Showing posts with label tax policy. Show all posts
Showing posts with label tax policy. Show all posts
Sunday, September 8, 2019
Why Donald Trump Can't Stop a Recession
A recession may be on the horizon. The Federal Reserve doesn't think so. Some others do. Only time will tell who is right. But if there is a recession, President Trump can't stop it before the 2020 election.
The principal tool for the President to fight a recession would be to partner with Congress and put together a package of spending bills that would increase federal expenditures. This sort of program, called fiscal policy, sometimes includes tax cuts, but not always. The greatest fiscal stimulus in U.S. history, military spending for World War II, included a massive tax increase and an even greater increase in deficit spending. The result was both victory in the war and an economic revival at home.
Today, however, there is an almost complete absence of agreement between the President and the Democrats in the House as to how to deploy fiscal policy. Although both sides speak of infrastructure spending, agreement on the fine points and details has remained elusive since the President was inaugurated and won't be achieved before November 2020. For more than the past 20 years, the federal budgetary process has been largely dysfunctional, and it has grown more so as political divisiveness has increased. With only one full budget cycle remaining before the election, it's simply too late to implement fiscal measures in time.
To make things worse, the President would likely seek a tax cut as part of the stimulus package. But, having alienated the Democrats by ramrodding through the 2017 tax cuts with nary a shred of consideration for Democratic views, the President has essentially no good will left with the House majority when it comes to tax policy. The Democrats will agree to tax changes only if there is a substantial rollback of the 2017 cornucopia of tax cuts for the wealthy, and the President won't agree to that. So no deal on tax legislation is possible.
Of course, central banks can endeavor to combat recessions. But the President does not control central bank policy. Monetary policy and other economic management measures such as quantitative easing and the setting of bank reserves lie within the purview of the Federal Reserve. The President attempts to influence the Fed with shrill demands on Twitter for much more aggressive interest rate cuts than the Fed seems inclined to make. But the Fed strives to maintain its independence, and the President would be wise to back off. If the financial markets lose confidence in the independence and integrity of the Federal Reserve, stocks will crater and the economy will get a tummy ache. Moreover, Fed interest rate adjustments often take 18 months or longer to affect the economy. Although they may almost instantaneously be reflected in asset prices in the financial markets, they take a long time to wend their way through the processes of the economy. There isn't enough time before November 2020 for interest rate cuts to have a big impact.
The prospects for a recession remain uncertain. Unemployment is at a 50-year low, a remarkable development that no doubt informs the Fed view of the economy. The stock market is dancing near its all-time highs. Transportation and manufacturing are slowing, and the business community is pulling back on new investment because of confusion and caution arising from President Trump's trade wars. It's difficult to tell how things will go. But if a recession is coming, it's coming.
Friday, March 24, 2017
Can the Republicans Govern?
With the postponement of the House of Representatives' vote on repealing Obamacare twice in two days, one must ask whether the Republicans can govern. They control Congress and the White House, but they weren't able to fulfill one of their signature promises from last year's elections. Dissidents on the far right and in the moderate middle couldn't, for different reasons, sign up for the repeal measure. President Trump, drawing on his dealmaking experience in business, gave them a take it or leave it compromise--and they left it. In business, if you pass on a good deal and go for a great deal, you can blow the deal. But in politics, as Trump may be learning, you can often score points with your constituents by going for a great deal and losing the deal instead of compromising. Politicians get ahead by telling voters what they want to hear--indeed, that's how Donald Trump got himself elected President. But doing things that leave voters with mixed feelings--like compromising--places politicians at risk in the next round of primaries. It's better to look and sound good than doing anything that could leave you open to criticism.
Obamacare will now become a permanent part of the American landscape. Its essential features--universal access to coverage, subsidies or Medicaid for those unable to pay, no exclusion of pre-existing conditions, and substantial coverage of health problems--will form the foundation of American health insurance for the future. Surely, Obamacare will be modified over time. But Barack Obama's greatest legacy will live on.
For the Republicans, the Party of No, a more important question is whether they even understand what it takes to govern. It's necessary to compromise, and to take the heat from compromising. The Republican Party, like the Democratic Party, is a coalition. If coalition members don't work together, governance does not happen. The next great challenge for the Republicans will probably be the budget bill and tax reform, which will have to go hand-in-hand if the Republicans hope to accomplish everything they've promise. Their problem is they've made too many promises for the amount of tax revenues the federal government will collect. They can't boost defenses spending by $54 billion, build the Wall at the border with Mexico, cut corporate taxes, cut taxes for the wealthy (which is an unstated but obvious goal of theirs, given that the proposed repeal of Obamacare was more a bill to cut taxes on the wealthy than improve the health insurance system), and rebuild America's infrastructure, all at the same time. Something has to give. Either taxes are raised, federal deficit spending increases, and/or the Republicans give up on some of their goals. The Republicans will have to compromise to accomplish anything. But their failure to work out a compromise to repeal Obamacare does not portend well for their future.
Although virtually powerless right now, the Democrats must have gotten a lift today. Their fortunes have started to turn around. As devastating as their defeat in 2016 was, it's not the end of the world, or of their party.
Obamacare will now become a permanent part of the American landscape. Its essential features--universal access to coverage, subsidies or Medicaid for those unable to pay, no exclusion of pre-existing conditions, and substantial coverage of health problems--will form the foundation of American health insurance for the future. Surely, Obamacare will be modified over time. But Barack Obama's greatest legacy will live on.
For the Republicans, the Party of No, a more important question is whether they even understand what it takes to govern. It's necessary to compromise, and to take the heat from compromising. The Republican Party, like the Democratic Party, is a coalition. If coalition members don't work together, governance does not happen. The next great challenge for the Republicans will probably be the budget bill and tax reform, which will have to go hand-in-hand if the Republicans hope to accomplish everything they've promise. Their problem is they've made too many promises for the amount of tax revenues the federal government will collect. They can't boost defenses spending by $54 billion, build the Wall at the border with Mexico, cut corporate taxes, cut taxes for the wealthy (which is an unstated but obvious goal of theirs, given that the proposed repeal of Obamacare was more a bill to cut taxes on the wealthy than improve the health insurance system), and rebuild America's infrastructure, all at the same time. Something has to give. Either taxes are raised, federal deficit spending increases, and/or the Republicans give up on some of their goals. The Republicans will have to compromise to accomplish anything. But their failure to work out a compromise to repeal Obamacare does not portend well for their future.
Although virtually powerless right now, the Democrats must have gotten a lift today. Their fortunes have started to turn around. As devastating as their defeat in 2016 was, it's not the end of the world, or of their party.
Tuesday, February 28, 2017
Will Donald Trump Be a Traitor to His Class?
The most important legislative priorities of the Trump administration--tax and health insurance reform--will be enacted within a matter of months. Both of these measures will greatly impact the working class whites who propelled Trump to the White House--either for better or for worse.
Preliminary assessments of the proposed tax reform indicate that taxes for the middle class will drop about a couple hundred dollars. One percenters can look forward to many thousands in tax savings. This isn't exactly what folks in small town America were hoping for. To make up for the loss of income tax revenues from these cuts, the President may endorse a border adjustment tax (basically, a tariff on imports that would likely increase the prices of the inexpensive food and goods that low and moderate income Americans rely on). To many, this might feel like another kick in the teeth.
Health insurance reform is turning out to be a very tough nut to crack. President Trump has said he wants to preserve the protections that many low and moderate income Americans count on--guaranteed acceptance, coverage against pre-existing medical conditions, and subsidies for those unable to pay full freight. But these conditions are very expensive. How will the President cover the costs? There seems to be little consideration of progressive taxation of the wealthy or increasing the federal debt. Yet there's no free lunch. One possible "solution," so to speak, would be to offer low cost policies with skimpy coverage--prior medical conditions would be covered but total coverage might go only up to $25,000 or $50,000 a year. This would be expedient, but would effectively deprive people of coverage when they needed it the most.
On top of this, the President's desire to turn Medicaid into a program of block grants for the states has significant potential to reduce coverage for the low income. Many of these people voted for him. Where will they go for care without health insurance? Medicaid covers around 74 million Americans--almost 1 in 4. Cuts to this program could mean many millions of people mad at the President.
President Trump's problems are exacerbated by his proposal to increase military spending by $54 billion. Where will this money come from? The Republicans in Congress won't agree to more deficit spending. So the President can either raise taxes, or piss off many millions of voters by cutting other federal programs.
Donald Trump is President at a time when stark choices are necessary. He was elected as an insurgent. But he's stacked his cabinet with establishment Republican types, people who have no demonstrated concern or sympathy for his core constituents. The Republicans who control Congress gave him scant and faint-hearted support during his campaign. But today they stack the legislative agenda with bills that would make the rich richer and offer the working class hardly more than a crumb or two--and stale ones at that.
