Monthly Archives: February 2011

Should Government Borrow to Invest?

Should America borrow trillions of dollars to build new infrastructure?

A number of commentators have recently advocated devoting significant federal dollars to rebuilding the nation’s infrastructure.  The Obama Administration has followed these suggestions by implementing or proposing major spending programs in several areas including high speed rail, smart electric meters, and expanded broadband service.

Proponents make several arguments in favor of these initiatives.  First, additional infrastructure would increase the nation’s productive capacity, leading to faster economic growth.  Second, infrastructure projects create jobs, which would help reduce unemployment from its current high levels.  Third, the nation’s current infrastructure could definitely use improvement.  The American Society of Civil Engineers has rated various categories of the nation’s infrastructure.  Bridges get the best grade with a C.  The Society recommends spending $2.2 trillion over the next five years.  Finally, interest rates are at historic lows with the government issuing 30-year bonds for under 5 percent.

There is another, more subtle, rationale as well.  The recurring financial crises of the last two decades have been exacerbated, if not caused, by the enormous amount of “hot money” in the world’s financial system.  This money crosses borders quickly to seek the highest rate of return, often through short-term speculation.  It leaves just as quickly, often precipitating financial collapse.  Much of this money has recently been invested in developing countries and commodities, sparking significant problems in both.  If future crises are to be avoided, it is enormously important that this capital be devoted either to consumption in the rapidly developing countries or to productive investment anywhere rather than further speculation.

The idea certainly has merit, but several points caution against quick action.  The first is that the United States is already on a path of unsustainable deficits.  Adding trillions of dollars of more debt, no matter how good the cause, would only hasten the date of economic collapse, when America’s creditors are no longer willing to extend additional credit at rates that the government can afford.  Even if the possibility of a Grecian financial crisis is discounted, the burden of debt already being placed on our future strongly argues for funding new programs by cutting existing spending rather than issuing new debt.   It is not clear that the government is ready to do this.

One problem is that many people confuse investment with consumption.  Given that a lot of the current economic problem is due to the fact that America borrowed a lot of money to finance consumption, it is very important that we not do more of the same.  Any borrowing has to be productively invested, which means that it has to earn a rate of return.  If an investment earns a rate of return higher than the cost of borrowing we are better off, provided we can safely manage the financing and liquidity problems.  If it does not generate a high enough rate of return, we are worse off.  Yet there has been very little analysis of the exact rate of return that different infrastructure projects might be expected to produce.  A great deal of past spending has represented wasteful consumption.

The rate of return is strongly influenced by the cost of any investment.  Federal requirements such as Davis-Bacon requirements for wages, environmental restrictions, and permitting processes often unnecessarily raise the cost of investments, thereby pushing many from the investment to the consumption category, lowering the rate of return on all, and reducing the amount of investment that Americans can get for for any given expenditure.  Labor restrictions also reduce the number of jobs that are created on any project.  One way to measure how important proponents of infrastructure are is to see whether they are willing to relax some of these restrictions on even a temporary basis so that we can get as much investment for the dollar as possible.

Some of infrastructure proposals recognize the current budget constraints by proposing loan guarantees rather than direct spending.  There is a great danger, however, that the true cost of federal guarantees will be underestimated in order to make it seem like they are cheap.  This is what was effectively done for Fannie Mae and Freddie Mac even though in those cases the guarantees were not explicit.  The result is that taxpayers are likely to end up with a huge bill several years later when projects turn out to be riskier than was promised.  Nor is it clear what market failure a loan guarantee addresses.  Most builders, whether they are private companies or other governmental units are able to borrow on their own credit.  Most likely the real purpose of a guarantee is to let the project borrow at the same low rate as the federal government even though it is a worse credit risk.

