Several of my colleagues on the Harvard faculty have recently been casualties in the cross-fire between fiscal austerians and stimulators.   Economists Carmen Reinhart and Ken Rogoff have received an unbelievable amount of press attention, ever since they were discovered by three researchers at the University of Massachusetts to have made a spreadsheet error in the first of two papers that examined the statistical relationship between debt and growth.   They quickly conceded their mistake.

Then historian Niall Ferguson, also of Harvard, received much flack when — asked to comment on Keynes’ famous phrase  ”In the long run we are all dead” — he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.”  

There is a lot more to be said about each of the two cases.  (i) Reinhart and Rogoff’s 2010 estimates had already been superseded by a subsequent 2012 paper of theirs written along with Carmen’s husband, Vincent, which used a more extensive data set where the error does not appear.  (ii) The debt-growth causality is debated.  (iii) “Some of Ferguson’s best friends are gay.”   (iv) Keynes was actually bi-sexual.  (v) He tried to have children.  And so forth.  Most of this has already been said many times by now.  Apparently people are even more fascinated by Harvard than they are by macroeconomic theory.

But what does it all have to do with the debate between austerians and stimulators?   Not much.  But the battle lines of the austerians have been wavering lately under the continuing onslaught of facts (most notably the recessions in Europe and Japan’s recent conversion to stimulus), and the stimulators find the missteps of Reinhart-Rogoff and Ferguson to be convenient stones to throw into the attack as well.   But they are barking up the wrong tree.  Sorry;  they are throwing the wrong stones.

The Reinhart-Rogoff controversy is not in fact relevant to the question whether governments should expand or contract at a given point in time.  The basic finding in their papers continues to hold up, that subsequent growth tends to be lower among countries with debt/GDP ratios above 90% than below 90%; but neither that finding nor their policy advice was designed so as to support the proposition that a recession is a good time to undertake fiscal contraction. 

The Ferguson controversy is even less relevant, because the phrase “in the long run we are all dead” was neither about fiscal policy when Keynes wrote it nor an argument against deferred gratification.   Nor was Keynes in favor of uninhibited fiscal stimulus regardless of economic conditions;  he argued, rather, “the boom, not the slump, is the right time for austerity at the Treasury.”     Fix the hole in the roof when the sun is shining, not when it is raining.

Neither of the controversies bears on the policy proposition that is important at the moment, which is the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (the conditions that hold in rich countries today, as in the 1930s), fiscal expansion is expansionary and fiscal contraction is contractionary.

Some research by yet another highly valued colleague at Harvard does bear much more directly on this important proposition.   Alberto Alesina has not been receiving his “fair share of abuse.”  His influential papers with Roberto Perotti  (1995, 1997) and Silvia Ardagna (1998, 2010) found that cutting government spending is not contractionary and that it may even be expansionary.  

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other euro members.  But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that academic research finds fiscal austerity to be expansionary in general.  Nevertheless, the conclusions are clear:  “Even major successful adjustments do not seem to have recessionary consequences, on average” (1997).  And “several fiscal adjustments have been associated with expansions even in the short run” (1998).   And “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions” (2010, p.3).   Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi finds “that spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”  

Alesina’s recent policy advice is that the US should cut spending “right away.”  By contrast, the advice of Reinhart and Rogoff seems to favor inflation and financial repression and, if anything, postponing fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today).  In more far-gone cases like Greece, they favor restructuring the debt.   If the thunderstorm is too severe and the roof is too far-gone to be fixed, it may be necessary to rebuild from scratch.

A new attack on Professor Alesina’s econometric findings comes from an unlikely source:   Perotti, the co-author of the first two of the five articles, has now recanted (2013a, b).    He points out some problems with the methodology (including the papers that Alesina wrote with Ardagna).  Under the dating scheme, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year.   It turns out that some of what have been treated as large spending-based consolidations, though announced by the governments, were in fact never implemented.  Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth, for example, the touted stabilizations of Denmark and Ireland in the 1980s.  His conclusions:  “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth” and so “the fiscal consolidations implemented by several European countries could well aggravate the recession” (2013b, p.10).   To me, this is a more powerful indictment of the reasoning behind recent attempts at fiscal discipline during recession than is a spreadsheet error or a too-flippant line about Keynes’ sexuality.

References
    Alberto Alesina, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy Vol.13, no, 27, October, 487-545.
     Alberto Alesina, and Silvia Ardagna, 2010,  ”Large Changes in Fiscal Policy: Taxes versus Spending,” in Tax Policy and the Economy, Volume 24 (University of Chicago Press).
     Alberto Alesina, Carlo Favero and Francesco Giavazzi, 2013, “The Output Effect of Fiscal Consolidations,” IGIER, May.
     Alberto Alesina and Roberto Perotti. 1995, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, October.  NBER WP 5214.
   Alberto Alesina and Roberto Perotti, 1997, “Fiscal Adjustments In OECD Countries: Composition and Macroeconomic Effects,”  International Monetary Fund Staff Papers, vol.44, no.2, June, 210-248.
     Francesco Giavazzi and Marco Pagano, 1990, “Can Severe Fiscal Contractions be Expansionary?” NBER Macroeconomics Annual 1990, Vol.5, Olivier Blanchard and Stanley Fischer, editors (MIT Press) p. 75 - 122.
    Thomas Herndon, Michael Ash, and Robert Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute WP Series 322,University of Massachusetts Amherst, April.
     Roberto Perotti, 2013a,”The ‘Austerity Myth’: Gains Without Pain?” A. Alesina and F. Giavazzi, eds.: Fiscal Policy After the Financial Crisis (University of Chicago Press). BIS WP 362.  NBER WP no 17571.
     Roberto Perotti, 2013b, “The Sovereign Debt Crisis in Europe: Lessons from the Past, Questions for the Future,” Academic Consultants Meeting , Federal Reserve Board , Washington DC , May 6 , 2013.  Bocconi University.
     Carmen Reinhart and Ken Rogoff, 2010, “Growth in a Time of Debt,” AER, 100, May, 573-578.
     Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, 2012, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol.26, No.3-Summer, 69-86.