If the President really wants to help his constituents, he'll have to be a traitor to his class. He'll have to offer substantial improvements in life to the working class, and sorry to say, but wealthier people will have to pay for them. America got itself into its current mess by believing that somehow everyone can get more of everything all the time at no cost to anyone else. The last two large nations to subscribe to this notion--the Soviet Union and Communist China--had to abandon their illusions and now struggle with the consequences of the their wishful thinking.
Franklin Delano Roosevelt, the greatest President of the Twentieth Century, was labelled a traitor to his class. And he was. He endorsed legislation like Social Security and a strengthening of protections for workers and labor unions that uplifted many millions of ordinary Americans out of poverty and into the middle class. The cost was born to a large degree by a sharp increase in federal income taxes paid by the well-to-do. The rich grumbled and plotted against him. But he ushered in the prosperity of the 1950's and 1960's, now viewed as a golden age in America. America's perceived decline from those days also correspond with ever increasing inequality of wealth and income. If Donald Trump really wants to make America great again, he'll have to make it great for the working class. That isn't the direction he's been going in since his inauguration. The next few months, when his most consequential legislative initiatives will be enacted, will likely make him both a traitor--either to his core constituents or to his class--and a hero--to the wealthy, many of whom didn't support him but are glad to free-ride on his policies and program, or to the working class that vaulted him into office. The choice is his.
Preliminary assessments of the proposed tax reform indicate that taxes for the middle class will drop about a couple hundred dollars. One percenters can look forward to many thousands in tax savings. This isn't exactly what folks in small town America were hoping for. To make up for the loss of income tax revenues from these cuts, the President may endorse a border adjustment tax (basically, a tariff on imports that would likely increase the prices of the inexpensive food and goods that low and moderate income Americans rely on). To many, this might feel like another kick in the teeth.
Health insurance reform is turning out to be a very tough nut to crack. President Trump has said he wants to preserve the protections that many low and moderate income Americans count on--guaranteed acceptance, coverage against pre-existing medical conditions, and subsidies for those unable to pay full freight. But these conditions are very expensive. How will the President cover the costs? There seems to be little consideration of progressive taxation of the wealthy or increasing the federal debt. Yet there's no free lunch. One possible "solution," so to speak, would be to offer low cost policies with skimpy coverage--prior medical conditions would be covered but total coverage might go only up to $25,000 or $50,000 a year. This would be expedient, but would effectively deprive people of coverage when they needed it the most.
On top of this, the President's desire to turn Medicaid into a program of block grants for the states has significant potential to reduce coverage for the low income. Many of these people voted for him. Where will they go for care without health insurance? Medicaid covers around 74 million Americans--almost 1 in 4. Cuts to this program could mean many millions of people mad at the President.
President Trump's problems are exacerbated by his proposal to increase military spending by $54 billion. Where will this money come from? The Republicans in Congress won't agree to more deficit spending. So the President can either raise taxes, or piss off many millions of voters by cutting other federal programs.
Donald Trump is President at a time when stark choices are necessary. He was elected as an insurgent. But he's stacked his cabinet with establishment Republican types, people who have no demonstrated concern or sympathy for his core constituents. The Republicans who control Congress gave him scant and faint-hearted support during his campaign. But today they stack the legislative agenda with bills that would make the rich richer and offer the working class hardly more than a crumb or two--and stale ones at that.
If the President really wants to help his constituents, he'll have to be a traitor to his class. He'll have to offer substantial improvements in life to the working class, and sorry to say, but wealthier people will have to pay for them. America got itself into its current mess by believing that somehow everyone can get more of everything all the time at no cost to anyone else. The last two large nations to subscribe to this notion--the Soviet Union and Communist China--had to abandon their illusions and now struggle with the consequences of the their wishful thinking.
Franklin Delano Roosevelt, the greatest President of the Twentieth Century, was labelled a traitor to his class. And he was. He endorsed legislation like Social Security and a strengthening of protections for workers and labor unions that uplifted many millions of ordinary Americans out of poverty and into the middle class. The cost was born to a large degree by a sharp increase in federal income taxes paid by the well-to-do. The rich grumbled and plotted against him. But he ushered in the prosperity of the 1950's and 1960's, now viewed as a golden age in America. America's perceived decline from those days also correspond with ever increasing inequality of wealth and income. If Donald Trump really wants to make America great again, he'll have to make it great for the working class. That isn't the direction he's been going in since his inauguration. The next few months, when his most consequential legislative initiatives will be enacted, will likely make him both a traitor--either to his core constituents or to his class--and a hero--to the wealthy, many of whom didn't support him but are glad to free-ride on his policies and program, or to the working class that vaulted him into office. The choice is his.
Thursday, December 1, 2016
Donald Trump's Head Fakes
Donald Trump loves Twitter. At least, so it would seem with his irrepressible use of the 140-character megaphone. It grabs peoples' attention, particularly the attention of the press. A 140-character message is usually easy to grasp and react to. Not much work for a reader or a reporter.
But what's the purpose of his tweeting? During the election, he tweeted or retweeted about a deceased Muslim veteran, a former Miss Universe, assertions by white supremacists, and other things that contravened the social values of the Democratic electorate, provoking vigorous and extended efforts by his opponent to argue that he was unfit for the Presidency.
Meanwhile, back on Main Street, Trump was holding rallies and talking about jobs, jobs and jobs. He kept his eye on the ball (i.e., the economy, stupid), while diverting his opponent with social values head fakes. She took the bait, and lost sight of the fact that economic distress drives elections more than the character flaws of candidates. She paid for her mistakes.
Now, Trump has tweeted that flag burners should be imprisoned and lose their citizenship. Surely he knows that flag burning is protected by the First Amendment to the Constitution and cannot be punished with criminal prosecution or deprivation of citizenship. So why tweet? Could it be that he wants to divert attention from other things he's doing? His tax proposals look like they'll make the rich a lot richer, and maybe even increase taxes on some members of the middle class. His possible changes to Medicaid might leave some folks less well-insured. His infrastructure proposal seems to focus more on giving businesses tax breaks than fixing the roads and bridges that are in the worst shape. He's promised to repeal Obamacare, and to roll back financial regulatory reforms of the Dodd-Frank Act.
If you're concerned about what soon-to-be President Trump is going to do, watch out for his head fakes. Don't be diverted by transparent attempts to yank your chain. Focus on the big stuff, the things that will change things fundamentally. Keep your eye on the bottom line, because that's what our incoming businessman President will do.
But what's the purpose of his tweeting? During the election, he tweeted or retweeted about a deceased Muslim veteran, a former Miss Universe, assertions by white supremacists, and other things that contravened the social values of the Democratic electorate, provoking vigorous and extended efforts by his opponent to argue that he was unfit for the Presidency.
Meanwhile, back on Main Street, Trump was holding rallies and talking about jobs, jobs and jobs. He kept his eye on the ball (i.e., the economy, stupid), while diverting his opponent with social values head fakes. She took the bait, and lost sight of the fact that economic distress drives elections more than the character flaws of candidates. She paid for her mistakes.
Now, Trump has tweeted that flag burners should be imprisoned and lose their citizenship. Surely he knows that flag burning is protected by the First Amendment to the Constitution and cannot be punished with criminal prosecution or deprivation of citizenship. So why tweet? Could it be that he wants to divert attention from other things he's doing? His tax proposals look like they'll make the rich a lot richer, and maybe even increase taxes on some members of the middle class. His possible changes to Medicaid might leave some folks less well-insured. His infrastructure proposal seems to focus more on giving businesses tax breaks than fixing the roads and bridges that are in the worst shape. He's promised to repeal Obamacare, and to roll back financial regulatory reforms of the Dodd-Frank Act.
If you're concerned about what soon-to-be President Trump is going to do, watch out for his head fakes. Don't be diverted by transparent attempts to yank your chain. Focus on the big stuff, the things that will change things fundamentally. Keep your eye on the bottom line, because that's what our incoming businessman President will do.
Sunday, October 21, 2012
Manufacturing Matters
In the end, Steve Jobs got his revenge. Once marginalized by Microsoft and its monopoly on PC operating systems, and then kicked out of Apple, the company he founded, Jobs was recalled to Apple as it was sliding into a death spiral. He proceeded to rebuild his brain child into the most successful business corporation today. Apple is the leader of its market segment--that segment being the mobile world. It manufactures visually attractive and highly efficacious mobile devices. Okay, they had a problem with maps. But Apple has overcome its previous belly flops, and it will surely overcome this one. Its high prices may keep it out of the reach of some consumers. But those that can afford its products tend to be the well-off who are highly sought by advertisers.
