Unattended Consequences

This article reminds me of one of my favorite questions. Here's the question:

Suppose that, in an attempt to induce citizens to conserve energy, the government enacted regulations requiring that all air conditioners be more efficient in their use of electricity. After this regulation was implemented, government officials were then surprised to discover that people used even more electricity than before. Using the concept of price elasticity, explain how this increase might have occurred.

The Debate to Provide Unemployment Insurance

During the past year Congress has fiercely debated the extensions to unemployment compensation.  Typically unemployment compensation lasts 26 weeks, during the current recession recipients are allowed to receive compensation for 99 weeks. Democrats argue unemployment compensation provides a large economic stimulus. The Congressional Budget Office estimates for every $1 provided in unemployment compensation increases GDP by as much as $2. It is by far the biggest bang for our buck program (you can view the report here). With that said, Republicans argue extensions to unemployment compensation create a disincentive to find employment.

In the current labor market, most available jobs are paying near minimum wage. If someone found a job paying $10/hour working 40 hours per week they would earn approximately $1600 per month (less taxes). This same individual can receive $1500 through unemployment compensation. Individuals would conduct a minimal job search. Robert Barro argues that if we had only extended unemployment compensation to 39 weeks the unemployment rate would be 6.8% (you can view his article here).

Now 6.8% sounds like a magical number. Previously I argued the large losses in manufacturing would make it difficult to have unemployment under 7%. Who am I to argue with Robert Barro. After all he is a Harvard economist and a fellow at the Hoover Institute. I see two major problems with Barro's analysis. First he uses the 1982-83 recession as his baseline and second he fails to account for any structural change in the economy.

The 1982 recession was largely driven by a supply side shock, high oil prices. Once oil prices started to drop the economy slowly began to recover. Our current recession is driven mainly by a large fall in demand. The recovery is conditional on household spending and firms increasing production. During the 1980's firms were able to increase production as oil prices fell, the same is not true today.

The second, and perhaps larger problem, is the failure to account for a structural change. From 1999-today our economy has lost 7.5 million manufacturing workers. Simply put the jobs are not available for these workers. Perhaps the following graph will help my cause:

What do we learn from the graph. First, job losses were minimal in 1980 compared to today (notice the small decrease in the red line from 1982-1984). Second the job losses were not in the manufacturing section, there were about 1.5 million jobs lost in manufacturing compared to the 7.5 million today. Once we include the construction industry we have 10 million unemployed workers. Given the skill set of these workers I fail to see how they could have found employment in the current labor market.

Finally, Mr. Barro assumes the labor force would remain constant at 153 million workers. This is hardly true. From the beginning of 1982 through 1984 the labor force increased from 109.5 million to 114.7 million. The labor force in 2008 was 154 million. In order to compare apples to apples Mr. Barro should have assumed a labor force of 160 million. So now where do these 6 million workers go? I think most would agree they are discouraged workers, students, and full time parents. Inevitably they would be in the unemployed group. If we add in these workers the unemployment rate today increases to 13.1% and even under Mr. Barro's analysis it would be 10.7%.

Mr. Barro's magical 6.8%, is indeed a magical illusion. The government needs to tie in work and school programs for those wishing to receive unemployment compensation. Why not make them go back to school or work in community service programs. Mr. Barro is right, we should not pay people for doing nothing, but simply cutting unemployment compensation does not solve our unemployment problem. We need to find 21 million jobs (15 million that are unemployed and 6 million not in the labor force) or even if we minimized unemployment compensation like suggested our economy still needs to find 17 million new jobs.

The 5 new normals

Fortune magazine published an article addressing permanent changes likely to occur following the Great Recession. You can view the article here.

We have already discussed the likely causes of higher long-term unemployment and higher taxes for the wealthy. The article also mentions saving over spending. Households have shifted from consumption to saving. Over the last decade US households relied on asset price appreciation for accumulating wealth. Houses became ATMs. Households stopped saving money. We used the stock market and homes to buy an excessive amount of goods. These spending levels contributed to record trade deficits and debt levels. Following the housing crash, most families saw their retirements shrink and housing equity disappear. Additionally it has become more difficult to obtain credit for major purchases.

