Obamacare’s Medical Devices Tax is a Heart Stopper

Almost exactly two years have gone by since I posted about the Medical Devices Tax (Obamacare, Jobs, and Global Competitiveness, November 22, 2011). In that post I worried about the negative impacts of the new tax on US employment. Two years later there is evidence that the worries were well founded even though the tax has not yet begun to bite. Since Congress may have the chance to save the day for the Medical Device Tax yet in 2013 and since there are some who would not repeal this part of Obamacare, I thought I would wade into this topic one more time.

This time I am spouting about an article written by Kent Gardner, chief economist for the Center for Governmental Research (Rochester Business Journal, November 15, 2013).  Gardner alleges that “Joint replacement earns a whopping profit for the implant manufacturers and a very good living for the surgeons and hospitals involved. And private insurers, Medicare, Medicaid and the Veterans Administration pay most of the bills.” He thinks these firms are doing just fine and uses three arguments to explain why the tax won’t have negative effects”:

1.     These firms are cartels and therefore medical device firms won’t pass the tax along to higher prices

2.     The tax will not cause US jobs to go overseas

3.     The tax will not cause any reductions in innovation and competitiveness

So let’s take a closer look at Gardner’s arguments. He says medical device firms are like cartel members. Wikipedia offers this definition of a cartel,

a formal (explicit) "agreement" among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production.^[1] Cartels usually occur in an oligopolistic industry, where the number of sellers is small (usually because barriers to entry, most notably start-up costs, are high) and the products being traded are usually homogeneous.

Implicit in this definition is that the cartel brings the members high or excessive profits. 

So Gardner is wrong on a lot of counts. First, there is no formal agreement among medical devices companies as there is in OPEC. Second, if there is an informal agreement to do all this bad stuff, then this is against the law – and these guys must be pretty good to have eluded the regulators for so long.

Third, these companies are not homogeneous. There is a relatively large number of medical device companies, and there is plenty of entry and exit, especially among the smaller innovative firms. . While there might be small numbers of companies in very specific segments of the industry, this is what one should expect when advanced science is behind specialization, continuous invention, and innovation. A company that leads in a particular kind of product, for example, may enjoy a monopoly position for a little while. But this is also true for cellular phones and many other electronic products – do we want to put additional taxes on Apple and Samsung because they lead their industry? Probably not. A small number of firms doing everything they can to take leadership is good for product price and quality and, of course, the consumer. Think Nokia if you want evidence that even a small number of firms can produce real competition.

Fourth, most of the data I am finding does not support the notion that these companies are making obscene or even risqué profits. I looked at rankings of profit measures by industry –published by Yahoo Finance and a consulting company, Analyxit . These rankings generally show that the Healthcare and Medical Devices sectors make very reasonable net profits as a percentage of revenue. For example Yahoo Finance found Medical Devices had a net profit ratio of about 13%, ranking it 42^nd among industries. In contrast Finance sectors had returns ranging from 36% to 81%.  The return on equity ranking showed Medical Devices at 14% with a ranking of 82^nd. Analyxit ranked Healthcare, including Medical Devices, as eighth among nine sectors based on net profits as a percentage of revenue. Again financial companies led the list with returns averaging 17%. Healthcare’s percentage was 4%. In the middle of the pack were utility companies with a ratio of 8%.

Gardner says these firms will not pass the extra cost of the tax onto consumers. He reasons… “When firms hold significant market power – as they do in this industry – the connection between cost and price has been weakened. Price is largely driven by demand factors, not cost: Monopolists already charge what the market will bear.” Gardner’s argument flies in the face of what we teach freshmen in economics every year. Market power translates into an inelastic demand curve -- which means that firms without much competition do not have to worry much about losing customers when they increase prices – and would as a matter of fact pass the extra costs caused by the tax into higher prices.

I would agree that these firms will eat the tax as a reduction in profits and not pass the cost along to medical consumers in the short-run. But this is not because these firms have market power. The main reason that profits will fall is that medical device manufacturers have long term contracts with hospitals and other health providers and cannot easily increase revenues to offset rising costs from the new tax. Won’t these firms benefit from a tidal wave of new enrollees in Obamacare? Probably not. Many of the newly insured will be younger and not require medical devices like new hips and knees.

What I showed two years ago is that while a 2.3% tax on revenue sounds trivial, the result is that the tax is a much larger percent of a company’s profits. While some people think profit is a dirty word, the fact is that profits are used to invest in research, product development, safety, and other critical outlays that invent and improve products. The more the government takes of these profits the less is available for increasing product quality and being competitive. Large for-profit firms are already seeking foreign locations and will be followed by private companies. And the negative impact on smaller entrepreneurial firms is disproportionate because in the early years a company often makes small or no profits despite having rising revenues. The upshot is that a 2.3% revenue tax will mean business losses and an end to these small businesses. Inasmuch, the bigger firms will gobble their assets and this will lead to less, not more, competition. A correlated worry is that all these firms will turn away from devices that cannot promise immediate returns or serve smaller markets. This bodes ill for future important improvements in the device industry.

But aren’t corporate taxes low? The answer is that despite some loopholes, US corporate income taxes are among the highest in the world. Domestic companies are already reducing employment and globalization means many are seeking production and market opportunities globally. The medical device news is full of stories about layoffs and new joint ventures, both domestic and foreign. Combining a high corporate tax with another 10-30% of income going to a medical device tax makes it more desirable for medical devices companies to find locations and markets where better profits can be made. China, India, Ireland, Costa Rica, Singapore and a growing list of countries are quite willing to compete on corporate profits as a way of winning production as well as R&D facilities.

The upshot is that this tax is not good for US employment nor US-based innovation and competitiveness. The US should be happy to have the world’s leading medical device companies and it should be fighting to keep it that way. Worse yet is the misleading contention that this tax increase will break up this medical devices cartel and lead to more competition. It will do just the opposite as large US companies get larger by combining with suppliers and competitors – and as they move more and more operations abroad. 

The Economics of Thanksgiving

For those of you who do not live in the USA you might not know about Thanksgiving. Americans celebrate it on the fourth Thursday of each November because apparently it was too complicated to just have it on the 24^th of every November. It is okay to have Christmas on the 25^th and May Day on the 1^st and Cinco de Mayo on the Mayo – but no, Thanksgiving had to be different. So that’s why numerically-challenged Americans appear to be confused in November and often resort to counting on their fingers.

I have to say that I know that Koreans, Kanadians and Kardashians also have Thanksgiving holidays in their countries and while I don’t want to seem small I will say that their celebrations are copycats and should not be confused with the REAL thing here in the USA, eh.

