Economic Reporting Review By Dean Baker May 5

Economic Reporting Review
By Dean Baker
May 27, 2003

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OUTSTANDING STORIES OF THE WEEK

Leading Drugs for Psychosis Come Under New Scrutiny
Erica Goode
New York Times, May 20, 2003, Page A1
http://query.nytimes.com/gst/abstract.html?res=F60611FA3B5A0C738EDDAC0894DB404482

This article presents the findings of a significant body of medical research which indicates that a new generation of drugs designed to treat psychosis may not be nearly as effective as had been generally believed. The article notes that drug manufacturers have been eager to tout the benefits of these new drugs, but their claims have often not been supported by evidence.

Firms’ Push to Enter Banking Wins Hill Support
Kathleen Day
Washington Post, May 23, 2003, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A28446-2003May22.html

This article reports on a proposal before Congress that would ease restrictions on other firms owning banks. The article carefully presents many of the key arguments for and against such a change in the law.

Deflation

Consumer Prices Fall Slightly
John M. Berry
Washington Post, May 17, 2003, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A1161-2003May16.html

Treasury Chief’s Words Send Dollar Lower
Paul Blustein
Washington Post, May 20, 2003, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A12822-2003May19.html

Greenspan Hints at Another Rate Cut
John M. Berry
Washington Post, May 22, 2003, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A22977-2003May21.html

Greenspan, Broadly Positive, Spells Out Deflation Worries
David Leonhardt
New York Times, May 22, 2003, Page C1
http://www.nytimes.com/2003/05/22/business/22FED.html

These articles discuss the possibility that the economy will be facing a deflationary situation in the near future. The problems created by deflation are not presented entirely accurately in these articles.

For example, several articles note that the nominal interest rate cannot turn negative, which means that the Fed loses its ability to stimulate the economy with lower interest rates, once the Federal Funds rate reaches zero (it is currently 1.25 percent). If the price level is actually falling, then the real Federal Funds rate (the nominal interest rate minus the inflation rate) would still be positive if there is deflation, and the Fed would have no ability to lower the rate further.

While this is true, the bigger problem facing the Fed is that long-term interest rates, such as the mortgage interest rate and the interest rate paid on corporate bonds, which have much more impact on the economy, are not likely to come down much further, even if the Fed were to lower the Federal Funds rate. (This is the case of the “liquidity trap” first described by Keynes.) This means that the real interest rate on mortgages and corporate bonds will likely rise if inflation falls further, regardless of the actions of the Fed. The situation will become worse if there is actually deflation, but it is not qualitatively different from the situation the economy is currently facing. After all, the Fed cannot lower short-term rates all that much right now, from 1.25 percent.

The articles also note that borrowers will find it more difficult to repay their loans if there is deflation. Again, this is true, but it is also true any time there is a fall in the rate of inflation. Lenders always assume a certain rate of inflation when they borrow money. For example, a corporation may issue a bond paying 9.0 percent interest, when they anticipate that the rate of inflation will be 3.0 percent. If the rate of inflation ends up being just 1.0 percent, then it will be harder to repay this loan than they had expected. The situation is worse if the economy ends up with a deflation rate of 1.0 percent annually, but the impact of the drop from a 3.0 percent inflation rate to a 1.0 percent inflation rate is approximately the same as the drop from a 1.0 percent inflation rate to 1.0 percent deflation rate.

Several of these articles also discuss the possibility that falling prices will lead to a situation in which consumers defer purchases, in the hope that prices will be lower at some point in the future. This view also misrepresents the movement from modest rates of inflation to modest rates of deflation. The inflation rate is an average of all price movements in the economy. Even when the inflation rate was in a range between 2.0 percent and 3.0 percent, as has been the case over the last seven years, there were many items, such as apparel and computers, which had falling prices. As the inflation rate falls further, and possibly turns to deflation, it only means that the percentage of items subject to falling prices increases. It is not a qualitatively different situation than what we are currently experiencing.

Finally, several articles implied that the inflation that could result from rising import prices in the wake of a falling dollar could be good for the economy, since it will help prevent deflation. While the increased demand for U.S. made goods, both here and in foreign countries, will be a beneficial outcome from a falling dollar, the higher inflation will not be. This is easy to demonstrate. Suppose that 15 percent of U.S. GDP is imported (approximately the current percentage) and that the price of these goods rise an average of 10 percent, as a result of a falling dollar. If there were no changes in the prices of domestically produced goods, except to pass on the higher cost of imports, this would lead to an increase in the inflation rate of approximately 1.5 percent (the 10 percent price increase multiplied by the 15 percent share of GDP). This rise in prices corresponds to money leaving the country – as opposed to domestic price increases, which effectively redistribute money within the U.S. economy. In this respect, the increase in prices due to higher import prices can be viewed as similar to a tax increase. In the example given here, the 10 percent increase in import prices would be roughly equivalent to a single year tax increase of $160 billion in the amount of money it would pull out of the economy. Having this amount of money drained out of the economy will definitely have a negative effect. Eventually, the quantity responses to the higher prices – fewer imports purchased in the United States, more exports to other nations – will provide a stimulus to the economy, but the price change itself is clearly a negative factor.

