Logistics: We on the teaching staff do realize that in today's Age of the Internet we can very easily throw more material at you than you can possibly absorb.
But you are 21st century Americans. You are used to swimming in a deep sea of information.
And you are students at U.C. Berkeley: you are among those whom by genetic endowment and luck and hard work are best-prepared to absorb whatever we throw at you to build your human capital.
And you are not paying for a good chunk of your education. The good citizens of Paso Robles and San Dimas are, even though you are highly likely to be richer over your lives than they are. They are paying for a good chunk of your education because they believe that money spent educating a technocratic elite is money well spent because you will use the knowledge you build here to go do great things to better California and the world. It is our job up here not to make sure that you have fun but to teach you as much as possible so that the chance that the good citizens of Paso Robles and San Dimas get good value for their subsidy to the University of California is as high as possible.
Thus whenever we prepare or run across anything that we think might be useful to some of you, our natural inclination is to throw it up on the web so that you can take a look and judge whether it is of significant use--to you.
So as you start to prepare for the midterm, do take a look at the files we have thrown up. Be sure to do problem set three. And I highly recommend that you do the practice midterm--it should be easy because you can use the time you would otherwise you to do problem set 4, which we are postponing until after the midterm.
Inflation Economics: One final note about "inflation economics." At this moment, out of the seven seats on the Federal Reserve board three are vacant. The Obama administration has--after long and unconscionable delays--nominated MIT economist Peter Diamond, San Francisco Federal Reserve Bank President Janet Yellen, and my wife’s college classmate Sarah Bloom Raskin. The Republicans in the Senate have blocked their confirmation. It is not clear why--as I understand it, no Republican senator admits to blocking their confirmation, but one of them is and the rest are standing behind him.
The Chair of the Federal Reserve Board can be an overwhelming and dominant voice. But this Federal Reserve Chair, Ben Bernanke, is not: he sees his role as that of expressing the consensus of the Board and of the other committee he chairs, the Open Market Committee. That means that right now the voting members of the FOMC excluding the chair consist of one Democratic nominee, Daniel Tarullo; two Republican nominees of whom, in the words of one of my colleagues, "one of them is pretty good"; and four Federal Reserve Bank presidents who have been largely chosen by their local bankers.
By this time you should be scratching your head: Why hasn't a new president made it a point--in what is now 20 months in office-- of getting his people confirmed to the board that performs the important task of making monetary policy? Why is such an important public and governmental function as the making of stabilizing monetary policy made primarily by guys chosen by bankers? Back when the Federal Reserve was established there was a worry that bankers had too great an influence--and the solution enacted during the Great Depression was to make sure that a majority of voting members would be presidential nominees coming from the government--people who had been appointed by the president who had been elected by the people--and that only a minority would be chosen by the bankers on the grounds that while you wanted their expertise you did not want them to dominate the discussion.
But that solution does not work if the president does not nominate and the senate does not confirm.
Government Budget Economics: With that commercial for Federal Reserve reform--and senate reform--we leave inflation economics and turn to the long-run government budget. I have here in my hand a piece of currency, a dollar bill. It is from Zimbabwe. It is for $100,000,000,000,000 Zimbabwean dollars.
How does a government get into a situation in which it is printing bank notes like this? How does a government make sure that its successors will never get into a situation in which they are printing bank notes like this?
A government that finds itself printing hundred trillion dollar bills is a government that is doing very badly indeed. It is destroying its system of monetary exchange. It is deranging its economic division of labor. It is severely crippling if not eliminating altogether the ability of people to make and trade things on markets for predictable prices--which is one of the things that makes us all so rich. It is returning the economy to barter and to the autarchy of unspecialized production for yourself. It is throwing away what we have learned through 6000 years of progressing civilization about how to organize economies.
The answer is that governments find themselves resorting to printing things like these Zimbabwean hundred trillion dollar bills when they have proven permanently unable to balance their budgets.