By contrast, Google and Facebook are now looking at the abyss. They haven't figured out mobile, at a time when mobile products are the fastest growing consumer high tech segment. Both Google and Facebook rely heavily on advertising, but mobile screens are too small for the kinds of ads that have proven successful on PCs and traditional laptops. There isn't yet a mobile-specific advertising strategy that really works. As the world becomes more mobile, Google and Facebook face the potential for a Yahoo-style decline, unless they solve the advertising problem or find alternative revenue sources. Solving the advertising problem requires gathering more and more detailed information about individuals using their products. But that could bring them into greater conflict with governmental protections for privacy. This is a particular issue in Europe, and a growing issue in America. These privacy protections will ultimately limit the extent to which Google and Facebook can facilitate the targeting of ads. One interesting notion is perhaps Yahoo, with its banner ad business (which doesn't rely on detailed personal information), will eventually prove the tortoise in its race against Google and Facebook.
In part, Google and Facebook confront the problem of all successful high tech companies. No matter how well you're doing, the next big thing is coming and you'd better be prepared for it or others will out-innovate you and leave you in the dust. IBM didn't anticipate the PC, and it lost its standing as the predominant computer company. Microsoft didn't anticipate the ubiquity and importance of the Internet, and it's in a slow fade. RIM didn't anticipate how consumers would flock to the smart phone, and it's barely staying alive on its corporate customer base.
But failure to anticipate the next big thing isn't the only dynamic. Part of the dynamic is that Apple manufactured the next big thing. By creating products that elevated the mobile experience by quantum leaps, Apple made consumers want mobile products. By manufacturing and selling these products, Apple derives a very large part of its revenues from selling hardware and software packaged together. It doesn't give consumers stuff for free and hope that it can slip in a few ads here and there. It makes and sells stuff for cash money.
Making and selling stuff has, for millenia, been the heart of economic activity. The evolution of the industrialized world revolved around elevating the manufacturing process to a grand scale, so that vast quantities of stuff could be made efficiently and sold at prices a lot of people could afford. Steve Jobs' relentless commitment to manufacturing--and thus control over product design and quality--placed Apple at the core of the industrial process. By manufacturing high quality and innovative stuff, Apple avoided the commoditization of PCs (which bedeviled Dell, Hewlett Packard and other companies) and elevated itself to the top of the high tech world.
This isn't a sales pitch for you to run out and invest in Apple. Its stock, on a tear earlier this year, has been falling back recently. Its maps debacle hurt, and its future--always uncertain because it's in the most volatile of industries, high tech--has been made more unpredictable by the death of Steve Jobs. The point here is that Apple's business strategy of manufacturing made it strong, and is a sound idea for American economic policy. America increasingly doesn't manufacture. But you can't build a strong national economy on management consulting, investment banking, hedge funds, law practice, health care, restaurants, and services like hair salons, pet walking, personal shopping, and the secondary and tertiary retailing in websites like eBay. The foundation of a strong economy is manufacturing. Look at Germany. Look at China. America was once the manufacturing giant of the industrialized world. While it can't return to that status, it can look for ways to encourage manufacturing. We all know Apple manufactures a lot of components in China. But well under half of its revenue dollars are spent in China. Much more is allocated to spending in America, for things like retailing, distribution, employee payroll and so on. Successful manufacturing companies make their home countries strong.
Most of the debate today over fiscal policy revolves around the amounts of federal spending and federal taxation. But fiscal policy isn't just a matter of accounting. The nation benefits by spending and taxing wisely. Keeping Social Security, Medicare and Medicaid in the black will be easier if we have a robust manufacturing sector. The pie is much easier to divide if it's bigger.
By contrast, Google and Facebook are now looking at the abyss. They haven't figured out mobile, at a time when mobile products are the fastest growing consumer high tech segment. Both Google and Facebook rely heavily on advertising, but mobile screens are too small for the kinds of ads that have proven successful on PCs and traditional laptops. There isn't yet a mobile-specific advertising strategy that really works. As the world becomes more mobile, Google and Facebook face the potential for a Yahoo-style decline, unless they solve the advertising problem or find alternative revenue sources. Solving the advertising problem requires gathering more and more detailed information about individuals using their products. But that could bring them into greater conflict with governmental protections for privacy. This is a particular issue in Europe, and a growing issue in America. These privacy protections will ultimately limit the extent to which Google and Facebook can facilitate the targeting of ads. One interesting notion is perhaps Yahoo, with its banner ad business (which doesn't rely on detailed personal information), will eventually prove the tortoise in its race against Google and Facebook.
In part, Google and Facebook confront the problem of all successful high tech companies. No matter how well you're doing, the next big thing is coming and you'd better be prepared for it or others will out-innovate you and leave you in the dust. IBM didn't anticipate the PC, and it lost its standing as the predominant computer company. Microsoft didn't anticipate the ubiquity and importance of the Internet, and it's in a slow fade. RIM didn't anticipate how consumers would flock to the smart phone, and it's barely staying alive on its corporate customer base.
But failure to anticipate the next big thing isn't the only dynamic. Part of the dynamic is that Apple manufactured the next big thing. By creating products that elevated the mobile experience by quantum leaps, Apple made consumers want mobile products. By manufacturing and selling these products, Apple derives a very large part of its revenues from selling hardware and software packaged together. It doesn't give consumers stuff for free and hope that it can slip in a few ads here and there. It makes and sells stuff for cash money.
Making and selling stuff has, for millenia, been the heart of economic activity. The evolution of the industrialized world revolved around elevating the manufacturing process to a grand scale, so that vast quantities of stuff could be made efficiently and sold at prices a lot of people could afford. Steve Jobs' relentless commitment to manufacturing--and thus control over product design and quality--placed Apple at the core of the industrial process. By manufacturing high quality and innovative stuff, Apple avoided the commoditization of PCs (which bedeviled Dell, Hewlett Packard and other companies) and elevated itself to the top of the high tech world.
This isn't a sales pitch for you to run out and invest in Apple. Its stock, on a tear earlier this year, has been falling back recently. Its maps debacle hurt, and its future--always uncertain because it's in the most volatile of industries, high tech--has been made more unpredictable by the death of Steve Jobs. The point here is that Apple's business strategy of manufacturing made it strong, and is a sound idea for American economic policy. America increasingly doesn't manufacture. But you can't build a strong national economy on management consulting, investment banking, hedge funds, law practice, health care, restaurants, and services like hair salons, pet walking, personal shopping, and the secondary and tertiary retailing in websites like eBay. The foundation of a strong economy is manufacturing. Look at Germany. Look at China. America was once the manufacturing giant of the industrialized world. While it can't return to that status, it can look for ways to encourage manufacturing. We all know Apple manufactures a lot of components in China. But well under half of its revenue dollars are spent in China. Much more is allocated to spending in America, for things like retailing, distribution, employee payroll and so on. Successful manufacturing companies make their home countries strong.
Most of the debate today over fiscal policy revolves around the amounts of federal spending and federal taxation. But fiscal policy isn't just a matter of accounting. The nation benefits by spending and taxing wisely. Keeping Social Security, Medicare and Medicaid in the black will be easier if we have a robust manufacturing sector. The pie is much easier to divide if it's bigger.
Tuesday, July 12, 2011
The Debt Ceiling Crisis: Did McConnell Just Throw Obama Into a Briar Patch?
Today, Mitch McConnell, the leader of the Republicans in the Senate, proposed a "backup" plan for the debt ceiling crisis: a law that would allow President Obama to raise the debt ceiling in three steps over the remainder of his presidency. The proposed law provides an elaborate procedure for Democrats and Republicans to tag each other "It." Obama would tell Congress of an increase in the debt limit. Congress could (and perhaps would) adopt a resolution opposing the increase. The President would then veto Congress' resolution. The Republicans would be unable to override the veto since Congress, as currently constituted, would not give debt ceiling opponents the two-thirds majority needed. Obama could use this procedure to increase the debt ceiling by a total of $2.4 trillion through the end of 2012.
Failure to raise the debt ceiling could cause chaos in the financial markets, and trigger an economic downturn. Opinion polls show that much (and perhaps most) of the blame would fall on the Republicans. McConnell surely wants to steer his party away from self-immolation. At the same time, unilateral increases in the debt ceiling might weaken Obama's standing with swing voters in the middle, bettering the chances for a Republican victory in next year's presidential elections.