Thanksgiving got started because after the famous Tea Party incident Americans were very happy and thankful that we didn’t have to drink all that tea during the winter. That explains why we never drink tea on Thanksgiving and why most American families drink copious amounts of champagne and JD that day.

The central focus of Thanksgiving is around the cooking of the turkey. Turkeys can be baked, barbq’d, smoked, grilled, or boiled and preferably all this is done after your local Kroger store has removed the feathers, the beak, and Nancy Pelosi. But no turkey is complete and no meal is planned that doesn’t supplement the turkey with enough food to feed an entire turkey farm. Of course on Thanksgiving many of us down a small keg of Wild Turkey (no offense to JD). My family believes that eating copious starches on Thanksgiving gives you good luck for 7 years and that is why we have mashed potatoes, sweet potatoes, dressing from inside the turkey, dressing cooked outside the turkey, three breads, and of course kimchi fried rice.

If the starches don’t kill you there are the sweets. Cranberry sauce accompanies the turkey, the starches and of course grandma. Despite being so full you could explode after all that food, the coup d’etat comes at the end when grandma proudly unveils the pies – of apple, cherry, pecan, pumpkin, rhubarb, and whatever else Marie Calender provided from the shelves at Kroger late on Wednesday night.

Don’t think there aren’t any vegetables on the table. It seems some item in this cornucopia ought to be good for you. But nay even the vegetables have been cooked with fried onion rings, creamy gravies, and God-knows what other toppings designed to make them equally damaging as the rest of the components of the meal. Did I mention that Wild Turkey goes swimmingly on the turkey, the starches, vegetables, grandma, and on most desserts?

My favorite part of the meal is when the crane lifts me to the liquor cabinet where I bring out the cognac. There is something about a nice cognac filtering through the congested digestive tract that brings on a feeling of calm and overall spirituality. That is, cognac makes a nice nap ever so possible and enjoyable.

Of course the meal is just part of the Thanksgiving Celebration. This holiday brings together the entire family including some members who do not seem to be so thankful and some who do not even seem to belong in your family. But let’s not be picky. Every family has those people who seem like they came from outer space. And that is precisely why we drink heavily before, throughout, and then after the meal. Once that nice haze comes over me it is amazing how interesting and funny I am. But then Betty puts an end to that. After several hours of washing the dishes, I am permitted to return to the social part of the day and of course to another round of Wild Turkey shots.

Since it is coming on Thanksgiving, I thought I would tell you that I don’t really have the energy to write about the macro environment or the turkeys in Washington D.C. this week but I did want you to know that Betty and I wish you the very best this week – whether you celebrate Thanksgiving or Chuseok or the Maple Leafs. Translated – you get the week off from the usual blog paranoia. So enjoy! When I recover next week I promise to return to form unless I am captured by aliens.

Alan Blinder Gets an F in Healthcare 101

Cartoon by Jim Gibson

On November 2, 2012 I wrote a post titled “Alan Blinder gets an F in Econ 101”. At that time I took issue with his contention that a government deficit of 8.5% of GDP was not a significant economic stimulus. Now Blinder is writing in the Wall Street Journal again about Obama Care (“Despite a Botched Rollout, the Health-Care Law is Worth it”, WSJ, November 12, 2013, page A17.) I have no problem with people making their views known even when their views depart from mine. :-)  But I do take offense when a writer makes a conjecture and comes to a conclusion without any real explanation. It makes one seriously wonder if he is acting as an economist and analyst or is just showing support for his party.

Blinder’s article reads like a condemnation of Obama care but viola near the end he concludes with “America cannot be a humane society if we leave 15% of our population uninsured. America cannot be an efficient society if we spend 50% to 100% more of our incomes on healthcare than other countries." The bottom line is that Blinder says that Obamacare is going to make the US more humane and more efficient. So I hunted and hunted through his 16 paragraph article and I could not find one bit of discussion, analysis, or evidence that would support such a conclusion. For starters the terms “humane” and “efficient” are never defined or discussed in any way.

First consider his condemnation part. These are quotes from his November 12, 2013 article that reflect what he believes,

• The botched rollout of ACA has been an unmitigated disaster. Choose your favorite adjective: horrible, embarrassing, inexcusable.
• …virtually no one understands how the new law works….
• Thus tech “glitches” make the law’s critics look better and make the administration look like the gang that couldn’t shoot straight.
• Becoming a national laughingstock is worse than getting off to a bad start. It undermines trust in health-care reform and more generally in the government’s ability to solve problems.
• “If you like your (Health Insurance) plan you can keep it.” Well, it turns out that maybe you can’t.

At this point in the article I was ready to stop reading because it sounded like Blinder had become a card-carrying member of the Tea Party . But then Blinder makes three allegations:

• But even with all the delays, most of the uninsured will get covered.
• Millions of people under the age of 26 are already benefiting by being kept on their parent’s policies.
•  He worries that cost containment might be delayed now but then concluded “But there is at least some reason to think that the “affordable care” part of the act may be working already. The rate of inflation of medical care costs has tumbled in recent years.

At this point I was seeing what Blinder really wanted to say to strongly support Obamacare. But then he adds two more points of concern or worry on his part (and I am assuming that he was not being held hostage by Sara Palin when he wrote them):

•             If many low risk people stay out of the pool, we have a problem: The insured pool will be less healthy than the total population
•             So pure self-interest will push firms to drop coverage.

At this point I felt more disoriented than my last night out with JD. Is Alan Blinder against, for, or against Obamacare? Luckily he had not gone beyond his generous article word count when he popped his belief that despite all that other stuff – we need Obamacare to become a humane and efficient country. Thankfully a conclusion. Recall that President Truman always wanted a one-armed economist. I don’t think he would have liked Alan Blinder – who seems more like a multi-headed hydra.

Okay so he flip flops. Who doesn’t? So let’s move on to bigger potatoes. Standing back from the whole article, does Blinder prove or support his conclusions? Let me work on that for the remainder of this piece. So please WAKE UP.

First, he doesn’t make use of one of his key points and that has to do with the influence of the botched rollout on the support and faith people have for government. He said a lot of really nasty things about the rollout. But let’s face it – if they were so negligent in the rollout, are we really so confident that they are going to be able to manage such a new and complicated healthcare program? Can they really educate prospective clients by using people who have not been properly screened for that purpose? Can they really insure that people don’t scam the system and add unnecessarily to the costs? Can they really protect the confidentiality of all that information that goes to so many different government organizations?    

