[This is a follow-up for a longer piece at Econlog.]

Yes, the “official” top tax rate on capital income is lower than on wage income, but the very first thing you learn in public finance is that appearances can be deceiving.  The economic incidence of a tax is often very different from  the legal incidence of a tax.

While reading a recent book review by Robert Solow I came across a statement that made me want to pull my hair out.

We are politically unable to preserve even an estate tax with real bite. If we could, that would be a reasonable place to start, not to mention a more steeply progressive income tax that did not favor income from capital as the current system does.

Solow is a brilliant economist, indeed a Nobel Prize winner.  But this is an EC101 error.  I see this sort of nonsense so often it makes me wonder whether I am hallucinating.  Is it possible that the standard theory of taxation was overturned after I left grad school?  For those who have not taken public finance, here’s the intuition in a simple example:

I earn $100 wage income, and face a tax of 50% on wage income and 20% on capital income.  I have two choices, spend the money today, or save it for 14 years, in which time (at 5% interest) my money will double.  I pay 20% tax on the capital income.  So let’s look at the two options:

A.  Spend the money today:  $50 in consumption, vs. $100 in a tax-free world.

B.  Save the money for 14 years:  $90 in consumption in 14 years, vs. $200 in a tax free world.

In case A I face a 50% tax rate.  In case B I face a 55% tax rate.  I’d love for someone to explain to me how this sort of tax system “favors” income from capital.

There are certain terms that when uttered almost immediately lower one’s IQ by 5 points: bubbles, beggar-thy-neighbor, inflation, deserve, endogenous money, inequality.  Add “income” to that list.

Sound economics deals with consumption.  Taking about “income” is about as silly as talking about how many “fruits” are produced in California each year, counting both a watermelon and a blueberry as “one fruit.”  Just shoot me.

PS.  Of course this is just the tip of the iceberg.  Corporate income is triple taxed. Interest income is not adjusted for inflation, distorting inequality data.  Etc., etc.

PPS.  Did I just mention inflation?  Even worse, I put all four “i-words” in one sentence.  Please deduct 20 points from my estimated IQ.

Over at Econlog I have a post discussing the German jobs miracle.  One counterargument is that all countries can’t be like Germany, because their success comes from a large current account surplus. And if there is one thing that all economists agree on, it’s that all countries cannot simultaneously run CA surpluses.

Those who have not studied economics might be surprised to discover that standard economic theory suggests CA surpluses have no impact on job creation.  Many people draw the wrong implication from an accounting identity:

GDP = C + I + G + (X – M),     Where (X – M) is the CA surplus.

It looks like a bigger CA surplus would boost GDP.  That ignores the ceteris paribus problem. Here’s another accounting identity:

I  = Sp + (T-G) + (M-X)   [money for investment comes from private, government, and foreign saving]

If one ignores the ceteris paribus problem, then it looks like a CA surplus reduces investment dollar for dollar.  So accounting identities get us nowhere.  There is a slightly more sophisticated argument that CA surpluses can have a negative impact on foreign AD when the entire world is at the zero bound.  The argument is that CA surpluses created by thrifty Germans will increase global saving and depress global AD for old Keynesian reasons.  The monetary authority is assumed not to offset the effect.

I’m skeptical of that argument, but even if true it’s a cyclical argument not a secular argument.  If other countries reduce their W/NGDP ratios, then in the long run the number of hours worked should rise.  Remember that macro is not a zero sum game; all countries can simultaneously increase employment and output.  And even if central banks are letting inflation run a bit below target, surely there are limits as to how low they’ll allow inflation to go.  Cut wages by more than that and you create jobs.

By the way, I’m not suggesting everyone should work super hard; German hours per year are fairly low. Their jobs miracle comes from creating more jobs, having fewer people who are completely unemployed.  Nor am I suggesting lower living standards.  The share of income going to labor in Germany has been rising.  If total income also rises (as it should with more employment), then Germans are better off.  (Unless you don’t think unemployment is a problem.)

It’s ironic that back in the golden 1990s the Clinton Democrats favored many of these policies. They advocated thrift (budget surpluses).  They advocated moving people from welfare to work with welfare reforms and low wage subsidies.  Finally a major country adopts the Clinton Democrat plan and achieves great success in job creation relative to other developed economies.  And how do Democrats react?  All they seem to do today is trash the German model:  “Run deficits”, “put more people on welfare and food stamps”, “raise the minimum wage”, “low wage subsides just help fat cat corporations pay workers less.”  Very sad.

Take a look at one of the very first articles at the new website “The Upshot”

http://www.nytimes.com/2014/04/23/upshot/how-underpaid-german-workers-helped-cause-europes-debt-crisis.html?rref=upshot

Sometimes all I have to do is read a post title.

