By: Michael W. Lodato Ph.D.
Where I’m coming from: I’ve been skeptical about economics and economists for a long time. I come from a discipline, theoretical mathematics, where there is absolutely no ambiguity. In fact most of the reading is of symbols – each having very precise definitions.
In economics there seem to be all kinds of conflicting theories with names like
- Keynesian economics, that argues that economic activity is stimulated when government lowers taxes on the middle class and increases government spending.
- Supply side economics, that suggests that when economic activity is less hampered by government controls or higher taxation it produces more economic benefits for the poor in the form of jobs and cheaper goods.
- The Laffer Curve that looks like this
- Trickle-down economics – a theory that says benefits of the wealthy trickle down to everyone else – sort of like John D. Rockefeller’s wealth trickling all the way down to grandson Nelson.
- and more.
But while there are times when the economy is good, the deficits persist and debt keep rising to astounding levels. But mostly I am concerned that economics is so political. My friend Ernie Wassmann says: “There is no true economy; it is always a political economy.” No matter what the theory, politicians, on both sides of the aisle, as they say, “kick the can down the road” for future politicians to solve. Something is wrong with this picture.
Full Disclosure: Before you make any judgments about what I write here, you should know that I never took a course in economics nor worked as an economist. It is only recently – after attending the UCLA Economic Outlook on December 6, 2016 – that I got interested enough to think about it. I have since attended two more of these quarterly meetings and my interest intensified. When I get that interested I write a Think Piece – an article not intended to tell people what I know about something, but to find out for myself what I know about it. I send Think Pieces to a very small audience, if at all. All of them can be found on my blog www.michaelsthinkpieces.com. If you encounter one, and you don’t agree with it, please let me know so I can continue to know more. While, as a voter, I’m not Republican or even conservative in the strict sense, I have always been a fiscal conservative. I think governments, especially at the federal level, should resist the temptation to try to guide things – especially the economy.
So let me rant on.
A few things I picked up on the internet. Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation’s economy. So, fiscal policy is about taxes and spending. It is the sister strategy to monetary policy through which a central bank influences a nation’s money supply, the total amount of money in circulation. So, this is about money supply and interest rates. These two policies are used in various combinations to direct a country in achieving its economic goals.
Before going on let me present an opinion which is key to this think piece.
Two Solid Truths. What I have known for a long time is that there are two truths related to economics that you can take to the bank. They are:
- supply and demand theory always works and
- compound interest is one of the most important discoveries in history. That’s what Albert Einstein said, at any rate.
Economic theories that mess with them are bound to lead to trouble as we have seen in both our fiscal and monetary policies.
The Law of Supply and Demand
[If you want to study supply and demand in some depth there is a lot of excellent coverage of the subject on the internet. I present a summary below – enough, I hope, to support my conviction that economists have not given enough respect to the subject in steering our economy.]
Supply and demand is a fundamental concept of economics.
Demand refers to how much (quantity) of a product or service is desired by buyers The quantity demanded is the amount of a product or service people are willing to buy at a certain price during a specific time period. The relationship between price and quantity demanded is known as the demand relationship. (See the figure below.)
Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good or service producers are willing to supply when receiving a certain price during a specific time period. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. (See second figure below.)
Price, therefore, is a reflection of supply and demand.
The Law of Demand: The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
The Law of Supply: Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity producers are willing to provide. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).
A, B and C are points on the supply curve (below). Each point on the curve reflects a direct connection between the quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.
The next graphic puts supply and demand together.
Equilibrium: When supply and demand are equal (i.e. when the supply curve and demand curve intersect) the economy is said to be at equilibrium. As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curves, which indicates no allocative inefficiency. At this point, the price of the goods and the quantity are referred to as equilibrium price and quantity.
At Equilibrium, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.
In the real market place, equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. You experience this with the almost daily change in the price of gasoline.
Surplus occurs when the price is too high for the demand or when the quantity supplied is greater than the quantity demanded. Prices are above Equilibrium. To eliminate surplus you lower the price. If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
Shortage occurs when the price is too low for the supply or when the quantity demanded is greater than the quantity supplied. Prices are below Equilibrium. To eliminate shortages you increase the price.
Elasticity: The degree to which a demand or supply curve reacts to a change in price is the curve’s elasticity. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price changes. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost (see below) of buying the product will become too high
A good or service is considered to be highly elastic if a slight change in price (say from P2 to P1) leads to a sharp change in the quantity demanded or supplied (say from Q2 to Q1).
An inelastic good or service is one in which changes in price witness only modest changes in the quanitty demanded or supplied, if at all.
In the real world economy, there are many examples of demand being too high or too low for the supply and/or supply being too high or too low for the demand. Take professional sports, e.g. the NFL. The demand, e.g. the fans that want to see a game, far exceeds the number of seats at games that are available for viewing. A result is that the teams can and do charge a high price for tickets.
