Archive for the ‘Government’ Category
Surprise! Another post on state budgets. Apparently, this topic has become at least a pet peeve and perhaps a mild obsession. Today, I saw that Tyler Cowen replicated a graph from a post by Karl Smith, a professor at UNC. The claim is that government tax revenues aren’t growing as fast as they used to and that eventually this may result in a relative decrease in the role of government. (There’s a backstory of political commentary here that I’m ignoring because it’s not relevant to my point.)
Of course, Karl only looked at federal government revenues. However, with my state budget OCD, I immediately saw the flaw in this analysis. As one would expect from a public economics professor, he did a good job of controlling for inflation and population, but he forgot that the federal government isn’t the only one with it’s hands in our pockets.
Here are his graph of real per capita federal revenues and my graph of real per capita federal+state+local revenues.
Karl claims that the slope has changed since 2000 so that the rate of growth has significantly slowed or even turned negative. But I claim that if you add in state and local revenues, the peak to peak trend seems relatively steady since about 1980. (Note that Karl’s graph is of quarterly data and mine is of annual data, because the state and local series is only available yearly.)
Here are his graph and my graph of the 10 year growth rates:
The peak and trough from this last business cycle look very slightly lower, but my eyeball estimate is that it’s not significant. Government spending has continued it’s inexorable rise. All that’s happened is we’ve shifted the relative tax burden modestly from the federal level to the state+local level.
(Like Karl, I generated the data using the Federal Reserve Bank of St Louis’ FRED Graph tool.)
Yesterday, Mark Perry at Carpe Diem looked at state and local tax revenues. Then Don Boudreaux at Cafe Hayek observed they should be adjusted for inflation. Given my previous analysis (here, here, and here), I thought I’d chime in and adjust them for population*:
Over the entire period, real per-capita revenues rose 22%. On the graph, you can clearly see the 2001-2002 and 2008-2009 recessions. If we go peak to peak in the last business cycle, 2001 to 2007, the growth was 13%. If we go trough to trough, 2002-2009, the growth was 9%.
Notice that even from the peak of the previous business cycle in 2001 to the trough of the current business cycle in 2009, real per-capita revenues were still up 6%. So the recession is clearly not the proximal cause of the state and local budget problems.
State and local government agencies have more inflation-adjusted dollars per person today than they did at the peak of the boom in 2000.
Their revenues are consistently growing. The problem is that they can’t get their damned spending under control!
* State and local government tax revenue from this Census Bureau data. 2000-2009 population estimates from here. 1990-1999 from here. Ironically, 2010 population data is not yet available so I couldn’t generate a per-capita datapoint for 2010. I used the CPI-U series for inflation. I did all the analysis in this spreadsheet file.
You may recall my two posts on the California budget back in May 2009. I just haven’t had the heart to dive back into this issue again, even though it’s obviously timely. However, I though it was worth mentioning this article in Reason Magazine highlighted in one of today’s Coyote Blog posts.
Funnily enough, the article was published in the May 2009 issue. So I guess great minds not only think alike, they do so at the same time. What struck my about the article was that they performed a similar exercise to that of my post, which looked at real, per-capita spending in California. Reason compared actual revenues to a constant real, per-capita baseline totaled across all 50 states. Here are the money graphs for all revenues and just taxes:
When times were relatively good, the money was flowing in. So we went on a spending binge. When we hit the recession in 2008, we discovered that this level of real, per-capita revenue was not permanent. But by then, a bunch of people had been accustomed to getting their money from the states and it was hard to cut them off.
One budget watchdog estimates that the states are in a combined $112B budget hole for 2012. As you can see, if we’d stuck to our 2002 baseline, we’d have accumulated plenty of surplus during the good times to plug this hole. But asking a state to save money is like asking an addict to go without a fix.
This weekend, I was at a party chatting with two of my friends who have PhD’s in Education. They were explaining the sources of the inefficiency they see in the public school system. That’s when I had yet another Production Function Space (PFS) epiphany.
Recall my previous discussion about how I think large companies devote much of their energy to searching PFS rather than implementing specific production functions. However, in listening to how public education works, the contrast struck me.
