Tax lever of fiscal policy

In the last blog I explained about monetary and fiscal policy. Here, in the Khan Academy, it explains some more about taxes as they pertain to fiscal policy. In the last example, under fiscal policy, taxes remained constant and spending went up. To do that, the government has to take on more debt. So the formula looks like this:

⬆️ GDP = C + I + G ⬆️ – NX

Where C = private consumption, I = mostly business investments, G = government expenses, and NX is net exports.     C and I remain constant, government expense goes up, so GDP goes up.

If taxes go down and government spending remains constant, private consumption and business investments will go up, so GDP will also go up. It is another way government can influence GDP:

⬆️ GDP = ⬆️ C + ⬆️ I + G – NX

Another way show it is in diagram format:

Govt. spending constant

As I stated in my last blog, the difference (for the most part) between the two parties, Democrats and Republicans, is that the Democrats, usually tend to want to increase taxes and the Republicans want to decrease, or at least not increase, taxes. In both cases National Debt takes the brunt. The Republicans want to see business investments increase, and consumption along with it. Fiscal policy, as desired by the Democrats, is a more direct government influence, so they see quicker results than the Republicans. Again, this is just a very generalized point of view, and depends very much on the market conditions.

The question remains: How much more debt can the government take on?

The correlation between GDP, taxes, and debt.

This will be a lesson based on the Khan Academy economics course to explain how government tries to affect the economy. I say “try to,” because evidently government cannot fully control the economy as it might wish. This makes sense, when we want to compare government policies between, say Democrat vs. Republican leadership. There is no clearly defined border between the two. There is always a delay, number one, and number two: depending on the conditions (economic and otherwise) the implemented policies may or may not result in its intended purpose to the desired degree.

There are basically two kinds of policies: Monetary and Fiscal policy. Monetary policy deals with how much money to print by the “Central Bank”. In the USA that is a quasi independent institution. It is run by the government, but also gets input from private industry, such as banks. It is given the right to print money, but it is mostly electronic money. It buys “debt”. An interesting way of “lending money”. When someone buys bonds, he/she directly lends money to the government. This increases the amount of money.

Screen Shot 2015-02-24 at 6.17.40 PM

When the supply curve moves to the right, interest rate will drop, as seen in the graph by the little yellow line on the demand curve, while the supply of money increases as seen on the yellow line on the horizontal supply axis. This is like micro economics. When more money is available because of the shift in money demand, that shifts the aggregate demand on the macro economical side to the right, stimulating the economy, thus increasing GDP as can be seen in the graph below:

Screen Shot 2015-02-24 at 6.18.14 PM

This graph compares Price on the vertical axis to GDP on the horizontal axis. So, GDP can increase because more money is available.

Another way that aggregate supply can increase is through fiscal policy. Fiscal policy is the government directly demanding goods and services from the economy. It uses two sources to finance those demands: taxes and / or debt in the form of treasury bonds and other means. Say, the government issues more bonds, thus increasing the debt, but taxes remain the same. This will increase spending, having the same effect as the increase in money supply in the previous example.

This brings up an interesting difference between the Democrats and Republicans. Typically, but not always, the Republicans want to hold the line on taxes and at the same time not increase the debt. Democrats tend to want to increase social programs meaning increased taxes. The way I see it, is that the Republicans, for the most part, want to increase or stimulate the economy, at the appropriate time through printing more money (micro economics), while the Democrats want to stimulate more directly through tax increases (macro economics). Both parties want to promise the moon, so need more money to fulfill their promises, but since neither can get the full amount they want in their own way, debt on the fiscal side goes up, unchecked. I say “unchecked”, because debt keeps rising no matter which party is in the majority. That is just my simplistic opinion, looking at how our economy functions.

GDP and Luca Pacioli

In my last blog, I wrote that GDP ignored the difference between credits and debits, or assets vs. expenses. It only records “transactions”. In a prior blog I also referred to National Debt as a humongous concept and was wondering what we as “peons” can do about it. I think we can do something about it! We have to speak up against the “Enrons” of the world, who misrepresent the accounting principles. They should be forced to explain their accounting processes. Also banks often use very “loose” accounting practices to make their status look good; better than it really is. Paclioli addressed not only double entry accounting, but also the ethics of accounting. Alas, the ethics today are going by the wayside.

Thomas G Rooney: “Paclioli was a Catholic monk who observed local Italian parissoners often in need of a hand out, not able to keep track of their activites, so he came up with a kind of community outreach plan in the form of a work book to help people 500 years ago keep track of their transactions by type. Debitiere is what one was to do with where something was put, and creditiere was what one was to do in recording where something came from. But in the “Nobody is going to tell me what to do” society, people often do not want to be told to keep track of messy things like that, and just enjoy the fact that transactions are occurring.  Paclioli’s system spread far and wide, now used by just about every entity that exists to keep track of things…. banks, trust companies, realtors, insurers, the professions, businesses, many churches, etc. But for some reason, governments only like half the system, emphasizing trnasaction volume, happy with inflows, whether the source is income or debt….. happy with outflows whether the object is an asset or an expense … as long as there is movement, you got that right Bert.”

