Tuesday, December 27, 2011

My Forecasts for 2012

Since it is only a couple days after Christmas I thought I might try something a little different in the blog this time.  All of you are probably still in the giving spirit or in the spirits. So there is no sense in me trying to be too analytical. Many of you are already sick of shopping and you have returned most of your gifts to Walmart so you are open for diversion. Those of you with visiting relatives are posting signs on your refrigerator that indicate that fish and visitors begin to smell after three days.

But this is a MACRO blog and I can’t just blather on about post-Christmas blahs. So what I am going to do is provide you with my forecasts for 2012.

First Peyton Manning will overcome his neck injury and will star with Kim Kardashian in a new reality TV show about the art of hiking a football. I won’t say who will play center but some of you wise guys have already figured it out.

Second, the Indiana University Football Team will win the conference championship in 2012 but will not be bowl-eligible because high school conference winners are not allowed to compete at the university level.

Third, the US election in 2012 will be won by David Letterman. He will run on the Funny Party Ticket arguing that the current batch of DC politicians are not funny and he is.

Fourth, the euro currency will go out of use and will be replaced by the Hungarian forint.

Fifth, Andra Klemkosky will replace Robert Klemkosky as the Dean of Business at SungKyunKwan University in Seoul.

Sixth, small business owners will be given a new Eli Lilly growth hormone so they are not so small.

Seventh, with the FDA closed for roof repair, any drug having gone through testing by movie stars at the Betty Ford Clinic will be approved and available for immediate sale at whatever price the market will bear.

Eighth, Pharmaceutical companies,  Cook Medical, the Post Office, and Topless Bars in DC will become government enterprises managed jointly by Kim Jung Un and the Donald.

Ninth, Vietnam, North Korea, Sanibel Island, and Ireland will become the 59th and 60th states of the USA.

Tenth, US rich people will be asked to move to Nova Scotia and Latvia but will be required to send their pay checks to President Letterman.

Eleventh, poverty status will be extended to all remaining US citizens so there will be no need for anyone to have to work or even pretend to work. The unemployment rate, therefore, will fall to zero percent, the lowest level in 362 years, guaranteeing re-election of the Letterman /Bashar al-Assad ticket.

Twelfth, world GDP will be equal to this year’s plus or minus.

Thirteenth, I cannot remember where I left my car keys and the 13th thing.

I hope you are having a great holiday with lots of spirits and whatever else your usual holiday rituals might dictate. Please do not harm your relatives because some of them might be planning to leave you money. I look forward to bringing you more Macrocrapola in the New Year. 

Tuesday, December 20, 2011

Don’t Open that Gift if from Obama, Reid and Boehner!

The political debate in the USA over the extension of payroll tax cuts and the unemployment benefits (Extensions) is as hot as it is wrong-headed. It’s like two caged female dogs in heat. They both have incredible passion but they have no real ability to make the transaction work. Please no angry letters from dog lovers or my lesbian relatives and friends. No insult is intended.

Anyway, this Extensions fiasco reveals what is so wrong with politics now. Consider first that both parties seem to agree that the extensions are necessary.  They disagree about how to pay for them but they seem to say over and over and over and over and over – getting irritated? – and over that they want to extend the cuts but the extensions must be paid for. The guys wearing stripes think the rich should pay for them while the guys in the polka dots believe it has to come out of other spending.

Like the two dogs in heat, this dog won’t hunt. That’s not the metaphor I was after but I think you know what I mean.  Both sides seem to agree that without these extensions, the US economy is going to go careening off the ends of the earth.  Like driving on the right and eating foot-long chili dogs with ROC-CO-COLA, one cannot question the validity of this truth.  Either we do the EXTENSIONS or the US economy is going to slide head-first into the outer atmosphere.

But we do drive on the left on one-way streets and we sometimes eat foot-long Philadelphia Steak and Cheese sandwiches, so it might be possible to think a teeny-weeny little bit about what might happen if we did not do the extensions. Will the US really slide off the planet? First and foremost it is possible that if we did not make these extensions we would find that US government and other bonds would increase in value. The very thought of increasing government spending right now in a time of huge government deficits could be taken as another sign that the US government cannot govern. This would be true whether or not we enact means to pay for these Extensions. Notice where we are today. It is not yesterday it is today. Today we have failed yet another time to do anything about a solution for government debt and deficits. We can't even find a solution for next year's budget. Not only did the special committee not come to a decision, but now we are being told that the so-called automatic cuts are going to be undone. So let’s be honest here—in financial terms we are looking like the guy who applies for his tenth credit card after maxing out the other nine.

Okay – it’s just another $100 billion or so. To some it seems like nothing. But they are living in yesterday. Yesterday was when love was such an easy game to play. Now I need a place to hide away. Oh yesterday came suddenly. Anyway, the Beatles were right-on in many ways. $110 billion three years ago might have been okay. But now we are on our 10th credit card. Pass these extensions with or without a tax on the rich and the credit markets are going to chew up our bonds and precious dollar as if they were a male dog coming between those females in heat.

What that means is that interest rates will soar, net worth will decline, and spending will come to a halt. Some of you will say it is worth taking the risk. You will say that by not doing the Extensions we have two major sure-thing problems – the average family will lose income per month and those families will curtail their spending. You will conclude that stopping the extensions, then, is both unfair to the average family and will lead to reductions in national spending.

But let’s put these two points together. Let’s suppose that the average family understands that when financial markets look down their collective snoot at the US demand for a 10th credit card, all hell will break out. Let’s suppose this makes the average employed or unemployed worker worry even more worried about the economy. I am guessing that those workers will not readily part with their extension money. They will become even more judicious about how they spend because they need to make sure they continue to have some spending power in the future – as this stupid economic policy makes sure the economy stays weak for a long, long time. Notice that the extension plan does two things – (1) it initially gives more income to some Americans but they will prudently reduce their spending anyway; and (2) it creates a gigantic financial disturbance that will reduce even more spending by all Americans.

So call me insensitive if you want. But the fact that both parties are saying we need these Extensions is exactly the reason you should believe we don’t. Do you really believe these guys? They are continuing to do what they have been doing for years --- avoid the real solutions and pander to people who they think are easily fooled – you and me. Can you imagine what you will get when a smiling trio of Obama, Reed, and Boehner hand you your Christmas gift. I suggest you leave it on the ground and run like hell!

It seems to me that we would all be better-off without this cut...or more succinctly, without this cut in isolation. What we really need is an overall solution for the debt/deficit/growth issues. The special committee failed but Congress could do it tomorrow. Part of that overall solution could include these Extensions but in a responsible fashion whose goal is to deal with deficit/debt/growth.

Tuesday, December 13, 2011

GUEST BLOGGER: Lies, Damn Lies and Occupy Wall Street—Charles Trzcinka

Charles Trzcinka is the James W. & Virginia E. Cozad Chair in Finance at the IU Kelley School of Business

In all the discussion about the tactics of the OWS movement there has not been much attention on what the movement believes about the economy.  The purpose of this memo is to provide students with facts, analysis and a guide to sources of information to help evaluate the claims of the OWS movement. From the title you can see my opinion—the OWS assertions are just anti-establishment babble. I strongly believe that a career choice in finance is both socially useful, moral and clearly remunerative.

Investment Banks are Bad
If any opinion is clear, it is that OWS do not like investment banks. It is not clear what they would do differently. Investment banks help companies raise capital to create jobs. Countries without this ability are poor and the poor in these countries are destitute relative to the United States. How else will savings get to companies who need to invest?  During the 20th century many countries attempted to severely restrict investment banking by government ownership of firms. The result was large scale poverty. There a many studies examining this and for a nice overview read:  Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity by Raghuram Rajan and Luigi Zingales.