Only a tiny sliver of effort goes to searching PFS in public education. Instead, the vast majority of overhead consists of two tasks. First, because there’s no market discipline, government organizations use a rigid system of rules in an effort prevent waste. So they have a bunch of people and processes dedicated to enforcing these rules: the bureaucracy. Of course, in an ever-changing landscape, these rules aren’t anywhere close to optimal for long. But hey, they are the rules. So a big chunk of effort that would go towards innovation in a commercial organization actually goes toward preventing innovation in a government organization. Because there’s no systematic way to tell waste from innovation without a market.
Without market signals, there’s also no obvious way for employees to improve their position by improving organizational performance. But don’t count out human ingenuity. That’s the second substitute for searching PFS: improving job security and job satisfaction. So you see workers seeking credentialing, tenure, guaranteed benefit plans and limitations on the number of hours spent in staff meetings.
From what I’ve read, this observation generalizes to other government agencies. If searching PFS is a major source of continuous improvement in commercial organizations, it’s conspicuous absence in government organizations means they are even less efficient than we thought. We don’t just lose out on the discipline of market signals today. We lose out on the inspiration they provide for improvement tomorrow.
In Part I, we saw how Money is an emergent phenomenon. In Part II, we analyzed how changes to the supply of Money affect trade. Now, we’re going to examine how expected changes to the supply of Money in the future affect trade today.
Earlier, we considered what would happen if Sally became ill and were unable to meet the ever-growing demand for new silver figurines created by population growth and innovation. We concluded that families would increase their reserves of figurines and the frequency of trades would decrease. A current event affected future activity. Now consider whether a future event could affect current activity.
Suppose Sally announces that she will retire in one year. Moreover, she declares that she has not seen any other metalsmith whose work matches her standards for beauty and quality (and most people trust Sally’s opinion). She’ll continue to manufacture figurines for a year, so there’s no effect on the actual supply of Money today. It will just stop growing a year from now. But what do you think will happen?
If I lived in this country, my wife and I would put a plan into place to accumulate a greater reserve of figurines over the next year. If there were a significant fraction of people like us, the frequency of trades would immediately begin decreasing , with the negative impact growing over time as those with less foresight began initiating reserve plans as well. You can see the potential for a snowball effect here: a constricting supply of figurines in circulation due to accumulating household reserves causes everyone to update their plans and desire… even greater household reserves!
We should also expect a general price decrease. Here’s why. Bob and Brad would probably tell their wives, Sue and Sara, that they need to accumulate a larger reserve of figurines to ensure they’ll be able to trade for necessities in the future. So Sue and Sara will thus want to increase their sales. But when Bob goes to buy clothes from Sara, he’s going to be less willing to part with his figurines due to his accumulation plan. How will Sara convince Bob to buy clothes so she can help Brad build their family’s reserves? That’s right, by lowering prices. Same for when Brad goes to buy milk and meat from Sue. So as the frequency of trade decreases due to greater demand for reserves, prices would go down.
But the worst part would be the effect on innovation. If I were an entrepreneur and I knew that the supply of Money would stop growing a year from now, how would I adjust my efforts at creating new products and services? I would probably reduce them because any innovation might end up in no man’s land; people want it, but they need to use their Money for higher priority items. Lower chance of a payoff means lower investment. Heck, entrepreneurs with currently successful products might well stop making improvements or even stop maintaining their means of production due to the combination of an expected future decrease in demand and their own desires to accumulate reserves. Our country could actually go backwards technologically! Not surprising though if you think of Money itself as a technology. You’d expect a similar effect if metal or computers became relatively scarce.
Of course, the opposite sequence of events would occur if everyone expected a future increase in the supply of Money. Suppose Sally announces that her daughter, Sunny, will finish her metalsmithing apprenticeship in a year and the capacity to product new silver figurines will increase (but not double, Sunny won’t be nearly as productive as Sally to start). I would expect the frequency of trades, prices, and investments in innovation to all increase.
Now, if Sally had ten apprentices and everyone expected the rate of new figurines introduced into the economy to skyrocket, our little economy might have a problem with runaway inflation. Similarly, if someone figured out a way to mass produce silver figurines equivalent in quality to Sally’s handcrafted ones, people’s trust in silver figurines as Money might erode. So more is not always better.
