Author Archives: Lucas Morrison

Canada’s Strange New Budget Legislation (Revised)

Thesis: A government outlawing deficit spending is overly idealistic and restricts lawmakers by making fiscal stimulus overcomplicated.

Tomorrow, April 21, Canadian Finance Minister will deliver his budget proposal, including an unprecedented piece of legislation that would outlaw government budget deficits, per the Wall Street Journal.  The bill includes a necessary loophole clause that would make exceptions for recessions or extraordinary circumstances such as wartime or a natural disaster.  It’s a proposal that seems to be addressing a problem where one doesn’t exist – Canada has historically run a fairly responsible budget, with a very modest ~35% net debt to GDP ratio.  And as one of the most politically and economically stable countries in the world, it doesn’t cost Canada much at all to borrow.

Basic countercyclical policy dictates that governments should spend during economic downturns in order to prop up aggregate demand, financing itself by issuing debt, which it then pays off during economic booms.  This law tries to make this behavior a mandate by forcing the government to cut spending during good time.  It’s a nice idea in theory, but it may make the use of fiscal policy to stimulate recessions a bit tricky.  Specifically, a problem arises when the government tries to define where a recession actually ends – cutting a stimulus package the moment a quarter shows a positive growth rate (however small) is rarely ideal.  In fact, we only have to look back a few years to demonstrate this in practice.  Canada’s stimulus package for the recent global recession was introduced in 2009 and continued throughout 2011, according to The Star, even though the Canadian economy showed positive growth rates as early as mid-2009.  By allowing stimulus to continue past the point where a recession technically stops, the government can ensure that the spending has boosted the economy throughout the entirety of the country, since growth rates in some outlier areas may skew the aggregate growth rate positive even when other parts of the country are still hurting.  It also gives consumers a solid timeline to base their expectations on – if households know that the fiscal stimulus could be cut off at any time, they may be more reluctant to go out and spend.

What the Canadian Finance Minister is proposing would force stimulus packages to be reluctantly designed in small, short-term packages, which may require the government to respond to a recession multiple times, dragging out its length.  What’s more, the increased scrutiny on deficit spending might make lawmakers reluctant to even consider introducing stimulus proposals.  And since the spending would have to be so short-term (and maybe even cut off if the economy recovers prematurely), the government can’t commit funds to longer infrastructure projects – a major component of many federal stimulus packages.  There’s no good reason for the Canadian government to restrict itself like this besides political grandstanding.  A more prudent step towards managing federal debt would be to expand the budgeting process to require a balanced budget over the course of a business cycle.

IRS Refunds Boost Savings

Thesis: Despite common wisdom of financial planners who claim that receiving a tax refund represents a missed opportunity, wage withholding promotes more responsible uses of income by households – a behavior that could be easily reinforced with a tax-savings program.

Tax day, for most Americans, is the culmination of a grueling process of government paperwork and stress over their financial position.  But for most (51% of Americans, according to a Bankrate survey) there’s a light at the end of the tunnel – a refund check that represents a large chunk of disposable income that can be spent, used to pay off debt, or put away and saved.  The federal wage withholding tax serves a rather obvious purpose.  It’s a safety net to ensure that people are able to pay their taxes, since many households might otherwise find themselves unable to pay their income tax when it arrives in the form of a lump sum.  But there’s a positive externality to the tax mechanism – it causes households to act more responsibly, saving more.

Financial advisors have sneeringly dubbed tax refunds ‘interest free loans to the federal government’, since a person who files taxes such that they’re receiving a refund is essentially letting the IRS hold on to part of their wages for the whole year.  Said advisors base their criticism on the time value of money, and would instead advise a household to adjust their withholding to receive larger paychecks rather than a refund, so that they can invest the money in the interim.  But this analysis depends on the veracity of the permanent income hypothesis, which states that a household will base spending (and conversely, saving) on an internalized expected stream of income – and in the short run, there’s evidence that suggests that consumers don’t treat a large chunk of income the same as they would a smaller stream.

Behavioral economist Richard Thaler claims in his paper on mental accounting that larger payments, as opposed to small bumps to wages, will be coded differently by consumers.  Households perceive large gains as significant assets, for which they have a very low (almost zero) marginal propensity to consume.  On the other hand, current income, composed of cash on hand and checking accounts, is treated with a marginal propensity to consume of nearly one.