We are seeing the paradox of thrift. As households respond to the economic downturn by saving more, consumption will decrease. Subsequently, GDP will decrease. In the short run added saving will hurt our recovery effort, but I believe added saving will greatly improve our countries fundamental positions. Added domestic saving we help offset government deficits and the need for foreign funding. Added saving levels will help keep interest rates low in the long run. Later in the term we will look at some of my research that looks at the relationship between domestic saving rates, economic growth, and business cycle volatility. I would rather see the government focus on policies that promote added domestic saving levels. This is something we will continue to discuss throughout the term. Here is a picture of current domestic saving levels. As you can see, domestic saving rates have steady decreased from 1980-2007.

New Economic Paradigm

Below is piece by Joseph Stiglitz. Stiglitz is critical of the standard economic models that guided policies for the last 25 years. Although I agree we are seeing a shift in how economists model the economy, I don't necessarily believe he's story is right. First of all, our models did not assume supply always equaled demand. In more technical terms, this is equivalent to using perfect price/wage flexibility models. Most papers assume some wage/price stickiness. When the economy experiences a demand side shock (assume positive), firms can respond to the added demand by increasing production and prices. If they are operating at capacity, the added demand would raise prices without a large increase in output. But it is also likely these firms will hire more workers at the market wage. In the end, we get higher prices and employment. In time, workers will demand higher wages which will reduce employment.
 
Without question, the financial crisis will change how policy is formed, but we must not forget that modern macro models gave us nearly 25 years of uninterrupted growth.

Needed: a new economic paradigm, by By Joseph Stiglitz, Comentary, Financial Times:

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used “representative agent models” – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality.

Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. After all, their models said that financial markets were always efficient. Remarkably, standard macroeconomic models did not even incorporate adequate analyses of banks. No wonder former Federal Reserve chairman Alan Greenspan, in his famous mea culpa, could express his surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the perverse incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking.

The standard models should be graded on their predictive ability – and especially their ability to predict in circumstances that matter. Increasing the accuracy of forecast in normal times (knowing whether the economy will grow at 2.4 per cent or 2.5 per cent) is far less important than knowing the risk of a major recession. In this the models failed miserably, and the predictions of policymakers based on them have, by now, totally undermined their credibility. Policymakers did not see the crisis coming, said its effects were contained after the bubble burst, and thought the consequences would be far more short-lived and less severe than they have been.

Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient. Celebrated results, such as Adam Smith’s invisible hand, did not hold; the invisible hand was invisible because it was not there. Few today would argue that bank managers, in their pursuit of their self-interest, had promoted the well-being of the global economy.

Monetary policy affects the economy through the availability of credit – and the terms on which it is made available, especially to small- and medium-sized enterprises. Understanding this requires us to analyse banks and their interaction with the shadow banking sector. The spread between the Treasury bill rate and lending rates can change markedly. With a few exceptions, most central banks paid little attention to systemic risk and the risks posed by credit interlinkages. Years before the crisis, a few researchers focused on these issues, including the possibility of the bankruptcy cascades that were to play out in such an important way in the crisis. This is an example of the importance of modelling carefully complex interactions among economic agents (households, companies, banks) – interactions that cannot be studied in models in which everyone is assumed to be the same. Even the sacrosanct assumption of rationality has been attacked: there are systemic deviations from rationality and consequences for macroeconomic behaviour that need to be explored.


But a new paradigm, I believe, is within our grasp: the intellectual building blocks are there and the Institute for New Economic Thinking is providing a framework for bringing the diverse group of scholars striving to create this new paradigm together. What is at stake, of course, is more than just the credibility of the economics profession or that of the policymakers who rely on their ideas: it is the stability and prosperity of our economies.

The writer, recipient of the 2001 Nobel Memorial Prize in economics, is University Professor at Columbia University. He served as chairman of President Bill Clinton’s Council of Economic Advisers and as chief economist of the World Bank. He is on the Advisory Board of INET

The Unemployment Debate

Here is a debate posted on the Economist talking about the issue of cyclical or structural unemployment.

Here is another good blog post talking about the increase in structural unemployment.