It is possible that investments in highways, rail, broadband, the grid, and other areas could be very productive.  These could be funded through a combination of direct expenditures, explicit loan guarantees, and privatization.  These are less likely to lead to hidden liabilities.  But in order to make sure that the projects do generate a high rate of return, it is very important to approach these them as large, interconnected projects rather than as discrete pieces.  For example any spending on the smart electric grid should follow the development of a national plan that shows how all the pieces of the grid fit together and that includes other reforms such as faster approval for transmission construction and charging higher rates for peak use.  In the absence of broader planning, much of the money recently spent on smart meters will not generate a strong rate of return because in the absence of rate changes individuals still lack any incentive to shift their consumption to nonpeak times or because the meters being installed turn out not be be compatible with later technology.  Similarly, highway expenditures would have a higher return if they are accompanied by congestion pricing and if they are wired to convey traffic conditions on a real-time basis and accommodate the greater use of IT in cars.

Finally, there is the continued risk that technology will outpace spending on infrastructure.  Just imagine a country that spent billions on new land line phone systems just as the wireless revolution was happening.  For instance, a modern highway system needs to incorporate the capability to carry not just vehicles, but also information at high speeds.  It is not clear yet what the best technology for broadband  expansion will be, but it is likely to be faster and less expensive than today’s choices.  And the smart grid still needs standards and a comprehensive vision in order to adapt to whatever the future brings.  Absent foresight we could find that much infrastructure spending is outmoded soon after it is installed.

Despite the budget problems, the current impediment toward more infrastructure investment is neither a lack of feasibility nor a lack of capital.  The federal government can still borrow significant sums if bondholders think that the funds are going to investments that make the country richer in the long run.  The problem is that voters just do not believe that Congress will spend the money wisely.  Rather than propose vague but grandiose plans, the Administration needs to develop a well-thought out vision for each major part of the nation’s infrastructure, accompanied by policy changes that increase the value of the components while minimizing their cost.  Then it will be in a position to make it case to Congress and the American people.

 

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Only Leadership Will Get Americans Out of This Dilemma

A variety of structural crises threaten America’s economic and social health.  Massive stimulus has mortgaged the nation’s future in exchange for a temporary boost in national income and employment.  Its inevitable withdrawal now threatens to hold down future growth.  Government deficits and debt are reaching new highs.  In the short-term this is largely because of the recession and efforts to counteract it.  However, the long-term threat stems largely from a long pattern of promising government benefits but not setting aside the funds needed to pay for them.  As a result, pensions and health care benefits on the federal, state and local level have reached unsustainable levels.

Two things are needed for long-term recovery.  The first is a readjustment of government spending to match government revenue.  In the private sector this is usually accomplished by the renegotiation of contracts, either voluntarily or through bankruptcy.  This process can be helped by a series of broader policy initiatives that increase economic growth.  Worthwhile policies include devoting a large share of public and private spending to investment rather than consumption, tax reform, and the elimination of unnecessary regulation.  So why can’t we accomplish these reforms?

The problem is that progress on each of these area is made nearly impossible because current laws contain a morass of special provisions that benefit one group of Americans at the expense of everyone else.  The vast majority of these policies lower national wealth in two ways.  First, they divert productive effort away from beneficial activities and into those activities that the government has chosen to favor, that is unless the current beneficiaries can also get the government to pass laws that protect them from competition.  Second, the government’s use of this arbitrary power encourages large investments in attempts to influence its decisions.  These investments include lobbyists, campaign contributions, personal gifts, and outright graft.  Mancur Olson wrote that stable societies were in danger of facing sclerosis as the gradual growth of special interests skewed incentives and limited innovation.

The the crux of this problem can be understood if we look at how an individual might choose between four alternative states of the world and how government policy might or might not affect their incentives to act on these preferences.  In evaluating an area such as tax policy, each individual faces four alternatives which we will call winner, social cooperation, social loss, and sucker.  The situation that the individual faces is determined by whether he retains those government policies that specifically benefit him and whether the rest of society retains the benefits that favor them.  It is important to realize that, while an individual has some ability to choose whether to give up his benefits, she takes the choices of others as given.