This theory seems to hold up in practice.  The same Bankrate survey cited above found that 33% of households plan to save or invest their refund and 34% plan to spend it paying off debt (which can be interpreted as saving), while only 3% plan to spend it on frivolous items.  In comparison, Americans spend 10.1% of their annual income on entertainment, alcohol, and clothing alone, according to Department of Labor data.  So even if households may be better off foregoing the refund to invest more throughout the year, the temptation to spend is too great for most – thus the advantage of the refund system.

And the tendency to save could be further promoted, as Michal Grinstein-Weiss of The Brookings Institute preaches.  Along with colleagues and TurboTax, she conducted an experiment to see whether tax filers would be more likely to save a portion of their refund if prompted immediately after receiving it.  Of course, that’s precisely what happened.  Grinstein-Weiss advocates for a government-sponsored program that offers the same thing.  Such a program would be incredibly simple to incorporate into tax filings, and would help promote the asset accumulation and financial security of American households.

A Potential New Electricity Market

Thesis: Companies should invest in R&D for household batteries, as inevitable improvements in renewable energy technologies are on the verge of creating a massive market for such products.

It’s somewhat difficult to be advocating for investments in renewable energy right now – oil prices have been in a pit for almost an entire year now, and with the natural gas industry booming, it seems as if alternative electricity sources are still a ways away from becoming economically viable.  But the surplus of cheap energy is bound to end sooner or later, especially since much of it was caused by drillers oversupplying, which has since been corrected.  Oil mogul T. Boone Pickens pointed this out in a Wall Street Journal interview, noting that the US had 1,400 natural gas rigs active seven years ago compared to only 250 today.  In addition to the supply correction, there is a slingshot effect: the current weak market dissuades producers from taking on new projects as they continue to produce from existing fields, and once those reserves expire, prices will surge upwards.  With the inevitable price recovery of fossil fuels, technology and industrial companies should be jumping at the opportunity to beat everyone else to market – the home battery market.

Solar energy technology for household application is rapidly becoming feasible.  While fossil fuel-based grid electricity is still king, sitting at around 12¢ per kWh, solar panels in Los Angeles have produced electricity at 19¢ per kWh, reaching costs as low as 11¢ after subsidies (although that won’t matter, since once solar becomes cheaper, governments will no longer have a reason to subsidize).  And solar prices have fallen 50% in the past five years, according to data from the Institute for Local Self-Reliance, a trend we can expect to continue (albeit at a slower pace).  But the biggest problem facing solar electricity is one of consistency.  The panels cannot produce at a sufficient rate all throughout the day, or some days even at all, which is why fossil fuels will continue to dominate the grid for years to come.

elecP

ILSR graph showing the convergence of solar and grid electricity prices

Current solar panel owners ‘store’ their electricity with net metering, which is when a utility company credits a homeowner for excess electricity that they feed back into the grid.  But recently there has been a movement against net metering, since it essentially provides a subsidy for owners of solar panels and passes on the cost to other non-owners.  Other critics have pointed out that those who benefit from net-metering don’t end up paying for grid maintenance despite using it.  Because of these issues, many states are taking measures to limit the concept – and thus arises the need for household batteries.  Such a product would allow owners of solar panels to minimize their energy expenditure: it would allow them to spend fewer hours feeding from the grid, and avoid peak prices (generally early evening, when solar panels aren’t producing much).  One would imagine that with the high capital costs of producing batteries, there are significant economies of scale associated that would reward an early investor.  As such, we may soon see a bevy of companies like GE, Samsung, and even Tesla fiercely competing in the household battery market.

Canada’s Strange New Budget Law

Thesis: A government committing to outlawing deficit spending may sound nice in theory, but it makes providing fiscal stimulus incredibly tricky and ties lawmakers hands when trying to design stimulus packages. 

Next Tuesday, April 21, Canadian Finance Minister will deliver his budget proposal, including an unprecedented piece of legislation that would outlaw government budget deficits, per the Wall Street Journal.  The bill includes a necessary clause that would make exceptions for recessions or extraordinary circumstances such as wartime or a natural disaster.  It’s a proposal that seems to be addressing a problem where one doesn’t exist – Canada has historically run a fairly responsible budget, ranking 51st in the world in net government debt to GDP ratio (Wiki), a list where the top is dominated by the most highly developed countries.  And as one of the most politically and economically stable countries in the world, it doesn’t cost Canada much to borrow. 

