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. 

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!

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. 

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 25^th, 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. 

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.

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.

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.

Currency Manipulation and the Wrong Super Hero

This week our US Senate is taking up the issue of China’s currency manipulation. It appears that we have an almost bi-partisan attempt to create even dumber international trade policy. The stock market hasn’t fallen enough – so our Senate has decided it can do even more to impoverish Americans. Way to go Reid! The Republicans who normally wouldn’t go along with this kind of stupidity (since they have their own kind of stupidity) seem to be worried that they need to play this populist card too.  Let’s blame everything on China. China– you bad. US Congress – we good.  So much for intelligent representation and policy!

What do these guys want to do? While the exact legislation is changing each day, the basic idea is that China depreciates its currency to create a competitive advantage for its exports. So we have legislation that would ask someone to calculate the degree of advantage China gets from currency manipulation and that would be fed into a Robot that would spit out the size of a tariff to apply to some or all of China’s imports into America. Sounds easy, right? Sounds fair, right? Sounds like it will save American jobs, right? Sounds like it will make 65 year old men more potent and attractive, right?

This reminds me of that cold day back in the 1970s when a car-full of Indiana University economists slid off a snowy highway between Terre Haute and Indianapolis and found themselves in a ditch wishing that a truck driver would stop and help them. We had a lot of PhDs in that car but no one who actually could figure out which end of the car to push. Luckily a truck driver did stop and offered some advice. He suggested that we push the car down further into the ditch and then floor it enough to drive out of the ditch. We concluded that this particular truck driver must have gotten his license from Purdue University and that there was no way in H___ that we were going to push the car down further into the ditch.  That was really stupid advice and even a bunch of professors knew it. We convinced the brawny driver to help us push the car upward and we were soon out of the ditch and on our way to Indianapolis. 

The point is that sometimes you really want to be rescued but sometimes you get a super-hero who just isn’t up for the task. In the case of China we in America feel threatened. We worry about China taking away our jobs and companies. So it is not wrong that we worry about how to better compete with China.  But this idea to tie US import tariffs to an estimate of Chinese currency manipulation is impossible to implement, will not increase US jobs and competitiveness, and will more than likely than not be counter-productive.

First, it is impossible to do. While we may have lots of theoretical models that might tell us how much China’s currency is under-valued, there are so many different ways to calculate this number that even a robot named Curly-Larry & Moe might sputter around in endless loops of break dancing. Then there is the small issue that implementing increased tariffs based on this number is not only novel but is illegal within the rules of the WTO. There is no precedent for this. While it sounds like a desirable thing to treat currency manipulation as a trade barrier worthy of reacting against, the WTO has not sanctioned this kind of retaliation. 

Then there is the question of other countries that routinely depreciate against the dollar to gain competitive advantage. Would it be proper and fair to only single out the Chinese? So are we really going to work Curly, Larry & Moe overtime on Brazil, and the others too? Do we really want to risk a global trade war right now?  In short it is really hard to find any way to actually implement this policy. It’s like making it illegal for Martians to own homes in Nevada. It sounds good to try to keep them out of Nevada – but I am not sure we have a good way to do this.

Second, this policy is not going to work. Notice that over the last years the Chinese currency has appreciated against the dollar. While it might have appreciated somewhat more, it is not the case that Chinese policy has been to reduce the value of yuan.  Other developing countries have done more.  Note also that these increases in the value of the yuan have not worked to reduce the US-China trade imbalance. So why would more work?

The answer is that it won’t work and it is because there are more fundamental factors at work causing the US to have a large trade deficit with China. Simply put, we in the USA make Miss Piggy look anorexic. We don’t save. We consume. The trade deficit is an expression of this imbalance. We buy from China and what we don’t buy from China we buy from other countries to meet our ever growing appetite for goods. If somehow we reduced our trade deficit with China, the spending would show up as a deficit with another country or countries. Of course China has a similar but opposite imbalance – they consume less and save more. This is perfect for us. We want to buy and they want to sell. Currency manipulation has very little to do with this. The problem is saving/spending and not currency values.  Altering fundamental attitudes and habits with respect to saving and spending is not something that can be done easily or quickly. Thus, our politicians would rather grasp at populist policies that do not work instead of doing the hard work of focusing on the real problems and solutions.

