The Economy Under Trump in 8 Charts – Mostly as Under Obama, Except Now With a Sharp Rise in the Government Deficit

A.  Introduction

President Trump is repeatedly asserting that the economy under his presidency (in contrast to that of his predecessor) is booming, with economic growth and jobs numbers that are unprecedented, and all a sign of his superb management skills.  The economy is indeed doing well, from a short-term perspective.  Growth has been good and unemployment is low.  But this is just a continuation of the trends that had been underway for most of Obama’s two terms in office (subsequent to his initial stabilization of an economy, that was in freefall as he entered office).

However, and importantly, the recent growth and jobs numbers are only being achieved with a high and rising fiscal deficit.  Federal government spending is now growing (in contrast to sharp cuts between 2010 and 2014, after which it was kept largely flat until mid-2017), while taxes (especially for the rich and for corporations) have been cut.  This has led to standard Keynesian stimulus, helping to keep growth up, but at precisely the wrong time.  Such stimulus was needed between 2010 and 2014, when unemployment was still high and declining only slowly.  Imagine what could have been done then to re-build our infrastructure, employing workers (and equipment) that were instead idle.

But now, with the economy at full employment, such policy instead has to be met with the Fed raising interest rates.  And with rising government expenditures and falling tax revenues, the result has been a rise in the fiscal deficit to a level that is unprecedented for the US at a time when the country is not at war and the economy is at or close to full employment.  One sees the impact especially clearly in the amounts the US Treasury has to borrow on the market to cover the deficit.  It has soared in 2018.

This blog post will look at these developments, tracing developments from 2008 (the year before Obama took office) to what the most recent data allow.  With this context, one can see what has been special, or not, under Trump.

First a note on sources:  Figures on real GDP, on foreign trade, and on government expenditures, are from the National Income and Product Accounts (NIPA) produced by the Bureau of Economic Analysis (BEA) of the Department of Commerce.  Figures on employment and unemployment are from the Bureau of Labor Statistics (BLS) of the Department of Labor.  Figures on the federal budget deficit are from the Congressional Budget Office (CBO).  And figures on government borrowing are from the US Treasury.

B.  The Growth in GDP and in the Number Employed, and the Unemployment Rate

First, what has happened to overall output, and to jobs?  The chart at the top of this post shows the growth of real GDP, presented in terms of growth over the same period one year before (in order to even out the normal quarterly fluctuations).  GDP was collapsing when Obama took office in January 2009.  He was then able to turn this around quickly, with positive quarterly growth returning in mid-2009, and by mid-2010 GDP was growing at a pace of over 3% (in terms of growth over the year-earlier period).  It then fluctuated within a range from about 1% to almost 4% for the remainder of his term in office.  It would have been higher had the Republican Congress not forced cuts in fiscal expenditures despite the continued unemployment.  But growth still averaged 2.2% per annum in real terms from mid-2009 to end-2016, despite those cuts.

GDP growth under Trump hit 3.0% (over the same period one year before) in the third quarter of 2018.  This is good.  And it is the best such growth since … 2015.  That is not really so special.

Net job growth has followed the same basic path as GDP:

 

Jobs were collapsing when Obama took office, he was quickly able to stabilize this with the stimulus package and other measures (especially by the Fed), and job growth resumed.  By late 2011, net job growth (in terms of rolling 12-month totals (which is the same as the increase over what jobs were one year before) was over 2 million per year.  It went to as high as 3 million by early 2015.  Under Trump, it hit 2 1/2 million by September 2018.  This is pretty good, especially with the economy now at or close to full employment.  And it is the best since … January 2017, the month Obama left office.

Finally, the unemployment rate:

Unemployment was rising rapidly as Obama was inaugurated, and hit 10% in late 2009.  It then fell, and at a remarkably steady pace.  It could have fallen faster had government spending not been cut back, but nonetheless it was falling.  And this has continued under Trump.  While commendable, it is not a miracle.

C.  Foreign Trade

Trump has also launched a trade war.  Starting in late 2017, high tariffs were imposed on imports of certain foreign-produced products, with such tariffs then raised and extended to other products when foreign countries responded (as one would expect) with tariffs of their own on selected US products.  Trump claims his new tariffs will reduce the US trade deficit.  As discussed in an earlier blog post, such a belief reflects a fundamental misunderstanding of how the trade balance is determined.

But what do we see in the data?:

The trade deficit has not been reduced – it has grown in 2018.  While it might appear there had been some recovery (reduction in the deficit) in the second quarter of the year, this was due to special factors.  Exports primarily of soybeans and corn to China (but also other products, and to other countries where new tariffs were anticipated) were rushed out in that quarter in order arrive before retaliatory tariffs were imposed (which they were – in July 2018 in the case of China).  But this was simply a bringing forward of products that, under normal conditions, would have been exported later.  And as one sees, the trade balance returned to its previous path in the third quarter.

The growing trade imbalance is a concern.  For 2018, it is on course for reaching 5% of GDP (when measured in constant prices of 2012).  But as was discussed in the earlier blog post on the determination of the trade balance, it is not tariffs which determine what that overall balance will be for the economy.  Rather, it is basic macro factors (the balance between domestic savings and domestic investment) that determine what the overall trade balance will be.  Tariffs may affect the pattern of trade (shifting imports and exports from one country to another), but they won’t reduce the overall deficit unless the domestic savings/investment balance is changed.  And tariffs have little effect on that balance.

And while the trend of a growing trade imbalance since Trump took office is a continuation of the trend seen in the years before, when Obama was president, there is a key difference.  Under Obama, the trade deficit did increase (become more negative), especially from its lowest point in the middle of 2009.  But this increase in the deficit was not driven by higher government spending – government spending on goods and services (both as a share of GDP and in constant dollar terms) actually fell.  That is, government savings rose (dissavings was reduced, as there was a deficit).  Private domestic savings was also largely unchanged (as a share of GDP).  Rather, what drove the higher trade deficit during Obama’s term was the recovery in private investment from the low point it had reached in the 2008/09 recession.

The situation under Trump is different.  Government spending is now growing, as is the government deficit, and this is driving the trade deficit higher.  We will discuss this next.

D.  Government Accounts

An increase in government spending is needed in an economic downturn to sustain demand so that unemployment will be reduced (or at least not rise by as much otherwise).  Thus government spending was allowed to rise in 2008, in the last year of the Bush administration, in response to the downturn that began in December 2007.  This continued, and was indeed accelerated, as part of the stimulus program passed by Congress soon after Obama took office.  But federal government spending on goods and services peaked in mid-2010, and after that fell.  The Republican Congress forced further expenditure cuts, and by late 2013 the federal government was spending less (in real terms) than it was in early 2008:

This was foolish.  Unemployment was over 9 1/2% in mid-2010, and still over 6 1/2% in late-2013 (see the chart of the unemployment rate above).  And while the unemployment rate did fall over this period, there was justified criticism that the pace of recovery was slow.  The cuts in government spending during this period acted as a major drag on the economy, holding back the pace of recovery.  Never before had a US administration done this in the period after a downturn (at least not in the last half-century where I have examined the data).  Government spending grew especially rapidly under Reagan following the 1981/82 downturn.

Federal government spending on goods and services was then essentially flat in real terms from late 2013 to the end of Obama’s term in office.  And this more or less continued through FY2017 (the last budget of Obama), i.e. through the third quarter of CY2018.  But then, in the fourth quarter of CY2017 (the first quarter of FY2018, as the fiscal year runs from October to September), in the first full budget under Trump, federal government spending started to rise sharply.  See the chart above.  And this has continued.

There are certainly high priority government spending needs.  But the sequencing has been terribly mismanaged.  Higher government spending (e.g. to repair our public infrastructure) could have been carried out when unemployment was still high.  Utilizing idle resources, one would not only have put people to work, but also would have done this at little cost to the overall economy.  The workers were unemployed otherwise.

But higher government spending now, when unemployment is low, means that workers hired for government-funded projects have to be drawn from other activities.  While the unemployment rate can be squeezed downward some, and has been, there is a limit to how far this can go.  And since we are close to that limit, the Fed is raising interest rates in order to curtail other spending.

One sees this in the numbers.  Overall private fixed investment fell at an annual rate of 0.3% in the third quarter of 2018 (based on the initial estimates released by the BEA in late October), led by a 7.9% fall in business investment in structures (offices, etc.) and by a 4.0% fall in residential investment (homes).  While these are figures only for one quarter (there was a deceleration in the second quarter, but not an absolute fall), and can be expected to eventually change (with the economy growing, investment will at some point need to rise to catch up), the direction so far is worrisome.

And note also that this fall in the pace of investment has happened despite the huge cuts in corporate taxes from the start of this year.  Trump officials and Republicans in Congress asserted that the cuts in taxes on corporate profits would lead to a surge in investment.  Many economists (including myself, in the post cited above) noted that there was little reason to believe such tax cuts would sput corporate investment.  Such investment in the US is not now constrained by a lack of available cash to the corporations, so giving them more cash is not going to make much of a difference.  Rather, that windfall would instead lead corporations to increase dividends as well as share buybacks in order to distribute the excess cash to their shareholders.  And that is indeed what has happened, with share buybacks hitting record levels this year.

Returning to government spending, for the overall impact on the economy one should also examine such spending at the state and local level, in addition to the federal.  The picture is largely similar:

This mostly follows the same pattern as seen above for federal government spending on goods and services, with the exception that there was an increase in total government spending from early 2014 to early-2016, when federal spending was largely flat.  This may explain, in part, the relatively better growth in GDP seen over that period (see the chart at the top of this post), and then the slower pace in 2016 as all spending leveled off.

But then, starting in late-2017, total government expenditures on goods and services started to rise.  It was, however, largely driven by the federal government component.  Even though federal government spending accounted only for a bit over one-third (38%) of total government spending on goods and services in the quarter when Trump took office, almost two-thirds (65%) of the increase in government spending since then was due to higher spending by the federal government.  All this is classical Keynesian stimulus, but at a time when the economy is close to full employment.

So far we have focused on government spending on goods and services, as that is the component of government spending which enters directly as a component of GDP spending.  It is also the component of the government accounts which will in general have the largest multiplier effect on GDP.  But to arrive at the overall fiscal deficit, one must also take into account government spending on transfers (such as for Social Security), as well as tax revenues.  For these, and for the overall deficit, it is best to move to fiscal year numbers, where the Congressional Budget Office (CBO) provides the most easily accessible and up-to-date figures.

