Wednesday, August 17, 2011

Good vs. Bad Government Spending

Paul Krugman believes that the problem with the fiscal stimulus is that it just wasn’t large enough and that we are in need of another one to improve the economy. He even went so far as to suggest that a military buildup to protect us from a fake alien invasion would be a good thing.

As support for this he brings back his argument that World War II brought us out of the depression. The idea that war is good for the economy is absolutely wrong. While it may be true that war (or any fiscal stimulus) increases GDP, a higher GDP does not mean an improved economy. (I will give him the benefit of the doubt and assume that he doesn’t believe that the death of 400,000 military personnel isn’t good because of the higher per capita GDP.)
An economy only improves if people have more of the things they want. War does not do this and neither does wasteful fiscal spending. Professor Krugman also argues that cutting federal spending and austerity is bad which is wholly incongruous with his argument that World War II was good for the economy because the war was a period of tremendous austerity with the rationing of many goods.

Now this is not to say that Krugman is entirely wrong about fiscal spending. Government spending is worth it if the benefits outweigh the costs and this is true whether the economy is in a recession or an expansion. Some spending, such as protection against fake alien invasions, provide no benefits and should not be undertaken. I would also include land wars in Asia, most entitlement spending, and most wealth redistribution efforts in this category of wasteful government. Beneficial government spending would include some amounts of national defense, education, infrastructure, legal and regulatory framework, scientific research, and even some entitlements and wealth redistribution.

I would even agree with Keynesians that federal spending should increase during recessions. Not because it stimulates the economy, but because the cost/benefit tradeoff changes resulting in more beneficial projects. If unemployment is high, then the government can hire people at lower wages. If interest rates are low, then future benefits have a higher present value. Thus, a bad project during expansions becomes a good project during recessions. However, paying people to do nothing and trying to keep wages high completely nullifies this.

The main problem with the economy isn’t the lack of fiscal stimulus, it is the excessive use of bad government spending. If the government were to cut the wages of current employees and cut out a lot of the bad spending, then it could fund spending that actually has benefits.

Sunday, August 7, 2011

Social Security does contribute to the deficit

There are many ways to solve the budget deficit and reasonable people may disagree as to which method is the best. Revenues could be increased through some combination of higher levels of GDP, faster growth of GDP, and higher taxes as a percent of GDP through either higher tax rates or eliminating tax expenditures (such as home mortgage interest deductions). Realistically, there is some limit to the ability to raise revenues because higher tax rates may also limit the level and growth rate. I have posted on the Laffer Curve before as have others with opposing views.

The deficit could also be reduced through spending cuts. There is also a limit here as lower spending could lower the growth rate of GDP (higher spending may also reduce growth if the spending crowds out private investment with greater growth opportunities). For convenience, the US budget can be broken down into four broad areas: health care (Medicare and Medicaid), Social Security, Defense, and discretionary non-defense. Right now, health care, Social Security, and defense are all in the $700-$800 billion dollar range, but health care has the highest projected growth rates and is definitely the biggest threat to the deficit. However, today I would like to talk about Social Security.

Many people, including Nobel-prize winning economists, argue that Social Security does not contribute to the deficit because we have historically raised more in revenues into Social Security than we’ve spent resulting in a large surplus in the “trust fund” that won’t run out for many years. While this is technically true, it ignores the fact that by soaking up such a large portion of US tax revenues, there is less opportunity to raise additional revenue.

Imagine if there were a law that said that 50% of all tax revenues were dedicated to the Department of Defense. If the defense department only spent 20%, would that mean that they are saving us money or that we don’t spend enough on defense? Of course not, the problem would be that we are dedicating too much of our revenue on defense.

That is the problem with Social Security. By dedicating 12.6% of most workers paychecks (including the “employers” portion, another myth), we are crowding out revenues that could be used for better purposes. An individual with an income of $50,000 would pay 15.3% in Social Security and Medicare, another 15% in federal income taxes, and maybe 10% in state and local taxes, sales taxes, property taxes, … No wonder so many people feel that they are Taxed Enough Already.