Finally is the recognition that it is counterproductive to focus our policy so strongly on currency manipulation and trade protection. Rome is burning and we throw gasoline on the fire. If this legislation were actually to be passed and signed by president Obama, we would not only be not addressing the real problems but we would be inflaming China and other countries. They know about our imbalances and they fully recognize protectionism when they see it. Other countries will not sit around and wait for us to focus on them next. Other countries are experiencing the continuing painful global slowdown and there is much populist demand for more protectionism in countries all over the world. 

Of course China has plenty of weapons beyond a simple trade war. How will we have served our own interests when China reacts by buying fewer US government bonds as the US government is trying to sell another $1.5 trillion of them? Or what happens if China aggressively sells the government bonds it already holds. W should not stir up trouble if there is nothing to gain. We should not stir up trouble if there is so much to lose! Instead, we should be the leader. We should be the leader for the right policies. We should not be the leader of a downward spiral of devastating protectionism.  If there are any real leaders in Congress we can only hope they will quickly step forward and put a quick end to this very harmful legislation.  

Class Warfare

Republicans huff and puff about Democrats’ assault on richer people. Democrats retort that they are not interested in class warfare – they just want to be fair. Finger pointing. Hateful words. My mother is bigger than your mother.

Is there a way to prove who is right or wrong about class warfare? I doubt it but we sure have fun slugging it out. As my Mom used to say, I don’t care who did it. You are both going to your room.

Instead of debating which came first the chicken or the egg let’s try another approach. Let’s just focus in on the question of taxing the rich more.  Taxing the rich is being discussed today as part of a program to reduce future debt and/or find a way to stimulate employment. Taxing the rich, according to some Democrats is a way to generate tax revenue so that future government deficits will be smaller. It seems fair to them since the rich, after all, are rich. Less of their income is devoted to buying goods and so there is less potential to harm spending in an already weak economy.  So the basic intuition of taxing the rich is that this is a way to reduce future deficits without overly slowing the recovery. In terms of fairness, it is believed that the rich have done well in the last 20 years and if anyone can take the load of higher taxes right now, it would/should be them.

Like any proposition, this one needs to be objectively evaluated. I don’t care if you are a Democrat or a Republican, you might not favor taxing the rich more if (1) it did not raise revenue, (2) it did not reduce future deficits, and/or (3) higher taxes for the rich had a negative implication for economic growth and employment

As is usual, I will not prove anything below, but I do hope to show that in 2011 there are many good reasons to believe that higher taxes on the rich will not be a good thing for the country. I’d rather take this approach than argue endlessly about whether or not this is class warfare. Let’s take one thing at a time.

First, what exactly do we mean when we say we are taxing the rich more? As I understand the current proposal it means reducing income tax deductions for persons having taxable income of $200,000+ and imposing a higher tax rate for people who earn a million dollars or more. So to begin with we could have a discussion about whether or not income tax returns of $200,000 imply that people are rich. While a Midwestern college professor living in small town who makes that amount might feel pretty wealthy I am told by people who live on the coasts of the USA that $200,000 per year does not indicate a lifestyle that involves high priced call girls and large shiny cars. And many entrepreneurs who file individual tax returns might quibble about whether such an income level would suggest even medium priced call girls or a Kia Soul.

This question of defining who is rich and who really has the capability to pay the tax and not reduce consumption has some relevance. This is not just a game of defining what rich means.  Is it possible that the current plan hits people who will make real spending cutbacks? Is it possible that entrepreneurs faced with such a tax will compensate by reducing wages or hours of employees? Thus, while it might be plausible to tax the rich for the purposes expressed above, it might be useful to do some serious homework about at what level you might be able to define rich and succeed. But even if this level can be found there is another issue that relates to how the rich will react when they are singled for punishment. Without significant changes in the overall tax code, is it not predictable that very rich people will feel singled out and work extra hard to find ways to exploit the existing code to reduce their tax liability?

