Monetary Policy in Response to the Pandemic and the Prospects for Inflation over the Next Few Years

In 2020, the Federal Reserve expanded the money supply substantially, with M2 increasing by more than 22 percent from December 2019 to December 2020. This was accompanied by an even larger increase in the monetary base. As spending declined dramatically in the weeks following the implementation of shutdown orders connected to the pandemic, the monetary expansion was intended to offset the contractionary effects of that spending decline. Although CPI inflation rates remain low, below the Federal Reserve’s 2 percent target, there is good reason to expect that if the Fed does not act to restrain the rate of monetary expansion in the next year or two, we will see a substantial increase in inflation.

With interest rates as low as they are and continued reductions in certain categories of consumption spending, the effect of the increase in the money supply has largely been to offset the increase in money demand induced by the pandemic and response to it. But when enough people get vaccinated, people will start spending again and reduce their rate of saving. Although some of the increased spending may stimulate increased supply of real goods and services, potential output is limited by the economy’s productive capacity. Thus, although inflation may remain subdued for a few more months, as the economy approaches capacity, more money likely means that spending will continue to increase. To the extent that the increase in output cannot keep up with the increase in spending, we will see inflation.

Hetzel argues that if the Federal Reserve sticks to its announced commitment to overshoot its 2 percent inflation target and to keep interest rates near zero, then inflation may well rise to the point where it becomes a problem. He equates recent monetary policy to the expansionary monetary policy of the 1960s. During that time, the Fed was able to exploit widespread expectations of price stability to use expansionary monetary policy to stimulate output and employment. But as that expansionary monetary policy continued, it eventually led to runaway inflation.

Because inflation has been low for so long, market participants are now expecting prices to remain stable. This makes it easier for the Fed to pursue expansionary monetary policy with no short run increase in inflation. But, just as in the 1960s, rapid money growth will eventually lead to inflation, even though expansionary monetary policy may effect the inflation with a long lag as it did in the past. By committing to allow inflation to overshoot the two percent target, the Fed has effectively taken away the option of preemptively restraining money supply growth to keep inflation from rising to well above 2 percent before changing course.

Given its commitment to keep interest rates low until we actually see inflation, the Fed may wait too long to reverse its policy. The likely consequence is inflation overshooting a level that the Fed might consider reasonable and that for as much as a year or two, given what we know about the length of lags in the past.

Thus, we should be prepared for an increase in inflation in the next few years.

Getting More out of Public Transit Spending

An important part of the transportation infrastructure crisis is the state of public transportation systems in America. Many public transit systems are having difficulty covering the cost of maintenance. Tracks are deteriorating, stations need to be refurbished and outdated equipment is not being replaced quickly enough, which makes it difficult to attract riders. Governments struggle to find the money to pay for these expenses. Meanwhile, governments spend billions on new rail systems and bus rapid transit systems and propose further transit expansions in the future.

Advocates of transit emphasize that by expanding transit systems and enticing riders to use transit instead of driving, highway congestion can be reduced. Yet many recent transit expansions have not been cost effective. Much of the money spent on expanding transit would be better spent improving existing transit service in corridors where there is sufficient demand or on improving highways.

Transit ridership has declined in many US metropolitan areas due to deteriorating quality of transit service along with the growth of ride sharing. Yet many people still depend on transit to get to work.

If more people used transit instead of private automobiles, fewer freeway lanes and parking lots would be needed and cities could be more walkable.The benefits of living in walkable neighborhoods in densely populated communities include better fitness, more visually appealing streetscapes, and more opportunities to interact with neighbors than in typical car dependent suburbs. But for a variety of reasons, most US metropolitan areas are not densely populated. Transit, especially fixed route transit, whether rail or bus rapid transit, does not attract nearly enough riders to cover its costs except in relatively dense corridors connected to urban centers with substantial employment concentrated in a relatively small area.

Auto-oriented development has come to dominate newer US cities as well as suburbs of US and European cities. A growing share of jobs and businesses are decentralized throughout metropolitan areas. For most of those who commute to jobs located where there is not a high concentration of jobs in a relatively small area, the most cost effective and least time-consuming way to commute to work is by automobile. But in large metropolitan areas this requires extensive systems of freeways, arterial roads and parking facilities.

