Sunday, July 31, 2011

How Smart Fiscal Rules Keep Sweden's Budget in Balance

Almost three decades ago, Herbert Stein, the former Chairman of Nixon's Council of Economic Advisors, lamented that the United States had no long-run budget policy—no policy for the size of deficits and for the rate of growth of the public debt over a period of years. He pointed out that Congress makes annual budget decisions that are wholly inconsistent with professed long-term goals, hoping that something will happen before a point of crisis is reached. He might have added that when the crisis does arrive, it is resolved by a combination of hasty, one-off measures; the making of promises that are rarely kept; and the appointment of special commissions whose advice is rarely heeded.

What Stein said then remains true today. The rational way out of this destructive cycle of irresponsibility and crisis is to establish long-term fiscal policy rules and stick to them. There is at least a vague recognition among some members of Congress of the need to do so. The problem is that the rules they actually propose are primitive and counterproductive. The debt ceiling itself, which Congress routinely sets at levels that are inconsistent with its own spending and taxing decisions, is one such rule. The balanced budget amendment championed by many fiscal conservatives is also deeply flawed, for reasons detailed in this earlier post.

Instead of these "dumb" fiscal policy rules, we need to be looking at what can be learned from countries that have faced the same problems and introduced smarter rules to overcome them. Last week's post examined how intelligent budget rules have helped Chile prosper Today we look at the smart fiscal rules that have put Sweden's budget on a sustainable path and made that country's economy one of the strongest in Europe.

Monday, July 25, 2011

How Intelligent Budget Rules Help Chile Prosper: Lessons for the US

Flag of Chile.svg

As everyone knows who has followed the current budget debate, U.S. fiscal policy needs more than a quick fix. It needs budget rules to put the debt and deficit on trajectories that are sustainable in the long run. Where better to look for workable rules than to countries that have done things right? Chile, which has managed to prosper under an intelligent set of budget rules, is a good place to start.

Chile's economic indicators are not the very best in each category, but they score near the top in so many that it is arguably the strongest economy in its region. In 2011 Chile is expecting 6.6 percent real GDP growth. Inflation and unemployment are both moderate, at 4.0 percent and 7.2 percent, respectively. The government's budget is expected to end the year in surplus by 1.3 percent of GDP. Gross government debt is 8.8 percent of GDP, which is less than the government's holdings of financial assets, meaning that net debt is negative. On top of all that, it has a current account surplus approaching 2 percent of GDP.

The centerpiece of Chilean fiscal policy is a balanced budget rule of a much more sophisticated variety than the one endorsed last week by the U.S. House of Representatives. The House bill calls for strict year-to-year balance of total receipts and outlays, whereas Chile's rule requires annual balance of the structural budget. The two are not at all the same.

The difference between an annually balanced budget and a structurally balanced budget lies in the operation of an economy's automatic stabilizers. Automatic stabilizers are elements of the budget that tend to increase revenues during an expansion (such as taxes on incomes and profits) and increase expenditures during a recession (such as spending for unemployment compensation and antipoverty programs). When automatic stabilizers are allowed to operate, the budget automatically swings toward surplus during an expansion and toward deficit during a recession. The automatic move toward surplus helps prevent overheating when the business cycle approaches its peak. At the other end of the business cycle, the automatic stabilizers move toward deficit and help to moderate the depth of the downturn.

Friday, July 15, 2011

Is a 56.2 MPG Fuel Economy Standard Really a Good Idea?

 According to news reports, the Obama administration is talking to automakers about raising the Corporate Average Fuel Economy standard for passenger cars to 56.2 miles per gallon by 2025, more than double the  27.5 MPG in force for the 20 years up to 2010. Economists, even those like myself who favor policies to reduce fuel use, have argued that CAFE standards are a bad idea. Has anything changed to make stricter fuel economy standards look better now than in the past?

The fundamental problem with CAFE standards is that they attack the negative externalities of motor fuel use (pollution, national security concerns, highway congestion, accidents) only partially and indirectly. As a result, the cost of achieving a given reduction in fuel use via CAFE standards is higher than it would be if the same result were achieved more directly through an increase in the federal gasoline tax.

To understand why, we need to consider the various ways consumers can cut back on fuel use. In the short run, they they can buy an efficient hybrid instead of a gas-guzzling SUV, they can reduce discretionary driving, or they can shift some trips from their Ford F-250 to their Honda, if they happen to have one of each in the driveway. Given more time to adjust, they can make work and lifestyle changes like moving closer to public transportation, work and shopping, changing jobs, or working at home.

