Interest Payments on the Federal Debt

March 18, 2011

Massive increases in the federal debt have garnered public attention, however rising interest on the national debt is another concern among policy makers. In addition to challenges in lowering the total debt, the government may face additional challenges given its abundance of short-term debt with fast-approaching maturity dates. Furthermore, difficulties in predicting the level of future interest payments on the debt may mean that unexpected expenditures may place additional pressures on economic growth and future private investment. In any case, addressing concerns over large government spending and exercising fiscal discipline may be the best way to ensure sustainable interest payments in future years.

Does Government Spending Affect Economic Growth?

June 10, 2010

In response to the financial crisis and its impact on the economy, the federal government has increased government spending markedly in order to stimulate economic growth. With billions of taxpayer dollars appropriated toward this effort, policy makers should examine whether federal spending actually promotes economic growth. Although the studies are not all consistent, historical evidence suggests an undesirable, long-run effect from government spending: it crowds out private-sector spending and uses money in unproductive ways.

Policy makers should use the best literature available to analyze government spending designed to spur growth for the likelihood of achieving that effect. Where the assumptions or data are uncertain, the analysis should fully explore the potential consequences of different assumptions or different potential values for the uncertain data.

TRADITIONAL GROWTH RATIONALES

Proponents of government spending claim that it provides public goods that markets generally do not, such as military defense, enforcement of contracts, and police services.1 Standard economic theory holds that individuals have little incentive to provide these types of goods because others tend to use them without paying.

John Maynard Keynes, one of the most significant economists of the 20th century, advocated government spending, even if government has to run a deficit to conduct such spending.2 He hypothesized that when the economy is in a downturn and unemployment of labor and capital is high, governments can spend money to create jobs and employ capital that have been unemployed or underutilized. Keynes's theory has been one of the implicit rationales for the current federal stimulus spending: it is needed to boost economic output and promote growth.3

These views of spending assume that government knows exactly which goods and services are underutilized, which public goods will be value added, and where to redirect resources. However, there is no information source that allows the government to know where goods and services can be most productively employed.4 Federal spending is less likely to stimulate growth when it cannot accurately target the projects where it would be most productive.

POLITICS DRIVES GOVERNMENT SPENDING

In addition to this information problem, the political process itself can stunt economic growth. For example, Professor Emeritus of Law at George Mason University Gordon Tullock suggests that politicians and bureaucrats try to gain control of as much of the economy as possible.5 Moreover, demand for government resources by the private sector leads to misallocation of resources through "rent seeking"—the process by which industries and individuals lobby the government for money. Rather than spend money where it is most needed, legislators instead allocate money to favored groups.6 Though this may yield a high political return for incumbents seeking reelection, this process does not favor economic growth.

The data support the theory. A 1974 paper by Stanford's Gavin Wright found that political attempts to maximize votes explained between 59 and 80 percent of the difference in per capita federal spending to the states during the Great Depression.7 Ultimately, spending under the Democratic Congress and the president was much more concentrated in Western states, where elections were much tighter than in the Democratically controlled South. Wright's analysis indicates that instead of allocating spending based purely on economic need during a crisis, the party in power may distribute funding based on the prospect of political returns.

THE CONSEQUENCES OF UNPRODUCTIVE SPENDING AND THE MULTIPLIER EFFECT

Proponents of government spending often point to the fiscal multiplier as a way that spending can fuel growth. The multiplier is a factor by which some measure of economy-wide output (such as GDP) increases in response to a given amount of government spending. According to the multiplier theory, an initial burst of government spending trickles through the economy and is re-spent over and over again, thus growing the economy. A multiplier of 1.0 implies that if government created a project that hired 100 people, it would put exactly 100 (100 x 1.0) people into the workforce. A multiplier larger than 1 implies more employment, and a number smaller than 1 implies a net job loss.