Because it would be far too costly to provide transit service connecting all parts of a metropolitan area, transit expansions that do occur only benefit a limited number of residents. Those who live in areas served by high quality transit often pay more to live close to transit stops or stations. But without sufficient density, too few people use transit so that fares do not cover a major share of the operating cost and capital costs of high quality service, particularly if it involves a fixed guideway.

Unfortunately, political incentives often result in cities building expensive new rail transit lines in areas without sufficient density to utilize close to the capacity of the trains, buses and fixed guideways. According to Cervero, out of 54 rail transit investments that occurred since the 1970s, only 23 have combined net operating and capital costs (what is left over after fare revenue) less than $0.85 per passenger mile. If we assume average fare revenue of 50 cents per mile, that is equivalent to total operating costs of less than $1.35 per mile, which is the estimated marginal cost of commuting by automobile during peak periods.

Transit proponents argue that new rail transit systems have contributed substantially to reduced congestion and that the benefits from reduced congestion are large enough to cover the cost of transit subsidies. Although good public transit service has reduced traffic congestion substantially in a few cities, reductions in congestion from most recent transit expansions are small, for several reasons. First of all, when cities expand rail transit, many of the new users are former bus riders, so not many cars are taken off the road. Another problem is that as former drivers switch to transit, the reduced traffic on urban expressways makes it easier for people to commute a longer distance to work so that there is an offsetting increase in expressway traffic.

Some transit proponents argue for expanding transit systems into less densely populated areas and then encouraging transit-oriented development (TOD)– dense mixed-use development of apartments, offices, and retail near transit stations. Residents in many suburbs resist the increased density required for TOD to be successful. They express their political power through zoning that limits density.

Even in suburbs were transit-oriented development is permitted, many residents are affluent enough to own cars and rely on those cars for most non-work trips as well as many work trips. Although the resulting dense neighborhoods may attract residents whose jobs are accessible by transit, if families have two or more workers, many of those additional workers will find a job that is not accessible by transit.

The further suburbs are from the central city the less dense they are, which means highway lanes cost less to build and transit is less likely to attract enough passengers to come close to covering its costs. Thus, if governments spend scarce transportation funds investing in rail transit or bus rapid transit, the money should be spent in urban centers or first ring suburbs that are dense enough so the system can generate enough fare revenue to cover a substantial share of capital and operating costs. In many cases, rather than spending to expand transit, cities should spend more to maintain the systems they already have or improve the quality of service in corridors where transit is already heavily used.


What problem was zoning intended to solve

Spencer Gardner wrote an interesting piece for Strong Towns, A History of Zoning, Part II. Contrary to the views of some, zoning was not intended as a means to protect people from nuisances like air pollution, noise, etc.  He argued that the purpose of zoning, at least as originally developed, was to protect single family homes from apartment houses. It was the view of Frederick Law Olmstead, an early advocate of zoning,  that apartment houses and multi-family homes should be assigned to separate districts from single family homes, that single family homes should be located in such a way that they have adequate protection against apartment houses.  Detached, single family homes were viewed as inherently superior for advancing civic virtue and good morals.

I am not sure that this view is the same as the reason people support zoning today.  Clearly many today believe that when people own their homes, they will take better care of them.  Most people also want to keep apartments or rental housing from being located close to their single family homes for fear that it would limit the potential appreciation of their homes.

This piece followed part I of a planned three-part series on the history of zoning.  Part I talks about what zoning does and the legal underpinnings of zoning. Zoning law specifies height limits, setbacks and lot coverage.  Zoning derives from the police power, which the US Constitution granted to state and local governments to regulate for the purpose of insuring the health, safety, morals, and general welfare of the people.

Limits of Tolling as an Answer to Highway Funding Problems

Making users pay directly for the highways they use is an idea whose time has come. One aspect of this is recent efforts to impose tolls on selected portions of interstate highways. Tolling express lanes on congested highways, such as the Capital Beltway around Washington, DC, has been a very effective way to earn revenue while providing lanes that are almost always free of congestion. By providing a source of revenue to finance construction of additional lanes, this arrangement can reduce overall congestion. General and widespread tolling of interstate highways, however, will not work well unless drivers get superior service in exchange for the tolls they pay or can be required, through some means, such as mileage based user fees, to pay for the miles they travel on competing highways.