Higher fuel prices directly affect all of these choices. They encourage people to make whatever marginal adjustments best suit their circumstances. A recent New York Times article gave these examples of how people were reacting as gasoline approached $4 per gallon in May, 2011:
  • An upstate New York customer relations manager moved to a new apartment that cut her daily commute from 50 miles to 8 miles. She preferred that to trading her beloved truck for a low-mileage vehicle.
  • Traffic on San Francisco's bridges fell while ridership on buses and ferries rose.
  • New York-based Topical BioMedics switched to cloud computing to make it more convenient for employees to work from home.
  • A Los Angeles hair products business found more workers taking advantage of a long-standing offer of a 20-cent per mile bonus for car pooling.

The problem with higher CAFE standards is that they encourage fuel saving only with regard to the choice of what car to buy. Once a consumer buys a low-mileage vehicle, the cost of driving and extra mile goes down, thereby reducing the incentive for fuel-saving measures like moving closer to work, working at home, riding the bus to work, or consolidating errands.

The tendency of more fuel-efficient vehicles to induce additional driving is known as the "rebound effect." For example, suppose that the elasticity of demand for driving with respect to fuel-cost per mile is -0.3. That means a 10% increase in fuel efficiency would cause a 3 percent increase in driving. The increased miles driven would partly offset the increase in miles per gallon, so that total fuel consumption would decrease by only about 7%.

Even taking the rebound effect into account, higher CAFE standards are still somewhat helpful in reducing those externalities that are proportional to the quantities of fuel consumed, including externalities of pollution and national security. However, the rebound effect causes an absolute increase in those externalities that are proportional to miles driven, including road congestion and traffic accidents. It also increases the cost of road maintenance, because the wear and tear from more miles driven is only partly offset by the lower average weight of high-mileage vehicles.

The very fuel-saving strategies that CAFE standards discourage, like moving closer to work or consolidating errands, are often the ones that have the lowest costs. That is why the total cost of reaching a given national fuel-saving target will be greater when achieved through CAFE standards than when induced by an increase in fuel taxes. A 2004 study from the Congressional Budget Office concluded that an increase in the federal gasoline tax would achieve a given reduction in fuel economy at a cost 27 percent less than that of an equivalent tightening of CAFE standards. Furthermore, its effects would be felt more quickly, because they would not have to wait for the gradual turnover of the national motor vehicle fleet. Over the 14-year time horizon of the CBO study, the gas tax increase would save 42 percent more total fuel.

The variable most critical to the size of the rebound effect, and therefore to the relative merits of CAFE standards vs. fuel taxes, is the price-elasticity of demand for fuel. The less elastic is demand, the stronger is the case for CAFE standards; the more elastic, the larger the rebound effect and the stronger the case for raising fuel taxes. So what do we know about price elasticity?

Of all the many elasticity studies, the most widely cited is a 1996 meta-analysis by Molly Espey. She concluded that the best estimate for the price elasticity of gasoline demand was -0.26 in the short run and -0.58 in the long run. Those estimates strongly undermine the case for CAFE standards. However, Espey's results, which are based on data from 1936 through 1986, have been challenged by more recent estimates that show a decrease in elasticity in the early years of the 21st century.

In particular, a 2006 NBER working paper by Jonathan E. Hughes, Christopher R. Knittel, and Daniel Sperling found evidence that the short-run price elasticity of gasoline for the period 2001-2006 had fallen to a range of -0.034 to -0.077. That finding would seem to strengthen the case for higher CAFE standards.
The authors of the NBER study suggest several reasons that the elasticity of demand for fuel may have fallen during the period studied. One is that the real price of gasoline and its share in household budgets was below its historical average in those years. A second possible reason is that suburban sprawl and longer commuting distances meant that a lower proportion of all driving was discretionary. A third explanation was that after more than a decade in which CAFE standards had remained unchanged at 27.5 MPG, there were fewer opportunities for saving fuel by trading in an older car for a new one or shifting driving from one car to another within the family fleet.