 [Comments can be posted at On Deck of Project Syndicate or on the site of the shortened op-ed version.]

The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

     Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12^th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

    Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.  

     There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

    Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

     Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

    Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

   Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

    It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).  

   Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent. 

   Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

     [The original of this post appears at Project Syndicate.  Comments may be posted there.]

          The year 2013 marks the 100^th anniversaries of two separate major institutional innovations in American economic policy:  the Constitutional Amendment enacting the federal income tax, ratified on February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.  
           It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively.   It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy.  John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression.   Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall.    [Tools of fiscal policy used by governments, in addition to tax rates and tax deductions, are spending and transfers.  Tools of monetary policy used by central banks include interest rates, quantities of money and credit, and instruments such as reserve requirements and foreign exchange intervention used in various (non-US) countries.]

           In subsequent debate, Keynes was associated with support for activist or discretionary policy.  The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms.  (It is a myth that he favored big government generally.  He said “the boom is the time for austerity.”)    Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right.   But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered. 
          After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers.  But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s.  As a result, many politicians in advanced countries are repeating the mistakes of 1937 today.  This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.

         The austerity-versus-stimulus debate has been thoroughly hashed out.   On the one hand, proponents of austerity correctly point out that the long-term consequences of permanently expansionary macroeconomic policy [both fiscal and monetary] are unsustainable deficits, debts, and inflation.    On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down.  Procyclicalists, both in the US and Europe, represent the worst of both worlds:  they push in the direction of expansion during booms such as 2003-07 and in the direction of contraction during recessions such as 2008-2012, thereby exacerbating both the upswings and downswings.  Countercyclicalists have it right:  working in the direction of fiscal and monetary discipline during booms and ease during recessions.

           Less thoroughly aired recently is the question whether — given recent conditions - monetary or fiscal expansion is the more effective instrument.   This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.”  The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”   
           The answer to the question which form of policy is more effective:  under the circumstances that held in the 1930s and that hold again now - which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion.   Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.  (Flat LM curve.)  This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound.  In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have.  (Steep IS curve.)  The hoary — but still evocative — metaphor is “pushing on a string.”  Meanwhile, fiscal expansion is rendered relatively more effective than in normal times, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.
           Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  It is worth trying all sorts of things:  quantitative easing, forward guidance, nominal targets.   Even if the short-term interest rate channel is inoperative, such steps may work through other channels:  long-term interest rates, credit channel, risk premia, expected inflation, asset prices, commodity prices or exchange rates.  But the effects of each are highly uncertain. 

          That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position.  But many economists have forgotten much of what they knew and politicians may not have even heard the proposition. 
          Introductory economics textbooks have long talked about the Keynesian multiplier effect:  the recipients of federal spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on.  Again, the multiplier is much more relevant under current conditions than in the normal situation where the expansion goes partly into inflation and interest rates and thus crowds out private spending.  By the time of the 2008-09 global recession even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier — intimidated, perhaps, by theories of policy ineffectiveness.   (These are some of the same theories that predicted that a tripling of the monetary base over five years, or a near-doubling of M1, should double or triple the price level !)
          The subsequent continuing severity of recessions in the United Kingdom and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that fiscal multipliers are not just positive, but greater than one, as the old wisdom had it.   The IMF Research Department has now reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with under-estimates of multiplier magnitudes.
          A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others.   Baum, Poplawski-Riberio and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap.  Batini, Callegari and Melina (2012) allow regime-switching, across recessions versus booms.  Others that similarly distinguish between multipliers in periods of excess capacity versus normal times include Auerbach and Gorodnichenko (2012a, 2012b), Bachman and Sims (2012), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012).  Most of this research finds high multipliers under conditions of excess capacity and low interest rates.  Gordon and Krenn (2011) and Shoag (2012) have the same implication.    Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example that they are lower in small open economies because of crowding out of net exports.  (Perhaps due to fear of sounding old-fashioned, few of these studies have the courage to mention that these are the findings that one would have expected from the elementary textbooks of 50 years ago.) 

          Needless to say, the effects of fiscal policy are subject to substantial uncertainty.   One never knows, for example, when rising debt levels might suddenly alarm global investors who then start demanding abruptly higher interest rates, as happened to countries on the European periphery in 2010.    (For this reason, the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus.)   In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth.   And it is true that monetary policy is much better understood than it was in the past. 
            Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter.  One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”

            A much-admired 2010 paper by Eric Leeper had it the other way around: it characterized monetary policy as science and fiscal policy as alchemy.   It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer.    It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and motivated largely by politicians’ desire to be re-elected.  These political realities may be what the author of “Monetary Science, Fiscal Alchemy” had in mind.
             But the ancient alchemists were not in fact stupid or selfish people in general, notwithstanding their search for the “philosopher’s stone” that was to turn lead into gold (of which modern proponents of returning monetary policy to the pre-1914 gold standard are reminiscent).  Nor was the alchemists’ problem that the monarchs of their day refused to listen to them.  It was rather that the state of knowledge fell far short of what the modern science of chemistry can tell us.   
            The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon (whose Depression prescription was that President Herbert Hoover should “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system”).  It could also be applied to the “Treasury view” in the UK of 1929. (Churchill:  ”The orthodox Treasury view … is that when the Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it.” ).  But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as alchemy.