Second, if his two worries are true and low risk people and many firms do not sign up for the program, will we be able to afford it? He says that healthcare costs are already falling but naively attributes that to Obamacare. That is silly. Economists know there are many reasons besides Obamacare for the decline in healthcare costs – including the recession and slow economic growth. A main reason why Obamacare might reduce prices is because they stick it to doctors and other healthcare providers. This is not a political winner and will not likely happen when the plan fully unfolds.  Adding 30-50 million people to healthcare is not going to reduce its costs. Why can’t Blinder spend a paragraph seriously defending these cost reductions?

This thing is getting too long so I better take a nap. Let me end with humane and efficient. Compare the US to many countries and you will conclude that this is a pretty humane and efficient place. Many people do not want insurance and do not want to be coerced into buying it. And while some people will stop going to emergency rooms they will soon find a system wherein they will spend as much or more  time waiting for a private doctor in a nice clean waiting room. Surely as the US healthcare system becomes more like healthcare systems of other countries (ie we can’t afford it) all of us who cannot afford Cadillac plans will find the quality of our care greatly reduced. I seriously doubt the US will make it on the cover of USA today for Obamacare’s great humanitarian contribution.

Now consider efficiency and Obamacare. When did you ever learn that a law composed of thousands and thousands of pages of new regulations that seem to be changing haphazardly over time would lead to the average health practitioner getting more done at a lower cost? Is it possible that there are reasons, perhaps unique to the US, that will keep our healthcare costs as a large percentage of national income even after we impose Obamacare? We in the USA spend more of our income than any other country on American football and JD. We also do most of the drug and device long-term research and development. America is unique in many ways. Maybe we will always spend a large share of our income on healthcare?

But Blinder would rather draw conclusions out of a hat. He can do better than that and we deserve better than that. So I give him another F with the hopes that he will learn from this grade and be more careful with his words in the future.

Note to reader – Alan Blinder is a truly important and gifted economist. I am pretty much a grain of sand on his proverbial beach. As you know I like to sometimes take a humorous approach to some pretty dry issues. I have no personal issue with professor Blinder but I sure do take issue when I think important people take us for granted. High income and status has no monopoly on truth. Larry spouts...

Let the Monetary Weaning Begin

Cartoon by Jim Gibson

Janet – hey doc when are you going to get me off this pain medicine? You removed that nasty goiter three months ago and while I cannot leap tall buildings in a single bound, I am back at work as a pole dancer in Peoria. 

Doc – I’d hate to take you off the medicine too soon there is always a chance that you might stub your toe and then – there we go again with all that shrieking and gasping.

Janet -- Okay Doc – you are da man. But I gotta say, you are starting to worry me. My Uncle Charlie told me that drugs can be dangerous and that some people even get hooked on them. My Uncle Pete had his large intestine removed last year and he was off the pain meds by the first Friday night poker game.  How come a mere thyroid-ectomy requires so much pain meds? I am starting to think you are holding out on me. Maybe my Adam’s Apple is rotten to the core? Fess up Doc please.

Janet Yellen might take some of this to heart as the Fed Chief nominee prepares to be grilled in her confirmation hearing. She seems quite intent on helping unemployed persons – but so long as the Fed continues to inject pain medicine into the US national economy some four-plus years after the end of the recession she has to understand what the Fed is doing to the psychology of domestic producers and investors. Every time the Fed announces it will not begin tapering its dose of pain killers it will raise two damaging questions. First, is the economy really so horrible that we can’t even reduce the dosage a tiny bit?

Posing this question raises a cloud of uncertainty that is not good for --- guess what – employment.  It seems that every time the Fed announces it will not begin tapering, the stock market soars. That reaction suggests that more medicine is appreciated by someone. But that doesn’t mean it is good for the patient. As you know, someone hooked on drugs is the last person to recognize what is good and what is bad for them. And the logic is perverse anyway. The government and the Fed perpetuate a myth that the patient is weak and needs more support. The patient appreciates more support. But the truth is that despite unprecedented amounts of Fed policy, the patient is not leaping over tall buildings. Maybe the Fed should understand that the more they tell the patient she is too weak to stand without help, the more the patient believes this is true. It becomes a self-fulfilling prophecy. People wonder why firms have been so slow to return to strong hiring. But why would they want to hire more workers if the Fed tells them the economy is not self-sustaining?

Second, won’t another month or more of medicine have damaging side effects to the economy? Drugs keep the patient going but we all know that drugs can have side-effects. The longer you take drugs the more you raise the chance that these nasty side-effects will occur. Many have already pointed out the bubbles that seem to be forming again in real estate and financial markets. It would be awfully strange and perverse if the solution for the past crisis creates another one with similar characteristics. The message from Washington has to be confusing to the financial markets. On the one hand regulators are telling financial companies to hold more reserves and/or reduce financial leverage and risks. On the other hand the Fed is handing out money like Mars Bars on Halloween. With interest rates held so low – banks and other investors do not want to invest in assets that give no yield – so they are very tempted to buy assets that promise higher returns – and of course more risk.

But the risks associated with a permanently low interest rate environment are broader than these bubbles. China is a great example of a country that has highly unbalanced economic growth. Economic development in China has come mainly through international trade and investment. That sounds pretty good. What could be wrong with that? It’s like saying that since protein creates muscle, you should mostly eat big, juicy ribeye steaks and minimize your portions of vegetables and fruits. It makes sense to have a balanced diet. We all know that. It ALSO makes sense to have a balanced economy. A strong economy capable of withstanding global macroeconomic shocks has balanced growth across sectors. In that balanced country consumers buy more goods and services, firms invest in equipment and research, foreigners want to buy everything for i-phones to mining companies, and the government buys airplanes and tablets for students and teachers.

Current Fed policy is troublesome and needs to be reversed. The USA needs to be weaned or we risk a debilitating addiction to money and low interest rates that just makes us less confident about the future and promises us bubbles and a more unstable economy. If Janet Yellen wants to help the unemployed she needs to distance herself quickly from Bernanke’s risky policies.

Japan: A Road Not to be Taken By Guest Blogger Buck Klemkosky

Japan experienced stock market, credit and real estate bubbles in the late 1980s, but with more intensity than the U.S. experienced later. Prior to 1990, the Japanese economy and financial system was considered to be superior to the U.S. as expressed in several books, such as Japan as Number One (1979). Japanese society was considered to be more thrifty and conservative than Western societies. By hindsight Japan was not immune to speculative euphoria and bubbles.

Japanese euphoria was reflected in both stock prices and real estate prices. By the end of 1989, the market value of publicly traded Japanese stocks exceeded those of the U.S. even though the size of their economy was of one-third that of the U.S. Stock valuations were astronomical even compared to the dot.com era in the U.S. While the stock market was soaring, the real action was in the property markets. By the end of 1989, Japanese property was valued four times more than that in the U.S. The grounds of the Imperial Palace in Tokyo were supposedly worth more than all of the real estate in California. Real estate prices in Japan had never declined in the post-WWII period, so investors, including households, corporations and banks, were convinced that property price increases were a certainty.