Obama himself may be wary of the Republican proposal, because he would three times be taking action that would appear profligate in a time when austerity seems to be in political vogue. The amount of increased borrowing he could authorize--$2.4 trillion--is slightly below the $2.5 trillion to $2.7 trillion projected as the government's increased borrowing needs through the end of 2012. So McConnell's proposal would keep Obama on a fairly tight leash, and expose him to being excoriated by right wing debt ceiling zealots three more times before he faces the 2012 election.
At the same time, though, Obama would get an opportunity to shift his attention away from the deranged histrionics that now permeate the debt ceiling debate. He could focus on tax and entitlements reform (where the budget deficit problem will really be solved). He could also stay on top of defense matters. Completion of our withdrawal from Iraq, and a brisk drawdown from Afghanistan might do much to close the gap between the $2.4 trillion debt increase McConnell would allow, and the $2.5 trillion to $2.7 trillion Obama is projected to need.
Although the White House hasn't reacted to McConnell's proposal, it may go along in the end. One clever aspect of the McConnell proposal is that it allows both Democrats and Republicans to cater to their respective alternative political universes. The Republicans would allow the debt ceiling to increase--something they really have little choice about--while forcing the President to take the blame for this heresy by vetoing Congressional objections. The debt ceiling ideologues on the right would have a field day doing what they like best--babbling 17-second soundbites for the evening news. The Democrats in Congress would avoid a distasteful task (neither party likes having to raise the debt ceiling), while the President would three times have to grit his teeth momentarily but then be able to get on with more substantive matters. This may be a briar patch he doesn't mind being tossed into.
Commentators on the right have already blasted McConnell's proposal. That alone tells you it could be a sensible compromise. It wouldn't give the President the grand $4 trillion long term deal he's been seeking, so he can't claim it's a victory. Moreover, McConnell has now positioned the debt ceiling zealots to take the blame if his proposal isn't enacted, the debt ceiling isn't raised, and the financial markets tank. That surely infuriates the Tea Partiers who have bedeviled McConnell's efforts to negotiate with the President.
McConnell may be aiming to forestall a longer term checkmate for the Republicans. The extension of the Bush tax cuts, enacted last fall, expires at the end of 2012. That means the Democrats get the tax increases they want simply by not agreeing to extend the Bush cuts again. They don't need to negotiate with the Republicans to raise taxes. They can simply wait, and they win the waiting game if President Obama is re-elected next year. By forcing the President to take the initiative on raising the debt ceiling, three times no less in the next 18 months, McConnell may weaken Obama's chances for re-election.
Because of right wing fury, there's no certainty that McConnell's proposal will become law. Many in his own party already question it. McConnell himself may have floated the idea simply to send his Tea Partying colleagues a message that they should talk turkey instead of preaching hellfire and damnation. The debt ceiling crisis remains far from resolution. Don't bet the rent money on the financial markets being stable in the near future.
Failure to raise the debt ceiling could cause chaos in the financial markets, and trigger an economic downturn. Opinion polls show that much (and perhaps most) of the blame would fall on the Republicans. McConnell surely wants to steer his party away from self-immolation. At the same time, unilateral increases in the debt ceiling might weaken Obama's standing with swing voters in the middle, bettering the chances for a Republican victory in next year's presidential elections.
Obama himself may be wary of the Republican proposal, because he would three times be taking action that would appear profligate in a time when austerity seems to be in political vogue. The amount of increased borrowing he could authorize--$2.4 trillion--is slightly below the $2.5 trillion to $2.7 trillion projected as the government's increased borrowing needs through the end of 2012. So McConnell's proposal would keep Obama on a fairly tight leash, and expose him to being excoriated by right wing debt ceiling zealots three more times before he faces the 2012 election.
At the same time, though, Obama would get an opportunity to shift his attention away from the deranged histrionics that now permeate the debt ceiling debate. He could focus on tax and entitlements reform (where the budget deficit problem will really be solved). He could also stay on top of defense matters. Completion of our withdrawal from Iraq, and a brisk drawdown from Afghanistan might do much to close the gap between the $2.4 trillion debt increase McConnell would allow, and the $2.5 trillion to $2.7 trillion Obama is projected to need.
Although the White House hasn't reacted to McConnell's proposal, it may go along in the end. One clever aspect of the McConnell proposal is that it allows both Democrats and Republicans to cater to their respective alternative political universes. The Republicans would allow the debt ceiling to increase--something they really have little choice about--while forcing the President to take the blame for this heresy by vetoing Congressional objections. The debt ceiling ideologues on the right would have a field day doing what they like best--babbling 17-second soundbites for the evening news. The Democrats in Congress would avoid a distasteful task (neither party likes having to raise the debt ceiling), while the President would three times have to grit his teeth momentarily but then be able to get on with more substantive matters. This may be a briar patch he doesn't mind being tossed into.
Commentators on the right have already blasted McConnell's proposal. That alone tells you it could be a sensible compromise. It wouldn't give the President the grand $4 trillion long term deal he's been seeking, so he can't claim it's a victory. Moreover, McConnell has now positioned the debt ceiling zealots to take the blame if his proposal isn't enacted, the debt ceiling isn't raised, and the financial markets tank. That surely infuriates the Tea Partiers who have bedeviled McConnell's efforts to negotiate with the President.
McConnell may be aiming to forestall a longer term checkmate for the Republicans. The extension of the Bush tax cuts, enacted last fall, expires at the end of 2012. That means the Democrats get the tax increases they want simply by not agreeing to extend the Bush cuts again. They don't need to negotiate with the Republicans to raise taxes. They can simply wait, and they win the waiting game if President Obama is re-elected next year. By forcing the President to take the initiative on raising the debt ceiling, three times no less in the next 18 months, McConnell may weaken Obama's chances for re-election.
Because of right wing fury, there's no certainty that McConnell's proposal will become law. Many in his own party already question it. McConnell himself may have floated the idea simply to send his Tea Partying colleagues a message that they should talk turkey instead of preaching hellfire and damnation. The debt ceiling crisis remains far from resolution. Don't bet the rent money on the financial markets being stable in the near future.
Saturday, July 9, 2011
How Statistics Can Lower Your Standard of Living
What you don't know can hurt you.
Nothing glazes over as many eyes as economic statistics. And with good reason, since most of them, even if accurate (a big assumption) don't mean much of anything by themselves. At best, even the most important economic statistics are meaningful only when considered in light of numerous other statistics and the big picture revealed thereby.
But there are a few statistics that really matter: the ones used to figure out how much we are paid and taxed. The ongoing debate over Social Security and tax reform revolves around three of them. Pay attention, because money talks and these statistics are talking loudly.
Social Security benefits and federal pension payments are adjusted by an inflation index called the CPI-W, or the Consumer Price Index for Urban Wage Earners and Clerical Workers. Federal income tax brackets are adjusted by the the CPI-U, or the Consumer Price index for All Urban Consumers. The CPI-W and CPI-U are not identical. But they both gather information about the prices and amounts of goods and services people buy, put the information in a giant mixing bowl, swirl things around vigorously, dump the contents in a large blender, and churn out a value that reflects a composite price value, weighted by the relative amounts of goods and services people buy. Changes in prices over time increase or decrease (usually increase) the value of the composite. These changes are treated as the measured inflation rate. The CPI-W and CPI-U also take account of changing consumption patterns of consumers--i.e., as consumers buy less iceberg lettuce and more arugula (or vice versa, which may be the case in times of recession), the weights assigned to the prices of iceberg versus arugula are adjusted. These adjustments are made once every few years.
The debt ceiling/budget deficit debate has included a proposal to use the Personal Consumption Expenditures Index (or Chained CPI) in place of the CPI-W and CPI-U as the measure of inflation for adjusting Social Security, federal pensions and tax brackets. The Chained CPI takes account of substitution of goods as prices rise. For example, if the price of beef rises, consumers may eat less beef and more chicken, thus lowering their overall spending on meat. The Chained CPI doesn't increase as much as the CPI-W and CPI-U because overall meat expenditures don't rise as fast when chicken is substituted for beef. If consumers substitute beans for beef and chicken, then the Chained CPI would rise even less. The Chained CPI may, over time, rise about one-third more slowly than the CPI-W or the CPI-U. (Actually, the CPI-W and CPI-U also incorporate the substitution effect but reflect those changes only once every few years, while the Chained CPI accounts for the substitution effect much more quickly.)
Using the Chained CPI, instead of the CPI-W, to increase various federal payments will be less costly to the federal government. But that's only part of the story. The Chained CPI, as an index for increasing Social Security and pension payments, punishes people for economizing, because it treats substitution solely as a matter of price, without taking account of the loss of perceived quality. Given a more miserly inflation adjustment, people might economize some more, only to be further punished through next year's use of the Chained CPI to get a lower inflation adjustment. That in turn would continue the cycle of skimping, followed by punishment, followed by more skimping, resulting in more punishment, until people are eating sawdust instead of bread. At a time when we need to sustain and support consumer spending in order to have a foundation for economic recovery, using the Chained CPI lessens the potential for recovery.