Tracing the overall federal fiscal deficit, now by fiscal year and in nominal dollar terms, one finds:

The deficit is now growing (the fiscal balance is becoming more negative) and indeed has been since FY2016.  What happened in FY2016?  Primarily there was a sharp reduction in the pace of tax revenues being collected.  And this has continued through FY2018, spurred further by the major tax cut bill of December 2017.  Taxes had been rising, along with the economic recovery, increasing by an average of $217 billion per year between FY2010 and FY2015 (calculated from CBO figures), but this then decelerated to a pace of just $26 billion per year between FY2015 and FY2018, and just $13 billion in FY2018.  The rate of growth in taxes between FY2015 and FY2018 was just 0.8%, or less even than just inflation.

Federal government spending, including on transfers, also rose over this period, but by less than taxes fell.  Overall federal government spending rose by an average of just $46 billion per year between FY2010 and FY2015 (a rate of growth of 1.3% per annum, or less than inflation in those years), and then by $140 billion per year (in nominal dollar terms) between FY2015 and FY2018.  But this step up in overall spending (of $94 billion per year) was well less than the step down in the pace of tax collection (a reduction of $191 billion per year, the difference between $217 billion annual growth over FY2010-15 and the $26 billion annual growth over FY2015-18).

That is, about two-thirds (67%) of the increase in the fiscal deficit since FY2015 can be attributed to taxes being cut, and just one-third (33%) to spending going up.

Looking forward, this is expected to get far worse.  As was discussed in an earlier post on this blog, the CBO is forecasting (in their most recent forecast, from April 2018) that the fiscal deficits under Trump will reach close to $1 trillion in FY2019, and will exceed 5% of GDP for most of the 2020s.  This is unprecedented for the US economy at full employment, other than during World War II.  Furthermore, these CBO forecasts are under the optimistic scenario that there will be no economic downturn over this period.  But that has never happened before in the US.

Deficits need to be funded by borrowing.  And one sees an especially sharp jump in the net amount being borrowed in the markets in CY 2018:

 

These figures are for calendar years, and the number for 2018 includes what the US Treasury announced on October 29 it expects to borrow in the fourth quarter.  Note this borrowing is what the Treasury does in the regular, commercial, markets, and is a net figure (i.e. new borrowing less repayment of debt coming due).  It comes after whatever the net impact of public trust fund operations (such as for the Social Security Trust Fund) is on Treasury funding needs.

The turnaround in 2018 is stark.  The US Treasury now expects to borrow in the financial markets, net, a total of $1,338 billion in 2018, up from $546 billion in 2017.  And this is at time of low unemployment, in sharp contrast to 2008 to 2010, when the economy had fallen into the worst economic downturn since the Great Depression  Tax revenues were then low (incomes were low) while spending needed to be kept up.  The last time unemployment was low and similar to what it is now, in the late-1990s during the Clinton administration, the fiscal accounts were in surplus.  They are far from that now. 

E. Conclusion 

The economy has continued to grow since Trump took office, with GDP and employment rising and unemployment falling.  This has been at rates much the same as we saw under Obama.  There is, however, one big difference.  Fiscal deficits are now rising rapidly.  Such deficits are unprecedented for the US at a time when unemployment is low.  And the deficits have led to a sharp jump in Treasury borrowing needs.

These deficits are forecast to get worse in the coming years even if the economy should remain at full employment.  Yet there will eventually be a downturn.  There always has been.  And when that happens, deficits will jump even further, as taxes will fall in a downturn while spending needs will rise.

Other countries have tried such populist economic policies as Trump is now following, when despite high fiscal deficits at a time of full employment, taxes are cut while government spending is raised.  They have always, in the end, led to disasters.

The Mismanagement of Fiscal Policy Under Trump: Deficits When There Should be Surpluses

A.  Introduction

Since World War II, the US has never run such high fiscal deficits in times of full employment as it will now.  With the tax cuts pushed through by the Republican Congress and signed into law by Trump in December, and to a lesser extent the budget passed in March, it is expected that the US will soon be running a fiscal deficit of over $1.0 trillion a year, exceeding 5% of GDP.  This is unprecedented.

We now have good estimates of how high the deficits will grow under current policy and in a scenario which assumes (optimistically) that the economy will remain at full employment, with no downturn.  The Congressional Budget Office (CBO) published on April 9 its regular report on “The Budget and Economic Outlook”, this year covering fiscal years 2018 to 2028.  In this report to Congress and to the public, the CBO assesses the implications of federal budget and tax policy, as set out under current law.  The report normally comes out in January or February of each year but was delayed this year in order to reflect the tax bill approved in December and also the FY18 budget, which was only approved in March (even though the fiscal year began last October).

The forecast is that the deficits will now balloon.  This should not be a surprise given the magnitude of the tax cuts pushed through Congress in December and then signed into law by Trump, but recall that the Republicans pushing through the tax bill asserted deficits would not increase as a result.  The budget approved in March also provides for significant increases in legislated spending – especially for the military but also for certain domestic programs.  But as will be discussed below, government spending (other than on interest) over the next decade is in fact now forecast by the CBO to be less than what it had forecast last June.

The CBO assessment is the first set of official estimates of what the overall impact will be.  And they are big.  The CBO forecasts that even though the economy is now at full employment (and assumed to remain there for the purposes of the scenario used), deficits are forecast to grow to just short of $1 trillion in FY2019, and then continue to increase, reaching over $1.5 trillion by FY2028.  In dollar terms, it has never been that high – not even in 2009 at the worst point in the recession following the 2008 collapse of the economy.

That is terrible fiscal policy.  While high fiscal deficits are to be expected during times of high unemployment (as tax revenues are down, while government spending is the only stabilizing element for the economy when both households and corporations are cutting back on spending due to the downturn), standard policy would be to limit deficits in times of full employment in order to bring down the public debt to GDP ratio.  But with the tax cuts and spending plans this is not going to happen under Trump, even should the economy remain at full employment.  And it will be far worse when the economy once again dips into a recession, as always happens eventually.

This blog post will first discuss the numbers in the new CBO forecasts, then the policy one should follow over the course of the business cycle in order to keep the public debt to GDP under control, and finally will look at the historical relationship between unemployment and the fiscal deficit, and how the choices made on the deficit by Trump and the Republican-controlled Congress are unprecedented and far from the historical norms.

B.  The CBO Forecast of the Fiscal Deficits

The forecasts made by the CBO of the fiscal accounts that would follow under current policies are always eagerly awaited by those concerned with what Congress is doing.  Ten-year budget forecasts are provided by the CBO at least annually, and typically twice or even three times a year, depending on the decisions being made by Congress.

The CBO itself is non-partisan, with a large professional staff and a director who is appointed to a four-year term (with no limits on its renewal) by the then leaders in Congress.  The current director, Keith Hall, took over on April 1, 2015, when both the House and the Senate were under Republican control.  He replaced Doug Elmensdorf, who was widely respected as both capable and impartial, but who had come to the end of a term.  Many advocated that he be reappointed, but Elmensdorf had first taken the position when Democrats controlled the House and the Senate.  Hall is a Republican, having served in senior positions in the George W. Bush administration, and there was concern that his appointment signaled an intent to politicize the position.

But as much as his party background, a key consideration appeared to have been Hall’s support for the view that tax cuts would, through their impact on incentives, lead to more rapid growth, with that more rapid growth then generating more tax revenue which would partially or even fully offset the losses from the lower tax rates.  I do not agree.  An earlier post on this blog discussed that that argument is incomplete, and does not take into account that there are income as well as substitution effects (as well as much more), which limit or offset what the impact might be from substitution effects alone.  And another post on this blog looked at the historical experience after the Reagan and Bush tax cuts, in comparison to the experience after the (more modest) increases in tax rates on higher income groups under Clinton and Obama.  It found no evidence in support of the argument that growth will be faster after tax cuts than when taxes are raised.  What the data suggest, rather, is that there was little to no impact on growth in one direction or the other.  Where there was a clear impact, however, was on the fiscal deficits, which rose with the tax cuts and fell with the tax increases.

Given Hall’s views on taxes, it was thus of interest to see whether the CBO would now forecast that an acceleration in GDP growth would follow from the new tax cuts sufficient to offset the lower tax revenues following from the lower tax rates.  The answer is no.  While the CBO did forecast that GDP would be modestly higher as a result of the tax cuts (peaking at 1.0% higher than would otherwise be the case in 2022 before then diminishing over time, and keep in mind that these are for the forecast levels of GDP, not of its growth), this modestly higher GDP would not suffice to offset the lower tax revenues following from the lower tax rates.

Taking account of all the legislative changes in tax law since its prior forecasts issued in June 2017, the CBO estimated that fiscal revenues collected over the ten years FY2018 to FY2027 would fall by $1.7 trillion from what it would have been under previous law.  However, after taking into account its forecast of the resulting macroeconomic effects (as well as certain technical changes it made in its forecasts), the net impact would be a $1.0 trillion loss in revenues.  This is almost exactly the same loss as had been estimated by the staff of the Joint Committee on Taxation for the December tax bill, which also factored in an estimate of a (modest) impact on growth from the lower tax rates.

Fiscal spending projections were also provided, and the CBO estimated that legislative changes alone (since its previous estimates in June 2017) would raise spending (excluding interest) by $450 billion over the ten year period.  However, after taking into account certain macro feedbacks as well as technical changes in the forecasts, the CBO is now forecasting government spending will in fact be $100 billion less over the ten years than it had forecast last June.  The higher deficits over those earlier forecast are not coming from higher spending but rather totally from the tax cuts.

Finally, the higher deficits will have to be funded by higher government borrowing, and this will lead to higher interest costs.  Interest costs will also be higher as the expansionary fiscal policy at a time when the economy is already at full employment will lead to higher interest rates, and those higher interest rates will apply to the entire public debt, not just to the increment in debt resulting from the higher deficits.  The CBO forecasts that higher interest costs will add $650 billion to the deficits over the ten years.

The total effect of all this will thus be to increase the fiscal deficit by $1.6 trillion over the ten years, over what it would otherwise have been.  The resulting annual fiscal deficits, in billions of dollars, would be as shown in the chart at top of this post.  Under the assumed scenario that the economy will remain at full employment over the entire period, the fiscal deficit will still rise to reach almost $1 trillion in FY19, and then to over $1.5 trillion in FY28.  Such deficits are unprecedented for when the economy is at full employment.

The deficits forecast would then translate into these shares of GDP, given the GDP forecasts:

The CBO is forecasting that fiscal deficits will rise to a range of 4 1/2 to 5 1/2% of GDP from FY2019 onwards.  Again, this is unprecedented for the US economy in times of full employment.

