to finance most investment in business infrastructure/ equipment, housing) - Reasons for savings decline: o Rising prices of stocks and homes made Americans wealthier o Stocks nearly doubled in past decade, despite tech bubble crash o Real estate values up 50% in last 5 years  People thought they didn’t have to save as much because of these things o Decreasing mortgage rates allowed for mortgage refinancing  Most cash from this was used for consumption  Home mortgage debt increased by 3 trillion in past 5 years Dependency Theory - Low savings rate has forced the U.S. to “become increasingly dependent on funds from the rest of the world to finance domestic business investment” o ¾ of U.S. net investment is now from foreign capital inflows o Rate of net capital inflows was 5 fives that of 1997 and 2x 2001 o Accounted for 6.4% GDP in 2005 - Foreign investors get these dollars from current account deficit (imports/exports) - Thus our dependence on foreign capital can be reduced only be reducing current account deficit, which will require slowdown in growth of consumer spending - The increase in consumer spending / decreasing in savings is the primary reason for large trade deficit - A large amount of the capital inflows that are coming in are likely from governments o This means the capital inflows aren’t dependable into the future because we can’t predict their action, a reason we need to decrease our dependence - There is a coming rise in household savings o House prices/share prices will not increase at same rate o Mortgage rates have stopped falling (this is 2006) o Then eventually we will be less dependent on foreign capital for investment  Which other countries need to prepare for, ie. They will have fewer exports o Potential for a recession if the trade deficit does not adjust quickly to higher savings rate, causing a slowdown in growth of output and employment

Feldstein and Horioka – “Domestic Saving and International Capital Flows” (1980) Two views on saving and capital flows: 1. With “perfect world capital mobility” there should be no relation between saving and domestifc investment 2. With portfolio preferences and institutional rigidities impeding capital flow, domestic saving and domestic investment should coincide a. Evidence has shown #2 to be most true Paper reconciles this with the fact that short term capital is highly mobile internationally and the existence of substantial international flows of long-term portfolio and direct investments Implications for knowing this information 1. Optimal Savings policy affected because in a closed economy the country gets all the benefit of the pretax marginal product of capital. In a capital-mobile world, most incremental saving
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of the pretax marginal product of capital. In a capital-mobile world, most incremental saving will leave country and so country only benefits from net-of-tax-return of investor (doesn’t get tax revenue) 2. Tax incidence: owners of capital bear tax on capital in closed economy. In capital mobile country – burden could be shifted from domestic labor to foreign capital owners Seems reasonable that capital flows among countries to eliminate short term arbitrage in yields - However, risk aversion considerations effect long-term arbitrage potential o Thus, changes in savings rates or tax rates can occur without incudcing international capital flows - Also, there are restrictions on capital export - Also, there are institutional rigidities, such as in the U.S. savings institutions must be invested in local mortgages - Also some evidence that investors are not maximizing returns net of tax - Also most capital outflow is used for marketing, overcoming trade restrictions, and not necessarily finding most profit Due to all these considerations, must look at empirics to find answer. Evidence shows that nearly all of incremental savings remains in country of origin! Rest of paper describes statistics and facts and numbers. Conclusion: International differences in domestic savings rate among major industrial countires have resulted in almost equal corresponding differences in domestic investment rates. Yet, this is compatible with short-term liquidity, since most capital is actually not available for arbitrage among long-term investments. Also it is compatible with long-term portfolio and direct investments, since much of this is not direct maximum profit seeking

Feldstein – “Did Wages Reflect Growth in Productivity” (2008) - Many studies have shown that wages have not kept up with productivity increases since 1970 - Two main mistakes have led to this incorrect assessment o o People deflate the nominal wages using CPI  Should be using the “product price”, the nonfarm output price index  This is because CPI includes prices of imports and of services provided by owner occupied homes, among other things o Focus on wages rather than total compensation  Fringe benefits and non-cash payments have risen greatly so must consider these - Once you factor these things in, wages have kept up with productivity - Also, the figures line up even closer when you consider non-financial (industry) income, because this eliminates many high earners which distory - “Changes in productivity are not immediately reflected in compensation” o There is a lagged effect o Since 2000, the wages have not kept up, but that’s likely due to the lag and maybe increase in capacity utilization, but needs further analysis - Summary: “Real compensation should be measured using the same price index that is used to calculate productivity”

4. Budget Deficits and the National Debt
Ball and Mankiw – “What do Budget Deficits Do” (1995) Federal Reserve Bank of Kansas City – 1995 I. Budget deficits and the economy a. The immediate effects of budget deficits
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a. The immediate effects of budget deficits i. The effects of budget deficits all follow from the fact that deficits reduce national saving. 1. National saving is the sum of private and public saving. When the government runs a budget deficit, public saving is negative, which reduces national saving below private saving. ii. A decrease in public saving produces a partially-offsetting increase in private saving. iii. Another way to define national saving is current income not used immediately to finance consumption by households or purchases by the government. 1. S = Y- C – G 2. S = I + NX iv. **When budget deficits reduce national saving, they must reduce investment, reduce net exports, or both. The total fall in investment and net exports must exactly match the fall in national saving. 1. In reducing net exports, budget deficits create a flow of assets abroad. 2. These changes are brought about by changes in interest rates and exchange rates. 3. A decline in national saving reduces the supply of loans available to private borrowers, which pushes up the interest rate. 4. A rise in interest rates increases the demand for the domestic currency in the market for foreign exchange, causing the currency to appreciate. a. Domestic goods are more expensive for foreigners. b. Budget deficits in the United States i. It is hard to find empirical work on the effects of budget deficits, since countries do not run fiscal policies as controlled experiments (identification problem). ii. Beginning in the 1980s, the U.S. began to run a deficit. 1. As compared to the period of 1960-1981, the period of 1982-1994 saw public savings fall 2.4% of GDP, private savings fall .4%, national savings fall 2.9%, domestic investment fall .8%, and net exports fall 2%. c. Long-run effects of deficits: output and wealth i. When a government runs deficits for a sustained period, a stock up debt is built up. The accumulated effects of the deficits alter the economy’s output and wealth. 1. When deficits reduce investment, the capital stock grows more slowly than it otherwise would. 2. National income falls when foreigners receive more of the return on domestic assets. ii. Deficits also alter factor prices: wages and profits. 1. Because budget deficits reduce the capital stock, they lead to lower real wages (smaller marginal product of labor) and higher rates of profit (greater marginal product of capital). d. Long-run effects of deficits: future taxes i. The resulting government debt may force the government to raise taxes when the debt comes due. ii. The government may never need to raise taxes. Instead, it can roll over its debt. 1. **As long as the rate of GDP growth is higher than the interest rate, the ratio of debt to GDP falls over time. Thus, the economy can grow its way out of the debt. 2. However, future interest rates and GDP are uncertain. 3. The government may be forced to increase taxes or cut spending. 4. **By raising taxes or cutting spending initially, the government can reduce the risk of more difficult fiscal adjustments later. II. The size of the effects a. A parable
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II. The size of the effects a. A parable i. Assume: “one night, the debt fairy travels around and replaces every U.S. government bond with a piece of U.S. capital.” This would affect: 1. The burden of debt service – A debt service of ~1% of GDP would be eliminated. 2. The level of GDP – The creation of capital raises GDP by ~6%. 3. The real wage – Rises by ~6%. 4. The return to capital – Falls from 12% to 10.3%. b. Is this the right calculation? i. Experiment is correct if economy is closed and fiscal policy does not affect net private saving. ii. Capital inflows partly offset the crowding out of capital by debt. iii. It is uncertain how private saving responds to the deficit. c. Are these effects a big deal? i. “The 3 to 6% fall in income due to government debt can be viewed as only a moderate problem.” III. Deficits and economic well-being a. By the measure of GNP, deficits are unambiguously harmful. i. Based on consumption, budget deficits are a type if income redistribution. This occurs because of the change in the timing of taxes and because of changes in factor prices. b. Who wins and who loses? i. **Pecuniary externalities – A shift in the tax burden will cause the demand for some goods to rise, and the demand for other goods to fall. ii. **Under a deficit, current taxpayers gain and future taxpayers lose. 1. Wages fall, harming workers, and returns on capital rise, benefiting capital owners. These changes are pecuniary externalities. iii. **The winners from budget deficits are current taxpayers and future owners of capital, while the losers are future taxpayers and future workers. c. Are the redistributions desirable? i. Ability-to-pay: Income should be redistributed from those who are better-off to those who are worse-off. 1. When crowding out raises the returns to capital and reduces wages, the wealthy gain at the expense of the less wealthy. ii. Because budget deficits shift taxes forward in time, they benefit relatively poor current taxpayers at the expense of relative rich future taxpayers. d. Should you worry about deficits? i. If you save more to give to your children, you need not worry about deficits. 1. However, national income may be depressed by more than estimated. 2. A large poor population might threaten living standards of the wealthy. IV. A hard landing? a. How a hard landing might occur i. **Hard landing - A rising debt-income ratio in a country may at some point lead to a sharp decrease in demand for the country’s assets arising from a fall in investor confidence. 1. Investors may fear government default, or policies aimed at not paying back loans. 2. This is especially true if the debt is external (owed to foreigners). 3. Since much of the U.S. debt is owned domestically, a hard landing is less likely. ii. Latin American countries that had “hard landings” had less debt than the U.S., but most of it was external. b. The costs of a hard landing i. A hard landing would cause: a sharp fall in the price of domestic assets, a fall in the stock market, an increase in interest rates, a depreciation of domestic
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i. the stock market, an increase in interest rates, a depreciation of domestic currency, and an increase in exports. 1. In turn, there would be lower levels of physical investment. ii. A hard landing could trigger a general financial crisis through an increase in bankruptcies c. A call for prudence i. The fear of hard landings may be the most important reason for seeking to reduce budget deficits.

Elmendorf, Liebman and Wilcox – “Fiscal Policy and Social security Policy During the 1990s” (2002)  Two Fundamental changes in US fiscal policy in 1990s: o 1. Dramatic improvement in current and projected budget balance o 2. Shift to a new political consensus in favor of balancing the budget excluding Social Security rather than the unified budget.  Few changes in Social Security policy.  1. Improvements in budget balance: o 1990 – CBO projected unified budget deficit exceeding $100 billion during fiscal year and remaining next five years. o 1992 – CBO projected budget def. would hit $350 billion and fall by half over next 4 years and turn up again to pass $400 billion in 2002 o 2001 – budget recorded third consecutive unified surplus, CBO projected with unchanged law, surplus would total more than $5.5 trillion over next decade. Stemmed from favorable developments in economy and deliberate policy changes to reduce deficits. o The remarkable improvement in budget outlook during 1990s can be much attributed to policy actions, but also because of an economic boom and higher tax revenues.  2. Balancing budget excluding SS (rather than unified) o Always thought it was important to balance the unified budget o Summer 1999, political consensus shifted to excluding Social Security when balancing the budget. Aimed to put SS into 75-yr actuarial balance. o Part of the shift was because of projected long-term imbalances in the SS and Medicare. They would require reform because of the aging population and rising cost of health care (still a problem). o In 1998 Clinton declared that saving Social Security was a priority and he would not support any uses of the surplus besides for SS until the reform was accomplished. o Despite Clinton’s policy reform efforts, Congress did not adopt the central features of his budget framework  SS and Medicare reforms were not enacted.  Major point: Clinton’s ideas on the reform of budget reporting (on-budget instead of unified) and Social Security were worthwhile and ended up being a missed opportunity.
Office of Management and Budget – Budget of the United States Government: Analytical Perspectives, 2008 Very long-run budget projections can be useful in sounding warnings about potential problems. The key drivers of the long-range deficit are, not surprisingly, Social Security, Medicare, and Medicaid. These entitlements are projected to grow much faster than the rest of the economy for the next several decades. Under current law, there is no offset anywhere in the budget large enough to cover all the demands that will eventually be imposed by these programs. The Impending Demographic Transition The first members of the baby boomers just started to retire. In the next several decades, the elderly population will steadily increase, putting serious strains on the budget. By the time most of the baby boomers have retired, the ratio of workers to Social Security beneficiaries is projected to decline from its current level of 3.3 to 2. From that point forward, it is expected to continue to decline because of lower fertility and improved mortality. The problem posed by the demographic transition is a permanent one. An Unsustainable Path
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An Unsustainable Path The budget is on an unsustainable path. Without comprehensive entitlement reforms by 2080, rising deficits will drive debt to GDP ratios above their peak levels reached at the end of World War II. Comprehensive entitlement reform could help avoid a budgetary crisis.

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CBO – The Long-Term Budget Outlook, Dec. 2007 Federal Budget Future of long-term fiscal situation is uncertain, but definitely unsustainable (debt is growing faster than the economy in the long-term) Concerns: rising cost of healthcare, aging of US pop. To avoid problematic future deficits, revenues must rise as a share of GDP or spending must fall Medicare/aid as a % of GDP is at 4% today. CBO projects it will rise to 12% by 2050 and 19% by 2082 (the total amt the Federal Gov spends today is roughly 19% of GDP). o This increase is expected to be caused by higher costs per patient, rather than an increased number of patients covered by Medicare/aid. o Rise in healthcare spending is largest contributor to growth projected for federal spending, making it the country’s central challenge for long-term federal fiscal policy. Aging population will exaggerate these pressures. Social Security spending is at 4% of GDP today. CGO projects it will rise to 6% in 25 years and stabilize thereafter. Two scenarios for long-term projections based on different assumptions: o Extended-baseline scenario: adheres to current law, extends CBO’s baseline for the first decade and extends it past that time frame. Assumes that policy adjustments made in the past will not occur (stick with current law). Projects that revenues would be higher than ever before. Increases in real income, pushes people into higher tax brackets. Favorable in the near future, but rising deficits would be very detrimental in the long-term. o Alternative fiscal scenario: continue today’s underlying fiscal policy. Deviates from the CBO’s baseline because it incorporates changes in policy that are expected to occur because they have occurred in the past. Revenues would remain constant as a share of GDP. Large fiscal gap, debt would climb rapidly. Threatened by the spiraling costs of interest payments. Under both scenarios, total primary spending (all except interest payments on fed debt) would grow sharply in coming decades. Both scenarios have unsustainable fiscal path, but differ in projections of revenues and timing. Cost of delaying action o Cause rise in amount of government debt, displacing private capital and increasing borrowing from abroad o Exacerbate uncertainty. Greater chance that policy changes would occur suddenly, creating difficulties for households. Should announce before changes take place so people have time to adjust their plans for savings and retirement. o Raise the cost of interest on federal debt, creating additional costs for lawmakers to deal with. Policymakers would be less able to finance other national spending priorities and be left with less flexibility to deal with unexpected developments. Economy would be more vulnerable to a crisis. Major points o Biggest challenge: rising costs of healthcare. Second is social security and the aging population. o Must develop policies now. Delaying action only increases the size of the tax increases needed to eventually close the fiscal gap.

CBO – Economic and Budget Outlook 2009-2019
Economic Outlook Current recession is anticipated to last until second half of 2009
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- Current recession is anticipated to last until second half of 2009 o Economic output over next 2 years will average 6.8% below its potential o Recession was caused by drop in house prices, which undermined solvency of financial institutions and functioning of financial markets - Near-Term Economic Outlook (2009-2010) o Real GDP will drop 2.2% in 2009, not including effect of stimulus package o Recovery in 2010 is anticipated to be slow because credit will continue to be tight as a result of a slow recovery of financial institutions from their losses o Excess supply of houses will suppress house construction o Spending will still be muted due to reduced wealth of consumers o Lowering of tax liabilities and increased Federal spending on unemployment insurance will somewhat stabilize economy. But state spending will not increase. o However, economic outlook will be uncertain because of lack of historical precedence of the degree of trouble in the financial market  There might be further losses on mortgage-backed securities that will continue to contribute to the credit freeze - Outlook from 2011 to 2019 o The gap between actual and potential GDP will not be closed until 2015 - Housing Market o National average price of a house will fall by an additional 14% between 3rd quarter 2008 and 2010 because of high number of vacant homes o Foreclosure rates are likely to remain high while house prices continue to fall during the next year - Financial Market o Late September 2008: financial market on the verge of freezing up o Stock market plunged: further depressing household spending o In addition to cutting Fed Reserve rate, the Fed had also extended its loan facilities to buy troubled assets from banks o Treasury provided 1st round of bailout money to banks and auto industry in late 2008 in order to get credit to flow again (Troubled Asset Relief Program) o However, it is too early to see if these actions will have an permanent effect - Personal Consumption Spending o Decline in employment, large decrease in wealth, and tight credit conditions all contributed to reduce in consumption, which will continue to be restrained in the coming year as unemployment rises even more.  Tight Credit decreases banks’ willingness to lend to consumers Budget Outlook - Baseline budget projection is designed to serve as a benchmark that legislators can use to assess the potential effect of political decision, but not intended as a forecast of future budgetary outcomes o Thus, CBO’s baseline budget projection does not incorporate potential changes in policy such as the stimulus package - Outlooks for 2009: very bad… o Enactment of stimulus package will further add to a $1.2 trillion budget deficit (8.3%GDP) in 2009 o Operation of Fanny Mae and Freddie Mac are included in federal budget because of their takeover by the government  Adds $240 billion to total outlays o Drop in tax revenue and increase in federal spending on bailouts also contributes to deficit o Outlays: discretionary spending (Iraq, Afghanistan) and mandatory government spending such as unemployment compensation, Medicare, Medicaid, Social Security  Unemployment compensation expected to double  The 3 entitlement programs anticipated to grow at 8% this yr Discretionary spending expected to grow 4.6%
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The 3 entitlement programs anticipated to grow at 8% this yr  Discretionary spending expected to grow 4.6% o Revenue  Tax revenue from both income and corporate income tax decreased from 17.7% to 16.5% of GDP due to sharp drop in values of assets and losses in the financial industry - Outlook for 2010 to 2019 o Deficit will decline to 4.9% GDP in 2010 due to increase in tax revenue from alternative minimum tax and the expiration of Bush’s tax cuts o Will continue to fall to 3.3% in 2011 o Outlays:  Increase in Federal spending comes mostly from Medicare and Medicaid, which grows by 7% a year o Revenues will increase as a result of the expiration of previous tax cuts that restores tax rate back to its level in 2001 and from growth in individual’s real income - Budget Projection under Alternative Scenarios o Used to project how different fiscal policies might affect baseline budget projection o Spending on War in Iraq and Afghanistan: 2 scenarios  1. Troop level would be rapidly reduced in 2 yr period, allowing discretionary spending from 2010 to 2019 to be $281 billion less than baseline estimate  3. Troop level would be reduced gradually over 4 yr period: discretionary spending from 2010 to 2019 exceed baseline by $165 million o Revenue:  Modification of Alternative Minimum Tax: lowers revenue

5. Housing and Financial Markets

Feldstein – “How to stop the mortgage crisis” (2008)  Housing crisis background o Housing prices down 10% since 2006, forecasted to fall another 15-20%. Danger of falling further with defaults and foreclosures. o Securitization of mortgages makes foreclosures more difficult to prevent o Because mortgages are "no recourse loans", homeowners whose mortgages > value of house have incentive to default  Other proposals o Incentivize bankers to reduce mortgage-loan balances - does not work because of syndication of mortgage loans o Home Owners' Loan Corporation (from depression) - requires too much bureaucracy  Proposed Solution: voluntary loan substitution program o Federal government lends 20% of individual mortgage at adjustable interest rate based on two-year treasury debt o Interest payments tax deductible, individuals must repay government first. o Lowers total interest but not total debt. In exchange, decrease the amount of debt they escape by defaulting on mortgage, cannot default on government loan. o Participation attractive to home owners whose mortgages are in danger of exceeding value, but not those who already have mortgage > value  Benefits of proposed solution o reduce the number of homeowners who have the incentive to default o makes remaining mortgage debt more secure for creditors o program can be running within months o no net effect on government debt

Feldstein – “How to help people whose home values are underwater” (2008) MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse
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MAIN ARGUMENT: Providing an incentive to shift the current negative-equity loans to full-recourse mortgages, while also injecting mortgage-replacement loans to stabilize the current positive-equity mortgages, is best way to stabilize the economy.  Negative-equity homeowner: Mortgage debt exceeds value of home o 12 million negative-equity homes with an average negative equity gap of $40,000 o Most mortgages in the US are “no recourse” loans: creditor can take the property if the owner defaults, but not other assets or income o Negative-equity homeowner has incentive to default because future income and other assets will not be affected  Existing proposals do not eliminate the incentive to default o Hope for Homeowners: provide government guarantee of the mortgage if the creditor writes the loan down to 95% of the property's current value  But only 400,000 of the 12 million homes with negative equity would benefit because creditors are unwilling to make large write-downs without government assistance o FDIC Proposal: reduce the monthly mortgage payment to fraction of the homeowner's income by stretching out the repayment schedule of the mortgage or providing a temporary reduction in the interest rate on the mortgage  But homeowner still has incentive to default because has to pay full amount eventually. o Academics: creditor writes down the mortgage debt now but gets a share of any future appreciation when the house is sold  Homeowner would sell the house as quickly as possible and buy another one so that he can keep all of the appreciation on the new home.  Key to preventing further defaults and foreclosures: shift no-recourse mortgages into loans with full recourse o To induce homeowners to substitute for a full-recourse loan, there must be substantial write-down in their current outstanding loan balance. o Creditors have an incentive to accept some write-down in exchange for the much greater security of a full-recourse loan o Replace 20% of existing positive-equity homeowner’s mortgage with a separate, fullrecourse loan from the government  “Mortgage replacement loan” would have attractive interest rate & payment schedule  Even if housing prices fall another 20%, all mortgages would still have positive equity  Involve no actual government spending and therefore no increase to budget deficit  Example o Mortgage: $240,000 & House: $200,000 o Gov’t pays 1/3 and creditor pays 2/3 of $40,00 gap  Homeowner takes on $200,000 full-recourse loan o Creditor writes down $27,000 for certain  But avoids the extra loss that comes with selling a foreclosed property and achieves a much more secure loan. o Total Cost to Taxpayers: at most $156 billion

Feldstein – “The Problem Is Still Falling House Prices” (2008) MAIN ARGUMENT: The recent financial recovery plan that Congress enacted will not rebuild lending and credit flows. That requires a program to stop a downward overshooting of house prices and the resulting mortgage defaults. A mortgage-replacement loan program may be the best way to achieve that.
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that.