In its 2009 assessment of the job effects of the stimulus plan, the incoming Obama administration used a multiplier estimate of approximately 1.5 for government spending for most quarters. This would mean that for every dollar of government stimulus spending, GDP would increase by one and a half dollars.8 In practice, however, unproductive government spending is likely to have a smaller multiplier effect. In a September 2009 National Bureau of Economic Research (NBER) paper, Harvard economists Robert Barro and Charles Redlick estimated that the multiplier from government defense spending reaches 1.0 at high levels of unemployment but is less than 1.0 at lower unemployment rates. Non-defense spending may have an even smaller multiplier effect.9

Another recent study corroborates this finding. NBER economist Valerie A. Ramey estimates a spending multiplier range from 0.6 to 1.1.10 Barro and Ramey's multiplier figures, far lower than the Obama administration estimates, indicate that government spending may actually decrease economic growth, possibly due to inefficient use of money.

CROWDING OUT PRIVATE SPENDING AND EMPIRICAL EVIDENCE

Taxes finance government spending; therefore, an increase in government spending increases the tax burden on citizens—either now or in the future—which leads to a reduction in private spending and investment. This effect is known as "crowding out."

In addition to crowding out private spending, government outlays may also crowd out interest-sensitive investment.11 Government spending reduces savings in the economy, thus increasing interest rates. This can lead to less investment in areas such as home building and productive capacity, which includes the facilities and infrastructure used to contribute to the economy's output.

An NBER paper that analyzes a panel of OECD countries found that government spending also has a strong negative correlation with business investment.12 Conversely, when governments cut spending, there is a surge in private investment. Robert Barro discusses some of the major papers on this topic that find a negative correlation between government spending and GDP growth.13 Additionally, in a study of 76 countries, the University of Vienna's Dennis C. Mueller and George Mason University's Thomas Stratmann found a statistically significant negative correlation between government size and economic growth.14

Though a large portion of the literature finds no positive correlation between government spending and economic growth, some empirical studies have. For example, a 1993 paper by economists William Easterly and Sergio Rebelo looked at empirical data from approximately 100 countries from 1970-1988 and found a positive correlation between general government investment and GDP growth.15

This lack of consensus in the empirical findings indicates the inherent difficulties with measuring such correlations in a complex economy. However, despite the lack of empirical consensus, the theoretical literature indicates that government spending is unlikely to be as productive for economic growth as simply leaving the money in the private sector.

Figure 1

Figure 2

WHY DOES IT MATTER RIGHT NOW?

In 2009, Congress passed the American Recovery and Reinvestment Act, which authorized $787 billion in spending to promote job growth and bolster economic activity.16 The budgetary consequences of this legislation and other government spending initiatives aimed at improving the economic outlook for the federal budget can readily be seen in recent federal outlays. As seen in figure 1, total federal outlays have risen steadily over time, and a sharp increase occurred after 2007. As seen in figure 2, total federal spending as a percentage of GDP has risen sharply in the last two years to nearly 30 percent. As explained above, this spending may have countervailing effects that could actually hamper economic growth by crowding out private investment.

CONCLUSION

Government spending, even in a time of crisis, is not an automatic boon for an economy's growth. A body of empirical evidence shows that, in practice, government outlays designed to stimulate the economy may fall short of that goal. Such findings have serious consequences as the United States embarks on a massive government spending initiative. Before it approves any additional spending to boost growth, the government should use the best peer-reviewed literature to estimate whether such spending is likely to stimulate growth and report how much uncertainty surrounds those estimates. These analyses should be made available to the public for comment prior to enacting this kind of legislation.

ENDNOTES

1. Richard E. Wagner, Fiscal Sociology and the Theory of Public Finance: An Explanatory Essay (Cheltenham: Edward Elgar Publishing, Ltd., 2007), 28.

2. John Maynard Keynes, The General Theory of Employment, Interest, and Money (Orlando, FL: First Harvest/Harcourt, Inc., 1953) 1964 ed.

3. Jane G. Gravelle, Thomas L. Hungerford, and Marc Labonte, Economic Stimulus: Issues and Policies, Congressional Research Service Report for Congress, December 9, 2009, http://assets.opencrs.com/rpts/R40104_20091209.pdf.

4. This is the concept of the "knowledge problem" elucidated by Friedrich A. Hayek, who explained that information necessary to foster efficiency in a market is dispersed among myriad participants and cannot be held by one central organization. For more information, see his essay, "The Use of Knowledge in Society," American Economic Review XXXV, no. 4 (1945): 519-30, http://www.econlib.org/library/Essays/hykKnw1.html.