C.  Fiscal Policy Over the Course of the Business Cycle

As noted above, fiscal policy has an important role to play during economic downturns to stabilize conditions and to launch a recovery.  When something causes an economic downturn (such as the decision during the Bush II administration not to regulate banks properly in the lead up to the 2008 collapse, believing “the markets” would do this best), both households and corporations will reduce their spending.  With unemployment increasing and wages often falling even for those fortunate enough to remain employed, as well as with the heightened general concerns on the economy, households will cut back on their spending.  Similarly, corporations will seek to conserve cash in the downturns, and will cut back on their spending both for the inputs they would use for current production (they cannot sell all of their product anyway) and for capital investments (their production facilities are not being fully used, so why add to capacity).

Only government can sustain the economy in such times, stopping the downward spiral through its spending.  Fiscal stimulus is needed, and the Obama stimulus program passed early in his first year succeeded in pulling the economy out of the freefall it was in at the time of his inauguration.  GDP fell at an astounding 8.2% annual rate in the fourth quarter of 2008 and was still crashing in early 2009 as Obama was being sworn in.  It then stabilized in the second quarter of 2009 and started to rise in the third quarter.  The stimulus program, as well as aggressive action by the Federal Reserve, accounts for this turnaround.

But fiscal deficits will be high during such economic downturns.  While any stimulus programs will add to this, most of the increase in the deficits in such periods occur automatically, primarily due to lower tax revenues in the downturn.  Incomes and employment are lower, so taxes due will be lower.  There is also, but to a much smaller extent, some automatic increase in government spending during the downturns, as funds are paid out in unemployment insurance or for food stamps for the increased number of the poor.  The deficits will then add to the public debt, and the public debt to GDP ratio will rise sharply (exacerbated in the short run by the lower GDP as well).

One confusion, sometimes seen in news reports, should be clarified.  While fiscal deficits will be high in a downturn, for the reasons noted above, and any stimulus program will add further to those deficits, one should not equate the size of the fiscal deficit with the size of the stimulus.  They are two different things.  For example, normally the greatest stimulus, for any dollar of expenditures, will come from employing directly blue-collar workers in some government funded program (such as to build or maintain roads and other such infrastructure).  A tax cut focused on the poor and middle classes, who will spend any extra dollar they receive, will also normally lead to significant stimulus (although probably less than via directly employing a worker).  But a tax cut focused on the rich will provide only limited stimulus as any extra dollar they receive will mostly simply be saved (or used to pay down debt, which is economically the same thing).  The rich are not constrained in how much they can spend on consumption by their income, as their income is high enough to allow them to consume as much as they wish.

Each of these three examples will add equally to the fiscal deficit, whether the dollar is used to employ workers directly, to provide a tax cut to the poor and middle classes, or to provide a tax cut to the rich.  But the degree of stimulus per dollar added to the deficit can be dramatically different.  One cannot equate the size of the deficit to the amount of stimulus.

Deficits are thus to be expected, and indeed warranted, in a downturn.  But while the resulting increase in public debt is to be expected in such conditions, there must also come a time for the fiscal deficits to be reduced to a level where at least the debt to GDP ratio, if not the absolute level of the debt itself, will be reduced.  Debt cannot be allowed to grow without limit.  And the time to do this is when the economy is at full employment.  It was thus the height of fiscal malpractice for the tax bills and budget passed by Congress and signed into law by Trump not to provide for this, but rather for the precise opposite.  The CBO estimates show that deficits will rise rather than fall, even under a scenario where the economy is assumed to remain at full employment.

It should also be noted that the deficit need not be reduced all the way to zero for the debt to GDP ratio to fall.  With a growing GDP and other factors (interest rates, the rate of inflation, and the debt to GDP ratio) similar to what they are now, a good rule of thumb is that the public debt to GDP ratio will fall as long as the fiscal deficit is around 3% of GDP or less.  But the budget and tax bills of Trump and the Congress will instead lead to deficits of around 5% of GDP.  Hence the debt to GDP ratio will rise.

[Technical note for those interested:  The arithmetic of the relationship between the fiscal deficit and the debt to GDP ratio is simple.  A reasonable forecast, given stated Fed targets, is for an interest rate on long-term public debt of 4% and an inflation rate of 2%.  This implies a real interest rate of 2%.  With real GDP also assumed to grow in the CBO forecast at 2% a year (from 2017 to 2028), the public debt to GDP ratio will be constant if what is called the “primary balance” is zero (as the numerator, public debt, will then grow at the same rate as the denominator, GDP, each at either 2% a year in real terms or 4% a year in nominal terms) .  The primary balance is the fiscal deficit excluding what is paid in interest on the debt.  The public debt to GDP ratio, as of the end of FY17, was 76.5%.  With a nominal interest rate of 4%, this would lead to interest payments on the debt of 3% of GDP.  A primary balance of zero would then imply an overall fiscal deficit of 3% of GDP.  Hence a fiscal deficit of 3% or less, with the public debt to GDP ratio roughly where it is now, will lead to a steady debt to GDP ratio.

More generally, the debt to GDP ratio will be constant whenever the rate of growth of real GDP matches the real interest rate, and the primary balance is zero.  In the case here, the growth in the numerator of debt (4% in nominal terms, or 2% in real terms when inflation is 2%) matches the growth in the denominator of GDP (2% in real terms, or 4% in nominal terms), and the ratio will thus be constant.]

Putting this in a longer-term context:

Federal government debt rose to over 100% of GDP during World War II.  The war spending was necessary.  But it did not then doom the US to perpetual economic stagnation or worse.  Rather, fiscal deficits were kept modest, the economy grew well, and over the next several decades the debt to GDP ratio fell.

For the fiscal balances over this period (with fiscal deficits as negative and fiscal surpluses as positive):

Fiscal balances were mostly but modestly in deficit (and occasionally in surplus) through the 1950s, 60s, and 70s.  The 3% fiscal deficit rule of thumb worked well, and one can see that as long as the fiscal deficit remained below 3% of GDP, the public debt to GDP ratio fell, to a low of 23% of GDP in FY1974.  It then stabilized at around this level for a few years, but reversed and started heading in FY1982 after Reagan took office.  And it kept going up even after the economy had recovered from the 1982 recession and the country was back to full employment, as deficits remained high following the Reagan tax cuts.

The new Clinton budgets, along with the tax increase passed in 1993, then stabilized the accounts, and the economy grew strongly.  The public debt to GDP ratio, which had close to doubled under Reagan and Bush I (from 25% of GDP to 48%), was reduced to 31% of GDP by the year Clinton left office.   But it then started to rise again following the tax cuts of Bush II (plus with the first of the two recessions under Bush II).  And it exploded in 2008/2009, at the end of Bush II and the start of Obama, as the economy plunged into the worst economic downturn since the Great Depression.

The debt to GDP ratio did stabilize, however, in the second Obama term, and actually fell slightly in FY2015 (when the deficit was 2.4% of GDP).  But with the deficits now forecast to rise to the vicinity of 5% of GDP (and to this level even with the assumption that there will not be an economic downturn at some point), the public debt to GDP ratio will soon be approaching 100% of GDP.

This does not have to happen.  As noted above, one need not bring the fiscal deficits all the way down to zero.  A fiscal deficit kept at around 3% of GDP would suffice to stabilize the public debt to GDP ratio, while something less than 3% would bring it down.

D.  Historical Norms

What stands out in these forecasts is how much the deficits anticipated now differ from the historical norms.  The CBO report has data on the deficits going back to FY1968 (fifty years), and these can be used to examine the relationship with unemployment.  As discussed above, one should expect higher deficits during an economic downturn when unemployment is high.  But these deficits then need to be balanced with lower deficits when unemployment is lower (and sufficiently low when the economy is at or near full employment that the public debt to GDP ratio will fall).

A simple scatter-plot of the fiscal balance (where fiscal deficits are a negative balance) versus the unemployment rate, for the period from FY1968 to now and then the CBO forecasts to FY2028, shows:

While there is much going on in the economy that affects the fiscal balance, this scatter plot shows a surprisingly consistent relationship between the fiscal balance and the rate of unemployment.  The red line shows what the simple regression line would be for the historical years of FY1968 to FY2016.  The scatter around it is surprisingly tight.  [Technical Note:  The t-statistic is 10.0, where anything greater than 2.0 is traditionally considered significant, and the R-squared is 0.68, which is high for such a scatter plot.]

An interesting finding is that the high deficits in the early Obama years are actually very close to what one would expect given the historical norm, given the unemployment rates Obama faced on taking office and in his first few years in office.  That is, the Obama stimulus programs did not cause the fiscal deficits to grow beyond what would have been expected given what the US has had in the past.  The deficits were high because unemployment was high following the 2008 collapse.

At the other end of the line, one has the fiscal surpluses in the years FY1998 to 2000 at the end of the Clinton presidency.  As noted above, the public debt to GDP ratio stabilized soon after Clinton took office (in part due to the tax increases passed in 1993), with the fiscal deficits reduced to less than 3% of GDP.  Unemployment fell to below 5% by mid-1997 and to a low of 3.8% in mid-2000, as the economy grew well.  By FY1998 the fiscal accounts were in surplus.  And as seen in the scatter plot above, the relationship between unemployment and the fiscal balance was close in those years (FY1998 to 2000) to what one would expect given the historical norms for the US.

But the tax cuts and budget passed by Congress and signed by Trump will now lead the fiscal accounts to a path far from the historical norms.  Instead of a budget surplus (as in the later Clinton years, when the unemployment rate was similar to what the CBO assumes will hold for its scenario), or even a deficit kept to 3% of GDP or less (which would suffice to stabilize the debt to GDP ratio), deficits of 4 1/2 to 5 1/2 % of GDP are foreseen.  The scatter of points for the fiscal deficit vs. unemployment relationship for 2018 to 2028 is in a bunch by itself, down and well to the left of the regression line.  One has not had such deficits in times of full employment since World War II.

E.  Conclusion

Fiscal policy is being mismanaged.  The economy reached full employment by the end of the Obama administration, fiscal deficits had come down, and the public debt to GDP ratio had stabilized.  There was certainly more to be done to bring down the deficit further, and with the aging of the population (retiring baby boomers), government expenditures (for Social Security and especially for Medicare and other health programs) will need to increase in the coming years.  Tax revenues to meet such needs will need to rise.