 Fundamental cause of the crisis: the downward spiral of house prices o destroys household wealth and the capital of financial institutions o Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks. o Bailout Bill doesn’t stop this spiral  Downward Spiral of Home prices o Individuals with loan-to-value ratios greater than 100% have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. o Homeowners default on mortgageCreditors foreclose houseHouse added to stock of unsold homes  housing prices depressed furtherincreases # of negative equity homesmore defaults! o Depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions  Marty’s Proposal: Mortgage Replacement loans o Homeowner replaces 20% of the mortgage with a low-interest full recourse loan from the government, subject to a maximum of $80,000  New buyers and those with mortgages currently eligible  Full recourse Loan: allows the government to take other property or income in the unlikely event that the individual does not pay  A 30-year amortization of the government loan would make the payments low  Life-insurance policy would protect taxpayers if the borrower dies before the loan is repaid o If the homeowner takes this loan, creditors would have to accept the 20% mortgage repayment  reducing the monthly payments of principal and interest by 20%.  Mortgage-replacement loans cannot solve all the problems of the housing sector. o Doesn’t do anything for people who already face foreclosure

Glaeser – “Why should we let housing prices keep falling” (2008) Current financial crisis caused by unsuccessful bets on the Real Estate Market - the crash in the real estate market caused wall street and global economy to collapse - some suggest that this means the government should prop up the housing market Three reasons why this is a poor idea: 1. Government "has no business trying to make housing less affordable to ordinary Americans" - in new York, san Fran housing prices were out of control, problem is not housing decline, but previous unsustainable growth of market - government needs to reduce supply side barriers not artificially inflate them 2. Most of the suggested intervention proposals by the government will be expensive failures - government "doesn't have the tools to rewrite laws of supply and demand" - after initial reductions in interests rates (100 basis points) further intervention has little effect 3. An increase in government intervention will create long term problems - example fannie mae and Freddie mac show that there are high costs "of having government sponsored enterprises play mortgage lender to the nation" Author concludes by saying housing isn't something to speculate on the short term but rather live in and enjoy for the long run

The Economist: “Popping Sounds: House prices are falling just about everywhere” (2008) Housing prices in Las Vegas are 31.3% lower this year (2008) than last. The housing slump in America is being echoed around the globe In America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities
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The housing slump in America is being echoed around the globe In America the slump is unique due to its breadth and severity - housing prices have fallen in all 20 cities covered by the case-shiller index Housing prices in China during the third quarter fell by over 16% in some cities This article was very short and basically just said that housing prices are falling over the globe Diamond and Kashyap: “Everything you need to know about the financial crisis” Why has the stock market been so erratic for the last two weeks? (october 1 -14 2008) Fundamental concern that the banking sector is going to collapse which will drag down the economy. - the banking sector drives the economy because banks are integral to public confidence with investing - if lending markets freeze then the economy stalls - this has been offset by rumour that the banking sector will be bailed out by government intervention What is the government doing about this? 1. Working to prevent the collapse of the banking system in the short term - it is trying to do this by guarantying certain debt - these guarantees are temporary (up to three years) and are aimed at enhancing stability - it is also buying the preferred stock of banking companies - this helps ease concern that banks cannot absorb their losses from the loan and security investments they've made 2. Working to promote lending while the banking system recovers - For very highly rated companies it will lend short term money directly - this is so these companies which would otherwise be unable to have access to funds can resume normal planning and spending Why can't the market correct for this? Why should taxpayers have to pay for the mistakes made by banks? - The problem has become too large to be left to the market to correct. - The Banking sector is paramount to the economy and the government is simply trying to keep the banks solvent - The private sector has no motivation to correct the problem because the banks are in such extreme distress Why are banks so hard to value now? - "This crisis started because of losses related to mortgage-related securities and loans. The value of such assets is very difficult to assess, in large part because the securities are not trading, and so there is some guesswork in establishing their value" Will the government plan work or are there risk? 1. The plan must be setup to ensure that banks emerge with enough capital to survive - if they don't it’s a great waste of taxpayers’ money 2. The plan needs to be set up to avoid further panics 3. The taxpayers liability needs to be protected

6. Keynesian Economics: Retreat and Return Feldstein – “The Retreat from Keynesian Economics” (1981)  Keynes’ thinking has been very influential  Early rejectors: Milton Friedman, Friedrich Hayek  Keynes wrote “The General Theory of Interest, Income, and Employment” In 1935 (British econ had high rate of unemployment for 15 years) Misdiagnosing Unemployment  “Unemployment is due to inadequate demand for labor”  Keynes’ view intended to explain how high rate could persist and how to lower it  American policy makers of 60’s and 70’s assumed it was true for them (unemployed=pool of prospective workers who would remain unemployed until the aggregate spending increased>> expansionary fiscal and monetary policy to stimulate spending
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expansionary fiscal and monetary policy to stimulate spending  NOT TRUE: In 1979 unemployment=6% (higher than average), but econ wasn’t in recession. Spells of unemployment were short (mostly less than 4 weeks), usually under 25, especially teens looking for part-time work or people new to labor force looking for first job. Those who lost job were laid off and waiting to return (75% went back to original job).  Most of unemployment in American economy was due to adverse incentives and artificial barriers (results of government policy) NOT inadequate demand o Existing high unemployment benefits add to total unemployment by encouraging delay to work. Under Keynes, it would relieve financial hardship without adverse effects o In Keynes, there is inadequate demand, so minimum wage can raise wages without reducing employment; in fact, min wage raises unemployment among those with low skills  Keynesian thinking exacerbated unemployment problem and contributed to rising inflation. (Increasing inflation was caused by excess demand from expansionary monetary and fiscal policies) The Keynesian Fear of Saving  Keynes shows lack of interest/outright fear in savings  Capital accumulation is irrelevant: Depression brought high unemployment and low rate of utilization of existing plants and equipment. Increase in demand could lead to higher output without addt’l capital. Adding new capital might increase capacity, but not actual output.  Increased savings is harmful: Too much savings is the root of the depression (households want to save more than firms want to invest)  Keynes’ ideas led to anti-savings policies (seen more in Britain/US than Europe)  The possibility of new depression from inadequate spending seemed to be less serious issue than urgent need to replace and rebuild capital stock that had been damaged  US and Britain have some of the lowest savings rate (US=15% of GNP) o 60% of that is needed to replace stock that is wearing out o Only 6% of GNP has actually been devoted to increasing new capital stock aka net investment  That’s about half other industrial countries  Half of that goes to housing an inventories  Leaving 3% of GNP for real stock of plant/equip o Stock of Plant and Equipment grew by 3.8%, # workers in labor force grew 2%, amount of capital per worker only grew 1.8% (about half of other countries) o In more recent years, share of national income dropped, growth of labor increased, meaning capital per worker is unchanged, perhaps even falling Growth and the Investment Imperative  Additions to the stock of plant and equip can earn real net rate of return (before tax, after adjusting for inflation/depreciation) of about 11% o Giving up $1 of consumption today leads to additional $0.11 each year for indefinite future.  Reason why American should save and invest more because investment translates into increased productivity, greater national income, and higher standard of living  Faster capital accumulation does NOT create jobs/reduce unemployment  Increased rate of investment does NOT eliminate/reduce inflation  Our low rate of savings reflects series of policies that trace back to Keynesian fear of savings: tax rules that penalize savings, social security which makes savings unnecessary, credit market rules that encourage large mortgages/extensive consumer credit, large gov’t deficits that absorb private savings o Impact of sum of all policies is greater than of individual policies taken alone  Now, no longer fear that savings will lead to unemployment and we understand that higher savings is needed for increased investment.>> label of “supply-side economists”  Tradition of easy money goal should be rejected in favor of tight money, high real interest rates, and fiscal incentives to encourage investment in plant and equip The Faith in Government Activism  Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should
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 Belief that the gov’t should use discretionary fiscal policies to eliminate unemployment and should develop spending policies to eliminate social problems  Pre-Keynes view= economy functions best when it is disturbed the least  Depression changed that view>> lack of faith in market system>>belief in active gov’t stabilization and general confidence in gov’t ability to solve social problems  Keynes’ calling on gov’t to spend changed perceived role of the gov’t o Gov’t spending is no longer limited to necessary public services, like defense/court system, and could be used to stabilize employment and output o This lead to idea that gov’t should use its power to interfere in ind mkts to cure social prob (gov’t health care, housing, social security) The Uncertain Future  Keynes’ thoughts are deeply ingrained and will be difficult to change  Democratic political process may not be forward looking enough-many policies reduce unemploy in short run, but increase in long run; also difficult to develop policies to encourage savings

Feldstein – “Rethinking the role of fiscal policy” (2009) What are the principles for designing a potentially useful fiscal stimulus? And what will happen in the current fiscal stimulus fails?
Rise and Fall of Fiscal Activism  After the war, most American macroeconomists focus on contribution of Keynesian fiscal policy to preventing unemployment  Further analysis showed Keynesian multiplier was much smaller than earlier assumed (reduced by a crowding out of interest; leakage of demand through imports; effect on exchange rate)  Difficult for economists to assess the current state of business cycle; even harder to asses where economy was heading and how much it would be affected by stimulus. All uncertainty means fiscal policy could increase cyclical volatility  Long lags between gv’t decisions means that stimulus could occur at wrong point in cycle  Rise in both inflation and unemployment in the 1960s made it clear that Keynesian fiscal strategy wasn’t working  Focus shifted from fiscal to monetary (can adjust more rapidly) low inflation rate since 1980’s reinforced case for monetary policy

Recent Revival of Fiscal Policy  Current downturn is different from previous recessions, monetary policy is not effective  Past recessions generally began after Fed raised interest rates sharply to counter excess inflation, Fed felt it succeeded, revered policy, and lowered the interest rate  Not due to high interest rates, could not be fixed by reversal of Fed policy  Comes from: under-pricing of risk and resulting excessive leverage  Fed tried to reduce, but mortgage and security rates remained high  Temporary one-time tax rebate was chosen as fiscal stimulus (could get bipartisan support and get implemented quickly); unfortunately consumer spending increased only weakly (80 billion tax cut, 12 billion increase in spending)  MPC real income=.7, MPC tax cut=.13  Federal Reserve and Treasury have taken steps to improve credit markets: policies prevented further meltdown of a credit availability in banks, money market mutual funds, and ability of firms to issue commercial paper; measures haven’t increased credit or solved issue.
Designing Current Fiscal Package  Fall in the stock market and value of owner occupied real estate has depressed household wealth by @10T  Wealth effects imply decline of annual consumer spending by $400B (implies lower production, lower incomes, and further reductions in spending Leads to reduction by additional $200B, Automatic stabilizers offsets about 1/3 of this, leaving
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lower incomes, and further reductions in spending  Leads to reduction by additional $200B, Automatic stabilizers offsets about 1/3 of this, leaving GDP gap of $400B  Need to increase by $400B in 2009, 2010: MUST turn to fiscal  Avg recession lasts 12 months, this one, already longer  Suggest: Permanent tax cut of $500 per employed person>> annual tax cut of $70B, increase in consumer spending by $50B  R&D tax credit could help to offset decline in private R&D  Obama is postponing tax increase for high-income ind. Until 2011, but they look ahead. Taxes on dividends and capital gains are scheduled to increase, but promise to leave the rates unchanged would raise share prices, offsetting some of the fall in the market, leading to more spending and increased business investment  Gov’t still needs to spend $300B to $400B (speed of outlays is important; as is avoiding bottlenecks—ie bridges are important, but there are limited number of bridge engineers)
Spending Priorities  Health, energy, education, infrastructure, and support for poor  Some = from fed, but much from state/local  Surprising that: o defense isn’t part of it, and that military spending will decrease o Military training can be used to decrease unemployment, can lead to education in variety of technical skills o Temporary increases in FBI/intelligence would be good too o No increase for research spending What if it Fails?  Gov’t spending could increase more  Fiscal stimulus could shift from increased spending to substantial permanent reduction in personal and corporate taxes  Fall in value of dollar (either spontaneous or planned) that is large enough to eliminated today’s large trade deficit, thus boosting exports

John Taylor – “The Lack of an empirical rationale for a revival of discretionary fiscal policy” (2009) There has recently been a dramatic revival of interest in discretionary fiscal policy, and the purpose of the paper is to review empirical evidence during the past decade and determine whether the evidence calls for such a revival (he concludes it does not).

Taylor uses empirical evidence from two temporary tax rebates is 2001 and 2008 to show that even though the rebates were given during the recession (Lack of good timing is not to be blamed) there is virtually no increase in aggregate demand. Taylor then runs a regression to test whether the rebates had a positive effect on consumption and he includes a lagged dependent variable to allow for lagged effects on changes in income. He then adds controls such as the price of oil which would be expected to have a depressing effect on consumption. He still finds that the rebates had a statistically insignificant effect on consumption.
Taylor then posits that we should continue to focus on the Automatic stabilizers and more lasting long run reforms (i.e tax reform, entitlement reform, infrastructure spending) rather than discretionary countercyclical actions. He runs a regression to test how the automatic stabilizers have effected the GDP gap (potential gdp – actual gdp) and he concludes that they have become more instrumental over the years. He also concludes that the effectiveness of monetary policy over the past decades is all the more reason that we should never turn to discretionary fiscal spending.

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that we should never turn to discretionary fiscal spending.
Conclusion: A decade ago there was widespread agreement that fiscal policy should avoid countercyclical discretionary actions and instead should focus on the automatic stabilizers and on longer term fiscal reforms that positively affect economic growth and provide appropriate government services, including infrastructure and national defense. In this paper I briefly summarized the empirical evidence during the past decade on (1) the temporary rebate programs of 2001 and 2008, (2) macro-econometric model simulations, (3) the changing cyclical response of the automatic stabilizers, and (4) the role of monetary policy in a zero interest situation. Based on this review I see no empirical rationale for a revival of countercyclical discretionary fiscal policy.

Auerbach – “Implementing the New Fiscal Activism” (2009)  Tax Equity and Fiscal Responsibility Act (TEFRA) – Scaled back large Reagan tax cuts.  Budget Enforcement Act (BEA) – During a 1990 summit to combat the recession, the BEA brought new budget rules.  2008 – The general consensus in support of a large fiscal stimulus represents a marked change from the 1982 and 1990 episodes.  Estimates show that both revenue and expenditure policies have been countercyclical and budgetstabilizing, with larger responses on the expenditure side. o The lack of a recession during the 1990s weakened the case for intervention. o Still, the stage was set for policy decisions during the current recession. I. Explaining the New Activism a. Automatic stabilizers have been weakened over time by the indexation of the individual income tax and reductions in marginal tax rates. b. The zero-nominal-interest rate bound limits monetary policy. II. Investment Incentives and Stabilization Policy a. “Business fixed investment is volatile and forward-looking. The former characteristic makes investment an obvious target for stabilization policy while the latter characteristic suggests the need for caution in adopting any such policy.” b. Bonus depreciation was introduced as a temporary measure in 2002 allowing a 30% immediate write-off of qualifying investments. i. “Such incentives aim to increase investment, but even if well -timed, their anticipation might be destabilizing, as provisions targeted at new investment can discourage investment prior to enactment.” ii. Government investment policy changes can be predicted to a considerable extent. iii. Temporary investment incentives can exert a more powerful short-run impact by encouraging the speed-up of projects. c. Bonus depreciation increases the incentive to invest by increasing the present value of depreciation deductions. i. For firms without taxable income that may become taxable only years later, bonus depreciation is of little value. ii. This may be an important issue now, given the sharp surge in losses. iii. There are two approaches to dealing with this situation. 1. Adapt corporate tax rules to make them more symmetric with respect to the treatment of tax losses 2. Adapt investment incentives that allow for the transfer of the tax benefits. d. Household tax cuts should be constructed in a way that would influence the timing of household decisions, as through a temporary reduction in consumption taxes. III. Conclusions a. “The current recession provides compelling circumstance for renewed fiscal policy activism. The strong support for fiscal policy intervention reflects a renewed belief in policy activism
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The strong support for fiscal policy intervention reflects a renewed belief in policy activism that had already appeared before the present crisis.” b. We are still relying on past approaches to discretionary policy. i. Since discretionary policy is traditionally not favored, much attention has not been given to its design. ii. We need to pay more attention to policy design this time around.

Feldstein – “How to Avoid a Recession” (2007) Looking at economic indicators late, such as credit conditions, housing, and consumer sentiment, in 2007, Feldstein predicted that the American economy was headed for a recession. He suggested lowering interest rates to increase output and employment, as the threat of inflation with this policy would do less damage than a deep recession. He predicted that the coming recession would be deeper and last longer than recent recessions. Looking at the credit market at the time, Feldstein predicted that interest rate cuts would not be as powerful a stimulus as they recently were. The credit crunch was caused by low confidence in creditworthiness of those seeking credit and accuracy of asset prices, on top of low liquidity. A great deal of capital was being used to recuperate recent losses and balance their balance sheets. A lower interest rate would reduce monthly payments for people with adjustable-rate mortgages, increasing the amount of excess cash they have to spend. New loans for people and business would also clearly have lower rates, increasing borrowing. Feldstein argued that a fiscal stimulus was necessary to avoid a recession. He recommended a tax rebate that would start automatically if the economy worsened (perhaps if unemployment increased) in 2008 and stopped automatically if it improved. This would increase household and business confidence in the case of a recession. It would also work automatically to correct the negative effects of a recession, such as unemployment, very quickly, instead of having to wait for the legislative process to come up with a plan after the recession has already started. The Fed would not raise rates during the tax cut, as the Fed wants to avoid the recession and this SR stimulus puts less inflationary pressure on the economy than lowering the interest rate. Using fiscal instead of monetary policy would also put less pressure on the exchange rate, as a rapidly declining dollar (caused by increased US money supply) might lead to retaliatory action by trading partners, even as a lower dollar would shrink the trade deficit. Fiscal policy would cause less of an increase on asset prices, such as real estate. Using both fiscal and monetary policy would cause a more balanced increase in demand for assets.

Lawrence Summers – “Why America Must have a fiscal stimulus” (2008) Summers writes early in 2008 that a recession was likely because of low employment, weak holiday spending, increasing oil prices, poor housing data, and writedowns in the financial sector. The Fed would probably continue to cut rates. Now would be a good time to enact a fiscal stimulus. He believed in a diversified policy for four reasons: 1. Outcomes less uncertain with diversified stimulus 2. Middle class families were suffering and fiscal stimulus is more direct aid to them than monetary policy which mainly affects financial institutions 3. Using fiscal policy to address this would mean the Fed wouldn’t need to cut interest rates so much, meaning the dollar won’t fall so drastically, inflation wouldn’t increase so much, and everything would be more stable 4. Because interest rates wouldn’t need to be so low, there’s less of a risk of a bubble Demand would also be more stable with fiscal policy, offsetting a decrease in consumer spending which would lead to job losses and further decreases in spending. Troubled financial institutions meant that people were less able to borrow against their home equity or with credit cards. Summers also cautioned 3 things about fiscal policy: 1. Must be timely, so should be enacted right away 2. Only works if spent, so should be targeted to those with low incomes and those whose incomes have decreased because their spending is most urgent, least likely to have credit
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decreased because their spending is most urgent, least likely to have credit 3. Must be clearly temporary or threat of huge deficits will raise long term interest rates and lower confidence in long term growth. His plan (looks small in retrospect): payments to people paying income or payroll taxes, increases in unemployment insurance for long term unemployed, and food stamps benefits. It would be quick and temporary. Any further stimulus would be provided by measures to reduce future deficits and increase confidence in the long run.

Elmendorf and Furman –“If, When, How: A Primer on Fiscal Stimulus” (2008)  Martin Feldstein and Lawrence Summers have argued that fiscal stimulus may be necessary to help economy in serious economic downturn where monetary policy and automatic stabilizers fail o May include tax cuts and/or spending increases o Fiscal stimulus is more immediate than encouraging investment and can occur more quickly  Principles of Fiscal Stimulus o Timely –should be enacted in certain circumstances at the right time o Targeted – should raise short-run output and end up in the hands of the most vulnerable and struggling o Temporary – should increase short-run output and not increase long-term deficit  When to Intervene? o History of Great Depression intervention o Monetary policy is first line of defense – quicker and does not require legislative approval  Often best because economists should be the ones to analyze data and forecast results, not Congressmen with limited knowledge o Automatic stabilizers are good intermediary between monetary and fiscal policy o Fiscal stimulus is important if monetary policy is powerless  Principle 1 : Fiscal Stimulus Should be Timely o Difficult to time it appropriately o Immediate tax cut or spending increase is good if growth is supposed to be much weaker than forecasted o Usually used in conjunction with monetary policy and automatic stabilizers  Principle 2 : Fiscal Stimulus Should be Well-Targeted o Direct tax cuts should be targeted to those who need it most (typically low-income persons who spend it quickly)  Principle 3 : Stimulus Should be Temporary o Fiscal stimulus can raise short-term economic output to move to outer bound of economic possibilities frontier, but this is a short-term increase o Would be best if it is repaid within five to ten years  Good Examples of Effective Options o Extend unemployment benefits temporarily o Increase food stamps temporarily o Issue flat, refundable tax credits temporarily  Less Effective Options o Increase infrastructure investment o Create temporary investment tax incentives  Ineffective Options o Reduce tax rates, or make 2001/2003 tax cuts permanent  Goal is to build better long-run policy

Mankiw – “What would Keynes have done?” (2008) the current economic downturn. Keynes believed downturns were caused by low aggregate demand. This causes employers to fire workers, leading to less demand, leading to more layoffs, etc. This cycle stops when either an event or polic increase aggregate demand. Mankiw breaks down the 4

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components of GDP and explains why they are low. *Consumption: Consumer confidence was very low (house prices decreased, 401(k)s shrunk, unemployment high). This leads to greater saving. If everyone saves at the same time, there is a huge drop in consumption, leading to lower incomes. *Investment: Usually decreased consumption leads to increased investment. But the housing market was in shambles, as prices continued to decline, and there was lower residential investment as fewer new homes were being built. Financing business investment was difficult, as the stock market was down, interest rates on corporate bonds up, and the banking system in a precarious position. *Net exports: Despite a recent depreciation of the dollar and increase in net exports, net exports were most likely not going to continue to increase. The financial crisis spread from the United States to the rest of the world, and people have been sending their capital back to the US thinking that this is the safest place. This has caused an appreciation of the dollar that should lead to a fall in exports. *Government purchases: Plan is for government to increase infrastructure spending with stimulus, hopefully leading to multiplier of greater than one. This works in the short run, but would add to the budget deficit and threaten the ability of the government to pay for its future obligations (such as Social Security and Medicare for boomers). Mankiw warns that the Fed has already cut the interest rate to practically its lower bound of zero, so it can’t increase aggregate demand through rate cuts anymore. But the Fed can also signal that it plans to keep longer term interest rates low and will work to avoid deflation. It has also been buying mortgage debt.

Broda and Parker – “The impact of the 2008 tax rebates on consumer spending: a first look at the evidence.” Between May and July of 2008, the government distributed approximately $90 billion in tax rebates to American households. They find that households are doing a significant amount of extra spending because of these rebates. They find that the typical family increased its spending on nondurable goods such as food, mass merchandise, and drugs by 3.5% when its rebate arrived relative to a family that had not yet received its rebate. Of the families who received rebates, low income and low asset households increase their spending at nearly double the rate of the average American family. Moreover, shoppers are spending a higher fraction of their rebates at supercenters such as Walmart and Target relative to their normal behavior. Their findings suggests that tax rebates, especially ones made to low-income families, are an effective way to stabilize consumer spending during downturns.