Most individuals probably rank their preference for each outcome in the following order:

  1. I win you lose.  I get to keep my special tax breaks but we repeal yours in order to get faster growth.
  2. We all cooperate.  Everyone gives up their tax breaks.  This allows benefits society the most.
  3. No one cooperates.  We all keep our special privileges.  This comes close to the status quo.
  4. I am a sucker.   I give up my tax break in order to improve public policy, but no one else does.  We are stuck with basically the same system, but I am worse off.

From the point of view of society as a whole, the proper ranking should be; 1) we all cooperate, 2) I win, you lose (because only one special tax break exists), 3) I am a sucker, and 4) no one cooperates.   Given this, how can we productively look at issues such as tax reform?

The first thing to notice is that we are largely stuck in the system where no one cooperates.  The tax code is riddled with special provisions benefiting one group or another.  There is a growing consensus that the complexity of system as a whole imposes large burdens on Americans and that few of the tax provisions can be justified on policy grounds.  Most people think that comprehensive tax reform, similar to the 1986 reforms would make the country better off.

If the average taxpayer would prefer universal cooperation (which in this case would mean everyone giving up their individual tax provisions) why is it so difficult to enact reform?  Largely because, without leadership,  each person or group takes the actions of others as largely given.  The  choice they face is not between we all cooperate and no one cooperates.  It is beween  no one cooperates and I am a sucker.  If homeowners voluntarily step forward to give back  the tax deduction for home mortgages, the oil industry is unlikely to follow their lead.  The extra revenue will be divided among everyone else or, worse, be used to give a new tax break to another group.  In this case, the homeowners have indeed become suckers, sacrificing their interests for the sake of others but not achieving the social benefits that would come from broader reform.

The role of government in this situation is to craft a comprehensive agreement that allows the parties to effectively chose broader social cooperation.  It is to frame the debate in terms of the status quo or full cooperation (or close to it).  Groups are more likely to cooperate if their sacrifices can be made conditional on the cooperation of others.  Bringing more groups into the agreement increases the total social gains that each group realizes in return for its cooperation.  This argues for bold and comprehensive reforms like the 1986 act.  But it also means moving toward simplicity rather than complexity in the way laws are drafted.  Unwieldy reforms such as health care reform, climate change legislation, and financial reform add further layers of special privileges onto an already burdened system, reducing the public’s trust that true reform has been achieved.

But even if comprehensive reform is enacted, the government’s role is not done.  Social cooperation is never a stable outcome because each group has a higher preference: that it gets its special provision added back while others are cooperating.  Having achieved cooperation, they now want to win.  These changes deliver large benefits to the targeted group and, although they reduce total national income, the burden felt by others is often minor.  The problem is that every group wants this outcome and success by one only encourages other attempts.  Thus government must remain ever vigilant in protecting the broader agreement against special interests that attempt to undermine it.  This requires policymakers to forswear the power to dole out special favors, even in cases where there is a good policy argument for using it.

There are strong indications that Americans see the benefits of comprehensive reform and are ready to make sacrifices to achieve it.  Putting America back on course could be this generation’s contribution to posterity.  But few people are willing to give up their own benefits unilaterally.   Unfortunately, they are losing faith in their elected leaders who seem largely uninterested in giving up the discretion to benefit some at the expense of others and who shrink from the leadership needed to craft bold reforms.

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The Revolution in Egypt: Now for the Hard Part

In both Egypt and Tunisia the task now turns to figuring out what will replace the overthrown regime.  This task will not be easy.  It is possible, perhaps even probable, that we will see the establishment of a new regime largely controlled by the same people who benefited from the former dictatorship.  While some minimal concessions may be made in terms of elections and legal rights, power and opportunity would still reside with those who held it before.  In this case a great opportunity will have been lost.

Another option is that a new faction, long oppressed but no more dedicated to the principles of democracy than the old order, will gain power in one way or another and then use all of the tactics of the old regime to keep it.  Thoughts turn immediately to radical Islamists, but they do not present the only danger.  As Iraq shows, in any society that is deeply split along racial, religious, political, or geographic lines each faction has to worry about being oppressed if other factions are allowed to gain power.