Second, speaking of the rich and very rich, let’s talk about saving. Saving is boring. Except for a few exceptional people, most of us would rather have dinner with the in-laws than save. But consider the fact that saving greases the wheels of the economy. Thankfully in most countries there is plenty of saving going into the banks and other financial institutions each month so that entrepreneurs who want to invest have a source of funds. Consider, however the USA right now. The government is not saving. In fact the government is basically running down its saving to the tune of almost $1.5 trillion per year. That is, instead of that amount of money going to private borrowers it is being diverted to the government. The Fed has done its part to replace those savings but that is not a permanent solution. Every country needs for its businesses and households to save. And guess who does most or nearly all of the saving in the USA? That’s right – it is the richer people and the companies. If we aim a bigger tax bite at these richer folks and the small businesses who earn more than $200,000 per year, then this will mostly be seen by a reduction in US saving. Some might continue to save but they will use every loophole still available to park their money in places where they can get a decent after tax return. As a result we will see our preciously small savings going abroad and making our country even more financially dependent on China and other countries. You might call that a very significant unintended effect of taxing the rich more.

So the upshot is that while higher taxes on the rich looks like a nice way to improve the country’s debt problems, mostly what it will do is make them worse. As wealthier people save less or move their saving off shore, it just makes it harder for our banks and financial institutions to survive and make good loans for investments and houses. It also makes it harder for the country to grow. Remember that a country’s aggregate demand is composed of household spending AND spending by business firms for plant, equipment, office buildings, software, etc. Taxing the rich might seem to protect household consumption, but it does very little to similarly shield the rest of the spending. Higher taxes on the rich could very well mean more problems in banking and finance – and less spending and employment.

Let’s get back to the fairness issue. Measuring changes in fairness is to look at how the low, middle, and high income people have prospered over the last 10 years. It is absolutely true that of these groups, the wealthier ones have done the best. But does that mean that a policy to redirect money from the pockets of the wealthy to the pockets of others will improve things? I doubt it. Do we really think that the issues that plague the very poorest will be solved through another government poverty program? If you are concerned about wasting society’s money, do you really trust government to use these dollars to make a real dent in poverty? I doubt it. And the proof of this is the very fact that in the face of rising poverty we have not one single clearly espoused and forcefully lobbied analysis of poverty. Name one politician who is pushing a clear program to reduce poverty in the USA. You can’t because instead of one good program we have a mess of individual programs that are rife with inefficiency and corruption. That’s the way these politicians want it.  They make it look like they advocate for the poor every day and every way and the end result is all talk and no action. The rich are an easy target. But will taking from the richest really help the people who might benefit the most?  Give me a real poverty program to replace the current mess and I think the rich would be happy to vote for it and pay for it.

The same basic story relates to the middle class – a group that has suffered because of industrialization, globalization, reduced power of unions, bunions, and more. In the name of helping the middle class we have a myriad of conflicting and wasteful programs not to mention an almost constant outcry for business regulation and against any program that appears to assist business. We come back over and over and over to this silly notion that prosperous business comes out of the hide of the middle class. Some people honestly believe that for business succeed they must injure or take advantage of their workers.  It is so simple and wrong that most people forget the notion that it is a healthy business that hires more people. Imagine a time in the last 100 years when it wasn’t true that employment rose rapidly because businesses were thriving. How can one argue against creating a better climate for business flexibility, creativity, and competitiveness?

The present proposals to extract more income taxes from the rich won’t work and they won’t improve fairness. Class warfare or not, they simply miss the point. They won’t help the poor or the middleclass and will only be one more attempt to dupe the nation into supporting an inefficient government. If our policy makers really cared about the poor and the middle class then we should have seen a real program aimed at specific problems.

I have one last point. I took the high road here. But one has to wonder why it is that the President can believe that it is fair when half the country’s citizens don’t pay any income taxes. I suspect he would have a lot more luck in raising taxes from those who can afford to pay the extra taxes if he would just stop repeating his mantra about millionaires and billionaires and just get to the hard business of a comprehensive tax reform. It is silly to think that the country’s debt and other issues can be solved by taxing rich people more.  He could end up soaking the rich if he would just elucidate a program that examines the whole tax system and treats all people with dignity and respect. 