Mileage based used fees are preferable to tolling selected highways. With mileage based user fees, technology, such as GPS, could be used to record miles driven by each car. Drivers would pay directly for the miles they drive, whether those miles were on Interstate highways, arterial highways, or local roads and streets.  Prices could vary depending upon the highway and time of day with drivers paying more for premium services, such as congestion free express lanes or bridges across major rivers.

Implementing a system of mileage based user fees would require that vehicles be equipped with a device that would record mileage driven including some information about the location of each mile, even if just the state. Some, such as Robert Poole, advocate tolling interstate highways as part of a transition to direct user fees until a system of mileage based user fees could be implemented. But carrying out a transition to tolls would be difficult politically. Many drivers oppose tolls for interstate highways because they already pay for the construction and maintenance of those highways via fuel taxes.  Another problem with tolls is that drivers could avoid them by using a parallel road or highway that does not have limited access. This will increase maintenance costs, the number of accidents and the amount of congestion on those parallel roads and highways.

With existing technology, it is easy to collect tolls for limited access highways, but much more difficult to charge direct user fees for other roads and highways. Yet interstate highways have a dedicated source of funding that, depending on the state, may not be available to fund local streets and roads.  States often give priority to interstate highways over local streets and roads in decisions about allocating revenue from federal fuel taxes. When drivers use alternate routes to avoid tolls on limited access highways, they may be using roads funded by cash strapped local governments through property taxes rather than by fuel taxes.

It is best to limit tolls to those highways for which comparable un-tolled alternate routes do not exist for most drivers.  Furthermore, it is inequitable to impose tolls on some interstate highways, but not others, as a source of additional revenue to fund all highways or transit within a given jurisdiction.  Beginning in 2007, the state of Pennsylvania tried to toll interstate 80 and use the revenue to fund other highways and public transportation in the state.  Local citizen groups objected strongly, and the Federal Highway Administration rejected the proposal on three separate occasions.

As a long-term solution to highway funding problems, mileage based user fees are equitable and offer the promise of more efficient funding and management of highways, particularly if the fees can be used to cover the cost of the particular roads and highways for which they are collected. As an intermediate step on the way to mileage based user fees, tolls are problematic because they can only be used on selected highways, leading to traffic diversion and an inequitable distribution of the costs of funding highways.  Tolls can and should be used selectively to allocate space on congested highways. But rather than trying to impose tolls on rural interstate highways, it may be better for the federal and state governments to continue using fuel taxes, while promoting a gradual replacement of fuel taxes with mileage based user fees.

Do we need a massive influx of federal money to fix infrastructure?

One dramatic example to illustrate the seriousness of the infrastructure crisis in the US is the recent problem with lead in the water supply of the city of Flint, Michigan. According to one estimate, fixing the entire water infrastructure in Flint so that everyone could get safe drinking water from their faucets would cost about $1.5 billion or approximately fourteen thousand dollars per resident.  Combining this with the needs of other cities and with work that needs to be done on transportation and other infrastructure, it is easy to see how Trump’s proposal to invest a trillion dollars in infrastructure could be justified.  Spending huge amounts from the federal government budget, however, is not an efficient or cost effective way to respond to infrastructure problems.

The prospects of solving infrastructure problems in a much more cost effective way can also be illustrated by considering the case of providing clean drinking water for the residents of Flint. This illustration is based on an article by Charles Marohn, recently posted on the Strong Towns website.

Marohn points out that “the primary function of the water system in your city is not — as is widely believed — to provide you safe drinking water.” The existing system in most cities including Flint, made up of eight-inch water pipes, was designed to provide enough water for fire-fighting. If the only purpose was to provide water for household needs like drinking and bathing, much smaller pipes would suffice. This is the approach used by rural water systems in some small towns and agricultural areas where clean well-water is not readily available. These smaller pipes make it possible to provide safe drinking water at a lower cost per resident than with conventional urban water systems.

Instead of replacing the entire water system in Flint, where many pipes may be able to last 20 years or longer, the city could build a less expensive parallel system of small pipes. The existing system of lead pipes could be left in place for fire-fighting purposes only. This is but one example of how innovative and unconventional approaches could be used to fix infrastructure for a lower cost.