Factors Affecting Demand Elasticity: There are two main factors that influence a demand’s price elasticity:
The availability of substitutes. In general, the more substitutes, the more elastic the demand will be. As an example, if the price of hamburgers goes up, some people may switch to hot dogs – if they are more affordable.
Amount of income available to spend on the good. This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. So, if one’s income is reduced there is an elastic reaction in demand. That is, one is forced to reduce his/her demand for the good or service unless there is a corresponding reduction in the price. If there is a decrease in income, demand tends to decrease as well.
Basically, supply and demand says that if there is a lot of something available you don’t have to pay as much for that something as you would if the supply of it was low. From the demand side, if there is a high demand for a good or service, a supplier of that good or service can raise and get a higher price for it than if the demand was lower.
From here on I will try to support my claim that economists seem to be ignore supply and demand more often than not.
How Fiscal Policy Works
Fiscal policy is very important to the economy. The idea is to find a balance when changing tax rates and public spending and reflect that balance in tax laws.
Let’s say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making substantial profits. A government thus decides to fuel the economy’s engine by decreasing taxation, which gives consumers more spending money. At the same time it increases government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. In the meantime, overall unemployment levels will fall.
With more money in the economy and fewer taxes to pay, consumer demand for goods and services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in money supply decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation exceeds the reasonable level which leads to a lowering of demand for goods and services. For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between a productive economy and one that is infected by inflation can be easily blurred.
On the other hand, when inflation is too strong, the economy may need a slowdown. In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles.
Who Does Fiscal Policy Affect? Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.
The Bottom Line: One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends.
From my perspective, the degree of government involvement has been excessive. Just look at the tax code and regulations on business before the 2018 Income Tax Reform bill. The federal budget process doesn’t seem to allocate spending effectively, as evidenced by the 2018 spending bill. Government agencies and programs are almost never closed down or ended, regardless of poor performance. I am concerned about the current administration’s efforts in tax policy. Trump’s spending plans, with a projected $1 trillion deficit in 2018, may have us in a fiscal policy that is reckless.
Income Tax Reform
| Economic growth should not be the objective. It should be a consequence |
I’m convinced that cutting tax rates, as was done in early 2018, is the wrong way to achieve sustained economic growth. The evidence is just not strong enough that a cut in tax rates leads to strong economic growth for very long. To the contrary, the evidence is that while economic growth does follow a tax cut, it only lasts for a while and it is always accompanied by significant increase in deficits and the debt. Rather than cutting rates as a goal, why not have rate cuts be a consequence of tax code simplification and reform? Economic growth should not be the objective. The objective should be to fix a very broken tax system. Economic growth will be a consequence.
If the idea of a tax cut is to give consumers more spending money and businesses more money for investments and hiring, why not, as a first step, simplify tax preparation so much that taxpayers will not have to spend as much time and money on it each year as they do now. There is very little simplification in the new tax code, if any.
Let me give an example or two. Say you get rid of the deduction for state and local taxes – (a policy that means that lower tax states have in effect been subsidizing higher-tax states). Suppose further that you want to keep the tax revenue neutral. This means you can lower the tax rate to make up for the lost deduction. The higher-tax states could help the situation by lowing the taxes they impose on their citizens, but there is no evidence that this will happen.
Another example would be to get rid of the special tax rates for capital gains and qualified dividends. That alone would get rid of having to complete Form 1040, Line 44 that consists of 27 lines of very complicated arithmetic – a big step toward tax simplification. This was not done in the new tax law.
My guess is that simplification of the tax code would result in enough reduction in tax rates (even while keeping revenue neutrality) so that for most people the amount they earn from gains on investments would be taxed at rates at or below the current capital gains rate. Sure, high income people might pay a rate higher than the current rate on capital gains, but they will be getting help in other parts of the simplification including the elimination of the cost and time of tax preparation.
The need for simplicity. Tax preparation may be done by the taxpayer with or without the help of tax preparation software, online services or a tax preparation professional such as an attorney or certified public accountant.
I’ve read that, over the years, the tax code had grown to over 70,000 pages reaching nearly four million words. This imposes an unconscionable burden on taxpayers. This includes 2,113 forms and explanatory pamphlets. If done without help the cost is the number of hours spent by the taxpayer in tax preparation, amounting to literally billions of hours per year. According to a report from the U.S. Government Accounting Office, the efficiency cost of the tax system—the output that is lost over and above the tax itself—is between $240 billion and $600 billion per year. For tax return preparation, Americans spent roughly 20% of the amount collected in taxes. That’s huge. The Tax Foundation estimates that Americans spend 8.9 billion hours to file their taxes, the equivalent of 5 million full-time jobs. At a national average wage of about $30 per hour, that comes to $267 billion worth of our time. The estimate might have flaws, but it is the best guess as to the time it takes for businesses and individuals to fill out tax paperwork. Because of the complexity about 60% of individual tax returns are filed by paid preparers.
