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.[1]

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.

[1] 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.

13 Responses to “How The MBAs Ruined America”

  1. Sun Gumbs Says:

    Notable particulars! Good to learn about companies, experts, a few other sentiments and even up coming events.

  2. How The MBAs Ruined America « Economics Info Says:

    [...] Source [...]

  3. JT Says:

    I don’t have hard numbers to back it up, but historically’ doesn’t a more progressive tax regime correlate with higher growth rates? The top marginal rate hasn’t been this low in how long?

  4. JSeydl Says:

    It’s all about balance, JT. A too progressive tax code will reduce the incentive to produce, hurting the economy. A too regressive tax code will lead to declining social mobility, hurting the economy. It is true that tax rates were much higher in the 40s, 50s, and 60s, and the economy did just fine. That plus my earlier point about how the demand for public goods and services rises when economies develop probably suggests that the U.S. tax code could become more progressive without hurting growth. Personally, I favor a progressive consumption tax (PCT), which would not only make the tax code more progressive, but also encourage more saving and investment if the proceeds from the PCT were used to reduce income and investment taxes.

  5. Citizen Journalist Says:

    This is all conjecture if it’s not backed up by studies and examples. Wouldn’t it be easier to look through history to see what did and did not work?

    The equation for GDP quoted, is missing a key part, which is taxes and regulatory costs, which are a negative. GDP will go up if spending by government goes up and taxes goes down. Just the opposite will happen when taxes goes up, and government spending goes down. If taxes and government spending both go down, a temporary adjustment takes place in a lower GDP, but then will shoot up, as the adjustment is completed.

    A comparison of 2 different decades in the 1900′s offer a stark contrast of what seems to work and doesn’t work. All you have to do is look at the 1920′s and the 30′s.

    At the beginning of the 20′s, was the end of WW1 and a huge depression that lasted all of 18 months, a normal time frame. The country had to adjust from both a world war and a very progressive heavy taxing administration of Woodrow Wilson. Libertarian leaning Republicans were elected to all 3 branches of the federal government and set to cut taxes and reduce spending by large amounts.

    The result was a huge rebound in the GDP and unemployment went way down. Prices also stayed relatively flat Problems developed though at the end of the decade when the federal reserve was trying to balance interest rates and the flow of gold with France. Things tipped over when a huge tariff was placed on imports, and a trade war erupted.

    Those in government from the start of the 30′s did all the wrong things. They increased regulation, and tax rates, along with artificial wage and price controls. This threw the economy out of whack because the economy wasn’t allowed to reset itself. The Great Depression continued through the 30′s and early 40′s because of all the artificial work programs, high taxes and regulations.

    We are suffering the same thing today with the same type of policies from the 30′s. And to JT, no more progressive tax regime doesn’t correlate with higher growth. The higher rates always had huge loopholes and higher levels of income before it was collected. The 20′s saw higher revenues with very low (24%) rates, than was seen in the 30′s with 80-90% rates. GDP was also higher in the 20′s than the 30′s, even though there was huge federal spending.

  6. finance Says:

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  7. JSeydl: Economics / Art / Adventure » Blog Archive » Making The Case For Fiscal Stimulus In An Econ 101 Framework Says:

    [...] my previous post, we saw how deficit reduction in an economy where consumers are debt-constrained, where short-term [...]

  8. JSeydl Says:

    Hi Citizen Journalist. Thanks for the comment.

    Every economic argument made is conjecture. Economics is an area of philosophy. Even really applied fields, such as econometrics, invoke philosophical questions because of the simplifying assumptions that are made (i.e., the zero conditional mean assumption in OLS).

    I have a different view on the Great Depression. First, the 1920s was nothing to celebrate. Growth was being driven by unsustainable stock market and housing bubbles, and corruption in the financial sector was widespread. The 2000s was a similar decade.

    First and foremost, the Great Depression was a monetary policy failure. The Fed was unable to stop the money supply from contracting, because banks were failing; because they didn’t have deposit insurance. The sharp decline in the money supply lead to a debt-deflation spiral, which crippled the economy.

    Once the Fed did finally stabilize the money supply and once banks eventually got deposit insurance, the economy stabilized. However, there was still a massive demand gap that needed to be filled. The wealth effect that falling home prices and stocks had consumer spending and business investment depressed the “animal spirits.” Despite this demand gap, policymakers foolishly implemented fiscal austerity in 1937, causing the economy to slip back into a slump.

    It wasn’t until government spending for WWII came that the demand gap was filled. The added benefit of WWII spending was that it caused a huge pickup in inflation, which eroded the debt burden that many consumers were struggling with. It was for this reason that the economy didn’t slip back into recession once WWII ended.

  9. Dorcas Bester Says:

    Dead pent content, thank you for entropy. “He who establishes his argument by noise and command shows that his reason is weak.” by Michel de Montaigne.

  10. How to trade Says:

    How to trade…

    [...]JSeydl: Economics / Art / Adventure » Blog Archive » How The MBAs Ruined America[...]…

  11. JT Says:

    My point is historically, rates are low, and growth may have been robust in the earlier part of this century, but it was meaningless, poor quality growth. Conjecture? Maybe. But as Joe stated, all philosophy is. Its the philosophy which drives my interest in macro, not the math.
    But, for the record, facts and numbers matter.

  12. JT Says:

    BTW. Keep up the good work, your right up there on my list with Tyler’s Marginal Revolution.
    On that note, I’d love to hear your thoughts on The Great Stagnation.

  13. PPI Says:

    JSeydl: Economics / Art / Adventure » Blog Archive » How The MBAs Ruined America interesting post. I tought this piece of news would be of interest: The UK economy shrank by less than previously thought between April and June, official figures have shown. Revised data from the Office for National Statistics (ONS) show the economy contracted by 0.5% during the quarter, less than the 0.7% it announced last month.

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