Laying Pundits End to End

"A desk is a dangerous place from which to watch the world."
-- John le Carre

A desk may be even a more dangerous place from which to shape the world. Nonetheless, I'm going to try to do so in this post. I have been struggling for the last week or so to think through what steps government should be taking to aid middle income (note that I didn't say middle class) families, both for the here and now and for the indefinite future and to do so in such a way that those of us at or above the 80th percentile in the income distribution (the vast majority of whom feel they are middle class) would willingly agree these are good things to be doing. For the last year where the Census data is available, 2009, median household income in the U.S. was not quite $50,000, while at the 80th percentile household income was $100,000.

Income as a welfare measure is far from perfect. Work that is done outside the marketplace isn't counted in the measure. Spending on things like security don't directly raise welfare at all. Such spending simply aims to prevent loss of what has already been attained. So there certainly can be a critique of what I propose in this post simply on those measurement grounds. With that caveat, the proposal aims to raise income, at the median (and below) as well as at 80th percentile (and above).

Revenue Side

In the Facebook group I started, For A More Compassionate And Saner America, I've taken as a theme that the people in this relatively well off group should shoulder greater social responsibility by paying more in Federal income tax. Let me do a quick and dirty calculation to aggregate up the revenue increase likely to be generated by this proposal if it were approved. For this we need to know the average adjusted gross income of those in the relatively well off group. I don't know what that is, so I'm simply going to make a guesstimate and say it is $150,000. This is a source of error in the calculation but one can readily see how to adjust the calculation with a better number if one had it. Since in my proposal only income above the 80th percentile would be subject to increased tax we are talking about $50,000 per household subject to the tax increase.

Next we need to know how many households are in the group. To do this, I used the Census QuickFacts page. The population growth rate was 9.1% from 2000 to 2009. I'm going to assume the household growth rate was the same. There were 105,480,101 households so the guess on the number of households in 2009 is: 1.091 x 105,480,101 = 115,078,790. To benchmark this number, note that the QuickFacts page also provides the number of housing units, not quite 130 million. If my household number is in the ballpark then the excess of housing units would be explained either by some people having multiple homes or by there being an excess supply of housing units available due to over building (more on this later in the piece). To me, that makes the number seem plausible. We will take 20% of this number as the size of the privileged group (since we are at the 8oth percentile and above).

Finally, if this group returned to the Clinton era tax rates, I take this as an increase in marginal tax rates of 3%. The revenue so generated is then:

$50,000 x .03 x 115,078,790 x 0.2 = $34,523,637,057

This amount, about $34.5 billion, is on the low side because I used 2009 households instead of 2011 and population is growing. Further, it is again on the low side since the highest marginal tax rate (for married filing jointly) was 39.6% while now it is 35%. So people in the highest bracket would see more than a 3% increase in their taxes if we returned to the Clinton era rates. Even still, it is a large amount of income. So it behooves us to suggest how it should be spent and not simply take on faith that it will be spent well.

Before getting to the proposal, let me note that while large it is nowhere near large enough to itself solve the Federal budget deficit issue. For my own understanding, I break up the Federal budget into three large components - the real economy, social insurance, and military. Here the focus is entirely on the first component, the real economy. The other components require their own modifications. I believe there is much confusion because the components get lumped together. So the real economy part gets wacked in the budget proposals because the social insurance and military spending pieces are out of balance. This is a mistake.

The Issues

Structural Changes in the Economy - Michael Spence, an eminent economist and Nobel laureate was on the Charlie Rose Show last week. Contrasting the period in the aftermath of World War II, where the U.S. was the clear dominant player economically around the globe, to the present with the emergence of Brazil, China, India and other rapidly developing nations we are moving much closer to parity. This implies substantially increased competition in the global marketplace with no guarantee at all the American made products and services will be preferred worldwide. In turn this means there will be pressure put on employment in sectors of the economy that deal in "tradeables" and either that American economy must expand its production of non-tradeables to employ the population in full or that workers must acquire the appropriate human capital to be valued in the tradeables sector.

My own view on this issue is that many families at or near the median in the income distribution have historically done blue collar work. The ethos of the family unit has been built around that notion. While Spence may be right about the human capital acquisition, it is probably wrong to infer that large numbers of blue collar worker and their families should be switching to white collar work. What is needed instead is to find competitive blue collar work. Consider, for example, this feel-good story about the rejuvenation of the American auto industry, which now seems to be focused on building fuel-efficient small cars. Auto manufacturing provides a case in point for what needs to happen across the entire economy.