The use of the CPI-W as an index for adjusting payments to retirees has been criticized for not fully reflecting the rising costs of health care, which are more burdensome for retirees than younger, healthier people. But the Chained CPI would only make things worse, and if people turn to alternative medicine because they can't afford mainstream care, their cost of living adjustments will be further limited by the Chained CPI. Witch doctors will rejoice.
As if retirees and other Americans receiving Social Security haven't been penalized enough, look at what happens when the Chained CPI is applied to the tax code. By law, the CPI-U is applied to increase the level at which higher tax rates are imposed. In other words, the more inflation there is, the lighter taxes become at a given income level because inflation has effectively lowered the value of that amount of income.
The inflation adjustment was enacted in the 1980s as a matter of fairness and to take away an incentive for the federal government to inflate the dollar, slyly obtaining tax increases without legislating them. If the Chained CPI is substituted for the CPI-U, the effect will be to weaken that policy by raising tax brackets less quickly when there's inflation. The Chained CPI would, in effect, to raise taxes from what current law provides. That, in turn, would squeeze consumers, forcing them to cut back on their standard of living.
The combined effect of substituting the Chained CPI for the CPI-W and CPI-U would be that retirees and others receiving federal payments would be hammered harder by inflation, and their taxes would increase in real terms to reward them for having to live with lower standards of living. As they tried to cope with their reduced circumstances, their inflation adjustments would be even less, while their taxes would effectively rise some more. Catch-22, only this isn't fiction. Even if you're not receiving Social Security yet, don't think this doesn't affect you. Your taxes will be higher than otherwise because the brackets will adjust slower.
The Chained CPI provides useful information to economists and others trying to understand consumer behavior. But if it becomes the legal basis for deciding how much the government pays to retirees and other people (recall that many receiving Social Security are disabled), and also for how much government will tax its citizens, then it may end up automatically lowering standards of living. Why this beggar the citizens policy in a time of economic stagnation is a good idea hasn't been explained. Yes, it would tend to reduce the federal deficit, but only by making the electorate poorer.
The times are beginning to hark back to the pinched, self-flagellating malaise of the late 1970s, when it seemed we could do little about OPEC oil price hikes except turn down the heat and wear sweaters. The Chained CPI proposal takes advantage of the unfamiliarity of most citizens with the complexities of economic statistics. It would lower standards of living for tens of millions of Americans while raising taxes on all, and encourages the federal government to foster inflation. Why is this a good thing? The federal deficit needs to be addressed. But surreptitiously eroding the prosperity of citizens, most of whom aren't prosperous anyway, is the wrong approach.
Nothing glazes over as many eyes as economic statistics. And with good reason, since most of them, even if accurate (a big assumption) don't mean much of anything by themselves. At best, even the most important economic statistics are meaningful only when considered in light of numerous other statistics and the big picture revealed thereby.
But there are a few statistics that really matter: the ones used to figure out how much we are paid and taxed. The ongoing debate over Social Security and tax reform revolves around three of them. Pay attention, because money talks and these statistics are talking loudly.
Social Security benefits and federal pension payments are adjusted by an inflation index called the CPI-W, or the Consumer Price Index for Urban Wage Earners and Clerical Workers. Federal income tax brackets are adjusted by the the CPI-U, or the Consumer Price index for All Urban Consumers. The CPI-W and CPI-U are not identical. But they both gather information about the prices and amounts of goods and services people buy, put the information in a giant mixing bowl, swirl things around vigorously, dump the contents in a large blender, and churn out a value that reflects a composite price value, weighted by the relative amounts of goods and services people buy. Changes in prices over time increase or decrease (usually increase) the value of the composite. These changes are treated as the measured inflation rate. The CPI-W and CPI-U also take account of changing consumption patterns of consumers--i.e., as consumers buy less iceberg lettuce and more arugula (or vice versa, which may be the case in times of recession), the weights assigned to the prices of iceberg versus arugula are adjusted. These adjustments are made once every few years.
The debt ceiling/budget deficit debate has included a proposal to use the Personal Consumption Expenditures Index (or Chained CPI) in place of the CPI-W and CPI-U as the measure of inflation for adjusting Social Security, federal pensions and tax brackets. The Chained CPI takes account of substitution of goods as prices rise. For example, if the price of beef rises, consumers may eat less beef and more chicken, thus lowering their overall spending on meat. The Chained CPI doesn't increase as much as the CPI-W and CPI-U because overall meat expenditures don't rise as fast when chicken is substituted for beef. If consumers substitute beans for beef and chicken, then the Chained CPI would rise even less. The Chained CPI may, over time, rise about one-third more slowly than the CPI-W or the CPI-U. (Actually, the CPI-W and CPI-U also incorporate the substitution effect but reflect those changes only once every few years, while the Chained CPI accounts for the substitution effect much more quickly.)
Using the Chained CPI, instead of the CPI-W, to increase various federal payments will be less costly to the federal government. But that's only part of the story. The Chained CPI, as an index for increasing Social Security and pension payments, punishes people for economizing, because it treats substitution solely as a matter of price, without taking account of the loss of perceived quality. Given a more miserly inflation adjustment, people might economize some more, only to be further punished through next year's use of the Chained CPI to get a lower inflation adjustment. That in turn would continue the cycle of skimping, followed by punishment, followed by more skimping, resulting in more punishment, until people are eating sawdust instead of bread. At a time when we need to sustain and support consumer spending in order to have a foundation for economic recovery, using the Chained CPI lessens the potential for recovery.
The use of the CPI-W as an index for adjusting payments to retirees has been criticized for not fully reflecting the rising costs of health care, which are more burdensome for retirees than younger, healthier people. But the Chained CPI would only make things worse, and if people turn to alternative medicine because they can't afford mainstream care, their cost of living adjustments will be further limited by the Chained CPI. Witch doctors will rejoice.
As if retirees and other Americans receiving Social Security haven't been penalized enough, look at what happens when the Chained CPI is applied to the tax code. By law, the CPI-U is applied to increase the level at which higher tax rates are imposed. In other words, the more inflation there is, the lighter taxes become at a given income level because inflation has effectively lowered the value of that amount of income.
The inflation adjustment was enacted in the 1980s as a matter of fairness and to take away an incentive for the federal government to inflate the dollar, slyly obtaining tax increases without legislating them. If the Chained CPI is substituted for the CPI-U, the effect will be to weaken that policy by raising tax brackets less quickly when there's inflation. The Chained CPI would, in effect, to raise taxes from what current law provides. That, in turn, would squeeze consumers, forcing them to cut back on their standard of living.
The combined effect of substituting the Chained CPI for the CPI-W and CPI-U would be that retirees and others receiving federal payments would be hammered harder by inflation, and their taxes would increase in real terms to reward them for having to live with lower standards of living. As they tried to cope with their reduced circumstances, their inflation adjustments would be even less, while their taxes would effectively rise some more. Catch-22, only this isn't fiction. Even if you're not receiving Social Security yet, don't think this doesn't affect you. Your taxes will be higher than otherwise because the brackets will adjust slower.
The Chained CPI provides useful information to economists and others trying to understand consumer behavior. But if it becomes the legal basis for deciding how much the government pays to retirees and other people (recall that many receiving Social Security are disabled), and also for how much government will tax its citizens, then it may end up automatically lowering standards of living. Why this beggar the citizens policy in a time of economic stagnation is a good idea hasn't been explained. Yes, it would tend to reduce the federal deficit, but only by making the electorate poorer.
The times are beginning to hark back to the pinched, self-flagellating malaise of the late 1970s, when it seemed we could do little about OPEC oil price hikes except turn down the heat and wear sweaters. The Chained CPI proposal takes advantage of the unfamiliarity of most citizens with the complexities of economic statistics. It would lower standards of living for tens of millions of Americans while raising taxes on all, and encourages the federal government to foster inflation. Why is this a good thing? The federal deficit needs to be addressed. But surreptitiously eroding the prosperity of citizens, most of whom aren't prosperous anyway, is the wrong approach.
Tuesday, September 28, 2010
Congressional Action in the Lame Duck Session
The mid-term elections in five weeks are likely to produce political deadlock. The Republicans will probably win control of the House and perhaps the Senate. The Dems have the White House. From January 2011 through December 2012, not much is likely to happen in Washington (although you'll need earplugs to save your hearing from all the partisan yammering).
