How Much Was Bank Regulation Weakened in the New Budget Bill? And What Can Be Done Now?

A.  Introduction

In a rare, late-night and weekend, session, the US Senate on Saturday night passed a $1.1 trillion government funding bill to keep the government running through to the end of fiscal year 2015 (i.e. until September 30, 2015).  The House had passed the bill on Thursday, and it has now gone to Obama for his expected signature.  Had it not been passed, the government would once have been forced to shut down due to lack of budget authority.  It was a “must-pass” bill, and as such, was a convenient vehicle for a number of provisions which stood little chance to pass on their own, but which could only be blocked by opponents now at the cost of forcing a government shutdown.  The specific provisions included were worked out in a series of deals and compromises between the leadership of the Republican-controlled House and the now Democrat-controlled (but soon to be Republican-controlled) Senate.

One such provision was an amendment to the Dodd-Frank Wall Street reform bill, originally passed in July 2010, which enacted a series of measures to strengthen the regulatory framework for our financial sector.  The failure of this framework had led to the 2008 economic and financial collapse in the last year of the Bush administration.  The amendment in the new budget bill addressed just one, and some would say relatively minor, provision in Dodd-Frank.  But its inclusion drew heavy criticism from liberal Democrats, led by Senator Elizabeth Warren of Massachusetts.  Senator Warren argued that the amendments to Section 716 of Dodd-Frank would “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system.”  The amendments were reportedly first drafted by lobbyists for Citibank, and would benefit primarily a very small group of large Wall Street banks.

The amendments do reflect a backwards step from the tighter controls on risk that Dodd-Frank had provided for.  In my view, it would have been better to have kept the original provisions on the issue in Dodd-Frank.  But with a positive response now by the regulators to the reality of this new provision, the impact could be negated.  This blog post will discuss what was passed, what could be done now by bank regulators to address the change, and the politics of it all.

B.  The Amendment to Dodd-Frank, and the Economics of Derivatives

The amendment to Dodd-Frank addresses one specific provision in a very large and comprehensive bill.  An important link in the 2008 financial collapse was the risk major banks had carried on their books from certain financial derivative instruments.  “Derivatives” are financial instruments that derive their price or value from the price or value of some other product.  For example, oil derivatives derive their value from the price of oil (perhaps the price of oil at some future date), foreign exchange derivatives are linked to foreign exchange rates, credit default swaps are linked to whether there is a default on some bond or mortgage or other financial instrument, and so on.

Derivatives can be quite complicated and their pricing can be volatile.  And they can lead to greater, or to reduced, financial risk to those who hold them, depending on their particular situation.  For example, airlines must buy fuel to fly their planes, and hence they will face oil price risk.  They can hedge this risk (i.e. face reduced risk) by buying an oil derivative that locks in some fixed price for oil for some point in the future.  An oil producer similarly faces an oil price risk, but a bad risk for it is the opposite of what the airline faces:  The oil producer gains when the price of oil goes up and loses when it goes down.  Hence both the airline and the oil producer can reduce the adverse risk each faces by entering into a contract that locks in some future price of oil, and derivative instruments are one way to do this.  Banks will often stand in the middle of such trades, as the buyer and the seller of such derivative instruments to the airlines and the oil producers (in this example), and of course to many others.

Derivatives played an important role in the 2008 collapse.  As the housing bubble burst and home prices came down, it became clear that the assumptions used for the pricing of credit default swaps on home mortgages (derivatives which would pay to the holder some amount if the underlying mortgages went into default) had been badly wrong.  Credit default swaps had been priced on the assumption that some mortgages here and there around the US might go into default, but in a basically random and uncorrelated manner.  That had been the case historically in the US, for at least most of the time in the last few decades (it had not always been true).  But this ignored that a bubble could develop and then pop, with many mortgages then going into default together.  And that is what happened.

Dodd-Frank in no way prohibits such derivative instruments.  They can serve a useful and indeed important purpose.  Nor did Dodd-Frank say that bank holding companies could no longer operate in such markets.  But what Section 716 of Dodd-Frank did say was that banks that took FDIC-insured deposits and which had access to certain credit windows at the Federal Reserve Board, would not be allowed, in those specific corporate entities, also to trade in a specifically defined set of derivatives.  That list included, most notably, credit default swaps that were not traded through an open market exchange, as well as equity derivatives (such as on IBM and other publicly traded companies) and commodity derivatives (such as for oil, or copper, or wheat).  The bank holding companies could still set up separate corporate entities to trade in such derivatives.  Thus while Citigroup, for example, could set up a corporate entity owned by it to trade in such derivatives, Citibank (also owned by Citigroup), with its FDIC-insured deposits and with its access to the Fed, would not be allowed to trade in such derivatives.  That will now change.

It is also worth highlighting that under Dodd-Frank, banks with FDIC-insured deposits could still directly trade in such derivatives as interest rate swaps, foreign exchange derivatives, and credit default swaps that were cleared through an organized public exchange.  That had always been so, and will remain so.  The banks could also always hedge their own financial positions.  But they will now be allowed to trade directly (and not simply via an associated company under the same holding company) also in the narrow list of derivative instruments described above.