Banks Caused the Crash of 2008
Wrong again. The crash was caused by the fall in housing prices. Some banks took big risks with securitization and made the situation worse but the crash also happened in countries where the banks did not take the risks such as Canada and China.  There have been many books written about the crash. For a review of 21 books (10 by academics and 11 by journalists) see http://www.argentumlux.org/documents/Lo__2011__-_Reading_About_the_Financial_Crisis__JEL_.pdf

The article describes some facts that would make the OWS crowd uncomfortable:
·         There were higher levels of leverage in 1998 than 2006 for Goldman Sachs, Merrill Lynch, and Lehman Brothers.   In 2006 the compensation of the top 95 bank CEO was almost all concentrated  in stocks and options which means that the CEO stood to lose the most personally by any risk-taking and they did lose. 

Bank Bailout hurt the common person
This is not close to true. The bailout was about $250 billion and was mostly paid back. The Obama administration claims that the taxpayers have already made $20 billion on this deal. That is, the administration is bragging about its investment. You can see a report by the General Accounting Office that more or less supports this (www.gao.gov). It’s worth noting that the Tea Party movement also made this claim and they were also wrong.

Corporate Greed Causes Poverty
It’s often shouted that corporate greed is causing the income distribution to be skewed to the rich, commonly defined as the top 1% of the income distribution. The claim ignores the fact that corporations have been seeking profits for over 200 years. They are not more profit –seeking today than they were 50 years ago when the income distribution was much flatter.

Corporate Greed is immoral
The OWS movement is constantly asserting that the profit motive is immoral. To me this is a perversion of Judeo-Christian values since capitalism is by far the best system for raising the income of everyone. For a mainstream argument, you could look at Michael Novak, a leading Catholic social theorist, who has written widely on the morality of democratic capitalism - and advocated a moral-cultural system that would nourish the values and virtues on which free societies depend. "Three in One: Essays on Democratic Capitalism" introduces his basic ideas. The point is simple: if we want to increase human welfare this is no better way than the market system.

The Income Distribution is the widest its ever been
This is another distortion -lie. Here is a graph from Paul Krugman. The 1% is increasing but is not yet close to the “gilded age” 

(Note from Larry -- I could not insert the diagram. Sorry. It shows the share of the top 1% was much higher than now until about 1940. The share declined and then began to rise. Chuck gives you a link below where you can draw income share graphs for many countries from the early 20th century through 2008.)

You can generate more plots like this at (http://g-mond.parisschoolofeconomics.eu/topincomes/).  You find a similar U-shaped pattern in Australia, Canada, Ireland, and New Zealand but less so in France, Germany, Japan, and Sweden. The rising tide started during the Carter administration and continued through Reagan, Bush, Clinton, Bush and Obama. It is worldwide and hardly due to US policy. It appears to be strongly related to education.
Finally it is worth noting that the “99%” has also gained in the past 10-20 years just not enough to satisfy the OWS crowd.

Wall Street Controls Politics with its money
This is simply wrong. Nobody has ever found a reliable relationship between political contributions and policy. Most conclude that campaign spending has a very small effect on election outcomes regardless of who does the spending. (For example see Stephen Levitt’s Using Repeat Challengers to Estimate the Effect of Campaign Spending on Election Outcomes in the U.S. House." Journal of Political Economy, 1994, 102(4), pp. 777-98. ). There are of course examples of how money twisted some policy but for every such example there are plenty of examples of political contributors who wasted their money.  The OWS movement appears to believe that because people have money and because some of them make big contributions that politics is corrupted by money. But this is like arguing that because companies spend money on advertising, it must be effective. It is not. Most advertising expenditures are wasted because it’s so hard to predict which will be effective. Political contributions are for the most part simply wasted and there is plenty of money on both sides of most issues.

Challenges for Capitalism
The OWS movement appears to believe that the 2008 global financial crisis marks the beginning of the end of modern capitalism. It is a strange belief because it presumes that there is a viable replacement waiting in the wings. The truth is that, for now at least, the only serious alternatives to today’s dominant Anglo-American paradigm are other forms of capitalism. But there are challenges to market economies. See for example an essay by  Kenneth Rogoff (http://www.project-syndicate.org/commentary/rogoff87/English)

Rogoff points to five serious challenges currently facing modern capitalism: a failure to price public goods (clean air, water, etc.) effectively, high levels of inequality, “the provision and distribution of medical care,” the undervaluing of “the welfare of unborn generations” and, finally, financial crises. Rogoff points out that economics has solutions these problems, if politicians dare to implement them:

On being a finance major
Your choice to be a finance major puts you at the heart of these challenges. Congratulations on having the insight, intelligence and now the courage to do so.

Tuesday, December 6, 2011

Good Policy and Employment Growth in the USA

Hey Pete isn’t it a pity that you can’t run the mile in eight minutes.  Yes, Pete said, but I am happy to be walking after that hip operation last month.  But the surgeon said you would be as good as new in a couple of weeks. Yes, and the surgeon needed a new hot tub cover too. Anyway, despite worries that the US economy is not improving fast enough to bring us back to normal, the Labor Department release last Friday was heartening and suggests further improvement. The payroll survey revised upward job growth in October and reported an increase in jobs for November of 120,000. The companion and broader household employment survey showed employment growing by 278,000 jobs. The unemployment rate fell below 9% to 8.6% as well.

In terms of the overall economy, this is a bit like Pete being able to walk a mile but it is still a ways from his normal mile run. The real issue today is one of false expectations. Activist politicians and economists wanted us all to believe that that their hocus pocus policies would have us running faster much quicker than was really possible. They are just now admitting that the global crisis was larger and deeper than first described – and will take longer than normal to heal.  So while we won’t do a back flip over the recent report, the truth is that the US economy seems to be on the mend.

One of my colleagues – let’s call him Joe since that is actually his name – pointed out to me as I was busting a gut trying to do three consecutive push-ups at the gym – that Europe was at it again. All the news last week was about a possible new compromise that would save the euro, Europe, and seals. But Joe pointed out that every time the EU seems on the verge of an agreement, Merkel and Sarkozy once again decide they are going to re-enact the economic equivalent to World War II.  Merkel wants Europeans to behave more like the Swiss – Sarkozy wants them to act more like Zorba.  Maybe Merkozy could come together and agree that Europeans should act more like the Dutch.  The Dutch are very conservative, save parts of their paychecks each month, smoke dope in Turtle Bars, and generally enjoy life as they ride around the town square on 300 pound 25 year-old bicycles that were given to them by their grandparents. They also say things like Als tublieft and debankt.

Before I go much farther I just wanted to tell you that I have not had sex with any sports coaches or Herman Cain. I do recall several times in high school when my coach said that if I didn’t play better he was going to put his size 16 High Top Converse All Star up my youknowwhat. But that is the closest I came to sex with coaches or politicians.

Financial markets want to see real solutions to our global financial problems. It seems worth thinking about that if the EU and the US were to fashion reasonable compromises that these markets would  be utterly delighted and increase further, consumers would feel wealthier, banking bottlenecks would be relieved, and the world economy could get back to an 8 minute mile. If I was a US politician up for re-election next year I would think about the political payoff to finding a real solution. The payoff to good policy choices has never been stronger. I would worry a lot, however, that if the EU actually does fashion a decent compromise while US government officials continue to approximate the monkey cage at the zoo, the political cost could be quite heavy. Our politicians will look even dumber than the monkeys if they are the only ones to let the milk spoil.