In a recent post I claimed that monetary policy failure associated with the zero bound, not financial turmoil was the cause of the Great Recession.  Brad DeLong had correctly noted that the S&L fiasco of the late 1980s involved losses similar to the subprime crisis as a share of GDP.  Where I disagreed with DeLong is that he focused on differences between the resolution of the 1980s and 2008 crises, whereas I focused on differences in monetary policy.  In particular, I argued that rapid NGDP growth in the late 1980s put us so far above the zero bound that it was never an issue in the 1990 recession, and hence there was no failure of monetary policy.  I argued that falling NGDP caused by overly tight monetary policy explains the severity of the 2008-09 recession.

I also argued that we could have had a severe recession in late 2008 even if the financial turmoil had been handled optimally.  For instance, suppose Lehman had been successfully resolved and there was no post-Lehman banking crisis.  Even in that case the tightening of lending standards would have depressed the Wicksellian equilibrium rate, perhaps below zero, and we could very well have had the same monetary policy failure. Here’s how DeLong responds:

As I have said repeatedly: I simply do not buy this. From the fourth quarter of 2005 through the fourth quarter of 2007 lending standards tightened enormously, and investment is residential construction collapsed. By the end of 2007 residential investment had fallen 2.5%-points from its peak-of-the-boom level. But the heightening of lending standards and the unwillingness of people to make further NINJA (no income, no job or assets) loans had not sent the economy into any sort of a recession. It was the spiking of risk premia in 2008 that sent us to Wicksellian natural-rate-of-interest-below-the-ZLB territory. And there is no reason to think that we would have been in such a situation but for the financial crisis-and every reason to think that the whole mishegas would have been avoided had congress simply put the too-big-to-fail banks into conservatorship in January 2008…

Let me first concede that DeLong might be correct, my claim is certainly not a necessary part of the general market monetarist worldview.  But I don’t think he is correct.  Consider the following:

1.  I agree that the long downslide in residential real estate between late 2005 and the end of 2007 was not associated with a recession.  Indeed I’ve made that argument myself on a number of occasions, as a way of pointing to the importance of monetary policy (aka NGDP growth.)

2.  Here’s how I read the events of 2008.  During calendar 2008 the Wicksellian equilibrium rate fell gradually, under the impact of both the housing slump, and feedback from sharply slowing NGDP growth, which was itself an indication of tighter monetary policy.

3.  Let me point to two important facts for people who don’t like the Bernanke-Sumner “NGDP” indicator of monetary policy, and who insist on “concrete steppes.”  The monetary base, which had been trending upward for many years at more than 5% per year, stopped growing between August 2007 and May 2008.  If you prefer interest rates as your concrete step, note that stock market responses to (timid) Fed rate cuts indicated that in late 2007 that the Fed was “behind the curve,” as even Bernanke later admitted.

4.  This accidental tightening of monetary policy tipped us into a very mild recession in early 2008. But still nothing severe, so at this point I still agree with DeLong.

5.  The inflation surge in the first half of 2008 scared the Fed, and prevented them from doing what they otherwise would have done, as it became increasing clear we were in a recession.  By May 2008 the rise in unemployment was already more than you ever observe in non-recessionary periods. And as (I seem to recall) Bernanke once observed, it’s almost impossible to be too expansionary when the economy is tipping into recession.

6.  But the Fed was not expansionary, even using the conventional interest rate indicator.  Fear of inflation led to them to keep their interest rate target on hold at 2% after April 2008; indeed they did not even cut interest rates at the first meeting after Lehman failed in September. Unemployment had reached an expansion low of 4.4% in 2006.  Here are the unemployment rates from April to August 2008, all fully known to the Fed at its September meeting:  5.0%, 5.4%, 5.6%, 5.8%, 6.1%. And there were no rates cuts at all!  Look at that data and ask yourself if a steady fed funds target represents normal Fed behavior on the edge of a recession.  Then think about the fear of inflation that is so evident in the minutes of the 2008 meetings.

7.  Because the Wicksellian equilibrium rate was falling during this period, the stable fed funds target tipped the economy from a mild recession into a severe recession.

8.  Ignore quarterly GDP numbers, which can be very misleading at turning points. The monthly GDP estimates from Macroeconomics Advisors show GDP (both real and nominal) suddenly plunging sharply between June and December 2008.  By December the plunge was almost over, even though quarterly data for 2009:1 were much lower, as the level had been falling sharply throughout the 4th quarter of 2008.