The task before the Tunisians and Egyptians is large.  They must agree on the constitutional rules that will govern their new governments and establish the institutions to protect them. And all of this must be done relatively quickly, involve numerous groups whose interests may or may not coincide and who may or may not have a history of talking to each other, all while maintaining the basic stability needed to let people go on with their normal lives.

Now we see the price the United States pays for its appeasement of tyranny.  In different circumstances it would be highly desirable if America could act as a guide in this process.  After all, we went through it ourselves once.  America certainly has many things that would help in the transition; money, a large body of highly trained civil servants with experience in running the police, judicial, welfare, infrastructure and other institutions necessary to a modern society, and social, economic, and cultural traits that appeal to a large part of the population.  Perhaps most important, the American people have a deep history of respect for religious freedom, individual autonomy, and civil society.

What we do not have, at least in Egypt, is legitimacy.  For decades American administrations supported the Egyptian government despite its oppression of the vast majority of its people.  Large amounts of military assistance were given because it served the interests of Mubarak and the army, not because it was at all useful to the vast majority of Egyptians.  America looked the other way as the regime became more corrupt and closed off more avenues of political expression and economic participation to more people.  Lectures in democracy were always enough to satisfy our conscience but never enough to change reality.  Protesters in Egypt have few reasons to think that the American government is really interested in helping them realize their desires with respect to economic growth, the role of Islam in society, and peace in the Middle East.  It could be different.

In the end, support for democracy implies that governments should represent the will of their people, even if this will is opposed to the interests of America and its allies.  The corollary of this principle is that citizens are responsible for the governments they support.  Belief in the right of Egyptians to make their own decisions on the peace treaty with Israel does not mean that America should support whatever decision they make.  But in a democracy arguments about public policy have to appeal to the interests of the people as a whole rather than the interests of the ruling class, the army, or the United States.  America’s foreign policy has never attempted to do this in the Arab world, preferring instead to talk over the heads of the citizenry to governments that do not represent common opinion.

Preservation of democracy requires the establishment of civil society; the routine treatment of social issues by individuals and groups based on dialogue, common respect, and trust.  A recent Foreign Affairs article by Clay Shirky makes three interesting points about this process.  First, the growth of civil society makes it easier to overthrow a repressive regime because the exchange of information erodes the government’s legitimacy and makes its weaknesses common knowledge.  When the revolution comes, civil society provides the strength to resist the government’s attempts to preserve itself.  Second, the existence of civil society makes the second stage of any revolution much more likely to succeed by providing public leaders with the popular authority to make constitutional decisions.  And finally, communications technology, especially social networking sites, can play a vital role in this process.  Shirky argues that, while access to Western media sources is important, the most vital role of technology is putting citizens in touch with each other so that they can start the dialogue needed to build a stronger society.

It may be too late for the United States to play a meaningful role in determining what replaces Mubarak.  But we can do better going forward.  First, by making it clear that, while the United States believes that every nation should be democratic, it is ultimately up to each people to demand their own freedom.  Attempts to overthrow or undermine regimes from outside are unlikely to produce democratic governments without a strong civil society ready to assume power when it is handed to them.  Second, by making it clear that when citizens do make a common decision to support a policy, America will always support their right to do so, even if it opposes the policy itself.  And finally, as Shirky argues, the United States should focus on supporting technology that increases personal and social communication among a state’s population.  These tools have the dual purpose of increasing economic growth and building civil society.  Any regime that attempts to shut them down faces the “dictator’s dilemma;” because these tools are central to modern economies and effort to shut down the medium of social communication also imposes large economic costs.

Let’s hope that future Administration’s do more to act on the belief that: “that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.”  Even if that form does not seem the most convenient for us.

