Federal Budget

College Students Need Macroeconomics Principles

Should we ditch macroeconomics or perhaps reduce it to two weeks?  In a recent blog post, Noah Smith argues that most of the material in a Principles of Macroeconomics class isn’t really necessary.  After teaching macro principles to more than 1,000 students per year since 2003, it is easy for me to find the blind spots in Noah’s view.  More than anything, it is pretty clear that Noah doesn’t spend much time with college students. 

Let me start with what Noah gets right: students should learn the Solow model for long-run growth, and the AD-AS model for business cycle analysis.  He also includes “the standard Milton Friedman, New Keynesian, AD-AS, accelerationist Phillips Curve theory of monetary policy.”

Now we come to Noah’s first howler: he believes that this material should take “about two weeks.”  Two?  What students is he teaching?  I teach at the University of Virginia, a really great university with super students.  But this takes six weeks, not two. When my students show up for macro principles, very few even know that interest rates are market prices.  I do teach the Solow model but most Macro principles instructors believe it is just too hard for the intro level. 

More than that, Noah leaves out a host of other macro topics that students need to learn at the intro level, whether they continue in economics or not.  This list includes:

1. Key macroeconomic variables.  These need to be defined, explained, and put in their proper historical perspective.  These include real GDP growth, unemployment, inflation, and interest rates.  And not just for the United States.

First off, the way we measure these variables actually matters.  Consider that unemployment rates do not include underemployed or out-of-labor force workers.  Or that GDP only includes market goods.  Both of these are relevant for policy and have been discussed in the media recently.  And historical perspective is really key here – it can be one of the best gifts you can give your students. What is a big number or a small number?  When unemployment is 7%, is that high or low?  How about in the U.S. versus Spain?  Or when real GDP grows by 4%, is that high or low?  How about the U.S. versus Mainland China?  Most college students won’t know this without a macro principles course.

2. The loanable funds market. You can’t understand financial collapse/contagion without a good understanding of the loanable funds market.  A big part of this discussion is also forming an intuitive understanding of interest rates, which is not natural for most students.  In my principles course (and textbook) I even cover mortgage-backed securities, securitization and moral hazard now so that the students understand the Great Recession.

3. Fiscal and monetary policy. In many universities, this is the one place where real economic policy is taught - Intermediate Macroeconomics typically focuses on theoretical models.  I view these policy discussions as voter education curriculum.  Students need to know what deficits mean and something about historical perspective here too.  They also need to know where government revenue comes from and how it is spent.  Hint: it’s not all spent on foreign aid and welfare!  And what about the Fed? This is the course where students learn about Fed policy and both actual and perceived effects on the economy. 

If time permits, it is great to also throw in international trade and finance, like the balance of payments (many misconceptions arise from a misunderstanding of how capital inflows are related to merchandise trade). 

Basically, to cover all of this takes about a semester.  It is foolish to think that two weeks is enough.

By the way, my favorite macro textbook covers all of these topics clearly in a great one-semester format.

Sex, Drugs and GDP in Europe

In September,  Eurostat waved a magic wand and increased the GDP in the European Union by 3.53 percent overnight. That is a full year's worth of very solid growth.  But it didn't make Europeans any wealthier because it was actually just due to a new definition of the way GDP is counted.  Eurostat (the economic statistics office of the European Commission) redefined GDP to include many transactions that were previously uncounted and are actually illegal across much of the Eurozone.
The new GDP definition includes illegal drug deals, prostitution, and even sales of stolen goods. Specifically, it includes illegal transactions as long as both parties agree to the transaction.
European-cannabis-lawsOstensibly, Eurostat is trying to capture part of the shadow economy that is typically not measured in GDP.  This makes sense, right? GDP is supposed to measure the output of final goods and services, so shouldn't we include all final goods and services even if the service is illegal?  In addition, this is complicated when the legality of goods and services varies across nations.  For example, the map to the right (from Wikimedia Commons) shows how cannabis laws vary across Europe - cannabis is essentially legal in some nations like the Netherlands but strictly illegal in others like France. 
So, normalizing the accounting standards across nations makes sense. But these illegal activities are difficult to measure.  In addition, if the illegal activities are a relatively stable portion of GDP, then there is really no bias when they are not included.  In fact, the new estimates, in an attempt to provide a more complete measure, may actually introduce more error into GDP measurement due to the difficulty of estimating illegal trade.  
So why the change in definition? There is another, perhaps insincere rationale: the new GDP measurements are a bit of an accounting trick to help nations lower their deficit to GDP ratios.  Many European nations are dealing with high deficit (and debt) to GDP ratios. The European Commission has explicit rules regarding these budget measures: a nation's deficit in a given fiscal year is not to exceed 3% of  their GDP, and the national debt is not to exceed 60% of GDP.  When nations exceed these bounds, the Council is directed to bring coercive measures called Excessive Deficit Procedures (EDRs). The Council has certainly been lax in enforcing these EDRs in recent years.  However, increasing GDP by simply redefining how it is measured automatically lowers deficit and debt ratios and helps nations with higher government debt levels. 
The figure below shows the effect of the new GDP definition on the GDP level each nation in 2013 (along with the overall EU and Euroarea).  The countries are ordered according to their GDP gains from the ESA 2010.
GDP percentage change ESA 10 mac
As you can see, GDP for Cyprus jumped 9.8% exclusively due to this accounting change.  This re-definition of GDP then shrank the debt-to-GDP ratio in Cyprus by a full half of a percentage point in 2013 - reducing it from 5.4% to 4.9%.  Therefore, this accounting rule change exaggerates any debt reduction in Cyprus, as they (hopefully) move closer to the EU goal of 3 percent.
So while new GDP accounting rules in Europe may normalize national income accounting across the continent, they are particularly helpful to those nations that already have high government debt levels.