This increased stock market and real estate wealth eventually fed into the credit markets and the financial system. A massive credit bubble evolved based upon the stock market and real estate bubbles – a nasty combination of corporations, banks and individuals all on a speculative binge. It couldn’t end well and it didn’t.

The Nikkei index peaked at 38,900 in December 1989 and eventually declined more than 80 percent. Property values started to decline in early 1990 and also eventually fell 80 percent. Both have never recovered. The economic consequences of the bursting of the bubbles were catastrophic and long lasting. Banks were technically insolvent and became “zombie” banks. The corporate and household sectors suffered massive losses. Japan has never fully recovered from the collapse of the bubble economy even after two decades. Economic growth has been stagnant and deflation has been a problem. Japan has other issues, such as demographics, but there is no more talk of Japan Number One. In fact, Japan has recently become the third-largest economy in the world after China.

If this all sounds familiar, it should. The U.S. experienced the same phenomena with the stock market, real estate and credit bubbles that collapsed in 2007-2009, but with less intensity and magnitude and also without corporate sector involvement. Japan has been a role model for the U.S. as what not to do when bubbles burst and affect the financial system and real economy. Hopefully Japan’s experience is not a glimpse of the U.S. future after the financial crisis.

Japan has a long-term problem of a declining and aging population and virtually no immigration; the population peaked at about 130 million and is expected to decline to 87 million by 2060, and 40 percent will be over 65 years of age. Since economic growth is a function of population growth and productivity, Japan has to have higher productivity to overcome a declining population just to maintain the same growth as other developed countries. A difficult task. The other major problem has been political leadership; Japan has had 15 prime ministers in the last 20 years. Not a good recipe for making tough economic changes.

Many think, including quite a few Japanese, this may have changed when Shinzo Abe was elected prime minister last year and his political party has taken control of both houses of Parliament, resulting in political stability for several years. He has instituted economic reforms referred to as Abenomics. It may be the last chance Japan has to rid itself of its economic paralysis.

Abenomic economic policy has three main arrows as dubbed by the media. Arrow number one is monetary easing. Because of low or zero economic growth and deflation, Japan has the lowest interest rates in the world, so that tool of monetary policy is not operable. So the Bank of Japan (B of J), like the U.S. Fed, has instigated a massive quantitative easing program. Their goal is to double the monetary base (money supply) in two years. But there are risks associated with this first arrow. The balance sheet of the B of J is already large relative to Gross Domestic Product (GDP); it has doubled in size in 2013 and is the largest relative to GDP among developed countries. At some point, investors may lose confidence in the central bank and then the banking and financial system.

The second arrow is a massive stimulus package. This is nothing new as Japan has had several in the past. They have resulted in recurring government deficits; Japan’s government debt to GDP is 245 percent, one of the highest in the world, especially for a developed country. Again, a risk is bond investors lose confidence in the Japanese economy. Most of the debt is held domestically and denominated in yen, so it will be Japanese investors who may eventually question the credit worthiness of Japanese government debt; some foreign investors already have. No one knows where the tipping point is for the ratio of debt to GDP, but there is one. To alleviate this problem, Japan plans to raise the consumption tax from 5 percent currently to 8 percent in 2014 and possibly 10 percent in 2015.

The third arrow is longer term and involves structural reform of the Japanese economy. This would include industrial revitalization, deregulation, lower trade barriers, new markets for industry and a more global outreach for society. This may be the most difficult of the three arrows to achieve. Japan has world-class multinational corporations and most are doing well, like the auto companies, but some, such as several consumer electronics firms, are faltering. But it is primarily the corporate structure below the large multinationals that needs to be revitalized.

The aim of the three arrows of Abenomics is economic growth. There are signs that it may be working in the short term. Japan has had three quarters of solid economic growth, and consumer confidence has picked up as well as stock and property prices. Like Bernanke and the Fed, the Japanese government and B of J are targeting 2 percent inflation by 2015. With deflation, it pays to delay consumption as goods and services will be cheaper. So a little inflation may help domestic consumption.

Another result of Abenomics is that the yen has depreciated from 78 yen per U.S. dollar to 98 per U.S. dollar. A weaker yen will not only make Japan’s exports more competitive, but imports more expensive, helping foster a little inflation. Recent inflation has been close to 1 percent annually, but most of this is due to higher energy costs due to the weaker yen.

Perhaps Abenomics is the last chance for Japan to reverse more than two decades of stagnant economic growth and deflationary pressures. It may take time and be painful to some in society, but change is needed. Monetary easing and the stimulus may help in the short term, but structural changes of the third arrow are prerequisite to long-term economic growth. Given a declining and aging population, growth in domestic consumption is problematic, especially if base salaries remain stagnant. Exports would help the Japanese economy but slow global economic growth weighs against that. All developed countries would like to export more, including the U.S. but exports and imports are a zero sum game in totality. So the global economy may not be the solution either.

Japan has painted itself into a corner economically. Even though Japan is playing a diminished role in the world economy, it is important to the U.S. to have a strong Japan, given the growth of China, both economically and militarily. If these arrows of economic reform don’t work, especially the third arrow, there may be none left in the quiver. Let’s hope three are enough.

The IMF and the G20 Blame Game

Cartoon by Jim Gibson

Whether we need it or not the International Monetary Fund (IMF) publishes a global forecast twice a year. The October 2013 World Economic Outlook was recently announced with about as much fanfare as a rodeo in Ithaca, New York. The link to this several hundred page tome is http://www.imf.org/external/pubs/ft/weo/2013/02/. Luckily one can read what they call the front matter to get the main points. The Wall Street Journal did a nice summary on October 9, "IMF’s Pessimism on Global Growth Widens". Pretty graphs reveal the key points – as compared to last April, the IMF has a revised downward the expected future growth of the world economy. They also forecast an increase in GDP on the Uranus but their interplanetary accuracy is not quite up to Earth standards. With respect to Earth the biggest story line is the downward revision of future economic growth rates of the emerging and developing countries. The average expected future growth of advanced economies was unchanged from April – but the IMF is much more downbeat about short-term prospects of places like Brazil, Russia, India and China.

