There Aint No Such Thing as a Free Lunch: August 2010

Friday, August 20, 2010

Restricting Trade with China will not hasten Economic Recovery

With the unemployment rate stuck at 9.5 percent, some economists, such as Richard Posner, maintain that we are experiencing a depression. Clearly we have not experienced much economic recovery, and the future does not look promising. Why has the US economy been recovering so slowly? Some economists, such as Paul Krugman, place part of the blame on China and other countries that are running large trade surpluses with the US. The US trade deficit soared to $49.9 billion in June and $26.2 billion of this deficit was with China. We also ran a $3 billion trade deficit with Germany in June, and Germany’s trade surplus rose 30 percent compared to 2009.

By undervaluing its currency, the Yuan, China is effectively taxing imports and subsidizing exports. This contributes to the US importing much more from China than it exports to China. Krugman says that this policy benefits China while hurting the US. He argues that the US should threaten to impose sanctions on China if it does not allow the Yuan to rise in value. This may result in a trade war between China and the US. Krugman believes that if conflict results in reduced trade between the US and China, Americans could actually benefit. He argues that because we are in such a severe recession, if the government restricts trade, more will be spent on goods produced in the US, more jobs will be created and we will be better off. This view of trade policy, of which most economists are critical, is known as mercantilism.

Krugman’s assessment of Chinese exchange rate policy is backwards. Rather than benefitting China, it makes Chinese residents worse off while benefitting Americans. For a detailed explanation of this, read the article on China’s currency manipulation by Jonathan Catalan in Mises Daily (mises.org/daily/4256). In short, by holding the value of its currency down, the Chinese government is reducing the number of dollars received by its exporters for each item that they sell. This in turn, raises prices and reduces the purchasing power of the Chinese currency for all Chinese residents. Americans, on the other hand, benefit from being able to buy Chinese goods at a lower dollar price than otherwise.

Mercantilism and Keynesianism have much in common and represent a faulty understanding of how an economy works. The large US trade deficit is not the cause of high unemployment in the US. Trade deficits mean that instead of buying US goods with the dollars they obtain from trade, foreign citizens or their governments are purchasing US financial assets. The Chinese government uses the dollars it accumulates from trade surpluses to buy US government securities. This increases the supply of savings in the US, which, by reducing interest rates, should lead to more investment. Krugman argues from the paradox of thrift, that in a time of mass unemployment, if anyone (including the Chinese government) tries to save more, demand and investment fall because there is excess capacity in the economy.

Reduced trade with China would result in lower standards of living for Americans and would not lead to a net increase in jobs in the US. If the Chinese government responded to the threat of trade sanctions by raising the value of its currency, would that hasten the economic recovery? Not necessarily, because in order to raise the value of the yuan, the Chinese government must sell US government securities, which would lead to higher interest rates in the US and less capital investment. The reduction in investment would offset the increase in exports. The Federal Reserve could keep interest rates from rising and investment from falling by increasing the money supply. This, however, would lead to more price inflation.

It would be a good thing for the Chinese people, if the Chinese government allowed their currency to appreciate. It might even result in a small short term reduction in unemployment in the US as the Chinese buy cheaper American goods and Americans buy fewer Chinese goods. It would also make it harder for the US government to fund its deficits and would not cure the fundamental problem that is hindering economic recovery in the US- uncertainty about the rules and tax policy that will determine the profitability of investment projects. A return to full employment and prosperity requires a stable market economy where entrepreneurs have the confidence to invest in anticipation of future profits. This is more likely if instead of taking over health care and a greater share of the economy, government reduces its role, ending bailouts and unsustainable government spending.

Labels: capital investment, exchange rate, inflation, interest rates, Keynesian, Mercantilism, savings, trade deficit

Wednesday, August 11, 2010

Why voters oppose higher fuel taxes

Most voters do not like taxes and tax increases. One of the few taxes that was generally accepted and even welcomed when it was first enacted was the tax on gasoline. Unlike most other taxes, Americans recognized that paying this tax would result in improved roads and highways, which they valued. More recently, however, state legislatures and the US Congress have experienced widespread public opposition when they consider increases in gasoline taxes, in spite of growing concern about deteriorating bridges and highways.

Recent strong opposition to fuel tax increases does not mean that Americans are less willing than before to pay taxes in order to have better roads. What it does reflect is voters’ opposition to money paid in fuel taxes being used for purposes other than highway spending. In recent years almost 20 percent of money paid into the Federal Highway Trust Fund (FHTF) has been spent on mass transit. In addition, FHTF money is being spent on recreational trails, historic preservation, and scenic easements. Besides the FHTF money allocated for nonhighway purposes, a growing share is used for earmarks, which reflect political priorities of individual members of Congress rather than the priorities of highway users who pay gasoline taxes. Many drivers do not want to pay higher fuel taxes when less than 75 percent of the money paid in federal fuel taxes is used to maintain and improve streets, highways, and bridges.

Is the answer then a return to the good old days when fuel tax revenue was used in a (relatively) responsible manner? That may no longer be possible. The federal government and many state governments are now controlled by a ruling class that has little respect for the preferences of the general public. Instead, they seek to impose their enlightened ideas of how society should be organized. Hence, they may continue to seek to use fuel and other taxes to subsidize public transit and otherwise promote greater density and less automobile use, even if this is contrary to the wishes of the general public.