It is arguable that this is not a big change.  All it does is allow bank holding companies to keep their trading in such derivative instruments in the banks (with FDIC-insured deposits) that they own, rather than in separately capitalized entities that they also own.  The then Chairman of the Federal Reserve Ben Bernanke noted in testimony in front of a House panel in 2013 that “It’s not evident why that makes the company as a whole safer.”

So why do banks (or at least certain banks) want this?  Banks with FDIC-insured deposits and who also have access to certain credit windows at the Fed, are seen in the market as enjoying a degree of support from the government, that other financial entities do not enjoy.  The very largest of these banks may be viewed as “too-big-to-fail”, since the collapse of one or more of them in a financial crisis would in turn lead to a financial cataclysm for the country.  Thus depositors and other lenders are willing to place their money with such institutions at a lower rate of interest than they would demand in other financial institutions.

Thus Senator Warren and others charge that the amendments to Dodd-Frank “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system”, as quoted above.  To be more precise (and less eloquent), any bank with FDIC-insured deposits will make investments with those deposits, those investments will have varying degrees of risk, and if there is a threat that they will fail, the government may decide that it is better for the country to extend a financial lifeline to such banks (as they did in 2008) rather than let them fail.  The amendments to Dodd-Frank will allow these banks to invest in a broader set of derivative contracts directly (rather than only at the holding company level) than they could have before.  Thus they could end up investing directly in a riskier set of assets than they could have before without this amendment, and all else being equal, there could then be a higher risk that they will fail.

Finally, it should be noted that the amendments to Dodd-Frank will benefit largely only four very large banks.  The most recent quarterly report from the Office of the Comptroller of the Currency indicates that just four big banks (Citibank, JP Morgan Chase, Goldman Sachs, and Bank of America) account for 93% of derivative contract exposure among banks (as of June 30, 2014).  While this figure includes all types of derivatives, and not just those on the list that is at issue here, it is clear that trading in such instruments is highly concentrated.

C.  What Can Be Done Now? 

Over the objections of Senator Warren and others, the amendments to Section 716 of Dodd-Frank have been passed as part of the budget bill.  Banks, and in practice a limited number of very large banks, will now be able to take on a riskier set of assets on their balance sheets.  But Dodd-Frank, and indeed previous bank regulation, has established a bank regulatory and supervision regime that requires that banks hold capital sufficient, under reasonable estimates of the risks they face, to keep them out of insolvency and an inability then to repay their depositors.  The bank regulatory and supervision framework was clearly inadequate before, as the 2008 collapse showed.  Dodd-Frank has strengthened it considerably.  The specific rules are now being worked out, and like all such rules will evolve over time as experience dictates.

The amendments to Section 716 of Dodd-Frank will now change the set of risks the banks will possibly face.  I would suggest that now would be a good time for current Fed Chair Janet Yellen, or one of the other senior bank regulators heading up the process or even President Obama himself, to make a statement that they will of course follow the dictate of the law (as spelled out in Dodd-Frank, as it still stands) to take into account these possible new risks as they work out the capital adequacy ratios for the banks that will be required.

Specifically, the statement should make clear that the capital ratios required of banks that trade in these newly allowed instruments will now have to be set at some higher level than would previously have been required, due to the higher risks of such assets now in their portfolio.  It could and should be made clear that the law requires this:  The regulators are required to determine what the capital ratios must be on the basis of the risks being held by the banks in their portfolios.  How much higher the capital ratios will need to be will depend on the riskiness of these new assets compared to what the banks previously invested in, and how significant such new assets will be in their portfolios.  It is quite possible that faced with such higher capital requirements, the banks that had pushed for this new latitude will decide that it would be wiser not to enter into those new markets after all.  They may well come to regret that they pushed so strongly for these amendments to Dodd-Frank.

This is perhaps not the best solution.  The prohibition on direct trading in the proscribed list of certain financial derivative instruments is cleaner and clearer.  Most importantly, while current bank regulators may use their authority to ensure banks hold sufficient capital to reflect the greater risk in their portfolio, there is the danger that regulators appointed by some future president may not exercise that authority as wisely or as carefully.  This was indeed the fundamental underlying problem leading up to the 2008 collapse.  The Bush administration was famously anti-regulation, and Bush appointed officials who were often opposed to the regulations they were in office to enforce.  In at least some cases, the officials appointed who were not even competent to carry out their enforcement obligations.  For example, Bush famously appointed former Congressman Christopher Cox as head of the SEC.  The SEC at the time had the obligation to regulate investment banks such as Lehman Brothers, Goldman Sachs, and Morgan Stanley.  As Lehman Brothers collapsed, with worries that Goldman Sachs, Morgan Stanley, and others would soon be next, Christopher Cox was at a loss on what to do, and was largely by-passed.  Dodd-Frank changed regulatory responsibility (the Fed and other financial regulators are now clearly responsible, where Goldman Sachs and Morgan Stanley had already been “encouraged” to become formal banks and as such subject to Fed oversight), but there is the risk that some future president will choose, like Bush, to put in place figures who either do not believe in, or are not capable of, serious financial supervision and oversight.