In many cases, entrepreneurs could devise private innovative solutions that are much more cost effective for replacing and repairing infrastructure. When a pot of federal money is available, cities and towns focus their efforts on getting as large a share of that money as possible, not on finding low cost ways to fix their problems. If instead, cities had to pay most of the costs of fixing infrastructure themselves, they would have a much bigger incentive to find the most cost effective way to do so.



The Federal Reserve and Interest rate increases in 2016

Since 2008, it has been very hard to find a bank that pays any interest on savings accounts. This state of affairs can be blamed on Federal Reserve monetary policy, which  kept short term interest rates close to zero for seven years. After talking about raising interest rates throughout most of 2015, the Federal Open Market Committee finally raised the target level for the Federal funds rate by ¼ point on December 16. Many now expect the Federal Reserve to gradually raise interest rates so that by the end of 2016 the federal funds rate is close to 2 percent.

If the federal funds rate continues to rise, other interest rates will likely follow. Rising interest rates are good for those of us who have money to save, but will discourage people from borrowing money to invest, which is important for economic growth. Higher interest rates in the US also cause the foreign exchange value of the dollar to rise. Given the fragile state of the world economy, this could hasten the coming of a recession to the United States.

Some economists have criticized the Federal Reserve for its quantitative easing, the policy of buying government bonds and mortgage backed securities, which expanded the monetary base by more than five-fold between 2008 and 2014.  Quantitative easing played a major role in holding down interest rates during that time period. It does not follow, however, that the Federal Reserve can improve the economy by now pursuing policy that would raise interest rates toward levels that commonly prevailed before the financial crisis of 2008. Interest rates are low today, not because of current Federal Reserve monetary policy, but because most of the nations of the world are on the brink of a recession.

All interest rates are market determined. Interest rates depend on the supply and demand for loanable funds, which the Federal Reserve alters by buying and selling US government securities or mortgage backed securities. By expanding the monetary base, the Federal Reserve put downward pressure on interest rates. In the past year however, the Federal Reserve has not increased the monetary base. A stable monetary base and money supply should keep inflation rates close to zero, which is a good thing for anyone who is trying to save money.

The federal funds rate, which is the rate banks charge for lending reserves to each other, has been largely irrelevant since 2008, because almost all banks have excess reserves and thus do not need to borrow from banks. Nevertheless, it does move with changes in the interest rate the Federal Reserve pays on excess reserves. Since banks must decide how much of their reserve balances to lend, the rate paid on excess reserves will have an effect on the interest rates banks charge for business and consumer loans.

To further increase the federal funds rate in 2016, the Federal Reserve would have to pay a correspondingly higher interest rate on excess reserves, which would likely discourage banks from lending money. For example, to raise the Federal funds rate to 1 percent, they would need to double the rate they pay on excess reserves, and their interest costs would more than double if banks increased their excess reserves in response to the higher interest rate. Holding more excess reserves is a less risky way for banks to earn interest than lending the money to a business or buying Treasury bills.

Most other central banks, including the European Central Bank, the Bank of Japan and the Chinese central bank have been increasing the supply of their currencies. This is why the dollar has been rising relative to the value of other currencies and the inflation rate in the US has been close to zero. As long as the Federal Reserve continues its policy of maintaining a stable monetary base, inflation should remain low. With recession looming in many parts of the world and many leading indicators pointing to a recession in the US, no good reason exists for the Federal Reserve to further raise interest rates. The Federal Reserve wants to prevent a recession and has indicated that it would like to see the rate of inflation increase so it is closer to the stated target of 2 percent per year.

Since little or no benefit can come to the Federal Reserve from raising the federal funds rate further, and the costs are substantial both in terms of increased likelihood of recession and reduced net income to return to the Treasury, do not be surprised if the federal funds rate remains stable or even falls in 2016. Although this means Americans will not earn much on their savings accounts, the Fed will at least be doing its part to delay the onset of the next recession.

Renewable Energy Mandates: A costly burden for the poor

Replacing fossil fuels with renewable energy to reduce carbon dioxide (CO2) emissions sounds like a good idea. It is certainly popular with government officials; twenty nine states, the District of Columbia, and Puerto Rico mandate use of renewable sources to generate electricity.