References

   Miguel Almunia, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua, 2010, “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons,” Economic Policy, 25 (62), pp. 219-65.
   Alan Auerbach and Yuriy Gorodnichenko, 2012a, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, vol. 4(2), pp. 1-27, May.
   Alan Auerbach and Yuriy Gorodnichenko, 2012b, “Fiscal Multipliers in Recession and Expansion,” NBER Chapters, in Fiscal Policy after the Financial Crisis, edited by Alberto Alesina and Francesco Giavazzi (University of Chicago Press).
   Rüdiger Bachmann and Eric Sims, 2012, Confidence and the transmission of government spending shocks,” Journal of Monetary Economics vol. 59, no.3, pp.235-249.  NBER WP No. 17063, May.
   Nicoletta Batini, Giovanni Callegari and Giovanni Melina, 2012. “Successful Austerity in the United States, Europe and Japan,” IMF Working Papers 12/190, International Monetary Fund.
   Anja Baum and Gerritt Koester, 2011, “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle - Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies  no. 2011,03.
   Anja Baum, Marcos Poplawski-Riberio and Anke Weber, 2012, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December.
   Olivier Blanchard and Daniel Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper No. 13/1, January.  Forthcoming, American Economic Review, May.  
   Steven Fazzari, James Morley, and Irina Panovksa, 2012, “State-Dependent Effects of Fiscal Policy,”  UNSW Australian School of Business Research Paper No. 2012-27, April.      
   Milton Friedman and Anna Schwartz, 1963,  A Monetary History of the United States, 1867-1960 (Princeton University Press).
   Robert Gordon and Robert Krenn, 2011, “The End of the Great Depression 1939-41: Policy Contributions and Fiscal Multipliers,” NBER Working Paper No. 16380.
   John Hicks, 1937, Mr. Keynes and the Classics: A Suggested Reinterpretation,” Econometrica, pp. 147-59.
   Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. “How Big (Small?) are Fiscal Multipliers?,” IMF Working Papers 11/52 (International Monetary Fund.)  Forthcoming, Journal of Monetary Economics.
   Eric Leeper, 2010, “Monetary Science, Fiscal Alchemy,” NBER Working Paper No. 16510.
   Christina Romer and David Romer, 2013, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” UC Berkeley, January.
   Daniel Shoag, 2012, “The Impact of Government Spending Shocks: Evidence on the Multiplier from State Pension Plan Returns,” Harvard Kennedy School.
   Antonio Spilimbergo, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,” Staff Position Note No. 2009/11, International Monetary Fund.

[This post appears at VoxEU.  And also at  Econbrowser. Comments may be posted there.]

          Needless to say, the US has a long-term debt problem.  The problem is long-term both in the sense that it pertains to the next several decades rather than to this year.  (Indeed, the deficit/GDP ratio has been falling since 2009, despite the weakness of the economy.)   The problem is also long-term in the sense that we have known about it for a long time; it was clear in 1991 and should still have been clear in 2001.
     It should be almost as needless-to-say that the approaching debt ceiling bomb is not helpful in solving our fiscal situation, any more so than were previous standoffs:  the January 1, 2013, fiscal cliff; before that, the August 2011 debt ceiling standoff, which led Standard and Poor’s to downgrade the credit rating of US debt for the first time in history; and before that, the 1995 shutdown of the government, which largely discredited Republican House Speaker Newt Gingrich.  
     The current debt ceiling bomb is, of course, another attempt to hold the country hostage under threat of blowing us all up.  The conflict is usually phrased as a question of ideological polarization, a battle between fiscal conservatives and their opponents.  This familiar frame does not seem right to me.  There is in fact no correlation or consistency between the practice of federal fiscal discipline and the political rhetoric, either across states or across time.

          What are the demands of the hostage-takers?   Even if there existed an explicit ransom letter detailing specific severe spending cuts, in exchange for which it credibly offered to raise the debt ceiling, President Obama’s refusal to negotiate under such conditions would be fully justified.  But the situation is worse than that.  There is no specific set of demands, and never has been.  I truly believe there does not exist any set of spending cuts that the blackmailers would accept if they came from Obama. 
     Remember the occasions in the past when he has announced that he will accept the Republican position on some issue, only to have his opponents switch places, saying “if you are in favor of it, we are against it”?    One example was the idea of Obamacare itself, which originally came from conservative think tanks and Mitt Romney.   Another example was the proposal for an automatic version of what in February 2010 became the Simpson-Bowles Commission.
     There are only so many dollars that can be cut out of PBS and foreign aid.   If, hypothetically, Obama were to come out in support of severe cuts in agricultural supports, oil and gas subsidies, Medicare benefits and other programs, Republicans would attack him for proposing hurtful cuts. (Remember attacks on Obama’s health plan for non-existent “death panels” and fictional cuts to Medicare benefits?)  Simultaneously, Republicans would say that the cuts were not big enough. 
     What would be enough?   Some debt crazies have said they think it would be fine if we failed to raise the debt ceiling.  Some are crazy enough to think it is not a problem if the US government were to default on its legal obligations.  (They may not realize that defaulting on the bill for office supplies that you ordered from Staples is as bad as  missing interest payments on your debt.)  But some want to enforce a balanced budget immediately:  the refusal to allow the government to borrow any more is not just a negotiating tactic, but is the outcome they want.  This is crazy in light of the adverse economic and financial impact (which would be much worse than that of the fiscal cliff that we just dodged two weeks ago).    
     But the prize for ultimate insanity must go to those who want to eliminate the budget deficit rapidly and insist on doing it without raising taxes, cutting defense, or cutting programs for seniors.  These people deserve the label “deranged” because what they are demanding is for a literally false proposition to be true.  It is arithmetically impossible to eliminate the budget deficit if the cuts are to come primarily in non-defense discretionary spending.  
     To be very clear, I don’t think most Republicans believe all of this.  Certainly my many economist friends who are Republicans do not.  The truly “deranged” people are just a subset of the “crazy” people, who are in turn a subset of those who are unwise enough to favor the debt ceiling threat as a tactic, who are in turn a subset of the Republican Party.   The problem is that it is this minority of a minority that is holding the whole country hostage.  The size of the minority evidently shrunk after the August 2011 debt ceiling debacle, after the November 2012 election, and after the January 1 cliff.   But it still has its finger on the grenade pin.