In addition, financial crises are always a surprise.  They occur for some unexpected reason.  If they were expected, actions could be taken to address the causes, and they would not happen and hence not be observed.  But surprises happen.  Hence Dodd-Frank, and indeed all financial regulation, includes an overlapping and mutually reinforcing set of measures to try to ensure crises will not occur and that banks will not become insolvent should they occur.  One does not know beforehand which of the regulatory measures might be the critical one for some future and unforeseen set of circumstances leading to a crisis.  it is therefore wise to include what others might call redundancies.  The amendment to Dodd-Frank will remove one of the possibly redundant measures to ensure bank safety.  The remaining measures (e.g. the capital adequacy requirements) may well suffice to address the safety issue, but in cases like this, redundancy is better.

D.  The Politics of It All

While the economics may suggest that the change resulting from the amendment to Dodd-Frank need not be catastrophic if regulators respond wisely, and hence that the amendment is not such a big deal, the politics might be different.

The biggest concern is that many see this as possibly the opening round of a series of amendments to Dodd-Frank and other laws identified with the Obama administration, that a Republican Congress and now Senate will push through on “must-pass” legislation such as budget bills.  Particularly if this had slipped through quietly, with little public attention until after the bill had been passed, the bankers and their Republican representatives could have seen this as a model of how to pass changes to legislation that would not otherwise have gone through.  While the model is certainly not a new one, its affirmation in this instance would have strengthened their case.

The loud objections by Senator Warren and others has served to bring daylight to the changes in financial regulation being proposed.  This will hopefully make it more difficult to push through further, possibly much more damaging, changes to Dodd-Frank at the behest of the banks.

Ensuring attention was paid to the issue also served to make clear who in the House and the Senate are in fact in favor of bank bailouts.  Weakening Dodd-Frank will increase the likelihood (even if only marginally so) that bank bailouts will be necessary in some future crisis to protect FDIC insured deposits and to protect the economy from a full financial collapse.  Republicans, including in particular Tea Party supported Republicans, have asserted they are against bank bailouts.  But their actions here, with the Dodd-Frank amendments inserted into the budget bill at the insistence of the House Republican leadership, belies that.

The actual economic substance of the Dodd-Frank amendments might therefore be limited, especially if there is now the regulatory response that should be required in the environment of certain banks holding more risky assets.  But the politics may be quite different, and could explain why there was such a vociferous response by Senator Warren and others to this ultimately successful effort to weaken a provision in Dodd-Frank.

The Impact of Austerity Policies on Unemployment: The Contrast Between the Eurozone and the US

Unemployment Rates - Eurozone and US, Jan 2006 to Oct 2014

A recent post on this blog looked at the disappointing growth in the Eurozone since early 2011, when Europe shifted to austerity policies from its previous focus on recovery from the 2008 economic and financial collapse.  There has indeed been no growth at all in the Eurozone in the three and a half years since that policy shift, with GDP at first falling by about 1 1/2% (leading to a double-dip recession) and then recovering by only that same amount thus far.  The recovery has been exceedingly slow, and prospects remain poor.

The consequences of the shift to austerity can be seen even more clearly in the unemployment figures.  See the chart above (the data comes from Eurostat).  Unemployment in Europe rose sharply starting in early 2008 and into early 2009.  But it then started to level off in late 2009 and early 2010 following the stimulus programs and aggressive central bank programs launched in late 2008.  Unemployment in the US followed a similar path during this period, and for similar reasons.

But the paths then diverged.  After peaking in early 2010 at about 10% and then starting to come down, the unemployment rate in the Eurozone switched directions and started to rise again in mid-2011.  It reached 12.0% in early 2013 and has since come down slowly and only modestly to a still high 11.5% currently.  In the US, in contrast, the unemployment rate reached a peak of 10.0% in October 2009, and has since fallen more or less steadily (with bumps along the way) to the current 5.8% (as of October 2014).  It has been a slow recovery, but at least it has been a recovery.

This divergence began in 2010, as Europe shifted from its previous expansionary stance to austerity.  Influential Europeans, in particular German officials and Jean-Claude Trichet (then the head of the European Central Bank) argued that not only was austerity needed, but that austerity would be expansionary rather than contractionary.  We now see that that was certainly not the case:  GDP fell and unemployment rose.

The most clear mark of that shift in policy can be found in the actions of the European Central Bank.  ECB interest rates had been kept at a low 0.25% for its Deposit Facility rate (one of its main policy rates) for two years until April 2011.  The ECB then raised the rate to 0.50% on April 13, and to 0.75% on July 13, 2011.  But European growth was already faltering (for a variety of reasons), and it was soon recognized by most that the hike in ECB interest rates had been a major mistake.  Trichet left office at the end on his term on November 1, replaced by Mario Draghi.  On November 9 the ECB Board approved a reversal.  The Deposit Facility rate was cut to 0.50% that day, to 0.25% a month later on December 11, and to 0.00% on July 11, 2012.