But with the high cost of these mandates and their impact on millions of low-income families struggling to make ends meet, state governments need to rethink their policy.

A recent study by the Manhattan Institute noted that these mandates have already increased electricity rates substantially in many states and will continue to do so. The mandates are called renewable portfolio standards (RPS) and require utilities to generate a specified minimum amount of electricity—ranging from 10 percent in Michigan to 40 in Hawaii—from wind, solar, biomass, hydroelectric, and geothermal sources. California’s standard requires that one-third of electricity in that state is generated from renewable sources by 2020.

The mandates have already had an impact in the states that have passed them. States with an RPS have seen bigger rate increases. Coal-dependent RPS states have seen residential rates increase by an average of 54.2 percent between 2001 and 2010, more than twice the increase in coal-dependent states without one. In Ontario, which is further along in this than most US states, the government has projected that electricity rates will increase by 46 percent over the next five years. The Manhattan Institute estimates that obtaining 20 percent of electricity from wind energy would lead to a 48 percent increase over the current price in coal-dependent regions of the US.

Besides the rising cost of electricity to consumers that will result from renewable energy mandates, the federal government is losing billions on subsidies and loan guarantees to companies, like Solyndra, that have gone or will likely soon go bankrupt. State and local governments, too, face expenses and loss of tax revenue from efforts to favor renewable energy. With unsustainable levels of debt, governments cannot afford to continue these policies.

Renewable energy costs considerably more than conventional. On-shore wind power, which is the least expensive renewable source widely available, costs more than natural gas even in the best locations, and is expected to cost an average of about fifty percent more by 2016. Instead of using more expensive renewable sources, gradually increasing the use of natural gas and using less coal can reduce the amount of CO2 generated per megawatt hour while lowering generating costs.

The biggest alleged advantage of renewable energy sources is that they will reduce CO2 emissions, but the case for bearing high costs to reduce CO2 emissions is weak. Besides the fact that it is not clear whether or how much increased CO2 emissions have raised global temperatures, or will in the future, the relatively modest reduction that can be achieved by renewable energy mandates will have little impact on atmospheric levels of CO2 and, more important, will reduce future temperatures by only an inconsequential few hundredths of a degree.

It’s time for voters to wake up to the underhandedness of their elected officials’ pursuing CO2 reductions indirectly in spite of public opposition, rather than openly debating whether that is a desirable goal. Cap and trade failed in Congress; RPS is just a sneaky way of slipping it past the public.

If the benefits of reducing CO2 are large enough, the costs of doing so should be openly discussed. Good stewardship requires not only finding a cost-effective way to achieve desirable goals, but also choosing a method that limits the size of any resulting increase in electricity rates for those who already have difficulty paying their utility bills. They are the ones who, as pointed out in The Cost of Good Intentions: The Ethics and Economics of the War on Conventional Energy, a major study by The Cornwall Alliance for the Stewardship of Creation, will be most hurt.

By imposing CO2 reductions on electric utilities, the government is effectively imposing a regressive tax in the form of higher utility rates. Low-income people spend a much higher share of their income on electricity than do high-income people. With the economy growing slowly and a recession looming in the not too distant future, now is not the time to impose higher energy costs on low income Americans.

The Roots of the 2008 Financial Crisis

It is easy and natural for conservatives to blame the 2008 financial crisis, the great recession and the governments flawed response to it of using massive bailouts on political liberals, or on the Bush administration that was not willing to stick to conservative principles. In reality, though, the roots of the crisis go back to economic policy during the Reagan years and before. Yes, Reagan, the icon of many conservatives, pursued policy that contributed to the economic crisis. So says David Stockman in his book, The Great Deformation, and his critique reflects sound economic analysis, not bad feelings directed towards his former boss.

Defenders of Reagan could argue that he wanted to cut government spending more than Congress would let him, and so the high and persistent deficits during his administration were not his fault. That may be the case, but if he was serious about cutting the deficit, he could have done much more than he did both to limit military spending and to seek cuts in the welfare state. The large Reagan-era deficits were part of the process of abandoning old habits of fiscal responsibility that opened the door for reckless policy that brought about the 2008 crisis and the explosive growth of the monetary base and government debt that followed.