Feldstein – “The tax rebate was a flop. Obama’s stimulus plan won’t work either” (2008)  Tax rebate program was enacted because of the growing risk of a recession. o Congress feared monetary policy alone would not be effective because of the dysfunctional credit markets.  The hope was that the tax rebate would boost consumer confidence as well as available cash. o It was hoped that households would spend a substantial fraction of the rebate dollars, leading to more production and employment. o Brookings Institution study – Each dollar of revenue loss would increase real GDP by more than a dollar if households spent at least 50 cents of every rebate dollar.  Government statistics show that between 10% and 20% of the rebate dollars were spent. o The rebate added nearly $80 billion to the permanent national debt but less than $20 billion to consumer spending. (Rebates amounted to $78 billion, additional consumer spending amount to $12 billion.) o Savings rose by $62 billion, showing that consumers saved much of the money. o GDP figures are supported by the more detailed monthly data on income and spending. There is also evidence in monthly retail sales. o “Although press stories emphasizing that the rebates induced additional consumer spending were technically correct, they missed the important point that the spending rise was very small in comparison to the size of the tax rebates.” “Although someone who receives a permanent annual salary increase of $1,00 typically
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small in comparison to the size of the tax rebates.” o “Although someone who receives a permanent annual salary increase of $1,00 typically would increase his annual spending by an almost equally large amount, a $1,000 rise in wealth caused by a share price increase or a tax rebate would raise spending only gradually over a number of years.” o **This confirms earlier studies that showed that one-time tax rebates are not a costeffective way to increase economic activity.  With this in mind, Obama’s proposal to distribute $1,000 rebate checks to low and middle income workers should be evaluated. o Cost of plan would be $65 billion. It would be funded through an extra tax on oil companies.  Tax on oil companies would reduce investment, keeping oil prices high. o According to past evidence, Obama’s plan to send $1,000 rebate checks would do little to raise consumer spending and stop the decline in employment.  “The distinction between one-time tax rebates and permanent changes in net income is also important for the debate about Obama’s proposal to raise income and payroll taxes. “ o Permanent tax increases reduce consumer spending and aggregate demand. o Taxpayers, anticipating a future tax hike, may reduce current spending. o Increasing future taxes is no way to stimulate the economy.

CBO – Options for responding to short-term economic weakness (2008) This paper first reviews the economic situation and then assesses different fiscal approaches to giving a temporary boost to aggregate demand in the economy. The last section examines policy options geared specifically toward the housing and mortgage markets.
The combination of continued weakness in housing activity and prices, the ongoing problems in the mortgage and broader financial markets, and persistently high price of energy have raised the risk of slow growth and recession (this was prior to when it was common knowledge that the economy was in a recession). Automatic stabilizers and actions by the fed will be our first line of defense against a recession, but if that fails, a fiscal stimulus should be used and it should focus on two things: focusing on right time period when it is most likely needed and increasing economic activity as much as possible. (A stimulus meaning household get increase tax cuts and transfer payments, business get investment tax credits, and the government consider buying goods directly in the economy to increase demand. The paper spends about 15 pages in details analyzing approach and expected results of achieving this). The stimulus should be consistent with Long-Run Fiscal Objectives, and the size of the stimulus should depend on our goals (i.e. enough money so that economic forecast do not project a recession, enough money to reduce chance of recession to an acceptable value, enough money to address the sharp drop in economic growth.) The three questions used to assess stimulus are as follows: 1)Are the proposals likely to be cost-effective, 2) are they likely to be timely (given bureaucratic inertia), and 3) how uncertain are its economic effects. The proposal specific to the housing markets are changing the terms on troubled mortgages, promoting the restructuring of Mortgage Loans, changing bankruptcy law, expanding opportunities to refinance subprime mortgages, expanding authority of the FHA, Fannie, and Freddie, Increasing Federal Assistance to community based organizations, allow state and local governments to issue tax-exempt bonds for refinancing, and government purchases of subprime mortgages. This is a comprehensive list and the concepts of the proposal are pretty self-explanatory. The paper goes through each in detail, so if you are unclear on one or want to learn more, just go back to the paper and look for the bold heading. Conclusion: Even if the individual options have small effects, some of the options taken together may help the
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Conclusion: Even if the individual options have small effects, some of the options taken together may help the economy by reducing the risks of a self-reinforcing downward spiral. In the case of the proposals for restructuring and refinancing mortgages, the main effects come from the help given to creditworthy borrowers who can avoid foreclosure and the attendant losses for both borrowers and lenders.

7. Fluctuations of the Dollar and the Trade Balance Caves, Frankel and Jones – “Expectations, Money and the Determination of the Exchange Rate” Assumptions: no transaction costs, capital controls, barriers to international investors Exchange rate= relative price of foreign versus domestic assets (not GOODS) --they are very volatile, just like the price of bongs, equities, gold, and other assets

Interest Rate Parity Conditions  If dollar is expected to lose value in the future against the yen, then the Japanese investors will subtract the expected rate of dollar depreciation from the dollar interest rate when contemplating the purchase of US assets  If investors do not care about any factors other than the expected rates of return on the two countries assets, then they will by the asset with the higher expected return and sell the other, until the expected rates of return are equalized  Expected rate of depreciation of the domestic currency (∆se)= nominal interest differential ( i-i*) o ∆se= i-i* is the uncovered interest parity  holds onliy if investorys treat domestic currency and foreign currency assets as perfect substitutes in their portfolios  it is an equilibrium condition  much stronger hypothesis than covered interest parity o covered interest parity, the arbitrage condition: i-i*=fd (forward discount)  any deviations would mean that investors could risklessly make as much money as they wanted (VERY unlikely that such options exist) The Monetarist Model of Exchange Rates, With Flexible Prices  It is as if there is one bond under (1) assumptions: no transaction costs, capital controls, barriers to international investors and (2) diff countries assets are perfect substitutes. Investors are indifferent to which country’s bonds they hold  Purchasing Power Parity countries goods can be aggregated together so long as their relative prices are fixed  Monetary approach to the balance of payments: focuses on international flows of money  Monetarist Model: adds assumption that prices are perfectly flexible so that goods and labor mkts always clear  Return to assumption of price flexibility despite evidence against it because one good and one bond is good starting point and PPP is a decent approximation for LR  Mundell-Fleming model assumed fixed prices in SR  PPP assumption: S (bar)=P/P* S(bard)=level of the exchange rate (the “spot” price of a foreign exchange), P=domestic price level, P*=foreign price level o Adding the bar means it is taken seriously only in the LR
Exchange Rate Price of Money  M/P = L(i,Y) M/P=real supply of money, L=real demand for money o Assumes demand for money is decreasing function of interest rate (wish to hold less money when other assets pay a high rate of return), and increasing function of Y (greater need for money to make transactions with when income is high)  Combine M/P equation with PPP: (*indicate for foreign country) o S(bar)= (M/M*)/ [L(i, Y)/ L*(I*, Y*)] o Exchange rate is defined as the price of foreign currency in terms of domestic currency; now modeling it as relative price of foreign money instead of goods
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modeling it as relative price of foreign money instead of goods o Money demand variables: S(bar)= (M/M*)/(Y/Y*) times ƒ(i-i*)  Increase Y»decrease in S, increase in i-i* » increase in S  These effects are the reverse of those in the Mundell-Fleming model  Mundell: Increase in Y means higher demand for imports and deteriorated trade balanced means depreciation  New equations assumes flexible prices so Y is always at level of potential output (all resources are fully employed), in this context if income increases, can only be due to higher level of national resources or improvement in efficiency all changes in output are changes in potential output, which is sign of economic strength and leads to appreciation  Mundell: increase in interest differential requires an appreciation of the currency. In new equation, increase in interest differential is associated with a depreciation of the currency  S(bar)= (M/M*)/(Y/Y*) times ƒ(∆se o If expectations regarding what will happen in the future change, even if no other variables change today, then today’s exhange rate will change o A high interest rate is not a sign of strength for a currency, it reflects expected future depreciation and is thus a sign of weakness o PPP in terms of rates of change: ∆s(bar)= ∆p-∆p*, ∆se =∆pe -∆p*e o Real interest parity: i-∆pe=i*-=∆pe* Expectations of Money Growth  What determines the expected inflation rate?  In simple montarist model: rate of money creation drives everything  Given rate of increase of price level presupposes as money growth rate of same magnitude  If money growth rate were NOT fully reflected in inflation rate (real money supply increasing), LM curve would shift to right and real income would be increasing >> no steady state  Permanent increase in the money growth rate leads to permanent increase in inflation by same amount, public recognizes change, expected depreciation and interest rate increase by same amount, and demand for currency falls  Magnification effect: The percentage change in the exchange rate in any given interval of time can be greater than the percentage change in the money supply during that interval (see page 543/4 for graph)

Hyperinflation  Germany 1923: price level and exchange rate were increasing at same rate (real exchange rate reached steady state), but in the transition to steady state, price level and exchange rate had gone up more than money supply; real money balances fell  Worse the hyperinflation, the more extreme the fall in real money holdings>>NOT true that in monetarist model no change in monetary variable can have an effect on any real variable When Money Supply Follows a Random Walk  If people expect a constant growth rate of domestic money, it is easy to understand; expected interest differential, nominal interest differential, forward discount, expected rate of depreciation ALL equal expected money growth rate differential  With random walk: people know the money supply will probably change, but it could go up or down, best forecast is zero, which means: expected inflation differential, expected depreciation rate, and interest rate differential ALL=0 o A 1% increase in money supply has 1% increase in price level and exchange, but no further effects.
When the Money Supply Is Expected to Jump in the Future  Expecting the money supply to increase in the future will cause today’s exchange rate to increase  The effect on today’s exchange rate is smaller the further into the future is the expected increase Future changes are discounted pack to the present
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 Future changes are discounted pack to the present

Feldstein – “Resolving the Global Imbalance: The Dollar and the US Saving Rate” (2008) Title: Resolving the Global Imbalance: The Dollar and the US Saving Rate Author: Martin Feldstein Year: 2008 Thesis: The recent surge in the US’s current account deficit (to a peak of $811 bil in 2006) is unsustainable, and its decline must be brought about by a higher US saving rate and a decline in the dollar. These changes will happen naturally because of various market forces, but can be accelerated by government actions at home and abroad.

Summary: - The US current account deficit cannot be sustained because the way in which it has been financed in recent years is not sustainable. o Until around 2000, the US was able to finance its entire current account deficit by attracting equity investments from primarily private investors. o Now, the US debt is mainly financed by foreign governments’ purchase of debt (Treasuries) in order to sustain their export surpluses and protect themselves against speculative attacks. Foreign investors will reduce their demand for dollar bonds soon for 3 reasons: (1) foreign govts can get a higher return by investing in their own economies (2) portfolio diversification (3) future decline of value of dollar (will reduce value of dollar investments) with no sufficient rise in the interest rate for compensation - A more competitive dollar is the mechanism that will cause the deficit to decline. o Mechanism by which dollar will fall: foreign exporters deposit dollars for goods they export to US in commercial banks, which then give to central bank central banks want to reduce dollar reserve holdings, so they sell the dollars  increased supply of dollars causes dollar to depreciate. - Other necessary factors for the decline in the US current account deficit: o Higher US National Saving Rate (= household + corporate + govt saving)  The primary reason for the US’s low national saving rate was low household saving, which was primarily caused by the rapid rise in household wealth and the high level of mortgage refinancing with equity withdrawl; both forces are weakening and will likely cause a rise in the household saving rate in the near future (sidenote: both have reversed, so savings rate has risen since this article was written) o Increased Incentive to Purchase US Goods – this will come from the depreciation of the dollar (which makes US good relatively cheaper) o Reduction of Trade Surpluses in China and Many Other Countries  China has achieved a very lare trade surplus (10% of GDP) by artificially depressing the value of their currency, the yuan; this is achieved by purchasing large quantities of foreign reserves  The key to shrinking China’s trade surplus to to reduce the remarkably high national saving rate (40+% of GDP)  Other countries must also reduce trade surpluses as part of global adjustment – this can be achieved without reducing domestic employment/growth if they pursue appropriate fiscal and regulatory policies (ex: revenue-neutral proconsumption tax changes) - in 2006, the IMF proposed a plan to achieve coordinated action to reduce global imbalances. However, their effort is doomed to failure becaue it is missing the key ingredient: the recognition that resolving the global trade imbalance requires a fundamental realignment of currencies (in particular, a depreciation of the dollar)

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Feldstein – “The Dollar at Home – and Abroad” (2006) -Politicians have traditionally emphasized “strong dollar” -Feldstein “We need a strong dollar at home and competitive dollar abroad.” -By a “strong dollar at home,” Feldstein means we need low inflation -By “competitive dollar,” Feldstein means an exchange rate that favors exports -We had this situation in late 1980s – low inflation, fall in value of dollar cut trade deficit -The US can achieve optimal situation because we borrow in our own currency – we don’t have to worry about a depreciating currency making it difficult to afford foreign currency debts -A more competitive dollar would encourage consumers to buy American goods -We don’t know exactly how much the trade deficit will decrease given a certain amount of depreciation of the dollar -Two secondary reasons to immediately strive for a depreciated dollar -The longer we wait, the more debt we accumulate to the rest of the world -While we have an overly strong dollar now, the debt we are accumulating decreases future consumption – we will need to devote more resources to servicing and paying off the debt -One more important and time-sensitive reason -An immediate increase in exports could sustain the economy, replacing the fall in consumption caused by the credit crunch -Because NX will not react immediately, it’s important to start now -To achieve competitive dollar, we need a higher US savings rate and a narrowing gap between US and foreign interest rates -The US government should publically announce that it tends to pursue this policy of a more competitive dollar – markets will do the rest -The US should also probably meet with the Asian countries that own massive reserves in dollars first

Feldstein – “A More Competitive Dollar is Good for America” (2007) Written in late 2007, Feldstein explains that the dollar is correcting itself by falling, on its way to a huge fall needed to shrink the current account deficit. At the time, the CAD was $800 billion, or 6% of GDP. The deficit is financed by capital inflow from foreign investors, mainly through purchasing US bonds. Why would foreigners want to keep buying $800 billion (or more with rising interest payments on external debt) of US debt every year? Foreign governments buy most of this debt. How long will they want to do this, especially as the dollar will eventually fall? They must sell these bonds to other foreigners if the trade deficit is to stay as it is. The amount of bonds held by foreigners can only decrease if America has a trade surplus. If foreign investors decide they don’t want to keep getting US bonds at this exchange rate, the dollar has to fall far enough that people do not believe it will continue to fall or US interest rates must increase to compensate for risk. A falling dollar would increase net exports, lowering chances of a recession, so it would be good for America. It would be all right for America’s trading partners if they stimulate demand in other categories of GDP besides net exports. If they instead lower their interest rates or their governments interfere with the exchange market, keeping their currencies weak against the dollar, US net exports will not increase, and America will not avoid a recession. Americans might blame foreigners, leading to protectionist policies. The fed can offset potential inflation in the US with its increased demand for American goods (as they are relatively cheaper than foreign goods with a weak dollar) by sticking to goal of price stability.

Implementing the New Fiscal Policy Activism Alan J. Auerbach – May 2009 American Economic Review History  Tax Equity and Fiscal Responsibility Act (TEFRA) – Scaled back large Reagan tax cuts.  Budget Enforcement Act (BEA) – During a 1990 summit to combat the recession, the BEA brought
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 Budget Enforcement Act (BEA) – During a 1990 summit to combat the recession, the BEA brought new budget rules.  2008 – The general consensus in support of a large fiscal stimulus represents a marked change from the 1982 and 1990 episodes.  Estimates show that both revenue and expenditure policies have been countercyclical and budgetstabilizing, with larger responses on the expenditure side. o The lack of a recession during the 1990s weakened the case for intervention. o Still, the stage was set for policy decisions during the current recession.
IV. Explaining the New Activism a. Automatic stabilizers have been weakened over time by the indexation of the individual income tax and reductions in marginal tax rates. b. The zero-nominal-interest rate bound limits monetary policy. V. Investment Incentives and Stabilization Policy a. “Business fixed investment is volatile and forward-looking. The former characteristic makes investment an obvious target for stabilization policy while the latter characteristic suggests the need for caution in adopting any such policy.” b. Bonus depreciation was introduced as a temporary measure in 2002 allowing a 30% immediate write-off of qualifying investments. i. “Such incentives aim to increase investment, but even if well -timed, their anticipation might be destabilizing, as provisions targeted at new investment can discourage investment prior to enactment.” ii. Government investment policy changes can be predicted to a considerable extent. iii. Temporary investment incentives can exert a more powerful short-run impact by encouraging the speed-up of projects. c. Bonus depreciation increases the incentive to invest by increasing the present value of depreciation deductions. i. For firms without taxable income that may become taxable only years later, bonus depreciation is of little value. ii. This may be an important issue now, given the sharp surge in losses. iii. There are two approaches to dealing with this situation. 1. Adapt corporate tax rules to make them more symmetric with respect to the treatment of tax losses 2. Adapt investment incentives that allow for the transfer of the tax benefits. d. Household tax cuts should be constructed in a way that would influence the timing of household decisions, as through a temporary reduction in consumption taxes. VI. Conclusions a. “The current recession provides compelling circumstance for renewed fiscal policy activism. The strong support for fiscal policy intervention reflects a renewed belief in policy activism that had already appeared before the present crisis.” b. We are still relying on past approaches to discretionary policy. i. Since discretionary policy is traditionally not favored, much attention has not been given to its design. ii. We need to pay more attention to policy design this time around.

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Lectures 11 and 12?
Friday, February 27, 2009 11:00 PM

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Lectures 13 and 14
Wednesday, March 11, 2009 11:09 PM

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Lecture 15
Monday, March 16, 2009 10:21 PM

Tax Policy taxes transfer funds, they also change behavior. In changing behavior, they create DWL. Evaluating a tax system: (1) Efficiency effects and DWL (2) Fairness/distribution issues (3) Simplicity DWL = (½) t2 ( )QP t= T/P (tax rate) • = elasticity of labor (Q/P) Lump-sum tax: no tax distortions (b/c tax rate = 0) Income tax DWL = ( ½ )t2()wH H = hours • = elasticity of labor supply Ways that taxes affect labor: Participation (taking the summer off, retiring early) Hours Reducing human capital supply (formal education, on the job training, other kinds of experience) If getting extra education Choice of occupation Some jobs pay more, more risky, more physically burdensome, etc. Extra pay is subject to taxes, so people will supply less of it Effort Risk taking Some jobs safer (smaller chance of big bonuses or getting fired) Higher average reward for risk path, but government takes some of this reward, so limits the amount of risk taking How do taxes affect labor income? Depends on form of compensation: Wages (which are taxed) Fringe benefits » government cannot take (e.g. health benefits, parking, etc.) Fringe benefits: (see graph) If price of fringe benefits reduced by (1-t) where t= tax rate, then people demand more, and there is a distortion Taxes reduce gross income, and change the form of compensation to lower taxable labor income (and increase in fringe benefits) Itemize deductions: someone can choose to enumerate things on which he spends money (e.g. mortgage interest, charitable contributions, state/local taxes, etc.) Some of these items can be deducted from taxable income Higher income tax payers are more likely to itemize deductions, b/c they’re more likely to own houses, spend on charity, etc. High taxes on itemized deductions » downward sloping demand and horizontal supply; so people demand more DWL shows up as reducing taxable labor income
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DWL shows up as reducing taxable labor income Marginal tax rates reduce taxable labor income by Reducing labor supply Changing the form of compensation into forms that are not taxable For those who itemize, by consuming more of “favorable consumption items” (items that can be tax deductible) They all reduce taxable income by the same amount All are “equally bad”, b/c all distort by (1-t) Increase spending on favorable (deductible) consumption items and increase fringe benefits by (1-t), reduce labor income by (1-t) DWL = ( ½ ) t2 ( ) (TLI) • =elasticity of taxable labor income TLI = taxable labor income 1986 Income Tax cuts: Reagan and O’Neill Took top tax rate, 50% at the time, and lowered it to 28%, and lowered other rates as well Made it “revenue” and “distributionally” neutral: Revenue remained the same, b/c these “loop holes” were removed as well Big increase in taxable income from high income individuals Elasticity discovered to be ~1 at this time, but there is debate (could be as low as .5) However, both substantial numbers, and show us that DWL is significant Implications for increase in marginal tax rate from 30% to 40%: t=.3 »» .32 = .09 t=.4 »» .42 = .16 • DWL = (½)(.07)TLI • Revenue = .05 TLI • DWL/Rev = .7 Revenue paid + DWL = $1.7 If everyone’s tax rate is raised proportionally, DWL/Rev is .6 Every dollar spent has an additional cost of $1.6 from society

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Lecture 18
Wednesday, April 01, 2009 9:48 PM

Social Security Lecture 1 - Feldstein thinks social security is the most important fiscal problem facing us today - Today we’re spending a lot of time on the financial crisis today, when we’re out of this, we’ll face the issues of how much money we’ve spent right now – how can we fund social security and medicare?? Costs of these are growing because number of people in group getting benefits is growing.