Fiscal policy had also been modestly expansionary up to 2010, as monetary policy had been up to that point, but then went into reverse.  Unfortunately, and unlike the quick recognition that raising central bank interest rates had been a mistake, fiscal expenditures have continued to be cut since mid-2010.

Germany in particular called for cuts in fiscal spending for the members of the Eurozone, and forced through a significantly stricter set of rules for fiscal deficits and public debt to GDP ratios for Eurozone members.  Discussions began in 2010, amendments to the existing “Stability and Growth Pact” were approved on March 11, 2011, and a formal new treaty among Eurozone members was signed on March 2, 2012.  The new treaty (commonly referred to as the Fiscal Compact) mandated a balanced budget in structural terms (defined as not exceeding 0.5% of GDP when the economy was close to full employment, with a separate requirement of the deficit never exceeding 3% of GDP no matter how depressed the economy might be).  Financial penalties would be imposed on countries not meeting the requirements.

The result was cuts to fiscal expenditures:

Govt Expenditures, Real Terms - Eurozone and US, 2006Q1 to 2014 Q2 or Q3

Government fiscal expenditures in the Eurozone had been growing in real terms in line with real GDP up to 2008, at around 2 to 3% a year.  With the onset of the crisis, fiscal expenditures at first grew to counter the fall GDP.  But instead of then allowing fiscal expenditures to continue to grow even at historical rates, much less the higher rates that would have been warranted to offset the fall in private demand during the crisis, fiscal expenditures peaked in mid-2010 and were then cut back.  By 2014 they were on the order of 14 to 15% below where they would have been had they been allowed to keep to their historical path.  This has suppressed demand and therefore output.

The path of US real government expenditures is also shown on the graph.  Note that government expenditures here include all levels of government (federal, state, and local), and include all government expenditures including transfers (such as for Social Security).  Government expenditures for the Eurozone are defined similarly.  The US data comes from the BEA, while the Eurozone data comes from Eurostat.

Government expenditures in the US also peaked in 2010, as they had in the Eurozone, and then fell.  This has been discussed in previous posts on this blog.  But while US government expenditures fell after 2010, they had grown by relatively more in the period leading up to 2010 than they had in the Eurozone, and then fell by relatively less.  They have now in 2014 started to pick up, mostly as a consequence of the budget deal reached last year between Congress and President Obama.  State and local government expenditures, which had been severely cut back before, have also now stabilized and started to grow as tax revenues have begun to recover from the downturn.  And in part as a result, recent GDP growth in the US has been good, with real GDP growing by 4.6% in the second quarter of 2014 and by 3.9% in the third quarter.

The fiscal path followed in the US could have been better.  An earlier post on this blog calculated that GDP would have returned to its full employment level by 2013 if government spending had been allowed to grow merely at its historical rate.  And the US could have returned to full employment by late 2011 or early 2012 if government spending had been allowed to grow at the more rapid rate that it had under Reagan.

But with the fiscal cuts, unemployment has come down only slowly in the US.  The recovery has been the slowest of any in the US for at least 40 years, and fiscal drag by itself can account for it.  But at least unemployment has come down in the US, in contrast to the path seen in Europe.

An Update on the Impact of the Austerity Programs in Europe and a Higher Tax on Consumption in Japan: Still No Growth


GDP Growth in Eurozone, Japan, and US, 2008Q1 to 2014Q3

A.  Introduction

With the release last Friday by Eurostat of the initial GDP growth estimates for most of Europe for the third quarter of 2014, and the release on Monday of the initial estimate for Japan, it is a good time to provide an update on how successful austerity strategies have been.

B.  Europe

As was discussed in earlier posts in this blog on Europe (here and here), Europe moved from expansionary fiscal policies in its initial response to the 2008 downturn, to austerity programs with fiscal cutbacks starting in 2010/11.  The initial expansionary policies did succeed in stopping the sharp downturn in output that followed the financial collapse of 2008/2009.  European economies began to grow again in mid-2009, and by late 2010 had recovered approximately two-thirds of the output that had been lost in the downturn.

But then a number of European leaders, and in particular the leaders of Germany (Chancellor Angela Merkel and others) plus the then-leader of the European Central Bank (Jean-Claude Trichet), called for fiscal cuts.  They expressed alarm over the fiscal deficits that had developed in the downturn, and argued that financial instability would result if they were not quickly addressed.  And they asserted that austerity policies would not be contractionary under those circumstances but rather expansionary.  Trichet, for example, said in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy):

Trichet:  … As regards the economy, the idea that austerity measures could trigger stagnation is incorrect.

La Republicca:  Incorrect?

Trichet:  Yes. In fact, in these circumstances, everything that helps to increase the confidence of households, firms and investors in the sustainability of public finances is good for the consolidation of growth and job creation.  I firmly believe that in the current circumstances confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today.