Huge Private Debt Overhang and High Unemployment - Paul Krugman, another Nobelist, argues in his most recent column that Washington is not paying sufficient attention to the unemployment problem. In his analysis the main culprit is weak aggregate demand. The cause is simple enough to understand - too many households became highly leveraged and now have to pay the piper. Their lack of spending encourages business to be cautious and sit on cash reserves rather than invest them. Add to this the decline in housing prices and the concomitant loss of wealth that those who had equity in their homes have experienced and the still large number of foreclosed homes that have yet to be resold which are keeping housing prices down and deterring new home construction. So in addition to the debt people hold they are apt to be glum about their future prospects. This pessimism further weakens demand.

I agree with the assessment and want to add a couple of points to it. First, with the unemployment rate high and wages depressed, it is hard for many people to reduce their debt substantially, even while they willfully restrain their spending. Second, even if optimism were restored at the consumer level, banks are not lending to people who had debt issues in the past. So individual access to credit is now limited and that further restrains demand. Third, these are likely to persist, a self-fulfilling negative cycle. Something external is needed to break this cycle.

Long Lags with Fiscal Policy Due to Lack of Shovel Ready Projects - One big issue with with President's Obama original stimulus package was that much authorized spending didn't happen in a timely fashion. Government procurement at the state and local level is regulated and bid processes must be followed. So even if funds have been authorized it takes a while to have those monies spent. We therefore didn't get as big an immediate kick to the to the economy as we needed back in winter of 2009.

Some have concluded from this that fiscal policy is the wrong instrument to use to address business cycle fluctuations and the clearly have a point. Monetary policy is certainly more agile. However, monetary policy doesn't address underlying structural issues. So in my view fiscal policy has a role but it needs attention on an ongoing basis, not simply as an emergency measure.

The Proposal

Let me use the following observation to motivate the idea. For years and years the Campus at Illinois had a structural problem - deferred maintenance. There are many older buildings and they required upgrades on their HVAC and electric systems and perhaps their plumbing too. Then given that work would be done, sprucing up the interiors makes sense as well. For many years the problem was discussed but not addressed at all. New buildings, funded in part by donors who made large contributions, but also with substantial Campus dollars (and until the past decade State matching dollars), got erected at a fairly rapid clip. In the meantime nothing was done about the deferred maintenance problem. Now the Campus is addressing the issue. What changed? There is now a separate student fee assessed specifically to address the problem. With targeted funding a credible plan was developed and has been put into place. The first of this activity started about a year ago.

Thinking about the analog at the national level, we seem to have little problem finding capital to build brand spanking new sports facilities - frequently financed by bond issues to be repaid with tax dollars, though the teams are privately owned. But to renovate or replace an old school, library, or community center, that is a different matter. Community support for funding such projects will vary directly with the business cycle. And to the extent that the funding requirement is episodic rather than recurrent there will be a psychological tendency to push off the funding pain and delay the project. Taxpayers are also sensibly reluctant for local governments to build "war chests" for fear that opportunistic politicians will squander the funds. Further, the benefit from such capital replacement may be visible to some citizens but not others. A parent who has a kid in the school is more likely to favor capital investment in the schools. It's easier to get endorsement to fix potholes in the roads than it is to upgrade water treatment facilities. This, however, doesn't speak at all to the necessity of the upgrade. It is a poor strategy to wait until a crisis has developed before doing replacement or upgrade investment.

The issue is by no means new. Consider this Report from the CBO on the issue dating from the Reagan years. (Note that buildings such as schools are not included in these numbers. Funding for buildings is in a non-infrastructure budget category.) As the graph below (from page xiv of the report) makes clear, while there was concern about the overall spending on infrastructure, the bigger issue seemed to be that operating expenditures were crowding out capital investment in infrastructure.

A more recent CBO presentation makes clear that the issue is mainly with State level funding of infrastructure. States do provide the lion's share of infrastructure funding.

Further - since States are supposed to balance their budgets on an annualized basis rather than over the entire business cycle, their spending is pro-cyclic. For infrastructure capital investment, however, it would be much better if the spending were acyclic, providing some stimulus in troughs and some restraint in peaks of the business cycle. (In other words, while the housing market is in the dumps now it would be good for their to be new construction in public works. When the housing markets heat up again, the public works construction will help to keep the housing market from overheating.)