But the Republican-controlled Congress and Trump pushed through measures that will do the opposite.  Taxes have been cut dramatically (especially for corporations and rich households), while the budget passed in March will raise government spending (especially for the military).  Even assuming the economy will remain at full employment with no downturn over the next decade (which would be unprecedented), fiscal deficits will rise to around 5% of GDP.  As a consequence, the public debt to GDP ratio will rise steadily.

This is unprecedented.  With the economy at full employment, deficits should be reduced, not increased.  They need not go all the way to zero, even though Clinton was able to achieve that.  A fiscal deficit of 3% of GDP (where it was in the latter years of the Obama administration) would stabilize the debt to GDP ratio.  But Congress and Trump pushed through measures to raise the deficit rather than reduce it.

This leaves the economy vulnerable.  There will eventually be another economic downturn.  There always is one, eventually.  The deficit will then soar, as it did in 2008/2009, and remain high until the economy fully recovers.  But there will then be pressure not to allow the debt to rise even further.  This is what happened following the 2010 elections, when the Republicans gained control of the House.  With control over the budget, they were able to cut government spending even though unemployment was still high.  Because of this, the pace of the recovery was slower than it need have been.  While the economy did eventually return to full employment by the end of Obama’s second term, unemployment remained higher than should have been the case for several years as a consequence of the cuts.

At the next downturn, the fiscal accounts will be in a poor position to respond as they need to in a crisis.  Public debt, already high, will soar to unprecedented levels, and there will be arguments from conservatives not to allow the debt to rise even further.  Recovery will then be even more difficult, and many will suffer as a result.

Taxes to Pay for Highways: A Switch from the Tax on Gallons of Fuel Burned to a Tax on Miles Driven Would Be Stupid

Impact of Switching from Fuel Tax on Gallons Burned to Tax on Miles Driven

A.  Introduction

According to a recent report in the Washington Post, a significant and increasing number of state public officials and politicians are advocating for a change in the tax system the US uses to support highway building and maintenance.  The current system is based on a tax on gallons of fuel burned, and the proposed new system would be based on the number of miles a car is driven.  At least four East Coast states are proposing pilots on how this might be done, some West Coast states have already launched pilots, and states are applying for federal grants to consider the change.  There is indeed even a lobbying group based in Washington now advocating it:  The Mileage-Based User Fee Alliance.

There is no question that the current federal gas tax of 18.4 cents per gallon of gasoline is woefully inadequate.  It was last changed in 1993, 23 years ago, and has been kept constant in nominal terms ever since.  With general prices (based on the CPI) now 65% higher, 18.4 cents now will only buy 11.2 cents at the prices of 1993, a decline of close to 40%.  As a result, the Highway Trust Fund is terribly underfunded, and with all the politics involved in trying to find other sources of funding, our highways are in terrible shape. Basic maintenance is simply not being done.

An obvious solution would be simply to raise the gas tax back at least to where it was before in real terms.  Based on where the tax was when last set in 1993 and on the CPI for inflation since then, this would be 30.3 cents per gallon now, an increase of 11.9 cents from the current 18.4 cents per gallon.  Going back even further, the gasoline tax was set at 4 cents per gallon in 1959, to fund the construction of the then new Interstate Highway system (as well as for general highway maintenance).  Adjusting for inflation, that tax would be 32.7 cents per gallon now.  Also, looking at what the tax would need to be to fund adequately the Highway Trust Fund, a Congressional Budget Office report issued in 2014 estimated that a 10 to 15 cent increase (hence 28.4 cents to 33.4 cents per gallon) would be needed (based on projections through 2024).

These fuel tax figures are all similar.  Note also that while some are arguing that the Highway Trust Fund is underfunded because cars are now more fuel efficient than before, this is not the case.  Simply bringing the tax rate back in real terms to where it was before (30.3 cents based on the 1993 level or 32.7 cents based on the 1959 level) would bring the rate to within the 28.4 to 33.4 cents range that the CBO estimates is needed to fully fund the Highway Trust Fund.  The problem is not fuel efficiency, but rather the refusal to adjust the per gallon tax rate for inflation.

But Congress has refused to approve any such increase.  Anti-tax hardliners simply refuse to consider what they view as an increase in taxes, even though the measure would simply bring them back in real terms to where they were before.  And it is not even true that the general population is against an increase in the gas tax.  According to a poll sponsored by the Mineta Transportation Institute (a transportation think tank based at San Jose State University in California), 75% of those polled would support an immediate increase in the gas tax of 10 cents a gallon if the funds are dedicated to maintenance of our streets, roads, and highways (see the video clip embedded in the Washington Post article, starting at minute 3:00).

In the face of this refusal by Congress, some officials are advocating for a change in the tax, from a tax per gallon of fuel burned to a new tax per mile each car is driven.  While I do not see how this would address the opposition of the anti-tax politicians (this would indeed be a totally new tax, not an adjustment in the old tax to keep it from falling in real terms), there appears to be a belief among some that this would be accepted.

But even if such a new tax were viewed as politically possible, it would be an incredibly bad public policy move to replace the current tax on fuel burned with such a tax on miles driven.  It would in essence be a tax on fuel efficiency, with major distributional (as well as other) consequences, favoring those who buy gas guzzlers.  And as it would encourage the purchase of heavy gas guzzlers (relative to the policy now in place), it would also lead to more than proportional damage to our roads, meaning that road conditions would deteriorate further rather than improve.

This blog post will discuss why such consequences would follow.  To keep things simple, it will focus on the tax on gasoline (which I will sometimes simply referred to as gas, or as fuel).  There are similar, but separate taxes, on diesel and other fuels, and their levels should be adjusted proportionally with any adjustment for gasoline.  There is also the issue of the appropriate taxes to be paid by trucks and other heavy commercial vehicles.  That is an important, but separate, issue, and is not addressed here.

B.  The Proposed Switch Would Penalize Fuel Efficient Vehicles

The reports indicate that the policy being considered would impose a tax of perhaps 1.5 cents per mile driven in substitution for the current federal tax of 18.4 cents per gallon of gas burned (states have their own fuel taxes in addition, with these varying across states). For the calculations here I will take the 1.5 cent figure as the basis for the comparisons, even though no specific figure is as yet set.

First of all, it should be noted that at the current miles driven in the country and the average fuel economy of the stock of cars being driven, a tax of 1.5 cents per mile would raise substantially more in taxes than the current 18.4 cents per gallon of gas.  That is, at these rates, there would be a substantial tax increase.

Using figures for 2014, the average fuel efficiency (in miles per gallon) of the light duty fleet of motor vehicles in the US was 21.4 miles per gallon, and the average miles driven per driver was 13,476 miles.  At a tax of 1.5 cents per mile driven, the average driver would pay $202.14 (= $.015 x 13,476) in such taxes per year.  With an average fuel economy of 21.4 mpg, such a driver would burn 629.7 gallons per year, and at the current fuel tax of 18.4 cents per gallon, is now paying $115.87 (= $.184 x 629.7) in gas taxes per year. Hence the tax would rise by almost 75% ($202.14 / $115.87).  A 75% increase would be equivalent to raising the fuel tax from the current 18.4 cents to a rate of 32.1 cents per gallon.  While higher tax revenues are indeed needed, why a tax on miles driven would be acceptable to tax opponents while an increase in the tax per gallon of fuel burned is not, is not clear.

But the real reason to be opposed to a switch in the tax to miles driven is the impact it would have on incentives.  Taxes matter, and affect how people behave.  And a tax on miles driven would act, in comparison to the current tax on gallons of fuel burned, as a tax on fuel efficiency.

The chart at the top of this post shows how the tax paid would vary across cars of different fuel efficiencies.  It would be a simple linear relationship.  Assuming a switch from the current 18.4 cents per gallon of fuel burned to a new tax of 1.5 cents per mile driven, a driver of a highly fuel efficient car that gets 50 miles per gallon would see their tax increase by over 300%!  A driver of a car getting the average nation-wide fuel efficiency of 21.4 miles per gallon would see their tax increase by 75%, as noted above (and as reflected in the chart).  In contrast, someone driving a gas guzzler getting only 12 miles per gallon or less, would see their taxes in fact fall!  They would end up paying less under such a new system based on miles driven than they do now based on gallons of fuel burned.  Drivers of luxury sports cars or giant SUVs could well end up paying less than before, even with rates set such that taxes on average would rise by 75%.

Changing the tax structure in this way would, with all else equal, encourage drivers to switch from buying fuel efficient cars to cars that burn more gas.  There are, of course, many reasons why someone buys the car that they do, and fuel efficiency is only one.  But at the margin, changing the basis for the tax to support highway building and maintenance from a tax per gallon to a tax on miles driven would be an incentive to buy less fuel efficient cars.

C.  Other Problems

The change to a tax on miles driven from the tax on gallons of fuel burned would have a number of adverse effects:

a)  A Tax on Fuel Efficiency:  As noted above, this would become basically a tax on fuel efficiency.  More fuel efficient cars would pay higher taxes relative to what they do now, and there will be less of an incentive to buy more fuel efficient cars.  There would then be less of an incentive for car manufacturers to develop the technology to improve fuel efficiency.  This is what economists call a technological externality, and we all would suffer.

b)  Heavier Vehicles Cause Far More Damage to the Roads:  Heavier cars not only get poorer gas mileage, but also tear up the roads much more, leading to greater maintenance needs and expense.  Heavier vehicles also burn more fuel, but there is a critical difference.  As a general rule, vehicles burn fuel in proportion with their weight: A vehicle that weighs twice as much will burn approximately twice as much fuel.  Hence such a vehicle will pay twice as much in fuel taxes (when such taxes are in cents per gallon) per mile driven.

However, the heavier vehicle also cause more damage to the road over time, leading to greater maintenance needs.  And it will not simply be twice as much damage.  A careful early study found that the amount of damage from a heavier vehicle increases not in direct proportion to its weight, but rather approximately according to the fourth power of the ratio of the weights.  That is, a vehicle that weighs twice as much (for the same number of axles distributing the weight) will cause damage equal to 2 to the fourth power (=16) times as much as the lighter vehicle.  Hence if they were to pay taxes proportionate to the damage they do, a vehicle that is twice as heavy should pay 16 times more in taxes, not simply twice as much.

(Note that some now argue that the 2 to the fourth power figure found before might be an over-estimate, and that the relationship might be more like 2 to the third power.  But this would still imply that a vehicle that weighs twice as much does 8 times the damage (2 to the third power = 8).  The heavier vehicle still accounts for a grossly disproportionate share of damage to the roads.)