Basic economic theory dictates that governments should spend during economic downturns in order to prop up aggregate demand, financing itself by issuing debt, which it then pays off during economic booms.  This law tries to make this behavior a mandate by forcing the government to cut spending during good times, but it may make the use of fiscal policy to stimulate recessions a bit tricky.  Specifically, a problem arises when the government tries to define where a recession actually ends – cutting a stimulus package the moment a quarter shows a positive growth rate (however small) is rarely ideal.  In fact, we only have to look back a few years to demonstrate this.  Canada’s stimulus package for the recent global recession was introduced in 2009 and continued throughout 2011, according to The Star, even though the Canadian economy showed positive growth rates as early as mid-2009.  By allowing stimulus to continue past the point where a recession technically stops, the government can ensure that the spending has boosted the economy throughout the entirety of the massive and diverse country, since growth rates in some outlier areas may be keeping the aggregate growth rate positive even when certain areas are still hurting.

What the Canadian Finance Minister is proposing would force stimulus packages to be reluctantly designed in small, short-term packages, which may require the government to respond to a recession multiple times, dragging out its length.  And that’s not even the worst-case scenario, since the increased scrutiny on deficit spending might make lawmakers reluctant to even consider introducing stimulus proposals.  Since the spending would have to be so short-term (and maybe even cut off if the economy recovers prematurely), the government can’t commit funds to infrastructure projects – a major part of the US government’s incredibly successful Recovery and Reinvestment Act. 

Why not every Industry can be “Too Big to Fail”

Thesis: The declining taxi industry of New York is a case of idiosyncratic risk, and the industry should be allowed to fail as it has a readily available replacement.  

This past Thursday in a New York Times interview, taxi mogul Evgeny Friedman called for the city of New York to back all loans made for medallion taxi purchases.  Friedman contends that the taxi market is threatened by lack of credit available to would-be taxi purchasers, and that a lack of action from the city would impact the taxi industry across the entire country.  He even went so far as to claim that the taxi industry is “too big to fail,” comparing the situation to that of the financial industry during that of the mortgage-backed security crisis.  But he is applying the label of “too big to fail” to an entire industry, whereas the term originated (and has historically been used) in reference to single corporations.  And it’s worth asking the question: if an entire industry needs government intervention to keep it afloat, then is it even worth saving that industry?

The financial institutions that received bailout packages during the recession got them because their failure would have meant a nationwide freezing of credit and shock to financial asset prices.  A failure of the medallion taxi cab industry would mean a loss of tax revenue to the city and a shortage of taxis available to riders.  But while the services provided by major banks are incredibly hard to replace, the problems associated with a failure of the taxi industry have easier solutions which would be quick to implement.  As taxi drivers see less and less income and take their cars off the road, their main competitors (Uber and Lyft drivers) will find their services producing more income, and new drivers will emerge until the supply of drivers and the demand for rides hit equilibrium.  And while the loss of tax revenue is certainly material (New York collects 50 cents for each ride, and at 600,000 rides per day [according to a New York City factbook], the city sees about $109.5 million in annual tax revenue), taxes can be applied to Uber and Lyft rides in the same fashion.

What Friedman is really asking for is a “save my business model” bailout.  There are few legitimate arguments to made as to why the taxi industry should not be allowed to fail.  And in reality, taxis probably won’t completely fail for quite a few years.  The price of a yellow medallion cab will certainly fall and taxis on the road will be replaced by drivers from other services, but taxis likely won’t suffer from a sudden mass extinction.  Friedman, who is significantly biased (he owns 1/6th of New York’s taxis – worth about $1 billion), is overstating the economic threat.  He merely overspeculated on the rising prices of an asset (taxis), and is now reaping punishment.

Why the Government’s Student Debt Portfolio Isn’t as Bad as it Seems

Thesis: Fear that the federal government’s student debt holdings have become too large is overstated – partially because the increase in holdings fall in line with expectations, and partially because the default rate is inflated by declining for-profit college students.  

