America's Real "Entitlement" Problem

Is health care, not social security

The Social Security and Medicare Trustees have released their 2007 annual report. As the summary makes clear, the more serious long-term financial problems are in medicare (officially known as "Hospital Insurance (HI)" and "Supplementary Medical Insurance (SMI)"), not social security.

The annual cost of Social Security benefits represented 4.2 percent of Gross Domestic Product (GDP) in 2006, is projected to increase to 6.2 percent of GDP in 2030, and then rise slowly to 6.3 percent of GDP in 2081...

Medicare's financial difficulties come sooner-and are much more severe-than those confronting Social Security. While both programs face demographic challenges, the impact is greater for Medicare because health care costs increase at older ages. Moreover, underlying health care costs per enrollee are projected to rise faster than the wages per worker on which payroll taxes and Social Security benefits are based. As a result, while Medicare's annual costs were 3.1 percent of GDP in 2006... are projected to surpass Social Security expenditures in 2028 and exceed 11 percent of GDP in 2081...Part B of the Supplementary Medical Insurance (SMI) Trust Fund, which pays doctors' bills and other outpatient expenses, and Part D, which pays for access to prescription drug coverage, are both projected to remain adequately financed into the indefinite future because current law automatically provides financing each year to meet next year's expected costs. However, expected steep cost increases will result in rapidly growing general revenue financing needs-projected to rise from 1.3 percent of GDP in 2006 to 4.7 percent in 2081-as well as substantial increases over time in beneficiary premium charges.

There's a nice assesment at Kash Mansouri's Street Light Blog.

So if we really want to deal with the future cost of entitlement programs, we need to take a hard look at our health care system. Perhaps a comparative perspective might help. As the World Baseball Classic reminded us, sometimes other countries get things right, and we might actually be able to learn from them. Or at least that's the message of this fascinating article, "The Health of Nations" by Ezra Klein in The American Prospect on the health care systems of Canada, France, England, Germany and the US Veterans Administration.

More Supply Side

The discussion provoked by Bruce Bartlett's opinion column on "Supply Side Economics" (see earlier post) has continued at Economists View. James Galbraith, who was on the Democratic staff of the Joint Economic Committee of Congress defends the "vulgar Keynesians":

Reaganomics was aimed at enriching the rich and destroying the economic life of working Americans and the poor. And this is no joke: it did exactly that. Recession, unemployment, the wanton and irreversible destruction of major industries and the fiscal base of the cities, the destruction of unions: all that happened. The cost of curing inflation in 1981-82 was enormous, far higher than the airy comments made above concede. We crude Keynesians believed then, and I believe now, that the steps taken were brutal and unnecessary, and that with hard policy work the problem could have been managed in ways that were far less costly, but that were rejected on ideological rather than economic grounds.

Paul Krugman, who was on the staff of the Council of Economic Advisors (yes, Paul Krugman was part of the Reagan Administration!) argues that "Keynesian" views are mis-characterized:

The key thing is that good Keynesianism, as embodied even in undergrad textbooks of the time, was *perfectly OK*: Dornbusch and Fischer, 1978 edition, offered a description of what disinflation would look like that matches the experience of the 80s reasonably well, and the textbook does not seem all that dated even now. The idea that we needed a new doctrine to get our heads straight is just all wrong.

Here's Brad de Long's take.
Separately, Greg Mankiw criticizes the Congressional Budget Office's finding that the effect of tax cuts is small.

Frank on Supply Side

Bob Frank's column in todays NY Times, "In the Real-World of Work and Wages, Trickle-Down Theories Don't Hold Up," presents some evidence against 'supply-side' tax policies ("trickle down economics" being a more derisive term for the same idea):

Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

The surface plausibility of trickle-down theory owes much to the fact that it appears to follow from the time-honored belief that people respond to incentives. Because higher taxes on top earners reduce the reward for effort, it seems reasonable that they would induce people to work less, as trickle-down theorists claim. As every economics textbook makes clear, however, a decline in after-tax wages also exerts a second, opposing effect. By making people feel poorer, it provides them with an incentive to recoup their income loss by working harder than before. Economic theory says nothing about which of these offsetting effects may dominate.

If economic theory is unkind to trickle-down proponents, the lessons of experience are downright brutal. If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.

On his blog, Greg Mankiw says "Frank Needs To Read More Widely" and presents some counter-evidence. Both agree, however, that it basically comes down to the relative strength of the income and substitution effects.

Economics Graduate School

I've created an unofficial guide for folks considering graduate school in economics.

Trade Creation vs. Trade Diversion

In the NY Times, Daniel Altman looks at some economic concerns raised by the new US - South Korea free trade agreement.
The economic issue: are these bilateral trade agreements (i.e. deals between just two countries) trade creating or trade diverting? If the reduction of barriers with South Korea leads us to import a good from them, rather than from a third country which is actually the low-cost producer (but doesn't have a trade deal with us), economic efficiency is actually decreased.
The political economy issue: does the increasing focus on bilateral and regional agreements reduce the effort devoted to the big multilateral deals like the Doha round of the GATT/WTO negotiations?