So what has actually happened since the austerity programs were imposed in Europe?  The chart at the top of this post shows the path of real GDP for the larger Eurozone economies as well as for the Eurozone as a whole, plus Japan and the US for comparison.  The data for Europe (as well as the US) comes from Eurostat, with figures for 2014Q3 from the November 14 Eurostat press release, while the data for Japan came most conveniently from the OECD.  Real GDP is shown relative to where it was in the first quarter of 2008, which was the peak for most of Europe before the 2008/09 collapse.

In a word, the results in Europe have been terrible.  Real GDP in the Eurozone as a whole is basically the same as (in fact slightly less than) what it was in early 2011, three and a half years ago.  To be more precise, real GDP in the Eurozone fell by a bit more than 1% between early 2011 and early 2013, and since then rose by a bit over 1%, but it has basically been dead.  There has been no growth in the three and a half years since austerity programs took over.  And Eurozone output is still more than 2% below where it had been in early 2008, six and a half years ago.

Since early 2011, in contrast, the US economy grew by 8.6% in real terms.  Annualized, this comes to 2.4% a year.  While not great (fiscal drag has been a problem in the US as well), and not sufficient for a recovery from a downturn, the US result was at least far better than the zero growth in the Eurozone.

There was, not surprisingly, a good deal of variation across the European economies.  The chart shows the growth results for several of the larger economies in the Eurozone.  Germany has done best, but its growth flattened out as well since early 2011.  As was discussed in an earlier post, Germany (despite its rhetoric) in fact followed fairly expansionary fiscal policies in 2009, with further increases in 2010 and 2011 (when others, including the US, started to cut back).  And as the chart above shows, the recovery in Germany was fairly solid in 2009 and 2010, with this continuing into 2011.  But it then slowed.  Growth since early 2011 has averaged only 0.9% a year.

Other countries have done worse.  There has been very little growth in France since early 2011, and declines in the Netherlands, Spain, and Italy.  Spain was forced (as a condition of European aid) to implement a very tight austerity program following the collapse of its banking system in 2008/09 as a consequence of its own housing bubble, but has loosened this in the last year.  Only in France is real GDP higher now than where it was in early 2008, and only by 1.4% total over those six and a half years.  But France has also seen almost no growth (just 0.4% a year) since early 2011.

C.  Japan

The new figures for Japan were also bad, and many would say horrible.  After falling at a 7.3% annualized rate in the second quarter of this year, real GDP is estimated to have fallen by a further 1.6% rate in the third quarter.  The primary cause for these falls was the decision to go ahead with a planned increase in the consumption tax rate on April 1 (the start of the second quarter) from the previous 5% to a new 8% rate, an increase of 60%.

The Japanese consumption tax is often referred to in the US as a sales tax, but it is actually more like a value added tax (such as is common in Europe).  It is a tax on sales of goods and services to final consumers such as households, with offsets being provided for such taxes paid at earlier stages in production (which makes it more like a value-added tax).  As a tax on consumption, it is the worst possible tax Japan could have chosen to increase at this time, when the economy remains weak.  There is insufficient demand, and this is a straight tax on consumption demand.  It is also regressive, as poor and middle class households will pay a higher share of their incomes on such a tax, than will a richer household.  With its still weak economy, Japan should not now be increasing any such taxes, and increasing the tax on consumption is the worst one they could have chosen.

With recessions conventionally defined as declines in real GDP in two consecutive quarters, Japan is now suffering its fourth recessionary contraction (a “quadruple-dip” recession) since 2008.  This may be unprecedented.  Japan’s output is still a bit better, relative to early 2008, than it is for the Eurozone as a whole, but it has been much more volatile.

Prime Minister Shinzo Abe was elected in December 2012 and almost immediately announced a bold program to end deflation and get the economy growing again.  It was quickly dubbed “Abenomics”, and was built on three pillars (or “arrows” as Abe described it).  The first was a much more aggressive monetary policy by the Central Bank, with use of “quantitative easing” (such as the US had followed) where central bank funds are used to purchase long term bonds, and hence increase liquidity in the market.  The second arrow was further short-term fiscal stimulus.  And the third arrow was structural reforms.

In practice, however, the impacts have been mixed.  Expansionary monetary policy has been perhaps most seriously implemented, and it has succeeded in devaluing the exchange rate from what had been extremely appreciated levels.  This helped exporters, and the stock market also boomed for a period.  The Nikkei stock market average is now almost double where it was in early November 2012 (when it was already clear to most that Abe would win in a landslide, which he then did).  But the impact of such monetary policy on output can only be limited when interest rates are already close to zero, as they have been in Japan for some time.

The second “arrow” of fiscal stimulus centered on a package of measures announced and then approved by the Japanese Diet in January 2013.  But when looked at more closely, it was more limited than the headline figures suggest.  In gross terms, the headline expenditure figure amounted to a bit less than 2% of one year’s GDP, but the spending would be spread over more than one year.  It also included expenditures which were already planned.  It therefore needs to be looked at in the context of overall fiscal measures, including the then planned and ultimately implemented decision to raise the consumption tax rate on April 1, 2014.  The IMF, in its October 2013 World Economic Outlook, estimated that the net impact of all the fiscal measures (including not only the announced stimulus programs, but also the tax hike and all other fiscal measures) would be a neutral fiscal stance in 2013 (neither tightening nor loosening) and a tightening in the fiscal stance of 2.5% of GDP in 2014.  The fall in GDP this year should therefore not be a surprise.