We need such a focused entity at the Federal level to direct new investment and substantial upgrades to the existing stock of public capital. I would call this thing the Federal Investment Bank, an independent entity with the discretion to optimize for the long run public capital growth and maintenance. In its governance structure, the Federal Investment Bank could be modeled after the Federal Reserve. This history of the Fed makes for a fascinating read. There were prior attempts at a national bank. Those failed. Many now view Woodrow Wilson's Presidency as largely failed (due to the Treaty of Versailles and the League of Nations). Yet the Fed endures and serves as a fitting tribute to Wilson's legacy. Though many have criticized the Fed for improperly conducting monetary policy from time to time, there is no doubt it has played a very important economic role in encouraging balanced growth and combating inflation. Likewise we need to encourage balanced growth in our public capital and ensure there is adequate capacity that is in good working order. A dedicated entity that vigilantly pursues the maintenance and growth of public capital and that has the funding necessary to make such growth a reality would be a marked improvement over the status quo.

The above is an entirely un-sexy argument. Who gets excited about infrastructure and other public capital? But it clearly is important since there are obviously issues with how investment in public capital is managed at present, so the above is actually a pretty easy argument to make. And it is an argument that's been made without considering the employment implications. Now let's look at those briefly. Public capital is non-tradeable. The jobs created in public capital investment would largely be construction jobs. The beneficiaries of that employment would be middle income people. We need the public capital for the consumption benefit it provides, but that there is an employment benefit as well makes the argument for doing this well more compelling. Let's use that observation as we move to the more sexy and more controversial part of the recommendation.

Let's consider industrial policy, a subject that appears taboo in the political discourse in Washington, but that is likely to become increasingly discussed if the employment picture doesn't brighten. The economist Dani Rodrik makes the point that though Americans don't like to talk about industrial policy, certainly it has been very important in the high growth sectors of our economy, information technology in particular.

But when it comes to industrial policy, it is the United States that takes the cake. This is ironic, because the term “industrial policy” is anathema in American political discourse. It is used almost exclusively to browbeat political opponents with accusations of Stalinist economic designs.
Yet the US owes much of its innovative prowess to government support. As Harvard Business School professor Josh Lerner explains in his book Boulevard of Broken Dreams, US Department of Defense contracts played a crucial role in accelerating the early growth of Silicon Valley. The Internet, possibly the most significant innovation of our time, grew out of a Defense Department project initiated in 1969.

Yet Rodrik's example suggests a critique based on intentionality. The Arpanet doesn't appear to have been conceived with Silicon Valley in mind. Originally, Arpanet had a military purpose. It is quite a different matter to invest in R&D broadly up front, taking a portfolio approach to the investment strategy, than to look historically at a specific R&D project and connect it to subsequent industrial developments. I believe a good case can be made that with the Arapnet, we just got lucky. (As we did with GPS.) Rodrik reports in fact that current Department of Energy projects are part of a broad portfolio approach to next generation technology development.

Much industrial policy, both here and abroad, happens not via R&D but rather via "strategic subsidies and tariffs." And with that one must ask: what are the goals - infant industry protection, monopolistic exploitation, patronage to certain sectors of the economy, or something else? Many seem to believe there are short run employment benefits to be had from this type of industrial policy. The media shapes our perception on these issues and nowadays many seem to feel that China is growing rapidly because it has a good an effective industrial policy while the U.S. is limping along because its policies are not nearly as coherent. Consider this piece that focuses on rare earth elements to illustrate how China leverages its own natural endowments for strategic advantage. One must also ask, what are the pernicious side effects from such market interference? The side effects seem mostly to occur in the long terms. A policy lingers well after it no longer is useful, because a powerful narrow constituency wants it and lobbies hard to retain it.

However, with this both the consumption benefit and employment benefit can get lost. Further, the opportunity cost of such policies is usually not considered. So, for example, subsidies on ethanol (a biggie where I live) or on sugar beets mean there is less to subsidize electric car production or new battery development. Even if the Department of Energy has a good portfolio of projects it is funding within its purview, it doesn't mean that overall there is a good portfolio of projects being put forward. And further the criteria used to support subsidies might vary, in which case we lose overall coherence.

So the argument put forward here is that the Federal Investment Bank should have a second division, this one focused on industrial policy. I would suggest further that the focus should be on infant industry protection and employment growth, on the one hand, and the deliberate expiration of protective elements once the sector has reached a degree of maturity. The division would keep a variety of programs intact that varied by their maturity. It's ability to start new programs would be disciplined by its retiring older programs. The idea would be to attain some sanity to the industrial policy and remove it from some of the harsher political calculus that comes into play at present.

The Federal Investment Bank is an idea whose time has come. Congress and the White House together don't seem able to manage the issues well. Let's bring about an independent entity that can do the job.