The federal government’s current student loan holdings are the highest they have ever been, sitting at about $876.1 billion.  As this graph of Fed data, published by QZ, demonstrates, the value of student burdens held by our government been steadily rising for the past two decades or so, with a shocking spike occurring right as the recession hit and no deceleration in sight.  The slow rise can be attributed to more and more Americans deciding to attend college over the past few decades, and the sharp rise can be attributed to two factors: students fretting about the job market and returning to school, and a reform of federal subsidies for student loans, which made the federal government the sole lender to students.  While we are likely seeing a permanent increase in loans, it is less shocking once one considers the circumstances – of course the federal loan holdings had to increase as the government captured the entire share of the student lending market.  And unlike the increased holdings, the increased rate of loan accumulation is not permanent – it will almost certainly begin to level off as the economy continues to grow and the job market improves, giving young Americans less desire to reach for higher levels of education.

federal-student-loans-outstanding-data_chartbuilder1

In its current state, the government’s loan portfolio provides a positive revenue flow, since the government borrows money at a much cheaper rate than students pay.  Despite this, some are worried about the size of that portfolio, as evidenced by a Bloomberg article which called it an “$800 billion gamble.”  Critics quoted in the article point to the high default rate on student loans (which hovers around 14%), claiming that the default rate may hit a breaking point, and the high level of federal lending will leave taxpayers to front a massive bill.  But that default rate is skewed by students of for-profit colleges, who take out (and default on) loans at a higher rate than the rest of the population.  And said colleges will soon be facing new regulations effective this July, per the Washington Post, meant to limit the amount of debt their students accrue.  This reform will have a huge impact on the riskiness of the government’s student debt holdings – as the article mentions, students at for-profit schools “represent only about 11 percent of the total higher-education population but 44 percent of all federal student loan defaults.”

Regardless of the risk that taxpayers may have to front a bill for a student loan default crisis, one cannot deny the necessity of educating our nation’s populace.  Critics argue that not every citizen should decide to attend college by default, claiming that college isn’t worth it for everybody as tuition continues to rise.  But a study conducted by the Brookings Institute indicates that the income of college graduates has kept in pace with the increase in debt loads: between 1992 and 2010, the annual income of an average household with student debt increased by $7,400 while their debt burden increased by $18,000, meaning that the student debt essentially pays for itself with increased income in about two and a half years.  As we look towards a future where competition is fierce due to global competition and low-skill jobs will begin to disappear to sophisticated machines, it’s important that our country provides as much opportunity as possible to hopeful students in securing the means necessary to receive a higher education.

The Efficiencies of a Land-Value Tax

Thesis: The imposition of a land-value tax on commercial property by the US government would lead to more efficient use of scarce land in urban areas.  

Most Americans are familiar with the concept of a property tax: a major tax levied against one’s real estate, based on the value of the land and the improvements made to that land.  The notion of a land value tax (essentially just a piece of a traditional property tax – the piece based on a plot of land’s value) and the efficiencies it can bring about has growing clout amongst economists today, as housing costs in urban areas skyrocket.

Data gathered by Yale economist Robert Shiller and cited in The Economist shows that  “the inflation-adjusted cost of building new housing in America is roughly the same now as it was in the 1980s. The inflation-adjusted cost of buying a new home, by contrast, has risen by 30% over the same period”.  There are two main driving forces behind this dramatic increase in land value.  One, the information era and the rise of skill-based services has drawn workers to highly-skilled areas (e.g. cities), where proximity to other similarly-skilled workers increases their productivity and job opportunities, effectively increasing demand for urban land.  Two, after cities became aware of the detrimental effects of unchecked growth and urban sprawl, they began to institute strict limitations on growth, effectively decreasing the supply of urban land.  Combined, these forces have made land in these urban areas incredibly costly, making it more difficult for labor to move to the most productive markets in the country.