What we really want is for Sally and Sunny to have a fairy godfather who tells them exactly how many figurines they should make to keep up with population growth, innovation, and any changes in demand for household reserves. I like to think he’d be named Alan. Everyone would love Alan. Unfortunately, nobody lasts in the fairy godfather job forever. So people in our little country would eventually need to somehow harness their collective wisdom to determine how many figurines they need.
(1) The seller must believe that, if she accepts the Money, her husband will be able to use it in future trades where he is the buyer. The extent to which she believes Money will be useful in future transactions affects the price at which she will be willing to sell.
(2) The buyer must believe that he will be able to acquire more Money from his wife’s selling activities to support future trades where he is the buyer. The extent to which he believes Money will be scarce affects the price at which he will be willing to buy.
Most people focus on expectation (1). They examine reasons why the seller might not like the buyer’s Money. Potential debasement (reducing the amount of a precious commodity represented by the Money) and inflation expectations are the chief worries.
But they forget all about expectation (2). Remember that Money enables transactions that would otherwise not be possible. If a buyer has only a limited amount of Money, he will make the most important of these trades first. When he runs out of Money, all the other potential trades will not happen. So if there isn’t enough Money in circulation, it will have a real effect on the economy.
Consider the following scenario, using the setup from the previous episode. Sally becomes so ill that she can’t produce figurines anymore. The economic success enabled by Money had caused a steady increase in demand for it. The geographic area where people use Money has grown, people have moved into the area to take advantage of the better life enabled by Money, and people are constantly discovering new products and services whose trade was profitable with Money. Now the Money supply can’t expand to meet this growing demand. What do you think will happen?
Obviously, there are a bunch of lower-value transactions that simply can’t occur because there isn’t enough Money in circulation to execute them once the higher-value transactions are completed. However, the situation is actually worse. Because people will feel uncertain about whether they will have enough Money to meet future critical and surprise needs, they won’t even spend all the Money they have! They’ll want a reserve. The worse the shortage, the higher the reserve they’ll want and the worse the decrease in Money-mediated transactions. It’s just common sense to increase your inventory when future resupply is uncertain. Whether it’s money or food.
Hopefully, you can now see the outlines of my argument for why commodity Money isn’t necessarily better than fiat Money. Sellers like commodity Money such as silver figurines because it has some intrinsic value: the value determined by its demand for use in products and services. If they accept silver figurines, at the very least their husbands will be able to use the silver as barter.
But when you take into account the buyer perspective, this intrinsic value is a double-edged sword. Inherently, the demand for the commodity as Money will always compete with the demand for the commodity as a good. So in our toy economy, if someone discovers a new use for silver or a new use for Sally’s metalsmithing skills, the supply of Money will come under pressure and potentially cause a Money shortage like the one discussed above.
I tend to think that human ingenuity will always come up with more uses for things over the long term, so I believe commodity Money tends to directly harm buyers more than sellers. However, sellers can get hurt directly too. If someone figures out a really good substitute for the commodity as good, its intrinsic value can drop dramatically. Consider the invention of white gold as a substitute for silver or machine stamping as a substitute for Sally’s smithing. Because the commodity Money would be worth fundamentally less as barter, every seller that accepted it would take a hit. What you really want is Money that has the common knowledge properties of silver figurines but whose supply can be directly managed, without competition from direct use in goods and services. That’s what fiat money is. Of course, someone has to properly manage the Money supply. But that’s a topic for Part III.
So in summary, shocks to the Money supply can affect real economic activity and commodity money is no panacea.
I am undertaking a Quixotic quest. I am going to try to explain Money. I believe that hardly anyone (including me) fully understands Money. Even economists. A few appear to mostly understand it. The vast majority, even some charged with running government monetary authorities, seem to get confused by Money some of the time. Unfortunately, we are currently living during one of those times. In my opinion, much of the sphincter tightening economic news we have been reading about is due to fundamental misconceptions about Money by the very people charged with supervising our economy.
It will take several posts for me to complete this tilt at the windmill. But before I get started by laying out the overall plan, I would like to thank Scott Sumner. First, his informative blog posts on monetary policy inspired me to undertake this venture. Second, he graciously reviewed parts of my approach. All mistakes (and there will some, I’m sure) remain my own.
