Fernandez-Villaverde and Ohanian on European Economic Errors for the U.S. to Avoid

Jesus Fernandez-Villaverde and Lee Ohanian, "European Economic Errors for the U.S. to Avoid," The Wall Street Journal, December 29, 2014

The story of the Continent’s moribund economy began long before the European Central Bank was founded.

The euro area’s gross domestic product grew a minuscule 0.2% in the third quarter, reflecting very weak performance in Germany (0.1%), France (0.3%) and Italy (minus 0.1%). Spain was the rock star of the large countries, clocking in at 0.5% growth. That investors reacted positively to this abysmal news shows how inured Europeans have become to economic stagnation.

Debates about how to revive the Continent have centered on the European Central Bank’s monetary policy, and on restoring fiscal responsibility in the euro area’s more profligate governments. But the story of Europe’s moribund economy goes back many years before there was an ECB, or before Greece, Spain and Portugal had piled up enormous debt. And that story has uncomfortable relevance for the U.S., if the American economy is going to sustain the encouraging 5% third-quarter GDP growth reported earlier this month.

Europe grew much faster than the U.S. in the decades after World War II. European firms rapidly adopted and developed new technologies and became vigorous competitors. Its people worked longer hours than in the U.S.

France’s per capita GDP, for example, rose from only about half of the U.S. level in 1950 to nearly 80% by 1980, according to data from the Penn World Table, the standard source for international comparisons. But the country began to slide almost immediately following the election of President François Mitterrand, head of the French Socialist Party, in 1981. Today, French per capita GDP is, in relation to the U.S., at about the same level as in 1967. A similar pattern holds for Italy, whose post-World War II boom also ended around 1980. Today, Italy’s GDP per capita is slightly below its 1997 level.

What happened? Europe began adopting high-tax, high-spending, high-regulation and competition-restricting policies that depressed the incentives to hire new workers, to invest in new plants and equipment, and to take risks to start new businesses. The result was a large drop in the number of hours employees worked, in business investment, and in the creation of new economic activity and the adoption and development of new technologies.

Total factor productivity growth, which reflects how technological progress and efficiency improvements make capital and labor inputs more productive, is widely agreed upon by economists as the major factor driving long-run living standards. This growth has been negative in the major euro countries—and today total factor productivity is lower in France, Italy, Spain and even Germany than in 1980. By comparison, U.S. total factor productivity is about 35% higher.

An important cause is the failure of European startups to achieve large-scale success. The Economist magazine has noted that between 1976 and 2007 only one Continental European startup, Norway’s Renewable Energy Corp., achieved a level of success (defined by market capitalization) comparable to Microsoft , Apple, Oracle and the other 20 U.S. startups from that period making the Financial Times Index of the world’s 500 largest companies.

A mare’s nest of economic policies impede European business formation. Tax rates are high—France, for instance, collects about 45% of GDP as tax revenue, compared with 24% in the U.S. Then there are the regulation and licensing restrictions that protect incumbent producers and raise barriers to entry. Obtaining a building permit can take years in Italy, and France has made free shipping from Amazon illegal to protect mom-and-pop bookstores. A 2002 study of how nations regulate the entry of new businesses ranked Italy 75th out of 85 countries, sandwiched between Mali and Senegal, and France ranked 71st, trailing Burkina Faso and Malawi, among others.

Returns to venture-capital firms in Europe have averaged only about 2% a year since 1990, according to Thomson Reuters, compared with an average of about 13% in the U.S. Not surprisingly, there is less private venture capital in Europe, where some 40% of venture funding comes from public money. The European Investment Fund, the EU-backed fund that doles out venture capital, chooses businesses influenced by political factors such as country location and industrial sector, rather than on their profit potential.

The lesson of all this—don’t be like Europe—should be clear enough. But U.S. policy makers have ignored it.

American business is facing an ever-increasing pile of regulations and subsidies that protect incumbents but discourage new entry. These range from established hospitals blocking new hospitals through Certificate of Need state laws, to taxicab restrictions that try to block Uber ride-sharing, to an explosion in licensing-board restrictions that make it difficult for average Americans to open small businesses such as auto shops or even hair salons. Meanwhile, subsidies continue to attract investment to uneconomic industries including wind power and solar power.

At the same time, increased marginal tax rates, higher tax rates on capital gains and dividends and the surtax on investment income discourage investment, hiring and new business formation. Since 2008, the U.S. startup rate has declined nearly 20%, and U.S. business sector productivity growth, which has historically grown at 2.5% a year, has only been growing about 0.9% a year since 2010, according to Bureau of Labor Statistics data.

How to help the U.S. economy keep building on its recent growth spurt? Antiquated and restrictive immigration laws that prevent high-skill workers and entrepreneurs from working in the country and starting businesses need to be updated. Corporate tax rates should be lowered while special deductions and loopholes should be eliminated. Overly restrictive regulation that makes it costly to finance small businesses need to be reformed.

