Thursday, June 23, 2011

Raising the Roof... on the National Debt

For the past month, House Republicans and the White House have been in a bitter standoff over the national debt ceiling, the legal limit to borrowing that the U.S. government imposes on itself. The law establishing the ceiling has been in effect since 1917, but the ceiling has been raised many times over the past century. The current limit is set at $14.3 trillion. Government spending would have exceeded this limit on May 16th, but the U.S. Treasury has enacted emergency measures that will keep the government and its lenders funded until early August. Failing to increase the debt ceiling could lead to the U.S. being unable to fund military salaries, pay for programs like Medicare, or make interest payments to creditors. But increasing the debt ceiling won’t be easy either.

In the worst-case-scenario, an agreement to raise the debt ceiling would not be reached, and the U.S. government would risk defaulting on interest payments to lenders. The United States government has consistently served as a safe haven for lenders looking to store funds; historically it has never missed a payment. As a result of this reliability, the U.S. economy has been able to enjoy relatively low interest rates. If the U.S. were to consider defaulting on its loans, investing in the U.S. government would become riskier. To attract borrowers and accommodate for the increased risk of not being paid back, real interest rates would have to rise.

John Maynard Keynes wrote in The General Theory of Employment, Interest and Money that aggregate demand (composed of consumption, investment, and government expenditures) is the main determinant of an economy’s level of output. Investment spending, such as the purchase of a new home, is typically financed through borrowing. As real interest rates rise, borrowing becomes more expensive. Because investment is a component of aggregate demand, an abrupt decline in investment would theoretically shift the aggregate demand curve inward as in the graph below. With the US economy struggling to overcome the recession caused by the 2008-2009 financial crisis, a reduction in output and the corresponding fall in employment would certainly be viewed as an unfavorable outcome.

As part of the ongoing debt ceiling discussion, President Obama recently unveiled a plan to reduce deficits over the next twelve years that includes nearly $2 trillion in spending cuts and an increase in the debt ceiling. The government spends nearly $700 billion annually on national defense alone, and it also employs millions of people. As mentioned, government expenditure is a major component of aggregate demand. Economists would expect a reduction in government expenditures to shift aggregate demand inward in a similar manner as decreases to investment.

It is important to also consider the concept of “crowding out.” Whenever there is an increase in government spending, the resulting increase in incomes leads to increased spending and thus a higher demand for money. This increased demand for money causes increased interest rates. The opposite is also true. As government spending is reduced, so too are incomes, money demand, and interest rates. This reduction in interest rates makes borrowing cheaper, and thus stimulates greater private investment. Increased investment would therefore lessen the impact of a shock to aggregate demand from government spending cuts. Those in favor of spending cuts point to the increase in investment to suggest that the cuts won’t significantly decrease aggregate demand. Those opposed to the cuts note that interest rates are already very low so doubt that the cuts would spur much private investment.

It is relatively unlikely that US elected officials would be stubborn enough to permit a seemingly preventable crisis. Remember, the debt ceiling is a constraint that the government arbitrarily places on itself. No matter how the government chooses to proceed, the short-run economy is likely to see some negative consequences. Economists like to talk about optimal decision making, and recognize that sometimes even a “bad” option can be optimal if no other choice will lead to a better outcome. When it comes to the debt ceiling, let’s hope that our elected officials think like economists.

Discussion Questions:

1.) A number of nations around the world hold the U.S. dollar as their reserve currency. Others have periodically pegged their exchange rate to the U.S. dollar (China, for example). What would the implications of a U.S. credit default mean for foreign economies?

2.) Suppose that the debt ceiling remains unchanged. How might the US government prevent defaulting on its loans? How does this compare to the current plan suggested by President Obama?

3.) If you were President of the United States, how would you deal with the current level of debt? Would you increase taxes? If you were to cut programs, which ones would you cut? How might your view change if you were up for reelection?

Tuesday, June 07, 2011

Correcting Faulty Defaults to Improve Society?

California recently cut $170 million from the amount the state must pay toward 2012’s retirement benefits, according to an article in the Mercury News. With the uncertainty regarding the future of pension plans and social security, private retirement savings are more important than ever. Despite this need, many people have difficulty making consumption sacrifices today to provide for their future selves.

Recent changes to many private firms’ retirement savings programs seem to reflect this need for personal savings. In the past, employees had to actively opt-in to company savings plans by changing their monthly contribution amount from the default of $0 to some positive amount. Traditional economic models of savings assume that people are perfectly rational and will choose the level of saving that maximizes their utility over the entire course of their lives, therefore people’s decisions of how much to save should not be affected by something as small as the effort required to “opt-in” to a plan. Companies have found, however, that merely changing the default option from “no savings” to “X% of paycheck automatically saved” causes a significant increase in employee savings. One firm found that after switching from standard to automatic enrollment in retirement savings plans, the participation rate for new hires was 35 percentage points higher after three months on the job (as compared to those hired before the automatic enrollment). The participation rate remained 25 points higher after two years.

Why would something as seemingly trivial as changing the default setting have such a large impact on the decision of how much to save? The field of behavioral economics acknowledges that people do not always act according to the model of perfect rationality, which requires weighing all costs and benefits (present and future) and accounting for all available information. Deciding how much to save for retirement is an important life decision, yet the “easy” choice of accepting the default option often prevails against the rational action of giving it more serious consideration. Traditional economic models do not explain the widespread tendency to stick with defaults regardless of their suitability, but behavioral economists can replicate this behavior in controlled research environments.

Applying this understanding of behavioral economics to the savings plan structure is an example of “libertarian paternalism,” a school of thought that strives to maintain freedoms (libertarian) while still guiding people towards the choice that society deems best (paternal). The new default setting does not interfere with employees’ rights to do what they please because employees can easily “opt-out” by making a short phone call and signing a form. At the same time, it benefits society by encouraging more people to save, since those who do not sufficiently save for their future needs pose a problem not only to their older selves (who may have to work past their desired retirement age), but also for the government (and thus taxpayers) who may then have to help provide for them as well.

Discussion Questions:

1) Do you think that a company changing the default behavior for a retirement program infringes on employee's rights?

2) How do you make decisions about long-term financial planning? Do you research and model your finances, base your decisions on suggestions (from an employer, family, or friends), or ignore it entirely?

3) Are you surprised that changing a default value has an effect on what people select?

4) Imagine you are a freshman in college choosing a meal plan. You don’t know what the other food options on campus will be like, nor what your schedule will be. What advantages does a “default” option provide in this situation?