- Figures for 2007 fiscal year: o Social Security (OASDI – old age survivors and disability insurance) -- $489B o Medicare -- $434B o Together – $923B, 6.7% of GDP a. nothing comes close in terms of any other part of budget, defense is next biggest at 4% of GDP - Medicare costs will rise, as more people get older
- Feldstein will focus on Social Security (much of it carries over to Medicare though) - SS actuaries say that social security costs will rise by 6% themselves, and Medicare will rise even faster - Medicare costs per retiree have been rising faster than GDP in general, no one knows how to slow that down - Major driver of taxes in future will be increases in SS and medicare - These are so-called entitlement programs because they are not subject to annual appropriation by Congress - Question: how do we continue to provide benefits for retirees without the dramatic increases in tax breaks? - Start by talking more generally on how to think about pensions, structure of pensions. In US, we have a pay-as-you-go, defined benefit program (this isn’t the only way to structure this) - Then we’ll talk about how our program generally works - Then impact of SS on economy – how does it affect labor supply, savings - Demographic problem, aging of population – challenges going forward - Finally will talk about ideas for SS reform We have a private pension and SS system in US SS program is universal, everyone in US is covered by SS Private pension depends on if your employer provides it Programs: o Types: Defined benefit, Defined contribution / Investment-based, Pay-as-you-go

1) Defined benefit + Investment-based: a. Defined benefit might look like this: benefit = 0.02 (number of years you worked for company) (final wage). If N = 20, benefit = 0.40 (final wage) b. Investment based: Saving by the company in form of stocks and bonds – designed so these stocks and bonds can finance benefits that have been promised c. Emulates private saving by individual – instead of individual saving money, company saves it and gives it later d. Since its an investment based program, this ultimately increases capital stock of country (which occurs when individual saves too) o Over time, companies have been moving away from DB programs and towards DC programs 2) Defined contribution + Investment-based: a. Defined-contribution – employer promises a certain percent and then employee can
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a. Defined-contribution – employer promises a certain percent and then employee can pick where the money gets invested, how much to put into stocks/bonds, etc. b. Employer puts in a percentage of wages, benefit is based on how employee’s investment choices pan out c. It is investment based, so it leads to increase in capital stock o Companies have been moving from defined benefit to defined contribution for 3 main reasons: b. More mobile labor force – people change jobs more often so made more sense to have DC  For someone who changes jobs a lot, he gets very little money because wages have gone up a lot since he had some of his older jobs. Everytime he moves, he stops the accumulation of that pension. Overall, gets very very little in real terms. c. Shifts the risk and responsibility from the company to the employee, individuals prefer this too d. Some companies tend to promise more in benefits than they can deliver. When the company gets in trouble, the government has an insurance program that insures this pension program – this gets funded by taxing companies that have defined benefit plans. This tax has been rising rapidly. So companies get out of this tax by closing down their DB plan and moving to a DC plan. 3) Defined benefit + Pay-as-you-go: a. This is what social security is b. Pay-as-you-go means that the benefits that are paid out to all of the ppl in a single year are equal to the taxes that are collected in that year c. Paygo means Bt = Tt i. Defined benefits = taxes at time t d. Now, we actually collect a little more in taxes than we deal out in benefits (just to smooth things out, not to invest like in other systems) e. Key things: i. Tax financed ii. Benefits pay out all of the money collected in taxes, thus there is no saving iii. No increase in capital stock

4) Defined contribution + Pay-as-you-go: a. In this case, there is a notional defined contribution plan – Italy has this, Sweden has this, China thinks it has a DC, IB plan but actually has a notional DC plan b. How does this work? You get an account. Every year, a certain percentage of your wage is credited to that account. The taxes that you pay are used to finance existing benefits (not saved). This is a defined contribution because you are not promised a certain amount of benefits, but you are promised a certain rate of return on your contributions. (ex. If you’re required to put in 10% of your wages every year, then we will give it a rate of return, say 3% -- then you’ll get this 3% return whenever you ask for it) c. Very much like an IB account, but there is no savings d. Where does this rate of return come from? e. Money as you get back as a retiree is more than you ever paid in in taxes. How does this work if there is no real investment in taxes?
o Where does the rate of return come from in a notional DC plan or a pay-as-you-go DB plan? e. This is true because of the growth of the tax base. Due to the growing number of workers and growing wages of workers. f. Ex. People live for 2 periods.  1st period – young, earn wage w, N people and pay taxes t – so total taxes paid
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 1st period – young, earn wage w, N people and pay taxes t – so total taxes paid are: wNt  2nd period – old, retire, get benefits, benefits at time t+1 = taxes collected at time t + 1  So is Bt+1/Tt greater than one? This equals t t+1/tt = wt+1Nt+1/wtNt  This equals (1+g)(1+n) = 1+g-n = 0.03 (in example) o g – growth rate of wages o n – growth rate of population g. so this rate of return just comes from the implicit growth in tax base o problem with pay-as-you go system – generates much lower return than other systems (3% versus and maybe 6 or 7%) o Differences between notional DC plan and paygo DB plan? What caused governments to switch from DB to DC paygo plan? h. Allows people to see the differences between the taxes they pay and the benefits they are eventually going to get i. This tax is very different from the personal income tax j. If I understand the formula well enough, I can probably understand what the increase in my benefits will be. This type of system makes it much more transparent. k. Appearance that it is a pure tax is changed – reality is that you’ll get some back  This is true in DB plan too, but DB formula is so complicated that people don’t understand that. l. While these advantages exist, this system still has really low rate of return

- Do we want to stay in DB, paygo plan or do we want to switch to more clarity with DC, paygo or do we want to switch to DC, IB or a combination of what we have and DC, IB? - Why do we have a SS program at all? o Roosevelt believed we could provide benefits while taxing younger people who would eventually get benefits later o As economists, was it a good reason to create SS benefits with this program? Usually we make decisions like this due to a market imperfection/externality. Feldstein cannot find any externalities here. o There are missing markets – there are imperfect annuity markets, and no real annuity markets. Less of a missing market now than there was before. o Real reason for our SS program: combination of 2 things m. Myopia (short-sightedness)  People do not save for themselves.  Back then, people died earlier. Then, many people didn’t get to age 65 and then they’d just move in with family. But now life expectancy is about 7 years greater. n. Gaming  So why don’t we just wait until people get to age 65 and see if they have any money. If people don’t have money, then we’ll give them money. This is called a “means test.” So this makes people with lower incomes not want to save because they’ll just get the same amount from the money from the government. o. We have no idea of telling the people who are plain short-sided from the ones who are trying to game the system. - We have a DB, pay-as-you-go system. How does it work? Etc. – talk about on Friday

4/3/09

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4/3/09 Social Security Reform - Today: how social security works in the US - Pay as you go, DB program Tax part: (How it is financed) - Financed by a payroll tax o On all wage a salary income (up to $102,000) o 6.2% tax paid by individuals, 6.2% tax on employers o Who actually pays the tax is irrelevant – it’s a total 12.4% tax o Includes a Medicare component of 2.9%, 1.45% by employers and 1.45% by employees o Total: 15.3% tax - No deductions, very different from income tax (where you have deductions for number of people in family, etc.) - Since there are no deductions, for more American households, this payroll tax is the largest tax they have to pay (has really grown into a huge tax) Benefit part: Depends on your wages and how much you worked Average index monthly earnings (AIME) – take inverse of person’s wage in month t, multiply by average wage of that month o sum of Wit/Wt over 35 years of your highest earnings o AIME = 1/420 sum (from 1 to 420) Wit/Wt Primary Insurance amount (PIA) – amount of benefit that a retiree would get (without a spouse) if they retired at a normal age Graph of PIA versus AIME – looks like four line segments that start out really steep and levels out at the top o As you get older, you get more benefit, but at a decreasing rate Rule used to be that you can get your benefit at 65, now the rule is that if you were born after 1938, you have to wait longer (2 months more per year—creeps up to age 67 max) This formula looks quite re-distributive –everyone pays the same amount of tax, but benefits are decreasing returns over time How does this look? o Someone with median earnings ($40,307) would get benefits of $16846 per year or 42% of their immediate, pre-retirement income o Someone with maximum earnings ($90,737) would get benefits of $26220 per year or 29% of their immediate, pre-retirement income o Someone with lower incomes ($18,138) would get benefits of $10224 per year, or 56% of their immediate, pre-retirement income This makes it look like this is a very redistributed program by percentages However, statistics say there is not redistribution for 3 reasons: o People in higher incomes start working later, so they pay for less years than the poorer people who generally start working at age 18 (everyone only gets benefits for 35 years of their work, even if they worked much longer) o Life expectancy depends on earnings – if you are a high income person, you are much more likely to reach age 65 and get benefits, and you are much more likely to last longer than 65 and receive benefits every year o 2-earner households. Social security was made for a single-worker home. If there is a spouse, they have the choice of getting 50% of the primary earner’s PIA or they have the choice of getting their own PIA. Women generally drop out of labor force for many years so they get more if they earn 50% of husband’s PIAs. It’s a strange system, where a woman can pay in for many years and get no benefits because of it (because they get money because of husband’s earnings.) If one spouse dies, surviving spouse gets 100% of higher PIA.

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- Marginal tax rate is the PIA minus the actuary expected value of future benefits
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- Marginal tax rate is the PIA minus the actuary expected value of future benefits - For people who are working not in their top 35 years, they get nothing back for what they put in - For woman who are going to collect on behalf of their husband, they get nothing for what they put in - If you choose to retire early (within 36 months of retirement age), you get a lower benefit based on how early you retire (FRA – 36 months) o Many people are choosing this route - If you choose to delay retirement, there is an actuarial adjustment. Benefits rise by 7% per year.

- Historically, SS began as a much smaller program. When it began in the 1930/1940s, it began as a 2% tax. By 1960, it was a 6% tax. By 1980, it was a 12% tax including Medicare. Since 1990, it is a 15.3% tax including Medicare. - Bt+1/Tt = (thetat+1/thetat) (Wt+1 Nt+1 / W2 N2) - If you were lucky enough to be working in the 40s and then getting benefits in 80s, you paid only 2% while workers in 80s were paying 12%…get a much higher rate of return - Example: Joe was born in 1923, works from 1948 to 1988, has max salary o In lifetime, taxes paid by both him and his employers were total: $68000 o Benefits that he gets in 1989 for himself/spouse are: $15000 (CPI indexed) p. In less than 6 years, he would get everything he paid in plus interest o His life expectancy was 16 years, so he expected to get $255,000 total before he died - This good deal was there because of the growing population and growing tax rate - Our generation will be hurt by the demographic shift – more retired people and not a growing tax rate. We will get a negative rate of return because we are at the higher end of the spectrum.
Social Security Trust Fund Is just an accounting device – taxed money goes in, all benefits must be paid from trust fund Once the trust fund benefits are used up, then there’s no money to pay benefits. What happens in future when taxes aren’t enough to fund benefits? Government is going to issue bonds from trust fund. Something has to change when this happens.

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How does Social Security affect the economy? - Has enormous effects of labor supply, savings behavior, etc.

- Effect on Labor Supply: - Effect of SS on retirement age people: o Guy earns $40,000 pre-tax. Pays: income tax of 4000, Payroll tax of 3000. Net pay is $33000 o If he chooses to retire, his benefits would be $17000. So his net reward for work = $16000. o He’s facing a 60% effective tax rate in his marginal decision to decide whether to work – very big distortion here. - Effect of SS on pre-retirement years: o Middle income person whose tax rate is 25%, Massachusetts tax of 5%, and payroll tax of 15% -- total tax of 45%. Should subtract present actuarial value of benefits (PAVB) which is 8% (since they’re working in top 35 years and will get benefits based on what they pay in payroll tax). Thus, total tax is 37%. o Tax DWL is really high.
Effect on Saving: Replacement rate –how much of income you get back through SS Replacement rates for pre-tax income: 41%, 60+% if individual has spouse Replacement rates for after-tax income: 70% (will be indexed for inflation, so will keep pace with inflation) An old couple, has a house that’s paid for, has medical bills paid by Medicaid, medicare would cover them if they needed to go to a nursing home. So they have little incentive to save at this point. - 2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to
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- 2-earner couple: 41% of pretax, 50% of net of tax earnings, they want 70% of pre-retirement income to survive after retirement, so they calculate how much they need to save to get 70% of pre-retirement income. o Savings w/o SS – enough for 70% of pre-retirement income o Savings w/0 SS – enough for 20% of pre-retirement income - Because of social security, savings when people are young is about 2/7 of savings if there were no SS

4/6/09 Social Security Reform - Question: since SS reduces saving during working years but also reduces dis-saving during retirement years, what is the net impact on aggregate saving for the economy as a whole? - Why don’t they just cancel out? They would cancel out in an economy that wouldn’t grow. If each generation of savers were the same size and had the same growth as the previous economy. But in reality, the economy grows – more young people, higher average incomes - Thus, for economy as a whole, we see a positive savings rate - Over the past few decades, savers started saving less. And retirees started consuming more – dissaving of dissavers increased. Thus aggregate savings rate in economy came down from 10% in early 1980s to essentially 0 currently. - Now with collapse of wealth, household savings rate has returned to 5%...estimated to increase as wages rise –so people can gradually increase their consumption and their saving.

- SS increases saving and dissaving, but in a growing economy has the same net effect - If each individual reduces his or her saving by 5/7th, then aggregate saving will decrease by 5/7th - Net impact of SS: o Creates a smaller savings rate o -o Lower productivity, lower growth in productivity - What is forcing politicians to take this problem seriously? The aging population. In the future, there will be more retirees for workers. o Currently, we have 3 workers per retiree. By 2020, there will be only 2 workers per retiree. o Because of the retirement of the baby boom generation – this is accelerating the trend of rising number of retirees per worker - Implication of this? o We must have a 50% increase in the tax rate o Right now, we have 3 workers paying 12.4%, then we must have 2 workers paying 19% (50% higher) q. However, with the smaller tax base – we need an even higher tax rate to get same revenue r. Personal tax rate/payroll tax would probably actually have to rise to 22% - Net impact: 10% increase in personal tax rates. This has an enormous impact on DWL. o Today we have combined marginal tax rate of 0.25 + .05 + .15 = .45, it will go up to .55 o DWL of tax will increase by 50% (is proportional to square of tax rate) - What is the alternative? o Cut benefits: could scale back benefits by a third o Change retirement age o Change inflation index – so benefits don’t automatically increase with inflation - All of these changes impact different groups of people in different ways, all of these would be hard to pass
- There is a better way – partially or fully finance benefits in an investment based way o This is the way our private pensions work - Advantages to this plan:
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- Advantages to this plan: o Has higher rate of return. Don’t have to save as much during working years - Lets compare a paygo system and IB system o Paygo system rate of return of 3%, IB system of 7% o Person works from age 25 to 65 and gets benefits from 65 to 85. So simplify by saying person does ALL of saving at age 45 (right in the middle) and ALL of their dissaving at age 75 – this model fits actual numbers very well o Person saves $1000 over 30 years s. with 3% rate of return gets $2427 in benefits later t. with 7% rate of return gets $7612 in benefits later o implication: 19% payroll tax could go down to 6% tax in IB plan - Question: can we get from a paygo system to an IB system? o Transition generation might have to make a huge sacrifice, paying double taxes to support retirees and to support new program o Answer: yes, we can – if we do this gradually we can shift systems. We can gradually shift - Second question: How risky would this be? o Answer: it would be quite risky. If we went to a pure investment-based system – would impose risks which most people would say are too high. - Let’s think about an IB system with savings rate of 4%, where we invest 60% in stocks, 40% in bonds o At age 67, median annuity that could be paid out would be 1.41 x “benchmark” o Lets look at the 30th percentile of retirees – 0.92 x “benchmark” o At 10th percentile of retirees – its only 0.52 x “benchmark” o At 1st percentile – its only 0.26 x “benchmark” o This is too high of a risk for individual retirees - What should we do then? o We could have an IB system where government provided guarantees u. Guarantees would add into national debt o Mixed system where we use paygo and IB

- Mixed System: o Use IB to provide high returns, use paygo to provide less risky base
- Is it possible to 1) retain the current retirement income of retirees, 2) not raise the payroll tax rate from 12.4%, 3) not use general revenue funds/not run a deficit further than what is allocated for this, 4) achieve a permanent solution (a lot of plans only achieve temporary solutions), and 5) to avoid serious risk? o Feldstein’s research project o Strategy: mixture of paygo system and personal retirement accounts (PRA) that would generate IB annuity o idea is to gradually reduce paygo benefits relative to current law v. we wouldn’t actually reduce benefits, they would just grow more slowly o while substituting PRA annuities for missing paygo benefits o if we combine these two, could we maintain retirement income? YES. - How this scheme would operate? o Paygo accounts would continue o Everyone would get a PRA account – should it be mandatory or voluntary, if its voluntary should it be automatic enrollment? (automatic enrollment has a very high impact on participation rates) o Each individual, in order to participate, must put in 1.5% of covered wages from out of pocket (referred to as an “add-on”) w. The amount that has to be paid is very small (1.5%) in the transition period o If the individual does that, then the government will match by taking 1.5% of covered wages from the payroll revenue (referred to as a “carve-out” system) Funds are invested in diversified portfolio – 60% stocks, 40% bonds (diversified, no strong
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o Funds are invested in diversified portfolio – 60% stocks, 40% bonds (diversified, no strong bets on one thing) o Why individual accounts? Why PRA way? x. Main reason: to avoid potential government interference in investment practices. These accounts grow really rapidly—funds that accumulate in this way add up to 50% of GDP. Thus, Congress would pass rules saying that you couldn’t invest in companies that outsource jobs/bad industries/etc. There would also be pressure to invest in social investments, housing etc. This would be bad, would cause smaller rate of returns for peoples’ accounts. It would also cause a huge interference in markets. o Feldstein has analyzed this based on personal retirement accounts. Has found a real rate of return of about 7%. Calculations reduce this number to 5% (to have a margin for uncertainty, for accounting purposes). At retirement, persons would receive an annuity based on same combination of stocks/bonds. If individuals die early, before they reach annuity stage, this would trigger bequest benefit – all of these funds would go to heirs.
- We can’t afford to continue paygo system, so we will gradually decrease paygo benefits o Someone who has been in this system for 15 years would get paygo benefits equal to 91% of benchmark o Someone who has been in this system for 20 years would get paygo benefits equal to 85% of benchmark o Someone who has been in this system for 40+ years would get paygo benefits of 60% of benchmark - Replace lost income from paygo benefits with personal account annuities - Combined amount: o Benefits of 150% o 2050: benefits of 120% o 2070+: benefits of 130% o We don’t need benefits so much higher than benchmark  so could scale back too - Objections to this plan: 1) What about the transition costs? a. Transition people will have to pay double. To meet demands of current retirees and to pay for your own in the future. However, this plan minimizes transition costs b. Variant on this objection: won’t this deplete the trust fund? Yes, but we are also reducing the benefits that come out of the trust fund. Calculations show that trust fund never goes negative. 2) Administrative costs a. SS is very effective in that there are very low administrative costs b. PRA systems’ administrative costs seem relatively large… *will finish this on Wednesday

4/8/09 Finishing Social Security Reform - From last time, we talked about how the transition to a mixed system would be feasible - What’s wrong with this new system? - Objections to the Plan: o Transition costs (look above) o Administrative Costs y. People say that we get rid of a lot of administrative costs in current system. They point to Chile/Mexico as examples of countries with high administrative costs. However, this is due to the way Chile/Mexico set up their SS program.
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this is due to the way Chile/Mexico set up their SS program. z. These countries gave their people a lot of choices, with a lot of different systems to choose from. This caused administrative costs to rise. They didn’t give the people incentives to pick from the most cost-efficient programs. aa. Ways to avoid administrative costs: Best alternative is to have funds collected by payroll. Limit frequency by which people can change plans. Investments must be in broad indices so you don’t pay fancy management fees. Estimated that costs would be less than 30 basis points (30 hundredths of a percent). o Redistribution (check this?) bb. Current system is not very redistributive. We could make new system redistributive by adjusting payroll tax to make it more redistributive or adjusting benefits. o Risk cc. Pure IB plans are risky. In a mixed system, risks are much much lower. dd. 15 years from now: the only risk you would have are between 91% to 100% of amt you put in, in 20 years: 85%, 40 years: 60%  What does this mean? In 40 years from now, if stock market literally goes to zero, you’ll only have 60% of what you put in. (Stock markets don’t go to zero, though.) ee. Median: In 40 years, a person putting in 3% of wages, has a 50% chance of getting 1.06 + 0.60 = 166% of benchmark ff. 30th percentile: in 40 years… combined benefit will be 1.29% of benchmark gg. 10th percentile: in 40 years…combined benefit will be 100% of benchmark hh. Thus, there’s a 90% chance that you’ll do just as well in this system as what you put in! ii. Looking further, at 1th percentile  combined benefit would be 80%, this is a low risk, 1 in 100 people
- Will this mixed system happen? o So far, it has almost happened o President Clinton presented a really detailed plan for transition to retirement-based accounts. Clinton was about to implement this when he was impeached o Republicans and Democrats never got to sit down at table and figure this out. o What about Obama? jj. In speech to congress recently, he said one of the major long-term problems we face is SS and how we are going to finance the benefits for future seniors. kk. In that context, he said, “we need a universal investment based account” ll. This wouldn’t be part of SS. The idea is that everyone would have an account, so when trust fund goes to zero…we wouldn’t have to raise taxes as much and can ask people to rely on the universal investment based account. mm. He said that all employers must automatically enroll employees in an IRA. nn. Feldstein thinks that if this happens, it is the first step to moving towards a mixed system.

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Lecture 19?
Monday, April 06, 2009 10:05 PM

Social Security Lecture 2 - In reality, the economy grows so the saving of the savers exceeds the dissaving of the dissevers. - What happened recently has been quite unusual: we used to have a savings rate of approximately 10 percent. As people became wealthier, people saved less during their working years and the retirees consumed more. The savings of the savers was less and the dissaving of the dissevers was more. The savings rate declined to nearly 0 in the past several decades. In the recent recession in abruptly climbed to 5 percent. - Even though Social Security discourages savings and encourages dissaving, it has the same net effect in a growing economy. The net impact of Social Security is to create a lower national savings rate, a lower increase in the Capital Stock, and hence lower productivity. - The action-forcing event: The aging of the population. Going forward, we can predict with certainty that there will be more retirees relative to the number of workers. By 2020, there will be only 2 workers per retiree. The reason that this transition will happen very fast is the retirement of the baby boom generation. The baby boom accelerates a trend that is the rising number of retirees per worker. - If we want to retain the same formula that we do today, if we go from three workers per retiree to two workers per retiree, we are going to have to increase taxes per worker by 50 percent. The higher marginal tax rate shrinks the tax base, implies higher tax rate to get same amount of revenue, the personal income tax revenue will go down as a result of the shrinking of taxable labor income. We may need to go up to about a 22 percent payroll tax. Net effect of increase of 10 percent in marginal tax rates. - We have a combined a marginal tax rate today of about 45 percent. This would go up to 55 percent. Deadweight losses are proportional to the square of the marginal tax rate – There is about a 50 percent increase in the deadweight loss of the tax. - What is the alternative? 1. To cut benefits – We would need to scale benefits back by one third. 2. Change the retirement age. Push the retirement age forward by four or five years then the cost of the program will be cut by one third. 3. Change the inflation indexing so that it doesn‘t already increase with inflation. These different ways of dealing with it affect different group in the population differently. None of this is politically easy to image passing. - There is a better way: partially of fully finance benefits on an investment-based way. Employers take some of salary and invests it and continues to pay paychecks when workers retire. - Advantages of investment based program: 1. Higher rate of return so that you don‘t have to set aside as much during working years. - Compare Paygo and Investment Based system: Someone who works from 25, retires at 65, and passes away at 85. Think of all saving at 45 and all of retirement consumption at 75 because these lie in the middle of the working and retirement spans. Saves $1,000 at 45 and gets $2427 with a 3 percent rate of return. With a 7 percent rate of return, they will receive $7,612. The implication is that you need only one third as much saving with a seven percent return than with a 3 percent return. - If you do it gradually, it is possible to get from a pure Paygo system to a pure Investment Based system in which the tax rate would come down to just 6 percent. How risky would this be? Quite risky – A pure Investment Based system would pose huge risks for the average retiree. - Say we have Investment Based system in which savings rate is 4 percent versus 12 percent. We invest in a portfolio where stocks are 60 percent and bonds are 40 percent. The median benefit per median retiree would be 1.41*Benefits that Median retiree would expect to get under current law. The median worker would be ok but let‘s look at the 30th percentile. They would receive 92 percent of the benchmark, at the 10th percentile, it is only 52 percent
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They would receive 92 percent of the benchmark, at the 10 th percentile, it is only 52 percent of the current benefits. At the first percentile, the benefits would be only 26 percent. If we did this at 77 rather than retirement age, we would find even lower annuities relative to the benchmark. We could go to a pure Investment Based system where the government provided guarantees of topping off benefits. Marty wants to consider a compromise of a mixed Paygo and Investment Based system. He wants a system that can do the following: 1. Not use general revenue funds, 2. Not raise payroll tax rate, 3. Keep benefits of current retirees, 4. Achieve a permanent solution, and 5. Avoid too much risk. Mixture of current system and current retirement accounts that generate an annual annuity. Reduce Paygo benefits relative to current law and substitute PRA annuity for missing Paygo benefits. If we combine these two, we can maintain retirement income. How would it work? 1. Paygo accounts continue, 2. Everyone would get a personal retirement account (do we make voluntary or mandatory or automatic enrollment), 3. In order to participate, each individual must put in 1.5 percent of covered wages from out of pocket – the amount that needs to be paid is very small in transition (carve out) and government will match by taking 1.5 percent of the payroll tax from the payroll revenue (add-on because we add more money to the current system), 4. these funds invested in a diversified portfolio – the same 60-40 mix of stocks and bonds, 5. You can only change once a year. We will limit tax rate to 12.4 percent. Gradually reduced Paygo benefits. Why individual accounts rather than a single central account? 1. Avoid potential government interference in investment decisions. Personal accounts grow very rapidly. The funds accumulated in this way would grow to 50 percent of GDP. The Social Security administration would have a lot of say in how the economy operates. The temptation to allocate funds away from a variety of things would be bad and there would be the pressure to do things like social investing in housing, schools, healthcare, etc., and a great interference in the economy, and a system of private accounts with managers would protect it from government expropriation. For past 60 years, a 60-40 portfolio produced a real rate of return of 7 percent but administrative reasons reduced this to 5.5 percent. At retirement, individuals would get an annuity based on stocks and bonds. If individuals die early, all of the funds accumulated before started annuity would go to people that I designate as my heirs. People often opt for ten year certain – promise that individual will get benefits for at least 10 years and if individual dies during those years, benefits go towards heirs.