Why do I bother you with this? For one thing I needed a good reason to pour a cool JD. JD seems to go well with this activity and we all know the old saying that a JD a day keeps the doctor away. But I jest. The real reason I write about this is to gloat. On September 20 my blog was entitled The G20 Blame Game and in that blog my main point was that the emerging countries should quit pointing their fingers of blame at the US and start taking care of their own destinies. I know many of you think I make this stuff up between taking out the garbage and sharpening my dart skills – but I am always pleased to find out that REAL working economists agree with my stuff.

Oliver Blanchard, the IMF’s Chief Economist said, “Emerging markets should use the small window of time available to get their economic houses in order.” The small window is the time before the US Fed begins to taper monetary policy. With Janet Yellen as the new Fed chair that window could be longer than Blanchard believes. But let’s go along with the idea of a short window – what is Blanchard recommending?

The first thing he is not recommending for the emerging nations is more Keynesian policy. He seems to be suggesting that Keynesian expansion is what helped them get into their current mess when he says “the potential reversal of years of cheap cash exposed years of financial and economic weakness.”

So what do you do if you can’t simply open the fiscal and monetary spigots? While Blanchard would probably never utter the words “supply-side economic policies” it is hard to differentiate the IMF’s recommendations from a supply-side approach. I cherry-picked  some of the report’s main points…

• Curbing potential economic expansion are competitive constraints, infrastructure bottlenecks, and slowing investments
• China should rebalance away from exports to domestic consumption
• India and Brazil should remove barriers to foreign investment
• Countries with large budget deficits need to tighten
• Turkey and other countries with high inflation rates must raise interest rates and put in more credible monetary policy
• Emerging markets should let their currencies depreciate
• Europe needs to work on a unified fiscal budget and a banking union
• Japan must continue its economic restructuring
• The Fed should not begin to taper this year but should be ready by 2014 and 
• The US government must solve its budget stalemate

It is true that the IMF worries that US tapering could cause some negative overshooting in emerging markets – drawing precious funds away from those countries. Inasmuch the IMF agrees that these withdrawals should be offset with domestic monetary policy. But this is seen as a replacement for the missing money and not a return to expansionary monetary policy. The IMF is very clear that the world has had plenty of stimulus and now the challenge for most countries is to focus on competitiveness and making capitalism work better.

Inching Closer to a Homeless USA?

Cartoon by Jim Gibson

Now that we avoided one cliff in October we now have a little time to avoid another one in early 2014. Predictably what gets done will be decided by real and imagined descriptions of past and future government spending growth. During the last standoff we heard about the sequester and how it limited government growth. Some Democrats use that fact today to strengthen their case for more future spending and higher taxes. 

But the government’s own forecasts belie that interpretation of austerity and show a real cause for alarm coming from future federal spending. Lawrence Summers recently argued in the Wall Street Journal that national debt is a secondary issue but I argue here that a continuing debt explosion threatens to make us all homeless.

I wrote on October 8 about the national debt and how the CBO believes that under current budget law the US net debt will hover around 70% through 2023 – staying well above the pre-recession rate and historical norm of about 36% of GDP. The implication is that even with the spending constraint implied by the Budget control Act of 2011 and the sequester, we cannot make even a tiny dent in the swollen national debt. Guest Blogger Jerry Lynch followed up on October 13 with a similar story citing the gross national debt staying at about 100% of GDP. It is one thing for debt to rise temporarily in an emergency like the world recession of 2008/2009 but it is another thing to let it remain so high for another 15 years or so!

Today’s posting reinforces this discussion of debt by focusing on government expenditures. I do that because of the many distortions we are hearing from politicians who do not want face up to tough spending challenges. Some are pointing to the fact that the US government deficit and federal government expenditures fell in 2012 and 2013 and conclude that we have taken care of the government’s financial problems and can now get on with more spending and higher taxes. But just like the debt figures already cited, the spending data show that we are on our way to financial disaster. Okay – so you lost 2 pounds on your new popcorn diet – but if you are 100 pounds overweight this is no time to celebrate with an upside-down pineapple cake with Jack Daniels flavored icing.

It is true that government spending declined during fiscal year 2012 by $61 billion dollars and by $82 billion in fiscal year 2013. That’s a two-year total decline of $143 billion. But that is a small part of a bigger story.  Between 2007 and 2011 – government spending rose by a total of $870 billion dollars. In those four years, government spending rose from $2.7 trillion to about $3.6 trillion. That’s an increase of about 30%. If we account for the spending reductions in 2012 and 2013, we are left with an increase of government spending from 2007 to 2013 of $727 billion – meaning that since 2007 government grew by about 27%.With or without the recent reductions we are nowhere near to anything one might call restraint or austerity.  

Now let’s look at the future. Whatever gains might have been started in 2012 and 2013 they are over, finished. The CBO budget scenarios assume the continuation of the budget caps and so called restraint from the Act of 2011 – but notice they do little to overcome inertial government growth. The CBO estimates that with restraint, government spending will grow by $147 billion in 2014 alone. That is, in just one year the federal government will make up for all reductions in 2012 and 2013. The yearly increases following this $147 billion increase will be (again assuming spending caps in place):

           

            2015  $175 billion

            2016  $261 billion

            2017  $223 billion

Some 10 years after the US recession began and almost eight years after it ended, government spending will have gone from $2.7 trillion in 2007 to $4.3 trillion in 2017. Government spending will have increased by about $1.5 trillion or by 56%.

Governments swear to us that crisis spending is always temporary to get permission to go deep into debt. As soon as someone suggests that the bloat be reduced, they immediate call these requests unreasonable or worse.

Debt problems are real. They won’t go away by raising taxes. The more taxes we raise the more these fiends will spend. The really sad thing is that government has the capacity to do a lot of good. But doing this good becomes harder and harder when the country goes further and further into debt. We put ourselves in the worst jeopardy by not getting the financial crisis under control. What happens if we have another recession? What happens if terrorism requires more military and security spending? What happens if the Fed tapers and interest expense doubles or triples? What happens if Larry needs more JD?

Many people become homeless because they get themselves into debt and then an emergency strikes. What happens when a country goes into debt and suffers a similar crisis? The answer is not good. Don’t listen to Washington crying. Something has to be done about government spending. Even if the progress is gradual – something must be done. For every year we remain with high debt, the more we weaken our economy and open it up to risk of crisis. That is no way to run a country.

Debt Ceiling Redux

*Jerry Lynch has been an economics professor at Purdue for over 30 years.  He also served as Associate Dean and Interim Dean of the school in various past fits of insanity.  He has returned to teaching the core Macro Policy class in the MBA program and is pleased to have this blogging opportunity to spout off.