9.  My claim is that accidentally tight monetary policy caused the NGDP plunge in the second half of 2008.  Because of data lags (and later revisions in data) we didn’t know about that NGDP plunge until after the post-Lehman financial crisis broke.  So at the time it seemed like the financial crisis caused the severe recession.  And almost all economists still believe that to be the case.  But markets were already sensing problems before Lehman, and falling asset prices caused by falling NGDP almost certainly helped trigger the September to December financial crisis, which occurred in the last half of the tight money-induced June to December fall in NGDP.

Let me finish by admitting that financial crises can have real effects, and thus it’s possible that DeLong is correct.  It’s possible that I’ve underestimated the independent impact of financial distress on RGDP.  Maybe RGDP would have fallen sharply even with a monetary policy aggressive enough to boost NGDP in late 2008.  But I’d point to one observation in my favor.  FDR enacted a highly expansionary monetary policy during the spring of 1933, when much of the US banking system was closed down.  Both NGDP and RGDP rose very strongly.  The technique FDR used (dollar depreciation) has some similarities to NGDPLT, as it raises expectations of future NGDP.

PS.  I have one quibble with DeLong’s post.  His use of ellipses in a quotation of material from my earlier post somewhat mischaracterizes what I wrote:

One area where I slightly disagree with Krugman is his focus on inflation. A 5% NGDPLT target path would have been enough, we didn’t need 4% trend inflation. Nor do we need fiscal stimulus…. All stabilization policies eventually fail…. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon. NGDPLT would have given us just that in 2008-09.

The ellipsis right before “The trick is” makes it seem like the final sentence refers to failed stabilization policies of each President.  Not so, I was discussing their overall performance.  Here is the complete passage:

All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon. NGDPLT would have given us just that in 2008-09.

It’s no big deal, and my comment was probably ambiguous.  But Nixon’s big failure was Watergate, and Clinton didn’t even have a modest failure of stabilization policy, just a silly scandal.

For years I’ve been fighting against the (new) conventional wisdom in economics—that the 2008 crisis shows that monetary policy must move beyond macro stability, and focus on asset price bubbles. Unfortunately, Ambrose Evans-Pritchard reports that we seem to have achieved our first important success.  I say unfortunately, because it came at the expense of Sweden:

The Riksbank has been trying to “lean against the wind” to curb house price rises and consumer credit, pioneering a new policy that gives weight to the dangers of asset bubbles. But this is proving easier said than done without hurting the productive economy, suggesting that it may be better to use mortgage curbs or other means to rein in property mania.

But Jeremy Stein says that regulation doesn’t “get in all the cracks,” you need to smash asset price bubbles with a monetary sledgehammer.  Or like a tidal wave that gets in all the cracks of a leaky old boat. Here are the results:

Swedish consumer prices fell 0.4pc in March from a year earlier, catching the authorities by surprise and leading to calls for immediate action to avert a Japanese-style trap.

Lars Svensson, the Riksbank’s former deputy governor, said the slide into deflation had been caused by a “very dramatic tightening of monetary policy” over the past four years. He called for rates to be slashed from 0.75pc to -0.25pc to drive down the krona, and advised the bank to prepare for quantitative easing on a “large scale”.

Prof Svensson said Sweden was at risk of a “liquidity trap” akin to the 1930s, with deflation causing debt burdens to ratchet up in real terms. Swedish household debt is 170pc of disposable income, among Europe’s highest.

Here’s Jordan Weissmann:

The blue line traces the consumer-spending trend in states where home prices fell the least, while the red line traces it in states where they fell the most. Each group contains about 20 percent of the U.S. population. And as you can see, the crash states are still well behind.  .  .  .

Sufi and Mian have made the academic case that spending before the recession really was driven by the “wealth effect” of rising home prices. People saw their housing values rocket up, and felt richer. Often, they took out second mortgages to spend. When the market crashed, so too did their finances. It may sound like an intuitive point to some, but it’s a key part of understanding why the recovery has been so underwhelming. The difference between states that got the full brunt of the housing collapse and states that didn’t, as shown in this chart, suggests that its scars are still very much with us. And they probably will be for a long while.  (emphasis added)

It’s important to distinguish between regional shocks and aggregate shocks.  All parts of the US use the same type of money, and hence all are affected by the same monetary shocks.  On the other hand the relative performance of various regions is dependent on all sorts of real variables. The factors that cause some regions to do worse than other regions play absolutely no role in the slow growth in aggregate demand since 2008, which is 100% a monetary policy failure.

The following analogy might be helpful.  Imagine a lake where the water level is controlled by the operators of a dam.  Also assume that the surface of the lake is very choppy, due to high winds.  The factors that explain the peaks and troughs of each wave have nothing to do with the factors that explain the average level of water in the lake.  In the same way, Federal Reserve policy determines the rate at which NGDP rises in the typical state, whereas local real factors explain why NGDP grows faster in some states than others.