As things are, Congress isn't likely to do anything significant before the elections--it's easier for a candidate to make promises to voters than explain a vote in Congress. There will be one moment for action: the lame duck session that follows the elections. In the last two months of this year, the current 111th session of Congress will have its last hurrah. The Democratic-dominated body will have one final chance to push through legislation it favors. The President will probably sign anything that vaguely serves his agenda, since he's not likely to get his way with Congress again during the remainder of his first term.
A number of Democrats facing re-election contests are momentarily wavering on their party's agenda, such as continued Bush tax cuts for all but the wealthy. After the election, though, some may be lame duck legislators, with nothing to lose by voting their convictions instead of for their survival. Others may see a last chance to serve the needs of supporters.
The Republicans will be in a tight spot. If they block all Democratic initiatives, the Bush tax cuts end on December 31, 2010, and everyone in the U.S. gets a tax increase. The Republicans won't want be tagged with responsibility for that. You can bet the Dems will introduce in the lame duck session a bill continuing the Bush tax cuts for all but the wealthy. They will also introduce the annual fix for the alternative minimum tax (a tax-the-rich measure signed by Republican President Richard Nixon to make sure the wealthy didn't deduct their way to no taxes). The alternative minimum tax isn't adjusted automatically for inflation, so over time it has reached well down into the middle class. It has to be fixed every year so that it hits only the upper middle class (the alternative minimum tax now taxes many millions more than just the wealthy and is a key revenue raiser that no one, Democrat or Republican, has the guts to fix permanently because doing so would cost the government a shipload of money).
The Republicans will have to find a way not to block all tax relief, lest they betray their asserted principles. But they don't have the numbers in the 111th Congress to control legislation. Even though the Republicans squirmed and squealed noisily during the last two years, the Dems had their way with stimulus legislation, expansion of health insurance coverage, and financial regulatory reform. Neither party can afford to allow nothing to happen during the lame duck session. Alternative minimum tax relief is an annual Congressional ritual, and will be accompanied by one or more attempts to extend at least some of the Bush tax cuts. It's impossible to predict how things will turn out. But keep your eyes open because the upcoming lame duck session may be the most important legislative event of the next two years.
As things are, Congress isn't likely to do anything significant before the elections--it's easier for a candidate to make promises to voters than explain a vote in Congress. There will be one moment for action: the lame duck session that follows the elections. In the last two months of this year, the current 111th session of Congress will have its last hurrah. The Democratic-dominated body will have one final chance to push through legislation it favors. The President will probably sign anything that vaguely serves his agenda, since he's not likely to get his way with Congress again during the remainder of his first term.
A number of Democrats facing re-election contests are momentarily wavering on their party's agenda, such as continued Bush tax cuts for all but the wealthy. After the election, though, some may be lame duck legislators, with nothing to lose by voting their convictions instead of for their survival. Others may see a last chance to serve the needs of supporters.
The Republicans will be in a tight spot. If they block all Democratic initiatives, the Bush tax cuts end on December 31, 2010, and everyone in the U.S. gets a tax increase. The Republicans won't want be tagged with responsibility for that. You can bet the Dems will introduce in the lame duck session a bill continuing the Bush tax cuts for all but the wealthy. They will also introduce the annual fix for the alternative minimum tax (a tax-the-rich measure signed by Republican President Richard Nixon to make sure the wealthy didn't deduct their way to no taxes). The alternative minimum tax isn't adjusted automatically for inflation, so over time it has reached well down into the middle class. It has to be fixed every year so that it hits only the upper middle class (the alternative minimum tax now taxes many millions more than just the wealthy and is a key revenue raiser that no one, Democrat or Republican, has the guts to fix permanently because doing so would cost the government a shipload of money).
The Republicans will have to find a way not to block all tax relief, lest they betray their asserted principles. But they don't have the numbers in the 111th Congress to control legislation. Even though the Republicans squirmed and squealed noisily during the last two years, the Dems had their way with stimulus legislation, expansion of health insurance coverage, and financial regulatory reform. Neither party can afford to allow nothing to happen during the lame duck session. Alternative minimum tax relief is an annual Congressional ritual, and will be accompanied by one or more attempts to extend at least some of the Bush tax cuts. It's impossible to predict how things will turn out. But keep your eyes open because the upcoming lame duck session may be the most important legislative event of the next two years.
Friday, August 6, 2010
How Can the Economy Recover If Bad Must Become Good?
The path to economic recovery, it would seem, requires bad to become good.
We're told consumer spending must rise. Instead, it's stagnant or dropping as consumers save more and pay down their debts. Improving balance sheets is good for consumers, because they can't spend with confidence if they're swamped in debt. When they try, we end up with a credit crisis, like the one in 2008-09. But policy makers want consumers to spend more even though it would be bad for them.
The Fed keeps lowering interest rates. The economy is growing, yet there is a good likelihood the Fed will resume buying longer term bonds after its August 10 meeting in order to rates. The effect is the same as printing money. Somehow, the concoction of dollars out of thin air is considered good even though it defies any common sense notion of value. Monetary relaxation hasn't spurred the economy because the banks aren't lending. Even though ultra low interest rates subsidize banks, they don't produce much of anything for the rest of us. Holders of capital are punished for their thrift. It's no surprise even the well-to-do are spending less. Lower rates will only discourage them more, but the Fed seems to believe that bad is good.
Conservatives want to reduce federal deficits while keeping in place the Bush 2001 tax cuts. Those are the same cuts that, along with President George W. Bush's foreign misadventures, produced the monumental deficits we have today. Why repeat Bush the Younger's errors? But conservatives think bad is good.
Liberals never see a spending bill they don't like. The most recent is a $26 billion bailout of the states that has passed the Senate and will probably pass the House next week and be signed by the President. This bill is couched as a measure to prevent more layoffs of teachers, police officers and firefighters. But money is fungible. If states didn't get this money, they wouldn't necessarily lay off more teachers, police officers and firefighters. They might make other cuts to keep important personnel on the payrolls. The $26 billion bailout allows the states to avoid facing problems of their own making. It's one thing to bailout unemployed people who were laid off through no fault of their own. Even bailing out Wall Street banks in order to save the financial system is defensible on some level. But providing a bailout to states that can raise taxes if they want to keep spending or cut their budgets, simply pushes the costs of state government political miscalculations and profligacy onto federal taxpayers. This bailout is bad, even though it's couched as good.
So, we can see that bad must become good for the economy to improve. If we can just bring ourselves to believe six impossible things before breakfast, everything will be all right.
We're told consumer spending must rise. Instead, it's stagnant or dropping as consumers save more and pay down their debts. Improving balance sheets is good for consumers, because they can't spend with confidence if they're swamped in debt. When they try, we end up with a credit crisis, like the one in 2008-09. But policy makers want consumers to spend more even though it would be bad for them.
The Fed keeps lowering interest rates. The economy is growing, yet there is a good likelihood the Fed will resume buying longer term bonds after its August 10 meeting in order to rates. The effect is the same as printing money. Somehow, the concoction of dollars out of thin air is considered good even though it defies any common sense notion of value. Monetary relaxation hasn't spurred the economy because the banks aren't lending. Even though ultra low interest rates subsidize banks, they don't produce much of anything for the rest of us. Holders of capital are punished for their thrift. It's no surprise even the well-to-do are spending less. Lower rates will only discourage them more, but the Fed seems to believe that bad is good.
Conservatives want to reduce federal deficits while keeping in place the Bush 2001 tax cuts. Those are the same cuts that, along with President George W. Bush's foreign misadventures, produced the monumental deficits we have today. Why repeat Bush the Younger's errors? But conservatives think bad is good.
Liberals never see a spending bill they don't like. The most recent is a $26 billion bailout of the states that has passed the Senate and will probably pass the House next week and be signed by the President. This bill is couched as a measure to prevent more layoffs of teachers, police officers and firefighters. But money is fungible. If states didn't get this money, they wouldn't necessarily lay off more teachers, police officers and firefighters. They might make other cuts to keep important personnel on the payrolls. The $26 billion bailout allows the states to avoid facing problems of their own making. It's one thing to bailout unemployed people who were laid off through no fault of their own. Even bailing out Wall Street banks in order to save the financial system is defensible on some level. But providing a bailout to states that can raise taxes if they want to keep spending or cut their budgets, simply pushes the costs of state government political miscalculations and profligacy onto federal taxpayers. This bailout is bad, even though it's couched as good.
So, we can see that bad must become good for the economy to improve. If we can just bring ourselves to believe six impossible things before breakfast, everything will be all right.
Sunday, August 30, 2009
The Obama Administration's Best Bet: Take the Common Sense Approach
The unifying theme in President George W. Bush's two terms was his wealth of self-assurance. He was certain he knew the answers. He stuck hard to the principles in which he believed. He had too much faith in the amen chorus with which he surrounded himself, and gave them too much free rein.