Step 1 will explain how Money is an emergent phenomenon. Step 2 will illustrate the concept of “monetary shocks”, culminating with dispelling the fallacy of commodity money’s superiority over fiat money. Step 3 will extend this illustration to show how expectations about Money help steer the economy. If I haven’t painted myself into a corner by then, I may try to push my luck even further.
So let’s tackle the concept of Money as an emergent phenomenon. I claim that Money will emerge out of a desire to trade. As a didactic device, I propose analyzing an imaginary country. All the adults are married, the women do all the selling, and the men do all the buying. Conveniently, all the women’s names start with S and all the men’s names start with B. The reason for this device to create an explicit need for households to coordinate production and consumption behaviors. So let’s start by examining this country back in a time before Money existed and barter was the only means of trade.
Sue is married to Bob and is shepherd. Sara is married to Brad and is a seamstress. Sally is married to Billy and is a metalsmith. Now, suppose that Billy needs clothes for his children. He must to go to Sara and trade metal objects made by his wife for those clothes. Unfortunately, Billy can’t just go and trade with Sara. Billy doesn’t have enough information about the relative production value of the various metal items his wife could make to trade. Moreover, Sara doesn’t have enough information about the relative consumption value of those metal items because that’s Brad’s responsibility. So Sally & Billy and Sara & Brad must all get together to arrange the trade. In many cases, the expected value from the trade won’t be worth the hassle of getting them all together, so they won’t bother.
Now, let’s consider trades between the Sue-Bob and Sally-Billy households. Sue always has a supply of wool and sometimes has a supply mutton. Of course, wool is useless by itself to Billy. So if Bob needs metal items from Sally and his wife hasn’t slaughtered any sheep lately, Bob has to first go to the Sara-Brad household. As a seamstress, Sara can always use wool. After he trades for clothes, he can go back to Sally-Billy who always have some demand for them. Of course, he doesn’t have enough information about the Sally-Billy clothing preferences to tell Sara what he wants. Moreover, we have the same household coordination problem as before. So Sue & Bob, Sally & Billy, and Sara & Brad all have to get together to hash out a trade or one person has to go back and forth among the others until they converge on an acceptable series of trades. This inter-household coordination cost is even higher than the intra-household coordination cost discussed above, so even fewer of these trades are worth the hassle.
Notice that a lot of potential trades won”t happen because the transaction costs are greater than the expected gains. Then one day, something important happens. Sally makes a little silver figurine for her and Billy’s daughter, Sunny. Bob sees it one day when he’s over completing a trade and wants one for his son, Bert. Pretty soon, all three families and everyone in their town is in the grip of a silver figurine collecting craze. Almost everyone wants to trade for figurines. Everyone knows almost everyone wants to trade for figurines. So even those people who don’t care much for the figurines know they can easily trade them to people who do want them.
Billy finds he no longer needs to bring Sally along when he trades with Sara. Sally can simply give him five figurines to trade for clothes because they know roughly how much clothing Sara will trade for figurines. Things also get easier for Bob when he needs metal items from Sally. He can just trade her some of his figurines for other metal items. Even though she can make figurines herself, especially because she makes them herself, she realizes their value in terms of trades that Billy can make down the line.
So Money has emerged. It didn’t have to be figurines. It could have been turquoise, salt, or leather. The key ingredients were that it was relatively portable and a group of people began expecting everyone in the group to accept it in trades. Within the group, the item’s trading value became common knowledge (in the game theory sense of the term). In this case, a collecting craze precipitated this mutual agreement. In other cases, it could arise out of established tradition, explicit negotiation, or random discovery.
Notice that Money adds value. It’s not merely an accounting fiction. All sorts or trades that weren’t possible before become possible, creating new sources of value. Moreover, a lot of trades that did occur previously now produce more value because they cost less to make. So there’s a lot of “pull” for Money to emerge. Once it happens, there’s an equilibrium that will tend to hold unless perturbed.
Moreover, once Money emerges, it’s like any other technological innovation such as electricity or steel. It becomes embedded in the pattern of trade across the economy. People will be out and about more often because there will be more trades to make. Hey, that means more restaurants and hotels. Smaller trades become possible. Hey, that means whole new markets for accessories to larger items. Trades across larger distances become practical. Hey, that means more regional specialization of industries. And so on.
But what happens to this network of effects if something undermines common knowledge foundation of Money? We’ll explore the possibilities in the next post.