Another study presented by the same Economist article above found that the inefficient patterns of land use imposed by high urban housing costs could mean that US GDP in 2009 was a whopping 13.5% lower than it had the potential to be.  Land-value taxes are a potential mechanism for keeping inefficient land use in check.  Since they do not carry the same downfalls as other forms of taxation (land supply cannot be reduced and the tax cannot be evaded), they carry no deadweight loss.  Unlike property taxes, they don’t de-incentivize investment on a plot of land.  Not only do they increase revenue, but that increase is compounded by public investment: the construction of a neighborhood monorail would increase the value of land in that neighborhood, and thus the new revenue from land-value taxes could help pay for the investment.  Since the value of a plot of land increases as a result of the activities of others, it would make sense to tax that value.  But most importantly, land-value taxes lead to more efficient uses of incredibly scarce land as owners must ensure that their land is being used in the most productive way possible.  New York mayor Bill de Blasio has introduced a tax increase on New York’s vacant lots, as described in Brokelyn, in an effort to put the land to productive use.  I predict it won’t be long before we see other cities following in his footsteps.  But the idea is politically difficult: for most Americans, their home is their biggest asset, and they won’t take kindly to anything that threatens that asset’s value.  And the idea of low-income families being pushed out of a house so that some developer can put up a new set of condos has media frenzy written all over it.  For that reason, I propose that the tax be limited to commercial properties for the foreseeable future.

Was Clinton’s Executive Compensation Policy a Mistake? (Revised)

Thesis: The current tax code has created an incentive for management to focus corporate profits on short-term stock-boosting strategies rather than long-term investment, and thus is a contributing factor to the stagnation of wages in the US.

One of the most troubling issues facing economists studying the United States has been the stagnation in wage growth over the past few decades.  Common wisdom would dictate that as marginal productivity of labor rises, so would wages.  As evidenced by the graph below, courtesy of the Economic Policy Institute, this was the case for some 25 years during the US postwar boom era, but beginning in the 1970’s, wages began to flatten out as productivity continued to rise.

wage growth

Economists have attributed this trend to a handful of factors: rapid globalization creating a massive increase in competition in the labor force, technological improvements reducing the supply of jobs, erosion of large-scale union power, and more recently, rising health care costs to employers.  In a recent opinion piece in the Washington Post, Harold Meyerson has added a new factor to the discussion: the recent tendency of corporations to use capital to increase shareholder value, rather than investment in the company.  As Meyerson writes, investment has slowed down significantly while earnings have been funneled at an increasing rate towards shareholders through stock repurchases (which increase stock price with artificial demand) and dividend payments.  The prioritization of shareholder payouts over investment puts a damper on job creation and wage increases, and makes it harder for traditional monetary policy to stimulate the economy.  So why the dramatic shift in corporate cash flow allocations?  I would argue that the single biggest driving force is the rise in stock-based compensation packages for executives.

A little background on the concept of stock-based compensation: in 1993, facing pressure from institutional investors and in an effort to limit the rise of executive compensation, Bill Clinton created section 162(m) of the IRS tax code (wiki), which stated that companies could only deduct the first $1 million of executive pay.  However, the code included a provision that excluded performance-based pay, which is why we see the executive compensation packages we have today: a seemingly meager base salary, under $1 million, with substantial stock options that make up the bulk of pay.  In theory, there are certainly some benefits to stock-based compensation: they help ensure that management’s actions are in line with shareholder goals, as executives have a vested interest in the company’s performance.  But there are two sides to this coin.  Since executives receive such an overwhelming portion of their pay via equity, they have an incentive to boost the company’s stock prices even when it might not be in the best long-term interest for shareholders.  The disparity in time horizons between executives and corporations exacerbates this problem: according to the Wall Street Journal, the average CEO’s tenure is just 9.7 years, meaning that executives rarely stick around long enough to see the company benefit from gradual growth and investment.  Instead of re-investing earnings, an executive is better off allocating capital to stock repurchases and dividends to increase stock prices in the short run.

The trend has troubling implications for the economy.  Undoubtedly, declining corporate investment means slower growth in output and employment.  But more importantly, if companies aren’t allocating capital to investment, then monetary policy is somewhat crippled.  A paper published by The Roosevelt Institute found that in the 60’s and 70’s, an additional dollar of corporate borrowing or earnings led to a 40-cent increase in investment.  Today, that same dollar leads to less than 10 cents of new investment.  That means that stimulating borrowing with low rates has had an increasingly diluted effect on actually stimulating investment.  So it may be time for regulators to re-think whether performance-based compensation is really in the best interest of shareholders – the shift in corporate capital seems to suggest otherwise.