“Since Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar Luca is often called the “Father of Accounting,” he did not invent the system. Instead, he simply described a method used by merchants in Venice during the Italian Renaissance period. His system included most of the accounting cycle as we know it today. For example, he described the use journals and ledgers, and he warned that a person should not go to sleep at night until the debits equalled the credits! His ledger included assets (including receivables and inventories), liabilities, capital, income, and expense accounts. Friar Luca demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise alludes to a wide range of topics from accounting ethics to cost accounting

Pacioli was about 49 years old in 1494 – just two years after Columbus discovered America – when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa’s 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added “in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business,” and to “give the trader without delay information as to his assets and liabilities” (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli’s Treatise, 1914).”

 

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Luca Pacioli: The Father of Accounting

GDP – The Nation’s Economic Hero

By the curious standard of the GDP, “the nation’s economic hero” is a terminal cancer patient who is going through a costly divorce. The happiest event is an earthquake or a hurricane. The most desirable habitat is a multibillion-dollar Superfund site. All these add to the GDP, because they cause money to change hands. It is as if a business kept a balance sheet by merely adding up all “transactions,” without distinguishing between income and expenses, or between assets and liabilities.

The strange fact that jumps out from Bennett’s grim inventory of crime, divorce, mass-media addiction, and the rest is that much of it actually adds to the GDP. Growth can be social decline by another name. Divorce, for example, adds a small fortune in lawyers’ bills, the need for second households, transportation and counseling for kids, and so on. Divorce lawyers alone take in probably several billion dollars a year, and possibly a good deal more. Divorce also provides a major boost for the real-estate industry. “Unfortunately, divorce is a big part of our business. It means one [home] to sell and sometimes two to buy,”a realtor in suburban Chicago told the Chicago Tribune. Similarly, crime has given rise to a burgeoning crime-prevention and security industry with revenues of more than $65 billion a year. The car-locking device called The Club adds some $100 million a year to the GDP all by itself, without counting knock-offs. Even a gruesome event like the Oklahoma City bombing becomes an economic uptick by the strange reckonings of the GDP. “Analysts expect the share prices [of firms making anti-crime equipment] to gain during the next several months,” The Wall Street Journal reported a short time after the bombing, “as safety concerns translate into more contracts.”   by:  Clifford Cobb, a policy analyst, is the author of Responsive Schools, Renewed Communities (1992).   Ted Halstead is the founder and executive director of Redefining Progress, a nonprofit public-policy organization in San Francisco.  Jonathan Rowe has been an editor at The Washington Monthly and a staff writer for The Christian Science Monitor.

That is the economy for us. Next time you read in the paper (or see a graph) how the GDP has increased, don’t get too enthusiastic too quickly. Consider why it increased. Is it an “asset” or a “liability”?  National Debt is seen, in part, in relationship to GDP. If GDP goes up, typically National Debt is allowed to move up as well.

US GDP growth rate

How can we influence national debt?

I missed two weeks of blogging, while on an RV trip to Long Beach and Yuma Arizona. During that time I was able to re-evaluate my goals using The 7 Habits of Highly Effective People.

Habit 1 is: to be pro-active. The problems, challenges, and opportunities fall into two circles, if you will: A circle of concern and a circle of influence. The circle of influence includes things like our health, children, problems at work. Those are what we can do something about. Other things we have very little control over, such as the weather, terrorism and the national debt. But National Debt is my topic!

Habit 2 is: “begin with the end in mind”. How do you envision the end? If I cannot influence the National Debt, then how do I envision the end? In my last blog, I challenged young people to look for options of paying for college. I envision the end as looking for ways to learn and share the mechanics of how National Debt works. In the process I find confidence and a sense of relaxation while the world is in turmoil. Learning about business cycles made me realize that I don’t have to become nervous when we get in a recession.

So, I may not be able to influence National Debt directly, nor do I envision the end of National Debt, but I can learn and share the mechanics of how National Debt works. I can envision that in the end my audience (you!) and I will understand it better and can explain how it fits in our society.

“Families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

This was clearly true of the debt incurred to win World War II. Taxpayers were on the hook for a debt that was significantly bigger, as a percentage of G.D.P., than debt today; but that debt was also owned by taxpayers, such as all the people who bought savings bonds. So the debt didn’t make postwar America poorer. In particular, the debt didn’t prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation’s history.” (Nobody Understands Debt, Paul Krugman)

debt-as-percent-of-gdp

This graph shows how the National Debt was over 100% in the mid-forties as described by Paul Krugman.