It is important to find a reasonable estimate of our potential level of output. This includes understanding the unemployment dynamics and what economists call the natural rate of unemployment. Right now the current unemployment rate is 9.7% if the potential level of output corresponds with a natural rate of unemployment of 5% than we would need to use some form of monetary/fiscal policy to eliminate the output gap. Now the natural rate of unemployment implies no workers are left unemployed due to the economic downturn, there is no cyclical unemployment only structural and frictional. Now suppose over the last decade there has been a structural shift in the make up of our economy. Suppose the United States has a large segment of the population that lacks the skills to find employment in the new economy. This would show up as an increase in structural unemployment. The natural rate of unemployment might be 7% instead of the original 5%. We would still need to use monetary/fiscal policy to close the gap, but with a higher natural rate of unemployment the policy needed would be smaller. So you can see, understanding the make up of unemployment has important consequences for understanding the magnitude of policy.

Further, the level of potential output in our economy, which is based off of the natural rate of unemployment, is used to project future levels of output, government spending, and tax revenues. So as we debate tax reforms it is a necessity to have an understanding over the levels of cyclical and structural unemployment. If we believe the natural rate of unemployment is 5% this would cause estimates of the potential level of output to be subsequently higher leading to higher tax revenues and poor policies today. To give you an idea over the range of estimates this note by the San Francisco Federal Reserve shows nearly every possible estimate of the natural rate to be around 6.3 to 8.4% (ignoring the CBO unemployment based). Notice the low estimate of 6.3% comes for the CBO, who also acts as the government forecaster for future deficits.

As most of us know the unemployment rate is still hovering around 10% and is not showing any sign of dropping. I don't think many economist would disagree over the economy turning out to be worse than we expected, so now we need to ask ourselves why is it at 10% and what can we do to lower it? When we look at policy we need to have an understanding over the type of workers that are unemployed. Are these workers in the manufacture, service, or construction industries? Additionally, we need to ask if they are unemployed for cyclical or structural causes. If all the workers were unemployed because of the recession, i.e. the cyclically unemployed, than the priority of the government should be on the economic recovery and finding programs to increase GDP. Here is where you could advocate for direct government spending programs. Unfortunately, I suspect the high unemployment has more to do with a structural shift in the labor market. Essentially, those looking for jobs lack the available skills to find employed. I will discuss this more in a bit.

Before getting to these answers it will be helpful to review some key figures. The first figure shows our the national unemployment rate (in percent, blue line) and median duration of being unemployed (in weeks, red line) dating back to 1970. There are a couple things to notice. First the unemployment rate is decreasing, but it remains near that 10% level. Unlike previous recessions the unemployment rate has not dropped suddenly. The median duration of unemployment shows no signs of decreasing. The median worker has been unemployed for nearly 26 weeks with a large number of workers unemployed for over a year. 

Workers are having difficulty finding jobs.  The graph on the right shows that workers are slowly moving into the group unemployed for more that 27 weeks (blue line). Nearly 7 million workers are in this situation. Further these numbers are not accounting for the million or so workers that have left the workforce and fall into the discouraged worker category. So where did these workers come from and what can we do to find them jobs?

To fully understand the unemployment problem we need to look at our economy over the last decade. Starting in 1999 manufacturing sectors began losing jobs. From 1999 through 2003 nearly 4 million manufacturing jobs were lost. Now many people will point the finger at China and claim they stole our jobs. Unfortunately, that is just not true. If the jobs didn't go to China they would have moved to Mexico, Brazil, or a number of other Asian or Latin American countries. China didn't steal our jobs as much as we handed our jobs to them.