I keep saying words like – real solution.  It is possible that the Europeans and US politicians might come to some agreement or compromise that was not a real solution – and I am NOT advocating that. The room for real solutions, however, is quite ample. For those nuts who read me regularly, you may find this next part redundant but a compromise does not necessarily mean we sell our souls to Bobby Knight. A compromise recognizes that you cannot get exactly what you want but you do not have to give up on your basic principles. It is sort of like me when I agree to participate in our household’s Christmas decoration activities. As a relative to the famous Grinch and the son of two unreligious Jews, I don’t love the idea of spending hours putting together manger scenes, Christmas villages, and lifting a 900 pounds Santa out of the basement. But I do it anyway because I know two things. First, Betty will buy me some really nice Christmas presents. Second, my kids will buy me expensive bourbon.  So it is a good compromise.

A reasonable fiscal package in the US would recognize that housing and finance are the source of our current problems and need to be addressed. This  would entail dealing with the housing default overhang in a way that recognizes the difference between those who might realistically be able to repay with some contract adjustment – and those who might be able to repay but only if they won the top prize in the lottery. A real solution would also put us on a path toward smaller debts and deficits though recognizing that stimulus cannot be withdrawn too fast. A plan to begin reducing government stimulus but at a pace that accelerates over time could be designed by economists.  Should the US Congress come up with something that seriously addresses these two issues, incumbents could laugh their way back to their usual payola and corruption in 2012.

In summary, things in the USA are not as alarming as some people say but are not as good as they could be. We are on the mend from a serious illness but we need to keep following the doctor’s orders. The time for alarm and extreme policies has passed. Even small changes in the right direction can and will have great impacts on wealth, confidence, economic growth and employment. Politicians have much to gain by doing the right things. They do not realize how much they will personally lose if they continue to fritter away time and voter patience. 

Tuesday, November 29, 2011

Inequality and Compromise

A basketball team works because players take different roles. Look at a box score --  the point totals are usually very unequal. Some players score points, some rebound, some excel at defense. The player with the most assists rarely gets the attention given to the high scorer – and it gets worse as the season progresses. The star players and the best teams get all the ink and airtime. Yet the team concept works and it performs well. This happens and you don’t hear much about the majority of the players complaining about the excessive treatment afforded to the few.

A marriage often brings together two people who are quite different. One spouse sometimes brings in the income while the other takes care of the household and families. Even when both spouses work one might be the main income earner while the other supplements. This often works very well and it makes no sense that one is jealous of the other’s public accolades.

A person from another planet might observe all this and marvel at the benefits brought by specialization, division of labor, and trade. Working together really works! A person from a completely different planet might, in contrast, worry about the obvious inequalities. Why does one player always seem to sit on the bench? Why does one spouse not go on exciting business trips to Ellettsville Indiana? Why don’t those people demand equal rights?

Some of you have already decided to quit reading. Obviously I must be a person who is totally insensitive to the profound historical and current injustices of discrimination that produce harmful inequality. Let me just say -- that it isn’t so. Trying to convince you that I am not a bigot is not, however, a useful or effective use of my time. Most of you know me and know who I am. What I will try to do – if you are still reading – is just point out that there are times and places when inequality is dead wrong – and other times when it is quite right. And it helps a lot to know the difference. Apparently our politicians either do not know the difference or they do and they think they can fool us.

Basketball teams and marriages are not the same as jobs and business firms. But let’s make no mistake about it – these same ideas hold. A business firm exists because an entrepreneur takes a risk with his own or borrowed funds. Whether it is a new neighborhood restaurant or a multi-billion dollar corporation, the owner or owners begin the process by taking what would have been their saving or spending and applying it to the land, capital, licenses, payola, and other things necessary to start a business. 

Then the firm has to find partners and employees to make the plan work. The government is one of the partners when it supplies infrastructure, police protection, or it gives the firm a tax break. Clearly the business is not going to be a success without employees – from the person who sweeps the driveway to the Chief Executive Officer.
Like the marriage or the sports team, the business firm is a team effort. And like any team effort, we would be fooling ourselves if we did not admit that some activities or decisions will impact some of the partners differently from others. It is traditional for the CEO to get different pay, benefits, and working conditions from the person who sweeps the floor. Furthermore, like most other partnerships, decisions are NOT made in a democratic fashion. The coach is chosen for his or her technical expertise. The coach makes the decisions. Sometimes the star player may not like the decision. Sometimes a bench player may not like it. Sometimes a team member might dislike a decision or a coach enough to quit and move to another team. But much of the time if the decisions seem to be made for the benefit of the team or the organization – people might grumble but they go along with it. Sometimes the grumbling turns into an effective communication that helps the coach understand that changes need to be made. 
Maybe a star player is getting too much attention and that negatively impacts the team. Either a coach makes use of this information and improves the team or the team begins to fail because of poor teamwork.

When the team begins to fail is when we learn even more about its weaknesses. Everything comes under the microscope including the owners, coach, the star players, bench players, and so on. This creates a “season” for focus on every aspect of the team. And that is as it should be. Open and transparent analysis and discussion might lead to saving an otherwise doomed organization.

Call me naïve but this little discussion helps us to think about problems in the US, Europe, and various other places. Whether Obama started this or not – right now we are in the middle of a blame-game that fails to recognize one very plain fact – WE ARE ALL ON THE SAME TEAM. That team has generated new businesses, successful existing businesses, profits, jobs, incomes for the middle class, and more. It has generated all that for centuries despite the very obvious and salient fact – blatant inequality of income, net worth, and other aspects of economic life. We exonerate some of the inequalities and we deplore others.

What makes these days different is the depth and severity of the world slowdown. There were failures in the system and we are now busy trying to figure out how to solve them. In the present negative environment we are not so much really trying to figure out the causes of our problems than we are pointing fingers at each other. Let the damn rich pay for it. Those lazy workers need to work harder. The poor and elderly are dragging us down with their entitlement mentality. Those corporations are rich and selfish.

Can you imagine a good athletic team winning with all those fingers pointing? Italy was smart enough to move to a technocratic (non-political) new government. It may or may not work. But clearly it is an attempt to reduce the finger pointing and have someone come up with a plan to improve the country. Ideally the plan will help the country – the whole team. But we would be naïve to think that the implementation of the plan will have equal impacts on everyone in Italy. So in a highly politically-charge environment it will be hard for people to see beyond the initial unequal impacts to the eventual positive impacts on the country. People will scream that a rising tide does not raise all boats the same. But what Italy and the USA and the rest of Europe need right now is a rising boat.

How to raise the level of the boat – going from sports to boating? Sorry. Anyway this is where some compromise has to be involved. This is not 2005 and it is not 1966. It is a very frightening and frenetic time. It is a time when all parties are going to have to be at the table. Any proposal designed to favor one group at the expense of another is not going to succeed in this environment. Focus should be on the national or team health and not on righting past grievances.  If this were not a moment of weakness then it might be possible to work harder on past inequalities. But that is not the case. The nation is weak and the focus must be on what will make it strong. It will take compromise to achieve this. 

As both the EU and the USA move the world toward another debt crisis we can only hope that our political leaders will understand that political ideology might appear to help their set of “good guys” but will only result in the suffering of all of us. Germany may have to give a little more toward a compromise but let's hope the bargain gives them more of what they want as well -- so long as the solution intends to strengthen Europe. The US will have to accept higher tax revenues but let's hope this is done in a way that the burden of adjustment does not single-out or penalize one group over others enough to risk a further crisis.  

Tuesday, November 22, 2011

ObamaCare, Jobs, and Global Competitiveness

President Obama has recently underlined two related themes -- improved opportunities for workers and opening up trade opportunities abroad for US firms. Breaking down trade barriers, it is explained, would increase opportunities for exports and that too would lead to more jobs. I will write another blog post about the recent attempts toward a free-trade agreement with Pacific countries. This posting will instead focus on ObamaCare and jobs.