As of late October 11, 2013, nothing had yet occurred to solve the problem of the debt ceiling.  So hysterical is the rhetoric that one may think bumping into the debt ceiling comes around about as often as Haley’s Comet.  In fact, the government has raised the debt ceiling five times since 2001 typically without this much fanfare.   What started all this? Is it a new phenomenon? Why do we have a debt ceiling anyway?  Let’s look at the history and then think about the consequences to not allowing the debt ceiling to be raised next week.

The government raises tax revenue and spends money and there are three possible outcomes from this.  Tax revenue can equal spending and we have a balanced budget.  Tax revenue can exceed spending and we have a surplus. Or, tax revenue can be less than spending and we a deficit.  What does the government do when it has a deficit?  Up until recently my bet is that most people would have said the government prints money.  Not exactly.  There is not, thank God, a printing press in the basement of the Rayburn office building or in the Oval office.  While only the congress has the power to tax and spend, the Federal Reserve actually controls the money supply. So, if the government spends more than it takes in it sells bonds, borrows money.  What it borrows per year is the deficit and the past accumulation of borrowing is the debt.  There is not a deficit limit.  There is no legislation that states how much Congress can spend over its collection of taxes in a year.  There is, however, a debt limit.  Total federal debt has been limited since the Second Liberty Bond Act of 1917. The statutory limit was denominated in an actual dollar amount and given that government runs deficits nearly every year, it is no wonder we are constantly bumping against that limit.

When the debt ceiling was first established in 1917 it was $11.5 billion.  It has been raised 74 times since March 1962. The first time it was raised during the Reagan administration in 1981, it went just over $1 trillion.  The National Debt right now is just under $17 trillion.   It is difficult to find a source to say what the exact number of the debt ceiling is. Perhaps that is because some of the debt is exempt from the ceiling and the calculation is not all that easy.  The magic date seems to be October 17^th.  The US will reach the maximum amount it can borrow and there will be no new bonds issued. Why are we facing this crisis? There are really two questions there.  The first is: why is there a debt ceiling and the second is, why have we waited so long to address the issue?

When Congress passed a debt ceiling back in 1917 it was trying to impose an external restraint on how much it could spend.  It seemed comforting to know that we would not borrow past a certain limit.  The party not in charge of the Congress can always point to reaching the debt ceiling as a sign of the profligate spending by the group in power. A number of times when the debt ceiling has been raised, it has been raised by a percentage of the existing debt as opposed to a strict number.  Who knows what will happen this time.  We have come to this crisis point in part because of a breakdown in civility in Washington and in part, because the debt has really grown in recent years.  As recently as 2007 the debt was under $10 trillion but more importantly, it was about 65% of GDP. The measure of the scale of the debt is not the absolute number, but its relative size to, say, GDP.  Now, it is bumping up against 100% of GDP and people have become alarmed.  Even though the deficit has fallen in recent years, the debt to GDP ratio continues to grow and that is what is sounding the alarm. We have waited this long to address the issue because Congress, like all people, prefer to kick the can down the road.  In this particular instance, Congress has become the Sebastian Janikowski[i] of can kickers and there are threats that we will let the government reach its limit and stop borrowing.  What will happen?

The big discussion seems to be about the US defaulting on its bond obligations.  In truth, that does not have to happen.  The US can roll over the existing debt it has without surpassing the ceiling and it can pay the interest on the debt.  That said, what could happen is not a pretty scenario. The US government spends about $3.5 trillion a year and brings in $2.7 trillion in tax revenue.  Thus, spending would have to be reduced by $800 billion in order to balance the budget and not have to spend based on issuing bonds.  Some might think that an $800 billion reduction in federal spending would be good.  Without debating the long term consequences, it would not be good in the short run.  In fact, it is such a large cut in spending that it would almost be impossible to carry out.  Even those who might think that an $800 billion reduction in spending would be good would complain as soon as their ox is getting gored.  However, the long term consequences of following our current path are not something we want to see either.

What will happen?  As loathe as I am to forecast, we will come up with some short term deal and may already have done so by the time you read this.  What one hopes this crisis brings about is a meaningful discussion of the size of government and how it should be financed.  There are many concerns about the debt, here is my largest.  Interest payments on the debt come from tax revenue and that is how it should be.  You don’t want to service your debt, whether you’re a country or a firm, by borrowing every time interest payment comes due.  So, interest payments should be made out of revenue which for the government means tax revenue.  How much of that tax revenue will go toward servicing the debt?  Net interest on the debt right now is about $330 billion per year or maybe 12% of tax revenue.   We are currently financing our debt with some of the lowest borrowing rates in history on Treasury bonds and bills.  However, as the debt to GDP ratio continues to rise, and once interest rates return to their historical levels, the interest cost to service the debt will rise.  No one knows exactly how high because we don’t know what will happen to interest rates.  Some sources predict a trebling of interest cost on the debt within the next three years. Of course tax revenue will grow over that time but we could easily be looking at 25% of tax revenue going just to service the debt.   As that happens, our ability to do the kinds of things we want to do with tax revenue is diminished.  If 25% of your income is going to pay the interest on your credit card debt, you have a reduced standard of living.  That is, I think, the biggest long term concern of the size of the debt relative to GDP.

Will we pass a temporary debt ceiling increase and kick this can down the road?  Yes.  Is the debt ceiling an artifice to allow for these discussions to move into crisis mode? Yes.  But, do we need to address the long term implications of the debt in a calm and meaningful way sometime soon? Absolutely yes.  Unfortunately, Congress acts too much like a freshman with a term paper. We won’t get back to it until the next crisis comes to a theatre near you.

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[i] NFL kicker – known as the Polish Cannon. Larry Davidson will be upset I used this analogy instead of him as he kicked field goals in high school and college football.

An Easy Budget Compromise

Cartoon by Jim Gibson

The President won’t talk to the Republicans because voters elected him to do his thing. Republicans retort that Nancy Pelosi famously said that we would not know much about Obamacare until it was legislated. Well it was legislated and as Pogo once said, “We are confronted with insurmountable opportunities.”

Here’s my take on this current fiscal madness. There are some real economic and political problems coming down the pike in the next 10 years. Neither party is going to like them. They really ought to be doing something about them. Playing Hatfields & McCoys is entertaining but it won’t help. Sorry to say this but one part of what is wrong about the next 10 years is Obamacare or at least our desire to quickly be like other grown up countries that have national healthcare. But the problem is broader than Obamcare.

As usual these guys take us to the brink so there are presently no good choices. But it seems pretty logical that both sides could agree on a truce that would stall things until January 1 while they focus their attention on what they could reasonably do about our budgeting problems. That would, of course, include Obamacare. Some of you call me Laughing Larry (or LL for short) because I am sometimes too optimistic about things and by things I mean politicians. As usual I will use this space to lay out why these guys need to get focused on the right issues. But do I really think they will listen to LL? Of course not. But I have a choice. I can walk the dog or I can hide away in my basement with a half-gallon jug of JD pretending to be solving national problems.