          So that leads us to the question of tactics.  A variety of stratagems have been proposed for the White House to use to defuse the bomb, if it comes to that.  These are all designed as ways that the federal government can continue to meet its legal obligations beyond March, even if the Congress doesn’t raise the debt ceiling.   While these unconventional proposals are beyond anything that would have been contemplated under normal conditions, they must be considered, in light of the correspondingly absurd situation in which the country would find itself.  If the Congress refuses to act, the White House would have to choose between two contradictory laws: the one that Congress passed to authorize spending and taxes versus the debt ceiling law that apparently prohibits the government from borrowing to make up the difference between spending and taxes.  Following the implication of the latter law would have disastrous impacts on the country and the world if obeyed.

• Given the contradiction between the two laws, President Obama could just ignore the debt ceiling and follow the direct implications of the spending and taxation laws. I am not qualified to judge the legality of this course of action. The courts would eventually have to sort it out. The hope is that by then the Congress would have come to its senses and raised the debt limit.
• In the meantime, the White House might try invoking the 14^th Amendment, as Bill Clinton suggested at the time of the last debt ceiling standoff, in 2011.  The Amendment includes the passage “The validity of the public debt of the United States…shall not be questioned.” Again the Supreme Court would eventually have to decide the issue.
• The Treasury could issue “IOUs” to the office supply stores, soldiers, Social Security recipients, etc. The IOUs would just be written acknowledgements of a legal fact: that the government owes these people money. Maybe the Federal Reserve could let it be known that it will honor these IOUs. (There must be something wrong with this, or somebody besides me would have proposed it already.)
• The government writes an option to buy all its property and buildings for $1, and then sells that very valuable option to the Federal Reserve for something like its true value. This proposal has been made by the Yale constitutional expert Jack Balkin last time around, from which I infer that it is not obviously contrary to the law.
• And finally, the most colorful of the proposals: the trillion dollar coin. The Treasury would exercise its legal authority to mint a commemorative coin made out of platinum, with a face value of $1 trillion. The Federal Reserve would then buy the coin for $ 1 trillion, allowing the Treasury to pay its obligations by drawing down its checking account at the Fed up to that amount. This proposal originated in the blogosphere and was one of those anointed by Balkin in July 2011. Paul Krugman greatly elevated its prominence by declaring his support earlier this month.

     Contrary to some fears, none of these proposals need result in the money supply being any larger than it would otherwise be.  The Federal Reserve determines the money supply.  If it creates a new component of money by buying a platinum coin, a property option or IOUs, it can offset it by shrinking other components of the money supply by the same amount, leaving the total unchanged.
     The Obama Administration so far is eschewing gimmicks, and is calling on the Congress to do its job in a responsible manner.  This is the right approach.  
     But in the event that the minority does succeed in blocking a debt increase, it may be worth turning to some legal gimmick to avert the financial and economic catastrophe.   Of the five proposals bulleted above, the platinum coin is the one that seems to have the most experts currently expressing belief in its legality.  It is certainly clever.  Unfortunately, it would probably be the worst from a political standpoint.  The reason is - I am guessing here - there is a fairly high overlap between the debt crazies (defined above) and people who have paranoid conspiracy theories that relate to the Fed, money and precious metals (especially gold, but platinum is too close for comfort). For all I know, some of these people are the same who believe that Obama was born outside the U.S.  (That would fall into the category of deranged propositions, also defined above; but there is no need for us to go there.)  When you are dealing with a crazy person, it is best to avoid anything that would pour gasoline on the flames of his paranoia.  We actually want to win back some of those people who are merely misguided but not really insane.  After all, just getting past the current debt cliff wouldn’t solve the problem, with sequester and shutdown deadlines also looming.   So I’d go for some other legal gimmick, one that would be less likely to feed the paranoia and more likely to continuing chipping away at popular support for the extremists.

[I was interviewed this week on the trillion dollar coin by Boston magazine and radio station WGBH.] 

This blogpost also appeared on Econbrowser, Jan. 17, courtesy of Menzie Chinn.  Comments may be posted there.

Politicians who advertise themselves as “fiscal conservatives” sometimes campaign on crowd-pleasing pledges to cut taxes and simultaneously reduce budget deficits.  These are difficult promises to deliver on in practice, since the budget deficit equals government spending minus tax revenue.

Aspiring fiscal conservatives may be interested in learning four innovative tricks that are commonly used by American politicians who like to promise what seems impossible.   Each of these feats has been perfected over three decades or more.  Indeed they first acquired their colorful names in the early years of the Ronald Reagan presidency:

1. The “Magic Asterisk”
2. “Rosy Scenario”
3. The Laffer hypothesis
4. The “Starve the Beast” hypothesis.

As shop-worn as these four conjuring tricks are, voters and journalists continue to fall for them. Thus they remain useful equipment in the repertoire of the fiscal conservative.