California’s Constant Water Woes

Thesis: A better mechanism for reducing California’s water consumption would be to allow prices to rise, rather than to place a hard cap on utilities.  

It seems as if we hear the same thing every year – California is in the midst of a drought due to its dry climate and lack of rainfall.  This year is no different, as governor Jerry Brown called the drought to be “near-crisis proportions,” and issued a historic executive order mandating the state’s water utilities cut consumption by 25%, as the New York Times writes.  The governor cited a lack of snowfall on the Sierra Nevada range as the cause of the drought, but there’s reason to suggest that overuse may also be a factor.  As the graph below, provided by the Hamilton Project, demonstrates, California (and all the other western states) consumes water at a much higher rate than the rest of the nation.

caliwateruse

Obviously part of this comes from the fact that these states are dryer and hotter, and as such will naturally demand more water.  But do they really need that much more water?  People can be expected to use water for things like showering, plumbing, and washing machines at roughly the same rate whether they’re living in a hot climate or not.  As data from the California Water Blog points out, Australians, who live in a similar climate, manage to consume almost half as much water per capita.  Where the higher rate of consumption really comes in to play is when homeowners desire vibrant green lawns, which require far more irrigation in a western climate.  And if the water is cheap enough for households to afford to be able to maintain a high level of consumption, why wouldn’t they keep their lawn in tip top shape?

Short of an actual state of emergency, California does not need to place hard limits on water consumption.  What California needs to do is ease up on controlling water prices and allow the market to reflect the relative scarcity of water.  The higher prices would lead to more efficient use as households and farmers make an effort to save water, both by changing patterns of use (many might find that they no longer gain a positive net utility from that shiny green lawn), and by making investments in high-efficiency appliances more appealing.  Raising utility prices (especially a utility which is considered to be a basic human right by most) would be politically difficult.  But so is flat out telling people that they need to use less water.  At least the market allows consumers to decide for themselves what they need to prioritize.  Placing limitations on use merely acts as a stop-gap, while allowing prices to float addresses the problem at its root: cheap availability of water.

Local Government – a Mechanism for Suburban Sprawl

Thesis: Local governments have an incentive to continually approve new suburban developments without considering the long term consequences.  This has led to the growth of inaccessible jobs.  

The United States is trending towards a state where its workforce is disconnected from the businesses that employ it, new research from the Brookings Institute suggests.  The data is stark: from 2000 to 2012, jobs within the average commute of major metro areas fell by 7%, with jobs within commuting distance declining for both urban and suburban residents of those areas.  Jobs are not only moving away from the center of cities and towards the suburbs, but they’re spreading out and becoming harder for people to get to.  Our very own metro Detroit is the worst city in the nation when it comes to job sprawl, with a whopping 77% of jobs located at least 10 miles away from the central business district.  Just as one might imagine, this poses a serious problem for the city’s many low-income residents who don’t own vehicles, unless they have access to some form of public transit that can connect them to their place of work.  As it currently stands, most cities can’t hope to create a public transit system extensive enough to connect non-car owners to the widening network of jobs.  So what can be done to make jobs more accessible?

The most obvious change that could be made would be a reverse migration of Americans from the suburbs back to the cities.  And although it seems that such change is taking place – young people are flocking to cities at the rate of millions per year, as The Atlantic writes – there isn’t much that local governments can do to support this trend that they don’t already do.  Where local government can have an impact is in its support for new suburban development.  County and municipal governments have a strong incentive to approve or even push for development to increase their revenue.  When a local government approves a new development it gets an influx of cash from public works contracts and registration taxation associated with the new suburbs.  In the long run, these governments struggle to keep up with the infrastructure required, providing incentive to approve new developments to keep up with revenue needs.  The result is an incredibly costly cycle with no ending point.  There are many other costs associated with suburban living.  One estimate produced by The New Climate Economy (which, admittedly, is not the most unbiased source for this approximation) prices the annual costs of America’s suburbs to be about $1 trillion, due to infrastructure costs, longer job searches, environmental impact, wasted valuable land, and many more factors.  Of course, some people will always crave suburban life, and so long as they pay for the associated externalities, they should enjoy that right.  But hopefully we can find a solution to local governments producing suburbs with no end in sight.