I had a few minutes between Fox News and Glee so I decided to read “The Patient Protection and Affordable Care Act.” That is I weighed into the 2074 page tome sometimes referred to as ObamaCare. It doesn’t exactly read like Dr. Seuss so I focused on the part of the bill that explains a new $20 billion tax on the revenues of medical device companies. A medical device company, as we all know, makes pumps for old men like me who need a little extra help in the bedroom. They also make parts for hips, knees, and shoulders as well as devices like catheters, stents, scalpels, and pacemakers.  As you can imagine, this kind of production takes a lot of capital and skilled workers. Wages are good. These are good jobs. One would hope that in this century our national policy would be aimed at allowing these companies to be as competitive as possible. It would be great to see these companies expanding employment in places like Indiana, Massachusetts, and Minnesota.

But the truth is that policy seems to be doing just the opposite. ObamaCare was passed in 2010 and we know that this Medical Devices Tax will go into effect in 2013. There are some in Congress who are trying to repeal this part of the bill but so far they have been unsuccessful. The House has the votes to repeal but the Senate does not. 

The tax will be levied on a company’s revenues and amounts to 2.3%. My first response to 2.3% was to say that 2.3 is a really teeny number. If I lost 2.3 pounds I would still look like an elephant. Big deal – slap those rich medical device makers with 2.3%! They can surely afford it. Right? WRONG! There are estimates this 2.3% tax increase could lead to a reduction of 10-30% of the medical device workers in the USA. My first reaction was No Way Jose. To understand where this comes from we have to open up our General Accounting Textbook. Really? Yes really!

Let’s make this easy. Let’s suppose Davidson Peepee Pumps (DPP) sells 10,000 pumps each year and earns revenue of $40 million per year.  Let’s now suppose that DPP Inc has labor costs of about $10 million per year and another $27 million in material, capital, energy, and other costs. That leaves them profits before taxes of $3 million. Since it is a privately held company – DPP nets $3 million. No, not quite. DPP has to pay corporate income taxes. Let’s suppose it pays 25% of the profits to the government – that means old Lar has about $2.25 million to give to his mean kids or to go on Mediterranean cruises. Of course, he may want to use a good bit of that to buy some new machines or otherwise invest in the enhanced competiveness of the company.

Now let’s bring in the sales tax of 2.3%. In 2013 DPP has to pay 2.3% of $40 million. That means old Lar has to pay another approximately $920 thousand to the Federal government.  His $2.25 million after income tax profit is now a $1.3 million after income and after revenue tax profit. Notice that while the tax is 2.3% of sales it has reduced after tax profits from $2.25 million to $1.33 million.  That is a 41% reduction in after-tax profits.  In summary a 2.3% sales tax reduces profits by 41%.

You sharp cookies will notice immediately that DPP is not a real company and Old Lar is really a worn out economics professor. You will claim that I have rigged the numbers to exaggerate the claim. But go ahead and do your research and talk to any profitable medical device company and ask them for some real numbers. I am betting that you will not get a reduction in after tax profits of less than 25% caused by this single feature of ObamaCare. Worse yet, my example assumes a fairly profitable company and a low tax rate (a medical device company could be paying as high as 50% on income to federal, state, and local jurisdictions). What about young entrepreneurial ventures with sales larger than $5 million (since the act exempts those with less than $5 million) that might take 5-10 years to generate good profits? During those 5-10 years they would be even further in the red because of this sales tax approach. Note that any medical device company that does not generate a decent profit in any given year will have losses in those years because of this onerous sales tax approach.

So much for you sharp cookies. Let’s move on to you other cookies. You might say – who cares if we take another $920,000 from DPP? Medical device companies don’t need such high profits anyway.  But let’s be serious. In today’s slow growth economy there are not many companies confident about the economy. Most companies are in the hunker-down mode trying to reduce their costs as much as possible. They do not know how long this slow growth period will last and they obviously are not giggling as they go to their favorite credit unions.

So even if you don’t like profits of these companies, the more probable truth is that the 41% decrease in DPP profits is going to spur the company to reduce costs even more. In this case, let’s look at what happens if DPP protects its profits by reducing labor costs by $920,000. Labor costs drop from $10 million to about $9 million, a decrease of about 10%. The 2.3% sales tax now becomes a reduction in labor expenditure of about 10%. If US medical device companies employ approximately 400,000 workers, then we are looking at a possible reduction in labor force of approximately 40,000 US workers. 

High tech companies that have already survived the recession by replacing labor with capital will continue to do so in the face of a new tax increase. Of course there is no real reason for these companies to wait until 2013 since it may take a little time to get ready for the year when the new tax is introduced.  These high tech companies are not apt to reduce their non-labor costs since labor is uniquely saddled with higher healthcare, pension, and other employment handicaps.

Sadly, the above analysis is the more optimistic of two scenarios. In the above example we only lose 10% of the current workers. Another likely aspect of the revenue tax coupled with other aspects of ObamaCare is for these companies to close their operations in the USA .This means that all or most of these jobs are in jeopardy. A 40% reduction in after-tax profits is another way of saying that the US is not the best location to remain competitive. US medical device makers have to compete against companies located on foreign soil. 

Not only is labor often cheaper in these others countries but these countries may also have lower profit taxes and regulatory bodies more conducive to quicker product approvals. Boston Scientific, an important US medical device company, recently announced a decision to invest $150 million in a Chinese factory.  Boston Scientific is not the only one weighing its options for overseas locations. Higher taxes, tougher price controls, and slower regulatory approvals from the FDA are not exactly the ways to improve US national competitiveness. 

The upshot is that no matter how you look at this new revenue tax on medical device companies, it is a job killer. Companies that face large reductions in their profits will not stand still. Capital intensive high tech companies are going to make most of their adjustments with labor. This means they will fight for survival by either reducing their US labor forces or by doing more of their work overseas.  

It was thought that since ObamaCare brought more people into the health system with means to pay, healthcare companies should pay for this increase in taxes with higher revenues. But given what we already know about the pricing pressures and expected reductions in payouts from insurers, it is not clear that medical device companies are going to benefit much from a larger number of people covered. 2011 is not too soon to revisit parts of ObamaCare if we REALLY CARE about employment. 

Tuesday, November 15, 2011

Latvians, Homework and Budget Balancing

I went to a Latvian wedding last weekend and the dog ate my homework. Anyway, because of this or that my usual blog post may be a little shorter than usual. But I have been wanting to do this with or without the excuses anyway. This post is just a little data exercise to provide some perspective on what the so-called special committee is doing. Politics aside, their assignment is not really that difficult. One takeaway is that there is too little attention given to the fact that we are trying to create one solution for two very different problems. It’s like trying to find one shirt for Dolly and Gary Coleman. One size just won’t fit all.

The special committee is supposed to find roughly $1.2 trillion in deficit reduction over a time period of 10 years. In looking at spending and revenue possibilities everything gets lumped in and examined together – the Bush tax cuts, loopholes, spending on the military, etc. As a result we have an economic and ideological debate about what is and what isn’t a fair change. But the truth is that we really have two issues. The first one has to do with the short-run. We have a recession followed by a slow growth economy. The second one is the longer term issue of how to deal with an aging population. Separating these issues might help create some simple insights – and some simple remedies.