A quick side bar: following the Asian, Russian, and Latin American crises throughout the 1990s many foreign investors began seeking safe investments within the United States. As they increased their demand for foreign assets the US dollar reached record highs. Yes, a large purchaser of US assets was China, but they only represent a modest amount when considering the many European, oil producing, Asian, and Latin American economies that were also seeking safe US assets. The large appreciation in the dollar made US goods more expensive on the global market but made foreign goods cheaper for Americans. As producers found it more difficult to sell their products to foreign and domestic buyers it made sense to move operations abroad. Now this situation only tells part of the story. Firms will only shift operations if they believe the exchange rate appreciation was a long-term event. The large appreciate was more likely the final straw. For years US manufacturing firms have been struggling to remain competitive due to union demands. Many unions hold monopolies within their industries (the United Auto Workers Union is the union for all US auto workers). This gave them tremendous leverage when negotiating wage contracts. Wage distortions created by the unions made it extremely difficult to remain in business. This left many firms shifting operations overseas. Back in 2005, NPR did a great comparison between GM and Toyota facilities operating in the United States. You can view it here. This comparison highlights the difficulties union firms have when facing competition from domestic non-union firms.

The graph on the right shows the large decline in manufacturing. Starting in 1999 the economy lost 3 million manufacturing jobs. The jobs losses slowed down during the housing boom, where we see the construction industry providing a temporary home for displaced manufacturing workers. As you can see today the recession has caused the manufacturing industries to lose another 2-3 million jobs but this time the construction industry has also lost 2-3 million jobs. 

At the peak in 2000 manufacturing and construction industries provided over 24 million jobs. This is nearly 20% of our labor force. Today the two industries have 17 million workers. We have lost over 7 million construction and manufacturing jobs. So what can be done to help the economy recover. Given these job losses it will be nearly impossible for the economy to return to the days of 5% unemployment. The structural factors we very likely keep unemployment around the 7% levels we discussed above.

In the short run we need to create projects for these workers. We needed to spend the $800 billion in stimulus funds on badly need infrastructural upgrades. This could have been building or updating schools, hospitals, highways, bridges, and/or the power grid. These projects could have been conducted using private/public partnerships and paid for through user fees.

Nevertheless these types of programs only address the immediate needs of the economy, they do not address the large job losses that have occurred in manufacturing. We need to spend considerable amounts of time, energy, and money retraining our labor force. We need to encourage more vocation training at the high school level and find incentives for small business to continue hiring. Pressuring China into letting the yuan appreciate will have a modest impact on the manufacturing jobs and ultimately place greater burdens on households in the form of higher prices. We need to break up the monopoly unions have in the labor markets (if we want to continue with a unionized labor force let's look at Germany and Japan for ideas, more on this later) which will allow American manufacturing to become relevant again.

More on the extension of Bush's tax cuts

Here are three articles written recently about the tax cuts set to expire at the end 2010.

Robert Frank (our textbook author) argues in favor of letting the tax cuts expire for the rich

Mark Zandi (chief economist for Moody's) discusses the benefits of not letting the tax cuts expire immediately for the rich.

Jeff Frankel (Harvard economist) discusses the political conundrum facing the republicans.
 
Stemming from the dot com bubble and subsequent economic growth during the late 1990's the U.S. government experienced their first annual government surplus since the 1960s. The graph below shows the net government saving from 1960-2010. To help offset the recession in 2001 both Democrats and Republicans were pushing for tax cuts. In the end George Bush lowered the tax rates and capital gains taxes through 2006 (in 2003 the tax cuts were extended through 2010). Many economists were against these tax cuts. They were very large and would worse the federal deficit (you can see this in the graph below). These tax cuts were not designed to help the economy recover but were politically driven. Tax cuts to help the economy recover would have been lasted a shorter duration, been more targeted toward businesses, and lower income households. Nevertheless, in 2003 Bush decided to extend the tax cuts while simultaneously embark on two wars. The Bush administration argued that reducing tax rates will increase tax revenue (see the previous post). Nearly all economists question this result. 

Here we are nearly a decade later, still engulfed in the largest economic downturn since the Great Depression. The federal government has already passed an $800 billion stimulus bill and now have found themselves wondering what to do now. Unemployment rates are near 10% and show little sign of returning to normal levels. Letting the tax cuts expire in their entirety will save the government between $3-5 trillion over the next ten years. This is a sizable chunk of the $20 trillion debt that is currently being projected. But given the current state of the economy letting the tax cuts expire is infeasible.