5. Gordon Tullock, "Government Spending," The Concise Encyclopedia of Economics, The Library of Economics and Liberty, http://www.econlib.org/library/Enc1/GovernmentSpending.html.

6. William F. Shughart, II, "Public Choice," The Concise Encyclopedia of Economics, The Library of Economics and Liberty, http://www.econlib.org/library/Enc/PublicChoice.html.

7. Gavin Wright, "The Political Economy of New Deal Spending: An Econometric Analysis," The Review of Economics and Statistics 56, no. 1 (February 1974): 30-38.

8. Christina Romer and Jared Bernstein, The Job Impact of the American Recovery and Reinvestment Plan, January 9, 2009, http://otrans.3cdn.net/45593e8ecbd339d074_l3m6bt1te.pdf.

9. Robert J. Barro and Charles J. Redlick, "Macroeconomic Effects from Government Purchases and Taxes" (NBER Working Paper no. 15369, September 2009).

10. Valerie A. Ramey, "Identifying Government Spending Shocks: It's All in the Timing" (NBER working paper, October 2009), 32, http://econ.ucsd.edu/~vramey/research/IdentifyingGovt.pdf.

11. Benjamin M. Friedman, "Crowding Out or Crowding In? Economic Consequences of Financing Government Deficits," Brookings Papers on Economic Activity 1978, no. 3 (1978): 596-597.

12. Alberto Alesina, et al. "Fiscal Policy, Profits, and Investment" (NBER Working Paper no. 7207, July 1999).

13. Robert J. Barro, "Government Spending in a Simple Model of Endogenous Growth," The Journal of Political Economy 98, no. 5 (October 1990): S122-S124.

14. Dennis C. Mueller and Thomas Stratmann,"The Economic Effects of Democratic Participation" (CESifo Working Paper no. 656 (2), January 2002), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301260.

15. William Easterly and Sergio Rebelo, "Fiscal Policy and Economic Growth: An empirical investigation," Journal of Monetary Economics, 32 (1993): 432.

16. "The Act," Recovery.gov, http://www.recovery.gov/About/Pages/The_Act.aspx.

Civic Participation and Government Spending

June 2, 2010

Economic theory suggests that the role of government is to spend resources to provide public goods and services that would be unprovided or underprovided by the private sector and to fix other market failures. Furthermore, Hayek (1944) suggested that one function of government is to provide a safety net. While, in theory, these rationales should be behind government spending, in practice, a number of alternative factors drive spending and the growth in government spending. These include citizen demand for government spending, fiscal illusion, institutional arrangements, and interest-group pressure (see, for example, Rodrik 1998, Besley & Case 2003, Rice 1986). These explanations provide alternative rationales for government spending; in many cases, these drivers may lead to outcomes that concentrate benefits on certain groups while reducing total economic welfare.

This paper will review the economics and, more specifically, public choice literature to evaluate some of these theories that explain government spending. Using state panel data from 1980–2008, this paper builds on the literature to empirically test the effect of citizen participation in the political process, measured by voter turnout and the effect of campaign contributions by individuals on state government spending. While individual political contributions and voter turnout are a measure of participation in the political process, they are also indicators of potential rent-seeking efforts or changes in the voting pool that could lead to redistributive policies. The paper will also discuss the implications that these results, controlling for other factors, have on government spending.

Our analysis of the effects of political engagement on government expenditures adds to an extensive and well-established literature on the drivers of government spending. While past work has discussed the effects of economic, geographic, and institutional factors, to the best of our knowledge, previous research has not studied the effects of both political contributions and voting activity on government size. This paper thus contributes to the literature by analyzing how civic participation, evidenced by voting, contributions, and the interaction of the two, influences government spending.

Potential Restrictions on Title Lending

November, 2009

One can hardly turn on a TV without seeing commercials in which cash-strapped individuals bring their car titles to a lender for quick and easy loans. While auto title lending may appear to be somewhat sketchy, it is actually a relatively safe and important source of credit for many Americans. However, current state legislation and a proposed federal rule seek to restrict this practice, with the very aim of protecting borrowers. This misguided paternalism will instead cut many people off from much-needed cash, encourage other, more dangerous lending practices, and potentially lead to other detrimental outcomes such as bounced checks or bankruptcy.

