Thursday, June 4, 2015

Return of the Laffer Limit

The excessive financialization of the U.S. economy reduces GDP growth by 2% every year, according to a new study by International Monetary Fund. That’s a massive drag on the economy–some $320 billion per year.

"Properly scaled," Steve Denning writes in Forbes, "the financial sector is a good thing. The financial sector plays a healthy role in translating products and services into exchangeable financial instruments to facilitate trade in the real economy." But
Problems occur when the financial sector gets too big.

Throughout history, periods of excessive financialization have coincided with periods of national economic setbacks, such as Spain in the 14th century, The Netherlands in the late 18th century and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline.

How big is too big? An IMF study in 2012 showed that “once the [financial] sector becomes too large—when private-sector credit reaches 80% to 100% of GDP— it actually inhibits growth and increases volatility. In the United States in 2012, private-sector credit was 184% of GDP.” So the U.S. financial sector is already way too big.

And what’s the cost? The new IMF study quantifies the direct cost to U.S. economic growth of an oversized financial sector: 2% of GDP per year. In other words, if the financial sector were the proper size, the U.S. economy would be enjoying a normal economic recovery of 3% to 4% per year instead of the dismal 1% to 2% of the last few years.

The Forbes article also provides this graph:

Graph #1; From the Forbes Article
Hm. That reminds me of something:

Graph #2, from HowStuffWorks

See it? Same shape.

Some time back, I described how these curves work:
The Laffer Curve was all about taxes. But the Laffer Limit is a practical maximum. In one of those Google hits, J.H. Cochrane refers to "the 'Laffer limit' of taxation." That suggests there can be Laffer limits on things other than taxes.

If you are a government trying to raise revenue, increasing the tax rate brings in more revenue up to a point; beyond the Laffer Limit it brings in less revenue.

If you are a gardener fertilizing your flowers, adding more fertilizer improves the garden up to a point; beyond the Laffer Limit it starts ruining the garden.

If you watch an economy using credit for growth, using more credit increases growth up to a point; beyond the Laffer Limit it starts ruining the economy.

The Laffer Limit refers to the notion of a practical maximum.

Laffer Limit: The point at which continuing to do the same thing begins to have the opposite effect.


jim said...

Hi Art,
The problem with the laffer curve is that it is the wrong answer to the wrong question.

The laffer curve was used as a justification for reducing the capital gains tax. By reducing the tax you end up with more capital gains and thus more revenue, but nobody bothers to ask the right question which is "how does that happen". The answer is asset price inflation. By inflating asset prices you get lots of capital gains but nobody seems to notice that asset price inflation results in no added production.

Finance is the Asset Price Inflation industry.

Economists have been wondering for decades why the velocity of money has been declining. Maybe its because they measure it wrong. Velocity is measured as a ratio of money to GDP transactions. But suppose they measured it as a ratio of money to all transactions? On any given day the NYSE has as much money change hands as the amount of money transactions that pay for that days productive output. Measured against all transactions velocity would be a lot higher. In other words, there is a lot more circulation of money than people think, but a lot of the circulating money isn't going to anything productive.

Jazzbumpa said...

Jim -

Well stated and i totally agree.

I took a look at this from a somewhat different angle a while back.


The Arthurian said...

What Jazz said.

This is a great insight, that velocity would be much higher if we included all transactions rather than just "final" transactions. I never saw that before.

I did read once, maybe twice in 35+ years, that Irving Fisher's version of the equation of exchange actually did consider all transactions. I think it was Friedman who pointed it out before merrily returning to the subset called final transactions.

But Jim, I hope it was clear that I was not arguing for the Laffer curve nor even saying it is right. I was trying to use a familiar concept that people understand, to develop the "The point at which continuing to do the same thing begins to have the opposite effect" idea, and to apply it to EROC, the excessive reliance on credit.