The Democrats want to extend the tax cuts to all but the wealthiest Americans (singles making over $200,000 and families making $250,000) while republicans want to extend the tax cuts for all Americans. So who's going to win? I think Frankel makes some very good points, can the Republicans afford (politically) to not vote for a bill that excludes extending the tax cuts on the wealthiest Americans? This is an election year.

By letting the tax cuts expire for the highest income group (less than 3% of American) will save approximately $1 trillion dollars. The old adage used to say the highest income group would save the money, channel it into financial institutions and allow these institutions to make more loans (home, consumer, and small business loans). Right now banks are not making more loans, the economic uncertainty has contributed to a massive slowdown in bank lending. Tax cuts should be targeted toward income groups that are most likely to spend them locally. These are the biggest bang for the buck programs.

In an ideal world here's what I would like to see happen. Republicans should negotiate with the Democrats to allow the tax increases to be phased in over the next 3-4 years. As it stands the highest tax brackets the 33% and 35% groups will increase to 36% and 39.6%, why not allow for gradual increase say 1% per year. This will prevent a further economic slowdown. Further if Republicans cared about the budget (like the say they do) they should push the Democrats for spending cuts (after 3-4 years) to pay for the tax cuts. This way you get the extension of the tax cuts for all income groups in the short run and future deficits will not be increasing in the long-run.

Of course this option requires political cooperation, something we've seen very little of. Whether or not all or a portion of the tax cuts get extended does not solve the long-term fiscal imbalances facing our country. The government needs to focus on medicare and social security. The CBO shows nearly half of all government spending programs will end up in either medicare or social security

You may notice net interest payments amount for 14% of government spending. That's right, by 2020 the government will be spending nearly $1 trillion a year to pay interest on the government debt.

Where does the Laffer Curve Bend

Back in the 1980's Arthur Laffer drew up the famous Laffer Curve on a napkin. This napkin became a staple in Reaganomics (and Bushonomics). The idea was simple, at what tax rate does the federal government maximize tax revenue. When we say tax rate we are looking at the highest margin tax rate. If the federal tax rates are zero or one hundred percent the government will not collect any revenue. So as the tax rate increases from zero the government will begin collecting more revenue. Eventually there is a point that maximizes tax revenue. Once tax rates increase beyond this maximizing point individuals will work less (higher tax rates reduce after tax income) as the cost of consuming added leisure decreases. Those clamoring for tax cuts often site the Laffer Curve as evidence in favor of large tax cuts. If current tax rates are above the maximizing tax rates then the government can increase revenues by cutting tax rates:

As we can see in the figure to the right, the government can lower tax rates (from B to the Equilibrium point) and increase tax revenue. This is a wonderful outcome. Everyone would like it to be true. Proponents of the Laffer Curve cite the tax cuts by JFK where the highest marginal tax rate was reduced from 90 percent to 70 percent and the Reagan tax cuts that reduced it to 28%. Reagan was later forced to increase the rates to offset large budget deficits.


So why does this matter today? Well under the Bush tax cuts of 2001 the top tax bracket was reduced from 39.6% to 35%, but these tax cuts are expiring at the end of 2010. So as you can imagine the issue has become highly political. We allowing the tax rates increase from 35% to 39.6% decrease tax revenues? This will in turn make the budget deficit even worse? Most seem to think not. So where does the revenue maximizing point lie?


Here's is a great review by Ezra Klein: Where does the Laffer Curve bend?

In reality the Laffer curve is not smooth. Perhaps a more accurate picture of the Laffer Curve is the right.

Economic Recover by Jeffrey Sachs

Here is a nice write up by Jeffrey Sachs focus on using economic stimulus to promote long-run growth.

Link to Financial Times article (you may have to register) 

Sow the seeds of long-term growth

By Jeffrey Sachs
Published: July 21 2010 14:59 | Last updated: July 21 2010 15:18

The world economy is entering a new phase after the failure of fiscal stimulus to create a sustained recovery in either the US or Europe. In the US, consumers have retrenched, housing starts have crashed and a double-dip recession is possible. In Europe, fiscal retrenchment is under way after intense market pressures. A new approach to recovery is needed.