The first term was coined by Reagan’s Budget Director, David Stockman.  Originally it was an act of desperation, because the numbers in the 1981 budget plan didn’t add up.  “We invented the ‘magic asterisk’:  If we couldn’t find the savings in time - and we couldn’t-we would issue an IOU. We would call it ‘Future savings to be identified.’” [p.124]   Since that time the Magic Asterisk has become a familiar device in the American policy arena.   Recent examples include the recommendation of the Simpson-Bowles commission to cut real spending growth by precise amounts, without saying where.   US Presidential candidate Mitt Romney has done the same in his spending plan.    Another current application of the Magic Asterisk is Romney’s plan to eliminate enough tax expenditures to make up the revenue lost by cutting marginal tax rates by 20% (which is $5 trillion in revenue), while steadfastly refusing to say what tax expenditures he would eliminate.

As Election Day nears, the pressure on a candidate to get more specific grows.  The conjurer is thus forced to go to Trick Two:  since he can’t find enough tax loopholes to eliminate, he must claim that what he meant by closing the revenue gap was that stronger economic growth will bring in the added revenue.   The most popular magician’s assistant of all time makes her encore on the stage.  Murray Weidenbaum, Reagan’s first Council of Economic Advisers Chairman, deserves the credit for originally dreaming up Ms. Rosy Scenario, “perhaps my most lasting legacy” [p.57].  The Reagan Administration in its early years forecast 5% income growth (twice the long-run average), in order to imply in its projections a boost to revenues big enough to make up for its many tax cut measures [p.93-97].   Since then candidates of every party have made use of Rosy’s talents.

Indeed official growth forecasts are systematically overly optimistic in almost all of a sample of 33 countries, contributing to overly optimistic budget forecasts.   European governments are particularly biased.

In the Republican primaries last year, candidate Tim Pawlenty assumed a 5 per cent growth rate to make his own plan work.   He was all but laughed out of the race.  Mitt Romney probably can’t get away with this sleight-of-hand either.   The press asks, “Why should we believe that the growth rate will magically accelerate just because you become president?   Where will this GDP come from?   It sounds like pulling a rabbit out of a hat.”  Right on cue, it is time for Trick 3.

Trick 3 is the famous Laffer Hypothesis.   This is the proposition, identified with “supply side economics,” that reductions in tax rates are like magic beans:  they stimulate economic growth a lot — so much so that total tax revenue (the tax rate times income) goes up rather than down.   One might think that the Romney campaign would never resurrect such a hoary and discredited trick.  After all, two of his main economic advisers, Glenn Hubbard and Greg Mankiw, both have textbooks in which they say that the Laffer Hypothesis is incorrect as a description of US tax rates.  Mankiw’s book, in its first edition, even called its proponents “charlatans.”  But the historical record is that each Republican presidential candidate since Reagan has had good economic advisers who disavow the Laffer Hypothesis.  Yet time and again the president (or candidate), and his vice president (or running mate) and his political aides read from a script that relies on the Laffer logic (Appendix I). They are the ones who make the policy if the candidate wins, not the academic economist.   George W. Bush had these same two top economic advisers in his first term, Hubbard and Mankiw, when he cut taxes and transmogrified a record surplus into a record deficit.

Trick 4, “Starve the Beast,” typically comes later, if and when the president is elected, has enacted his tax cuts, and discovers that smoke and mirrors don’t work against hard fiscal reality. He can’t find enough spending to cut (Magic Asterisk has disappeared up the conjurer’s sleeve); the acceleration in GDP is nowhere to be seen (Rosy Scenario has vanished in thin air); and tax revenues have not grown (no rabbit in the Laffer hat).   The audience is now told that losing tax revenue and widening the budget deficit was the plan all along.  The performer explains that the deficit is all the fault of Congress for not cutting spending and that the only way to tame the beast is raise the budget deficit because “Congress can’t spend money it doesn’t have.”  This trick never works either, of course.  Congress can in fact spend money it doesn’t have, especially if the “conservative” president has been quietly sending it budgets every year that call for that.   “Starve the Beast” as a budget strategy, like the other three, dates back to the first Reagan Administration. (Bartlett, 2007, p.6-7.)

By the time the crowd realizes it has been had, the confidence man has pulled off the greatest trick of all:  yet another audience who came to see the deficit shrunk instead leaves the theater with the deficit bigger than when it came in.

References
Bruce Bartlett, 2007, “‘Starve the Beast’ Origins and Development of a Budgetary Metaphor,”The Independent Review, XII, 1, summer, 5-26.
Jeffrey Frankel, 2008, “Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, September.
–2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications,” Oxford Review of Economic Policy vol.27, no. 4, 536-562. NBER WP 17239; Summary in NBER Digest.
David Stockman, 1986, The Triumph of Politics: Why the Reagan Revolution Failed (Harper & Row).
Murray Weidenbaum, 2005, Advising Reagan: Making Economic Policy, 1981-82 (Washington Univ., St.Louis).

[A version of this column appeared earlier at Project Syndicate, which has the copyright.  Comments can be posted there.]