Both conservatives and liberals came to believe based on the short run consequences of policy during Reagan’s presidency that deficits don’t matter. In spite of early promises to cut spending along with taxes, federal outlays during Reagan’s second term averaged 21.7 percent of GDP. This level of government spending as a share of GDP was the highest level of peacetime spending in US history up to that time.

Although the Reagan supply-side tax cuts did have a positive effect on the economy, the Reagan deficits did as much or more to the demand side of the economy. Those deficits, which were consistent with Keynesian dogma, contributed to prosperity which lasted for more than twenty years. Supply side growth is reflected in expansion of private investment, but private investment expanded by only 2.5 percent during the Reagan years, while the demand side of the economy grew by 3 percent per year.

The demand side of the economy continued to grow rapidly during the 1990s, while savings rates fell and investment remained low. Thanks to falling import prices due to the growth of low-cost manufacturing in East Asia made possible by cheap labor, American standards of living rose rapidly in spite of low rates of investment. This prosperity, however, was not sustainable. Growing public and private debt ultimately brought about the day of reckoning with the 2008 financial crisis.

Erroneous ideas learned during the Reagan years continue to guide attitudes toward taxes of government spending of many conservatives and liberals, few of whom care any longer about deficits and the explosive growth of government debt. Unfortunately the future obligations of the federal government are now so large that becoming fiscally responsible again could not prevent the government from defaulting. Nevertheless, reducing spending could delay the day of reckoning and would reduce the political pressure for raising taxes that is sure to come when the government can no longer afford to keep its promises to retirees.

How markets could provide affordable health insurance

A major problem with our health care system is that it costs much more to insure people with major health problems than it does to insure the majority who are in reasonably good health. Over the years, governments have used a variety of regulations and subsidies to make it easier for sicker members of the population to afford health insurance. These government regulations and subsidies, however, incentivize people to spend more on health care, raising the average cost of health insurance for everyone. Without the various government regulations and subsidies, markets could provide affordable health insurance for almost everyone by making it possible for people to insure against changes in their health status.
One way that the cost of health insurance is kept down for sicker people is through employer sponsored health insurance plans. Although these plans arose in response to wage controls during World War II, they have grown in importance because of tax deductions and a variety of regulations that have been implemented since then. If the tax deduction was not limited to group health insurance plans offered by employers, many of the healthiest workers would buy their own low cost health insurance in exchange for a higher wage from their employers, who would save the cost of premiums on those workers. If health insurance were not tax deductible, many people would choose less generous coverage for lower premiums than what employers now pay.
Employer sponsored insurance (ESI) works fairly well for those working for large corporations. One drawback is that it discourages workers from changing jobs, particularly if they develop a health condition that will increase the likelihood that they will incur major healthcare expenses. To keep premiums from rising for ESI plans before the Affordable Care Act prohibited them from doing so, health insurers often chose not to cover pre-existing conditions of newly hired workers.
Small companies that provide ESI have an incentive to hire only healthy workers if regulations do not permit insurance companies to exclude pre-existing conditions from the coverage they offer. A small firm also has an incentive to find an excuse to lay off a worker who develops costly health problems while employed, since insurers are likely to raise premiums for firms whose workers incur higher health costs.
Because all of the existing subsidies and regulations are not enough to keep those with chronic health problems from facing premiums that are much higher than average, the Affordable Care Act (ACA) requires insurance companies to provide full coverage for everyone who applies, regardless of health status, and it prohibits companies from varying premiums except based on age or whether the insured smokes. It includes an individual mandate so that healthy people will not opt out of buying insurance. The greater the percentage of healthy people paying premiums, the lower will be the premiums for everyone, including those with chronic illnesses.
Insurance companies will do everything possible to avoid providing insurance to people with chronic health conditions, if they expect to spend more on their care than the premiums they are permitted to charge. The ACA had to devise a complicated system of cross subsidies to get insurance companies to cover those with chronic health conditions at the same prices as everyone else. Government may be able to force insurance companies to provide affordable coverage to high risk people, but without adequate incentives, don’t be surprised if the insurance pays for care from a very limited network of health care providers, severely limiting the options of high risk clients.
Rather than fighting market forces, the best way to promote affordable health care for everyone is to allow entrepreneurs competing in the market to devise a solution that would make it profitable for insurance companies to cover those with high healthcare costs. One solution, proposed by the Heritage Foundation, is health status insurance, whereby people insure against declines in their health status. If early in their lives people could pay extra for insurance against developing a chronic health condition in the future, then insurance companies could afford to cover everyone regardless of what happens to their health over their lives. Premiums for health status insurance would be affordable, even if set high enough to compensate insurance companies for the expected cost of providing high quality care for chronic illnesses, because only a relatively small fraction of a pool of originally healthy young people will eventually develop chronic illnesses that are costly to treat.