The striking feature in the current debate about austerity and stimulus has been the lack of attention to investment. Consumers will not provide the engine of recovery, nor should they after overspending for a decade. Instead, the US and Europe should be using the recent corrective boost in saving rates to promote long-term investments in physical and human capital as the proper way back to sustained growth.

Despite the evident need for a rise in national saving after 2008, President Barack Obama tried to prolong the consumption binge by aggressively promoting home and car sales to already exhausted consumers, and by cutting taxes despite an unsustainable budget deficit. The approach has been hyper short term, driven by America’s two-year election cycle. It has stalled because US consumers are taking a longer-term view than the politicians.

By contrast, the administration’s interest in boosting investment has been haphazard. Mr Obama has shown a strange inability to articulate an operational and forward-looking policy framework in signature areas such as healthcare, energy, climate change, and long-term fiscal policy. At a time when China is building hundreds of miles of subway lines, tens of thousands of miles of highways, a couple of dozen nuclear power plants, and a network of tens of thousands of miles of high-speed intercity rail lines, the US struggles to launch a single substantial project. China saves and invests; the US talks, consumes, borrows, and talks some more.

It is wrong in this context to believe that the only choice is further fiscal stimulus versus a repeat of the Great Depression. Further short-term tax cuts or transfers on top of America’s $1,500bn budget deficit are unlikely to do much to boost demand, while they would greatly increase anxieties over future fiscal retrenchment. Households are hunkering down, and many will regard an added transfer payment as a temporary windfall that is best used to pay down debt, not boost spending.

Businesses, for their part, are distressed by the lack of direction. The US Chamber of Commerce was not simply lobbying when its director of government affairs recently declared to the Financial Times that: “When businesses try to plan out what their tax liabilities will be next year, or game out credit availability or the investment climate, they just don’t know what it will look like. Uncertainty is a real killer.”

A proper US investment recovery plan has five parts. The first is a significant boost in investments in clean energy and an upgraded national power grid. These should be promoted through guaranteed price subsidies to clean energy to be financed by gradually rising carbon taxes, as the clean energy capacity comes on line during the coming decade. The alternative cap and trade system is cumbersome, unnecessary and politically dead.

The second is a decade-long programme of infrastructure renovation, with projects such as high-speed inter-city rail, water and waste treatment facilities and highway upgrading, co-financed by the federal government, local governments and private capital. Such projects are complex, requiring government leadership in land management, project design, public-private co-operation and partial subsidy or credit guarantees. New tools can help, such as a national infrastructure bank – championed last year before plans were strangely downplayed.

The third component is more education spending at secondary, vocation and bachelor-degree levels, to recognize the reality that tens of millions of American workers lack the advanced skills needed to achieve full employment at the salaries that the workers expect. The unemployment crisis is largely a structural crisis of job skills. It is hitting young workers – many of whom should still be learning – and older workers who lack a degree.

The penultimate part of the plan is boosting infrastructure exports to Africa and other low-income countries. China is running circles around the US and Europe in promoting such exports of infrastructure. The costs are modest – essentially just credit guarantees – but the benefits are huge, in increased exports, support for African development and a boost in geopolitical goodwill and stability.

The fifth and final element should be a medium-term fiscal framework that will credibly reduce the federal budget deficit to sustainable levels within five years. This can be achieved partly by cutting defence spending by two percentage points of gross domestic product, meaning ending the Iraq and Afghanistan occupations and cutting wasteful weapons systems. Other measures should include gradually phasing out the tax subsidy on high-end health insurance, taxing Wall Street bank profits and bonuses, raising high-end marginal tax rates and, if necessary, introducing a small value added tax. Public investment costs could be financed mainly by public tolls, gradually rising carbon taxes and by repayments of international loans to finance the export of infrastructure.

The Obama administration and Republican opposition are both guilty of irresponsible short-termism and lack of forward-thinking. Both would dangerously prolong the budget deficit, the first through a combination of increased fiscal transfers and tax cuts, and the latter through even larger and more unsustainable tax cuts. Neither would do what America needs and China is doing better: investing for the future through serious attention to sustainable energy, cutting-edge infrastructure, enhanced labour-force skills and the promotion of international development through the export of infrastructure.