August 17, 2023

The Hutchins Roundup brings the latest thinking in fiscal and monetary policy to your inbox. Have something you'd like us to include in the next Roundup? Email us and we'll take a look.

This edition was written by Elijah Asdourian, Alex Conner, Georgia Nabors, and Louise Sheiner.

Rising household debt in China and South Korea spells trouble for future growth

Between 2015 and 2021, the ratio of household debt to GDP in China and South Korea rose more than 20 percentage points, an increase comparable to the rise in household debt in the U.S. before the Global Financial Crisis in 2007. Using the negative relationship between household debt and GDP growth found in previous papers, Amir Sufi of the University of Chicago projects that the high levels of household debt in China and South Korea will reduce each country’s GDP growth by about 2 percentage points. Though Sufi does not find evidence pointing towards another widespread financial crisis, he points to areas of concern. First, consumer spending will decrease in both countries as households have to service more debt, and second, the Chinese real estate market, which previously grew at a “historically unprecedented” pace, is faltering.

Long-run effects of incarceration on earnings may be negligible

Formerly incarcerated Americans have long faced lower wages and weaker labor market attachment. Using a large sample of matched administrative criminal justice and tax data, Andrew Garin and co-authors exploit discontinuities in sentencing guidelines and random judge assignment to estimate the effects of incarceration on labor market outcomes. They find that incarceration generates short-term drops in economic activity while individuals are in prison. A year-long sentence decreases cumulative earnings by 13% over a five-year period, meaningfully decreasing lifetime earnings. But the authors do not find any statistically significant effects of incarceration on employment or earnings beyond five years. “These patterns suggest that more upstream factors, such as other criminal justice interactions including conviction and arrest, human capital, or broader environmental and social influences are most likely responsible for the formerly incarcerated’s lack of labor market attachment,” the authors conclude.

High-income workers respond more to taxes than suggested by much of the literature

The degree to which workers adjust their behavior and, in turn, their earnings, because of a change in the tax rate—the earnings elasticity—is a contentious topic in labor economics. Micro estimates of the elasticity using individual-level data tend to be very small—suggesting that high taxes have little effect on work effort—while macro estimates using aggregate data are much larger. Henrik Kleven of Princeton and co-authors propose a model to better predict the long-run elasticity of earnings at the top of the income distribution. In contrast to traditional labor supply models that assume changes in effort directly affect a worker’s income, the authors assume that effort does not instantly translate to higher earnings and instead brings delayed returns through future promotions and job switches. Using administrative data from Denmark, the authors provide empirical evidence in favor of their model and predict a short-run earnings elasticity with respect to the marginal tax rate of 0.1 and a long-run elasticity of 0.4 to 0.5. The authors thus conclude that long-run elasticities are likely larger than micro estimates imply, but smaller than many macro estimates would predict.

Credit card balances rising after post-pandemic dip

Chart courtesy of The Wall Street Journal

Quote of the week:

“[W]e must be prudent in calibrating our monetary policy stance if we are to reach our inflation target without harming economic activity unnecessarily… [O]ur disinflationary monetary policy may be conducted by combining different approaches. One approach – the level approach – entails going higher than where the policy rate is currently, with the risk of then having to cut earlier and faster, as implicit in investors’ expectations about the future interest rate path. Another approach – the persistence approach – instead advocates delivering the same degree of overall restriction while avoiding ups and downs, namely by keeping policy rates at the prevailing level for an extended period,” says Fabio Panetta, Member of the European Central Bank's Executive Board.

“Emphasizing persistence may be particularly valuable in the current situation, where the policy rate is around the level necessary to deliver medium-term price stability, the risk of a de-anchoring of inflation expectations is low, inflation risks are balanced and economic activity is weak. Under such conditions, relying solely on an aggressive approach to rate hikes might amplify the risk associated with overtightening, which could subsequently require rates to be cut hastily in a deteriorating economic environment… Moreover, favoring persistence would be in line with our previous proportionate response to the evolving challenges to price stability…However, emphasizing persistence might pose communication challenges. It might give rise to concerns about the effectiveness of our disinflationary policy. Or it might prompt worries that persistence could simply amount to delaying tangible actions, such as rate hikes, in favor of a strategy of keeping rates higher at a later stage – which eventually may or may not be internalized by investors in their anticipation of future policy. Countering such misconceptions would require clear communication by the ECB. We need to explain that the same degree of restriction can be delivered with different combinations of rate levels and persistence.”