When the Lender of Last Resort Fails

Charlie only had one life jacket on his pontoon boat. Pete fell overboard and Charlie thought about throwing it to him but then realized that if he did, he would no longer have one for himself.  Being a true friend he threw it to him but unfortunately Pete went over the falls anyway – life jacket and all. Then Charlie noticed the leak in the boat.

I studied a lot of macro but I never got to the chapter that says what happens when the lender of last resort fails.  It is a widely shared view that the Fed has the right and the privilege to be the lender of last resort. So if the US economy is sinking and sinking badly, the Fed is supposed to use monetary policy to keep us all from drowning. We saw the lender of last resort activity in the last couple of years. Now the Fed has announced that it will be the lender of last resort for French and other European banks.

It all sounds pretty rational. Economic systems are prone to boom and bust cycles. We think we learned from the Great Depression and from other financial crises that monetary policy should play a stabilizing role. But one thing we didn’t learn is what happens when the central bank plays the role of lender of last resort and they fail. That is, Pete goes over the waterfall and there are no life jackets left. What now?

If there will be a lesson to be learned from the present global financial crisis it will be that central banks really did play their lender as last resort roles. Europeans often bemoan the fact that the European Central Bank did not bail out Greece and other countries fast enough or with enough gusto, but even the ECB has come forth with plenty of cash. Now the FED, ECB, and a few other central banks are printing money to help key European banks get enough dollars. There is enough money out there to sink a very large boat.

What is reassuring to some folks and frightening to others is that the lender of last resort role has no finite amount of ammunition. Unlike Charlie’s life jacket, the Fed has plenty of bullets. Why? Because modern central banks can print money whenever they want.  It is virtually costless to pump out another $100 billion. The problem is not so much the number of bullets – it is their impact. Maybe we should be using pharma as our example. Mike has a headache. Give him a couple of aspirins. Mike still has a headache. Give him a few more aspirins. The truth is that Mike has a headache because is wearing the wrong size undershorts. Aspirin isn’t going to help. Mike needs a bigger thong.

When the Fed was doling out all that dough last year did it ever wonder what would be left for them to do in a double dip? I don’t know what goes on behind those gold laden walls, but I didn’t hear much on this topic. And their seeming unflagging duty to pour in even more money recently suggests that the thought has not even entered their minds.  If one tranche wasn’t enough try two. If two wasn’t enough try three. It’s just math. It’s math at least until you realize that more and more aspirin in going to give Mike a bad stomach problem to complicate his undershorts issue. 

So there are two points to cover. First, why didn’t the earlier money expansions work? Second, why are they creating even worst problems as a result of the monetary addiction? The first part is easy. Monetary stimulus (and fiscal stimulus) do not address the most pressing problems. The causes of the Wall and Main Street problems were financial – too much leverage on top of two much leverage.  Very little has been done to solve those problems because politicians don’t have the guts to tell people there is no easy way out of that dilemma. So they prefer to drag us through a decade of horrible economic malaise instead. Don’t rip off the band-aid. Pull it off a little at a time. Only a politician would do this. Doctors don’t get paid for being popular. They rip off band-aids with fervor and sometimes glee. Our politicians use money as a drug to counter some of the negative side-effects of the slow band-aid pull.

So the answer to question 1 is simple – politicians give us money instead of real solutions. The second question is more interesting. Okay – so we slowly bleed for a while. Isn’t that better than the intense pain of a quick solution? I think the answer is no. Here are five why.

Reason #1. Weakening the economy for a long time makes it very sensitive to every economic virus that goes around. A strong patient bounces back from the flu quickly. The weak one may not survive. What economic shocks are around the corner? Clearly whether it is a jolt in energy prices or a spike in food prices after flooding, the economy will adjust more slowly and with less elasticity. This is very risky behavior!

Reason #2. Keynes was very specific in his book the General Theory that when credit markets lack confidence, the impact of monetary policy on output and employment all but disappears. There may still be a few people around who trust Bernanke, but as more and more money seems to work less and less, we are getting closer and closer to Keynes’ liquidity trap wherein money is totally useless to stimulate the economy.