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Lecture 22
Monday, April 13, 2009 10:19 PM

Economics of National Security  Global economic downturn o Destabilize economies Threats  Military threats o Major powers  Russia  Cold war o We raised the military stakes and their economy could not keep up with theirs o Russia could not keep hold of the empire  Russia’s triple threat. o Russia still has nuclear technology o Russia is dangerously unprotected  Nuclear material to be stolen/purchased o Russia has gas reserves that control gas pipelines  Russia has energy policy that threatens European allies  China  Chinese conflict with Taiwan  Chinese military buildup o Use it to justify confrontation with Taiwan o Resources in China is low as is GDP per capita but growing very fast o Military strength depends on aggregate GDP and % spending on defense  China will likely eventually spend more on military than America o Small nuclear powers  North Korea  Small and poor  Demonstrated nuclear capabilities  Japanese worry that NK will attack them  Could raise money by selling nuclear material to another country or extremists  Iranians  Developing nuclear weapon o Enriching uranium o Delivery mechanism  Dangerous to their neighbors  Nuclear capabilities allows them to be aggressive in a non nuclear way  Pakistan  Entire government unstable o Stateless terrorists  Al qaeda  Organized international force  Train terrorists  Organized terrorism greater threat in Britain because of large Pakistani population  Will America face alienated population that will damage this country?  Oil Why would countrys stop shipping to the US
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o Why would countrys stop shipping to the US  This would require more than one country to cooperate in not shipping  If cooperation/intimidation of rich states, then those states (UAE) could bankroll others into financing their activities  Stateless terrorist actors can disrupt flow of oil o Dependence on oil has grown over time  Sensitive to global price of oil  Risks to trade with other countries dependent on countries who need oil Cyberterrorism o Cyberespionage o Cyber attacks  Foreign power to shut down our utilities  Risk of extortion/terrorism Studying strategy of warfare by Tom Schelling o Mutually assured destruction between US and USSR was stable outcome o USSR used to worry that US could strike first, neutralize their capacity and win the war  Mitigate this risk by having second strike capability  Advised that we teach the Russians this to arrive at nash equilibrium o Game theory to stateless actors Understanding sources of terrorism o Poverty causes terrorism seems to be a myth  More educated and more affluent are more in favor of suicide bombing  Reducing poverty through economic growth would take decades to make a difference Economic weapons  Sanctions on Iran and North Korea  Sanction cut off access to banks for NK  Need access to cash for luxury goods  NK leader agreed to restart six party talks Oil o Outside of US state companies control oil and major source of budget o Since demand is quite inelastic we can increase supply which should lead to significant reduction in price Optimizing defense spending o Take it out of economic growth (although fiscal deficits) o Tax expenditures can be diverted to national security

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Lectures 23 and 24
Wednesday, April 15, 2009 10:33 PM

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Lecture 25
Monday, April 20, 2009 10:09 PM

Health Care Policy Lecture 1

 Need to construct effective health care policy o  Role of insurance in driving care Insurance is valuable for risk averse people because health care is highly variable and
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Role of insurance in driving care o Insurance is valuable for risk averse people because health care is highly variable and potentially very expensive Moral hazard drives higher consumption o When price is lower consume more o Health insurance lowers price of marginal consumption Moral Hazard vs. Risk protection o Purpose of insurance is to insulate from costs in bad state of the world o Fundamental tradeoff between risk protection and moral hazard  Patients and physicians affected  Pay based on outcome or pay based on symptoms? o Both extremes skew incentives of physicians and patients o Try to provide risk protection but all imperfect  Physicians bears a lot of risk and does not want to treat for someone with bad health conditions  Any way around it?  Contracting problem –capitation, pay for performance, cost plus Adverse Selection in Health Insurance Markets o Buyers: potential enrollees with different propensities to use services o Sellers: Health plans competing for enrollees o Asymmetric information: enrollees know more about health status than insurers  Individuals have an incentive to wait to get an insurance until sick  Young healthy people know that have de facto social insurance as hospitals cannot deny them care  Insurers have an incentive to attract healthier enrollees  Premium spiral where unhealthy people buy into insurance plan causing insurance company to raise premium and the cycle repeats  Ideally want health people to buy into insurance and lock in at low premium Avoiding Adverse Selection o Choices among plans foster competition, but facilitate adverse selection o One of reasons group market is appealing – ready – made risk pools  Employer sponsored market  Non-group market Who bears burden of Employee Sponsored Insurance o If workers fully value benefits and wages are unconstrained, workers pay for benefits in form of lower non benefit compensation o May not be in tha world  Mandated benefits may not be fully valued o Note that employer mandates and individual mandates likely to have quite different effects Additional Consequences of Tying Insurance to Employment o Job lock  Because workers risk losing insurance when change jobs, less likely to move if sick o Hinges on difference in underwriting between group and non-group markets  Individuals underwriting in non-group market; health status affects premium Why is ESI preferred to non group market o Economies of scale  Less costly to adminster  Bargaining clout o Adverse selection limited  Can be undermined by choice among plans- more on this below o Tax favored treatment of health insurance  If pay care out of pocket, paying with after tax dollars Current Tax Treatment of Health Insurance Premiums paid through employer not subject to taxation
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Current Tax Treatment of Health Insurance o Premiums paid through employer not subject to taxation  History rooted in WWII price controls  Makes a big difference on margin o Huge but hidden public expenditure  “tax expenditure” on ESI larger than federal share of Medicaid spending Unlevel Playing Field o Two bviases  Against those who obtain insurance on non group market  Against out of pocket spending o Who benefits the most from current treatment  Higher income  Regressive Improving Efficiency of ESI o Next week will discuss health reform proposals that include changing tax treatment of ESI o On private side, movement towards managed care  Associated with dip in cost growth in mid 90s  Recent movement towards lighter managed care o Choice among plans can promote competition Case Study: Harvard University Summary o Insuance likely to promote higher spending  Balance of risk protection and moral hazard o Most private HI in US through employers  Promoted by tax code  Fosters risk pooling  Favors inefficiently high spendin

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Lecture 26
Wednesday, April 22, 2009 10:12 PM

Health Care Policy Lecture 2

Review  Review Private health insurance dominated by employer sponsored insurance (ESI)
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o Private health insurance dominated by employer sponsored insurance (ESI) o Employer system rooted in tax treatment  Facilitates risk pooling  Promoted first dollar coverage  Minimal cost sharing o Disproportionally consume extra medical goods  Covers first medical cost (unlike other insurance)  Strong tax bias in favor of getting health care that way  Has labor market implications Rising role of public spending o In 1960, government responsible for only ¼ of US health spending o Adoption of Medicare and Medicaid in 1965 resulted in significant expansion  Compromise when national health insurance unlikely  Pay for private services with public dollars o Public check to private provider  Start with hospital only to appease AMA  By 1970 government share of spending incrased ot 38%  Now almost half – more if consider implicit tax subsidies Medicare o Covers 45 million including elderly and uninsured. $431 billion in 2007 o Medicare has substantial effect on private health care o Medicare spending growing more rapidly than social security not because of retirement of baby boomers but rather extra spending per person.  Rising health care costs  Unfunded liability of medicare is 5 times greater than social security o Coverage  Part A: Hospital care, automatic enrollment  Part B: physician and outpatient care, voluntary enrollment o Significant gaps in coverage  Covers only half of health spending on elderly  Elderly spend more than 20% of income on health care Medicare Major Driver of Patterns of Care o As major consumer of health care, Medicare prices and coverage patterns drive overall utilization o Introduction of medicare responsible for major ramp up in spending Cost containment in Medicare o Initially a retrospective cost plus reimbursement system o Introduction of prospective payment system o Interest now in pay for performance o Aimed to introduce care management Medicare Managed Care Part C o Since 1985 beneficiaries have had option of choosing an approved managed care plan  More than 16% of Medicare beneficiaries enrolled in managed care plans o Risk adjustment ot mitigate adverse selection  Imperfect but operational  Separate issue of average payment level o Effects on efficiency of care  Some systematic level of overpayment  Needs further adjustment  Medicare managed patients will drive more efficiency for the rest of patients Medicare Rx Coverage Part D o Before 2006, prescription drug coverage was not included in medicare o Most significant medicare benefit expansion in almost 40 yeraes By 2006 90% had rx coverage
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 By 2006 90% had rx coverage  Dually eligibly automatic enrolled  Administered by private D plans for fee for service enrollees  Plans bid to provide coverage in given region o Donut hole of spending for Medicare Part D paying for patients Cost for Part D o Enrollee cost structure  Enrollee premium about 25% cost average of $37 montth in 2006  Subsidies for premiums and cost sharing for low income o Plan competition  Enrollees must have choice of at least two competing plans  Plans differ based on deductible, premium, copayments and formularies o Early evidence  Enrollees choose lower cost plans  Most have “donut hole” coverage Coverage for non-elderly o Programs based on categorical elibigibility  Medicaid joint federal state program for some low income populations  SCHIP joint federal state program for low income children  Federal government reimburses states relative to their income  Subsidize low income states  Medicaid spending is crippling states at the moment  o More than 46 million non elderly uninsured Effects of Publicly Financed Low Income Insurance Coverage o Needs to raise revenues to cover costs  DWL  Balance health care benefits with DWL o Potential to affect private health insurance coverage  Some people switched their private insurance for public insurance So who is unsinured o 47 million uninsured o Dynamic process  People move in and out of insurance and eligibility  Around of those uninsured at a point in time are uninsured for a whole year Uninsured are heterogeneous o Disproportionately but not exclusively low income o Mostly in working familities  Smaller firms are less likely to offer ESI o Non white populations at higher risk of uninsurance o Some people are eligible for public insurance Why are people uninsured o Income – health care is expensive o Samaritan’s dilemma – free rider problem o Pricing problems – insurance is a bad deal for some  Cross subsidies mean low risks often paying more than expected costs  Exacerbated by different premium restrictions in large group, small groups, and non group markets Why should we care about uninsured o Health externalities o Paternalism/redistribution  Care about well being of low income people  Value some kind of consumption more than others  Adds particular interest in efficiency of care consumption  Primary care more cost effective than emergency care
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 Primary care more cost effective than emergency care

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Lecture 27
Monday, April 27, 2009 10:14 PM

Health Care Policy 3

 Insurance Status Related to Care and outcomes o Uninsured report worse access and outcomes  Less likely to use preventative care More likely to report postponing needed care, being unable to fill prescriptions
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 More likely to report postponing needed care, being unable to fill prescriptions o But: causal effects hard to nail down from observational studies o We care because of paternalism, but may also suggest potential ties between covering uninsured and cost growth  Don’t be misled: uninsured spend less than insured, so extending coverage unlikely to be cost saving Reform goals o Two common goals  Increase insurance overage – increase access  Stem rising health care costs – make system more “affordable” o Additional related goal  Reducing inequities in financing  Who bears burden of consumption. Individual payments/risk pooling among people with similar risk/general revenues o Rising costs may have put reform at top of domestic agenda – but is minimizing costs right goal Consequences of inefficient Spending o Health care dollars not allocated to highest value uses Reform Strategies o Attempts at broad implementation of national health insurance schemes largely unsuccessful o Narrower reforms more successful  Incremental federal reforms  Expansion of Medicaid SCHIP o But: Crowd-out, public costs, diminishing effectiveness  State reforms  Mandates, state programs, purchasing collectives o But: limited toolkid, heterogeneity o Federal government has policy levers that states do not  Income tax reform Principles for Evaluating Reform o Insurance is about Risk  Need insurance because of RISK and COST Uninsured Sick People need Health Care o Uninsured sick people need health care not health insurance o Two separate problems  Insured people whose expected costs go up  Uninsured people whose expected costs are high  When people start with different expected costs that are hard to distinguish without some socialized insurance  Subsidy that pushes people of disparate risks in same pool is social insurance o Perhaps not most efficient way to pool risk o Key distinction between social insurance and private insurance  Redistribution from low-risk to high-risk is hard to do through private markets alone  Social insurance need not be socialized Covering the uninsured unlikely to pay for itself o Will need to devote resources – but can be money well spent  Insured people consume more – but get much more health  Offsetting reductions in efficient utilization – but not total o Corollary: preventative care doesn’t pay for itself either  A few procedures that are cost –saving  Many more that are cost-effective  Lots left that are wildly cost-ineffective Employees Bear Burden of ESI
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 Employees Bear Burden of ESI o Empoyers don’t pay for health benefits – workers do  Ultimately comes out of wages  Employers mandates does not equal individual mandates  Not instantaneous or 1 for 1 though  Corollary: health care costs for current workers not primarily an issue about competitiveness  Retiree benefits are more complicated o Employer-based system promoted by tax code  Has negative effects on labor markets; reduces efficiency of health spending is regressive  Has advantages for risk pooling so wouldn’t want to eliminate without good alternative in place and transition strategy  High deductible Plans not magic bullet o First dollar coverage generates a lot of inefficiency, but nothing magic about HDHP/HAS structure  Strong evidence of price sensitivity and moral hazard, but  Evidence that some copayments may reduce efficiency of utilization  higher marginal payments to regulate consumption o premise is that individual payments don’t make best choices o Insurer competition may lead to innovation – but need to eliminate incentive to shed sick enrollees  Proposals such as risk adjusted vouchers o Single payer system not magic bullet either  Slow to innovate, not particularly efficient  Evaluating Reforms: o Results driven by price and income effects  Different effects on cost growth  Subsidy of marginal additional care  Subsidy of particular insurance forms Payment for quality v quantity o Different effects on insurance overage  Magnitude of incentive for coverage  Size of low income subsidy  Risk poling and subsidy of insuance for chronically ill  Different effects o ndistribution of burden  Income  Health risk  Politics of Reform: Economics not only factor o Politics affects both goals and metrics of success  Winners and losers  Problem if winners are more diffuse, harder to measure o Anyone whos taxes go up or whose insurance group changes, feel like losers and therefore form more effective political lobbies o Uninsured are not voters, but insured may soon become uninsured so they are an important voice  Simplicity  Problem if policy is hard to explain  Immediacy  Problem if effects unfold over years  Strategy  Problem of does not have natural allies and advocates  Problem if leaves no room for negotiation and compromise  Classes of Reforms Increasing information availability
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o Increasing information availability  Prices, quality  This information is hard to evaluate  Purchasing collective (with or without public option) o Public insurance  Pay for performance  Provider and insurer competition Proposals for Reforming tax Code o Flat deduction  Anyone with private policy gets same deduction  ESI contributions reported as taxable income (for individuals not employers)  Value would not vary based on premium, source of insurance o Flat Credit  A o Cap How would different grups fare o Uninsured o Insured o Nongroup – vs employer  Moving people away from employer program would create high transition costs Public Insurance Reforms o Provider payment forms o Promoting insurer competition o Introduction of comparative effectiveness Conclusions o Tough choices will be necessary  Some pareto reforms but quickly exhausted  Few cost saving, quality imporiving interventions  Evaluate trade-offs: Insurance coverage and financial protection(short and long run o Focus on promoting high value insurance

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Lecture 28
Wednesday, April 29, 2009 10:14 PM

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Lecture 29
Friday, May 01, 2009 10:14 PM

American Economic Policy Final Lecture  Prior recessions caused by Federal Reserve  Culprits o Rating agencies o Financial institutions o How risky these securities are  Traditional channels of lower interest rates resulting in greater lending and mortgage borrowing did not happen when home prices were falling at double digit rates o Couldn’t use monetary policy because credit marks were dysfunctioning  Focus from reliance on monetary policy to fiscal policy  Administration goals o Counter sharp fall in aggregate demand  1/3 of househould wealth lost  Decline in stock prices and real estate  Fall in residential construction  No supply or demand for business investment  Fixed investment fell 50% from Q408 to Q109  $800 billion stimulus  Focus over 1-2 years  Significant portion of one time reduction  Annual Gap of GDP of $750 billion with annual stimulus of $250 billion o Multiplier / accelerator effects o o Dysfunctioning credit markets o Housing market stabilization  30% of loans are underwater  Half of all homesales in California were foreclosures  Plan to deal with affordability problem rather than correct high LTV (they can get political support for people who are struggling to stay in their homes. Much harder to  We are going to see temporary strong second quarter o $60 billion a quarter from stimulus, one time increase in level o Annualized rate (1.5%  6%) o In Q109 DI rose by 9% because of tax rebates and transfers (1% increase in GDP) and that gives you 5% at an annualized rate. Some of that increase in disposable income will carry over to second quarter but it is based on one time increases in tax rebates  Fed buying mortgages, assets backing credit cards, buying commercial real estate,  Treasury fixing banking system o Stress tests  Shut them down or infuse additional capital  Not adequate because only looking ahead 18 months o PEPIP  Banks will offer toxic assets for sale  Real estate loans  Private investors will bid for them in auction and government will invest in parallel (50% contribution of government) o Gov provide credit from FDIC or Fed of $6 for every $1 from investors o Goal is to buy $500 billion in toxic assets aim to cleanse balance sheets
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sheets  Keeps toxic assets in private hands  Don’t have to go to congress  Criticisms  Not enough. $2 trillion of toxic assets  Banks are going to be reluctant to put forward securities because of prices to affect mark to market o Treasury should tell them they will provide them additional capital from the hole that will develop from selling toxic assets  Will shareholders like this because of dilution of equity?  Long term concerns o Fed buying wide range of unsecure assets  Explosion of reserves for banks as they hoard cash and deposit it at the Fed  $700 billion excess reserves that can create inflationary  Usually Open Market operations to sell bonds to take cash back from banks  Problem is excess reserves not created by buying treasury bonds  Will banks want to buy back assets they got rid of. o Budget  Top marginal tax rate will be over 50%  If cap and trade plan goes through as they tighten Co2 limits, the value of these permits will go up. Price of permits will go up to substantial numbers.

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Article Summaries After Midterm
Wednesday, May 13, 2009 9:44 PM

8. Environment Policy (February 27, March 2, 4 , 9 ) Professor Robert Stavins a. Basic Analytics of Environmental Policy (February 27)

Don Fullerton and Robert Stavins. "How Economists See the Environment." Nature, volume 395, pp. 433-434, October 1, 1998.
-Various myths exist about how economists think about the environment -Universal markets – idea that universal markets can solve any problem -In fact, markets are only perfectly efficient if there are no public goods, no monopolies, perfect information, no externalities, etc. -Economists consider how the government can correct these factors by limiting access to open-access resources or restricting emissions, for example -Market solutions – idea that economists always recommend market solutions -This can be a solution (maybe in the case of an emissions cap-and-trade system), but it still has to address issues with monopolies, information, etc. -Market prices – myth that economists try to figure out prices for everything -Economists understand that benefits extend far beyond the monetary -Costs/benefits are just expressed in monetary terms to use a common yardstick -Efficiency – economists only concerned with efficiency, not distribution -Economists think about both Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and Robert Stavins. "Is There a

Role for Benefit-Cost Analysis in Environmental, Health, and Safety Regulation?" Science, April 12, 1996.
 Benefit-Costs Analysis: a tool for comparing the desirable and undesirable impacts of proposed policies  In regards to environmental, health and safety regulation o Benefits: value of cleaner environment, etc. o Costs: direct costs of meeting regulation + indirect costs such as time spent waiting in line for vehicle inspection o B-C Analysis can help determine how much regulation is ―enough‖  Difficult to measure marginal benefit and costs though  Also question of equity, even when aggregate benefits exceed aggregate costs, there are winners and losers with regulation  Eight Principals to follow when using B-C Analysis to inform regulatory decisions o 1. Useful for comparing favorable and unfavorable effects of policy  help decision makers understand implications of decisions although hard to draw conclusions because of uncertainty in quantifying effects o 2. Decision-Makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Agencies should be allowed to use economic analysis to help set regulatory priorities. o 3. B-C A should be required for all major regulatory decisions. o 4. Despite number 3 agencies should not be required to follow strictly the B-C tests o 5. Best estimates for B and C should be presented along with the uncertainties that come with those estimates  these estimates should take into account actual trade off decisions that
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 these estimates should take into account actual trade off decisions that individuals would make o 6. The more external review regulation receives the better it will be o 7. A core set of economic assumptions should be used in calculating B and C. Key variables include: social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.  This will help in comparing results across analysis o 8. B-C A should also identify important distributional consequences

Lawrence Goulder and Robert Stavins. "An Eye on the Future: How Economists' Controversial Practice of Discounting Really Affects the Evaluation of Environmental Policies." Nature, Volume 419, October 17, 2002, pp. 673-674.
Richard Revesz and Robert Stavins. "Environmental Law and Policy." Handbook of Law and Economics, Volume I, eds. A. Mitchell Polinsky and Steven Shavell, pp. 499-589. Amsterdam: Elsevier Science, 2007. b. More Analytics and an Application to Acid Rain (March 2)

Richard Schmalensee, Paul Joskow, Denny Ellerman, Juan Pablo Montero, and Elizabeth Bailey. “An Interim Evaluation of Sulfur Dioxide Emissions Trading.” Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 53-68.
Title IV of the1990 Clean Air Act established the first program to deal with sulfur dioxide pollution (acid rain) by relying on tradable emissions permits. This article summarizes the results to date of the ongoing empirical analysis of compliance costs and allowance market performance under the U.S. acid rain program. What is the Acid Rain Program? - Came in 2 phases. Phase I, 1995 through 1999, aggregate annual emissions from the 263 dirtiest large generating units-the so-called "Table A units" -must be below a fixed cap. In Phase II, 2000 and beyond, virtually all existing and new fossil- fueled electric generating units in the continental United States become subject to a tighter cap on aggregate annual emissions. - Allowances can be bought or sold without restriction to cover emissions any- where in the continental United States. - Represented departure from previous command and control strategies which set efficiency standards but did not focus on total emissions. What Happened to Sulfur Dioxide Emissions? - They were reduced. The cap and trade system cut emissions in half by 1995/96. How Were Emissions Reduced? - the implementation of SO2 scrubbers (mechanism which remove SO2 from gaseous and other emissions) and the substitution towards low-sulfer coal in electric power plants contributed to an overall reduction in Sulfer Dioxide emissions. What Happened in Allowance Markets? - while allowance auction prices were initially very high ($150 to $200 range) a lower equilibrium price ($50 to $100) was reached after phase 2 of the acid rain program came in 1995. How Much Did It Cost? - Total costs of reducing emission by 3.9 million tons in 1995 was 726 million, a per ton cost of about $200 per ton. Why Have Allowance Prices Been So Low?
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Why Have Allowance Prices Been So Low? - High expectation about the price of allowances in during phase one (early 1990‘s) caused many infrastructure changes – mainly, investments in scrubbers which reduced the total amount of SO2 emissions for many firms without having to buy allowances. Demand for allowances in phase 2 was limited, so prices fell. What Have We Learned? - Tradable permit system is better than command-and-control.