The case is pretty compelling. Both sides have much to gain through some compromises. After all mutual gain is the basis of compromise, right? So below I use some data published by the Congressional Budget Office in Updated Budget Projections: Fiscal Years 2013 to 2023 http://www.cbo.gov/publication/44172

Republicans often stand up for smaller government deficits and debts. The federal budget deficit as a share of GDP will decline as we approach 2023. But hold on. In 2007 the deficit as a percent of GDP was about 1.2%. It went to 10.1% in 2009 but declined to 4% in 2013. It is expected to remain as high as 3.5% of GDP in 2023. The average GDP during the next 10 years will be about $21 trillion so 3.5% of a big number is also a big number!

Keep in mind that every year there is a deficit, it must be funded with brand spanking new government bonds – bonds that add to the national debt. 

Speaking of the national debt – the net debt in 2007 before the crisis was a reasonable 36%. It rose to 75% of GDP in 2013 and is supposed to top out at 76% next year. It is expected by the CBO to remain at 74% in 2023. So the nation’s debt doubled and the best we can do is maintain that doubling over the next 10 years? Seems to me we have it all backward. Why aren’t we trying to move it back to 36%?  Please do not tell me that these elevated deficits and debts will not have a negative impact on long-term economic growth and employment. Business as is in the government is not good business.

The Democrats won’t like the future either because it means that government interest expense, Social Security, and healthcare will eat up an increasing share of government expenditures. Thus both mandatory and discretionary programs will command much smaller shares of the economy in the future. See the table below. There you will see how healthcare, pensions, and interest expense will gobble up an additional 4% of GDP and that the CBO expects much of this will come out of the hides of other mandatory and discretionary programs.

Neither side has much wiggle room – because taxes and spending will be at all-time highs as a share of the economy in 2023. Tax revenues will have risen from 19.1% of the economy before the recession to 22.6% in 2023. Government spending will have gone from 17.9% to 21%. In short, government will be bigger in 2023 – not just absolutely but relative to the size of the economy. This will make it even harder to afford better government programs – military or otherwise.

So while the deficit might fall for a while, everything else really stinks – future debt, interest expense, growth and the flexibility of government to help people who are not sick or old.

My conclusion is that they ought to pay attention to the costs of Obamacare but they really need to get on with the task of changing all the budget lines. Neither side seems willing to do that…at least not yet.

Projected Spending for Major Budget Categories

(Percent of gross domestic product)

     2012       2023        Dif

Major Healthcare                         4.7           6.1        1.4

Social Security                              4.9           5.5        0.6

Net Interest                                  1.4           3.2        1.8

Other Mandatory                          3.5          2.4       -0.9

Defense Discretionary                  4.3          2.7       -1.6

Non-Defense Discretionary          4.0          2.7       -1.3

What is a Healthy Economy?

Cartoon by Jim Gibson

Your tweenage daughter wants to know when she can start dating guys with beards and motorcycles. Your first reaction is to tell her she can have her way when hell freezes over. But you are smarter than that. You tell her she is free to date whomever she pleases once she shows more maturity. Satisfied she goes back to texting her best friend about when they will meet at the mall.

This approach has great merit. What does it mean to show more maturity? Does it mean that she makes her bed every morning or does it mean that she has saved enough money for retirement? Clearly, any time she comes to you with another reached milestone in maturity, you can tell her she is still deficient and cannot yet date guys with beards and motorcycles.

Where is this heading? Has LSD been into the JD this morning? It sure sounds like it. My point is that this is exactly how the FED is treating us. Mr. Bernanke tells us that the economy is not mature enough yet to let it go out alone without a chaperone (Mr. Bernanke).  But Ben, when will we be mature enough to stand on our own? The answer is – when Ben says you can stand alone. Be good and go to the mall and spend a lot of money. Ask Ben again tomorrow.

When will the economy be strong enough for the Fed to taper? When will it be strong enough for the Fed to remove all that unwanted and unneeded monetary flab from the system?

Macro does not make this question easy to answer because there are so many ways to judge the present and expected future health of an economy. Most of us think the unemployment rate is a great macro indicator but we also know that the unemployment rate can go lower simply because more people give up looking for work. So it is possible that the unemployment rate could go to 6.9% and the Fed would still judge the economy too weak to walk without a cane.

So maybe if the unemployment rate was falling AND employment was growing, that would be good evidence of strength? But what if most of the new jobs were low-wage and/or part-time? What if most of the jobs were in occupations featuring pole dancing? 

What if employment was growing while events abroad portended a weakened China, Brazil, Canada or parts of Europe? What if those and other countries actively depreciate their currencies against the dollar? Wouldn’t we worry about exports and the President’s goal to double exports as our engine of growth and stability?

Or perhaps employment and unemployment are both improving but continued ambiguity about regulation in housing and financial markets leaves housing demand and supply weak. With housing at present depressed levels it would be hard to conclude that the US economy was out of the woods. What if interest rates start rising as employment improves? Won’t we worry about another housing crash?

You should be getting my point. If not, try a little more Soju. The Fed says the economy needs to be out of the woods but there always are and there always will be conflicting signals in the US economy. Business investment could remain weak for quite a while. The consumer has not exactly rebounded. So what really matters is not so much this excuse about the strength of the economy but rather the Fed’s intent.

This might sound blasphemous but whether it is Bernanke or Yellen, the truth is that we have two popular leaders who will always have a tendency to see weakness in the economy and worse yet – will not cherish the long fight for Fed independence and credibility. Without an independent and credible Fed we might as well let the Department of the Treasury spew money from helicopters as the government deems necessary. And of course, that will lead us sooner or later to catastrophe.

Surely I exaggerate? I don’t think so. Government debt is in outer space and on a trajectory to reach the sun. Yet the government has no plan to constrain our nation’s debt. Notice that the current congressional debate has almost nothing to do with future debt issues.We have known since about 1964 that the baby boom generation would bust the budget today and have had almost 60 years to deal with that – yet we are not much better off in 2013 than we were when I was 18 years old. 

What does Congress and national debt have to do with the Fed? This government debt has to be sold each year. The Treasury has been selling roughly a trillion dollars of debt each year. While the economic recovery is reducing that amount, the respite is temporary and the government will continue selling a s---load of debt each year. Someone has to buy it. That’s a lot of US bonds to soak up. To make this avalanche of bonds desirable the markets would ordinarily need to raise interest rates on the debt. While this is wonderful for the bondholder we all know this would be bad for the economy.