In short, incentives to hire, invest and start new businesses need to be a priority, lest the sclerotic U.S. economic growth of the past six years returns and, as in Europe, becomes a permanent condition.

Mr. Fernández-Villaverde is a professor of economics at the University of Pennsylvania. Mr. Ohanian is a professor of economics at UCLA and a senior fellow at the Hoover Institution

Rubin and Turner on the Cost of America’s High Incarceration Rate

Robert Rubin and Nicolas Turner, "The Steep Cost of America’s High Incarceration Rate," The Wall Street Journal, Dec. 25, 2014 4:36 p.m. ET

About one of every 100 U.S. adults is in prison. That’s five to 10 times higher than in Western Europe.

One of us is a former Treasury secretary, the other directs a criminal-justice institute. But we’ve reached the same conclusions. America’s overreliance on incarceration is exacting excessive costs on individuals and communities, as well as on the national economy. Sentences are too long, and parole and probation policies too inflexible. There is too little rehabilitation in prison and inadequate support for life after prison.

Crime itself has a terrible human cost and a serious economic cost. But appropriate punishment for those who are a risk to public safety shouldn’t obscure the vast deficiencies in the criminal-justice system that impose a significant drag on the economy.

The U.S. rate of incarceration, with nearly one of every 100 adults in prison or jail, is five to 10 times higher than the rates in Western Europe and other democracies, according to a groundbreaking, 464-page report released this year by the National Academy of Sciences. America puts people in prison for crimes that other nations don’t, mostly minor drug offenses, and keeps them in prison much longer. Yet these long sentences have had at best a marginal impact on crime reduction.

This is not only a serious humanitarian and social issue, but one with profound economic and fiscal consequences. In an increasingly competitive global economy, equipping Americans for the modern workforce is an economic imperative. Excessive incarceration harms productivity. People in prison are people who aren’t working. And without effective rehabilitation, many are ill-equipped to work after release.

For the more than 600,000 people who leave prison and re-enter society every year, finding employment can be a severe challenge. Prison time carries a social stigma, which makes finding any job, let alone a good job, all too difficult. The Labor Department doesn’t track the unemployment rate for people with prison records.

But a 2006 study by the Independent Committee on Reentry and Employment found that up to 60% of formerly incarcerated people are unemployed one year after release, with their unemployment rates rising to above 65% during the 2008-09 recession, according to a study in the Journal of Correctional Education. And even when they find employment, people who have been incarcerated earn 40% less than people of similar circumstances who have never been imprisoned, according to a study by the Massachusetts Criminal Justice Reform Coalition. Faced with obstacles to gainful employment, it’s no surprise that 43% of people released from prison end up back behind bars within three years, according to a recent Pew study on recidivism.

The costs of incarceration extend across generations. Nearly three million American children have a parent in prison or jail. Growing up with an incarcerated parent can harm childhood development. Research by Pew shows that children with fathers who have been incarcerated are nearly six times more likely to be expelled or suspended from school. Incarceration therefore helps perpetuate the cycle of family poverty and increases the potential for next generation criminal activity. A 2009 study by two Villanova sociologists found that, from 1980 to 2004, the official poverty rate would have fallen by more than 10% had it not been for our nation’s incarceration policies.

Many of the people who end up in prison are already acutely disadvantaged to begin with. In terms of basic education, more than a third of people in prison do not have a high-school diploma or GED, according to the Justice Department. And Columbia University researchers in 2010 found that two-thirds of people in prison struggled with drug addiction before incarceration. A study released in 2006 by the Bureau of Justice Statistics found that 45% of federal prisoners, 56% of state prisoners and 64% of local jail inmates suffered from mental-health problems.

Instead of allowing these disadvantages to fester in prison, we need new policies that are designed to foster positive change, giving those who are incarcerated the skills they need to re-enter society as productive members of the workforce. For example, the government currently bars people in prison from receiving Pell Grants, a counterproductive policy that should be reversed. Substance abuse and mental-health treatment programs, along with educational support, can help people leave prison healthier and better-equipped to make socially productive choices.

Model programs are being piloted at the state level. For example, the Vera Institute of Justice’s Pathways from Prison to Post-Secondary Education project is working with more than 900 students in 14 prisons. The program provides college classes and re-entry support such as financial literacy training, legal services, employment counseling and workshops on family reintegration. A 2013 meta-analysis by RAND has already found that recidivism decreases when a former inmate graduates from college, which also boosts lifetime earning potential.

And clearly, we need significant sentencing and parole reform. There is widespread bipartisan agreement that we are using prison for too many crimes and for too long, with concentrated effects in many communities. One possibility for reform is the Smarter Sentencing Act, introduced by Democratic Sen. Dick Durbin and Republican Sen. Mike Lee, which boasts 30 co-sponsors and was successfully reported out of the Senate Judiciary Committee this spring. The bill’s House companion also enjoys strong bipartisan support. There are also examples of progress in statehouses around the country. In 2013, 35 states passed bills to change some aspect of how their criminal justice systems address sentencing and parole; since 2009, more than 30 states have reformed existing drug laws and sentencing practices, according to reports from Vera this year.