CAR TITLE LENDING AS A CREDIT VEHICLE

Auto title lending grew out of traditional pawn shop operations, allowing borrowers to obtain larger loans by using one of their most valuable assets as collateral. The amount of a car title loan varies; though some studies have found that lenders typically lend about 33 percent of the resale value of the automobile,1 others have documented loans of 50 to 100 percent of the car's value.2 Most loans range from $250 to $1,000, although some are larger.3 This compares very favorably to a typical pawnbroker loan, for which the average value is $70.4 And unlike pawnbroker loans, the borrower is able to keep the asset against which she is borrowing.

Auto title loans also have highly transparent and easily understood pricing schemes. The only price point is the interest rate, and these loans generally do not involve up-front fees or prepayment charges. The Annual Percentage Rate (APR) on a title loan is typically 120–300 percent, depending on the amount borrowed.5 And while the borrower loses her vehicle in the case of default, the loan is usually non-recourse past that point, meaning that the borrower is not personally responsible for the debt. For example, if the car is not in operating condition because of a mechanical breakdown or is resold for less than expected, the lender is still limited to repossession and cannot sue the borrower for any deficiency.

WHO IS USING TITLE LENDING?

Auto title loans fall under the category of non-traditional lending products, which appeal to individuals who may not be able to obtain more formal lending products or need to obtain emergency cash quickly. Perhaps contrary to popular intuition, some title lending is used by moderate-income earners who have enough wealth to own a car of sufficiently high value but who also have impaired credit.

According to the American Association of Responsible Auto Lenders, the typical title loan customer for its members is 44 years old and has a household income of more than $50,000 per year, but is excluded from traditional lenders such as credit card companies, banks, credit unions, and small loan companies. In addition to these moderate-income borrowers, title loans also cater to lower-income consumers. A 1999 study analyzing data from the Illinois Title Loan Company found that 37.6 percent of title loan customers earn less than $30,000 per year, compared to 45.9 percent who earn more than $40,000 per year. Additionally, approximately 46 percent of borrowers are repeat customers, and the average loan duration is between three-and-a-half to four-and-a-half months.6

Title lending is especially attractive to customers without bank accounts and are a more attractive alternative than pawn shop loans. Unlike pawn shop loans, title loans allow consumers to borrow larger sums of money, do not require borrowers to part with collateral, and do not require the transportation of goods to the pawn shops.

In addition to consumers outside of the traditional lending channels, small, independent businesses rely on auto title loans as an important source of short-term working capital. For example, a landscaping company may need several hundred dollars to purchase sod or bushes for a job or to meet payroll expenses. The proprietor may pledge his pickup truck to obtain the necessary capital to buy the supplies to complete the job. Then when the job is complete, the businessman receives payment and can redeem the collateral.

RISKS AND REWARDS

While borrowing against one's car may seem to be an inherently dangerous practice, actual experiences with auto title lending have proven it to be a relatively reliable and stable lending tool. Far from preying on low-income borrowers who are unable to pay the loans back, title lenders seem to be catering to a group of rational consumers who use this method as a means to obtain needed credit because theirs has become impaired.

For consumers who rely on these loans for essential needs, the risks of outlawing title lending may outweigh the rewards. Although there is limited research on why consumers use title lending, research on other non-traditional lending products (such as payday lending) is informative. A 2007 study found that 43 percent of payday loan customers had overdrawn their checking accounts at least once in the previous 12 months7 and primarily used funds for "bills, emergencies, food and groceries, and other debt service."8 Research by two Federal Reserve economists found that when Georgia and North Carolina outlawed payday lending, the incidences of bounced checks, consumer complaints about debt collectors, and chapter 7 bankruptcy filings rose.9 Bounced checks and bankruptcy can be extremely detrimental to one's credit and can carry higher costs than non-traditional lending products. Legislative bans on these lending options exchange a more-stable lending practice for practices that hurt low-income consumers.

Industry sources report that about 14 to 17 percent of title loans default but that only about half of those (8 percent overall) result in vehicle repossession.10 This high percentage of defaults that do not lead to repossession reflects the reality that many of the cars used as collateral tend to be older vehicles that often become damaged or break down over the course of the loan, limiting the incentives to expend the cost of repossession. Furthermore, according to the American Association of Responsible Auto Lenders, more than 70 percent of its customers own two or more vehicles, making repossession more of an inconvenience than a disaster.