Let’s take the short-run first. The data is very clear. We jumped from having a very reasonable deficit of $161 billion in 2007 to one of about $1.3 trillion in 2010. That’s a 8-fold increase. The data is very clear about the source of that increase – between 2007 and 2010 government spending increased by $727 billion and taxes decreased by 406 billion. But that’s not the best measure of what happened. If government spending had grown at its normal rate (average rate since 1971) it would have increased in those years by $661 billion. Thus, only about $66 billion was an extraordinary increase in spending. It tax revenue had grown at a normal pace from 2007 to 2010, tax revenues would have increased by $602 billion. A tax decrease of $406 billion means that tax revenues were $1.008 trillion off their normal pace. It is absolutely clear that 2007 to 2010 was different from normal because: spending rose $0.066 trillion more than normal and tax revenues increased $1.008 trillion less than normal.

You spending clippers do not like this result because it focuses our attention away from cutting government spending to raising taxes. But you are wrong for two reasons. First, the spending issue has more to do with the long-run and I will get to that soon below. Second, I cannot tell you we need to raise specific taxes or tax rates because the tax reductions came from two very different sources – those that came from policies (e.g. Bush tax cuts, Obama tax cuts, etc) and those that came automatically as households, firms, and investors had less incomes and capital gains to claim. I can tell you that the fall-off of taxes was shared. Between 2007 and 2010 personal income taxes declined by $268 billion while business taxes decreased by $179 billion. Social Security taxes declined by only $5 billion.

Let’s move on to the longer-run. I am defining the long run as the 10 years from 2010 to 2020. Over those years government spending under existing law will increase by a total $1.705 trillion. This is, total federal government spending will go from $3.456 trillion in 2010 to $5.161 trillion in 2020. The changes in government spending over those years are projected to be:
Total                      $1,705 billion
                Social Security         502
                Medicare                 383
                Medicaid                 247
                Net Interest             436
                Everything else        137

Notice that if we don’t change any of those programs – and we cannot change net interest – we will need to raise taxes in 10 years by $1.7 trillion to cover spending. There isn’t much to cut from “everything else” and we can’t touch net interest. But we do have a nice hunk of future spending equal to $1.132 trillion that shows some promise.

Let’s emphasize now what is and what is not a cut. For example, Social Security spending is going to INCREASE by $502 billion. Just imagine that your check goes up by $502 billion by 2020. I would be pretty happy with that. But now, let’s say we decide to reduce the increase by 10% or by $50 billion. You would still find yourself $452 billion ahead of where you were in 2010. That will still buy a few nice prunes!  That is NOT a cut. It is an increase of $452 billion.

Speaking of Social Security, Medicare, and Medicaid if we slowed the increase by 10% we could save ourselves tax increases of $112 billion. If we cut the increase by 20% we would save $225 billion.

This short-run/long-run breakdown suggests that we have two different problems. The first one is to try to improve the tax system to offset reductions in taxes accruing from two recessions in the last decade and the tax cut policies that treated the recessions. As the temporary tax programs automatically are rescinded and as economic growth improves, much of that tax problem will disappear without any policy whatsoever. Of course, some attention to tax loopholes and attention to reversing temporary spending increases could hasten that short-run problem even more. 

With respect to the longer run the only game in town is spending. No program has to be cut. And tax revenues will increase. But reining in spending growth is necessary if we are to address our debt and deficit issues. Right now the baseline estimates have the deficit declining by a large amount in 2013 as temporary tax changes end with the deficit declining to 1.2% of GDP by 2010. I wouldn’t trust that number but it does show with some marginal attention to Social Security, Medicare, and Medicaid, all this is within reason.

I have not said a word about optimal spending and tax policies for long-term growth. I have not said anything about flat taxes or tax reform in general. Those are issues very worth addressing in another post. But what I am saying here is that we can do something about our worst debt and deficit problems. The solutions are not as impossible as our politicians make out.

If the European debt mess doesn’t send us a signal I don’t know what will. Our growth and our employment are dangling precariously as our leaders drink martinis and tell war stories. Boehner calls Obama a goof ball and ReidPelosi calls the Republican candidates worse names. They have within them to power to play political games that will soon seriously damage our country or they can wear big person clothes and address the humdrum but very doable task of letting the world know that we can handle our financial messes. From what I see in the news it sounds and looks more like continued political posturing and less attention to simple solutions. We should send all our government officials Barbie Dolls!

Tuesday, November 8, 2011

Hurricanes and Hot Air

Hurricanes have a notorious eye. I grew up in Florida and experienced a lot of hurricanes and it is true that after a hurricane hits you full force there is a time period when all again turns calm. But you know the devastation is not finished since the back end of the hurricane is coming in minutes. You have just enough time to close one set of windows and open the others to relieve the pressure that might blow your roof off and then bam along comes the trailing half. If that wasn’t enough, you know well that there is a hurricane season. Not long after you have dealt with the aftermath of one hurricane, your meteorologist warns of the next one heading your way. If the last one was a bad one, it makes you ever vigilant and always worried of impending doom despite the fact that most times most people never suffer through more than one bad hurricane in one season much less a decade.

It is human to expect tragedy to follow tragedy. Luckily when it comes to hurricanes, we don’t also have to worry that politicians will make hurricane policy the centerpiece of their campaigns for office. It is enough to deal with the uncertainty brought about by the winds. Worse can be the hot air and real policies advocated by politicians.

That little introduction brings us to the US economy right now. We had a once in a lifetime economic hurricane in 2008 known as the housing and financial crisis. The financial and housing crisis turned into a global recession. Despite the fact that the recession ended about two years ago, our policymakers seem to think we are still in the eye of the storm or perhaps between two equally devastating storms. Regardless, an impending presidential election year has these politicos acting as if we need saving from doom when in fact the worst is over and there is really very little they can do at this time to improve things. Politicians cannot benefit from that reality so they pretend like it doesn’t exist. The democrats want to pass another stimulus program they have labeled as a jobs program. The republicans play dueling banjos with their own means of stimulus. While stimulus sounds good to many people, the truth is that what we need now is a little patience and a little good policy addressed at what is really wrong with the economy.

Let me admit that I do not think that stimulus is a dirty word. When I teach macro I do cover cases where a Keynesian demand stimulus might be appropriate – usually when deficient aggregate demand is abetted by dismal expectations and spending needs a little boost. I think there have been times when such policies worked and I also think that the idea of some stimulus on 2008 was not a bad idea. I disagree with the form of much of the stimulus in 2008, but the general idea was not totally off base.

The trouble with stimulus can be likened to the idea of eating one potato chip. Maybe even one of those small bags of chips isn’t too bad now and then. But whether it is one chip or one small bag, the trouble comes when you eat 1.5 trillion of those little bags…each year.

That brings us to 2011. It is now November. Paul Krugman, Martin Wolf, and many other spokespersons for the economic left are strongly advising that governments avoid any rush into austerity programs and to immediately move to larger government deficits financed by an expansion of the money supply. This is very Keynesian stuff but 2011/2012 in no way fit the Keynesian requirements for such policies. Let me try to explain why this is medicine aimed at the wrong problem.

First, as recent economic data shows, the US economy has regained its legs. We are not ready for a marathon run, but let’s appreciate what we have. The US economy got socked by several shocks. These shocks all diminished our desires to spend. First was the diminished value of housing and other wealth that spilled over into Main Street. As sales of most goods were negatively impacted this led to layoffs and further reductions in spending. Despite the severity of all this, the economy did start to grow again and was on its way when bam along came a perfect storm of impacts from a tsunami in Japan, commodity price increases, and a whole chain reaction of supply chain disruptions. It didn’t help that Europe was falling apart and the financial impacts of the sovereign debt crisis were spilling over on wealth and spending in the US. This second storm had its predictable negative impacts on spending.

You might say – if the stimulus helped in 2008, then why not try it again in 2011? And my answer would be that while it appears like a similar situation again in 2011, it just isn’t the same. There are lots of differences. For one thing, the economy is growing now. Forecasters see further gains in employment. They are predicting that the unemployment rate will fall further in 2012 and that the economy could grow in that year by 2-3%. That is a lot different than 2008 when we had no idea when and where we would reach a floor in economic activity. The differences in consumer/business confidence are stark between 2008 and 2011.