But not so fast. Still more recent studies seem to show that the factors at work in 2001-2006 were temporary, and that after hitting a low, elasticity is on the rise again. A study by Todd Litman of the Victoria Transport Policy Institute, released just last month, provides a comprehensive review of the literature. His conclusion is that long-run fuel price elasticities have returned to a range of -0.4 to -0.8. In Litman's view, the rebound of the rebound effect (as he puts it) has occurred in part because rising fuel prices and stagnating incomes have once more increased the share of fuel costs in consumer budgets. Also, as a larger share of the population reaches retirement, a higher percentage of driving becomes discretionary, and therefore more sensitive to fuel prices.

It is worth noting that much of the observed variation in fuel prices on which the elasticity studies draw are market-driven, and therefore expected by consumers to be transitory. Elasticity is not only likely to be higher in the long run than in the short run, but also higher in response to changes in fuel prices that are expected to be permanent, such as those that would result from tax increases. The expectation effect would be even greater under a variable, price-smoothing oil tax of the type discussed in this earlier post. Such a tax would put a permanent floor under retail gasoline prices, providing maximum incentive to make the behavioral changes needed for long-run fuel economy. The effectiveness of higher fuel prices in mitigating externalities of automobile use would greater still if they were backed up by modern, time-of-day pricing policies for road use and parking, as well.

To be sure, not everyone will be convinced by elasticity studies. They are just numbers. Some people will continue to believe that prices have no effect on driving behavior, that people will just drive whatever and wherever they want regardless. Here is a picture, then, that is worth a thousand meta-analyses. Taken from the Litman study cited above, it shows a convincingly tight relationship between fuel prices and fuel use across OECD countries. Can it really be just coincidence that the United States, with the lowest fuel prices, also has the highest fuel consumption?

All this leaves one last question. If CAFE standards are such a bad idea, why do they remain so popular? If you are an economist, choosing higher fuel taxes over CAFE standards looks like a no-brainer, but if you are a politician, fuel taxes have an obvious drawback. Fuel taxes make the cost of reducing consumption highly visible. You see the big dollars-per-gallon number right there in front of you every time you drive up to the pump. CAFE standards, in contrast, hide the cost. You pay the price of a higher-mileage car only when you buy a new one, and even then, the part of the price attributable to the mileage-enhancing features is not broken out as a separate item on the sticker. You may notice that your new car costs more than your old one did, but there are lots of other reasons for that besides fuel economy.

It is a classic case of the TANSTAAFL principle—There Ain't No Such Thing As A Free Lunch. If you try to make something look like it’s free, it only ends up costing more in the long run. If you are a politician, you may well prefer a big hidden cost to a small visible cost. If you're a friend of the environment, you should know better.

Originally posted at

Sunday, July 10, 2011

Yes, the US Needs Budget Rules, but Not Hatch-Lee

Sometimes the United States is slow to join a global trend. Fiscal policy rules are a case in point. Economists love the idea of rules that decouple tax and spending policies from short-term politics and focus instead on long-term growth and sustainability. Such rules used to be rare; as recently as 1990, they were in effect in only 7 countries, according to an IMF survey. By 2009, the number had grown to 90. Aside from failed attempts like the Gramm-Rudman-Hollings Act of 1985, the United States has been missing from the list.

It won't be missing for long if Utah Senators Orin Hatch and Mike Lee have their way. They are pushing a set of budget rules in their Hatch-Lee Balanced Budget Amendment, which was introduced on March 31 with the backing of the entire Senate Republican delegation. Just this week, Senator Lee gave it added momentum by including it in his Cap, Cut and Balance Act. That new proposal would require the Hatch-Lee amendment to be passed, along with a set of short-term cuts and caps, before the debt ceiling could be raised.

Linking long-term rules to a short-term increase in the budget ceiling is an excellent idea. The IMF cites several examples, from Sweden to Bulgaria to New Zealand, where a fiscal crisis provided the impetus for the adoption of successful budget rules. But is Hatch-Lee the right kind of rule? Unfortunately it is not.

Follow this link to read the full post on Ed Dolan's Econ Blog at

Data for the Classroom: US Unemployment Rises in June

 U.S. job growth slowed again in June. Although total payroll jobs increased for the ninth straight month, the Bureau of Labor Statistics reported a disappointing total increase of just 18,000. At the same time, the May figure was revised down from 54,000 new jobs to just 25,000. An increase of 57,000 private nonfarm jobs was offset by a loss of 39,000 government jobs. Jobs decreased at all levels of government, federal, state and local.