The Fiscal Circus Has Two Rings

Now that Congress is making a little traction with a framework for fiscal policy, let’s not get carried away with dangerous partial solutions. It is one thing to keep the patient out of pain with an injection – it is quite another thing to apply the remedy to his problem. So let’s not get so excited about the easy part until we see the rest of it.

Any good circus has more than one ring.  In Ring 1 we have Congress working on an extension of the Bush tax cuts beyond 2010. That’s akin to a shot for the pain. In Ring 2 we have the serious stuff – a solution to fix our debt problems and therein address unemployment and economic growth.  It seems strange that the public has been so divided about Ring 1 since it is the easy one. Both democrats and republicans have joined hands in a holiday chorus and are singing a Hail Mary designed to focus on a possible deficiency of aggregate demand in the short-run. They had their little spats. The Ds don’t like it when stimulus includes the behaviors of high income earners – while the Rs don’t like the stimulus coming largely from the lower ends of the income scale. But let’s face it – they both get to go play on the monkey bars and jungle gyms at recess if they pass something before January 1. The public is going to shower them with love and kisses for saving our nation from a tax increase in a slow growth period with high and stubborn unemployment.  So it is unsurprising that they will find a consensus on the Bush Tax Cuts.

I am not against Ring 1 and am not against the general notion of keeping tax rates low right now. But I do see this as akin to a good dose of Demerol with no surgeon in sight. Ring 1 is okay so long as there is real action in Ring 2. This conclusion is based on one simple point – the Ring 1 solution will do little to reduce the unemployment rate without a satisfactory solution from Ring 2. Ring 2 contained the National Commission on Fiscal Responsibility and Reform. It went home with a few trout in the boat but not enough to start a real fish fry in Congress. It is true that 60% of the members of the commission voted yes to the spirit of a feasible but imperfect compromise law to attack our escalating government fiscal woes, but that wasn’t a strong and clear enough message.  Ring 2 is in limbo right now. The surgeon is not to be found.  Even if the Commission failed to get the required number of votes, it is still possible that the President and Congress can continue the work in Ring 2. So all is not lost.

While all is not lost, nothing yet is gained from a compromise in Ring 1. After all – in reality an agreement to leave the tax cuts in place for next year or beyond is simply a vote for NO CHANGE. The agreement keeps taxes from rising by keeping them the same as where they were in 2010. If we want 2011 to be better than 2010 then it takes some change. So the big question is – what needs to be changed?

Bernanke, Geithner, and many others still believe that the earth is flat. Oops, I mean they still believe that the problem with the US economy is deficient spending. So the kinds of change they are promoting in Ring 1 are fiscal and monetary policies that would stimulate more household spending.  They also believe that the economy has been very unfair to the average person so their preference is to help people with middle or lower incomes spend more. They don’t want to help Gazillionaires.

Another group sees it differently believing that aggregate demand is deficient because firms are hiring too few workers despite some signs of economic revival. Until firms start hiring more, no amount of stimulus is going to be effective. So all we need to do is figure out why firms are so reluctant to hire.  Or in other words, despite the fact that output has gone up in the last five quarters, employment has barely budged.  Why are firms not hiring? Without a significant resumption of hiring stimulus cannot work. First, the unemployed have few resources to spend. Second, even the employed people are reluctant to spend because until hiring picks up they are not sure that they won’t be the next to move to the unemployed pool.

Consider what happens when you hire a new permanent worker. First, the person must be trained. Second, the firm makes an implicit if not explicit contract to continue employment. If nothing else there is a goodwill gesture made on the part of both parties. Third, the firm will increase what it pays into the state unemployment pool. Fourth it will add to the payroll tax paid. Fifth the firm will probably incur expenditure for various benefits – including healthcare and pension. These are not entered into lightly.

Consider the alternative to hiring an additional new worker. Don’t hire anyone! When sales pick up it is possible to work the existing workforce harder. The firm can expect more output during the regular day or it can pay more for overtime. The company might also think harder about how to employ its workers. It might be possible to change its business practices in such a way that the same amount of labor can accomplish more in a given day. Clearly there are financial incentives for firms to not hire more workers. Buying a machine that makes existing workers more productive means not having to pay additional payroll taxes, healthcare benefits, pension benefits, etc.

So why would firms hire more? I love this question because it gets to the heart of economics since it is all about marginal benefits and marginal costs. According to marginal analysis, you hire another worker when the marginal benefit to the firm of one more worker exceeds the extra costs of one more worker. That is, the firm hires more if the increased employment increases its profits.

In a capitalistic system, firms are free to make hiring decisions and they generally hire more to capture higher profits. The government policy question, then, is as follows. If you want more spending, you need more employment. If you want more employment firms need to expect higher profits. Sales are expanding now so you would think that this would lead to higher profits. While profits are rising now the question is for how long? Firms would like some certainty that the recent short-term profits will not vanish as soon as they arrived.

And this is why Ring 2 is so important. To create the increased profit certainty that firms require will take increased attention to the things that might threaten future profits. Historically high government deficits and debt are real threats and all the current fuss over government instability in Europe points to how corrosive this can be. Government could go a long way to reducing profit uncertainty by crafting a solution for the government fiscal mess. This, of course, brings together the recent explosions of debt caused by stimulus legislation, health care, and by the ongoing and fully expected fiscal requirements of Social Security, Medicare, and Medicaid.  It is one thing to make a decision about the future of the Bush tax cuts – it is quite another thing to help firms better understand the tax and other regulatory impacts on them of dealing with the next 20 years of fiscal challenges.

Until you solve Ring 2 we will get no bang from Ring 1. Until you solve Ring 2 you get no decrease in profit uncertainty and no real commitment to hiring. Take no pride in a solution to the Bush tax cut extension until they get on with the real business of government.