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The United States Faces Five Big Challenges

In order to make its strategic and economic leadership secure, America must successfully deal with five complex challenges over the next 20 years.  A solution to each of these challenges is achievable with sustained effort and, if achieved, they will strongly improve America’s ability to enjoy rising livings standards and continued international leadership.  They will also have positive implications for the rest of the world.

The Reform of International Institutions

The United States has a fundamental interest in seeing other nations join it as wealthy, responsible members of the global community.  Yet as other nations develop, the relative power of the United States is certain to decline.  This makes it imperative to develop international institutions that effectively accommodate and constrain the rising power of other nations.

Americans are much better off in a world where the citizens of China, India, Brazil and similar countries enjoy rising living standards and greater freedoms and where their governments bear a proportionate responsibility for ensuring the maintenance of the Western liberal order that has governed during the last 60 years. This order stressing free trade, human rights, nuclear nonproliferation, and collective security has delivered enormous benefits to the world.  As globalization increases the number of problems needing a collective solution, international institutions will gain even more importance.

Yet important international institutions including the World Bank and the International Monetary Fund, have lost much of their relevancy.  Decision making needs to be changed to reflect the rising influence of developing countries.  Just as important, their operations need to be streamlined and focused on a new mission that better reflects the need’s of today’s international community.  Other institutions like the United Nations and the General Agreement on Tariffs and Trade, look increasingly unable to deal with increasingly complex global problems.  Both the United Nations General Assembly and its Security Council continue to have difficulty addressing global issues.

Countries such as India and China need to find that the institutional structure surrounding them both furthers their interests and restrains their ability to act unilaterally against the interests of the general community.  And the world community needs institutions capable of dealing with collective problems.

Preparing Society for the Impact of Technology

Technology continues to increase at an accelerating rate.  In fact, it is likely that the amount of change occurring during the next 30 years will be at least an order of magnitude greater than the changes over the last 30 years.  If one remembers the social, economic and political changes that technology forced over the last three decades and then multiplies by 10 or 20, it becomes clear that new technologies will have a tremendous effect on both the wealth and shape of society.

These changes will have dramatic effects on privacy, life expectancies, industrial structure, and ethics.  What will happen to entitlements and the work place when people routinely live to be 120?  Will parents be allowed to alter their child’s genetics?  Who will have access to all of the data on our personal movements and transactions that future information systems will collect?  Will everyone be guaranteed access to drugs that eliminate disease or enhance mental performance regardless of cost?  We cannot answer these questions now, but we prepare for them.  In addition, the government should change policies governing work, health care, and savings to accommodate a world in which workers need to be more mobile and continuously retrain and in which they will live much longer.  Second, the government can begin to lead a national dialogue about the responsible use and legal framework that should surround new technologies.  It should also begin to enact policies to ensure that the benefits of technology are widely shared.

Competitiveness and Innovation

Globalization will continue to require greater collective decision making by the world’s powers.  If in 20 years the United States is not among the world’s leading economic powers these decisions will still be made, but Americans will have less influence over them.  Remaining the world’s leader in economic competitiveness and innovation boosts our role in global governance and our ability to protect our vital interests.  Concerns about international competitiveness can easily be overdone and other nations face more serious hurdles than we do.  Yet there is little doubt that the United States could do a much better job of ensuring that its laws encourage rather than retard greater productivity.  Failure to generate additional wealth impacts both our national security and our living standards.

Continued technological change can make a large contribution to national productivity, but only to the extent that organizational changes allow for its full use.  Significant reforms to the education, health care, and finance sectors will be necessary before we can see the steady improvement in both performance and price that characterize other sectors of the economy.  Additional investments in the nation’s transportation, energy and communications infrastructures will also be necessary but great care will be needed to ensure that the spending generates a high rate of return.  Finally, we need broad reforms to taxes, worker training programs, and regulation in order to channel activity away from consumption and into productive activity.