When government spending has outrun taxation, and when their spending has outrun taxation so long and so far that nobody is willing to lend the government money because nobody thinks that they are ever going to get whatever they lent back--that is when a government finds itself printing hundred trillion dollar bills. The questions of how governments get into such situations, and of whether the US government now is close or getting closer to such a situation--those are the key questions of government budget economics.
The U.S. Debt-to-GDP Ratio Over Time: Look at this graph of the United States national debt truly held by the public divided by the annual GDP of the United States. Take the total amount of money the government has promised to pay its bondholders, divide that amount by annual GDP, and you have a measure of the potential burden of the debt on the U.S. economy. Here we have this measure back to the early 1790s.
Alexander Hamilton and the Origins of the National Debt: Back in the early 1790s, the national debt was close to 40% of annual GDP. It was close to 40% because the first Treasury Secretary, Alexander Hamilton, thought it was a good idea to make it close to 40%. He convinced congress to let him go to the states and say:
You know all that money you spent winning us our independence from Britain by raising armies during the Revolutionary War? The federal government is going to pay you back for all of that. We in the federal government are going to assume your Revolutionary War debts, and pay off all the bonds you issued at full face value.
Alexander Hamilton did this for three reasons. One was he had a bunch of friends who were financiers in New York. Once they got wind of how he was thinking they had the opportunity to buy up pieces of the debt from the merchants, the soldiers, and the others to whom the government owed money--to say:
You don't think New Jersey will ever pay off that piece of paper, do you? I'm willing to gamble that they will eventually pay something--how about you trade it to me for 40 cents? You get the cash, I take the risk, it is a good deal for both of us.
Then Alexander Hamilton announces his debt assumption plan. New York financiers who understand how Hamilton thinks make an awful lot of money. And they are grateful.
That, however, was only a minor reason.
One major reason was that Alexander Hamilton saw that the United States was then a relatively small country in a world dominated by two super powers, Britain and France. Both Britain and France had ocean-spanning ambitions and blue water navies. Hamilton thought it likely that we would at some time in the future get into a big war with either Britain or France. And he wanted to make sure that if we did get into a big war that the federal government would be able to borrow money in order to fight it effectively. Moreover, even if we did not get into a big war a U.S. federal government that could not borrow--that had no debt capacity--would be weak. Both France and Britain would both notice that we were weak, and they would steal our stuff, press our sailors and make them man their navies, et cetera et cetera. Thus Hamilton thought it was important for the federal government to start its existence by building up its debt capacity. And what better way to convince investors that the federal government would pay off its debts in the future than for it to pay off the debts of the United States incurred during the Revolutionary War--even or perhaps especially if those debts had not been incurred by the current federal government?
The most important reason, however, was that Alexander Hamilton was Secretary of the Treasury in a country where the rich were at best uneasy about the revolution and independence. Of America's upper class as it stood in 1775, full half of them were gone: had fled to Britain or Canada during the Revolutionary War. Those who remained remembered that back before 1775 the British monarch had protected property, that the British army and navy had protected them against deprivations of all kinds, that it was quite clear who the police worked for. Now you have a republic with a much broader electorate. Might politicians run on a platform of soaking the rich and redistributing wealth to the poor? Thus the rich people were nervous--and at least thinking about how maybe it would be good if the British came back and ruled again.
This was where Alexander Hamilton had his good idea. Suppose, he thought, he could set things up so that the rich owned a lot of U.S. government bonds. Then if the British returned--well, the British were not going to pay off the Revolutionary War debt of the United States of America under any circumstances. Having a national debt was a way to bind the United States rich to the country--giving them a stake in the new republic's survival. And by large it worked: the national debt was a national blessing.
Standard Debt Dynamics: In this figure from 1790 to 1980 we see what became the standard dynamics of the United States national debt. During big wars--the Civil War, World War I, World War II, and to a lesser degree the War of 1812--the United States borrows big time to fight. And so the debt-to-GDP ratio rises. When the United States goes into a significant economic depression--either the Great Depression or our current Great Depression--it also borrows frantically, sometimes enthusiastically and sometimes reluctantly, to avoid massive cuts to government spending programs and to try to keep the economy moving again.