So how do we get out of debt?  Should the USA do it again, as after WWII?

What can we do about national debt?

My answer to the question  : It is hard to cut taxes with high National debt. Monetary policy can only go so far in helping economic growth. In order to keep the interest cost of carry the National Debt, bond yields are too low so retired people don’t have enough income to pay their bills, investment returns for retirement savings plan will be lower and workers will have to either save more or work longer. ricodilello commented on The Multiplier, a theoretical concept invented by John Maynard Keynes in the 1930s

In another blog ricodilello refers to student loans and how they affect families and delay young people from buying a home, which in turn, cripples the economy.

So, you plan to spend (say) fifty thousand after-tax dollars to send each child to college.  This is a bad idea.  You don’t get what you pay for. You pay for what you get. What, exactly, does your child get for your money?  The first two years are wasted. Maybe more.

The average book assigned to college freshmen is at a 7th-grade level.   There are parents who pay for this. You should not be one of them. The RPC (Ron Paul Curriculum) suggests that a high school student should quiz out of the first two years of college. The exams cost about $2,000, total. A student can pay for this, and should.

RPC trains high schoolers to do this.    http://www.ronpaulcurriculum.com/public/department135.cfm

There are smart ways to earn an accredited college degree. Physically attending the first two years of college away from home is not one of them.

The above paragraphs are from the Ron Paul Curriculum website. My point is that students and families of students can save a lot of money for college to reduce their debt. That is where debt reduction must start. Ron Paul’s suggestion requires more initiative of the student and the support of the family to get him / her there. Do you set the example as a father? as a mother? as a family? Do you teach your children about debt? Do you pay off your credit card automatically every month? National debt does not come out of the blue. Our Senators and Congressmen willingly oblige to the public requests of more programs and more conveniences to get our votes. They conveniently forget having to scale back when the economy is down!

I am re-reading The 7 Habits of Highly Effective People by Stphen Covey. Habit 1 is to be pro-active instead of re-active. In the stimulus of going to college a pro-active response requires self awareness, imagination, and an independent will, by the student. He / she has the freedom to choose and their language should be: I can, I prefer, I will, instead of: I can’t, I must, if only. “If only my parents had enough money to send me to college.” They might, if the student would do the work and do the exams recommended by Ron Paul, thus saving two years of tuition plus room and board!

The Multiplier, a theoretical concept invented by John Maynard Keynes in the 1930s

The most fundamental concept in the whole of macroeconomics. The “multiplier” measures the eventual impact on the economy as a whole, GDP, of a sustained increase or decrease in public spending. An increase in such expenditure brings more people into work, they in turn will have more to spend, the companies whose products they buy will have more revenue, and will employ even more people. The initial impact is multiplied through the economy.  Paul Ormerod, an economist at Volterra Partners

Sounds simple, but what is that number? Economists cannot agree on that. The multiplier works both ways. If it is large, the economy will decrease substantially if GDP decreases, or increase substantially when GDP increases.  Most economists believe that figure is pretty small, but IMF chief economist Olivier Blanchard and his colleague Daniel Leigh published an IMF working paper on the size of the fiscal multiplier, according to Paul Ormerod, trying to prove that the multiplier is rather large.

So a fiscal contraction, the basis of the chancellor’s policies, will lead to a sharp reduction in GDP. Events have shown this to be wrong.  Paul Ormerod The IMF duo approvingly cited other estimates, derived from the exotically named dynamic stochastic general equilibrium (DSGE) models, that the multiplier is large. These models have been all the rage in both top academic circles and central banks. Blanchard eulogised them in a MIT discussion paper published three weeks before the collapse of Lehman Brothers in September 2008. “Great progress had been made with DSGE models in understanding how the economy really worked. The state of macroeconomics, he declared, was good (according to Oliver Blanchard in this publication).”  Paul Ormerod

My point is, that in my research, National debt is not all about economic models. Even the IMF cannot predict the economy! I did find it interesting, that the recession really did not affect GDP by that much, and that companies adjusted their production and seemingly, easily survived for the most part. It were the people who lost jobs and homes (7,000,000 of them!)

An inescapable problem for these highly mathematical models is that they do not take into account sentiment, the narrative which emerges around policy changes. Osborne’s fiscal contraction has gradually created a positive narrative across companies, so they are willing to create jobs and invest. Psychology rather than hardline math is needed to tell us what the multiplier really is in any particular situation.      Paul Ormerod is an economist at Volterra Partners, a visiting professor at the UCL Centre for Decision Making Uncertainty, and author of Positive Linking: How Networks Can Revolutionize the World.

QUESTION OF THE WEEK:

SO WHAT ARE SOME EXAMPLES OF HOW NATIONAL DEBT AFFECT US ECONOMICALLY?