What Should be Done about the Fiscal Cliff

Everybody in the media seems to be talking about the fiscal cliff- the likely impact of the expiration of the Bush tax cuts and the planned cuts in government spending that are part of Budget Control Act of 2011. People are right to be concerned about it. Much discussion about the fiscal cliff, and its likely consequences, however, is misleading. The media have emphasized how a tax increase or cut in government spending will reduce overall spending in the economy so that firms have to cut back production and lay workers off. We should be much more concerned about how the fiscal cliff affects investment and entrepreneurship than how it affects aggregate spending.  This is why allowing tax rates to rise, especially on the rich, will do more harm than good. 
Republicans and Democrats claim that they want to reduce the government deficit, which would require some combination of tax increases and government spending cuts. Many are convinced, however, that both the government and families need to spend more to bring the rate of unemployment down. If taxes are increased, households and businesses will reduce their spending. This reduction in private spending, especially if it is combined with a reduction in government spending, may cause a recession.
Although increasing taxes and cutting government spending may have negative short run effects, a more fundamental question is how can the US economy return to a faster long run rate of growth that will make it possible for the millions who are now unemployed to return to work. Contrary to popular belief, the primary reason for the poor performance of the US economy is not that Americans are spending too little. It is rather that businesses are not investing enough in capital equipment and are not willing to hire people because of uncertainty about the future of the economy.  Reducing government spending and borrowing, particularly if the spending cuts are permanent and not temporary, may actually give people greater confidence to invest and start businesses. 
The biggest problem with raising taxes is not that people will spend less.  Higher tax rates influence the incentive to work and invest.  If entrepreneurs and investors expect the government to take 40 cents or more out of every additional dollar they earn, many are going to be less inclined to take the extra risks associated with expanding their businesses and hiring more workers. If, however, the government were to increase its tax revenue by eliminating loopholes in the tax code, the incentive to work and invest would be affected much less than by an increase in tax rates. Certain provisions in the tax code, like the mortgage interest deduction, reward people for doing things that do not help and may actually hinder the long run growth of the economy.  Incentives are the key to a healthy economy, so tax increases are most harmful if they reduce incentives to work and invest, which happens when government requires workers and investors to pay a higher percentage of each dollar earned. 
Why can’t the two sides compromise for the sake of being fiscally responsible- combining moderate tax rate increases with spending cuts?    The debt of the federal government is so large that the token spending cuts being considered by politicians of both parties will do little to prevent government bankruptcy. If the federal government used accounting standards that businesses use, it would count all of its unfunded liabilities, which increase by $11 trillion a year and total more than $200 trillion, as part of the debt. The reported federal government debt excludes trillions of dollars of unfunded Medicare and Social Security benefits that workers expect to receive when they retire in exchange for the taxes they paid during their working years. If a compromise could be reached that involved cuts in promised Social Security and Medicare benefits large enough to make those programs sustainable, it might be worth considering.
A tradeoff exists between short term stimulus of the economy and long term growth. It may be that cutting government spending would slow the growth of the economy in the short run, but that is not a foregone conclusion.  The resulting reduction in government borrowing would mean that more of the money people save would be available to finance private investment.  Increased investment would lead to more and higher paying jobs.  
Continuing to postpone taking steps to drastically reduce government spending, though it may modestly help the economy in the short run, is not the answer. Raising tax rates, however, will do little to address the long run debt problem of the US government and may just make it easier to delay needed spending reductions.  Limiting the share of income taken in taxes and cutting government spending will encourage firms to invest in capital and hire more workers, especially if combined with steps to roll back some of the recent increases in regulation of health care and the financial system, which have contributed so much to uncertainty about the future.