Reason #3. The low interest rate environment just compounds our problems. So long as people cannot get decent returns on assets they will pressure financial institutions to innovate and create ways for them to take higher risk and get high returns. Banks would rather facilitate this madness than loan money to entrepreneurs. Isn’t it interesting that the Fed says they are saving us yet what they are really doing is engineering a repeat of the past financial crisis! Why does the Fed want to perpetuate leverage and risky investments? This could mean more downgrades and another financial crisis

Reason #4. All this focus on monetary policy diverts our attention away from reforms that would regulate the most egregious factors in the housing and financial markets. It is true that the positive effects of these kinds of policies will be slow in coming. But the longer you wait, the more the problems fester. The more the problem festers the more we raise the probability that a new shock will throw us for a loop.  

Reason# 5.The Fed has discounted an increase in inflation despite the fact that most indicators and expectations measures show it is bubbling below the surface. Despite all this economic sluggishness and large and persistent excess capacity, the psychological link between money and inflation remains as strong as ever. Inflation will not simply rise gradually. At some point it will explode. When it does it will be too late for the Fed to reverse engines. Bernanke stares at the cameras and solemnly says for us to trust him. The Fed is a very modern and scientific institution. When the economy recovers and inflation begins to be a larger threat, the Fed with utmost precision will remove money in the perfect amounts that will guarantee growth in output with stable inflation. Woowee. And if you believe that have I got a bridge to sell you!

In short, the Fed is entering uncharted waters. They seem to see no end and no risk to their policy of lender of last resort. They REALLY need to think about this some more. It is a very dangerous game they are playing with our jobs and welfare.  

Macroeconomic Policy and Fooling the Public

As policy leaders dispense with logic and grab at policy straws aimed at further demand stimulation, it is good to review the essential assumptions underlying the Keynesian model’s optimism about aggregate demand policy. The key assumption is something called Wage Illusion. A second one has gotten less notice but is something we might call Business Optimism illusion. I was going to call it Snake Oil but I had another JD and calmed down a bit.

While there are some who believe that economics and especially macroeconomic can be reduced to the terms hocus pocus (ie total nonsense) I cling to the notion that macro and macro policy have a basis in logic. When President Obama or one of his policy advisors recommends a stimulus package, the recommendation does not come out of the blue – it comes from a well spelled-out analytic framework. I keep resisting the urge to use this word – but I really should admit that our real world policy is based on THEORY. Whew, I went ahead and said theory. I feel a bunch better now.

One theory says that you might want to try stimulating demand as a way to exit a recession or improve the growth of the economy? Most of us learned something called Neo-Keynesian theory.  It turns out that Monetarists and Supply-Siders also pay homage to the Neo-Keynesian Model (NKM). While these groups of economists may disagree on policies and various technical aspects of the NKM, they tend to use the NKM to support their recommended policies. You might call the NKM an agreed common battleground. Monetarists and Neo-Keynesians do not usually agree about policy but they use the NKM to duke-it-out.

So let’s get back to stimulating the economy with a policy to increase spending or aggregate demand. It all sounds so reasonable. Give people tax cuts and they will spend. Give people bigger subsidies and they will spend. Have the government build roads and bridges and the people that build these roads and bridges will receive income from the government and they will spend. You have to admit, it sounds pretty straight forward and easy. Woowee!

I see that some of you are getting red in the face and are ready to inhale large quantities of funny cigarettes. So let me agree that the above oversimplified. Some of those people who receive the new incomes have big debts to pay and do not spend all of the money. And we know that at some point some tax payer will have to pay for the government handouts – and those who pay the extra taxes will spend less. So you can understand why some people might be doubtful that the government can create as much spending as I alluded (deluded?) to above. But that argument has already been made widely and loudly and I don’t want to get into that in my remaining three million pages below.

Let’s take a really big breath and just ASSUME that the government policy I described above does lead to more spending. So now we can imagine shops with more customers and companies enjoying higher sales and possibly higher profits. What does the NKM say happens next? First, business firms work down some of their inventories and given sanguine expectations about future sales they begin to hire more workers.  Workers are pleased as punch to take the job offers and are quite willing to accept the employment.  