A tax that is set based on miles driven would tax heavy and light vehicles the same.  This is the opposite of what should be done:  Heavy vehicles cause far more damage to the roads than light vehicles do.  Encouraging heavy, fuel-thirsty, vehicles by switching from a tax per gallon of fuel burned to a tax per mile driven will lead to more road damage, and proportionately far more cost than what would be collected in highway taxes to pay for repair of that damage.

c)  Impact on Greenhouse Gases:  One also wants to promote fuel efficiency because of the impact on greenhouse gases, and hence global warming, from the burning of fuels. By basic chemistry, carbon dioxide (CO2) is a direct product of fuel that is burned.  The more fuel that is burned, the more CO2 will go up into the air and then trap heat. Economists have long argued that the most efficient way to address the issue of greenhouse gases being emitted would be to tax them in proportion to the damage they do.  A tax on gallons of fuel that are burned will do this, while a tax on miles driven (and hence independent of the fuel efficiency of the vehicle) will not.

An interesting question is what level of gasoline tax would do this.  That is, what would the level of fuel tax need to be, for that tax to match the damage being done through the associated emission of CO2.  The EPA has come up with estimates of what the social cost of such carbon emissions are (and see here for a somewhat more technical discussion of its estimates).  Unfortunately, given the uncertainties in any such calculations, as well as uncertainty on what the social discount rate should be (needed to discount costs arising in the future that follow from emitting greenhouse gases today), the cost range is quite broad. Hence the EPA presents figures for the social cost of emitting CO2 using expected values at alternative social discount rates of 2.5%, 3%, and 5%, as well as from a measure of the statistical distribution of one of them (the 95th percentile for the 3% discount rate, meaning there is only an estimated 5% chance that the cost will be higher than this).  The resulting costs per metric ton of CO2 emitted then range from a low of $11 for the expected value (the 50th percentile) at the 5% discount rate, $36 at the expected value for the 3% discount rate, and $56 for the expected value for the 2.5% discount rate, to $105 for the 95th percentile at a 3% discount rate (all for 2015).

With such range in social costs, one should be cautious in the interpretation of any one. But it may still be of interest to calculate how this would translate into a tax on gasoline burned by automobiles, to see if the resulting tax is “in the ballpark” of what our fuel taxes are or should be.  Every gallon of gasoline burned emits 19.64 pounds of CO2.  There are 2,204.62 pounds in a metric ton, so one gallon of gas burned emits 0.00891 metric tons of CO2.  At the middle social cost of $36 per metric ton of CO2 emitted (the expected value for the 3% social discount rate scenario), this implies that a fuel tax of 32.1 cents per gallon should be imposed.  This is surprisingly almost precisely the fuel tax figure that all the other calculations suggest is warranted.

d)  One Could Impose a Similar Tax on Electric Cars:  One of the arguments of the advocates of a switch from taxes on fuel burned to miles driven is that as cars have become more fuel efficient, they pay less (per mile driven) in fuel taxes.  This is true.  But as generally lighter vehicles (one of the main ways to improve fuel economy) they also cause proportionately far less road damage, as discussed above.

There is also an increasing share of electric, battery-powered, cars, which burn no fossil fuel at all.  At least they do not burn fossil fuels directly, as the electricity they need to recharge their batteries come from the power grid, where fossil fuels dominate.  But this is still close to a non-issue, as the share of electric cars among the vehicles on US roads is still tiny.  However, the share will grow over time (at least one hopes).  If the share does become significant, how will the cost of building and maintaining roads be covered and fairly shared?

The issue could then be addressed quite simply.  And one would want to do this in a way that rewards efficiency (as different electric cars have different efficiencies in the mileage they get for a given charge of electricity) rather than penalize it.  One could do this by installing on all electric cars a simple meter that keeps track of how much it receives in power charges (in kilowatt-hours) over say a year.  At an annual safety inspection or license renewal, one would then pay a tax based on that measure of power used over the year.  Such a meter would likely have a trivial cost, of perhaps a few dollars.

Note that the amounts involved to be collected would not be large.  According to the 2016 EPA Automobile Fuel Economy Guide (see page 5), all-electric cars being sold in the US have fuel efficiencies (in miles per gallon equivalent) of over 100 mpg, and as high as 124 mpg.  These are on the order of five times the 21.4 average mpg of the US auto stock, for which we calculated that the average tax to be paid would be $202.  Even ignoring that the electric cars will likely be driven for fewer miles per year than the average car (due to their shorter range), the tax per year commensurate with their fuel economy would be roughly $40.  This is not much.  It is also not unreasonable as electric cars are kept quite light (given the limits of battery technology) and hence do little road damage.

e)  There Are Even Worse Policies That Have Been Proposed:  As discussed above, there are many reasons why a switch from a tax on fuel burned to miles driven would be a bad policy change.  But it should be acknowledged that some have proposed even worse. One example is the idea that there should be a fixed annual tax per registered car that would fund what is needed for highway building and maintenance.  Some states in fact do this now.

The amounts involved are not huge.  As was calculated above, at the current federal gasoline tax of 18.4 cents per gallon, the driver of a car that gets the average mileage (of 21.4 mpg) for the average distance a year (of 13,476 miles) will pay $115.87 a year.  If the fuel tax were raised to 32.1 cents per gallon (or equivalently, if there were a tax of 1.5 cents per mile driven), the average tax paid would be still just $202.14 per year.  These are not huge amounts.  One could pay them as part of an annual license renewal.

But the tax structured in this way would then be the same for a driver who drives a fuel efficient car or a gas guzzler.  And it would be the same for a driver who drives only a few miles each year, or who drives far more than the average each year.  The driver of a heavy gas guzzler, or one who drives more miles each year than others, does more damage to the roads and should pay more to the fund that repairs such damage and develops new road capacity.  The tax should reflect the costs they are imposing on society, and a fixed annual fee does not.

f)  The Cost of Tax Collection Needs to be Recognized:  Finally, one needs to recognize that it will cost something to collect the taxes.  This cost will be especially high for a tax on miles driven.

The current system, of a tax on fuel burned, is efficient and costs next to nothing to collect.  It can be charged at the point where the gasoline and other fuels leaves in bulk from the refinery, as all of it will eventually be burned.  While the consumer ultimately pays for the tax when they pump their gas, the price being charged at the pump simply reflects the tax that had been charged at an earlier stage.

In contrast, a tax on miles driven would need to be worked out at the level of each individual car.  And if the tax is to include shares that are allocating to different states, the equipment will need to keep track of which states the car is being driven in.  As the Washington Post article on a possible tax on miles driven describes, experiments are underway on different ways this might be done.  All would require special equipment to be installed, with a GPS-based system commonly considered.

Such special equipment would have a cost, both up-front for the initial equipment and then recurrent if there is some regular reporting to the center (perhaps monthly) of miles driven.  No one knows right now what such a system might cost if it were in mass use, but one could easily imagine that a GPS tracking and reporting system might cost on the order of $100 up front, and then several dollars a month for reporting.  This would be a significant share of a tax collection that would generate an average of just $202 per driver each year.

There is also the concern that any type of GPS system would allow the overseers to spy on where the car was driven.  While this might well be too alarmist, and there would certainly be promises that this would not be done, some might not be comforted by such promises.

D.  Conclusion

While one should always consider whether given policies can be changed for the better, one needs also to recognize that often the changes proposed would make things worse rather than better.  Switching the primary source of funding for highway building and maintenance from a tax on fuel burned to a tax on miles driven is one example.  It would be a stupid move.

There is no doubt that the current federal tax on gasoline of 18.4 cents per gallon is too low.  The result is insufficient revenues for the Highway Trust Fund, and we end up with insufficient road capacity and roads that are terribly maintained.

What I was surprised by in the research for this blog post was finding that a wide range of signals all pointed to a similar figure for what the gasoline tax should be. Specifically:

  1. The 1959 gas tax of 4 cents per gallon in terms of current prices would be 32.7 cents per gallon;
  2. The 1993 gas tax of 18.4 cents per gallon in terms of current prices would be 30.3 cents per gallon;
  3. The proposal of a 1.5 cent tax per mile driven would be equivalent (given current average car mileage and the average miles driven per year) to 32.1 cents per gallon;
  4. The tax to offset the social cost of greenhouse gas emissions from burning fuel would be (at a 3% social discount rate) 32.1 cents per gallon.
  5. The Congressional Budget Office projected that the gasoline tax needed to fully fund the Highway Trust Fund would be in the range of 28.4 to 33.4 cents per gallon.

All these point in the same direction.  The tax on gasoline should be adjusted to between 30 and 33 cents per gallon, and then indexed for inflation.

The Tax Plans of the Republican Presidential Candidates Are Not Even Close to Serious

TPC Evaluations of Tax Losses in the Republican Tax Plans, 2016

A.  Introduction

There is a good deal in the current campaign of candidates seeking the Republican presidential campaign that is worrying.  When one of the main remaining candidates (Marco Rubio) tries to belittle one of the other candidates (Donald Trump) on national television by alluding to the size of his penis, one has to wonder.  This would be considered juvenile even in a campaign for a high school class president.  Yet one of these candidates will almost certainly receive the nomination of the Republican Party to be the President of the United States.

This blog seeks, however, to focus on economic issues.  And a key economic issue in modern day political campaigns is what the candidate would seek to do, if elected to office, about tax policy.  Major candidates have therefore set out detailed proposals while campaigning, with these proposals developed by teams of trusted advisors who are specialists in the area, and then put out by the candidate as what he (or she) would try to enact if elected.

The major Republican candidates have done this, and four of these (the proposals of Donald Trump, Ted Cruz, Marco Rubio, and Jeb Bush) have been analyzed in depth by the non-partisan Tax Policy Center (a joint center sponsored by the Urban Institute and the Brookings Institution).  (The Tax Policy Center has also just recently issued similar analyses of the tax plans of Hillary Clinton and Bernie Sanders.)

Among the issues examined by the Tax Policy Center was what the impact would be on revenues collected of the Republican plans.  This blog post will look at those estimates, and calculate what they imply for government expenditure cuts if, as each of the candidates insist, they would not allow deficits to rise.  And what they imply is that these plans, like much else in this campaign, simply are not serious.

B.  The Revenue Losses from the Republican Plans

The chart at the top of this post shows what the Tax Policy Center calculates the government revenue losses would be if the tax plans of the major Republican candidates were implemented.  Ten year totals (for fiscal years 2017 to 2026) are shown rather than year by year numbers to keep things simple, even though the plans would still be ramping up in 2017 with the full impact not seen until 2018.  The total revenue losses would range from $6.8 trillion for Bush as well as Rubio, to $8.6 trillion for Cruz, to $9.5 trillion for Trump.