As noted above, the alternative for many title loan borrowers (specifically those who do not have bank accounts or credit cards) is pawn shop loans. By way of comparison to title loan default rates, one study found that 58 percent of all first-time pawn shop loans default and only 37 percent are redeemed.11 Another researcher found that default rates on all pawn shop loans range from 13.9 percent to 30.2 percent.12

EFFECTS OF LEGISLATION

Congress is considering two pieces of legislation that are particularly threatening to non-traditional lending products like title pledge lending. The Protecting Consumers From Unreasonable Credit Rates Act of 2009, authored by Sen. Richard Durbin (D-Il.), would place a flat interest cap of 36 percent on all consumer credit products. The House of Representatives is also considering legislation to create a new Consumer Financial Protection Agency (CFPA) that would have unprecedented authority to determine the types of financial products that consumers can choose.

From a broad perspective, usury regulations that impose caps on interest rates for certain types of loans tend to result in term re-pricing, product substitution, and credit rationing. Under term re-pricing, lenders offset limits of what they can charge on regulated terms by increasing the price of other terms of the loan or related loan products. Since the terms of a title loan are relatively transparent, this may be difficult.

Instead, title loans may be more susceptible to product substitution, which arises when a particular consumer loan product cannot be priced to be made economically feasible. Each consumer ultimately desires to hold a certain amount of debt based on income, saving preferences, and spending preferences. Restriction on auto title lending may force consumers into a less-preferred mix of credit by eliminating some loans that title lenders were previously willing to offer. In some cases, this substitution may lead borrowers to riskier debt instruments.

Restrictive regulations could lead to a scenario of credit rationing, in which lenders limit their supply of loans because it becomes economically impossible to make loans consistent with the regulation. In this case, it becomes impossible for certain borrowers to obtain formal credit, leading some borrowers to turn to friends and family or illegal loan sharks or to do without credit altogether.

A prime example of these adverse effects occurred in Florida, which was one of the earliest states to adopt title lending. In 2000, however, the state imposed severe interest rate ceilings on title loans.13 The number of auto title lenders operating in the state dropped severely, from 600 to 58 (see figure 1).14 And as mentioned above, such limitations may lead to a dangerous rise in bankruptcies and bounced checks. If auto title loans are severely constrained, low-income consumers may be limited in their availability to borrow from friends and family, who may come from a similar demographic. The answer, therefore, for many may involve illegal loan sharks and other dangerous avenues. This option is a very real consequence: A 2006 tightening of rate ceilings of consumer loans in Japan has also been correlated with a dramatic growth in illegal loan sharking in that country, primarily run by organized crime.15

Figure 1

Furthermore, while policy makers may seek to limit auto title lending to reduce consumer over-indebtedness, the effects of term re-pricing and product substitution will simply shift consumers to a different mix of terms (such as lower interest rates but higher up-front costs) or different, higher-cost products. In fact, one report concludes that interest-rate ceilings may exacerbate over-indebtedness by resulting in increased loan sizes and increased use of longer-term installment debt, which locks borrowers into less-flexible debt arrangements.16

CONCLUSION

American citizens and businesses rely on title loans for financial security and stability, and lenders are made up of a broad mix of Americans, each with unique risk and incentives. One-size-fits-all regulation is likely to be maladapted to each of these groups and will only hurt the consumers they are trying to help. The bottom line is that restrictions on auto title lending will eliminate an important funding option for many consumers, especially those of lower income, and will incentivize the use of more risky or dangerous credit channels. Auto title loans have proven themselves to be reliable and useful in the past; policy makers should weigh these low risks with the high benefits of this type of lending in making decisions for the future.

ENDNOTES

1. Tom Feltner, Debt Detour: The Automobile Title Lending Industry in Illinois, Woodstock Institute and the Public Action Foundation, September 2007, 8, https://www.policyarchive.org/handle/10207/18300.

2. Jean Ann Fox and Elizabeth Guy, Driven into Debt: CFA Car Title Loan Store and Online Survey, Consumer Federation of America, November 2005, 11, http://www.consumerfed.org/pdfs/Car_Title_Loan_Report_111705.pdf.