Finally, very little has been done on Abe’s third “arrow” of structural reforms.

On balance, Abe’s program supported reasonably good growth of 2.4% for real GDP in 2013 (see the chart above).  There was then a spike up in the first quarter of 2014.  However, this was largely due to consumers pulling forward into the first quarter significant purchases (such as of cars) from the second quarter, due to the planned April 1 consumption tax hike.  Some fall in the second quarter was then not seen as a surprise, but the fall turned out to be a good deal sharper than anticipated.  And the further fall in the third quarter was a shock.

As a result of these developments, Abe has announced that he will dissolve the Diet, hold new elections in mid-December with the aim of renewing his mandate (he is expected to win easily, due to disorder in the opposition), and will postpone the planned next increase in the consumption tax (from its current 8% to a 10% rate) from the scheduled October 2015 date to April 2017.  Whether the economy will be strong enough to take this further increase in a tax on consumption by that date remains to be seen.  The government has no announced plans to reverse the increase of 5% to 8% last April.

Japan’s public debt is high, at 243% of GDP in gross terms as of the end of 2013.  Net debt is a good deal lower at 134% (debt figures from IMF WEO, October 2014), but still high.  The comparable net debt figure for the US was 80% at the end of 2013 (using the IMF definitions for comparability; note this covers all levels of government, not just federal).  Japan will eventually need to raise taxes.  But when it does, with an economy just then emerging from a recession due to inadequate demand, one should not raise a tax on consumption.  A hike in income tax rates, particularly on those of higher income, would be far less of a drag on the economy.

Already Low Public Investment Has Fallen Sharply Under Obama

Public Investment Share of GDP, 1952-2013


A.  Public Investment as a Share of GDP

Public investment has fallen sharply under Obama, from already low levels.  This may come as a surprise to many, given the repeated assertions of conservatives that government has grown radically during his presidential term.  Obama has indeed repeatedly called for the need to revive public investment, particularly at a time when unemployment has been high, and government borrowing rates have been essentially zero in real terms.  But Republican control in Congress has blocked this.

Net public investment after depreciation (and excluding public investment by the military) has as a result fallen in half during Obama’s tenure in office, from an already low 1.2% of GDP in 2009, to just 0.6% of GDP in 2013.  And contrary to a common belief, net public investment in 2009 was not exceptionally high.  To be precise, it came to 1.20% of GDP in 2009, and an almost identical 1.19% of GDP in 2007 and again in 2008.  The 2009 stimulus program, with its focus on tax cuts, did not really do that much for public investment.  It rose, but only by barely more than depreciation rose that year on old investments.

The fall since 2009 would have been even greater had one included investment by the military, which has also been scaled back.  But the focus in this post will be on investment in our economy.

The figures are shown in the chart above.  The data are calculated from the numbers in the National Income and Product Accounts (NIPA accounts, often also referred to as the GDP accounts) from the Bureau of Economic Analysis.  The public investment figures shown here cover all forms of public investment by government other than by the military, and at all levels (federal, state, and local).  Using figures for 2013, 60% of the gross public investment was for public infrastructure, 27% was for research and development (as well as investment in software), and 13% was for equipment (such as computers).

Many observers focus solely on the gross investment figures, as these can be most easily measured.  The GDP shares for gross public investment are shown as the green line in the chart above.   But what matters for economic growth is the net addition to productive capacity from this investment, after one subtracts depreciation.  Investments wear out over time.  The BEA NIPA accounts include estimates of what this depreciation will be (worked out at the detailed individual product levels), and those estimates are shown as the blue line in the chart.  The difference between gross investment and depreciation is net investment, shown in red on the chart.

The net investment of 0.6% of GDP in 2013 is the lowest level of net (non-military) public investment as a share of GDP in 66 years, or two-thirds of a century.  In data going back to 1929 (the earliest year with official GDP estimates), it was only lower during World War II and the immediate post-war years (1942 to 1947), when non-military spending of all kinds was drastically scaled back.

Net public investment rose sharply as a share of GDP in the 1950s and up to the mid-1960s.  Its share of GDP doubled, from 1.5% in 1952 and again in 1953, to 3.0% at its peak in 1966.  This was the period when we invested in the then new Interstate Highway system, in new and expanded water and sewerage systems, and in government research and development (such as the Apollo moon mission).  The economy then grew strongly, with supportive infrastructure.  But public investment then started to be cut back sharply, reaching a trough in 1983 of just 0.9% of GDP, after which it fluctuated around a low level of generally 1.1 to 1.4% of GDP.  It then was cut back sharply again, by half, during the period Obama has been president.  Aside from 1942 to 1947, it is now at a historic low.

