How The MBAs Ruined America
Mark Thoma, a professor of economics at the University of Oregon, has a new column, in which he argues that many economists have correctly diagnosed the U.S. economy’s illness in recent years, arguing for effective policy treatments like fiscal stimulus. The problem, according to Thoma, is that the elite policymakers have ignored the policy recommendations. Why? Because “the influence of big money interests caused Congress to listen to the wrong voices.”
That sounds about right. But for kicks, I have an alternate explanation: The reason why policymakers won’t listen is because the MBAs have clouded the conversation.
Take, for example, Columbia Business School grad Erskin Bowles, who was a co-chair on President Obama’s deficit-reduction commission. In late-2010, Bowles played a pivotal role in shifting the conversation in Washington away from job creation toward deficit reduction, in the name of “fiscal responsibility.” If Bowles had an economics degree rather than a business degree, however, then he probably would have realized how irresponsible a discussion about deficit reduction was in late-2010.
The answer to the question of whether deficit reduction will hurt the economy can be found in the Econ 101 textbook. For starters, the textbook tells us that
Y = C + I + G + Nx
where Y is real GDP, C is consumption, I is investment, G is government spending, and Nx is net exports (i.e., total exports minus total imports). Deficit reduction, by definition, means that G will fall. So in order for Y to not fall along with a drop in G, some combination of C, I, and Nx must rise.
Let’s walk through each of these components.
In normal times, a decline in government spending need not necessitate a drop in consumption, provided that saving habits shift. When the government spends less money – or raises taxes – this translates into less income for consumers; both directly, because the government employs consumers such as teachers and firefighters, and indirectly, because government spending determines contracts for private firms. However, consumers generally like to keep their spending habits stable throughout the business cycle, if possible. And so, the only way that consumer spending habits can remain stable following a decline in government spending is if consumers save less and spend a larger proportion of their income. When consumers do reduce their saving habits to maintain a steady consumption pattern following a drop in government spending, they are said to be “smoothing” their consumption expenditures throughout the business cycle.
It was fairly obvious, however, that consumers were not going to smooth their consumption expenditures in the current cycle. The reason is because the debt buildup prior to the housing bust was so massive that consumers were forced to dramatically increase their saving rates to pay down debt when the bubble popped. This remains the story in today’s economy, where consumers are still deleveraging and where debt-to-income levels are still elevated. Until the deleveraging process is complete – which will probably take another year or so – any cuts in government spending are likely to reduce overall consumption expenditures; because consumers have no room to save less and spend more to smooth their consumption expenditures.
There is also usually room for business investment to grow following a drop in government spending when times are normal. By raising and lowering short-term interest rates, the Federal Reserve has the power to dictate business investment spending – a drop in short-term interest rates causes borrowing costs for firms to fall, boosting investment, and vice versa. So the Federal Reserve can offset the negative growth effects from a decline in government spending simply by lowering interest rates.
But times are clearly not normal. The Federal Reserve has already lowered short-term interest rates to zero percent, meaning that it has no more wiggle room to spur business investment in the event that government spending takes a nosedive.
The last offsetting mechanism involves a shift in global trading patterns. As previously mentioned, during normal times, a decline in government spending will force the Federal Reserve to cut interest rates. Along with boosting business investment, a cut in interest rates will also weaken a country’s currency, making its goods and services cheaper for the rest of the world to purchase and making it more expensive for domestic consumers and businesses to purchase foreign goods and services. This has the effect of increasing exports and decreasing imports, or boosting Nx in the above equation.
In the current environment, a dollar devaluation, while an incredibly welcome development, is probably unlikely. The U.S. trade balance is largely determined by trade flows with developing Asia, where countries purposefully peg their currencies to the dollar at artificially cheap rates – the currency manipulation game started after the 1997 Asian financial crisis. Given that developing Asia is having its own growth problems at the moment, it’s highly unlikely that the policymakers in that region will let their countries’ currencies appreciate significantly against the dollar anytime soon.
So in the current environment, with offsetting growth mechanisms nonexistent, the predictable outcome of deficit reduction is weaker real GDP growth – which is what the U.S. economy got following the drawdown of the 2009 fiscal stimulus package and the implementation of harsh austerity at the state and local level of government all across the country. This same story is true in Europe, where austerity has pushed some economies, such as Spain and Greece, into a full-fledged economic depression.
From this thought experiment, we can conclude that the standard Econ 101 explanation for fiscal adjustment following a recession is not on the curriculum at Columbia Business School. Though, unfortunately, the problem is not limited to just budget policy.
More generally, people with prestigious MBAs tend to dominate all other discussions in Washington, ranging from health care to trade policy to corporate welfare. For example, let’s take a look at the results of a recent survey on U.S. competitiveness at Harvard Business School (HBS). The survey contains this chart, which depicts, according to HBS alumni, the most important things that policymakers should do to restore competitiveness in the United States:
It’s easy to see how some of the policy recommendations in the above chart would do more harm than good. For example, HBS alumni place a key emphasis on balancing the federal budget; we already saw how the predictable outcome of a move toward budget balance would be contractionary in the short run. In the longer term, the budget deficit will certainly need to be reduced, but the only realistic way that can happen if the trade deficit is narrowed. Bizarrely, the trade deficit is not on the minds of HBS alumni.
On taxes, HBS alumni clearly want a simpler tax code, which would be a good thing. But “simpler” at HBS is seemingly code for “more regressive” and “less burdensome for corporations.” In terms of structure, a more regressive tax code is bad on both moral grounds and efficiency grounds.
On moral grounds, a progressive tax code helps to offset the luck factor that largely determines one’s financial success. Not everyone has the good fortunate to be born into a wealthy family, where academic resources are plentiful and where well-connected fathers have the ability to get their sons and daughters into the best colleges with one phone call. Redistributing money from wealthy families to poorer families helps to level the playing field by giving children in poorer families the resources they need to be successful in school, so that they can avoid getting involved with things like drugs and crime.
On efficiency grounds, a progressive tax code is needed to provide an adequate supply of public goods and services. Economic theory tells us that the demand for public goods and services rises as countries develop and suburbanize. With inequality as high as it is in the United States, a more regressive tax code will almost certainly lead to a shortage of public goods and services, making all Americans poorer.
One final point on the HBS study: The outcry for less-burdensome regulations is both economically and socially irresponsible. In terms of the economics, history tells us that a deregulated banking sector will lead to economic collapse. Since the HBS study advocates repealing the new financial regulations that were legislated in 2010 and supports other financial regulations that are stated only in purely vague terms, we can conclude that HBS alumni do not actually support more regulation in the financial sector.
In terms of the social impact of fewer regulations, the consequences could be much more severe. The United States has already engaged in a race to the bottom with the developing world in terms of weakening environmental regulations, and the HBS study presumably supports adding better fuel to win the race. While winning the race to the bottom may increase business profits in the short term, it will almost certainly dramatically reduce living standards for future generations.
The incredible irony of this whole story is that all of the elite business schools are considered to be “bastions of free trade,” where books like The World Is Flat and The Wealth of Nations are worshiped. It’s ironic because one of the basic tenets of free trade is labor specialization, implying, of course, that the economic gains from trade would be greater in the United States if businessmen didn’t cross specialize in business and in government policy.
 Some would argue that the Fed isn’t powerless and that it could lower real interest rates further by targeting higher inflation or stronger nominal GDP growth. I don’t disagree, but I think both of those options are unlikely in the near future; especially when you have some central bankers talking about the exit strategy toward tighter monetary policy as early as March 2011.