The convoluted code especially harms small businesses that can’t afford to hire expensive accountants or pay additional fees. Their tax compliance costs are 67 percent higher than those of big businesses.
A conclusion that I have reached is that, if tax preparation was a lot simpler, tax payers would have a tremendous amount more money to spend than now and businesses would have not only more money to spend and grow but also lower labor costs. The amount easily reaches to hundreds of billions of dollars. The positive effect on demand for goods and services is obvious.
If done right the economy could be stimulated without reducing tax income. Combine this with some government spending reductions (e.g. a smaller IRS) and we might just save the country from financial disaster. Unless we tackle the looming national debt crisis – and quickly – the best case is that the U. S. could grow briskly for a few years. I’ve read that interest on the national debt alone will triple, to about $800 billion, accounting for $1 for every eight the U.S. spends. Imagine what the country could do if it had that $800 billion available each year.
The law of supply and demand will then kick in as consumers spend and businesses invest more. Of course the increase in demand from a simple tax code will cause some inflation, just as a tax rate cut would, but a tax rate cut, by itself, increases the deficit and national debt and doesn’t reduce the burden of tax preparation.
How do we make tax preparation simple? Well, it wouldn’t be easy to do. And my think pieces, by their nature, are too short to develop and present solutions. To start with, powerful lobbyists and special interests colluding with the government to benefit themselves at the expense of taxpayers would fight tooth and nail to prevent making tax preparation easy and far less costly. Tax attorneys, CPA firms, tax prep companies like H&R Block, tax software companies like Intuit and other organizations that benefit most from complexity of the tax code would be vigorous in lobbying Congress against making tax preparation simple. Politicians that are the targets of their lobbying and who receive funding from them would try to bring ridicule on those favoring simplicity by charging them as being heartless in taking away the careers of attorneys, CPAs and the like.
Of course, supporters of tax preparation simplicity would be condemned, not for the idea, but as being inhumane and in favor of putting tax preparation people out of work. But we’ve had many of examples of an economy recovering after technology did away with the need for buggy whip workers, telephone operators, secretaries, and others.
My recommendation: Present a tax simplification bill that is revenue neutral. Then, if you insist on being reckless, make some further cuts in tax rates.
Monetary Policy – the Money Supply
Monetary policy can also be used to ignite or slow the economy but is controlled by the central bank, the Federal Reserve, with the ultimate goal of creating an easy money environment.
The Federal Reserve Board purchases and sells U.S. government bonds in the open market. This can increase or decrease reserves with banks while influencing the supply of money whether they are buying or selling bonds. The Fed can also change the reserve requirements (amount of cash a bank must hold in reserve against deposits made by customers) at banks thus directly increasing or decreasing the supply of money. The Fed can also make changes in the discount rate which flows through the banking system and ultimately determines what consumers pay to borrow and the interest they receive on their deposits. In theory, holding the discount rate low should induce banks to hold fewer excess reserves and ultimately increase the demand for money.
As interest rates fall, they stimulate economic activity by making it cheaper to borrow money, encouraging consumers and businesses to ramp up spending and investments. Rising rates do the opposite. By adjusting short-term rates, the Fed aims to keep the economy humming at a sustainable pace, without causing too much or too little inflation. But they don’t always succeed. Slashing rates to nearly zero in 2008 didn’t prevent the Great Recession. And the post-recession recovery was one of the most sluggish ever, even though the Fed kept rates near zero ever since.
Let’s look at housing. The Federal Reserve, (The Fed) kept interest rates near 0% for a long time. A result was that monthly mortgage payments by home buyers was lower than they would make if interest rates were determined by interaction between borrowers and lenders based on the supply of money for such loans and the demand for it.
For example, say a home buyer takes out a 30 year loan for $400,000. At 4% interest rate the monthly payment would be $1,910. At 6% it would be $2,398 – a difference of about $5,736 per year. Far more people can qualify for the lower monthly payment and so the demand for that $400,000 house would go up and so would the price, (because of the law of supply and demand). And so it has, substantially, in the past several years. This situation is a double-edged sword. Sure, the monthly payments are lower in a low interest environment, but the price for the house is much inflated. Now, with the Fed allowing rates to increase we can expect that rate of growth of housing prices to slow down, perhaps abate, because fewer people would qualify. But the decrease in demand should cause housing prices level off or to go down. This is supply and demand at work.
