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Friday, July 20, 2012

Two Economic Papers Really Worth Reading

These have a common theme regarding structural economic limits for western societies.

The first is an ECB working paper by Baum, Westphal and Rother. There is some discussion of it in this Bloomberg article

The abstract:
Against the background of the euro area sovereign debt crisis, our paper investigates the relationship between public debt and economic growth and adds to the existing literature in the following ways. First, we extend the threshold panel methodology by Hansen (1999) to a dynamic setting in order to analyse the nonlinear impact of public debt on GDP growth. Second, we focus on 12 euro area countries for the period 1990-2010, therefore adding to the current discussion on debt sustainability in the euro area. Our empirical results suggest that the shortrun impact of debt on GDP growth is positive and highly statistically signi cant, but decreases to around zero and loses signi cance beyond public debt-to-GDP ratios of around 67%. This result is robust throughout most of our speci cations, in the dynamic and non-dynamic threshold models alike. For high debt-to-GDP ratios (above 95%), additional debt has a negative impact on economic activity. Furthermore, we can show that the long-term interest rate is subject to increased pressure when the public debt-to-GDP ratio is above 70%, broadly supporting the above findings.
 The distortions of infinite-Keynesianists have somewhat polluted the culture.  Even to call their claims Keynesian is a slander of Keynes, because he never envisioned an infinite accumulation of debt. Keynes thought that the government should deliberately establish a counter-cycle to the business cycle, i.e., that the government should withdraw money from the economy when the economy was running hot, and insert money into the economy when the business cycle shifted into recession. 

The deficit of the above paper is that is doesn't address the problem of credit bubbles. Both Ireland and Spain had massive credit bubbles centered on real estate, and so if you had looked at their economies at the beginning of 2008, you would have seen very low levels of public debt in relation to GDP. However that GDP wasn't real, so the debt-to-GDP ratio analysis can be misleading.

The second paper is Trabandt and Uhlig's FRB paper International Finance Discussion No. 1048.
We seek to understand how La ffer curves diff er across countries in the US and the EU-14, thereby providing insights into fi scal limits for government spending and the service of sovereign debt. As an application, we analyze the consequences for the permanent sustainability of current debt levels, when interest rates are permanently increased e.g. due to default fears. We build on the analysis in Trabandt and Uhlig (2011) and extend it in several ways. To obtain a better fi t to the data, we allow for monopolistic competition as well as partial taxation of pure pro fit income. We update the sample to 2010, thereby including recent increases in government spending and their scal consequences. We provide new tax rate data. We conduct an analysis for the pessimistic case that the recent fi scal shifts are permanent. We include a cross-country analysis on consumption taxes as well as a more detailed investigation of the inclusion of human capital considerations for labor taxation. 
Because any realistic policy options for the US and many other western countries include a combination of tax increases and spending cuts, the issues addressed here are fundamental.  The analysis in this paper is done on a household basis model and corporate/associate basis model.

What is somewhat novel and important in this paper is their treatment of labor taxes:
Intuitively, higher labor taxes lead to a faster reduction of the labor tax base since households work less and aquire less human capital which in turn leads to lower labor income. We recalculate the implied maximum interest rates on government debt in 2010 when human capital accumulation is allowed for in the model. Table 9 contains the results: the US may only a fford a real interest rate between 5.8% to 6.6% in this case. Most of the European countries cluster between 4% and 4.9% except for Denmark, Finland and Ireland who can aff ord real interest rates between 5.9% and 9.5%. 
This is good because it addresses the stagnation effect generated by social benefits combined with high taxation of income. The analysis also addresses the tendency of higher consumption taxes to reduce labor income. 

All the meat and potatoes are in the appendices.

Comments:
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