Also, the fact that the dollar is falling could lead to upward pressure on long-term interest rates. This could be the result of bondholders demanding an inflation premium, if they come to believe that the fall in the dollar will lead to future inflation. In addition, there could be increased demand for borrowing in dollars, as firms (both domestic and foreign) see an opportunity to pay back their loans in dollars that will be worth significantly less than the dollars they borrowed. This pattern would also have the effect of pushing up interest rates.

In short, while a fall in the dollar is necessary and will ultimately help boost the economy, it does also have important negative effects (just as the strong dollar had benefits). The fact that the economy could be facing a deflationary situation does not eliminate the negative effects of a falling dollar.

The first article by Berry includes a quote from an economist: “Isn’t it ironic that after spending years working to achieve price stability we decide that we don’t want it?” It would have been useful to present the views of economists who had warned of the problems that could be associated with “price stability” (the words are used here to describe near zero inflation).

Bush Tax Cut

House Is Pushed to Accept Senate’s Tax Cut
Jonathan Weisman
Washington Post, May 17, 2003, Page A6
http://www.washingtonpost.com/wp-dyn/articles/A1550-2003May16.html

Tax Cuts Complicates Democrats’ Campaigns
Jonathan Weisman
Washington Post, May 20, 2003, Page A4
http://www.washingtonpost.com/wp-dyn/articles/A12449-2003May19.html

These articles report on the status of President Bush’s tax cut proposal in Congress. Both articles assert that the proposal to eliminate the tax on dividends from stock held outside of retirement accounts would end the double taxation of dividends. For example, the first article reports that the Bush tax cut proposal was “designed to ensure that all corporate income is taxed only once.”

All corporate income is already taxed only once. Income that corporations pay out to individuals, such as their workers and shareholders, is subject to taxation, but income at the corporate level is only taxed once. The tax at the corporate level is optional, in the sense that if shareholders believed that the benefits granted by the government to corporations did not outweigh the burden of the corporate tax, they would reform the corporation as a partnership. The fact that they voluntarily choose to structure their business as a corporation means that they think the benefits exceed the cost of the tax.

The second article includes assertions that the tax cuts will force Democratic presidential candidates “to concede that they will likely have to raise taxes to enact the central goals of their candidacies.” This assertion implies that Democratic presidential candidates will have their economic agendas subject to much more serious scrutiny by the media and will be more pressured to produce a coherent accounting of their plan, as compared to President Bush. This may turn out to be the case. President Bush's assertions that his tax cut plans will lead to growth and will not increase the deficit were treated far more seriously than they deserved to be, on the basis of current economic research and simple accounting. If Democratic candidates received the same sort of coverage, they might be able to make similar claims about plans for national health insurance or other social programs.

Talks in Congress Dim Hopes for Speedy Tax Cut
David E. Rosenbaum and David Firestone
New York Times, May 17, 2003, Page A13
http://query.nytimes.com/gst/abstract.html?res=F20816F63F5A0C748DDDAC0894DB404482

This article reports on the prospects for President Bush’s tax cut. It reports that the tax cut would provide a $400 per child tax rebate “to nearly all taxpaying families.” Actually, a large percentage of taxpaying families will not get this rebate. The child tax rebate is not refundable and only counts against the income tax. Tens of millions of families with children will not receive this $400 per child tax rebate because their income tax liability is not this large, even though they pay a much larger amount in Social Security and Medicare taxes.

Changing Tack in the Winds of Politics
Helen Dewar
Washington Post, May 18, 2003, Page A6
http://www.washingtonpost.com/wp-dyn/articles/A4053-2003May17.html

This article reports on Pennsylvania Senator Arlen Specter’s re-election campaign. The article reports that he opposed President Bush’s 2001 tax cut because he felt it was too large, but has come out in support of his 2003 tax cut. The article reports Mr. Specter as justifying this position by noting that the 2001 tax cut was $1.35 billion, while the proposed 2003 tax cut is $726 billion.

It would have been worth noting that supporting a $726 billion tax cut in 2003, after the passage of a $1.35 billion tax cut in 2001, is effectively the same as supporting a $2.076 billion tax in 2001. If Senator Specter believed that the 2001 tax cut was already too large, then supporting any further tax cuts two years later is inconsistent with that position.