UPDATE: This issue is the subject of discussion in the FT's "Economists Forum," which has a panel of economists discussing Martin Wolf's columns (the column itself is subscription-only, but the discussion is free).

"Supply Side" and the Evolution (and Abuse) of Economic Ideas

Though one must be wary of any claim that there is "a new consensus among economists on how to look at the national economy," (former Reagan and Bush official) Bruce Bartlett's op-ed in today's New York Times, "How Supply Side Economics Trickled Down" raises a number of interesting issues.
The basic idea of "supply side" economics is that, by altering incentives to work and save, changes in marginal tax rates will change the quantity of labor and capital supplied in the economy. This is in contrast to the traditional "Keynesian" focus on the effects on aggregate demand. Bartlett argues that supply side "has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy." He continues:

But today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue. Last year, President Bush said, “You cut taxes and the tax revenues increase.” Senator John McCain told National Review magazine last month that “tax cuts, starting with Kennedy, as we all know, increase revenues.” Last week, Steve Forbes endorsed Rudolph Giuliani for the White House, saying, “He’s seen the results of supply-side economics firsthand — higher revenues from lower taxes.”

This is a simplification of what supply-side economics was all about, and it threatens to undermine the enormous gains that have been made in economic theory and policy over the last 30 years. Perhaps the best way of preventing that from happening is to kill the phrase “supply-side economics” and give it a decent burial.

Mark Thoma has an extensive response, framed in terms of the contemporary academic debate between Real Business Cycle (RBC) models vs. New Keynesian models. RBC models are the modern incarnation of classical economics, and rely on the optimal response of utility maximising consumers and profit maximizing firms to productivity shocks - shifts of the production function - to generate economic fluctuations. Everything is driven by supply, and aggregate demand is irrelevant. In New Keynesian models, as in old Keynesian models, aggregate demand matters, though for different reasons. The New Keynesians use microeconomic frictions like menu costs and coordination failure to generate an upward sloping aggregate supply curve. Thoma writes:

Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. As we learned in the 1970s, demand side tools are not very effective instruments for offsetting supply-side shocks - trying to use demand side policy to offset supply shocks helped to generate the stagflation we saw at the time. We've learned since then, but practically we are still somewhat powerless to offset supply side shocks in the short-run - all we can do is manage demand to match changes in supply. That is, if a hurricane wipes out supply, we can use policy to reduce demand to match, but we can't do much to increase supply back to its initial level in the short-run.

Thoma picks up many of the important points that Bartlett seems to miss, but as Bartlett points out in his response to Thoma, RBC and New Keynesian models were developed in the 1980's, while the original debate over "supply side" started in the 197o's.
If there is any kind of "consensus" - or at least a "synthesis" - it is methodological. The work of Robert Lucas, among others, has convinced academic economists to build their macroeconomic models with more careful microeconomic foundations. Both the RBC and New Keynesian schools take utility maximization and expectations seriously.
On the specific issue of "supply side" tax cuts, if you are taking utility maximizing behavior seriously, then the effect of marginal tax rates on incentives should matter - in theory. Whether it does in practice is an empirical question that is difficult to resolve. For example, consider a cut in the marginal tax rate on labor income: whether this increases or decreases labor supply would depend on whether the income effect, which would cause people to work less (if leisure is a normal good, as your income rises you want more of it) is outweighed by the substitution effect (the opportunity cost of leisure increases). The supply-siders think the substitution effect is extremely strong. Perhaps if we follow Bartlett's wish and ditch the term "supply side" we should replace it with "substitution effect economics."
Incidentally, one of Reagan's supply side revolutionaries, David Stockman is back in the news.

Opening Day Economics

On the op-ed page of the NY Times, baseball economist JC Bradbury explains "What Really Ruined Baseball." Not steroids, but expansion. According to Bradbury, hallowed records have been falling because the increase in the number of teams has diluted the talent pool. He writes:

Today, the variance in quality of major league pitchers, based on E.R.A., is at an all-time high. By letting in the riffraff for baseball’s elite to exploit, expansion increased the likelihood of great achievements. Without even bringing steroids into the discussion, it is no surprise that some already fine hitters performed even better after the early 1990s.

Economists Against Free Trade!

Some heresy on trade from Harvard's Dani Rodrik, who argues in the Financial Times that the greatest threat to globalization is not from its opponents, but its "cheerleaders." He writes:

That is because the greatest obstacle to sustaining a healthy, globalised economy is no longer insufficient openness. Markets are freer from government interference than they have ever been. Import restrictions such as tariff and non-tariff barriers are lower than ever. Capital flows in huge magnitudes. Despite barriers, legal and illegal immigration approaches levels not seen since the 19th century.