Every pundit agrees that President Obama did badly in the first debate.  But I can’t help wondering whether he (and VP Joe Biden) would have been able to come out swinging as freely as they have in the subsequent debates, if it were not for what happened in Denver.  Obama must have been afraid of sounding unpresidential.   But because his initial performance was so roundly criticized for passivity, he was licensed after that to argue aggressively:  “What you are saying is not true, Governor Romney.”  And it helps that he was right, each time.   (My morning-after talking-head comments can be viewed: “Re-cap of 1st Presidential Debate,” Oct.4; and “Re-cap” of 2nd Presidential Debate, Oct.17.)

Of all the areas where Romney’s assertions in the first debate were rebutted successfully in each of the subsequent debates, his tax “plan” is one of the most important.  The credibility of independent analysts and fact-checkers has helped here.   The main problem is not that Romney hasn’t announced a plan detailed enough to be worthy of the name.   The main problem is, rather, that no plan can achieve three simultaneous goals, each of which the Republican candidate has repeatedly promised:   (1) cutting tax rates 20%,  (2) avoiding loss of tax revenue by elimination of deductions, and yet  (3) preventing overall taxes from going up on those earning less than $200,000 a year.    Romney and Ryan have been conducting a shell game:  they show the public what is under two of the three shells, but not all three at any one time.  For example, Republicans will argue that the tax cut won’t raise the budget deficit by citing a study that cuts middle class benefits like the tax-deductibility of mortgage interest.  Then when reminded that they promised not to do that, they will cite a study that lets taxes go up on those earning $100,000-$200,000.

The 20% cut in tax rates would in itself cost $480 billion on revenue in 2015 or about $5 trillion over the next 10 years.  I don’t think there is disagreement about that.  (But Bruce Bartlett estimates $6 trillion:Tax Notes, 10/29/12, p.2.)   All the disagreement is whether Romney can make up the revenue by eliminating deductions as he claims.  Yet in the first debate, when Obama started to address this question, Romney tried to shut him down by saying that a $5 trillion tax cut wasn’t his complete plan, as if anyone had ever said it was.  Worse, in the Vice Presidential debate, Congressman Ryan claimed that the Obama deputy campaign manager had “stipulated” that they had been wrong, that the tax cut wasn’t really $5 trillion.  The media was fooled by this one, failing to note that she had only made the (accurate) statement that the question of controversy was not whether the overall loss of revenue would be the full $5 trillion, but whether Romney could make all of that up by eliminating deductions.  This is an elementary point and Obama was able to get it across effectively in the second and third debates, even to number-weary viewers.

Some pundits say that, if Romney’s weakness is that his budget numbers don’t add up, Obama’s weakness is that he hasn’t laid out a specific agenda for his second term.  (Either that, or that he didn’t get us out of the recession fast enough.)

What will happen after the election?   It is typical that fervently debated plans of the candidates become mostly irrelevant soon after the winner’s presidential term begins.  (My Oct.22 talking head comments on this are viewable, at the 26-min. mark.) They are overtaken by unexpected events, such as a market crash at home or an armed attack somewhere in the world.  In the present case, we have a good idea of the events that, soon after the election, will quickly replace the sound-bites of the campaign.   In economic policy, a renewed euro crisis within the next year is likely to have serious spillover effects.   But more urgent for the American president will be the Fiscal Cliff, which arrives January 2013.   Immediately after the election it will become the dominant question.  Yet neither candidate is talking about it.  The explanation for this silence is in part that no politician wants to talk about the specifics of budget-cutting pain; but it is also in part that the two candidates genuinely can’t know what they will do before they know how many supporters they would have in Congress to do it. By the way, I have a prediction regarding monetary policy.   If Romney were to be elected president, his position that monetary policy has been much too easy would turn around on a dime.   Like Nixon, Reagan and Bush before him, he would seek to push the Fed toward easing, not tightening.

Foreign policy was the focus of the third debate.  (Incidentally, why does Romney believe that Syria “is Iran’s path to the sea?”  That is a strange rendering of geography.  Four years ago, McCain thought that Afghanistan bordered Iraq.  GWB said that Africa was one nation.  Reagan mixed up Brazil and Bolivia. Anyone see a pattern? )

The pressing foreign policy issues for the next president will likely be the withdrawal from Afghanistan, the nuclear standoff with Iran, and territorial disputes over islands off the coast of Asia.  Instead of discussing realistically the sort of policy decisions that will need to be made, the candidates have been debating “who said what, when” after the killing of four American diplomats in Benghazi last month.   Despite that tragedy, Obama’s overall policy in Libya remains a success on net.  His actions helped remove Qaddafi, which is reminiscent to me of Bill Clinton’s interventions in Kosovo (helping remove Milosevic) and Haiti (Cédras).   Removing bad guys without US combat deaths.   Libya ranks behind two other major Obama foreign policy successes: withdrawal from Iraq and removal of bin Laden.   Contrast that to the 4,000 Americans who died in the Iraq war; the 3,000 in the World Trade Center; and the global damage done to American foreign policy more generally during those years.

        Mitt Romney, presidential candidate, said in now-infamous comments that 47% of the American electorate is dependent on the federal government, that he will never be able to teach them to take personal responsibility for their lives, and that they are certain to vote for Barack Obama in November.   He continues a tradition in his party that goes back at least three decades:  building political campaigns around the proposition that folks in the heartland exhibit the American virtues of self sufficiency and personal responsibility and the implication that other, more urban, regions display decadent social values and dependency on government.

          It is a good general rule to judge individuals on their own merits and not on the supposed attributes of the racial, socioeconomic or geographic groups to which they belong. Cultural generalizations are dangerous.   But since questions have been raised, the fearless social scientist will not shrink from confronting them.  Are residents of “red states,” who tend to vote Republican, indeed more likely to take responsibility for their personal behavior than those who live in “blue states” and tend to vote Democratic?