The cost was enormous. Year after year, casualties in Iraq grew while the war continued with no end in sight. Even as military expenditures rose sharply, taxes were dramatically cut with little thought seemingly given to the long term consequences. The federal deficit ballooned, but we were told to take comfort from the beneficial effects that would come from making the wealthy wealthier. The financial markets were provided with vast amounts of cheap credit, and given a deregulatory atmosphere in which to mainline it. Real estate was favored because, in defiance of economic reality, it supposedly would be the golden goose of legend, the asset that would never fall in value. Derivatives were given the Mother of all legal loopholes, which led to the stealth creation of a vast, multi-trillion dollar unregulated banking system that went unnoticed by regulators until it collapsed.
Absent from the picture was a decent measure of proportion, moderation, and common sense. Adherence to the administration's received truths took precedence over contact with reality. Apostates were banished and true believers drew closer together in the firmness of their beliefs.
The Bush Adminstration's rigidity was one of the main advantages Barack Obama had going into last fall's general election. The electorate had had its fill of closed-minded, inflexible wackiness that threw away lives and money. The voters wanted change.
They've gotten less than they might have hoped for. The Obama administration has generally followed the same approach in dealing with the financial and economic crises as their predecessors. There is momentary calm, but really big deficits loom and the real estate market's problems have been swept under the carpet instead of being resolved. Its health insurance reform proposal is being shouted down, with volume substituting for reason. The American war in Iraq is winding down (although the Iraqi war isn't). However, the American war in Afghanistan is ramping up, as is the American proxy war in Pakistan.
It's important for the Obama administration to take some big steps back from the extremes of the Bush administration's policies. That's what Barack Obama was elected to do. At the same time, it's important for him not to become caught up in new extremes. We need some common sense.
For health insurance reform, let's institute the Great American Compromise. Like all industrialized nations, America spent much of the 20th Century coming to grips with the harshness of capitalism. While the free enterprise system is wonderful for innovation and economic growth, it spawns great inequality of wealth that triggers social unrest. Not all of the 20th Century solutions for this problem worked well (see history of Nazi Germany and the Soviet Union for illustrative examples). However, the American solution was to establish safety nets: unemployment compensation for wage earners innocently caught in economic downdrafts, Social Security to alleviate the poverty of the elderly and those unable to work, Medicare and Medicaid, and various welfare programs. The free enterprise system was largely left unchanged. People kept their private property, pursued their personally chosen careers, and in many cases vigorously exercised their Constitutional right to cuss out the government.
It's clear that those with good health insurance coverage don't want to give it up for the sake of health insurance reform. Nor should they have to. The biggest need is for a safety net--basic health insurance for those who can't find a private insurer. We already have such a system--it's called Medicare in some manifestations and Medicaid in others. These programs were created to provide health insurance for the elderly and poor, who would generally be uninsured anyway. Allowing other uninsured people to participate wouldn't be a terribly difficult modification. Their premiums could be adjusted for their ability to pay--a laid-off Wall Street millionaire would pay fair market rates while a laid-off furniture worker in North Carolina would get a break. Sidestep all the mouth-frothing about a National Health Service or single payer system. Just extend the safety net.
In Afghanistan and Pakistan, the U.S. and its allies are largely fighting members of just one ethic group, the Pashtun. The membership of the Taliban consists primarily of Pashtuns. They have successfully partitioned off part of Pakistan for their own country within a country, and give sanctuary to Al Queda in keeping with longstanding Pashtun traditions of hospitality and refuge for visitors in need. The United States has no strong interest in fighting the Taliban or other Pashtuns. They did not attack the World Trade Center or the Pentagon (the mostly Arab Al Queda did that). The U.S. should open channels of communication with the Taliban and other Pashtun groups, making it clear that harboring Al Queda will result in robust U.S. military action, but that peace is attainable if the house guests take a hike. It may seem implausible that the Taliban would make a deal with America. But the Shiites in Iraq did just that during the recent surge, and gave Al Queda the boot from their country. We should focus on destroying Al Queda, not fighting people who have not sought to fight with us.
The really big looming deficits stem from both the Bush administration's unwavering belief that they could get a free lunch--finance a tremendously expensive war in Iraq while sharply cutting taxes while increasing Medicare benefits (with Medicare D, the prescription drug program)--and the Obama administration's stimulus package. Since some 80% of government spending consists of entitlements like Social Security and Medicare, the government can't cut its way out of the fiscal mess. It will have to increase tax collections. That's just common sense. Letting the Bush tax cuts lapse would be a simple way of doing that--they're built into the Bush legislation anyway so nothing needs to be pushed through an increasingly rancorous Congress. But not fixing the alternative minimum tax would be a mistake. The alternative minimum tax is the stupidest tax in the Internal Revenue Code, taking back what the regular tax structure allows and hitting the middle class whom Barack Obama promised to protect against tax increases. The AMT has long ceased to serve its intended purpose and should be repealed or permanently adjusted way upward to hit only the wealthy (and kept upward with an automatic annual inflation adjustment, like the regular tax structure). Maybe more taxes will ultimately be needed. But let's start with the simple thing and let the Bush tax laws take their prescribed course.
In terms of financial and economic policy, the government has thus far dodged the difficult problems (like toxic bank assets, the festering illness that remains in the housing market and the spreading illness in commercial real estate) and softened their impact with the Federal Reserve's printing presses and stimulus legislation. But those problems haven't gone away, and with the real estate market likely to stagnate for years, they won't go away by themselves. These losses--cleverly pushed by Bush administration policies into President Obama's stewardship--will have to be booked eventually. That process is happening already, with each Friday afternoon's announcements of the past week's tally of failed banks. We're up to 84 failed banks for this year already, and many more collapses are expected. Real estate losses and losses from toxic assets will be booked one way or another. The only question is how and when. The banking system won't resume large scale lending while these zombie assets remain on its books. And the Federal Reserve can't keep printing money; indeed, it's trying to figure out how to get all those printed dollars back. Resolving these problems won't be simple. But common sense tells us that we can't avoid them indefinitely, and allowing them to fester may well make things worse in the long run. Green shoots can be overcome by noxious weeds.
One final common sense point. It's time for the administration to ignore the stock market. There is a fin de siecle quality to the market. Upwards of 40% of last week's trading on the New York Stock Exchange was in 4 financial stocks: Citigroup, Bank of America, Fannie Mae and Freddie Mac. There's nothing publicly known about these four companies that justifies this much attention. AIG stock is up some 250% for the month of August to date. That's even weirder, considering that there's no news about AIG, except that the new CEO has reportedly had some conversations with a former CEO, Hank Greenberg. Some rumors have it that Greenberg might be thinking of buying AIG back. But let's recall that the U.S. government, through the SEC, just settled an enforcement lawsuit against Greenberg, charging him with responsibility for improper accounting. He agreed (without admitting or denying wrongdoing) to pay $15 million. Do we really think that the U.S. government, which effectively owns AIG, would sell the company back to a guy it just punished? And then there's GM stock, which has traded all summer at a positive price. That's looney. The publicly traded GM stock is for ownership in the residual company that's going to be liquidated. The U.S. government bailed out, Fiat affiliated company that is making the Chevy Volt isn't traded publicly at all right now. The common stock of the residual company is worthless. But apparently not to numerous buyers in the stock market.
The market rally has become increasingly concentrated in a few large cap stocks. This brings to mind the halcyon days of late 1999 and early 2000, just before the big tech stock collapse. The market rally of those days also became increasingly concentrated in a few big stocks. If that handful of stocks stumbled, then the house would be revealed to be made of collapsing cards. They did, and it was.
Day trading is becoming fashionable again. That's always a bad sign, because the least knowledgeable and most inexperienced traders tend to jump in just before indexes nose dive. The fact that corporate insiders are now selling about 30 times as much of their own companies' stock as they buy (as opposed to an average of 7 times sales to buys) is another hint that the salad days will be short-lived. If the smartest money is selling heavily, what's the logic to buying?
Of course, all presidential administrations deny that their policies are affected by the stock market. But there hasn't been one yet that doesn't scrutinize market indexes. If the Obama administration fixates on stock market movements, it will find itself straitened into dysfunction or adopting policies that exacerbate problems instead of cure them. At some point, common sense dictates that governments can't stop lunacy snd shouldn't try.