Consequently, no country's growth prospects are significantly constrained by a lack of openness in the international economy. Even if the Doha trade round fails, poor countries will have enough access to rich country markets to achieve what countries such as China, Vietnam and India have been able to do. Closed markets may have been a fundamental problem during the 1950s and 1960s; it is hard to believe they still are. The greatest risk to globalisation is elsewhere. It lies in the prospect that national governments' room for manoeuvre will shrink to such levels that they will be unable to deliver the policies that their electorates want and need in order to buy into the global economy.

Globalisation's soft underbelly is the imbalance between the national scope of governments and the global nature of markets. A healthy economic system necessitates a delicate compromise between these two. Go too much in one direction and you have protectionism and autarky. Go too much in the other and you have an unstable world economy with little social and political support from those it is supposed to help.

The other side, from the Washington Post's Sebastian Mallaby, who takes on the argument that the US should take a "strategic pause" in pushing trade agreements:

If the United States refuses to do new trade deals, its partners will push ahead with agreements among themselves, reducing tariffs for each other's products while shutting out American ones. And if they are denied a chance to gain access to U.S. markets via negotiation, foreigners will seek it via litigation.

Meanwhile, over at Princeton, Alan Blinder is having doubts about trade, too, according to the Wall Street Journal. Greg Mankiw, who was an undergraduate student of Blinder's at Princeton, answered with a blog post "My Father is Darth Vader." Of course, that implies that Mankiw thinks he's Luke Skywalker. That's fine with me, provided I can be Lando Calrissian.

CEOs for Socialism Now!

Not exactly... but according to Jonathan Cohn in the New York Times Magazine, support for universal health insurance is growing among business leaders:

For many years, the only business leaders openly calling for universal coverage were mavericks like Howard Schultz, the chairman of Starbucks, who has long preached the need for business to show greater social responsibility. The C.E.O.’s rallying to universal coverage now — particularly in the last few months — are acting not so much out of social solidarity as out of financial necessity, as the burden of financing workers’ premiums has become ever more onerous.

“The refrain from business was, ‘We can’t afford to do universal health care,’ ” says [Senator Ron] Wyden, whose plan calls for shifting responsibility for buying insurance from employers to individuals. “Now the refrain is, ‘We can’t afford not to do it.’ ” The Business Roundtable, one of Washington’s most influential business lobbies, now endorses universal coverage, at least in broad principle. And probably no spectacle captured the spirit of the times more than a joint conference held in February by [service employees union leader] Andy Stern and a man he has spent much of the last few years attacking, Lee Scott, the C.E.O. of Wal-Mart. Together the two pronounced the need for universal coverage by 2012.

Cohn's article provides some useful historical background. He reminds us there was initially significant business support for President Clinton's plan in 1993:

Though it is not widely remembered, Clinton tried hard to curry favor with business. Ira Magaziner, the chief architect of the administration’s plan, met repeatedly with corporate leaders to seek their advice, understand their needs and anxieties and test their tolerance for various provisions. Although the final White House plan included an “employer mandate” — meaning all businesses would be required to pay for a portion of their employees’ health-care costs — Clinton constructed that mandate so that many employers would actually benefit... why didn’t business support the Clinton health plan?

Actually, there was some support — at least initially. Most notably, the U.S. Chamber of Commerce at first embraced the concept of an employer mandate. But when the chamber, which represents both big and small companies, announced its endorsement, it came under attack from the National Federation of Independent Businesses, which represents only small firms. The chamber quickly started to lose members — and to field irate calls from Republican legislators warning against giving any support to the Clinton plan. The chamber and other allies backed off.

Many of the current generation of univeral health care plans are more the liking of business because they place the responsibility for obtaining insurance on individuals rather then business. The plan offered by Senator Wyden, for example:

Wyden is quick to share credit for the plan with [Safeway supermarkets CEO Steve] Burd, particularly when it comes to what is arguably its most significant provision: the severance of the longstanding relationship between where you work and how you’re insured. Under the Wyden proposal, most Americans would still use private insurance. But they would not get that coverage through employers anymore. Instead, all employers that offer insurance would “cash out” their benefits — in effect, giving their employees higher wages rather than health benefits. Once that was done, people would be required to buy coverage on their own, directly from insurers.

Some would say that by going elaborate lengths that to use "private" rather than "goverment" (socialism, gasp!) insurance, this plan - like President Clinton's - will not lead to the most cost-effective outcome:

Of course, some experts would argue that, strictly on the merits, a single-payer system might actually work better. Unlike plans like Wyden’s that rely on private insurers, a single-payer plan substantially reduces the amount of money spent on administration, since insurance companies spend far more on overhead (and marketing, and profits) than public systems. And while the data on medical outcomes are notoriously uneven and hard to interpret, they don’t show that the United States provides uniformly better care than single-payer nations like Canada or France. In fact, on measures like “Disability Adjusted Life Expectancy,” which social scientists use to measure the performance of national health-care arrangements, single-payer systems actually seem to perform slightly better on the whole.

One political lesson Senator Wyden, the business backers of his plan, and others should learn from 1993 is that even if you make a point of relying on the private sector, you'll inevitably be labelled a "socialist" anyway.