So the Fed plows in with its capacity to create infinite waves of money and buys government bonds. A trillion dollars for bonds? No problem. Ben just writes a check. One does not need to be conspiratorial to believe Obama “makes” Bernanke buy those bonds – one can simply believe the Fed is trying to help the economy overcome this giant wake of the government’s incessant and huge demands for credit. Thus the Fed acts “as if” it were a part of the liberal democratic administration.

In doing so, the Fed abdicates its independence and along with that goes its credibility and ability to function. You know why credibility is important. Without credibility your threats as a parent go ignored. Honey – don’t put that screwdriver in the electrical outlet or I will put you in timeout with Dr. Phil. If the kid never gets put in timeout – the chances are she will ignore your directions. Likewise if the Fed puts in a policy designed to reduce interest rates and we all know that the Fed never acts against rising inflation – then it is likely that at some point a policy designed to reduce rates and stimulate the economy will fail. Future attempts to reduce interest rates will raise inflation expectations and will raise, not lower, interest rates. The Fed at that point becomes largely redundant.

The Fed needs to be independent. The Fed needs credibility. The Fed needs to point its boney fingers and forcefully lecture the government about proper fiscal finance. The Fed has to admit that the economy is ready to walk if not run. They will always find some data or some excuse to postpone proper monetary policy so long as they are in denial about proper central banking and its limits in solving all of man’s problems. The Fed can wait but in doing so it risks a jump from the frying pan into a volcano!

Trumpet of Doom? Fed Tapering in 2013

Cartoon by Jim Gibson

What to say about Fed policy? The Fed surprised the markets last week by not starting a tapering program. Apparently Miley Cyrus also surprised the markets by not taking proper dancing lessons. Anyway, the result was that the stock market surged on that day and interest rates fell. The next days saw a reversal but stocks remain at record levels.

Why do markets seem to love bad policy? Wait you say – stalling on tapering is not bad policy. The markets know that a tapering program today would be terrible for the markets.  After all, the US economy has a zillion problems and therefore the Fed is the only game in town. The Fed cannot risk the recession that might ensue if they started tapering. That is the story I keep hearing. While I buy that many investors believe this story, that doesn’t make it right. Tapering is the right thing to do despite stock market hyperventilation.

So let’s pretend this popular story is a big ribeye and dig in. Let’s talk about the many problems that make the FED worry about recessionary risk.  One thing mentioned is the government standoff. Maybe there will be a budget shutdown. Another problem is Syria and how future developments might affect oil flow and energy prices. Then there is long-term government budgeting that promises a rising national debt. What about a declining labor force? And Kim Kasrdashian?

There are many problems that threaten a recession. They are as real as that roll around your belly. But let me ask you this. Can you name many months or quarters in the past 50 years in which we were not plagued by similar risks. How many months or quarters in the last 50 years were we absolutely sure a recession was not around the corner? I would say not many.  I also ask you how many times we were five years into a recovery and we were still worried about a double dip recession? Again, not many. 

So why the paranoia today? One reason for the continuing worry is that we had one helluva financial global meltdown. It was not your mother’s recession. This was a perfect storm recession from which some people believe or believed we would never recover. But we did recover. While we are not happy with the strength of the recovery and its impacts on employment, income and poverty, the economy has recovered and grown. These years of growth should reduce some of the paranoia. But not all of it. We are not growing properly and something needs to be done.

A lack of money in the economy is clearly not our problem and therefore seemingly endless monetization of the economy is not what needs to be done. If pouring a container of water on a grease fire does not work then why would pouring two containers of water on a grease fire work better? Notice that we have had substandard economic results despite unprecedented infusions of money. So now we are going to do more? The reason the monetary solution worked in 2008 but not today is because the problem in the US today is not monetary. Keeping interest rates low might be good for the stocks, houses, and cars, but if we keep this up many of us will be leaving pretty houses each morning and driving our nice cars to the unemployment office. Fed policy can feed some sectors but right now what we need is stronger balanced growth.

The President said he wants to grow from the middle out.  I seem to have no trouble growing from the middle out but that’s a different thing. If he wants balanced growth then I am on his side. Balanced growth means, I think, that we pay attention to our real problems. And we have plenty of them. But the difficulty is that we have a government that doesn’t work. These guys and gals can’t even agree on how many Martinis to have for lunch.  So why list again all those problems. Those yokels are not going to solve them anyway.

So that’s the basis of well-deserved paranoia. There is a way to put out a grease fire. But it takes a metal lid, baking soda, fire extinguisher, etc. If you do not have any of that stuff, then it makes absolutely no sense to pour water on the fire. It just makes it worse. That’s our situation in the US. Money has no remedial power for our current problems yet since the government has abdicated its role we keep asking the Fed to pour water on the flames.

But there is still this lingering question – Davidson if you are right then why aren’t you rich? The stock market blessed the Fed’s decision to put off tapering. Those people thought it was a good move. My only answer is that the stock market is only one response to the Fed’s actions…and a few days of changes are hardly evidence of anything.  Investors have benefited from a stock market that has recovered and is now entering new record high values. Who can blame investors for responding positively to more of the same?  But what about the thousands of business organizations that are not doing the wave right now? After the QE bonanza why are banks still sitting on hoards of excess reserves? Why are firms reluctant to borrow? Why are workers dropping out of the labor force?  Those actions speak louder than one day’s change in the Dow Average. Those behaviors are crying for a non-monetary appropriate solution.

Okay so maybe extending the current Fed policy is not helping but won’t tapering be too much for the economy to take now? I don’t think so. If you take away something that doesn’t add anything how can that lead to a subtraction? Taking away QE does not mean the Fed cannot increase the money supply. But QE is adding almost a trillion dollars of reserves each year. Even if the economy was growing at 5% it would not need that much more money each year.

In the 10 years from 1998 to 2007, the average increase in the US money supply (the version called M1) was $30 billion per year. The highest annual increase of $77 billion was in 2003. In 2012 the US money supply increased by $301 billion. We injected in 2012 more than 10 times the amount of money we usually need in one year – and we did that after increasing the money supply by $267 billion in 2011. It looks like 2013 will find another huge dose. This stuff does not disappear. It accumulates. We have enough money out there to support economic growth for about 30 years! We don't need more money -- we need bankers who want to lend it and firms who want to borrow it!

Tapering will not cut off liquidity in the US economy! I can’t be sure how the markets will react right after an announcement to taper, but I will bet a week’s supply of JD that after the initial reactions we will find ourselves with another Y2K…much ado over nothing. Get on with the tapering Ben and Janet.