The cost was enormous. Year after year, casualties in Iraq grew while the war continued with no end in sight. Even as military expenditures rose sharply, taxes were dramatically cut with little thought seemingly given to the long term consequences. The federal deficit ballooned, but we were told to take comfort from the beneficial effects that would come from making the wealthy wealthier. The financial markets were provided with vast amounts of cheap credit, and given a deregulatory atmosphere in which to mainline it. Real estate was favored because, in defiance of economic reality, it supposedly would be the golden goose of legend, the asset that would never fall in value. Derivatives were given the Mother of all legal loopholes, which led to the stealth creation of a vast, multi-trillion dollar unregulated banking system that went unnoticed by regulators until it collapsed.
Absent from the picture was a decent measure of proportion, moderation, and common sense. Adherence to the administration's received truths took precedence over contact with reality. Apostates were banished and true believers drew closer together in the firmness of their beliefs.
The Bush Adminstration's rigidity was one of the main advantages Barack Obama had going into last fall's general election. The electorate had had its fill of closed-minded, inflexible wackiness that threw away lives and money. The voters wanted change.
They've gotten less than they might have hoped for. The Obama administration has generally followed the same approach in dealing with the financial and economic crises as their predecessors. There is momentary calm, but really big deficits loom and the real estate market's problems have been swept under the carpet instead of being resolved. Its health insurance reform proposal is being shouted down, with volume substituting for reason. The American war in Iraq is winding down (although the Iraqi war isn't). However, the American war in Afghanistan is ramping up, as is the American proxy war in Pakistan.
It's important for the Obama administration to take some big steps back from the extremes of the Bush administration's policies. That's what Barack Obama was elected to do. At the same time, it's important for him not to become caught up in new extremes. We need some common sense.
For health insurance reform, let's institute the Great American Compromise. Like all industrialized nations, America spent much of the 20th Century coming to grips with the harshness of capitalism. While the free enterprise system is wonderful for innovation and economic growth, it spawns great inequality of wealth that triggers social unrest. Not all of the 20th Century solutions for this problem worked well (see history of Nazi Germany and the Soviet Union for illustrative examples). However, the American solution was to establish safety nets: unemployment compensation for wage earners innocently caught in economic downdrafts, Social Security to alleviate the poverty of the elderly and those unable to work, Medicare and Medicaid, and various welfare programs. The free enterprise system was largely left unchanged. People kept their private property, pursued their personally chosen careers, and in many cases vigorously exercised their Constitutional right to cuss out the government.
It's clear that those with good health insurance coverage don't want to give it up for the sake of health insurance reform. Nor should they have to. The biggest need is for a safety net--basic health insurance for those who can't find a private insurer. We already have such a system--it's called Medicare in some manifestations and Medicaid in others. These programs were created to provide health insurance for the elderly and poor, who would generally be uninsured anyway. Allowing other uninsured people to participate wouldn't be a terribly difficult modification. Their premiums could be adjusted for their ability to pay--a laid-off Wall Street millionaire would pay fair market rates while a laid-off furniture worker in North Carolina would get a break. Sidestep all the mouth-frothing about a National Health Service or single payer system. Just extend the safety net.
In Afghanistan and Pakistan, the U.S. and its allies are largely fighting members of just one ethic group, the Pashtun. The membership of the Taliban consists primarily of Pashtuns. They have successfully partitioned off part of Pakistan for their own country within a country, and give sanctuary to Al Queda in keeping with longstanding Pashtun traditions of hospitality and refuge for visitors in need. The United States has no strong interest in fighting the Taliban or other Pashtuns. They did not attack the World Trade Center or the Pentagon (the mostly Arab Al Queda did that). The U.S. should open channels of communication with the Taliban and other Pashtun groups, making it clear that harboring Al Queda will result in robust U.S. military action, but that peace is attainable if the house guests take a hike. It may seem implausible that the Taliban would make a deal with America. But the Shiites in Iraq did just that during the recent surge, and gave Al Queda the boot from their country. We should focus on destroying Al Queda, not fighting people who have not sought to fight with us.
The really big looming deficits stem from both the Bush administration's unwavering belief that they could get a free lunch--finance a tremendously expensive war in Iraq while sharply cutting taxes while increasing Medicare benefits (with Medicare D, the prescription drug program)--and the Obama administration's stimulus package. Since some 80% of government spending consists of entitlements like Social Security and Medicare, the government can't cut its way out of the fiscal mess. It will have to increase tax collections. That's just common sense. Letting the Bush tax cuts lapse would be a simple way of doing that--they're built into the Bush legislation anyway so nothing needs to be pushed through an increasingly rancorous Congress. But not fixing the alternative minimum tax would be a mistake. The alternative minimum tax is the stupidest tax in the Internal Revenue Code, taking back what the regular tax structure allows and hitting the middle class whom Barack Obama promised to protect against tax increases. The AMT has long ceased to serve its intended purpose and should be repealed or permanently adjusted way upward to hit only the wealthy (and kept upward with an automatic annual inflation adjustment, like the regular tax structure). Maybe more taxes will ultimately be needed. But let's start with the simple thing and let the Bush tax laws take their prescribed course.
In terms of financial and economic policy, the government has thus far dodged the difficult problems (like toxic bank assets, the festering illness that remains in the housing market and the spreading illness in commercial real estate) and softened their impact with the Federal Reserve's printing presses and stimulus legislation. But those problems haven't gone away, and with the real estate market likely to stagnate for years, they won't go away by themselves. These losses--cleverly pushed by Bush administration policies into President Obama's stewardship--will have to be booked eventually. That process is happening already, with each Friday afternoon's announcements of the past week's tally of failed banks. We're up to 84 failed banks for this year already, and many more collapses are expected. Real estate losses and losses from toxic assets will be booked one way or another. The only question is how and when. The banking system won't resume large scale lending while these zombie assets remain on its books. And the Federal Reserve can't keep printing money; indeed, it's trying to figure out how to get all those printed dollars back. Resolving these problems won't be simple. But common sense tells us that we can't avoid them indefinitely, and allowing them to fester may well make things worse in the long run. Green shoots can be overcome by noxious weeds.
One final common sense point. It's time for the administration to ignore the stock market. There is a fin de siecle quality to the market. Upwards of 40% of last week's trading on the New York Stock Exchange was in 4 financial stocks: Citigroup, Bank of America, Fannie Mae and Freddie Mac. There's nothing publicly known about these four companies that justifies this much attention. AIG stock is up some 250% for the month of August to date. That's even weirder, considering that there's no news about AIG, except that the new CEO has reportedly had some conversations with a former CEO, Hank Greenberg. Some rumors have it that Greenberg might be thinking of buying AIG back. But let's recall that the U.S. government, through the SEC, just settled an enforcement lawsuit against Greenberg, charging him with responsibility for improper accounting. He agreed (without admitting or denying wrongdoing) to pay $15 million. Do we really think that the U.S. government, which effectively owns AIG, would sell the company back to a guy it just punished? And then there's GM stock, which has traded all summer at a positive price. That's looney. The publicly traded GM stock is for ownership in the residual company that's going to be liquidated. The U.S. government bailed out, Fiat affiliated company that is making the Chevy Volt isn't traded publicly at all right now. The common stock of the residual company is worthless. But apparently not to numerous buyers in the stock market.
The market rally has become increasingly concentrated in a few large cap stocks. This brings to mind the halcyon days of late 1999 and early 2000, just before the big tech stock collapse. The market rally of those days also became increasingly concentrated in a few big stocks. If that handful of stocks stumbled, then the house would be revealed to be made of collapsing cards. They did, and it was.
Day trading is becoming fashionable again. That's always a bad sign, because the least knowledgeable and most inexperienced traders tend to jump in just before indexes nose dive. The fact that corporate insiders are now selling about 30 times as much of their own companies' stock as they buy (as opposed to an average of 7 times sales to buys) is another hint that the salad days will be short-lived. If the smartest money is selling heavily, what's the logic to buying?
Of course, all presidential administrations deny that their policies are affected by the stock market. But there hasn't been one yet that doesn't scrutinize market indexes. If the Obama administration fixates on stock market movements, it will find itself straitened into dysfunction or adopting policies that exacerbate problems instead of cure them. At some point, common sense dictates that governments can't stop lunacy snd shouldn't try.
Tuesday, October 9, 2007
How the Government Fosters Market Instability
The U.S. government promotes instability in the financial markets. Not intentionally; but its policies have that effect. Here’s how.
Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.
Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.
The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.
Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.
Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.
Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.
The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.
The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.
The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.
In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.
Travel News: If you're headed for New York for a good night's sleep, here's a hotel to think about. http://www.wtop.com/?nid=456&sid=1263424.
Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.
Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.
The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.
Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.
Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.
Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.
The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.
The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.
The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.
In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.
Travel News: If you're headed for New York for a good night's sleep, here's a hotel to think about. http://www.wtop.com/?nid=456&sid=1263424.
Subscribe to:
Posts (Atom)
Posts