Let’s look at wages. There is a lot of talk about the minimum wage these days. It seems like a simple thing. Raise the wages of the lowest level workers, to say $15 per hour, and charge more for what they produce or earn less profit for the business. On December 27, 2016, a USA Today article reported that “higher wage minimums have led to the loss of hundreds of jobs in California alone as restaurants close or lay off workers to offset the higher costs.” And, more recently, in June 2017, a University of Washington team found that, although Seattle’s $15-an-hour minimum wage law has boosted pay in low wage jobs, there would be about 5,000 more low-wage jobs in the city without the law. This is another example of the law of supply and demand at work.
As for me, I’m willing to pay more for fast food to give these low level workers a little more money. But the minimum wage issue is much more complex issue than it seems. Take fast-food jobs and other low-paying work where young people just getting started in the labor market first learn about job responsibilities, inventory and customer service. An increase in the federal minimum wage to $15 from the current $7.50 would reduce many of those learning opportunities.
While the teen age worker is earning pocket change to buy lattes, sneakers and other items, there is another side to the issue. There are many low-wage workers these days trying to support a family – and those workers need a higher minimum wage. So the problem is complex.
I’m suspicious that our monetary policy with the Federal Reserve and other central bank’s obsession with keeping interest rates at extremely low levels has been reckless. Further, I’m concerned because the Fed has acquired such massive power that it owns over $4 trillion in government debt on its own say so, pays banks billions of dollars in interest with no oversight.
It tinkers with the strength of the dollar and seems to ignore supply and demand. It confuses changes in prices that come in response to supply and demand in the marketplace with movements in prices that result from changes in the value of the dollar.
The Fed’s suppression of interest rates has been a disaster for savers, money funds and lenders. Why not let the price of money be set by borrowers and lenders? (Let the market set interest rates.)
The flip side of money supply is the velocity of currency in circulation. If people do not, or slow to, spend their money, this has the same effect as a decrease in the money supply; it’s deflationary. If they do spend it, the effect is that of an increase in the money supply, inflationary. The Fed cannot control velocity, it can only control money supply. So the Fed – in policy change decisions – likely have to estimate what velocity is doing – how fast or slow money is being spent. In other words, to decide interest rates and money supply, they must guess about what 7.5 billion emotional humans are feeling about the US dollar.
Economic Systems
An economic system is the method used by a society to produce and distribute goods and services. The issue is: how much involvement should the government have in the economy? This takes on added importance as the appetite for more government involvement grows as evidenced by he appeal of 2020 presidential candidates who espouse socialism – a political system in which the government controls much of the economy.
All economic systems have three basic questions to ask:
- What to produce
- How to produce and in what quantities
- Who receives the output of production.
It might help here to discuss how an economy functions – helped by the following graphic.
The study of economic systems includes how these various agencies and institutions are linked to one another, how information flows among them, and how the social relations within the system, including how a resource or economic good is used and owned (property rights) and the structure of management.
An economic system determines how much the Government is involved in Production (supply) – what to produce, how to produce it and whom to distribute it to – and the Consumption of goods and services (Demand). The study of economic systems includes how these various agencies and institutions are linked to one another, how information flows between them and the social relations within the system. including how a resource or economic good is used and owned (property rights) and the structure of management.
In between Production and Consumption are:
- Businesses that employ land, labor, capital and entrepreneurship to create the supply of goods and services while paying wages, interest and incurring other costs. They receive income from customers for what they produce and incur profits or losses. There is risk involved. Businesses also pay taxes.
- Customers (‘Household’ on the graphic) who purchase and use the products and services and hence fill the demand role. Businesses sll to other businesses as wel las to customers.
- Government collects taxes and spends money (fiscal policy) and controls and influences the supply of money and has an effect on interest rates (monetary policy). Government also enacts laws and imposes regulations that affect businesses and customers.
The analysis of economic systems traditionally focused on the dichotomies and comparisons between
- market economies, where economic decisions regarding investment, production and distribution are made by individuals and are based on exchange or trade and guided by the forces of supply and demand, and
- planned economies, where the central government makes all decisions about the production and consumption of goods and services
and therefore, on the distinction between capitalism and socialism.
Subsequently, the categorization of economic systems expanded to include other topics and models that do not conform to the traditional dichotomy. Today the dominant form of economic organization at the world level is based on market-oriented mixed economies.
Market economies range from minimally regulated free market and laissez-faire systems where state activity is restricted to providing public goods and services and safeguarding private ownership, to interventionists forms where the government plays an active role in correcting market failures and promoting social welfare.
The degree of government involvement in the economy varies among nations.
Some examples of economic systems:
Most centrally planned: Iran, North Korea, and Cuba
Free Market: Hong Kong and Singapore have free markets with the US and UK close behind.
Centrally planned: Russia and China
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