Widespread opposition to increases in fuel taxes at the federal or state level thus reflects a fundamental distrust of government. This distrust is based on evidence that the ruling class has its own agenda, which is inconsistent with the preferences of the general public. Given their smaller size, state governments may be more accountable to the voting public, and thus more likely to spend fuel taxes wisely. Recent failure to pass an increase in fuel taxes by the Pennsylvania legislature, however, suggests that voters are not yet ready to trust the Commonwealth to make good use of additional fuel tax revenue. If the federal and state governments can no longer be trusted to spend tax money wisely, a better approach may be to develop innovative local approaches to funding transportation.

Labels: fiscal federalism, political economy, Public transportation, user fees

Monday, August 9, 2010

An Example of Wasteful Transit Spending in Pennsylvania.

Anyone who wants to understand how the political process leads to wasteful spending on public transportation need look no further than the North Shore Connector, a 1.2 mile extension of the light rail line in Pittsburgh. Senators John McCain and Tom Coburn recently criticized this project as one of the three most offensive uses of federal stimulus funds. Recent attempts by the Pittsburgh Post-Gazette and the Port Authority of Allegheny County (PAAC) to defend this project against the Senators’ criticism reflect economic fallacies and also illustrate the process by which interest groups seek to profit from federal and state government money at the expense of taxpayers as a whole.

Defenders of the project point out that its construction provides thousands of jobs while supporting economic development on Pittsburgh’s North Shore. They ignore, however, the opportunity cost. A comparable number of jobs would have been created if the money had been spent elsewhere and much larger benefits would have resulted if the $529 million spent on the North Shore Connector were invested in a private sector project that consumers were willing to pay for.

Consumers will not be willing to pay even close to the more than six dollar per ride cost that would be required to cover the annual interest on the money invested in this project, not counting the operating cost and depreciation. The money spent on this project could be used to buy a brand new $40,000 SUV for each one of the 11,500 riders per day that are expected to use the North Shore Connector.

If it had not been for $62.5 million of economic stimulus funds, construction of the Connector would likely have been halted due to cost overruns. Not only has the cost increased from an original estimate of $363 million to $528.8 million, as noted by the Allegheny Institute (http://alleghenyinstitute.org/administrator/components/com_policy/uploads/vol10no42.pdf), but the project was scaled back in size, as PAAC dropped a planned spur to the Convention Center from the project. The PAAC website does not mention the most recent increase in costs, listing the project as costing $435 million to construct.

Why is so much money being spent on this project? Because about 80 percent of the cost was borne by the Federal Government and one sixth came from the Commonwealth of Pennsylvania, leaving only 3.33% of the cost to be paid by local taxpayers. Thus many Pittsburgh residents are strong supporters of the project. Supporters believe that if the money is not spent in Pittsburgh, it will be spent in some other city. When Uncle Sam pays for it, the cost is divided among the entire US population while the benefits accrue to a much smaller number of local transit agency employees, construction workers, and city residents who expect to use the service. It is not worth the effort of individual taxpayers to oppose this project politically because it costs only a few dollars per taxpayer, while the benefits to local groups are large enough that they are more likely to reelect their representatives in Harrisburg and Washington if projects like this are funded. When this and numerous other projects that benefit interest groups get added to the federal and state budgets, we end up with enormous government debt, which may soon be unsustainable.

Labels: government debt, light rail, opportunity cost, political economy, Public transportation

Tuesday, August 3, 2010

Which Party will Promote Fiscal Responsibility?

Martin Wolf , writing for the Financial Times (http://blogs.ft.com/martin-wolf-exchange/2010/07/25/the-political-genius-of-supply-side-economics/) argues that if Republicans return to power, the accumulation of unsustainable government debt will continue. Wolf maintains that Republicans still promote “supply-side economics”, espousing the view that cutting taxes could balance the budget. He also points out that Bush-era tax and spending policy led to today’s extremely high deficits.

I think Wolf is onto something. Republicans are more concerned about cutting (or at least not raising) taxes than they are about fiscal responsibility. Few Republicans in Congress or the Senate are willing to propose serious spending cuts that would be necessary to bring the budget into balance (or even substantially reduce projected deficits). How many Republicans would consider cutting Medicare spending, for example? Rising Medicare costs as the baby boomers retire will be much larger than any recent economic stimulus spending.

Wolf argues further that Democrats are relatively fiscally responsible. Their support of tax increases does suggest that many of them care about fiscal responsibility. Nevertheless, just as the supply-siders exaggerate the incentive effects of tax cuts, those who believe that government can increase spending, as it will with health care reform and other progressive policy changes, and pay for it with tax increases, underestimate or ignore the negative incentive effects of tax increases.

Not only is it unlikely that the proposed tax increases will do much to bring down deficits, but it is doubtful that a big enough tax increase to make a dent in the deficit will succeed politically. And this is as it ought to be. Americans value freedom, but we cannot have the freedom to spend our money the way we want if government programs are absorbing a growing share of our income. Nevertheless, Democratic politicians play an important role in reminding Americans that tax increases will be necessary if the government is going to continue to spend as much as it has been spending recently.

The kind of fiscal responsibility that will preserve our freedom does not involve increasing taxes, particularly on the highest income groups who play such an important role in investment and entrepreneurial job creation. It does, however, require a commitment to make serious cuts in spending, including in some areas that are dear to many conservatives and Republicans, like national defense and Medicare. Keeping taxes low or reducing them without cutting spending is a recipe for a fiscal disaster that will eventually cripple the ability of government to perform even its necessary functions.

Labels: deficits, Fiscal responsibility, government debt, supply side economics

Sunday, August 1, 2010

More on renewable energy

World magazine had a good article on renewable energy in its July 17, issue. The link is www.worldmagazine.com/articles/16908.

Labels: Renewable energy

There Aint No Such Thing as a Free Lunch