The New Social Contract

To obtain the necessary political support for the above changes, a new social contract is needed that strikes a better balance between individual responsibility and collective security.  Workers need to become less dependent on their employers for pensions and health care and individuals need more control over them.  Government assistance should be conditioned on responsible behavior, including an affirmative obligation to work.  In exchange, workers should be able to count on a higher level of protection against the uncertainties and dislocations that accompany a dynamic society.  This includes a fair distribution of the benefits of higher growth, better access to decent education and health care, and tougher enforcement of laws against deceptive and anti-competitive behavior.

The new social contract should provide the minimum level of income needed for a decent standard of living.  It should take the form of an income supplement so that individuals have the maximum flexibility to meet their own needs.  And it should be accompanied by policy reforms that make it easier for everyone to find decent shelter, save, obtain the training needed to improve their prospects, and gain access to affordable health care.

Fiscal Balance

The achievement of each of these goals requires the government to have a long-term focus.  This is unlikely unless it first learns how to balance its commitments with its resources.

The recent fiscal crisis is highlighting the large gap that has developed between America’s commitments to the future in the form of entitlement programs, debt, and infrastructure needs and its present ability to pay for them.

Far too many sectors of society, including all levels of government, are burdened with commitments that they cannot keep.  These commitments need to be renegotiated so that resources are devoted to more productive uses and the burden of future investment is more evenly spread.  A government that tries to meet every want is unlikely in the end to be able to meet even its most important needs.

In facing these challenges it is important to remember that, not only do other nations face their own challenges, our problems are in many ways less serious and our strengths more solid than those of our major competitors.  But the failure of other nations should not give us hope for, until we face up to the challenges before us, we will fall far short of of our potential.

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The Revolution in Egypt: The Easy Part is Over

Now the hard part begins.

Although it is often overlooked, every revolution has two parts; the removal of the old regime and the creation of a new one.  The first is by far the easiest.  But as the revolutions in France (1789), Russia (1917), China (1949), and Iran (1979) all demonstrate, the second part is just as important, and often more difficult than the first.  Even in the American Revolution, five years elapsed between the Treaty of Paris and ratification of our Constitution.

The recent experiences in Tunisia and Egypt demonstrate important lessons with respect overthrowing regimes.  The first is that when enough people are willing to go up against the state, the government has no chance.  In this respect every government does in some sense rest upon the will of the people.  Even in a place as brutal as North Korea, the regime’s survival is just a matter of numbers.

Even when the regime has lost all support, rebellion is still a matter of strategy.  If only a few protesters raise their heads, the government can easily deal with them.  If everyone raises their head, there are not enough bullets or troops to put them all down.  While some opponents have no regard for danger, the participation of most citizens depends upon the number of other protesters and the chance of success.  In both Tunisia and Egypt the revolution gained momentum as each day’s successful protest drew more people into the streets.  The calculations have already started in other countries.  Opponents are learning that if they can only persevere, momentum will eventually sweep an unpopular regime away.  Governments may come to the conclusion that the first uprisings need to be ruthlessly suppressed.

The second lesson is that communications technology, especially social networking software, undoubtedly makes it easier for protesters to assemble the critical mass needed to topple a regime.  It does not guarantee success and governments certainly can use the same technology to fight back, but revolution is much easier with the presence of Twitter, Facebook, and file sharing software  than it would be without them.

The third lesson is that in the beginning, if not in the end, it comes down to the army.  Once most citizens oppose a regime, only force will keep it in power.  And even force is not enough if everyone rises up.  The answer then is that any serious uprising has to be crushed immediately, before it can be seen to gather momentum.  And for that the army is vital.  The problem from the regime’s standpoint is that even the army and police consist largely of ordinary people whose willingness to kill their fellow citizens to support a regime that largely benefits their superiors becomes more suspect as the regime becomes more unpopular and isolated.  In the end, the army may decide its interests do not coincide with the government’s.

The people of every nation have the ability  to overthrow tyranny by rising up united against it.  The United States should make it clear that it will morally support them whenever they do.  But that still leaves the hard part of establishing a stable democracy.  That is the subject of a subsequent post.

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