To put this in perspective, the chart includes (on the right) the projected total government discretionary budget expenditures for all purposes other than defense over this same ten year period.  The figures are from the most recent (January 2016) ten year budget forecasts of the Congressional Budget Office, and will exclude defense as well expenditures for mandatory programs (two-thirds of which are for Social Security and Medicare) and for interest on public debt.

Forecast non-defense discretionary expenditures total $6.5 trillion over this ten year period.  This is less than what the revenue losses would be under any of the Republican plans.  That is, even with the total elimination of government discretionary spending on everything other than defense, the deficit would increase.  Yet these Republicans insist that their plans would not increase the deficit.

Cutting non-defense discretionary expenditures to zero is of course absurd.  For those concerned with security, one should note there would be no more federal prisons, no more prosecutors, no FBI, no more border control.  There would be no more federal disease control, no more federally funded medical research, no more federal support for infrastructure building or maintenance, no more NASA or supported science research, and so on.  Everything would be eliminated, not just cut.

Taking this a step further, one can look at how much defense spending would need to be cut, on top of the elimination of all non-defense expenditure, to make up for the lost revenues:

Implied Defense Reductions, FY2017 to 2026, TPC

The necessary cuts in the defense budget would range from 5% of forecast ten-year defense expenditures for Bush and Rubio, to 32% for Cruz, to 47% (!) for Trump.  Yet Cruz, Rubio and Bush have all also called for sharp increases in defense spending.  Ted Cruz has laid out an ambitious plan for a bigger military that an analyst at the conservative Cato Institute would cost an extra $2.6 trillion over eight years, an increase in defense spending of over 50%.  Bush and Kasich have each proposed increases in defense spending of $1 trillion over ten years, an increase of over 15%.  Rubio is also arguing for big (but unspecified) increases in defense spending.  Things are perhaps less clear for Donald Trump, who has asserted he is “gonna build a military that’s gonna be much stronger than it is right now”, but “for a lot less”.  How he would do this he does not say, and it is doubtful he would get a “much stronger” military if its budget is to be cut by close to half.

C.  Conclusion

The Republican candidates assert their tax cut plans would not, however, lead to deficit increases, nor that they would cut defense spending (at least other than Trump).  Rather, they would cut non-defense spending.  However, as seen above, even if non-defense spending were cut to zero, budget deficits would increase unless there were also sharp cuts in mandatory programs (which are mostly Social Security and Medicare).

How do they believe they can do this?  Because they assert their tax plans would lead to big, indeed miraculous, leaps in growth.  Yet there is no evidence that such tax plans would do this.  Indeed, they are so large that the disruption in finances would almost certainly have large negative consequences for growth.

Economic theory does suggest that tax systems can affect growth.  The Tax Policy Center evaluations of the Republican tax plans, cited above, each have a balanced discussion of what they might be.  But as they point out, one would expect from economic theory that there would be both positive and negative effects, offsetting each other to at least some degree, and that in any case the overall impact in either direction is likely to be small. What the net impact will be, and in what direction, is then an empirical question, and careful studies of historical examples of tax reforms suggests that the overall impact on growth is, indeed, small.

One also does not find any evidence in the US historical data that tax cuts lead to more rapid growth.  As an earlier post on this blog found, federal taxes as a share of GDP were substantially lower in the decade following the Bush tax cuts of 2001 than for any decade in the previous half century, but this was not associated with higher GDP or jobs growth. Rather, it was associated with the lowest growth of GDP or jobs of any decade since at least the 1960s.  Furthermore, one cannot find any indication that a reduction of the highest marginal income tax rate (a focus of the Republican tax plans) led to higher growth.  The highest marginal federal income tax rate was 91 or 92% in the 1950s under Eisenhower, and always 70% or higher during the 1960s, but growth in GDP and in jobs during those periods were reasonably good, especially in comparison to what they have been since the Bush tax cuts of 2001.  High marginal income tax rates in the 1950s and 1960s did not kill growth.

One should not then expect miracles.  The Republican tax plans simply cannot be taken seriously.  But perhaps I am being silly to expect that in this campaign for the presidency.

The Failure of the Austerity Strategy Imposed on Greece, With Some Suggestions on What To Do (and What Not To Do) Now

Greece - GDP 2008-2014 Projection vs Actual

A.  Introduction

It appears likely now that Greece will continue, at least for a few more months, with the austerity program that European governments (led by Germany) are insisting on.  In return, Greece will receive sufficient “new” funding that will allow it to pay the debt service coming due on its government debt (including debt service that was supposed to have been paid in June, but was not), as well as continued access to the liquidity lines with the European Central Bank that allow it to remain in the Eurozone.  But it is not clear how long Greece can continue on this path.

The measures being imposed by the Eurozone members are along the same lines as have been followed since the program began in 2010:  Primarily tax increases and cuts in government spending.  The most important measures (in terms of the predicted impact on euros spent or saved) in the new program are increases in value-added taxes and cuts in government pensions.  This has been a classic austerity strategy.  The theory is that in order to pay down debts coming due, a government needs to increase taxes and cut how much it has been spending.  In this way, the theory goes, the government will reduce its deficit and soon generate a surplus that will allow it first to reduce how much it needs to borrow and then start to reduce the debt it has outstanding.

The proponents of this austerity strategy, with Germany in the lead, argue that in this way and only in this way will the economy start to grow.  Others argue that austerity in conditions such as where Greece finds itself now will instead cut rather than enhance growth, and in fact lead to an economic decline.  The priority should instead be on actions that will lead to growth by raising rather than reducing demand.  Once the economy returns to full employment, one will be able to generate the public sector savings which will allow debt to be paid.  Without growth, the situation will only get worse.

One does not need to argue these points in the abstract.  Greece is now in its sixth year of the austerity program that Germany and others have insisted upon.  One can compare what has in fact happened to the economy to what was expected when the austerity program started.  The Greek program is the work of a combined group (nicknamed the “Troika”) made up of the EU, the ECB (European Central Bank), and the IMF.  The IMF support was via a Stand-By Arrangement, and for this the IMF prepares and makes available a Staff Report on the program and what it expects will follow for the economy. The EU and the ECB co-developed these forecasts with the IMF, or at least agreed with them.  This can therefore provide a baseline of what the Troika believed would follow from the austerity program in Greece.  And this can be compared to what actually happened.

The “projected” figures are therefore calculated from figures provided in the May 2010 IMF Staff Report for the Stand-By Arrangement for Greece.  What actually happened can be calculated from figures provided in the IMF WEO Database (most recently updated in April 2015).  I used the IMF WEO Database for the data on what happened as the IMF will define similarly in both IMF sources the various categories (such as what is included in “government” or in “public debt”).  Hence they can be directly compared.

This blog post will focus on a series of simple graphs that compare what was projected to what actually happened.  Note that the figures for 2014 should all be taken as preliminary. The concluding section of the post will review what might be done now (and what should not be done now).

As will be seen, the program failed terribly.  I should of course add that Germany and the Troika members do not believe that this failure was due to a failure in the design of the program, but rather was a result of the governments of Greece (several now) failing to apply the program with sufficient vigor.  But we will see that Greece actually went further than the original program anticipated in cutting government expenditures and in increasing taxes.  To be honest, I was myself surprised at how far they went, until I looked at the numbers.

Austerity was applied.  But it failed to lead to growth.

B.  The Path of Real GDP

To start with the most basic, did the austerity strategy lead to a resumption of growth or not?  The graph at the top of this post shows what was forecast to happen to real GDP in the Troika’s program, and what actually happened.  The base year is taken as 2008. Output had peaked early in that year before starting to turn down later in the year following the economic and financial collapse in the US.  (Note:  For 2008 as a whole, real GDP in Greece was only slightly below, by 0.4%, what it was in 2007 as a whole.)

The IMF Stand-by Arrangement for Greece was approved in mid-2010, with output falling sharply at the time.  The IMF then predicted that Greek GDP would fall further in 2011 (a decline of 2.6%), but that with adoption of the program, would then start to grow from 2012 onwards.

That did not happen.  The situation in 2010 was in fact already worse than what the IMF thought at the time, with a sharper contraction already underway in 2009 than the estimates then indicated and with this then continuing into 2010 despite the agreement with the Troika.  National estimates for aggregates like GDP are always estimates, and it is not unusual (including for the US) that later, more complete, estimates can differ significantly from what was initially estimated and announced.

Going forward, GDP growth was then far worse than what the IMF thought would follow with the new program.  GDP fell by 8.9% in 2011, rather than the 2.6% fall the IMF predicted.  GDP then fell by a further 6.6% in 2012 and a further 3.9% in 2013.  The widening gap between the forecast and the reality is especially clear if one shifts the base for comparison to 2010, the start of the IMF supported program:

Greece - GDP 2010-2014 Projection vs Actual

Growth appears to have returned in 2014, but by just 0.8% according to preliminary estimates (and subject to change).  But with the turmoil so far in 2015, everyone expects that GDP is once again falling.  The austerity strategy has certainly not delivered on growth.

C.  Real Government Expenditures, Taxes, the Primary Balance, and Public Debt

Advocates of the austerity strategy have argued not that the austerity strategy failed, but rather that Greece did not apply it with sufficient seriousness.  However, Greece has in fact cut government expenditures by substantially more than was called for in the IMF (and Troika) program:

Greece - Govt Expendite 2008-2014 Projection vs Actual

By 2014, real government expenditures were 17% below what the IMF had projected would be spent in that year, were 27% below where they had been in 2010 at the start of the program, and were 32% below where they had been in 2008.  Real government expenditures were in each year far less, by substantial margins, than had been called for under the initial IMF program.

It is hard to see how one can argue that Greece failed to cut its government spending with sufficient seriousness when government spending fell by so much, and by so much more than was called for in the original program.

Taxes were also raised by substantially more than called for in the initial IMF program:

Greece - Govt Revenue 2008-2014 Projection vs Actual

 

Tax effort and effect is best measured as a share of GDP.  The IMF program called for government revenues to rise as a share of GDP from 37% in 2009 and an anticipated 40.5% in 2010, to a peak of 43% in 2013 (a rise of 2 1/2% over 2010) after which they would fall.  What happened is that taxes were already substantially higher in 2009 (at almost 39% of GDP) than what the earlier statistics had indicated, and then rose from 41% of GDP in 2010 to a peak of 45% in 2013 (a rise of 4% over 2010).

