I missed class on February 4th (my bad) when Martin Feldstein of Harvard University gave the 4th lecture of his course “American Economic Policy,” but fortunately my classmate Matthew Tyler took notes and kindly accepted an invitation to post them as a guest on this blog. He also offers some personal reflections on what it feels like to be a left of center observer in a class taught by a self-avowed “conservative economist.” You can reach Matthew on twitter @Matt_B_Tyler .
Feldstein takes to the podium on a relatively mild Cambridge morning for this term’s fourth American Economic Policy lecture. The crowd has thinned slightly since day one, although the rapid tapping of laptop keys throughout suggests those who remain hang on every word. Like sponges, the economists of the future are absorbing the insights of a distinguished five decade career. Today, these eager young minds cover much ground: reflections on the Obama administration’s response to the great recession; the accuracy of real GDP measures; and skepticism regarding the size of the inequality problem in the United States.
It’s December 2008. The National Bureau of Economic Research has just declared the American economy has been in recession for almost 12 months. Both fiscal and monetary policy responses are falling short. $78 billion of tax rebates introduced by President Bush generated only $20 billion of additional consumer spending which was far less than the multiplier predicted by Feldstein, Summers and others. Similarly, traditional monetary policy is not working as the crisis was not caused by rising interest rates.
The recently elected Obama administration gets to work by trying to change incentives. Cash for clunkers provides a tax rebate for people to trade in their old car for a new one. Tax breaks are also extended to first home buyers. Both policies brought demand forward; automobile production underpinned two-thirds of GDP growth in quarter 3 of 2009 and the free fall in house prices temporarily stalled. However, neither policy had a sustained impact. By 2010, new car sales over the prior two years had not increased, and when the first home buyer’s rebate was withdrawn, house prices continued their decline.
The administration also oversaw an $800 billion stimulus package over three years: the American Recovery and Reinvestment Act. According to Feldstein, the package did more to stimulate votes for Congressmen and women than it did for aggregate demand. Poor package design diluted its impact: additional tax cuts, again with a low multiplier, constituted half of the expenditure; new and existing federal education programs received support; and some funds were transferred to state budgets. As a result, substantial sums did not flow to government agencies that buy goods and services such as defense, transportation and energy. The timing of the stimulus was also compromised as the promised “shovel ready” projects did not materialize. By the end of quarter 2 2009, a measly $40 billion had been spent. Total expenditure for the full 2009 year came in at $200 billion. This left a $500 billion hole in demand as household spending adjusted to a $12 trillion decline in household wealth. The upshot? Per-capita incomes did not return to pre-recession levels until the end of 2012.
Feldstein switches gears to the long term business cycle. Some basics lay the foundation. In the short run growth is a function of consumption, investment, government spending and net exports. In the long run, assuming full employment, growth is explained by labor supply, capital supply and total factor productivity. Each is impacted by government programs and tax policy. For instance, a shortfall of corporate savings is attributed by Feldstein to profits flowing offshore due to differences in tax policy across countries. Feldstein also muses that declining household saving rates over the last three decades, in spite of rising wealth, remains a mystery. Is this due to declining returns to savings, increased confidence in social security or something else? We’re not sure.
With the basics in place, Feldstein rocks the very foundations he has built by questioning the accurateness of real GDP data. Even calculating nominal GDP is challenging he explains. The government must accurately measure growth across every industry in the economy. The measurement complexity sky rockets when converting to real GDP. An inflation estimate involves drawing a representative sample of goods and services and then estimating changes in price. How though do you deal with changes in quality which may be reflected in price? How are new products dealt with? We’re reminded that this is particularly challenging given that 80 per cent of the American economy is services. “The margin of error is overwhelming.” On balance, new products and increased quality likely result in prices looking as if they are rising more quickly than they actually are. As a consequence, official estimates underestimate growth and productivity.
Despite these misgivings, we’re gently reminded that official statistics are often the best we’ve got and can tell an important story. Annual average growth from the non-farm business sector between 1950 and 2014 was 3.5 per cent. Over the next 10 years, this is set to drop to 2.5 per cent. On a per capita basis, this is equivalent to a decline by almost half. The primary cause? Declining labor supply as growth in female labor force participation declines. Lower savings rates are also playing their part. Overall however, Feldstein is positive about America’s future growth prospects. Despite the “low hanging fruit” (Gordon, 2012) being behind us, America can continue to obtain higher standards of living through real growth of 1, 2 or 3 per cent.
In closing, Feldstein casts doubt over the prevailing progressive inequality narrative in the United States. First he questions whether middle class incomes are really stagnating. A report from the nonpartisan Congressional Budget Office finds real cash income for the median family has increased by less than 15 per cent since the early 1980s or under 0.5 per cent per year. However, when increases to non-cash benefits are included (food stamps, health care) income growth rises to 45 per cent or 1.25 per cent per year. Further, adjusting for changes in household size increases these growth rates to 53 per cent and 1.43 per cent. Substantive and important differences with implications for politics, says Feldstein.
Running short on time, the most controversial point is saved till last as Piketty’s Capital is critiqued. Feldstein explains that clear conclusions regarding inequality are hampered by difficulties estimating income growth at the very top and very bottom. Piketty uses tax data to estimate incomes at the top. However, tax data does not reflect real income and instead reflects taxable income. Decreases in tax rates on capital income in 1981 and again in 1986, according to Feldstein, undermine Piketty’s conclusions. In response to tax cuts, investors rebalanced their portfolios towards assets that were not tax exempt, thus artificially inflating changes in taxable income at the top. Whilst we were admittedly short on time, Feldstein did not go on to explain what has underpinned ongoing increases in American inequality during the 90s and 2000s.
Nineteenth century British philosopher John Stuart Mill said “he who knows only his own side of the case knows little of that.” For the most part, Feldstein’s arguments – based on data and a masterful understanding of economic theory – are difficult to refute. There are occasions though where the specter of ideology rears its head. The words of Mill bring comfort as I, someone who identifies with the center-left, digest perspectives that depart from my own world view. With a wriggle in my chair and a deep breath I put any frustration to one side. As I continue to strengthen my own economic perspectives, I’m grateful for the chance to be challenged by a world leading conservative thinker and economist.
Matthew Tyler is an economist studying for a Masters of Public Policy at Harvard University. His studies, supported by the Menzies Foundation, examine policies to increase prosperity and promote social mobility. He is a former policy adviser to the Australian Labor Party, was an economist in Australia’s Foreign Service and commenced his career as a management consultant primarily focused on financial services.