Robert Stavins. “What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.” Journal of Economic Perspectives, Volume 12, Number 3, Summer 1998, pages 69-88. Robert Hahn, Sheila Olmstead, and Robert Stavins. "Environmental Regulation During the 1990s: A Retrospective Analysis." Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415. With R.W. Hahn and S.M. Olmstead. Robert Stavins. "Regulating by Vintage: Put a Cork in It." The Environmental Forum, Volume 22, Number 3, May/June 2005, p. 12. Robert Stavins. "What Baseball Can Teach Policymakers." The Environmental Forum, Volume 22, Number 5, September/October 2005, p. 14.
Like in baseball, uncertainty is an absolutely fundamental aspect of environmental problems and the policies employed to address those problems. Any study that fails to acknowledge and take this uncertainty into account, which historically has been most of the studies regarding environmental policy, is fundamentally flawed. Uncertainties in underlying inputs used by analysts are propagated through analyses, leading to uncertainty in ultimate benefit and cost estimates (the core of Regulatory Impact Analysis, which are required for all ―economically significant‖ proposed federal regulations). Due to the complexity of interactions among uncertainties in inputs to RIAs, an accurate assessment of uncertainty can be gained only through the use of formal quantitative methods, such as Monte Carlo analysis. OMB‘s new requirement for formal quantitative assessments of uncertainty marks a significant step forward in enhancing regulatory analysis under E.O. 12866. It has the potential to improve substantially our understanding of the impact of environmental regulations, and thereby to lead to more informed policymaking. c. U.S. Climate Policy (March 4)

Gilbert Metcalf. “A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate Change.” The Hamilton Project, Discussion Paper 2007-12. Washington, D.C.: The Brookings Institution, October 2007. Robert Stavins. A U.S. Cap-and-Trade System to Address Global Climate Change. The Hamilton Project, Discussion Paper 2007-13. Washington, D.C.: The Brookings Institution, October 2007.
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Washington, D.C.: The Brookings Institution, October 2007. William Nordhaus. “To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming.” Review of Environmental Economics and Policy, Volume 1, Issue 1, Winter 2007, pp. 26-44. Robert Stavins. "A Tale of Two Taxes, A Challenge to Hill." The Environmental Forum, Volume 21, Number 6, November/December, 2004, p. 12.
Whether they are called ―revenue enhancements‖ or ―user charges,‖ fear of the political consequences of taxes restricts debate on energy and environmental policy options in Washington. However, a gas tax increase — coupled with an offsetting reduction in other taxes, such as the Social Security tax on wages — could make most American households better off, while reducing oil imports, local pollution, urban congestion, road accidents, and global climate change. This proposal could be politically feasible since it would be revenue-neutral (the increase in revenue from the gas tax would be given back to the people in the form of tax cuts on the payroll tax) and exemplifies efficient, market-based approaches to environmental protection and resource management.

"A Sensible Way to Cut CO2 Emissions." The Environmental Forum, Volume 24, Number 6, November/December, 2007, p. 18.
Getting serious about greenhouse gas emissions will not be cheap and it will not be easy. But if the current state-of-the-science predictions about the consequences of another few decades of inaction are correct, the time has arrived for a serious and sensible approach. Stavins proposes an up-stream, economy-wide CO2 cap-and-trade system that implements a gradual trajectory of emissions reductions over time (with selective inclusion of non-CO2 greenhouse gases), and includes mechanisms to reduce cost uncertainty. The cap-and-trade system reduces compliance costs by building on the scientific nature of the climate change problem, offering ―what, where, and when‖ flexibility. The system allows — indeed encourages — emission reductions through whatever measures are least costly, and it achieves reductions wherever they are least costly, adjusting automatically as control costs change over time. It provides temporal flexibility by permitting the banking and borrowing of allowances.

"Cap-and-Trade or a Carbon Tax?" The Environmental Forum, Volume 25, Number 1, January/February, 2008, p. 16.
 Countries are moving toward cap-and-trade systems, many economists favor a carbon tax  Stavins feels that both are good systems, but is opposed to the weak arguments often thrown out against cap-and-trade o Cap-and-Trade is the best option for the US in the short- to medium-term o Measured in terms of environmental effectiveness, economic effectiveness, and distributional equity o Cap-and-Trade can provide cost effectiveness while achieving meaningful reductions in greenhouse gas emissions. Also offers easy means of compensating for unequal burdens imposed by climate policy. Harmonizes with other countries‘ climate policies. Not a tax, not likely to be degraded by political forces, and has history of success in past 2 decades. o A tax is a straightforward tradeoff. Although it doesn‘t guarantee achievement of an emissions target, it provides greater certainty regarding costs.  Problem: political economy forces want less severe targets if carbon taxes
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 Problem: political economy forces want less severe targets if carbon taxes are used  Political pressures on carbon tax system will lead to exemptions of sectors and firms, reducing environmental effectiveness and driving up costs.  Economists should look at policy that would be optimal in Washington, not just from perspective of Cambridge, New Haven, or Berkeley.

“Inspiration for Climate Change.” The Boston Globe, Op-Ed, November 12, 2008.
 Written immediately after Barack Obama‘s election  Speculates whether Obama will respond effectively to tough environmental challenges, or let us down like Bush did 8 years ago  Ultimately, will Obama work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will he take on the difficult task of crafting meaningful climate legislation? Or will he make symbolic gestures to firm up his base while actually not enacting serious change?  Stavins suggests a comprehensive upstream cap-and-trade system to reduce CO2 emissions 50 to 80 percent below 1990 levels by 2050 o Declining cap increases cost of polluting, discouraging use of most carbon-intensive fossil fuels o Gradual reduction avoids dead weight loss  The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100 percent auction over 25 years.  Make program revenue neutral by returning all auction revenue to citizens  Still, costs will be high, reducing GDP by up to 1% per year. But waiting longer isn‘t going to make this action cost less. Bottom line: getting serious about global climate change will not be cheap or easy, but we cannot afford another few decades of inaction. d. International Climate Policy (March 9)

Robert Stavins. "Beyond Kyoto: Getting Serious About Climate Change." The Milken Institute Review, volume 7, number 1, 2005, pp. 28-37.
Joseph Aldy and Robert Stavins. Designing the Post-Kyoto Climate Regime: Lessons from the Harvard Project on International Climate Agreements. An Interim Progress Report for the 14th Conference of the Parties, Framework Convention on Climate Change, Poznan, Poland, December 2008. Cambridge, Mass.: Harvard Project on International Climate Agreements, November 24, 2008.

Robert Stavins. "Linking Tradable Permit Systems." The Environmental Forum, Volume 25, Number 2, March/April, 2008, p. 16.
 As more and more countries implement cap-and-trade systems, we should look into setting up a global trading system so permits can be traded between countries  Tradable permit systems fall into two categories: cap and trade and emission reduction credits. o CAT has a maximum level of allowed emissions o Credit systems award credits to firms who voluntarily take on emissions-reducing projects, and can then sell the credits on the market
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o projects, and can then sell the credits on the market  Linking reduces costs of individual systems and also allows us to achieve a greater level of emission reductions  Also opens up all systems to advances made in emission reducing technology  Some links may be harder to establish than others o Need international agreements governing aspects of the design of linked CAT systems o One-way and Two-way links both cause harmonization of cost-containment measures
9. Tax Policy (March 16, 18 and 30)

Martin Feldstein, “The Effect of Taxes on Efficiency and Growth,” Tax Notes, May 8, 2006 http://www.nber.org/feldstein/taxanalysis.pdf
Council of Economic Advisors, ―Tax Incidence,‖ 2004 Economic Report of the President, Chapter 4, pp. 103-116. http://origin.www.gpoaccess.gov/usbudget/fy05/pdf/2004 _erp.pdf

Martin Feldstein, “The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,” Journal of Political Economy, 1995, pp. 551-572. (A pdf will be provided.)
 This paper finds that there is a significant response of taxable income to changes in marginal tax rates, meaning that a change in income tax rates has substantially less impact on tax revenue than if there were no behavioral response to marginal tax rates. o High marginal tax rates create significant DWLes by inducing taxpayers to change their behavior.  Ways that changes in marginal income tax rates make individuals alter their taxable income. Changes in: o labor supply  affects females more than males  short run: change how hard you work  long run: change location and types of jobs o the form that employee compensation is taken  untaxed compensation is preferred such as fringe benefits i.e. health insurance, corporate cars, in-house sports facilities, etc. o portfolio investments  high marginal tax rates encourage individuals to invest assets in ways that reduce the portion of return included in taxable income, i.e. bonds and highdividend stocks are reduced in favor of untaxed municipal bonds o itemized deductions and other expenditures that reduce taxable income and taxpayer compliance  In sum, people change their behavior and taxable income in response to changes in the marginal tax rate. Taxable income can be changed by varying the labor supply and other forms of compensation, like investing and also the extent of spending on tax-deductible activities.

Joel Slemrod, “Methodological Issues in Measuring and Interpreting Taxable Income Elasticities,” National Tax Journal, 51: 773-788, 1998. (A pdf will be provided.)

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Robert E. Hall, “Guidelines for Tax Reform: The Simple, Progressive Value-Added Consumption Tax, in Alan Auerbach and Kevin Hasset, eds, Toward Fundamental Reform, (Washington, DC, AEI Press), 2005, pp. 70-80. (A pdf will be provided.)
Big Idea: Current US tax systems are inefficient, Euro-VAT is not progressive. A progressive VAT achieves all four goals of tax reform because it is: simple, provides incentives for capital formation, is progressive, and efficient. A progressive VAT is two parts: a business tax on everything but wages, and a personal consumption tax. The personal side can be made progressive but eliminating taxes for lowest level, and having scaling rates. Detailed Summary:  Goals of tax reform: simplification, incentives for capital formation, progressive distribution of tax burden, economic efficiency  Taxes are typically on consumption because taxing income creates too many distortions  Best structure: Value Added Tax (VAT): its simple provides right incentive for capital formation, rate is low so it is effective. Problem: lack of progressivity  VAT taxes all business receipts except export sales, business deducts all operating expenses  Another= personal consumption tax on all good purchased (like VAT except collected only from businesses that sell final product to consumers)  Cash flow consumption tax: businesses pay no tax, households file complex returns accounting for all inflows and outflows of cash (more complicated, not really considered much)  Attempts to redistribute burden of VAT (make it more progressive) o Reducing taxes on necessities (not quite enough) o Offset VAT taxes with rebate for families earning subsistence level or less (cash rebates create administrative problems, people who are eligible might not know it and file for it)  Steps to a Progressive VAT  Split VAT into two coordinated taxes:  One; Tax on all businesses, just like European VAT except business tax gives a deduction for compensation, carry forward is granted at market interest rates for tax losses ( rapidly growing business will have a negative tax base since investment exceeds cash flow)  Two: personal consumption tax  Base is same as before (all consumption), but splitting gives option of exempting lower income people from the personal consumption tax  Refer to this design as a flat tax, but people believe flat taxes put too much burden on middle class (where taxation starts) and not enough on prosperous  Can fix this by having differing rates for different levels  Need to have business rate = to top consumption rate (otherwise rich people will find ways to label earnings as business)  Unlike Euro-VAT, a progressive VAT families would have to fill out personal consumption forms, BUT they would be very simply (post-card sized)  Meets all four goals! o Simple: taxes fit on a post-card o Right incentives for capital formation o Fair : exemptions and progressive rates in personal tax o Efficient: top rate is no more than 30%  US Pursuit of Tax Reform  Attempts to correct current system by: Providing vehicles for tax deferrals (ie, retirement, college) and Lowering interest rates on return to capital
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 college) and Lowering interest rates on return to capital  Issues with tax shelters  Advocates shift to progressive VAT away from cash-flow taxes, should eliminate personal taxation of capital dividends and business gains  Mortgage deductions are seen as sacrosanct, they can be preserved in progressive VAT  Have all plant equipment deducted in year of purchase, like under Euro-VAT  Should not: consider national sales tales, or Euro-VAT, or expanding savings incentives at personal level

Martin Feldstein, "How Big Should Government Be?," National Tax Journal, Vol. 50, 1997, pp. 197-213. (A pdf will be provided for those who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w5868.pdf?new_window=1
Summary: Government simply represents a transfer of wealth from the private to the public sector through taxes. The economic burden caused by government depends on (1) the taxes required to raise incremental revenue and (2) the deadweight loss that results from those taxes. Both in turn depend on behavioral responses of taxpayers. Introduction: Feldstein prefaces his argument by citing the inevitable increases in government expenditures that will result from the aging population (i.e. Medicare, Medicaid and Social Security). By 2030 Government expenditures will have to rise from 9% to 17% just to pay for these three. What about increases in education, research, and defense? Thus, economists can play an important role in estimating the total cost plus the dead weight loss of financing such a government program. Section I: The official method used by the Treasury and Congress underestimates the amount of tax increase required to raise a certain amount of revenue. Because they do not take changes in GDP into account, they cannot use the observed responses of revenue to past changes in tax rates as a basis for estimating how future changes in tax rates would alter taxable income and tax revenue, thus they underestimate the substitution and income effects. Section II: Behavioral Effects of a Tax – Dead Weight Loss: 1. reduces the supply of labor and in the long run the amount of capital and thus a loss in revenue results from the loss in taxable income from labor and capital 2. induces a substitution towards untaxed fringe benefits and more pleasant working conditions from taxable income. 3. induces spending on tax deductible items like debt financed spending secured by real estate, charitable gifts, and healthcare 4. changes intertemporal allocation of consumption Conclusion: 1. Deadweight losses needed to be better understood by public officials so the desirability of incremental government spending can be better analyzed – it depends on the total cost (reduction income, disposable income, consumption, and thus GDP) as well as the deadweight loss, which includes the income, labor and substitution effects described above. 2. Better estimates of the changes in taxes rates and the resulting chages in revenue are needed – this scan be achieved by included effects that alter GDP and looking at past experiences. 3. Deadweight loss includes not only labor supply effects, but all changes in taxable income. Past experience estimates a cost of 2 dollars for every 1 dollar of incremental government spending. 10. Social Security Reform (April 1, 3 and 6):

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10. Social Security Reform (April 1, 3 and 6):

Martin Feldstein, “Rethinking Social Insurance,” 2005 Presidential Address to the American Economic Association, American Economic Review, March 2005. (A pdf will be provided.)
See summary under unemployment insurance

Martin Feldstein and Andrew Samwick, “Potential Paths of Social Security Reform,” Tax Policy and the Economy, 2002, Vol. 16, Issue 1, pp. 181-224. http://www.nber.org/papers/w8592.pdf?new_window=1 Martin Feldstein, “Structural Reform of Social Security,” Journal of Economic Perspectives, 2005. http://www.nber.org/feldstein/streformofss.pdf Alicia Munnell, “Social Security: It Ain’t Broken,” Social Security Reform, Federal Reserve Bank of Boston, June 1997, pp. 297-303. http://www.bos.frb.org/economic/conf/conf41/con41_24.pdf
I. Social Security can be adjusted over time -adjustments made through amount of benefits and types of accounts -article examines the state of SS for next 75 years starting with a surplus and moving to a deficit 1. S.S. has enough to pay benefits to 2029 -In 2029, revenues exhausted -Revenues would still pay for ¾ of costs -Between 1997-2012 SS will make profit (receipts and payroll taxes >outlays) -As there is an increased ratio of retirees to workers, expenditures>revenues -Misconception- In 2029, SS is going to implode -In reality, payrolls taxes and benefit taxation would cover 75% of benefits in 2040 and 70% in 2075 2. Actions required to eliminate shortfall are within the bounds of previous change. -the deficit amounts to 2.23 percent of taxable payrolls -thought experiment: fund 75 year deficit by increasing employee-employer tax from 12.4 to 14.6% immediately, a large but not unprecedented increase -Medicare program costs are also rapidly growing -system should not be left until 76th year then try to figure it out 3. Economic and demographic assumptions made for 75-year projection are reasonable. - demographic assumptions- fertility and mortality ( AKA people in labor force and how long people receive benefits) - economic assumptions- CPI and tax rates, also, growth in wages (real wage differential) - miscalculating real wage differential by .6 percent would be equivalent of increasing deficit by .6 percent of taxable payroll ( a relatively modest amount during 75 years) - 1997 ―low cost‖ 75 yr projection is a surplus of .21 percent of taxable payroll - 1997 ―high cost‖ 75 yr projection is a deficit by 5.54 percent of taxable payroll - LONG TERM UNCERTAIN
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- 1997 ―high cost‖ 75 yr projection is a deficit by 5.54 percent of taxable payroll - LONG TERM UNCERTAIN 4. Deficits reemerged in 1983 due to upsurge of disability case load and technical problems (not Greenspan commission recommendations) - Factors for costs increasing- increase years with deficit as time passes, increased disability caseload, and rising disability costs. - lower costs through improved CPI and increased immigration 5. Unhelpful to lump together SS and Medicare as out-of-control spending. -similarities: provide defined benefit (one cash and other insurance for medical services), same population, benefits haven‘t changed in past 15 yrs. -differences: Medicare‘s issues are more complex with a higher predicted deficit, driven by different forces Take away message: Social Security needs modest repair if action is taken today (written in 1997). It is not fundamentally broken.

Douglas Elmendorf, Jeffrey Liebman, and David Wilcox, “Fiscal Policy and Social Security Policy During the 1990s,” in American Economic Policy in the 1990s, Jeffrey Frankel and Peter Orszag, editors, 2002, pp 80-106 and 121-125. (A pdf will be provided for those who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w8488.pdf?new_window=1
 In the 1990s, there was a huge budget surplus, which were expected to continue  Surpluses came from tax increases and fiscal discipline, which were reversed under next administration  Committing to short run reductions in deficit lower future short term interest rates and current long term interest rates, stimulating the economy in the present  In the 1990s there was a huge increase in investment, in part because the deficit reduction freed resources for saving, helping to lead to expansion of economy  Projected need for entitlement reform with aging population and rising healthcare costs  There was debate about changing social security policy, with an emphasis placed on investing in equities (through the trust fund or personal accounts), Clinton supported lockbox, but no new system was adopted  Preserving budget surpluses would help solve the entitlement problem  Reeeeally long article

Jeffrey Liebman, “Redistribution in the Current U.S. Social Security System,” in Distributional Aspects of Social Security and Social Security Reform, Editors Martin Feldstein and Jeffrey Liebman, 2002, pp. 11-41. (A pdf will be provided for those who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w8625.pdf? new_window=1
Social Security: progressive because lower earners get a high fraction of lifetime earnings  Proposed Individual-Account based system: some think this would
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lifetime earnings  Proposed Individual-Account based system: some think this would decrease the redistribution of SS SS Transfers  From people with low life expectancy to those with high life expectancy  From single workers and married couples with a substantial secondary earner to married one-earner couples  From those who work more than 35 years to those work 35 or less

all of these other transfers partially offsets the progressiveness of SS Annual Redistribution  Individuals under 18 receive 2x the benefits as they pay in taxes since few children have labor income while some receive benefits for their parents that are disabled or deceased  Individuals 30-49 receive benefits= 8% of taxes paid  Over 65 receive benefits 30x what they pay  46% of SS goes to families whose non-SS income is below the poverty line  annual benefits for males are 68% of taxes paid, for women are 120% of taxes paid  benefits/taxes ratio is highest in the south with high number of retirees, lowest in the west with young working population  low education levels get higher ratio of benefits/taxes, reverse is true for highly educated (primarily reflecting the increase in education over time thus correlated to age) Intracohort Lifetime Redistribution  Payroll taxes are proportional up to a cap, the benefit formula replaces a higher fraction of lifetime earning for lower earners than for higher earners  This is altered by two factors o Higher earners tend to live longer o Spousal benefits in which spouses of higher earners get more than spouses of lower earners, even if the spouses themselves earned equal amounts Findings  A substantial number of high income individuals receive greater transfers than the typical low-income individual does o Part of this can be attributed to spousal benefits, wives receive higher transfers because they have longer life expectancy o This is not the full difference though. Among males variation is due to life expectancy, marital status, earnings of secondary earners, share of earnings earned in years outside the highest 35 years, and timing of earnings  Differences in transfer across race and education groups are not statistically significant  Significant amount of redistribution based on income and a significant amount that is not income related  **Variation in transfers at a given level of income is due to different mortality rates for people in different demographic groups, variation in earnings levels by secondary earners, and to marital status differences.
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earnings levels by secondary earners, and to marital status differences.  ** Income-based redistribution is fairly modest compared to the total benefits paid. It is important to note though, that some of the benefit of SS is inflation protection and absence of market risk which may be particularly valuable to low income families. Therefore, when examining alternative systems it is important to ask if it will provide a comparable level of income security.

Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, “Nonpartisan Social Security Reform Plan.” http://www.newamerica.net/files/archive/Doc_File_2757_1.pdf
The three authors come up with a plan, LMS Plan (their last names), full of compromises to aid in politicians coming to an agreement about Social Security changes. 4 Elements of LMS Plan 1.Benefit Cuts -reduction in PIA factors and an increase in retirement age -reduces aggregate spending by 35% relative to current benefit formulas -benefit cut for retirement is larger by 43% for typical worker because not reduced for disables and young survivors -cuts implemented by changing PIA and increasing full benefit age i. Changing PIA Formula -benefits reduced for higher earners ii. Increasing Retirement age -FBA of 68 and EEA of 65 iii. Protecting Disabled and Child Beneficiaries from Benefit cuts 2. New Revenue -Mandatory Account Contribution of additional 1.5% mandatory account contribution in Personal Retirement account (PRA) -end practice of government using SS Surplus to fund general operations. -Raising Taxable Maximum by gradual increase in payroll tax cap to 90% of earnings 3. Mandatory PRAs -3% of earnings, funded half by new contributions and half directed from SS trust fund, with full annuitization required upon retirement -all payments paid as annuities, fixed and inflation-adjusted 4. Updates to traditional system –minimum benefit for low-wage worker –increase widows benefits -decrease spousal benefits -possible progressive matches
MAJOR COMPROMISES Revenue Increases Vs. Spending Reductions -benefit cuts 2.7 percent of payroll and revenue increases equal 2.5 percent

Level of traditional benefits -keep traditional benefits at 12.4 percent of payroll tax, keeping them from crowding out
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Level of traditional benefits -keep traditional benefits at 12.4 percent of payroll tax, keeping them from crowding out spending on other programs -minimizes distortionary tax and Gov borrowing Level of Benefits Vs. Length of Time of collecting benefits -traditional benefits and PRA produce replacement rates (ratio of retirement income to preretirement income) -increase in age eligible for benefits Sources of PRA Financing -mandatory worker contributions (1/2) -SS Trust Funds (1/2) Storage for Saving -new revenue stored in PRA -increasing the likelihood that would contribute to Nat‘l Savings -decrease distortionary effects by workers receiving money back Size of Accounts -3%, PRAs large enough to accumulate wealth but not overshadow traditional benefits Level of Progressivity -Revenue and Tradition benefits more progressive but not to undermine support for universal social insurance ADVANTAGES OF THE PLAN I. Sustainable Solvency Achieved -actuarial balance would improve by 2.14 percent of 75-year projection, leading to .22 surplus II. Fiscally Responsible Plan -does not rely on general fund transfers, instead uses changes in benefits and revenues -In years benefits exceed Revenues, Gov. must make it up by the general funds of the government either through reductions in other government spending, increases in taxes, or issuing additional debt III.Many Practical Reforms are included –annuitization making sure don‘t spend savings too quickly IV.Economically Beneficial -future SS surpluses and revenues are invested in PRAs -raising national Savings
V. Good for future Generations -phasing in changes quickly, decreasing burden

VI.Balanced Compromise -political compromise -compromises on solvency, adequacy, and funding -amounts of taxes, amount of choice

11. Unemployment Insurance (April 8)

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11. Unemployment Insurance (April 8)

Martin Feldstein , “Rethinking Social Insurance,” American Economic Review, March 2005, pp 13-15. (A pdf will be provided.) Martin Feldstein and Daniel Altman, "Unemployment Insurance Savings Accounts," Tax Policy and the Economy, Vol. 21, 2006. (A pdf will be provided for those who do not have access to the NBER’s working paper series.) http://www.nber.org/papers/w6860.pdf?new_window=1
Big Picture: Look at system of Unemployment Insurance Saving Accounts (UISAs) where ind save 4% of wages in special accounts and draw from them for unemployment. Gov‘t lends money if account runs out, positive accounts earn balances, which is then paid out on retirement. Analysis finds that almost all ind will have positive accounts, even at end of unemployment spell. With UISA, incentives to be unemployed more frequently/for longer spells are removed. Cost to taxpayers is less. Minimal gain for top 25% of income, minimal loss for bottom. Detailed Summary:  Unemployment insurance distorts benefits, this program aims to fix that  Unemployed ind receive the same cash amounts during unemployment as now  Person with positive UISA can completely internalize cost of unemployment, and wouldn‘t have incentive to inefficiently increase frequency or duration of unemployment  Feasibility of account depends on extent to which unemployment is concentrated in subgroup of ind  Use Panel Study of Income Dynamics (PSID) to see that 5% of employees would retire or die with negative account balances, and that about half of all benefits from UISAs would go to such ind  Therefore, cost to gov‘t with UISA is less than current system, which permits a reduction in payroll tax and distortionary effects of existing benefit system  Current system: ind gets about 50% of previous gross wage (1997 ave weekly benefits = $193), benefits are subject to income tax, but not SS payroll tax, benefits are levied on firms by state gov‘t  Current system reduces costs of being unemployed, and can increase frequency or duration of spells (people search excessively for job)  UISA removes the incentives- costs are internalized, people search for right length of time  Feldstein runs through a variety of ways to design the UISA program, (like limited amount in fund to 3 times average wage, just above average wage, or making people more likely to be unemployed have a higher fund) but I don‘t think we‘d need to run through this in detail (Pages 8-12 if you‘re curious)  Analysis with/ PSID data shows that individuals are 95% sensitive to cost of unemployment benefits; about 7% would ever go into negative funds; UISA gives people stronger incentives to avoid unemployment,  Distributional effects: someone who never taken unemployment insurance gains because they don‘t have to pay the taxes and get to keep the funds from their UISA, someone who ends with a negative balance- the gov‘t contribution must come from a tax, but the tax is smaller than under previous system  Lowest quintile would lose $95 over 25 years, largest gains $468  Reduction of about 60% of taxpayer burden 12. Oil (April 10)

Martin Feldstein “We Can Lower the Price of Oil Now,” Wall Street Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html
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Journal, July 1, 2008 http://www.nber.org/feldstein/wsj07012008.html
In order to explain the source of the price rises in food and energy, Feldstein first looks at perishable agricultural commodities, specifically corn: · In the short run, the supply of corn cannot change much in response to a global increase in demand. · Since demand for corn is very price insensitive, it takes a very large price increase to bring global demand in line with global supply. · In the past year, global demand of corn rose by 10% à It took a 100% increase in the price of corn to offset this rise in demand. Now, looking at oil: · Unlike perishable agricultural products, oil can be stored in the ground. Thus, owners of oil will keep their oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money from selling the oil. Thus, their decision to sell is based on the expected price rise and any considerations of risk. Any expected change in the future price of oil will have an immediate impact on the current price of oil. · Thus, when oil producers concluded that demand for oil in China and other countries would grow more rapidly in future years, they inferred that the future price of oil would be higher than previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its original rate. · By understanding this, we can see how news stories, rumors and industry reports can cause substantial fluctuations in current oil prices – all without anything happening to actual current demand and supply. Good news: · Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. Thus, it is possible to bring down today‘s price of oil with policies such as increases in government subsidies to develop technology that will make future cars more efficient, tighter standards that gradually improve the gas mileage of the stock of cars, etc. · In addition, an increase in the expected future supply of oil would also reduce today‘s price. The fall in the current price would induce an immediate rise in oil consumption that would be matched by an increase in supply from OPEC producers that have inventories of oil. In summary, any steps that can be taken to increase the future supply of oil or to reduce the future demand for oil in the US or elsewhere can lead to both lower prices and increased consumption today.

John Deutch, James Schlesinger and David Victor National Security Consequences of US Oil Dependency Council on Foreign Relations, 2006 http://www.cfr.org/content/publications/attachments/EnergyTFR.p df
 Lack of sustained attention to energy issues is undercutting U.S. foreign policy and national security  Other nations (Russia, Iran, Venezuela) have used their energy resources to pursue their strategic and political objectives.  Energy consumers, like the U.S., are increasingly dependent on imported energy. This increases strategic vulnerability and constrains ability to pursue broad range of foreign policy and national security objectives. Also put in competition with other importing countries (China and India), creating
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    

o Also put in competition with other importing countries (China and India), creating further foreign policy challenges. Reliable and affordable supply of energy is a prominent feature in international political landscape, and it affects U.S. foreign policy. Although energy policy and foreign policy are distinctly different policies, they are still closely connected. This paper says that in the next 20 years, it is impossible to eliminate U.S.‘s dependence on foreign energy sources. The main focus should be to manage the consequences of energy dependence, not to act like we can get rid of it. This has been a problem for a long time, but growing global demand for oil has made the issue more pertinent. Policy Strategy proposed by Task Force o 1. While the U.S. has limited leverage to achieve energy security objectives through foreign policy, it can manage its energy future through domestic policies that complement short- and long-term international strategy.  Three measures to slow and eventually reverse growth in consumption of petroleum products. These measures would also encourage higher-efficiency vehicles, introduction of alternative fuels, and use of public transportation.  Tax on gasoline  Stricter and broader mandated Corporate Average Fuel Economy standards  The use of tradable gasoline permits that would cap the total level of gasoline consumed in the economy o 2. Task Force recommends that the U.S. take initiatives to encourage the efficient, transparent, and fair operation of world oil and gas markets. This means encouraging all countries to reduce subsidies and deregulate prices of oil and gas. o 3. U.S. must work closely with major oil suppliers to detect and deter attacks on their infrastructure. Producing and consuming countries have a common interest in reducing infrastructure vulnerability, from terrorist attacks, natural disasters, etc. o 4. Many countries exploit oil and natural gas resources but fail to manage their revenues in a way that improves the social and economic prospects of their people. U.S. should play a stronger role in promoting better management of revenues.  This is in U.S.‘s interest because stably governed countries are better able to attract the investment needed to maintain and increase hydrocarbon production. And because it supports the long-standing American goal of encouraging progress toward democracy and good governance. o 5. The U.S. needs to mobilize government resources to focus more on the integration of political, economic, technical and security perspectives needed for energy policymaking.  This is difficult because of the range of other issues that demand attention. The Task Force recommends a small energy security directorate is established to give adequate attention to energy policy issues.

Martin Feldstein and Henry Kissinger “The Power of Oil Consumers”, Washington Post, September 18, 2008 http://www.nber.org/feldstein/washpost_091808.html
· When oil tripled in price from $30 a barrel in 2001 to around $100 today, we saw a huge transfer in wealth from the world‘s most powerful nations to some of the world‘s weakest. Yet, the world‘s powerful nations stand by impotently as if the price of oil were some natural event that cannot be influenced by political forces. · The price of oil is not determined by a traditional competitive market—major producers can raise or lower the price of lower by reducing or increasing their rate of
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producers can raise or lower the price of lower by reducing or increasing their rate of production. The monopoly suppliers have very large market share and will continue to have this until the consuming nations 1) sharply reduce their dependence on imported oil and 2) develop a political strategy to counter political manipulation of the oil market. · The Group of Seven, along with India, China and Brazil should establish a coordinating group to shift the long-term trends of supply and demand in their favor. Their efforts could reduce the price of oil by reducing future demand and by establishing an effort to increase oil supply in all of these countries. While these efforts would take years to play out, the expected changes in oil supply/demand would reduce the price of oil today. · A cooperative policy should also include emergency sharing arrangements to counter selective boycotts or supply interruptions. · Overall, while the US can make many of these changes, a coordinated international effort would be much more effective to increase supply and reduce demand in the global energy market.

Martin Feldstein “The Dollar and the Price of Oil,” The Syndicate , July 2008 http://www.nber.org/feldstein/dollarandpriceofoil.syndicate.08.pdf
· In the past year, the price of oil rose by 85%, from $65/barrel to $120 · During the same period, the dollar fell by 15% relative to the euro, and 12% relative to the yen · Link between the two? Would the price of oil have increased less if oil were priced in euros instead of dollars? · Oil market is global, so the price reflects total world demand and total world supply · The increasing demand for oil from all countries, but particularly from the rapidly growing emergent- market countries like China and India, has been a huge force in pushing up the price of oil · The currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into any currency – market equilibrium is the same when translated into all currencies Did the dollar‘s fall cause the price of oil to rise? · This is only true to the extent that we think about the price of oil in dollars, since the dollar has fallen relative to other major currencies. · But if the dollar-euro exchange rate had remained at the same level as it was last May, the dollar price of oil would have increased less – in this case, the euro price of oil would be the same as it is today, but the dollar price of oil would have only risen by 56% (the amount that the euro price of oil actually did increase) · The only effect of the dollar‘s decline is to change the price in dollars relative to the price in euros/other countries · However, the rising price of oil does contribute to the decline of the dollar. The increasing cost of oil imports widens the US trade deficit. The dollar has declined in order to be more competitive and thus shrink the trade deficit to a sustainable level. · Thus, as oil prices keep rising, it will be more difficult to shrink the US trade deficit and the dollar will depreciate even more rapidly.

Martin Feldstein “Tradable Gasoline Rights,” Wall Street Journal, June 5, 2006 http://www.nber.org/feldstein/wsj060506.html
11. The Economics of National Security (April 13)
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11.

The Economics of National Security (April 13)

Martin Feldstein, “The Underfunded Pentagon,” Foreign Affairs, March/April 2007. http://www.nber.org/feldstein/the-underfundedpentagon.pdf
-Threats fall into three categories -Major states (Russia, China), rogue states (NK, Pakistan, terrorists) -Our defense budget is not enough to secure us against 21st century threats -Need to grow army, marine corps -Military is the quintessential public good -We should not raise income taxes to finance military – this would require extremely high marginal tax rates -Instead, take advantage of the fact that tax revenue growth exceeds GDP growth -Or eliminate tax expenditure categories

Martin Feldstein, “Defense Spending Would Be Great Stimulus,” Wall Street Journal, December 24, 2008 http://www.nber.org/feldstein/wsj12242008.html
Optional: Congressional Budget Office, Long Term Implications of the Current Defense Budget: Summary Update for Fiscal Year 2008, December 2007. http://www.cbo.gov/ftpdocs/90xx/doc9043/03-20-LTDP2008.htm 12. Trade Policy (April 15, 17) Professor Robert Lawrence Where we stand:

United States Trade Representative 2009 Trade Policy Agenda. http://ustr.gov/Document_Library/Reports_Publications/2008/2008 _Trade_Policy_Agenda/Section_Index.html
Big Picture: Managing trade policy in face of crisis is a great challenge. Trade is very important for the US, it brings in $1tril/year and accounted for all economic growth in 2008. Am. People are nervous about globalization because they see that it ―takes jobs‖ US Policy needs to reassure Am. People (through improving education, fixing unemployment insurance, creating training prog for people who lose jobs). US cannot withdraw from trade, because countries we trade with can find new partners, putting the US at a serious disadvantage.

Detailed Summary:  Needs:  Protectionist policies can aggravate the recession (it happened in the 1930‘s)  Post 9/11: G-20 summit led to a pledge to avoid new restrictions for 1 year  Need to reverse the erosion of US foreign policy/global standing  Initiative on global warming: has HUGE impact on global standing  Must restore confidence on American people: trade balance has provided all US econ growth over past year, but people view globalization as source of job insecurity, stagnant real ways, and growing income disparity  Will address these need with:a new narrative, a competitiveness agenda, and an adjustment policy
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 policy  A New Narrative:  Need to re-explain benefits of trade to Am. People  Issues: China has emerged as low-cost manufacturing giant; people who have worked hard feel that they aren‘t sharing in benefits,  Retreating from globalization isn‘t good idea (it makes us $1 trillion richer, can‘t give up the internet)  All Am can benefit from growth is: tackle budget deficit, modernizing financial regulations to assure security of international mkts, investing in people and tech to drive innovation, expanding trade  Resrore faith that gov‘t : understands challenges, can equip country to face challenges, can provide adequate support for workers facing career changes/job dislocation due to global econ changes  Strengthen ability to compete and innovate: improving telecommunications and rail, road, and air transport  Upgrade educ level and quality- educ reform, more careers in science, raising high-skill immigration  Address main causes of anxiety: portability of health care, pension security, social insurance  Refocus trade policy to target largest markets and emerging sectors  Restoring US Competitiveness:  Private investment in plant equip is 2% of GDP lower than at start of decande=> loss of $1.7 Trillion in potential investment  Gov‘t investment in physical ifrastructure, R&D, and educ has not kept pace with GDP growth  Lack much physical infrastructue (roads, bridges, dams are crumbling)  Need to invest more in new tech: high-speed wireless, energy/environ tech to meet  Must encourage more private/public invest in R&D,  human capital is important: have all US achieve a high school degree, better worker training  Budget deficit hurts competitiveness through exchange rate rising deficits raise interest rates, attracting inflows that push dollar to be overvalued (overvalue= MAJOR negative for US competitiveness)  Designing Strategy for Promoting Econ Adjustment  US labor market is very flexible; the programs supporting it (health care, social security) are in significant need of update  Trade Adjustment Assistance= newish program designed to help workers by providing extended unemployment insurance to people getting job training o Little uptake of program (people don‘t know about it and must go through lots of red tape to qualify)  Federal spending on training programs is at lowest rate in 45 years  Should: update unemployment insurance; make service workers eligible for TAA, provide assistance to communities facing severe job loss (ie plant closing), encourage employers to provide their own assistance to laid-off workers  Trade Policy  Most recent round (Doha Round) of multilateral trade negations in WTO= has little enthusiasm, must finish it or else countries will look elsewhere to make deals  Need to reassess approach to trade negotiations  Trade deficit is too large; good trade deals reinforce broader obj of US foreign policy (creates alliances to work with partners closely, we benefit when partners prosper)  US engagement in trade ensures that US interests will not be disadvantage as other trading powers pursuer trade pacts with each other (if Pan-Asian bloc makes deal with EU, US is in trouble)  WTO must adapt to increased number of members, address link between security (vias) and trade, clarify rules on taxes and subsidies, meet new challenges of climate change
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 and trade, clarify rules on taxes and subsidies, meet new challenges of climate change initiatives  US should refocus Free Trade Areas, particularly with Asia or the middle East  Relationship with China is key: esp exchange rate (which China undervalues)

The Trade Policy Study Group Report to the President Elect and the 111th Congress , available at http://iie.com/publications/papers/20081217presidentmemo.pdf
Year: 2008 Thesis: The United States needs a comprehensive new trade policy to increase its competitive stance and maintain domestic support in the context of a rapidly globalizing world economy. Summary:  Trade will need to be addressed by the new Administration/Congress for four reasons: o Trade is an important part of the policy response to the global financial/economic crisis. Protectionism will only worsen the current situation (as occurred during the Great Depression). o Cooperative trade policy is essential for reversing the erosion of US foreign policy and global standing in recent years. o Planned initiatives on global warming will necessarily include a trade component. o Trade and America‘s role in the global economy will need to be addressed as part of an effort to restore American confidence/optimism.  The proposed new strategy includes four components o A new narrative: new policies that allow Americans to succeed in a globalizing world, including policies that (a) strengthen our ability to compete/innovate, (b) upgrade the educational level and quality of our workforce, (c) increase the portability of health care, etc and (d) refocus trade policy to target the markets that will be central to our economy in the future. o A competitiveness agenda: increased private and public investment in activities that promote productivity gains and the creation of high-skill, high-wage jobs; this includes investment in infrastructure, R&D, education, training, new technologies, etc. We also must reduce the federal deficit, which harms our competitiveness by crowding out private investment and causing the overvaluation of the dollar. o A new adjustment policy: much stronger and effective national program of safety nets and empowerment initiatives, including reforms of health care, unemployment insurance, etc. o A new approach to trade policy: US should lead international trade negotiations (in the Doha Round, NAFTA, other FTAs, etc) for three reasons – (a) international trade supports US ec growth, (b) good trade deals reinforce US foreign policy, and (c) US trade negotiations ensure that US interests won‘t be disadvantaged as other major trading partners form trade agreements with each other.

(1) Summers, Lawrence “America needs to make a new case for trade” Financial Times, April 27 2008 http://www.ft.com/cms/s/0/0c185e3a-1478-11dda741-0000779fd2ac.html
Thesis: The traditional economic arguments for supporting trade policy, while valid, are no longer sufficient. Instead, policymakers have to convince the American citizenry that global success is in their best interest, which is not immediately obvious for several reasons.
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Challenges:

success is in their best interest, which is not immediately obvious for several reasons. Summary: American economic policy has traditionally supported globalization, but the recession likely will put this in question. This support is based on four valid economic arguments: o Trade has many benefits via comparative advantage (for exporters, consumers, and the economy as a whole). o Trade agreements are good mercantilism for the US, for two reasons. First, the US already has low trade barriers and thus will not need to reduce as much as trading powers. Second, not having trade agreements with countries with whom our competitors do will put us at a competitive disadvantage. o Increased income inequality in US is due to technology, not trade. o Acknowledged that not everyone wins out, but that trade agreements should be accompanied with polices to reduce income inequality/insecurity. However, just because trade barriers harm our economy, it is not immediately obvious that the US is helped by the success of its trading partners. There are several reasons why global success may harm us: o American producers benefit from having larger markets to sell into, but also have to face more competition. o Developing countries increasingly export goods that were traditionally produced by the US, which puts downward pressure on US wages. o Growth of developing countries puts pressure on energy and environmental resources, thus raising their prices. o Global growth encourages the development of stateless elites who are loyal to global economic success and their own prosperity, rather than the interests of their home nation. (i.e., rich CEOs who dislike regulation, taxation, etc) Therefore, these arguments above must be addressed in order to convince Americans that global economic success is actually in our best interest.

Free Trade's Great, but Offshoring Rattles Me By Alan S. Blinder Washington Post Sunday, May 6, 2007; Robert Z Lawrence. Comments on Alan Blinder: Off-shoring: Big Deal or Business as Usual? Given at Alvin Hansen Symposium on Public Policy, Harvard University, May 2007. THE TROUBLE WITH TRADE; Paul Krugman Pittsburgh PostGazette (Pennsylvania) December 29, 2007 Saturday
 US now imports more manufactured goods from third world than advanced economies  Trade improves lives of third world workers, but at the expense of real wages of many or most American workers, this problem is getting worse  Highly educated workers (a minority) benefit from trade  Should not lead to increased protectionism, but strengthened social safety net

Robert Z Lawrence The Globalization Paradox: More Trade Less Inequality. Vox EU 4 September 2007. http://voxeu.org/index.php? q=node/524
 Income inequality in the US grew because the wages of the rich have surged, not because of trade decreasing the wages of less skilled workers.  Despite huge increases in trade and immigration, these changes have not increased
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 Despite huge increases in trade and immigration, these changes have not increased conventional wage inequality, even though there is increasing competition from third world countries  One potential explanation is that goods manufactured in US might be more sophisticated and made by more skilled workers when compared to third world countries. Therefore, competition won‘t lower American wages  Another expectation is that the goods America imports are no longer produced in America. Therefore, the decreasing prices of imports will not lower wages in the United States or lead to job losses. This specialization will in fact decrease inequality.