A Tax Cut Without End
David E. Rosenbaum
New York Times, May 23, 2003, Page A1
http://www.nytimes.com/2003/05/23/national/23ASSE.html

This article provides an assessment of the battle over President Bush’s tax cut. At one point it comments that if the economy picks up, then he can claim credit for his tax cut, but if it doesn’t “he can blame Democrats for opposing his original bill.” While this statement may prove to be accurate, it is more of a comment on the quality of economic reporting rather than the shrewdness of President Bush’s tactics. While the final bill is not exactly what President Bush proposed, legislation almost never gets through Congress without some changes. As President Bush has indicated, he is very happy with the shape of the final bill. If he is later allowed to avoid responsibility for the impact of this tax bill, then it will a result of poor reporting on this issue by the media.

Health Care Reform

Kerry Unveils Health Care, Insurance Plan
Dan Balz
Washington Post, May 17, 2003, Page A7
http://www.washingtonpost.com/wp-dyn/articles/A1086-2003May16.html

Kerry Introduces Health Plan, Pointing Up Divisions Among Democratic Contenders
Adam Nagourney
New York Times, May 17, 2003, Page A12
http://query.nytimes.com/gst/abstract.html?res=F6071EF83F5A0C748DDDAC0894DB404482

These articles discuss the health care reform proposals being forward by the Democratic presidential contenders. The Post article only mentions the universal Medicare proposal put forward by Representative Dennis Kucinich in a single sentence, while the Times article does not mention this plan at all. There is no obvious reason for the neglect of this proposal. Unlike the plans put forward by the other candidates, this proposal is modeled after health care systems that are actually in place in countries such as Australia, Canada, and Denmark. In addition, numerous studies have shown that such plans are far more efficient than the current system in the United States (see the study by the Lewin Group of a series of health care reform proposals put forward in California [www.healthcareoptions.ca.gov]).

In their discussion of the various proposals being put forward the articles only refer to the public sector costs. It is likely that voters would be at least as concerned about the private sector costs, especially since rising costs are the main reason that large numbers of people currently lack health insurance coverage.

Medicare

Bush Drug Proposal in Medicare Plan Faces a Stiff Battle
Robert Pear and Robin Toner
New York Times, May 21, 2003, Page A1
http://www.nytimes.com/2003/05/21/politics/21MEDI.html

This article discusses President Bush’s plans to increase the role of private insurers in the Medicare program. It presents the poles in the debate as being Republicans who believe that increasing the role for private insurers will lower costs and Democrats who are opposed to privatization as a matter of principle. It would have been helpful to note that there is now a large body of evidence that indicates that increasing the role of private insurers in Medicare will raise costs (e.g. “Critics Say Proposal for Medicare and Private Health Plans Could Increase Costs,” by Robert Pear, New York Times, May 6, 2003, Page A23).

Given this evidence, it is reasonable to believe that many opponents of a larger role for private insurers do so out of a desire to save money. It is also plausible that proponents of a larger role are motivated in part by a desire to benefit the insurance industry, a powerful interest group.

The Dollar and the Euro

Euro Beginning to Flex Its Economic Muscles
Mark Landler
New York Times, May 18, 2003, Page A18 http://query.nytimes.com/gst/abstract.html?res=F70912F73E5A0C7B8DDDAC0894DB404482

This article reports on the sharp rise in the euro against the dollar. The article attributes the fall in the dollar in large part to rising federal budget deficits. It is not likely that a large budget deficit would lead to a fall in the dollar. Budget deficits are usually associated with higher interest rates, which would be likely to increase the value of the dollar, as happened in the early and mid-eighties. It is much more likely that the record trade and current account deficits that the United States has been experiencing are leading to a decline in the dollar. If the trade deficit were to remain constant as a share of GDP, within two decades the amount that foreign holdings of U.S. assets exceeded U.S. holdings of foreign assets would be equivalent to the value of the entire U.S. stock market and housing stock.

It is worth noting that when the euro was falling sharply against the dollar, it was often reported as a sign of the weakness of Europe’s economy. Some articles even questioned whether the euro nations were sufficiently competent to engineer a changeover in currencies (e.g. “An Anxious Countdown To New Cash,” Washington Post, August 20, 2001, Page A1). The sharp fall in the dollar has not been treated in the same way.

The article also notes that the decline in the dollar has not led to a shift away from the use of the dollar as a reserve currency. The last year of data available is 2001. Most of the decline in the dollar began after then end of 2001. The fact that countries continued to rely primarily on the dollar as a reserve currency in 2001 does not mean that they would continue to do so in the wake of its sharp decline.