Labor Force Participation Rate Keeps Falling

I've blogged about this before (see here), but the labor force participation rate (LFPR) just keeps falling.  Nobody sees this as positive news - more and more U.S. workers are sitting on the sidelines.  The latest jobs report brought the good news of a falling unemployment rate, but part of this is because workers are leaving the labor force.  As the graph below shows, the overall LFPR in the U.S. is now down to 62.7 percent, which is the lowest it has been since many women entered the labor force in the 1960s and 70s.  

One way to clarify the magnitude of this decline is to focus on the LFPR for men only.  This has steadily fallen from almost 90% in 1948 to just 69.1% currently (see the graph below).

Also, let's not conclude that this is all due to the aging of the baby boomers.  As Michael Strain recently noted in a series of tweets (here is one), the LFPR is declining even among those aged 25-54.  The LFPR for this age group is plotted below.
All of this means that the economy is not as healthy as we would like and that part of the reason why the unemployment rate is dropping is that people continue to leave the labor force.

Today's Unusual Fiscal Policy: Japan

Japan is simultaneously implementing both expansionary and contractionary fiscal policy.  According to The Wall Street Journal, the massive government debt has necessitated an increase in the national sales tax:

Prime Minister Shinzo Abe took a long-awaited decision to raise Japan's sales tax by 3 percentage points (LC: up to 8% total), placing the need to cut the nation's towering debt ahead of any risk to recent economic growth...

In order to offset this increase in taxes, Abe also promised an additional fiscal stimulus:

The stimulus measures total around ¥5 trillion ($51 billion), including cash-handouts to low-income families, Mr. Abe said. On top of that, there will be tax breaks valued at ¥1 trillion for companies making capital investments and wage increases.

Both of these policies are focused firmly on aggregate demand. 


CBO now Projects Higher National Debt Levels

Today, the Congressional Budget Office (CBO) revised upward its estimates for future U.S. federal debt levels.  As the graph below shows, the CBO  projects the federal debt held by the public to reach 100% of GDP in 2038. 

How bad is this news? Just last year, the CBO predicted that this debt measure would actually fall to just 53% by 2030.

The reasons for this massive revision are summarized nicely by Peter Coy at Bloomberg Business Week.  In short, they include:

  1. New budget agreements from January, which made the Bush tax cuts permanent for many Americans
  2. Longer life expectancy estimates, which mean higher costs for both Social Security and Medicare
  3. A growing number of worker disability claims
  4. Higher unemployment forecasts, which means lower GDP and higher Debt-to-GDP ratio

These factors work together to substantially worsen the long-term prospects of the U.S. national debt level.

Decline in Fertility Rate Finally Ends

The New York Times reports that U.S. birth rates were flat in 2012, ending a decline that began in 2007.  The falling birth rate seems to be linked to economic conditions:

In 2011, the Pew Research Center analyzed the fall in fertility by geography and found a strong link between falling fertility and economic malaise: the only state to show a slight increase in fertility between 2008 and 2009 was North Dakota, which had one of the lowest unemployment rates in the country.

Hat tip: Tyler Cowen.


People Confuse Deficits and Debt

Kevin Drum at Mother Jones reports on the public perception regarding the deficit and points to a google poll to illustrate his point. The chart below shows the current results. 

Deficit poll
Why do most people believe the deficit is increasing when we know it has been shrinking since 2011?  Kevin suggests that this is because people are too slow to change their opinion. 

I don't think that is the problem.  I think the problem is that people confuse deficits with the national debt, and the national debt is still growing because we actually still have large deficits.

Hat tip: Megan McArdle.