Second, you might correctly point out that the growth of the economy at 2-3% won’t have a big enough and fast enough impact on the unemployment rate. You might add that without further stimulus policy, growth will be too slow and this will hurt too many people. But hold on Toto. Another difference between 2011 and 2008 is that we have added a massive amount to national debt with no real prospect of near term reduction. A little Keynesian stimulus when debt is a major concern makes no sense. Our credit has already been degraded. We have skated for a while as Greeks and Italians have watched their interest rates soar. But another US stimulus package will focus the world’s investors on the USA and we do not want to see what happens when they start aggressively selling US bonds, stocks, and dollars.

Third, while inflation is not an immediate threat to US citizens, it is much more a potential issue than it was in 2008. Already prices of many critical food items have risen and it is no secret that inflation is at or above what the Fed usually considers okay.   Adding too much stimulus right now just risks a return bout of inflation. Moderate growth sounds terrible for the unemployed but if stimulus-induced short-term increases national spending, then whatever help we give to the work force in the near term will soon be undone by a future bout of stagflation. Inflation is no friend of the worker.
Finally, a return to fiscal and/or monetary stimulus simply interferes with doing the right thing. I am not in favor of an extreme short-term loaded austerity program. But I am for a quick agreement that would set out the size and parameters of a medium term program to reduce the size of government deficits. I also favor a faster and clearer attempt to address housing and financial problems. It is possible to find solutions for specific financial problems that do not create a moral hazard for the future. The depth of the financial problem does require that investors and tax payers share in the support of the solution.

In sum, neither a quick stimulus nor austerity will help us improve the US economy. Both will make us worse off. What we need to do is address the real causes of slow growth – out of control private and public debt. Once investors and business firms see that sensible policies are being put into play then you will see some real progress in economic growth and employment. In today's environment of political frenzy it is hard to imagine a good ending. 

Tuesday, November 1, 2011

Financial Tornados Part 2: Satellites falling from the sky

In my last blog I suggested that it is important to distinguish between events that will likely repeat and those that won’t. Policy cannot be backward looking or we waste the people’s money. No matter how devastating it might be to have part of an orbiting satellite fall on your head, it makes absolutely no sense to spend huge sums of money to prevent something that almost never happens. Yet, more and more evidence is piling up that policymakers continue to suggest remedies that make little sense when a repeat of the past financial crisis is so unlikely. That does not mean that there are not affordable and reasonable things that can be done. Building better satellites or programming them to fall in the ocean seems more reasonable than building a roof over the globe.

I want to continue this line of reasoning with some comments about various solutions that keep popping up in the business news. For example, in the Financial Times of October 25th, William Dudley, president of the NY Fed called for a “comprehensive approach that should start with an urgent effort to remove the obstacles that make it difficult for all borrowers to refinance at today’s low mortgage rates.” In my previous blogs I have been a strong advocate of finding ways to solve the housing finance crisis. And refinancing is clearly important in that regard. But Dudley’s message misses the point. What got us into this mess is exactly what Dudley is suggesting. It is like telling an alcoholic that he needs to drink more to cure his addiction. The “obstacles” he refers to include the very things that are necessary to make sure that loans are repaid by the people who borrow the money. Dudley should be more direct. He really wants the government to subsidize the loan process. If that’s what he really wants, then he should recommend that bankers continue to use good banking principles while he asks for direct government support to those who cannot afford to pay back the loans. The latter would be temporary and more befitting of the problem. Suggesting that banks use poor policy is more permanent and guarantees a replay of the financial crisis.

In the same issue of the FT is an article by Barry Eichengreen and Raghuram Rajan recommending that central banks expand their responsibilities to include a dual mandate for monetary policy.  Instead of central banks focusing on employment and inflation alone, they recommend central banks also aim their policies at financial stability. While it is true that financial regulators were and are part of the problem of the financial crisis, it is not clear that the lack of a dual mandate for central banks caused the current crisis. Every country has a regulatory system with one or more institutions that oversea financial stability. In some cases they have too many overlapping institutions. But the industry is covered. I do not know what it is that suggests that central banks have an advantage in producing good financial policy. Most experts believe that central banks have a difficult enough time with just one mandate – finding a satisfactory balance between inflation and unemployment. E&R want to saddle these struggling central bankers with tradeoffs between unemployment, inflation, and financial stability? Wow. Crazy.  It’s like asking a one-armed juggler to add a few more flaming rings to his act.

Then there are the recommendations for increased European integration. George Soros has a plan to save the eurozone. It was not enough to have a stability pact that required that eurozone nations be mindful of the sizes of their deficits and debt. This pact had penalty fines attached and seemed like a great solution to protect the value and reputation of the euro. That worked until Germany had a little problem with the requirements and fines and the Germans simply said nein. That ended that. So now we are to believe that since there is a sovereign debt crisis, Europeans will enact a new treaty that creates a common European Treasury, a newly empowered European Central bank with direct controls over credit lines and portfolios of all banks, and more.  Did the lack of explicit policy integration stop countries from exerting their own preferences for fiscal policy? The answer is no. There was a treaty and when it infringed their own sovereignty, they found ways to avoid it. When Frenchmen and Finns feel threatened by European events they will always find ways to preserve France and Finland, regardless of agreements and treaties. Perhaps in 50 years Finns and Frenchmen will believe their interests are best served by a United States of Europe. For now, however, the recommendations of Soros and others amount to treating a one-time bout of the flu with an Iron Lung Machine.

The problem with Soros’ and other proposals for more European integration of fiscal and monetary policy is that these are solutions to problems that do not exist. The EU is not the United States of America. The EU is mostly a single market with a single currency designed to make its members more productive and competitive. It was designed to be a loose federation of sovereign states. This worked well until 2008. Then a “satellite fell on their heads”. This satellite is likely not to return yet serious economists and political leaders want to "build a roof" over all of Europe.  The sovereign crisis of Europe is serious. But the solutions should fit the causes of the problem. It makes no sense to enact permanent edifices for rare events. It would be much better to find short-term remedies designed to overcome the worst problems and then get on with the task of being a loose federation of sovereign states with a single market and money. 

Tuesday, October 25, 2011

How to Deal with Financial Tornadoes

Being retired affords me some personal options. For example, I can sleep until noon and Betty dusts around me. It also gives me the flexibility to take on some overseas teaching. I have been fortunate enough to teach for the last two months in an MBA program in Seoul, Korea. My contract provides an unlimited supply of kimche in return for economics lectures. It seems pretty fair to me! Anyway, I am now in Bloomington with great intentions to rake leaves and otherwise be a productive household unit.

While in Korea I read my usual newspapers and watched a little business/political news and tried to write my blogs from afar. I am struck, however, as I sit here in little Bloomington Indiana at how common are the political breakdowns in most countries. The political breakdown and  government malfunction have got to be a defining signature of our times. In my last blogs I nibbled around the edges to try to understand why we get such bad policy and today I try a different angle. This one focuses on the difference between problems and big problems – or dealing with challenges versus emergencies.

Many of the important policies we are dealing with daily have had and will have relatively enduing consequences. The stimulus programs will have effects that last for years. Today we are confronted with a new debate about how best to improve the jobs situation. In parallel is a very heated question of taxation of rich persons. Health care policy and what to do about entitlements require policies and solutions that will be with us for decades. In short, our government is bent on making policies that could not be considered temporary – these are changes whose impacts will last. These are solutions whose effects will endure.