       Inspired by the role that religion plays in the red-state view of the world, I will organize the investigation in terms of the Seven Deadly Sins:   Greed, Gluttony, Lust, Sloth, Wrath, and so on.  We will see that measures of these “sins,” state-by-state, bear a statistical relationship with voting patterns - but not the relationship that many assume.  (For data sources and econometric details, see the statistical appendix at my website.)    

1)      Greed  
 
    The red states receive more federal spending, relative to taxes, than the blue states, as I wrote in a 2010 blog post.  Updated data show that the pattern continues.  Those who claim to be fiscally conservative are the ones who in truth tend to feed the most voraciously at the federal trough. Alaskans are the most dependent on the federal government, receiving $7,448 in spending (net of taxes) per capita.  New England, the Mid-Atlantic States, Minnesota and Illinois are the biggest net givers.  Regarding Romney’s specific  ”47%” allegation: the states with high percentages of people who pay no income tax tend to vote Republican, not Democratic.

     Figure 1 shows on the horizontal axis each state’s receipt of spending by the federal government, net of tax payments, per capita.  The vertical axis shows the ratio of Democratic to Republican votes state by state, in the last three presidential elections.    The red states (low in the graph) tend to be on the receiving end (high spending).  The blue states (high in the graph) constitute a majority of the ones that foot the bill (positive contributions to the nationwide kitty).  The relationship is highly significant statistically.
  

Figure 1:  Federal Spending Received minus Taxes Paid, among Blue vs. Red States
(Average of votes in 2000, 2004 and 2008 presidential elections)  Click here for larger image.

2) Gluttony

     States where residents suffer more from obesity, in part because they have worse eating habits, tend to vote Republican, as I showed in a blog post last June.  To illustrate, a mere 1 percentage point decrease in a state’s obesity rate is associated on average with an estimated increase in the ratio of Democratic to Republican voters from 1.00 to 1.07.  The relationship is highly significant statistically.   (Figure 2.)

               
Fig.2: Obesity (% of population) Click for larger image     Fig.3: Fitness Index  Click for larger image  

3) Sloth

     States where residents get less physical exercise tend to vote Republican.  (Figure 10d in appendix.) The relationship is highly significant statistically.    Figure 3 combines physical exercise and lack of obesity into a single index of physical fitness.

      In his recent book, Coming Apart, Charles Murray argues that those who live in the “super-zip codes” - the areas with high education levels, like Belmont, Massachusetts  - have maintained traditional American values of hard work, while those who live elsewhere show “crashing” rates of industriousness.   He writes that those who live in areas with less education have been leaving the labor force for years, often falsely claiming disability. They “goof off,” “sleeping and watching television” (p.180-181).  Those that remain employed have reduced the length of their work-week and their dedication to their jobs, at the same time that those living in the super-zip codes have increased theirs (p.176-77).  Some academic researchers and news media fear accusations of liberal bias if they talk about such things.  AEI scholar Murray may be immune from this fear: he is well-known as a conservative/libertarian whose earlier book The Bell Curve dealt with black-white differences in test achievement.  (The statistics in his recent book look at whites alone, so as to control for race.)   

4) Lust

     Sex is interesting.  Red states residents buy more online adult entertainment, according to a 2009 study in the Journal of Economic Perspectives by Benjamin Edelman.   Notwithstanding proclamations about the importance of pre-marital chastity, evidence suggests that young people in red states do have sex before marriage.  It is less likely to be safe sex than among those in blue states.   States that vote Republican have higher birth rates among 15-17-year-old girls, as Figure 4 shows.   Again, the difference is highly significant statistically.    They also have higher rates of the sexually-transmitted disease Chlamydia .  (This difference, unlike the others, is not statistically significant at the aggregate state level; but it is when combined into an overall measure of unsafe sex.)

      Apparently the gap between what they say and what they do is particularly wide for teen-agers who describe themselves as evangelical Christians.  According to research by Mark Regnerus, a sociologist at the University of Texas, Austin, white evangelical adolescents usually state a belief in pre-marital abstinence — 74 per cent — but in fact are surprisingly active sexually, compared to mainline Protestants and Jews who do not tend to state such a belief.  When the evangelicals do engage in sex, they are less likely to use protection than others.  The gap between word and deed is strikingly high for the millions of teenagers who take a formal pledge to remain celibate until marriage, typically in a ring ceremony, according to a New Yorker article by Margaret Talbott (”Red Sex, Blue Sex“).  The majority of them, though holding out for awhile, “end up having sex before marriage, and not usually with their future spouse.”   Two other sociologists, Peter Bearman (Columbia University) and Hannah Bruckner (Yale) find a positive correlation between the abstinence pledge and Sexually Transmitted Disease (STD).  Pledgers are less likely to use a condom if and when they first have sex and overall are slightly more likely to contract a STD.  (Under George W. Bush, the federal government subsidized such abstinence pledge program despite their questionable effectiveness.)
              

                  
Fig.4: Teen pregnancy rates  Click for larger image         Fig.5: Firearms Assaults  Click for larger image

5) Wrath

     Nobody is surprised to hear that red states have higher rates of gun ownership than blue states.  But there is an important distinction between those who use guns responsibly and those who do not.   The data show that ¾ of the states with high rates of firearms assaults vote Republican.  (Figure 5.)   The regression is statistically significant.

6) Drunkenness  

     People who drink too much endanger themselves and endanger others as well.  You guessed it: States with high rates of fatal accidents from drunk driving tend to vote Republican (Figure 6).     Statistically significant. 