Taxes as a share of GDP have therefore been substantially higher throughout the program than what had been anticipated, and the increase from 2010 to the peak in 2013 was far more than originally anticipated as well.  It is hard to see how one can argue that Greece has not made a major effort to secure the tax revenues that the austerity program called for.

With government spending being cut and government revenues rising, the fiscal deficit fell. For purposes of understanding the resulting government debt dynamics, economists focus on a fiscal deficit concept called the “primary balance” (or “primary deficit”, when in deficit).  The primary balance is defined as government revenues minus government expenditures on all items other than interest (and principal) on its debt.  It will therefore measure the resources available to cover interest (and principal, if all of interest can be covered).  If insufficient to cover interest coming due, then additional net borrowing will be necessary (thus adding to the stock of debt outstanding) to cover that interest.

With expenditures falling and revenues rising, the government’s primary balance improved sharply over the program period:

Greece - Primary Balance 2008-2014 Projection vs Actual

The primary balance improved from a deficit of 10.2% of GDP in 2009 to 5.2% of GDP in 2010, and then rose steadily to a primary surplus of 1.2% of GDP in 2013 and an estimated 1.5% of GDP in 2014 (where the 2014 estimate should be taken as preliminary). A rise in the primary balance of close to 12% of GDP in just five years is huge.

However, the primary balance tracked below what the IMF program had called for.  How could this be if government spending was less and government revenues higher?  There were two main reasons:  First, the estimates the IMF had to work with in 2010 for the primary deficit in that year and in the preceding years were seriously wrong.  The primary deficit in 2010 turned out to be (based on later estimates) 2.8% points of GDP higher than had originally been expected for that year.  That gap then carried forward into the future years, although narrowing somewhat (until 2014) due to the over-performance on raising taxes and reducing government expenditures.

Second, while the path of government expenditures in real terms was well below that projected for the IMF program (see the chart above), the decline in government expenditures as a share of GDP was less because GDP was so much less than forecast. If, for example, government expenditures are cut by 20% but GDP also falls by 20%, then government expenditures as a share of GDP will not change.  They still did fall as a share of GDP between 2009 and 2014 (by 7.7% points of GDP), but not by as much as they would have had GDP not collapsed.

Finally, from the primary balance and the interest due one can work out the path of government debt to GDP:

Greece - Govt Debt to GDP 2008-2014 Projection vs Actual

The chart shows the path projected for public debt to GDP in the IMF program (in blue) and the path it actually followed (in black).  Despite lower government expenditures than called for in the program and higher government revenues as a share of GDP, as well as a significant write-down of 50% on privately held government debt in 2012 (not anticipated in the original IMF program), the public debt to GDP ratio Greece now faces (177% as of the end of 2014, and rising) is well above what had been projected in the program (153% as of the end of 2014, and falling).

Why?  Again, the primary reason is that GDP contracted sharply and is now far below what the IMF had forecast.  If debt followed the path it actually did take but GDP had been as the IMF forecast, the debt to GDP ratio as of the end of 2014 would have been 131% and falling (the path shown in green on the chart).  This would have been well less than the 153% ratio the IMF forecast for 2014, due both to private debt write-off and to the fiscal over-performance.  Or if debt had followed the path projected in the IMF program while GDP took the path it in fact did take, the debt to GDP ratio would have been 207% in 2014 (the path in red on the chart) due to the lower GDP, or well above the actual ratio of 177% in that year.

One cannot argue that Greece failed to abide by its government expenditure and revenue commitments sought in the IMF program.  Indeed, it over-performed.  But the program failed, and failed dramatically, because it did not recognize that by implementing such austerity measures, GDP would collapse.  The program was fundamentally flawed in its design.

D.  Other Measures

While the fiscal accounts are central to understanding the Greek tragedy, it is of interest to examine two other variables as well.  First, the path taken by the external current account balance:

Greece - Current Acct 2008-2014 Projection vs Actual

For countries who have their own currency, but who borrow in a foreign currency, crises will normally manifest themselves through a balance of payments crisis.  This is not central in Greece as it does not have its own currency (it is in the Eurozone) and almost all of its public borrowing has been in euros.  Still, it is of interest that the current account balance of Greece (exports of all goods and services less imports of all goods and services) moved from a massive deficit of over 14% of GDP in 2008 to a surplus in 2013 and 2014. Relative to 2010, Greek exports of goods and services (in volume terms) were 12% higher in 2014, while Greek imports were 19% lower.

The IMF had projected that the external current account would still be in deficit in those years.  This shift was achieved despite Greece not being able, as part of the Eurozone, to control its own exchange rate.  The rate relative to its Eurozone partners is of course fixed, and the rate relative to countries outside of the Eurozone is controlled not by events in Greece but by policy for the Eurozone as a whole.  Rather, Greek exports rose and imports fell because the economy was so depressed that domestic producers who could export did, while imports fell in line with lower GDP (real GDP was 17.5% lower in 2014 than in 2010).  Lower wages were central to this, and will be discussed further below.

Finally, with the economy so depressed, unemployment rose, to a peak of 27.5% in 2013:

Greece - Unemployment Rate 2008-2014 Projection vs Actual

While the preliminary estimate is that unemployment then fell in 2014, most observers expect that it will go up again in 2015 due to the economic turmoil this year.  And youth unemployment is at 50%.

E.  What Can Be Done

I do not know Greece well, and certainly not enough to suggest anything that would be close to a complete program.  But perhaps a few points may be of interest, starting first with some things not to do (or at least are not a priority to do), and then some things that should be done (even if unlikely to happen):

1)  What not to do, or at least not worry about now:

a)  Do not continue doing what has failed so far:  While it should be obvious, if a particular strategy has failed, one should stop pursuing it.  Keeping the basic austerity strategy, with just a few tweeks, will not solve the problem.

b)  Do not make the austerity program even more severe:  Most clearly, the austerity program has savaged the economy, and one should not make things worse by tightening it even further.  Yet that is the direction that things appear to be heading in.

Negotiations are now underway as I write this between the Government of Greece and the Troika on the extension of the austerity program.  A focus is the government’s primary balance.  The original IMF program called for a primary surplus of 3% of GDP in 2015, and that has been still the official program goal despite all the turmoil between 2010 and now. The IMF program (as updated in June 2014) then envisioned the primary surplus rising to 4.5% of GDP in 2016 and and again in 2017.  Germany wanted at least this much, if not more.

Even the official Greek proposal to the Troika of July 10 had the primary surplus rising over time, from 1% of GDP in 2015, to 2%, 3%, and 3 1/2% in 2016, 2017, and 2018, respectively.  With the chaos this year, few expect Greece to be able to achieve a primary surplus target of even 1% of GDP (if one does not ignore payment arrears).  And while the IMF estimate from this past spring was that the primary surplus in 2014 reached 1.5% of GDP (reflected in the chart above), this was a preliminary estimate, and many observers believe that updated estimates will show it was in fact lower.

With even the Greek Government proposal conceding that an effort would be made to reach higher and higher primary balance surpluses, the final program as negotiated will almost certainly reflect some such increase.  This would be a mistake.  It will push the economy down further, or at least reduce it to below where it would otherwise be had the primary surplus target been kept flat.

c)  Do not negotiate over the stock of debt now:  There has been much more discussion over the last month on a need to negotiate now, and not later (some assert), a sharp cut to the stock of Greece’s public debt outstanding.  This was sparked in part by the public release on July 14 by the IMF of an updated debt sustainability analysis, which stated bluntly that the level of Greek public debt was unsustainable, that it could never be repaid in full, and that therefore a reduction in that debt will at some point be inevitable through some system of write-offs.

There is no doubt that Greek public debt is at an unsustainable level.  Some portion will need to be written down.  But I see no need to focus on that issue now, with the economy still deeply depressed and in crisis.  Rather, a moratorium on debt service payments (both principal and interest) should be declared.  The notional debt outstanding would then grow over time at the rate of interest (interest due in effect being capitalized).  At some future point, when the economy has recovered and with unemployment at more normal levels, there can be a negotiation on what to do about the debt then outstanding.  One will know only at that point what the economy can afford to pay.

Note that such a moratorium on debt service is fully and exactly equivalent to debt service payments being paid, but out of “new” loans that cover the debt service due.  This has been the approach used so far, and the current negotiations appear to be calling for a continuation of this approach.  Such “new” lending conveys the impression that debt service continues to be paid, when in reality it is being capitalized through the new loans. Little is achieved by this, and it wastes scarce and valuable time, as well as political capital, to negotiate over such issues now.

d)  Structural reforms can wait:  There is also no doubt that the Greek economy faces major structural issues, that hinder performance and productivity.  There are undoubtedly too many rules and regulations, inefficient state enterprises in key sectors, and codes that limit competition.  They do need to be reformed.

But there is a question of whether this should be a focus now.  The economy is severely depressed, with record high unemployment (similar to the peak rates seen in the US during the Great Depression).  Measures to improve productivity and efficiency will be important to allow the full capacity level of Greek GDP eventually to grow, but the economy is currently operating at far below full capacity.  The priority right now should be to return employment to close to full employment levels.

One needs also to recognize that many of the measures that would improve efficiency will also have the immediate impact of reducing rather than raising employment.  Changing rules and regulations that will make it easier to fire workers will have the immediate impact of reducing employment, not raising it.  Certain state enterprises undoubtedly should be privatized, and such actions can improve efficiency.  But the immediate impact will almost certainly be cuts in staffing, not increases.

Structural reforms will be important.  But they are not the critical priority now.  And far more knowledgeable commentators than myself have made the same point.  Former Federal Reserve Board Chairman Ben Bernanke made a similar point in a recent post on his blog, although more diplomatically and speaking on Europe as a whole.

2)  What should be done:

Finally, a few things to do, although it is likely they will not be politically feasible.

a)  Allow the primary balance to fall to zero, and then keep it there until the economy recovers:  As discussed above, the program being negotiated appears to be heading towards a goal of raising the primary surplus to 3 1/2% of GDP or more over the next few years.  The primary balance appears to have been in surplus in 2014 (the preliminary IMF estimate was 1.5% of GDP, but this may well be revised downwards), with a surplus also expected in 2015 (although the likelihood of this is now not clear, due to the chaotic conditions).  To raise it further from current levels, the program will call for further tax increases and government expenditure cuts.  This will, however, drive the economy down even further.