According to the NKM, the firms have excellent foresight but the workers are a little dim. The workers are afflicted with a macro-disease called wage illusion. That is, they are willing to work at a very low wage simply because they are asked. It is sort of like the plain girl at the dance who agrees to have her feet tromped on by any hayseed who requests a quick belly rub (that means dance for you people with dirty minds). Firms are assumed by the NKM to fully appreciate the fact that a stronger economy will bring about higher prices and make the worker worth the bargain. The worker, however, is assumed to not anticipate or not care about the higher prices that will further erode their buying power.

Upshot – Wage illusion is the key and critical assumption of NKM that translates an increase in spending into an increase in employment. From there it is all (Four) roses and JD – once employment increases this facilitates even more spending and we are on the Staten Island Ferry bound for glory.

So what about this wage illusion thing? My guess is that if this psychological/informational disparity ever existed between workers and managers, it does not have a pot to piss in today. I use words like piss in a pot so that economists like Paul Krugman will understand what I am saying. And when I say today, I mean anytime after about 1969. After 1969, when inflation was beginning its notorious charge into the upper atmosphere, very few workers were not paying attention to the myriad ways that inflation eroded the buying power of their incomes. I recall when the coal miners went on strike at the end of the 1970s and were demanding a three-year wage hike of something like 39%. That doesn’t sound like dim workers to me. Today’s papers show Greek workers smashing pumpkins and otherwise displaying their displeasures with Greek austerity programs that would diminish their incomes.  Wage illusion simply has no relevance to today’s situation. Without wage elusion, you have more resistance of workers to job offers. It is not as easy as the NKM assumes to find and hire workers at wages that are favorable to firms, given the state of the economy.

And this brings me to the second part of the NKM illusions – the one about the firms having optimistic views about future prices and profits as a result of the government’s new program and the ensuing first round of spending.  Note that in the NKM once the spending starts flowing the firms soon decide they need more goods and to get the extra goods they need more workers.  So we might ask the following question. What makes the firms so sure that this new spending is going to be permanent? After all, the avowed stimulation policies of the government are meant to be temporary. By design they will be removed soon in the future. So maybe the NKM was assuming something we might call OPTIMISM ILLUSION when it automatically assumed that firms would place their stamp of approval on the fiscal stimulus and fall over each other trying to hire a bunch of workers.

So there we are. Our fellow macro policy activists assume: (1) labor wage illusion and (2) Business Optimism Illusion. What happens if neither of these illusion assumptions really hold today? What happens if workers acknowledge that prices will rise in the future? What happens if firms are somewhat skeptical that government has addressed underlying factors that caused the recession in the first place? I wrote a blog post in the past where I likened recent monetary and fiscal stimulus to pushing the blood back into the patient. We want the doctors to address what caused the blood to flow out – not push the blood back in.  What if business firms worry that the government has not adequately addressed housing, finance, too big to fail, excessive and corrupt leverage, excessive government regulation of business, and other factors that caused the recent recession?

Wouldn’t it be nice to use a version of the NKM that assumes that both workers and managers are rational enough to take care of themselves properly? Do we really want our policies based on assumptions about illusions and people who do not know how to take care of themselves? I doubt it.

So if you agree with me you understand that liberal macro activists are misleading our poor government leaders into doing things to the economy that will either have little effect or will make things much worse. Also, if you agree with me, you can quote me on this new concept called Business Optimism Illusion and support my nomination for the Nobel Prize (for excessive creativity)) or at least for the Guinness Book of Records. Or you could just send money. 

The Scorpion and the Turtle make Friends and Fiscal Balance

A scorpion asked a turtle to take him across the stream. The turtle said no because he knows scorpions are mean and will sting him. The scorpion explains he REALLY needs to get across the stream and that he is really a different kind of scorpion. He promises to be good. Mid-stream the scorpion stings the turtle. As they are both going under the turtle asks him why he stung him ensuring sure death for both of them. The scorpion replies – I am a scorpion. That is what scorpions do.