The heft and durability of policies should, I think, reflect the nature of the challenges they seek to resolve. For example, if your kid stole a pack of cigarettes you would probably not send him to prison for 50 years. If your house burns to the ground you would not rebuild your house without a stove. If a tornado destroys your house you would not move to Venice Beach California or a place that almost never has tornados. If you got a stomach ache, you wouldn’t quit eating.

Most experts agree that the financial collapse and the ensuing recession and slow growth period, including the continuing dismal performance of unemployment came about because of a once-in-a lifetime-event.  I would not call it a random event but the swiftness, the depth, and the very sources of problems made it a rarity among economic shocks.  Tornados and fires are tragedies that sometimes unfold for reasons, but the truth is that most people never encounter these problems. If you live through one such event the likelihood is that you will not endure a second one. When someone is unlucky enough to experience one such tragic event, it is reasonable that they wonder what they could have done to prevent the problem and what they should do in the future.

It is equally reasonable to conclude that sometimes because of the severity of the negative consequences of such rare events, that people come to the wrong conclusions and sometimes make tragic decisions about how to avoid them in the future. I am afraid that is what is happening today with respect to economic events since 2007. Let’s go back to the tornado example. Surely moving to Venice Beach seems pretty outlandish unless you always wanted to live near Muscle Beach and were afraid to admit it. Less extreme would be to rebuild a house that has a basement, so you would be safer if another tornado did impact you. In between those extremes might be building a house that could stand the high winds of any tornado. I am guessing that such a house could be very expensive and well beyond the financial resources of most people. No matter which choice is made, however, there are financial consequences.

With respect to our current high rate of unemployment and slow economic growth, it seems to me we are barking up the wrong policy trees, especially if you believe that the economic shocks of 2008 were macroeconomic tornados – once in-a-life-time shocks that may never happen to us again. The negative economic consequences of the financial crisis are all around us and it is easy political picking to find demons and red herrings. Let’s blame it all on the capitalist system. Let’s blame it on rich people. Let’s blame it on China. Let’s blame it on globalization. Let’s blame it on….

If 2008 and thereafter really were the results of a rare event that has some small possibility of returning in the future then it seems to me that we want to do three things. First, realize that nothing you do right now will make the past go away. Second, don’t change things forever that have very little to do with a rare event. Third, whatever you do make sure that you are focused on what really may have caused the problem and attack those causes directly and with a budget that seems commensurate with the probable return of the problem.

So let’s create two lists. First we list all those things that did not cause 2008 and thereafter. Second, let’s list those things that we think did cause it and which could happen again without remediation.
List 1. Did not cause it:  people without healthcare insurance, rich people, insufficient taxes paid by rich people, the capitalist system, unions, worker demands, China, oil companies, inadequate infrastructure, air pollution, unemployed teachers and policemen, a disdain of small business to hire workers, immigrants
List 2. Did cause it: excessive leverage by financial and other firms, households incurring too much debt, governments incurring too much debt, unrealistic expectations about housing prices, corrupt practices among some individuals in financial firms, Fed policy that left interest rates too low for too long, realization that government revenues are insufficient for current and future liabilities, earthquake

Before you get too hot under the collar…note that List 1 does not imply that there are no problems with respect to income distribution, poverty, de-regulation, re-regulation, business costs including employee health and pension benefits. There are problems that need addressing in all those and other areas. But the point is to try to prioritize and to focus on cause and effect .If high unemployment and slow growth are the result of something – then let’s stick to those things. Let’s not use the current economic malaise as a cheap excuse to solve all of man’s ills.

Let me end this with a few words about the recent protests.  Those who have lost their jobs, houses, retirement incomes, and other means of living in the last several years have a right to be disappointed and angry. They have a right to peacefully protest and make their grievances known. There is much wrong with this country and we should all demand better solutions. But it helps no one to throw the baby out with the dirty bath water. What we all want is for things to get better. To do that with limited resources we have to focus and we have to be logical. Capitalism has served this country and most of the world well. Just imagine how the world has changed in the years since I was about 14 years old walking around Miami as Kennedy faced down the Soviets over rockets in Cuba. Since then country after country gave up central planning for some form of capitalism. It hasn’t been perfect and there are many things we can do to improve capitalism as it serves people of all incomes – but surely if we have learned anything it is that central planning is not a superior system.  We already have a mixed capitalist-socialist system. The financial crisis and resulting global slowdown will not be improved by radical departures from capitalism. Let’s keep our eye on the ball and not be diverted by people who are just using this crisis as a means to their own ideological ends.

Tuesday, October 18, 2011

Howling Wolf

On October 13 Martin Wolf wrote a column in the Financial Times called Time has Come for Intelligent Policy Making (http://www.ft.com/intl/cms/s/0/f4d3fdce-f42f-11e0-bdea-00144feab49a.html#axzz1auKt9tCY ). He ends the article with the following quote:
There are two big points here. First, fiscal and monetary policy converge when interest rates are close to zero. The authorities have to co-operate closely, to prevent an unnecessary disaster. As Deng Xiaoping said: “It does not matter if a cat is black or white, so long as it catches mice.” Who cares if a policy is called fiscal or monetary, so long as it works? Second, without economic growth, it is almost impossible to deleverage an economy. The prime minister revels in his pre-Keynesian views. When weak demand is the immediate constraint on output that is simply terrifying.
What is terrifying is that Wolf, a very influential writer, fails to recognize facts and continues to render advice that will truly harm the world for many years to come. He makes two important errors. First he believes that the present macroeconomic problem is deficient demand. Second he thinks that if past stimulus policies have failed then it behooves government to try them again – now with bigger doses of policy and with more coordination between the government and the central bank.
His belief that the main macro problem is a deficiency of demand or spending is like believing that driving accidents involving drunk drivers result from speeding. It is true that these accidents are correlated to driving speeds just as economic malaise is heightened by under-spending. But correlation is not causation. The accidents were caused by people drinking too much. Our lack of spending derives from very specific causes like years of unsustainable debt, a housing and financial crisis, a European sovereign debt crisis, and the attendant effects these trends have had on both Wall Street and Main Street. Calling for policy to induce people to spend more is like putting up new speed limit signs for drunks. Neither of these solutions addresses the root problem and the result is that neither will work. To the extent that Wolf continues to advise governments to focus on deficient demand means policymakers who follow his advice continue to avoid progress on true causes and thus threaten to make things worse.  
It is interesting that Wolf does not appear to read Wolf. In other columns he is quite lucid about the financial roots of our problems and is instructive on the need for private investors and tax payers to share in the solution burdens. Why he avoids his own advice and keeps coming back to strongly advise stimulus policies aimed at deficient demand is an interesting question. Maybe he doesn’t understand cause and effect? Maybe he believes the situation is so dire that cause and effect seem to be less important than trying ANYTHING to solve the problems. This is not 2008. I just don’t understand why he is so willing to throw caution to the wind and grab at straws.
This brings me to my second point. Wolf wants to see more stimulus and he wants a coordinated monetary and fiscal policy. Apparently the past programs were not enough. But Wolf doesn’t really say how much would be enough. By most measures the past fiscal and monetary injections were huge. And while there may not have been explicit coordination, the Fed and the US government were doing plenty without sending texts or tweets to each other. In theory a solo fiscal policy might lead to higher interest rates as government borrowing crowds out private borrowing. But that didn’t happen this time. I have read nowhere that rising interest rates have prevented recovery. Wolf seems to believe that if the Fed buys the government bonds that will somehow provide even more spending oomph. But does he really believe interest rates are not low enough now for people to want to buy a home or for firms to buy another machine? Does he really believe that the simple announcement of a new, large, and coordinated stimulus will cause people to run in droves to Amazon.com and Walmart with confidence and zest?
Much of Wolf’s conclusions derive from his belief that deflation is a bigger problem than inflation. I will give him that. I do not see imminent inflation for the world economy. But I see that fact different from him. This higher probability of deflation today stems from a belief that monetary and fiscal policy are spent and are NOT the right way to solve our macro problems. The more people listen to Wolf the more worried they become. This worry shows up in uncertainty and a desire to retrench. They don’t spend more when stimulated. The more the government tries to help, the more it nibbles off its own foot. I suggest we keep this Howling Wolf out of the hen house. More stimulus and more coordinated stimulus are going to scare the Hell out of people. What we need is for government to address the causes of housing and financial distress. Only then will we see a resumption of growth in output and employment. A wolf howls at the moon to no avail. I hope the same is true for the Wolf named Martin.