Keeping the primary balance at zero rather than something higher will at least reduce the fiscal drag that would otherwise hold back the economy.  Note also that a primary balance of zero is equivalent to a moratorium on debt service payments on public debt, which was discussed above.  Interest would then be fully capitalized, while no net amount will be paid on principal.

b)  Germany needs to take actions to allow Greece (and the Eurozone) to recover:  While I am under no illusion that Germany will change its domestic economic policies in order to assist Greece, the most important assistance Germany could provide to Greece is exactly that.

The fundamental problem in the design of the single currency system for the Eurozone system was the failure to recognize as critically important that Europe does not have a strong central government authority, with direct taxing powers, that can take action when the economy falls into a recession.  When a housing bubble bursts in Florida or Arizona, incomes in those states will be supported by US federal authorities, who will keep paying unemployment compensation; pensioners will keep receiving their Social Security and Medicare; federal transfers for education, highway programs, and other such government expenditures will continue; and if there is a national economic downturn (and assuming Congress is not controlled by ideologues opposed to any such actions) then stimulus measures can be enacted such as increased infrastructure spending.  And the Federal Reserve Board can lower interest rates to spur investment.  All of this supports demand, and keeps demand (and hence production and employment) from falling as much as it otherwise would.  This can then lead to a recovery.

The European Union in current form is not set up that way.  Central authority is weak, with no direct taxing powers and only limited expenditures.  Members of the Eurozone do not individually control their own currency.  If a member country suffers an economic downturn and faces limits on either what it can borrow in the market or in how much it is allowed to borrow in the market (by the limits set in the Fiscal Compact that Germany pushed through), it will not be able to take the measures needed to stabilize demand. Government revenues will decline in the downturn.  Any such borrowing limits will then force government expenditures to be cut.  This will lead to a further downward spiral, with tax revenues falling again and expenditures then having to be cut again if borrowing is not allowed to rise.  Greece has been caught in exactly such a spiral.

As was discussed some time ago on this blog, even Professor Martin Feldstein (a conservative economist who had been Chairman of the Council of Economic Advisers under Reagan) said such fiscal rules for the Eurozone could “produce very high unemployment rates and no route to recovery – in short, a depression”.  That is exactly what has happened in Greece.

The EU in its present form cannot, by itself as a central entity, do much to resolve this. However, member countries such as Germany are in a position to help support demand in the Eurozone, if they so wished.  But they don’t.  Germany had a current account surplus of 7.5% of GDP in 2014, and the IMF expects it will rise to 8.4% of GDP in 2015. Germany’s current account surplus hit $288 billion in 2014, the highest in the world (China was second, at $210 billion).  German unemployment is currently about 5%, but inflation is excessively low at 0.8% in 2014 and an expected 0.2% in 2015.  It could easily slip into the deflationary trap that Japan fell into in the 1990s that has continued to today.

To assist Greece and others in the Eurozone, Germany could do two things.  First, it could accede to the wage demands of its principal trade unions.  Germany’s largest trade union, IG Metall, had earlier this year asked for a general wage increase of 5.5% for 2015.  In the end, it agreed to a 3.4% increase.  A higher wage increase for German workers would speed the day to when they were in better alignment with those in Greece (which have been dropping, as we will discuss below) and others in the Eurozone.  Inflation in Germany would likely then rise from the 0.2% the IMF forecasts for 2015, but this would be a good thing.  As noted above, inflation of 0.2% is far too low, and risks dipping into deflation (prices falling), from which it can be difficult to emerge.  Thus the target set in the Eurozone is 2%, and it would be good for all if German inflation would rise to at least that.

Direct fiscal spending by Germany would also help.  It has the fiscal space.  This would spur demand in Germany, which would be beneficial for countries such as Greece and others in the Eurozone for whom Germany is their largest or one of their largest export markets.  Inflation would likely rise from its current low levels, but as noted, that would be good for all.

Of even greater direct help to Greece would be German support for EU programs that would provide direct demand support in Greece.  An example might be an acceleration of planned infrastructure investment programs in Greece, bringing them forward from future years to now.  Workers are unemployed now.  Bringing such programs forward would also be rational even if the intention was simply to minimize costs.  Unemployed workers and other resources are now available at cheap rates.  They will be more expensive if they wait until the economy is close to full employment, so that workers have an alternative. Economically, the opportunity cost of hiring workers now is extremely low.

A more balanced approach, where adjustment is not forced solely on depressed countries such as Greece but in a more balanced away between countries in surplus and those in deficit, would speed the recovery.  Far more authoritative figures than myself (such as Ben Bernanke in his blog post on Greece) have made similar arguments.  But Germany shows little sign of accepting the need for greater balance.

3)  What will likely happen:

With Germany not changing its stance, and with the Troika now negotiating an extension and indeed deepening of the austerity program Greece has been forced to follow since 2010 (in order to be allowed to remain in the Eurozone), the most likely scenario is that conditions will continue along the lines of what they have been so far under this program. The economy will remain depressed, unemployment will remain high, government revenues will fall in euro terms, and this will then lead to calls for even further government expenditure cuts.

One should not rule out that at some point some event occurs which leads to a more immediate collapse.  The banking system could collapse, for example.  Indeed, many observers have been surprised that the banking system has held up as well as it has. Liquidity support from the European Central Bank has been critical, but there are limits on how much it can or will be willing to provide.  Or a terrorist bomb at some resort could undermine the key tourism industry, for example.

Absent such uncontrollable shock events, there is also the possibility that at some point the Government of Greece might decide to exit the Eurozone.  This would also create a shock (and any such move to exit the Eurozone could not be pre-announced publicly, as it would create an immediate run on the currency), but at least some argue that following the initial chaos, this would then make it possible for Greece to recover.

The way this would work is that the new currency would be devalued relative to the euro, and by law all domestic transactions and contracts (including contracts setting wages of workers) would be re-denominated into the new currency (perhaps named the “new drachma” or something similar).  With a devaluation relative to the euro, this would then lead to wages (in euro terms) that have been reduced sharply and immediately relative to what they were before.  The lower wages would then lead to Greek products and services that are more competitive in markets such as Germany, leading to greater exports (and lower imports).  This is indeed how countries with their own currencies normally adjust.

It would, however, be achieved only by sharply lower wages.  It would also likely be accompanied by chaotic conditions in the banking system and in the economy generally in reaction to the shock of Eurozone exit.  Greece would also likely cease making payments of interest and principal on its government debt (payments that are due in euros).  This plus the exit from the Eurozone would likely sour relations with Germany and others in the Eurozone, at a time when the country needs help.

So far Greece has resisted leaving the Eurozone.  Given what it has accepted to do in the Troika program in order to stay in the Eurozone (with the resulting severely depressed economy), there can be no doubt that this intention is sincere.  Assuming then that Greece does stay in the Eurozone, what will likely happen?

Assuming no shocks (such as a collapse of the banking system), it would then be likely that the economy would muddle along for an extended period.  It would eventually recover, but only slowly.  The process would be that the high unemployment will lead to lower and lower wages over time, and these lower wages would then lead to Greek products becoming more competitive in markets such as Germany.  This is similar to the process following from a devaluation (as discussed above), but instead of this happening all at one point in time, it would develop only gradually.

The process has indeed been underway.  The key is what has happened to wages in Greece relative to where wages have gone in its trading partners.  One needs also to adjust for changes in labor productivity.  The resulting measure, which economists call nominal unit labor costs, measures the change in nominal wages (in euro terms here), per unit of effective labor (where effective labor is hours of labor adjusted for productivity growth).  While one cannot easily compare unit labor costs directly between countries at the macro level (it would vary based on employment composition, which differs by country), one can work out how much it has changed in one country versus how much it has changed in another country, and thus how much it has changed for one country relative to another.

Scaling the base to 100 for the year 2010 (the year the austerity program started in Greece), relative unit labor costs have fallen sharply in Greece relative to the rest of the Eurozone, and even more so relative to Germany (with the data computed from figures provided by Eurostat):

Greece and Eurozone Unit Labor Cost, 2010 = 100

Relative to 2010, nominal unit labor costs fell by 13% in Greece (up to 2013, the most recent date available).  Over that same period, they rose by 4% in the Eurozone as a whole and by 6% in Germany.  Thus relative to Germany, unit labor costs in Greece were 18% lower in 2013 than where they were in 2010.  This trend certainly continued in 2014.

The lower unit labor costs in Greece have led to increased competitiveness for the goods and services Greece provides.  Using the IMF WEO database figures, the volume of Greek exports of goods and services grew by a total of 12% between 2010 and 2015, while the volume of imports fell by 19%.  As noted in a chart above, the Greek current account deficit went from a large deficit in 2010 to a surplus in 2013 and again in 2014.  Greater exports and lower imports have helped Greek jobs.  And as seen in another chart above, Greek unemployment fell a bit in 2014 (although with the recent chaos, is probably rising again now).

This process should eventually lead to a recovery.  But it can be a slow and certainly painful process, and is only achieved by keeping unemployment high and wages falling.

Are Greek wages now low enough?  Changes in unit labor costs cannot really provide an answer to that.  As noted above, the figures can only be provided in terms of changes relative to some base period.  The base period chosen may largely be arbitrary.  The chart above was drawn relative to a base period of 2010, as that was the first year of the austerity program, but cannot tell us how much (and indeed even whether) wages were out of line with some desirable relative value in 2010.  And one can see in the chart above that Greek unit labor costs were rising more rapidly than unit labor costs in the Eurozone as a whole in the period prior to 2010, and especially relative to Germany.

Rebasing the figures to equal 100 in the year 2000 yields:

Greece and Eurozone Unit Labor Cost, 2000 = 100

The data is the same as before, and simply has been adjusted to reflect a different base year.  Relative to where they were in the year 2000, Greek unit labor costs in 2013 were below what they were for the Eurozone, but only starting in 2013:  They were higher for each year from 2002 to 2012.  And they were still above the change in Germany over the period:  German unit labor costs were 11% higher in 2013 than where they were in 2000, while Greek unit labor costs were 17% higher (but heading downwards fast).

Wages are therefore adjusting in Greece, and indeed adjusting quite fast.  This is leading to greater exports and lower imports.  Over time, this will lead to an economic recovery. But it will be a long and painful process, and it is difficult to predict at this point how long this process will need to continue until a full recovery is achieved.

Unless the depressed conditions in the country lead to something more radical being attempted, this is probably the most likely scenario to expect.

The recovery could be accelerated if Greece were allowed to keep the primary balance flat at say a zero balance (implying all interest on its public debt would be capitalized, and no net principal paid) rather than increased.  But this will depend on the acquiescence of the Troika, and in particular the agreement of Germany.  It is difficult to see this happening.