The time has come to make sensible reform in these four areas—sentencing, parole, rehabilitation and re-entry—a national priority. Doing so could accomplish a tremendous amount for families, communities and the U.S. economy.

Mr. Rubin, a former U.S. Treasury secretary, is co-chairman of the Council on Foreign Relations. Mr. Turner is president and director of the Vera Institute of Justice.

Cochrane on An Autopsy for the Keynesians

John Cochrane, An Autopsy for the Keynesians, The Wall Street Journal, December 22, 2014

We were warned that the 2013 sequester meant a recession. Instead, unemployment came down faster than expected.

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

U.K. Chancellor of the Exchequer George Osborne wrote in these pages Dec. 14 that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The land of John Maynard Keynes and Adam Smith is going with Smith.

Why? In part, because even in economics, you can’t be wrong too many times in a row.

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Our first big stimulus fell flat, leaving Keynesians to argue that the recession would have been worse otherwise. George Washington’s doctors probably argued that if they hadn’t bled him, he would have died faster.

With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly. The story is similar in the U.K.

These are only the latest failures. Keynesians forecast depression with the end of World War II spending. The U.S. got a boom. The Phillips curve failed to understand inflation in the 1970s and its quick end in the 1980s, and disappeared in our recession as unemployment soared with steady inflation.

Still, facts and experience are seldom decisive in economics. Maybe Washington’s doctors are right. There are always confounding influences. Logic matters too. And illogic hurts. Keynesian ideas are also ebbing from policy as sensible people understand how much topsy-turvy magical thinking they require.

Hurricanes are good, rising oil prices are good, and ATMs are bad, we were advised: Destroying capital, lower productivity and costly oil will raise inflation and occasion government spending, which will stimulate output. Though Japan’s tsunami and oil shock gave it neither inflation nor stimulus, worriers are warning that the current oil price decline, a boon in the past, will kick off the dreaded deflationary spiral this time.

I suspect policy makers heard this, and said to themselves “That’s how you think the world works? Really?” And stopped listening to such policy advice.

Keynesians tell us not to worry about huge debts, or to default or inflate them away (but please, call it “restructuring” or “repairing balance sheets”). Even the Obama administration has ignored that advice, promising long-run solutions to the debt problem from day one. Europeans have centuries of memories of what happens to governments that don’t pay debts, or who need to borrow for a new emergency but have stiffed their creditors once too often. More debt? Nein danke!

In Keynesian models, government spending stimulates even if totally wasted. Pay people to dig ditches and fill them up again. By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume. That’s a hard sell, so stimulus is routinely dressed in “infrastructure” clothes. Clever. How can anyone who hit a pothole complain about infrastructure spending?

But people feel they’ve been had when they discover that the economics is about wasted spending, and infrastructure was a veneer to get the bill passed. And they smell a rat when they hear economic arguments shaded for partisan politics.

Stimulus advocates: Can you bring yourselves to say that the Keystone XL pipeline, LNG export terminals, nuclear power plants and dams are infrastructure? Can you bring yourselves to mention that the Environmental Protection Agency makes it nearly impossible to build anything in the U.S.? How can you assure us that infrastructure does not mean “crony boondoggle,” or high-speed trains to nowhere?

Now you like roads and bridges. Where were you during decades of opposition to every new road on grounds that they only encouraged suburban “sprawl”? If you repeat in your textbooks how defense spending saved the economy in World War II, why do you support defense cutbacks today? Why is “infrastructure” spending abstract or anecdotal, not a plan for actual, valuable, concrete projects that someone might object to?

Keynesians tell us that “sticky wages” are the big underlying economic problem. But why do they just repeat this story to justify inflation and stimulus? Why do they not advocate policies to undo minimum wages, labor laws, occupational licenses and other regulations that make wages stickier?

Inequality was fashionable this year. But no government in the foreseeable future is going to enact punitive wealth taxes. Europe’s first stab at “austerity” tried big taxes on the wealthy, meaning on those likely to invest, start businesses or hire people. Burned once, Europe is moving in the opposite direction. Magical thinking—that, contrary to centuries of experience, massive taxation and government control of incomes will lead to growth, prosperity and social peace—is moving back to the salons.

Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working. Even supporters acknowledge that Dodd-Frank and ObamaCare are a mess. Too many people on the bottom are stuck in terrible education, jobless poverty, and a dysfunctional criminal justice system. But the policy world has abandoned the notion that we can solve our problems with blowout borrowing, wasted spending, inflation, default and high taxes. The policy world is facing the tough tradeoffs that centuries of experience have taught us, not wishing them away.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar at the Cato Institute.