Wednesday, October 12, 2011

Haircuts, Hazards, and Hand-Grenades

I need a haircut. It has been more than six weeks since my last visit to the Crosstown Barber Shop and the little hairs on the back of my neck are looking unsightly.  But the market’s down and I was hoping to get a little more mileage on the last haircut. And there is the odd chance that government, feeling sorry for old people like me, might come to my rescue with a haircut subsidy.

While the above sounds really silly it is not a bad description of what is happening today around the globe.  Today we use the term haircut to describe the ability or willingness of the private sector to share at least part of the credit losses that have occurred in the last several years. A haircut means that a creditor agrees to take less than the promised or expected return on an asset. When it comes to housing in the US, Ireland and a few other places the haircut has to do with financial institutions that hold bad mortgage loans and/or derivatives tied to these loans. When it comes to European and other banks it has to do with banks and other financial institutions that are holding sovereign debt or the official government debt of Greece and other European nations.

We are not used to talking about haircuts in this manner. In the past, banks and financial institutions that held bad investments were seen as poor decision makers and we generally believe they needed to take care of their own business problems.  If they made bad investments and could not stand behind their debts then they should go into bankruptcy or go out of business. One such institution might try to sell its investments and willingly take a price reduction or haircut in order to maintain cash flow. But this decision was a private one – taken by a troubled financial institution to resolve its difficulties. It was not a matter of public policy.

Today things are different. Today we are in a financial crisis in which the proportions of the problem go well beyond a few firms, a few industries and beyond a few countries. The proportions also go well beyond an amount of debt which could easily be paid with government assistance from a single country or even a consortium of countries. Simply put, the financial crisis has most of us in a very deep hole. If it was not such a deep hole, we would have been out of it by now. If it was not such a deep hole, we would not have so much discussion and such little real action. This is not only a deep hole but it is a new one. Financial crises have come and gone. But most of these past financial crises have been limited to one or a few countries. 

These crises came before the age of GLOBALEV. GLOBALEV is a time when leverage became excessive. GLOBALEV is a time of global interconnectedness that turned the financial industry into a highly interdependent organism.  GLOBALEV is a time when housing and financial market bubbles burst and the negative impacts were quickly transmitted to financial institutions in most countries.

In short, we find most countries of the world sharing a very large financial burden. While bankruptcy and debt reneging/renegotiation might have been appropriate in the past, these solutions won’t work in GLOBALEV. There is too much money involved and too many countries that would be part of a downward cycle of default. Asking private investors to assume the whole load of this debt crisis is like asking me to lift a building. A more relevant question, however, is to ask HOW MUCH of the current debt crisis could realistically be carried by the private sector. That is, how much of a haircut are private financial institutions able to take? One might argue that they should take 100% of the burden. This is the way things ought to work in more normal times. But in GLOBALEV it is not possible.  If we asked all financial institutions to clear their nonperforming debt by tomorrow, the world’s financial system would grind to a quick halt.

Many are quick to point out the phenomenon of moral hazard. And they are correct to do that. If you do not make private financial firms assume the full burden of their investments, then they will assume that they will never have to do that in the future. Whatever harmful practices got them into the current problem would surely continue in the future. So the moral hazard issue is real and worth considering when determining the size of the haircut. With the financial crisis so deep and wide, a moral hazard cannot be avoided.
So if the private financial firms cannot withstand full responsibility for their bad investments, then they must be assumed by society.  GLOBALEV implies there must be a shared responsibility. 

This issue reminds me of people who live in flood plains whose property is destroyed by over-flowing rivers and oceans. Whether they were insured or not, it always seems to be the case that society ends up sharing the costs when homes are destroyed by flooding waters. I always gripe that this is unfair to those of us who do not live near water. But it seems to go on and on. After the waters recede people rebuild in the very same places. It sounds crazy but I think about the outpouring of both private and public relief that is mobilized every time there is severe human misery inflicted by Mother Nature. If tax-payers are unable to protect themselves from irrational home location decisions, it seems that we are equally impotent when it comes to deep financial crises.

Some of you are grinding your teeth right now. But I think it is unavoidable that a financial bailout will be part of the solution to our financial crisis. It will send the wrong signal to bailed-out firms and it will not prevent future disasters from happening in the future, but it will be part of a solution that might work.  It might work because the problem is so deep and it requires more assets than the private sector can now provide.  GLOBLEV requires a tax-payer contribution and the only question is HOW MUCH of the total amount is paid through government. Many options are possible. At one extreme the government can shoulder 99%.  At the other tax-payers might fork over 1%. But more than likely, the amount paid by tax-payers will be somewhere in between. 

Unfortunately HOW MUCH the taxpayer pays has become a political/ideological stick of dynamite. Inasmuch we are several years beyond the beginning of the financial crisis and we have little in the way of policy progress. Much has not been legislated and much of what has been legislated has not been put into practice. Stalling, or not deciding HOW MUCH the taxpayer contributes, is the one and only reason why we are staring down the barrel of a double-dip shotgun and why we have made little or no progress in employment.

Right now most of the news is about Europe and the lack of progress on their sovereign crisis. This negative cloud is hanging over all of us. Why? This cloud exists because Germany leads a group of countries that insists on a larger haircut and a small government contribution. France is part of a block that thinks a larger social portion must be paid. In Europe the usual problem of who pays gets even tougher and more political because it not only pits the creditors against the tax-payers but it pits country against country. If most of the debtors are in southern countries and the richer tax payers are in the north, then it is much more difficult to find a sharing solution that seems fair.

What’s happening in Europe is no different than our experience in the US. We continue to have a huge overhang of mortgage debt. We continue to have banks that sit on a razor’s edge of financial stability. We wonder why housing prices keep falling and no clear end to the housing crisis is in sight. But our politicians, like their cousins in Europe, do not want to admit or deal with deciding on the private haircut and the public split. Conservatives want the market to bear the full brunt.  Liberals want the tax-payers to pick-up a larger share of the debt.  Yet nothing will be accomplished until they admit the reality of the situation and get on with a compromise. In the meantime no jobs bill will restore demand or supply to a nation that sees no solution to GLOBLEV. So long as GLOBDEV remains, banks will not lend and houses will not sell.  Firms will continue to have less than sanguine expectations and will see no need to expand employment.

I personally have no frog in this race when it comes to deciding the size of the private haircut. As I said above, the smaller it is the bigger is the problem of moral hazard. Furthermore, the more tax-payers bear the burden the more our national debt increases and the more our financial reputation is a stake. Shifting the burden of finance from the private to the public therefore has its risks. But then the bigger you make the private haircut, the larger the risk you take with respect to the crumbling of global financial markets. This is a deep hole and there is no free lunch. But the more we pretend this is an ideological problem the more we stall a solution and the longer we languish in economic purgatory. We need some experts to decide the proper ratio of public to private responsibility and then we need politicians to bring home the solution. I am not optimistic we will get what we need anytime soon.