3. Tennessee Department of Financial Institutions, The 2008 Report on the Title Pledge Industry, February 20, 2008, 4, http://www.state.tn.us/tdfi/compliance/tpl/TPLReport2008FinalFinal.pdf.

4. Paige Marta Skiba and Jeremy Tobacman, "Measuring the Individual-Level Effects of Access to Credit: Evidence from Payday Loans," (working paper, Vanderbilt University Law School and University of Oxford, July 3, 2007); see also Robert W. Johnson and Dixie P. Johnson, Pawnbroking in the U.S.: A Profile of Customers, Credit Research Center Monograph No. 34, 1998, 16; John P. Caskey, Fringe Banking: Check-Cashing Outlets, Pawnshops and the Poor (New York: Russell Sage Foundation, 1994), 44.

5. Figure based on personal conversations with members of the American Association of Responsible Auto Lenders. See also Michael S. Barr, "Banking the Poor," Yale Journal on Regulation 21, no. 121 (2004): 166 (reporting range of 264–300 percent APR for title loans); Amanda Quester and Jean Ann Fox, Car Title Lending: Driving Borrowers to Financial Ruin, The Center for Responsible Lending and The Consumer Federation of America, April 14, 2005, http://www.responsiblelending.org/other-consumer-loans/car-title-loans/rr008-Car_Title_Lending-0405.pdf (listing average APRs of 183–377 percent in survey of several states); Tom Feltner and Sara Duda, Beyond Payday Loans: Consumer Installment Lending in Illinois, Woodstock Institute, March 2009 (256 percent APR in Illinois).

6. Illinois Department of Financial Institutions, Short Term Lending: Final Report, 1999, http://www.idfpr.com/dfi/ccd/pdfs/Shorterm.pdf.

7. Gregory Elliehausen, An Analysis of Consumers' Use of Payday Loans, Financial Services Research Program Monograph no. 43, January 2009, 35.

8. Jonathan Zinman, "Restricting Consumer Credit Access: Household Survey Evidence on Effects around the Oregon Rate Cap," (working paper, Dartmouth College, December 2008), 9, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1335438.

9. Donald R. Morgan and Michael R. Strain, Payday Holiday: How Households Fare after Payday Credit Bans, Federal Reserve Bank of New York Staff Report no. 309, Feb. 2008.

10. Tennessee Department of Financial Institutions, The 2008 Report on the Title Pledge Industry (reporting 17.5 percent charge-off rate as measured in dollar amount).

11. Skiba and Tobacman, "Measuring the Individual-Level Effects of Access to Credit: Evidence from Payday Loans."

12. John P. Caskey, "Pawnbroking in America: The Economics of a Forgotten Credit Market," Journal of Money, Credit, & Banking 23, no. 1 (1991), 90.

13. Quester and Fox, Car Title Lending: Driving Borrowers to Financial Ruin, 10.

14. Policis, The Effect of Interest Rate Controls in Other Countries (London: August 2004), 17, http://www.microfinancegateway.org/gm/document-1.9.26998/25620_file_The_effect_of_interest_rate_controls.pdf.

15. Policis, Economic and Social Risks of Consumer Credit Market Regulation: A Comparative Analysis of the Regulatory and Consumer Protection Frameworks for Consumer Credit in France, Germany, and the UK (London: 2006), 47–49.

16. Ibid., 74, 78.

The Housing Market Crash

September, 2009

Widespread foreclosures and the collapse in home prices in many areas of the United States that began in 2007 and continued through 2008 and 2009, spawned an ongoing global financial crisis. As a result, the United States has engineered a series of unprecedented market interventions designed to stabilize the housing market and the financial markets dependent on mortgage-backed securities. However, standard economics provides a compelling explanation for much of the increase in household mortgage obligations. This working paper focuses on underlying questions related to consumer behavior and looks at the impact of these developments in the housing market on household financial condition.

The Cost of State Online Spending-Transparency Initiatives

April, 2009

Legislatures around the country have begun to propose spending-transparency Web sites. The most effective argument against these efforts is the potential high cost of such Web sites. We looked at ten recently established state spending sites and found that initial cost estimates often overestimated the final cost. The cost of the surveyed sites range from $30,000 to $300,000, and there is little correlation between the amount spent and the quality of the Web site.