In other non-war non-deep depression times between 1790 and 1980 the budget was always more-or-less balanced. There might be a small deficit. But because the economy was growing through immigration, through capital accumulation, and through the progress of knowledge about technologies and organizations that increases productivity, GDP was growing much more rapidly than the debt, and so the debt-to-GDP ratio was falling. Raise the debt-to-GDP ratio in wars and depressions. Watch it fall at other times. Those were the standard dynamics of the U.S. national debt.
The Reagan Revolution: That works until the 1980s. What happens to change it? In 1980 we elect Ronald Reagan, the first of the huge peacetime deficit presidents.
When Reagan was governor of California from 1966 to 1974, he was very much a balanced budget governor: he thought it important that the government not overspend, that it not run big deficits. He believed in investment in the future, yes--funding the University of California and building infrastructure--but not in large-scale deficit spending.
As soon, however, as Reagan gets elected president he pushes for massive peacetime deficits, and the debt-to-GDP ratio rises quite rapidly during his terms and during his successor George H.W. Bush's term. Then Bill Clinton gets elected in 1992. Clinton reverses course: he raises taxes and puts ceilings on spending growth. The debt-to-GDP ratio resumes its normal peacetime downward trajectory.
Then we elect--well, Justices Scalia, Rehnquist, Thomas, O'Conner, and Kennedy elect--George W. Bush. His vice president Richard Cheney believes that "Ronald Reagan showed that deficits don’t matter." Lo and behold, the deficits starts up again and the debt-to-GDP ration rises. Then the financial crisis hits. We react as we usually do in a big downturn: spending money--albeit not enough money--to to and keep the economy on an even keel.
Now the Obama administration is in a puzzling situation. How fast should it cut the deficit? When are we going to get out of our "depression economics" situation in which a deficit is a positive good as a demand stimulus? When will we start having normal times again in which the debt-to-GDP ratio should be on a downward trajectory? And how are we then going to put the debt-to-GDP ratio on its normal peacetime non-depression downward trajectory?
The scary thing is that as I look at the complexion of politics in Washington, putting the debt-to-GDP ratio on its normal downward trajectory appears a very difficult task. Things have definitely changed.
There are two theories to why things appear to have changed around 1980--why our political system no longer generates the small government deficits and the downward debt-to-GDP trajectory that it used to.
The first theory is ideological: that something has gone very wrong with the minds of the Republican Party's officeholders, apparatchiks, and their tame intellectuals. From the end of the Civil War all the way up to 1980 the Republican Party tended to be a small-government balanced-budget party: its consensus was that the first priority was to balance the budget, and that if the budget was balanced the next priority was to cut spending. Since 1980 the Republican Party has been a large-government unbalanced-budget party: its first priority is to cut taxes, its second priority is to raise spending on national defense and spending and tax expenditures on programs of interest to lobbyists who fund Republican campaigns, and balancing the budget is a distant third priority--if it is there at all.
The second theory is structural: that we have changed the character of government spending. It used to be that most of U.S. federal government spending was done through the appropriations process--spending that had to be decided upon and revoted year after year. The U.S. federal government spent on defense, on national parks, on building dams and ports, on building interstate highways, building canals. But that is not what the U.S. government spends on today: today the U.S. government spends on Medicare, Medicaid, and Social Security. Spending on those programs as a share of GDP goes up automatically as the population ages and as doctors and pharmacists become more inventive about how to treat people with diseases.
Health Care Spending and the Long-Term Budget Outlook: This particular chart here is by the Congressional Budget Office, an organization headed by my friend Douglas Elmendorf. This is his take on the long-term outlook for the U.S. federal government's spending and revenue--his "alternative fiscal scenario," which is his guess of what will happen if the budget votes that congress typically takes keep on going the way they have been typically going.