B.  Public Investment in Real Per Capita Dollar Terms

Another way to look at such figures is in real per capita terms.  Using prices of 2013, net non-defense public investment came to $291 per person in 1952.  It was only slightly more, at $313 per person, in 2013, an increase of just 8% in 61 years:

Real per Capita Dollar Terms Change Change
     2013 prices 1952 1968 2013 1952-2013 1968-2013
Non-Defense Net Public Investment $291 $783 $313 8% -60%
Per Capita Real GDP $16,675 $24,240 $52,985 218% 119%

Over this same period, real per capita GDP more than tripled, from $16,675 in 1952 to $52,985 in 2013.  It is ridiculous to say the US cannot now afford to invest more in infrastructure and other public assets.  We could afford to invest a similar amount to what we are investing now, when incomes were only one-third as high as now.

Per capita net pubic investment reached a peak in dollar terms in 1968, at $783 (in terms of 2013 prices).  (The peak as a share of GDP was in 1966, but GDP was growing strongly in those years, so the peak in dollar terms could come two years later.)  From that peak, per capita net public investment fell to the $313 of 2013, a fall of 60%.  But over that same period, real per capita GDP more than doubled.  We could certainly have afforded to have kept up, and indeed expanded, our investment in public infrastructure.  But the political choice was made not to.  The result has been our deteriorating public assets.

C.  Conclusion

The poor and inadequate condition of American infrastructure and other public assets should not be a surprise when one looks at how little we spend on such capital.  Net spending of just $313 per person in 2013 is tiny.  Doubling or tripling this would not be a big burden.

One can live on old capital, such as the roads and bridges we built in the 1950s and 60s, for a period of time, but eventually they do wear out.  Net public investment of just 0.6% of GDP will not suffice to support an economy that should be growing at 3 to 4% a year.  But what we have instead is an embarrassment at best (as anyone who has traveled abroad to Europe or East Asia knows), and one which will increasingly act as a drag on the economy.

Some Thoughts on the Midterm Elections in the US

The Democrats clearly did terribly in the midterm elections on November 4.  Here are some thoughts on some (not all) of the factors behind this:

1)  Turnout is the “name of the game” in US elections, and the Democrats did badly at getting their normal supporters to go to the polls and vote.  Only an estimated 36% of those eligible to vote in the US actually voted this time, 11% below the 41% rate estimated for the 2010 midterms.  One traditionally thinks of elections as if voters go to the polls regardless, with the issue then being whether their choice will be candidate A or candidate B.  Under such circumstances, a successful campaign strategy is to focus on how best to convince those voters to vote for you rather than your opponent.  An appeal to the voters who are politically in the middle would then be, under such conditions, a good strategy.

But most Americans do not vote.  The winner is then the candidate most successful at convincing those who would vote for him or her, to actually take the trouble to vote.  The need is to get those who would vote for you to overcome the hurdles they must go through to cast their ballot.  They are more likely do this the more committed they are to the candidate and what he or she represents.

2)  Obama, and Democrats generally, did a poor job at making such an appeal.  Possibly the clearest example of this was Obama’s decision (under pressure from several Democratic candidates for the Senate, most of whom then lost) to postpone any announcement of executive actions he would take on immigration reform – actions which would not require new legislation.  Obama publicly promised to make such an announcement this past summer, but then decided to postpone any such announcement until after the election.  This then led to strong criticism by many Hispanics, including heckling at some of his speeches, and a reduction in support from Hispanics.  This was manifested in part by a reduced share of the Hispanic vote going to Democrats, but even more in a reduction in Hispanics going to the polls at all.  The result will now be a Senate more averse to immigration reform than before.  But the reaction by Hispanics is understandable.

The strategy did not pick up many, if any, moderate votes.  But it did lead to a key constituency to be less interested in overcoming the hurdles that exist in the US (and increasingly exist:  see below) to go out and vote.

One can point to issues that have disappointed other key constituencies as well. Significant groups of Obama supporters were disappointed by his (so far) non-decision on the Keystone pipeline (he has not approved it, but nor has he decided against it); his extension of the Bush tax cuts for all but the extremely rich (which has weakened the fiscal accounts, with this then strengthening those opposed to the government spending that would have accelerated the recovery and reduced unemployment); his failure to prosecute aggressively those on Wall Street who through fraud sold mortgage-backed securities that misrepresented the financial capacity of many of those receiving such mortgages, which led directly to the 2008 financial crisis; the support provided to those Wall Street banks and other financial institutions then to rescue them from this crisis, while home-owners who were sold such mortgages received only limited, and in the end ineffectual, help; and more.

I would not argue that these positions did not reflect Obama’s genuine beliefs.  While conservative pundits have labeled him a far-left socialist, or worse, Obama has in fact governed from the middle.  But such positions then had the effect of leading many with more liberal views not to see a reason to go to the polls.

Obamacare provides a further example.  It has successfully reduced the number of uninsured in America by over ten million so far, and has been the most important health care reform in the US since Medicare was passed in 1965.  But it has been criticized by those on the left as an overly complex program.  As they note, it was a plan first conceived by the conservative Heritage Foundation in 1989.  Republicans in Congress in 1993 then championed this plan, with its individual mandate, as their counter-proposal to the health reform plan of the White House task force led by Hillary Clinton.  Many Obama supporters would have preferred the simpler approach of a health care plan built on extending Medicare to the full population (a single-payer system).  The problems with the launch of the Obamacare exchanges in October 2013 affirmed for many that such a simpler plan would have been better.