     
Fig.6: Drunk driving fatalities  Click for larger image       Fig.7: Smoking rates  Click for larger image   

7) Smoking

     Finally, states with high rates of smoking vote Republican too, as Figure 7 illustrates.   Again, the relationship is highly significant statistically.   

     Many of the Seven Deadly Sins can indeed be deadly.  It is particularly striking that the states where the most residents exhibit behavior that endangers their health and that of others - with many of these unhealthy people later free-riding on their fellow citizens when they show up uninsured in the hospital emergency room - are also the states where congressmen tended to vote against the Affordable Care Act (Obamacare) in 2010.  This risky behavior includes poor physical fitness (as measured by rates of obesity, lack of exercise, and poor diet), careless sexual behavior (as measured by rates of teen pregnancy and Chlamydia), smoking, drunk-driving (as reflected in fatalities) and irresponsible use of guns (as reflected in armed assaults). 

     Each obese American incurs medical costs 42%  higher than those of normal weight.  Often others are stuck with the bill, if the patient has not been able to get health insurance because of a weight problem.  These people are free-riders on the health care system even if they don’t want to be.   The individual mandate of Obamacare was designed to fix this free-riding problem and re-establish personal responsibility.  Yet congressmen in states with high rates of obesity or other health risk factors voted against the legislation.  (See my blogpost or an op-ed on Obamacare for the evidence.)   

     Utah is the most conspicuous outlier in most of these relationships.  It has a high population of Mormons. Apparently they follow the strictures of their religion more closely than those of other religious denominations.  (Could this be why evangelicals tend to resent Mormons so much, according to opinion polls?)   But Utah notwithstanding, the relationships hold on average.

     The five most “red” states are Wyoming, Oklahoma, Utah, Idaho, and Alaska.  The five most “blue” are New York, Massachusetts, Rhode Island, Vermont and Hawaii.   The average score of the five reddest states is worse in each category than the average score of the five bluest states: more obesity, smoking, Chlamydia, teenage pregnancy, drunk driving fatalities, and firearms assaults.  In the latter three of those measures, the “reckless” shares of the population are almost twice as high among the first five states as among the last five.  While we are at it, we might as well acknowledge that the red state populations also tend to be less educated and more prone to divorce. 

     There you have it, the surprising statistics.  ”Let he who is without sin cast the first stone.”

[This article draws in part on an op-ed concerning Obamacare in the Christian Science Monitor and another concerning Romney's "47%" remarks at Project Syndicate.    VoxEU also has a version.   Details on data and computations are available in a posted statistical appendix.]  

     I have argued that the best way to think of “black swan” events is as developments that, even though low-probability, can in fact be contemplated ahead of time.  Even if they are the sort of thing that has never happened before within an analyst’s memory, similar things may have happened before in the distant past or in other countries.   

     What current possible shocks have probabilities that, even if fairly low, are high enough to warrant thinking about now?  Some have been discussed ad infinitum, others hardly at all.

• Most widely discussed is the danger of a break-up of the euro. Considered unthinkable a short time ago, the probability that one or more euro members will drop out is now well above 50%. Currency unions have disintegrated before.
• Another is the possibility of a hard landing in China, analogous to the crisis that hit Korea and other East Asian markets in 1997.
• An oil crisis in the Mideast is the classic black swan event. Each one catches us by surprise: 1956, 1973, 1979, and 1990 (among others). Oil prices can rise for lots of reasons, not just crises in the Mideast, and have done so in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab government. The threatened loss of supply to world markets typically shows up as a sharp increase in demand for oil inventories and thus in prices.
• The most worrisome financial threat is a crash of currently over-priced bond markets. In theory such a crash could be precipitated by inflation (particularly commodity-induced inflation as in 1973 or 1979). But this seems unlikely. More likely triggers are (i) a breakdown in the eurozone or (ii) political dysfunction in Washington. A default in Greece or some other Mediterranean country could trigger a global debt crisis any time. The evidence of extreme dysfunction in US politics is already there for all to see, in the attempts by some politicians to repeat the macroeconomic policy mistakes of 1937 and in the debt-ceiling show-down of August 2011 (which led S&P to downgrade US government credit rating from AAA to AA). The obvious crunch date comes after the American election, as the “fiscal cliff” approaches in the last two months of this year. In theory, fears of what will happen January 1 should lead investors to start dumping bonds now. But it is still considered a sign of sophistication in financial markets to opine that, precisely because the consequences of going over the cliff would be so bad, the politicians will again find a last-minute way to avoid it. In truth, the fact that we haven’t gone over the cliff before does not necessarily mean we won’t this time. Perhaps observers think that a clear result in the election, one way or the other, would help settle things. A true black swan in the mix would be a repeat in November of the disputed 2000 presidential election; there has been no reform in the meantime to assure people that their votes will be counted or that a disputed outcome would be resolved by independent institutions rather than by interested political appointees.
• Scariest on the list is a terrorist attack with weapons of mass destruction. When politicians have used the specter of a September 11 repeat to scare the American public into supporting unhelpful policy responses, the mistake has been in the unhelpful policy responses, not in the “scare” part. There is long-standing gap between the probability of a nuclear event as perceived by terrorism experts and the probability as perceived by the public. Admittedly the probability is lower now that Osama bin Laden is dead.
• Last on this list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must of necessity be exhausted eventually. But the disbelievers are just as faulty in their reasoning that because a global climate disaster has not happened in the past it can’t happen in the future.

       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (”don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19^th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19^th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther - or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   ”Governments of advanced countries don’t default.”   ”European governments don’t default.”  Enough said.  Greece’s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.