Prescott, Taxes and GDP

Edward Prescott and Lee Ohanian wrote an article recently on the direction of the American economy. Prescott was a Nobel Price co-winner in economics in 2004 and Ohanian is an economics professor at UCLA. (Ohanian is also from the Hoover Institute where Sowell is so there may be some slanting here.) Their article focuses on income transfers from the private to public sector with its resulting changes in productivity.

The marginal tax rate in the U.S. is currently around 40% if state, local and consumption taxes are included. In California it is closer to 60% (as high as France, Germany and Italy.) The authors claim that such transfers depress production and, in Europe, have resulted in a decrease in almost 30% of work hours from 1400/yr to 1000/yr since the 1950s. (Although it must be said--though they do not--that the Europe of the Post-war period had significant stimulus to be productive.) Similarly, the Americans have had a decline in production of 13.5% since 2008 (as projected, not actual.)

Interestingly, they refer to an Economist assessment of start-ups reaching the Fortune 500 from 1976 to 2007 (like Microsoft or Apple) and can find only one European company to do so, Norway's Renewable Energy Corp.

Associations are, of course, not necessarily causation and such a decline could also be linked to the economic performance of the Chicago Cubs but it is a worry. But that is not what the Romer research says; their research is quite damning regarding taxation's effect on the GDP. Governments are, at least logically, not as good a steward of money as the owners are. Nor are the recipients of government largess the best investments; they are in need of help because they are failing at what they do. Prescott and Ohanian say that the further increase in taxation and regulation from the current government is certain to steal financing from the productive centers and underwrite the less productive.

The European laboratory must mean something.

A Formula Dangerously Easy for Politicians

gdp=consumer spending+investments+government spending+(exports-imports)

What about this formula is peculiar? This formula is how we judge our economic success yet it has a strange quality: Aside from exports, it measures spending, not production. Any money spent is inherently positive for the sacred GDP. So if the consumer or the government just borrows like crazy and spends the money on doughnuts, that raises GDP. Not to disparage doughnuts; they are wonderful. And certainly the money spent on them will percolate down through the doughnut industry for the betterment of all. But this does raise a point: Is some spending better than others? Is money saved and spent better than money borrowed and spent? Is money spent on small start up companies better than money spent on swampland in Florida? Is the money spent raising a building the same as money spent razing one?

Are all money and all spending created equal?

Debt and GDP

This graph haunts my days and nights. It compares the ratio of total U.S. debt (credit) versus U.S. GDP (Gross Domestic Product). It spiked off its norm during the Depression because of a fall in GDP (not a rise in debt) and has bounced in a stable range below 200% (the green circle) until the middle 1980's when it shot up and continues to climb (the red circle).
Imagine you deal only in cash, your twin deals in debt. (Remember, he may be doing this for a good reason. If he thinks he can borrow for 4% and buy an asset that will grow at 10% he will gain 6% a year.) You both make $100,000 a year. So you save your money and buy a $50,000 house for cash; your twin takes his $50,000 and uses it as a down payment for a $350,000 house. Amazingly, both your house and his debt-financed house are classified as assets, as growth in the GDP. He looks rich but his debt ($300,000) and yours ($0) are both maintained by the same income, $100,000. You have $100,000 to provide basics, invest, consume; your twin has a large interest bill which comes out of his income first. You are China; your twin is us. If he buys more, or if the interest rate rises, more and more of his income gets shunted to interest payments.What this graph shows is that debt is growing steadily, climbing until it is unsustainable.
At some point only three possibilities exist: Default on the debt, pay down the debt (which means a fire sale in assets or a contraction in spending elsewhere), or inflate the currency the debt is paid in. All those options will result in economic, and probably social, chaos.