The Obamacare system that works through private insurance companies may have been necessary politically, to get any health care reform passed through congress.  It was politically in the middle, derived from a plan first pushed by Republicans.  But it disappointed many liberals as overly complex and more costly than an extension of Medicare to all would have been, while picking up few votes from voters in the middle.

3)  Voter suppression works, and can be decisive in close elections.  A wave of more restrictive voting measures were enacted following the 2010 elections, in those states where Republicans took (or kept) control of both the governorship and both houses of their legislatures.  Courts have ruled against some of the new voting restrictions, while others were merely postponed.  Such new measures, which vary by state, were in place in 21 states for the first time in a midterm election in 2014.

The measures all act to increase the hurdles to voting.  They can have a particularly discriminatory impact on the poor and many minorities.  Voter ID requirements may not matter much to someone with a car and driver’s license, but if you are poor and do not own a car, and hence have had no need for a driver’s license, the burden can be significant.  And the intent of such laws was made especially clear in Texas, where a license to carry a handgun is counted as a valid ID for voting, while a state-issued photo ID at the University of Texas for an in-state student is not.

It is difficult to impossible to estimate the impact that raising the hurdles to voting has had on voter participation.  A recent study by the GAO estimated that in two states examined (Kansas and Tennessee), the result may have been a reduction in voter participation of about 2 to 3%.  If all this impact is focussed on one side of potential voters (e.g. poor who would vote for Democrats) in an otherwise evenly divided state, the impact would be to reduce the votes on one side by 4 to 6%.  This is huge, and could be decisive in many contests.

Two prominent states that introduced significant new voting hurdles since 2010 were North Carolina and Florida.  Republican Thom Tillis, who as speaker of the state House of Representatives pushed through the new voting measures, beat Senate incumbent Kay Hagan by a narrow 49.0% to 47.3%.  He may well owe his win to the new hurdles.  And Republican Governor Rick Scott of Florida signed into law new voting restrictions as well as implemented executive actions that made voting more difficult.  He won over his challenger (former governor Charlie Crist) by a margin of just 48.2% to 47.1%.

While it is impossible to say with certainty that the new hurdles were the deciding factors in these races, they figures are so close that they very well could have been.

4)  Obamacare has succeeded in its primary objective of making it possible for more Americans to obtain health insurance.   But the politics of whether such progress will translate into net votes in favor of politicians who supported it are not straightforward.

In the US, before Obamacare, roughly 85% of the population (using round numbers, but sufficient for the illustrative purposes here) had health insurance, whether through government programs such as Medicare and Medicaid, or through private insurance normally obtained via your employer.  About 15% of the population had no such health insurance cover, and the primary aim of Obamacare was to make it possible for this 15% to obtain health insurance coverage.

While making it possible for this 15% to obtain health insurance is an indisputable gain to the 15%, they of course only make up 15% of the total.  The other 85% already have health insurance, and health insurance coverage is of course important to all of us.  But with the complexities of the Obamacare reforms, the 85% who already with health insurance cover can understandably be worried whether Obamacare might have an adverse impact on them.  It won’t, and there will indeed be gains for most of them (health insurance policies must now meet certain minimum standards, including the provision of coverage for routine annual check-ups without a deductible, coverage for adult children up to the age of 26, an end to denial of coverage for pre-existing conditions, and other measures).  Only a relative few of the very rich will now pay more in taxes to cover in part the cost of subsidies that will make it possible for those of lower income to afford coverage.

But with the complexities of the Obamacare reforms, plus the anti-Obamacare campaigns by certain political groups (such as a number supported by the Koch brothers), as well as by Fox television and a number of radio talk programs (such as Rush Limbaugh), it is not surprising that people within the 85% may worry.  Access to health care is important to all of us, and if Obamacare would, in some unclear fashion but based on what critics are asserting, lead to loss of coverage within the 85%, one can understand the concerns.  And with the 85% far outnumbering the 15%, it would not take a very high share of the 85% to oppose Obamacare, under the mistaken belief they will be harmed in some unknown way, to offset the positive reactions among the 15% now able to obtain affordable health care.

There can be a similar political arithmetic in other areas as well.  Falling unemployment will matter a good deal to those now able to get jobs, but they constitute a relatively small share of the labor force.  After all, an unemployment rate below 6% (as it is now) means that more than 94% have jobs.  And if those with jobs are told that the measures being taken to spur growth will have an adverse effect on them (such as the assertions, completed unsupported by any facts on what has happened to inflation thus far, that the Fed’s monetary policy will lead to hyperinflation), the political gains from bringing down the unemployment rate may be more than offset by the worries of the 94%.


There were many reasons for the poor showing of the Democrats in the November 4 midterms.  The factors discussed above are only a few, and perhaps not even the most important ones.  But they did contribute.