World Trade Organization: 10 benefits of the WTO trading System. http://www.wto.org/english/res_e/doload_e/10b_e.pdf Top 10 Reasons to Oppose the WTO Global Exchange. Griswold, Dan NAFTA at Ten: An Economic and Foreign Policy Success. Center for Trade Policy Studies: Free Trade Bulletin, No1. December 2002 http://cato.org/pub_display.php?pub_id=4074
NAFTA delivered more trade Trade with Mexico has tripled from $81 billion to $232 billion Canada and Mexico are now the largest trading partners of the US The potential affect on the labor market was overestimated by both sides In reality, the agreement was never really going to have a huge effect on the US economy It is much larger than Mexico‘s economy and tariffs were already very low before Biggest impact has been in foreign policy Enticed a move from centralized protectionism to democratic capitalism in Mexico Also encouraged more political competition in Mexico There was no loss of jobs, in fact there has been an increase in employment from 120 million to 135 million and a decrease in the unemployment rate  There was an increase in manufacturing investment in Mexico, but too small compared to domestic investment to have a real impact Manufacturing output has actually grown in the US since NAFTA was passed
         

Faux, Jeff NAFTA at 10, The Nation February 2, 2002 http://www.epi.org/publications/entry/webfeatures_viewpoints_nafta_le gacy_at10/
13. Health Care Policy (April 20, 22, 27, 29) Professor Katherine Baicker

Moral Hazard and Adverse Selection

Cutler, David M. and Richard J. Zeckhauser. "Adverse Selection In Health Insurance," Forum for Health Economics and Policy, 1998, v1, Article 2
 · INTRODUCTION: Adverse selection exists in healthcare because people at higher risk differentially prefer more generous and expensive plans.
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 differentially prefer more generous and expensive plans. o Three classes of inefficiencies:  Prices to participants do not reflect marginal costs individuals select the wrong health plans on a cost-benefit analysis  Desirable risk spreading is lost: sicker people pay more  Health plans manipulate their offerings to deter the sick and attract the healthy o Healthcare reform tries to deal with adverse selection very present in employeroffered policies, government-sponsored insurance, or individuals purchasing their own  Medicare reform  Changes in employment-based health insurance  Efficiency of individual insurance markets  THEORY OF ADVERSE SELECTION o Employers offer multiple offerings: high-risk individuals differentially choose some plans and low-risk others differential selection  Occurs because individuals are not charged marginal cost adverse selection o Three parties play a role in differential selection:  Insurers set premiums on the riskiness of people  Employers pay some portion of premium  Employees choose a health care plan based on cost-benefit calculation and preferences o Two examples of inefficient plans:  Employers pay equal contribution to chosen plan: inefficient b/c employee pays the difference based on the average cost of other people in the plan  Employers pay a fixed percentage of plan‘s costs: distorts prices more  EMPIRICAL IMPORTANCE: Harvard University and the Group Insurance Commission (GIC) of MA o Group similarities: costly, generous plan & several HMOs o Harvard: changed to an equal contribution plan in 1995; negotiated lower prices for HMO while PPO (more generous plan) price rose  Healthy people departed from PPO raised risk premium more for PPO  Adverse selection death spiral: PPO became untenable in 3 years and was dropped o GIC: employees paid an equal share (from 10% to 15% in 1995)  Mixed HMOs into a PPO people enrolled, risk spreading was good, costs fell down to almost HMO levels  But ppl have been dropping out of the PPO plan and costs are rising while HMO prices have stayed the same  Adverse selection: working through lower risk people dropping out rather than high risk selecting themselves in  REFORM STRATEGIES: How can we encourage individuals to select the plans that they would choose if they faced the true posts of choosing one over another? o Individual‘s characteristics: assign them appropriate plans goes against the norm of great choice o Decentralized choices: individuals choose from a menu of options  Standardizing plans: requiring same coverage in all plans could help no particular selection for certain plans that are generous for mental health, diabetes, etc.  Debate on particulars of the plan to standardize  May impede valuable competition on program design plans need to negotiate, so what is right for one plan might not be for another  Disparate pricing: adjust prices to account for the risk mix; 4 strategies for risk adjustment  Premium subsidizes: subsidize the premium of the most generous policy
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 Premium subsidizes: subsidize the premium of the most generous policy so that it is more affordable than risk differences alone would indicate historically most popular, but maybe not most effective o Pays little attention to actual composition of populations w/in health plans; assumes that higher price is due to worse mix of enrollees o Eliminates many incentives for plans to operate efficiently or price competitively  Reinsurance: mandatory reinsurance for high-cost people to adjust premiums by risk; remove all spending above a certain amount—carve-out approach o If the high-cost group were primarily responsible for the high costs of the more generous plans, would reduce adverse selection o Danger: once the expenses of high-cost users are pooled, the plan loses the incentive to monitor their utilization o Doesn‘t make sense in that ppl want insurance to cover very expensive things, not routine small things  Prospective (ex ante) & Retrospective (ex post) risk adjustment based on the population composition of ppl in the plan o Incomplete b/c distribution of risk-spending is highly skewed o Severely hindered if insurers can alter their coding practices in light of the risk adjustment system

Manning, W., et al., Health Insurance and the Demand for Medical Care: Evidence from a Randomized Experiment, American Economic Review, Vol. 77, No. 3, June 1987.
 Design of the Rand Health Insurance Experiment: o Enrolled families in 6 cities from 1974 to 1977; assigned to 1/14 fee-for-service insurance plans or to a prepaid group practice  Fee-for-service plan had different levels of cost sharing: coinsurance rate and upper limit on annual out-of-pocket expenses o Dependent variable: health care services (not dental or psychotherapy) o Independent variables: health care plan coverage + controls o Statistical methods: ANOVA and estimates based on a four-equation model  Empirical results: o Main effects of the insurance plan:  differences in expenditures across plans reflect variation in the number of contacts (visits) rather than the intensity  No significant differences among the family coinsurance plans in the use of inpatient services, probably due to the upper limit on out-of-pocket expenses b/c 70% exceeded their upper limit o Use by subgroups:  Income groups: probability of use of any outpatient medical service increases with income with larger increases for family pay and individual deductible plans than the free plan; probability of use of inpatient services declines with income for the family pay plans net result is shallow U-shaped  Age groups: adults have significantly lower use of inpatient services on familypay plans than they do on the free plan  Health status: no differential response btw healthy and sickly—unusual b/c of the cap on out-of-pocket expenses  Sites: least access to doctors had the second highest probability of any use  Period of Enrollment: duration of plan (3 or 5 years) did not matter for
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  Period of Enrollment: duration of plan (3 or 5 years) did not matter for expenditure  Conclusions: demand elasticities for medical care are nonzero and the response to cost-sharing is non-trivial o Elasticities for a constant coinsurance policy are in the -0.1 to -0.2 range o Change in insurance can only explain a small part in the huge change in health care spending since WWII o Nontrivial welfare loss from first-dollar health insurance coverage

Newhouse, J., Medical Care Costs: How Much Welfare Loss?, Journal of Economic Perspectives, Vol. 6, No. 3, Summer 1992
 · Magnitude of health expenditure increase o Real medical care expenses per capital have grown at 4%/year for 50 years (more rapid in 1960s) o Growth in medical costs is different b/c of moral hazard and tax treatment of health insurance excessive insurance b/c costs are misaligned o But the moral hazard/risk sharing story is in a one-period model; distinguish between one-period from multiple period Accounting for the medical expenditure increase: method is to identify a series of factors, determine how much of the change they might account for, and account the residual to technological change o Aging: only accounts for a tiny fraction in the increase based on how their spending changed if just measuring the population age increases o Increased insurance: factor-of-five increase in real expenditure per person from 1950-1980 is perhaps 8x as large as one could account for solely from the effect of increased insurance on demand in the one-period model.  Largest single component of increase in real medical expenditure has been in the hospital sector, but the coninsurance for hospital visits has been about the same while expenditure has risen 50% o Increased income: medicare is a normal good so increased income could account for increase in expenditure; elasticity measured around 0.2 – 0.4 o Supplier-induced demand: if physicians have considerable discretion in treating ignorant consumers, to what degree might they have induced more and more demand? As supply of doctors increases, they demand higher costs to protect their incomes hypothesis not supported by the evidence. o Factor productivity in a service industry: medicare is a service so if productivity gains are lower for medical care, then the relative medical prices would rise over time, and b/c demand is inelastic, expenditures would also rise. Very difficult to measure— many reasons for why there‘s no empirical basis for decomposing the medical care expenditure increase into increase in price vs. quantity Technological change in medical care o Other factors probably account for 50% of rise in expenditure; rest due to technology o Highest increase in cost come from hospitals—where the newest technology is Was technological change induced by insurance? o Fallacious argument that insurance makes things more affordable and therefore more expensive technologies was the result and is a welfare loss What has been done about medical costs? o Initial cost sharing by patients has increased—probably will not change the long-term rate of cost increases o Increased enrollment in health maintenance organizations: rate of growth in HMO spending appears similar over an entire sector o Adoption of prospective payment systems: paying a lump sum per type of admission rather than the additional cost of a procedure length of hospital stay decreased, but bottomed out soon
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 

bottomed out soon The willingness to pay for new technology: welfare loss from additional spending on technology may be less than some of the rhetoric surrounding the need for cost containment would imply o Real rate of increase in costs is similar across countries o Rate of increase in HMO costs in the US has been similar to the overall medical care sector A note on the terminally ill: data offer little support for the notion that society is wasting an everlarger share of resources in a fruitless attempt to save those who are about to die—spending on the last year of life has not contributed disproportionately to the increase in medical care costs The uninsured: probably about average in risk on the whole; covering the uninsured would probably increase demand for medical care by less than 10%  universal insurance would add costs but would not wreak havoc on the nation‘s medical care economy o However, there would probably be deadweight loss associated with financing an increase in medical care costs Concluding thoughts: conventional wisdom that the tax subsidy increase demand for medical care; however, it‘s not apparent that ending the tax subsidy would address the increasing costs nor be an unambiguously good policy

Health Insurance Markets and Labor Markets

Summers, L, Some Simple Economics of Mandated Benefits, American Economic Review, Vol. 79, No. 2, May 1989.
 Mandated benefits are one way governments can ensure universal access to a good  The other is public provision  Today the issue is whether it is good to provide mandated health insurance, so those who are not normally covered will be  Economists standard view is of mandated benefits as a tax  Employee provided benefits can be efficient if they can be provided at a lower cost then their value to employees then it can be cost effective compensation  The paternalism argument supports the idea that mandated benefits will correct an undervaluing of a good in the market  There is a positive externality associated with health insurance  Prevention of contagious diseases spreading  Also, there is an unwillingness to refuse care to those who can‘t afford it  These creates an even larger externality  Also, it is more efficient to mandate health insurance because the market outcome does not provide universal insurance  The adverse selection will cause employees to set a high price so only sick people will pay for insurance and everyone loses money  Mandated benefits are a more efficient way to provide benefits than public provision  Allows employers to tailor policies to individuals and avoids government provision trap – those willing to pay for high quality care will settle for provided middle quality care  Also avoids deadweight loss of tax  The deadweight loss associated with mandated benefits is lower than that of a tax  Also, effects on employment are much less than with a tax  For health insurance a lump sum tax might be an efficient form of government provision, but this is not politically feasible  Since all get same benefits a payroll tax is largely more inefficient than employer provision  Major problem with mandated benefits is only help those with jobs  In those cases public provision is necessary  Wage rigidities also hurt this program by not allowing wages to fall in exchange for
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 Wage rigidities also hurt this program by not allowing wages to fall in exchange for benefits

Madrian, Brigitte, Employment-Based Health Insurance and Job Mobility: Is there Evidence of Job-Lock?, Quarterly Journal of Economics, Feb, 1994. Katherine Baicker and Amitabh Chandra, Myths And Misconceptions About U.S. Health Insurance, Health Affairs 27, no. 6 (2008): w533w543
Health Care Reform is Hindered by Confusion about how health insurance works What is health insurance? - Insurance, in its simplest form, works by pooling risks: many pay a premium up front, and then thosewho face a bad outcome (getting sick, being in a car accident, having their home burn down) get paid out of those collected premiums. - The premium for health insurance is the expected cost of treatment for everyone in the pool. -important for people to become insured when they are healthy Myth 1: The Problem With The Health Insurance System Is That Sick People Without Insurance Can‘t Find Affordable Policies i.Reality -Private health insurers will not charge uninsured sick people a premium lower than their expected costs. -Uninsured Americans need health care, not health insurance. Insurance is about reducing uncertainty in spending. It is impossible to ―insure‖ against an adverse event that has already happened, for there is no longer any uncertainty about this event. ii. Social insurance versus private insurance -Social insurance; viewed as a right, redistribute money from the healthy to the (low-income) sick, in the same way that we redistribute money from the rich to the poor - Private markets can pool risk among people starting out with similar health risks, and regulations can ensure that when some members of those risk pools fall ill, insurers cannot deny them care or raise their premiums -providing subsidies for individuals to purchase private insurance or providing the insurance directly (as through Medicare) are both forms of social insurance.
iii. How to provide care for the sick and uninsured?
-no private insurer wants to do this - we could force sick people and healthy people to pool their risks, such as through community rating coupled with insurance mandates - social insurance programs, including a nationalized health

care system, is that they can achieve redistribution that private markets alone cannot
Myth 2: Covering The Uninsured Pays For Itself By Reducing Expensive And Inefficient Emergency Room Care

i.Reality -empirical evidence does not support
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i.Reality -empirical evidence does not support -maybe in the case of diabetes to prevent amputations ii. Insurance and Use of Care -―Moral Hazard‖ -*** The RAND Health Insurance Experiment (HIE), the largest experiment in social science, measured people‘s responsiveness to the price of health care: people who paid nothing for health care used 30 percent more care than did those with high deductibles iii. Preventative Care and Health Costs -increases in preventative care do not pay for themselves -MOST preventative care goes along with greater spending and greater health outcomes -Example of cost-saving: Flu Vaccine -sometimes we should decide to spend money elsewhere iv. Money Well Spent -insuring the uninsured would raise total spending, but it would be money well spent -receive great amount of increased health benefits in those that were uninsured Myth 3: Lack Of Insurance Is The Principal Barrier To Getting High-Quality Care
i.Reality -having insurance my increase quality of care you get, but it is not a guarantee that you will get high quality care -Americans receive less than 60% of recommended care - Yet the likelihood of getting high-quality care has more to do with geography than with insurance status or spending -John Wennberg- in fact, in areas where the most is spent on Medicare beneficiaries, they are least likely to get high-quality care. Mammograms, flu shots, the use of beta-blockers and aspirin for heart attack patients, rapid antibiotics for pneumonia patients, and the use of simple lab tests to evaluate the management of diabetes are all lower in higher-spending areas. Higher spending is not even associated with lower mortality, which suggests that more generous insurance provision does not necessarily translate to better care or outcomes. -SO…discard the simplified notion that more spending guarantees better care or even basic preventive care

ii. What do people in high spending areas get? -high spending areas get receive surgery, but they see more specialists more frequently, have more diagnostic and imaging services, and get more intensive care at the end of life—none of which has been shown through clinical trials to improve health Myth 4: Employers Can Shoulder More Of The Burden Of Paying For Insurance i.Reality -workers bear costs of benefits in the form of lower wages - Regardless of a firm‘s profits, valued benefits are paid for primarily out of workers‘ wages. Workers may not even be aware of how much their total health premium is; however, employers make hiring and salary decisions based on the total cost of employment, including both wages and benefits such as health insurance, maternity leave, disability insurance, and retirement benefits. - employers may respond in other ways: employment can be reduced for workers whose wages cannot be lowered, outsourcing and reliance on temp agencies may increase, and workers can be moved into part-time jobs where mandates do not apply

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ii. Why an employer based system? - preference in the tax code for premiums paid by employers relative to premiums paid by individuals or direct payments for health care - this tie between employment and insurance comes at a cost: workers who leave or lose a job risk losing their insurance or facing much higher premiums, sometimes forcing them to stay in a job to retain health insurance iii. Advantages of the job-based system -including better pricing and risk pooling -the employer market is the primary mechanism for maintaining cross-subsidization from lowrisk populations to high-risk ones Myth 5: High-Deductible Health Plans And Competition, Not Government Action, Are The Keys To Lower Costs i.reality - encourages the use of care with very Low marginal benefit and that greater cost sharing would help reduce the use of discretionary care of questionable value. But there is also evidence that patients under use drugs with very high value -even $5–$10 increases in copayments for outpatient care can result in some patients‘ being hospitalized as a result of cutting back too much - Capping total insurance benefits is also short-sighted and imprudent: not only does evidence suggest that such caps result in adverse clinical outcomes, worse adherence, and increased hospital and ER costs, but the presence of caps means that patients are not insured against catastrophic costs—exactly what insurance is supposed to protect against the most.
ii. A role for competition - Competition between insurers to offer plans that have the mix of benefits that enrollees find most valuable could drive the innovative plans described

False Conclusion: We Shouldn‘t Do Anything Until We Know What To Do i.Reality - our health care system is not delivering the consistently high-quality, high- value care that we should expect - we cannot afford to wait to act - without regulatory safeguards, even the insured sick will be at risk of losing the insurance protections to which they are entitled - Private insurance fundamentally cannot provide the kind of redistribution based on underlying health risk or income that social insurance can - Single-payer systems are also slow to innovate— as suggested by the fact that it took Medicare forty years to add a prescription drug benefit, long aftermost private insurers had done so. - Reforms that promoted higher- value insurance could both extend coverage so that more people benefit from the protections that insurance affords and ensure that those protections are secure for those who fall ill TAKE-AWAY: comprehensive reform proposal that aimed both to extend insurance protections to those who lack them and to improve the value of care received by those who are insured would be more likely to succeed at each goal than proposals that focused on just one

Public Health Insurance Programs

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Public Health Insurance Programs

Iglehart, J., The American Health Care System: Medicaid, New England Journal of Medicine, Vol. 340, No. 5, 1999.
    
        Largest health insurer in the US Provides benefits to most of those that do not get employee-provided insurance Has changed in the past decade to include a lot more people Means higher expenditures and more forced managed-care programs Many physicians still don‘t accept Medicaid because it provides so little payment to doctors Medicaid is funded by both state and federal government Funding to states for Medicaid is roughly 40% of all money provided to a state States have significant influence over how to administer the payments They can even decide who is covered under their policy Result is almost 50 different Medicaids Low income adults and children make up most of the people covered But the elderly and disabled account for most of the spending The insurance provided is much more extensive than Medicare, and there is very little cost-sharing involved For elderly is effectively a form of supplemental insurance In the Clinton years, the program has become much more state run Also, Medicaid has cut ties with the welfare office This was supposed to allow benefits for those who were not getting cash assistance But has actually decreased the number of people applying for coverage Most of these people don‘t have insurance of any kind now Partly for this reason, the growth in Medicaid spending has decreased recently and is at its lowest level in years Was rising due to increased coverage, increased spending per person and high payments to compensate hospitals for treating low-income patients Now states are starting to limit their spending, even not accepting the full amount from the federal government Managed care is a way to control the costs of health insurance All states but Alaska now have mandated managed care programs The savings have actually only been modest, because the compensation was already so low under the fee for service system

           

Iglehart, J., The American Health Care System: Medicare, New England Journal of Medicine, Vol. 340, No. 4, 1999.
 Started in 1965 for the elderly, meant to be a interim step toward the broader goal of universal health care coverage  Today covers 39 million people  Spent on o Part A= Hospital Services  Inpatient hospital services, continued treatment or rehabilitation, hospice care  Everyone is enrolled in Part A o Part B= Physicians‘ Services  Physician services and outpatient hospital services such as ER visits, ambulatory surgery, diagnostic tests, etc.  Medicare pays 80% of expenses over annual $100 deductible
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 Medicare pays 80% of expenses over annual $100 deductible  Voluntary enrollment  Money comes from: mandatory contributions by employers and employees, general tax revenue, premium paid by beneficiaries, deductibles and co-payments o Money paid in today is spent today on current beneficiaries o 89% of revenue comes from people under 65, 11% from monthly premiums Financing Challenge  Since 1977 Medicare spending has increased 10x and eligible population has gone from 26 million to 38.6 million (Note: the article was written in 1999!)  A couple retiring in 1998 with one wage earner since 1966 would have paid in $16,790 and would receive a PV of Part A benefits equal to $109,000 Medicare + Choice  Bart of the 1997 Balanced Budget Act, expanded the array of insurance plan choices o Enactment has been “fraught” with problems  43 out of 347 plans announced their intention not to renew with Medicare, citing financial losses  54 HMO’s announced plans to reduce number of geographic regions Generalists v. Specialists  Doctors are paid based on time, energy, and skill (physicians’ work), practice expenses (like equipment), and premiums for malpractice insurance  The new payment schedule increased fees paid to generalists and decreased fees paid to specialists Future Directions  May need to shift more risk to beneficiaries  Replace Medicare’s commitment to provide a defined set of benefits to all eligible beneficiaries with a “premium support” system o Under this plan all beneficiaries would receive a predetermined amount to be applied to the purchase of a health plan providing defined benefits: essentially a voucher with an amount determined based on age, sex, geography, health risk, income, etc. Cutler, D., and J. Gruber, The Effect of Medicaid Expansions on Public Insurance, Private Insurance, and Redistribution, American Economic Review, Vol. 86, No. 2, May 1996 Health Reform

Feldstein, Martin, Balancing The Goals Of Health Care Provision And Financing Health Affairs, 25, no. 6 (2006): 1603-1611, 0.1377/hlthaff.25.6.1603
-Desirable healthcare system would achieve three goals -Provide healthcare to those who can‘t afford it -Mostly, it‘s only the very expensive bills that are problems for people. -People have different levels of interests in expensive treatments with low probabilities of success – need for choices -Avoid wasteful spending
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-Avoid wasteful spending -We need to be sure that value of improved health exceeds cost of additional healthcare -Allow care to reflect choices made by patient – problem of one-size-fits-all care -Maybe we should have a high coinsurance rate up to a certain amount -Health insurance reduces deprivation of care, but increases wasteful spending -There are essentially three important issues with health insurance -Patients are insulated from true costs -What to do about uninsured -What about expensive, untested emerging technologies? -Health savings accounts could solve some of these problems -Individuals deposit amounts equivalent to current deductibles -Withdraw money when they need care -Current HAS structure flawed -We want to make required contributions smaller -Concern about nonpayments – could be solved by giving hospitals ability to draw from HSAs

Fuchs, Victor R. and Ezekiel J. Emanuel, Health Care Reform: Why? What? When? Health Affairs, 24, no. 6 (2005): 1399-1414, 10.1377/hlthaff.24.6.1399

Why? o There are clear problems with U.S. healthcare system with many uninsured and high costs of care. Systematic problems include financing care and organizing delivery. o Employer-based insurance: fewer firms enjoy monopoly profits to draw on to subsidize health insurance for workers. Declines of unions also hurts this area. o Means-tested insurance: requires costly determination of eligibility, imposing a high marginal tax rate on recipients.  Medicaid and Medicare together cover 30%. This kind of insurance requires costly determination of eligibility, imposes high marginal tax rates on recipients, encourages evasion of reported income, and generates discontinuities of coverage as recipients move into and out of eligibility. o Organization and delivery of care: lack of information technology and quality control. o Also problematic are cost-benefit trade-offs, as financial incentives are often misaligned. Doctors want to deliver the best care possible, despite cost, but what about the uninsured?  Some experts advocate a complete overhaul of the financing of health care to give physicians the information, opportunity, and incentive to deliver costeffective care.

 What?

o Fundamental questions:  Should reform be incremental or comprehensive?  Should reform focus first on the financing of care or on the organization and delivery of care? o Incremental reform  Most of these kinds of reforms focus on financing and reducing the numbers of uninsured people.  Options  Employer mandates: all employers above some size offer their workers health insurance (maybe accompanied with tax credits or subsidies). o Attempt to eliminate ―free riders‖ Negative effects: loss of employment especially for low-wage
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 When?

o Negative effects: loss of employment especially for low-wage workers; mid-size firms could be discouraged from expanding and entering into the mandate; when mandates are at the state level, firms could have incentive to move to a state with a different mandate.  Subsidies o Provided for the uninsured through tax credits. o Advantage: increases freedom of choice; does not intrude directly on the labor market. o Indirect effects: could reduce the number of workers covered by employers; if subsidies are geared to income, additional disadvantages associated with determining eligibility and disincentives for those who might increase their income.  Other options  building on the Medicare/Medicaid programs  health savings accounts like consumer-directed healthcare focusing on cost-effectiveness  managed competition  quality incentives: paying for performance and subsidizing providers to install EMRs. o Comprehensive reforms  Goal is universal coverage.  Approaches  Personal mandates and subsidies: everyone American has health insurance that meets some minimum standard, government provides income-related subsidies or tax credits to the poor.  Single-payer proposals: imagine Medicare extended to cover all age groups, covering dental services, long-term care, prescription drugs, and more comprehensive mental health care. Private health insurance would be sharply restricted or eliminated entirely. o Good on paper, bad in practice. Patients and physicians make own arrangements for care, with patients paying out of pocket or with private insurance.  Voucher system: universal health care vouchers, combining publicly funded social insurance for base care with important elements of choice and competition. Individuals and families have free choice of plans and freedom to purchase additional services with their own after-tax dollars. o Reform priorities: finance or organization?  In order to reach organization, you need financial incentives. o Political climate makes changes difficult (note: article written in 2005). o Obstacles to reform  Satisfaction with status quo: many are satisfied with the current status quo. Even if two-thirds were dissatisfied, that is still a large minority that does not want reform  Single- issue groups: this group wants a change in the system, but they want different changes. Some want better coverage for demographic groups, others want more attention and resources for those with certain diseases, others want preventative care, others more patient involvement, and the list goes on.  U.S. system of government: checks and balances make change difficult. Any comprehensive change in health care will result in winners and losers. Prospective losers are likely to be more involved and effective in blocking the change than prospective winners.  Differences of opinion: proposal must overcome resistance from those who
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 Differences of opinion: proposal must overcome resistance from those who favor comprehensive reform but disagree on changes they want enacted. o Precipitators of reform  What could set the stage for comprehensive health care reform?  A major war, a depression, or large-scale civil unrest could change the political climate and overpower the obstacles.  Other possibilities: widespread dissatisfaction of the business community with employer-based insurance; state governments‘ ability to sustain the growing fiscal drain of means-tested insurance; a financial crisis with Medicare.  There also might be a growing realization by average Americans that the risk of the current system to them personally and to the country as a whole outweigh the risks of a comprehensive reform.

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