So is the scorpion/turtle a democrat or a republican? To me it doesn’t matter. They are playing a dangerous game. The question is why. It seems to me that politicians are more polarized than ever. It is a normal state of affairs to have difference of opinion and heated arguments. After all there are strong ideologies separating the parties here and everywhere. But both parties are using extreme tactics that get us nowhere. Republicans shout that liberals are ruining the country with too much government spending. Democrats respond that conservatives are destroying the country by hurting the poor and middleclass. These charges are typical. But the Democrats ran roughshod during Obama’s first two years and the Tea Party is playing dangerous games now. How does an objective person explain why things are so bad today? I don’t think one can blame it totally on one party or the other. What changed such that there is so much animosity and intransigence on both sides?

I don’t pretend to have the answers. But I do think that if we knew more about the causes of this political mess, then maybe we might have a hope of ending it. Finger pointing from both sides does little to create the healing and it appears to be making things worse. Thanks to conversation with some of my friends, I have come up with 5 trends that explain current political radicalism in the US and elsewhere. What do you think? Did I miss something?

First, it might be that problems are worse now. They may also be more complicated or different from past problems. As a result there is a real lack of consensus about what to do. Mike, there are little green men eating your Hosta leaves! Maybe I should use deer repellent? No, you better call in the B52s. Jerk! Butthead!

Second, we are now much closer to the day when the aging of the population finally has arrived – we can’t keep putting off financing solutions. So long as the baby boom generation was not yet 65, we could be nice to each other and talk about solutions. Well the baby boom is defined as starting with people born in 1946. Count it out – they are now 65 years old. Many started on Social Security as early as 62 and most of them are joining Medicare as soon as we hit 65. While the problems will surface only gradually the reality of not imposing a real plan hit home when S&P downgraded our debt. It is real and large and now we have to do something about looming debt. Politicians call these programs entitlements but many people see these programs more like a pension that was earned through a lifetime of work. It is NOT hard to see why such different views could inspire heated discussion.

Third, the social state has grown for 50+ years and Obama Care provided one more example of expansion. Perhaps that was the proverbial straw that energized support/attack of the whole social state. Many of us watch things grow and change and despite some displeasure we optimistically hope that things will work out okay. But then all of a sudden we reached a limit and years of concern turn into rage.  Ds are sick and tired of Rs moaning about the welfare state. Rs are fed up with increasing scope and size of government. Why the cork popped in the last few years I don’t know, but it ain’t champagne that is flowing.

Fourth, maybe we have too much TV/electronic news/entertainment. Is there a shred of news left? There is some notion that stuff happens every day and someone dispassionately decides what is important enough to inform and attract viewers – who then run out and buy large quantities of vacuum cleaners, soap, and heavily discounted car insurance. In the good old days when Walter Cronkite gave the news we had great confidence that it was unbiased. We also thought the earth was flat. Anyway, there used to be a time in a news program when the OPINION light went on and we all knew that was not news. It was an opinion. Well, despite Fox’s claim to be fair and balanced, there ain’t no opinion light and we are all pretty sure that news is chosen to fit the conservative agenda. Of course, all the other outlets are the same serving carious other agendas.

Finally, there is the idea that the public either doesn’t care or are simply easier to fool. None of the four above suggested causes makes any sense if you have an informed, educated, and energized public. For example, thoughtful voters know when the press is biased and can find ways to get better information. Or just because macro problems are more severe or more complicated, it doesn’t follow that an intelligent public can be duped into accepting untried and risky political policies. But if we have grown intellectually lazy then it is easy to see how and why our politicians have taken the low road. It is not effective to use logic about complicated economic and financial trends if the public just wants pretty, leggy newscasters and outrageous politicians who scream at each other in high definition, blue ray, 3D, 4G amazing colors.

So what do you think? What is behind all this nonsense? What makes today’s politicians take the low road? If I am right the best way to return to some normalcy is an energized and informed public. One way to get that result is a calamity. It seems wasteful to go through another financial collapse and a double-dip economy  to get citizens more focused. It would be much better if a leader stepped up who could deliver the right message. He or she would definitely occupy a grand place in our future history books.The President gets a chance to do that this week. Somehow I am not too optimistic.