The big black line at the top is total primary spending--spending excluding interest on the national debt. The rule of thumb is that in normal times the debt-to-GDP ratio will be constant if primary spending is equal to revenue, that the debt-to-GDP ratio will rise if primary spending exceeds revenue, and that the debt-to-GDP ratio will fall if primary spending is less than revenue.
Spending on government programs--primary spending--consists of mandatory or entitlement spending and discretionary spending. Mandatory spending makes up the bottom two layers of this cake. Discretionary or appropriated spending makes up the top, light blue layer: national defense plus everything that the civilian government used to do.
At the bottom are the big entitlement programs. The United States has promised it will pay Social Security benefits. We know that under current law Social Security spending is projected to rise from about 4% of Gross Domestic Product today up to 6% by 2035.
On top of that are the federal health spending programs: Medicare, Medicaid, the Children’s Health Insurance Program, and the "exchange subsidies" that are part of our brand-new newly-enacted but not yet implemented RomneyCare system by which people are required to buy health insurance on the yet-to-be-started health insurance exchanges, but this requirement is eased by providing poor people with subsidies to make buying private insurance affordable.
The amount of money that these health care programs will cost is, if things continue as they have been, scheduled to grow from a total of 5.5% of GDP today to something like 9% of GDP in 2035. And these spending programs are automatic. The United States government has promised that it will pay for them. For spending to grow less rapidly would require that congress vote and the president sign big changes in what categories of health spending the federal government will pay for. At the moment the federal government will pay for what your doctors and nurses say is medically appropriate. And Doug Elmendorf says that if he has learned anything from being a health economist over the past 30 years, it is that doctors are very good at figuring out new and expensive things to do that are medically appropriate.
Many of things are medically appropriate. Our revolutions in medicine and public health have doubled lifespan over the life of this country. But many of these things are expensive. And neither political party wants to make controlling the rate of growth of healthcare spending--changing the law so that Medicare will no longer pay for a kidney transplant for your grandma--its signature issue. The big Republican talking point this fall is that the Democratic Party's promises to streamline Medicare to make it more efficient are really plans for huge Medicare cuts that mean that someday your grandma or you will have to go in front of a government "death panel" that will turn their thumbs down. We, the Republicans are saying, are going to repeal all of the Medicare cuts and the tax increases in the recently-passed Affordable Care Act--but we are going to keep all of the parts of the ACA that actually cost money.
Feckless Congress: That is what drives the increase in expected federal government spending as a share of GDP over the next 25 years in Doug Elmendorf's Alternative Fiscal Scenario: that whenever it gets the chance congress will shy at the jump and push all steps to reduce the rate of growth of government health-care spending programs off for an extra year or two--as it has done with the Medicare Sustainable Growth Rate formula for a decade now--and keep pushing them off. That is the thing that makes the long-term budget outlook look extremely dicey. These increases in spending happen without a single congressional vote: they are build into the structure of Medicare and Medicaid, of SCHIP and of the exchange subsidies. If we simply have congressional gridlock as usual, spending goes up as a share of GDP. And if we simply have congressional gridlock as usual, taxes don't go up as a share of GDP.
Now, you can hear people say--you can sometimes hear me say--that the current law baseline is close to balanced: our primary fiscal gap is only 1.2% of GDP over the next twenty-five years. That assumes that congress will not do what it usually does--which is to change laws so as to reduce revenue and increase spending whenever the date for scheduled tax increases and spending cuts approaches. I believe that we will see this again at the end of this year, when the 2001 and 2003 tax-law provisions expire. While congress let them expire, or will it find some excuse to extend them?
Doug Elmendorf says: don’t bet on congress letting these tax increases take effect. When he looks at the congress and he counts the vote, he cannot see congress restraining itself. He believes that the United States is not on the current-law baseline path, but rather on the Alternative Fiscal Scenario path along which healthcare spending program growth drives an ever-increasing gap between what we are spending and what our revenues are.
