Recently in Tax Policy Category

I'm going to try to lay out the stresses pushing and pulling on the US economy in the medium term. I'm going to intentionally oversimplify some things in order to make the overall picture as clear as possible.

 

And I'm going to apply a bit of a curve to the analysis, to account for the uncertainty surrounding the banking sector. (By that, I mean that we don't know yet whether the private-sector crunch will abate, not abate, partially abate, or sectorally abate.)

 

In the medium term, the United States faces an unavoidable liability to fund healthcare for the baby-boomers.

 

As people age, they tend to consume more healthcare with each passing year. In the US, the next several decades will see steady increases in health spending, probably peaking around 2030 and declining thereafter.

 

This is mandated consumption. There is a firm expectation that rationing healthcare for the elderly is not an acceptable social outcome. Therefore we need to fund the spending.

 

There is also a firm expectation that no one may receive a level of care that far exceeds what is available to people without wealth. We may argue this point until we're blue in the face, but I won't waste my time. Social justice is non-negotiable. Therefore, some amount of income redistribution is inevitable.

I must admit to you that I was very surprised by the budget that Barack Obama announced on Thursday.

In the short time he's been President, we've seen a pattern of a man who talks big but passes the buck. Everything he wants to do is someone else's job -- responsibility is passed on to Congress, his own subordinates, or the future (as in, "today we're announcing a major initiative that will accomplish X, Y, and Z. You'll have the details in a few weeks").

Not so with the budget. This budget is something different. Whether anything like it actually becomes law is impossible to say at this point. But it does represent a radical change in its basic philosophy about the relationship between the American people and their government.

I'm one of the many people who have been throwing the phrase "New New Deal" around, although I claim some measure of paternity because I've been using it (and the companion phrase "Great Depression II") since late 2007, which is longer than anyone else I'm aware of.

The essential challenge for America is to simultaneously achieve two things that, in conventional ideology, are incompatible. These are to fulfill society's promise of affordable necessities and comfortable retirement for all, and also to preserve America's culture of freedom and economic opportunity, where anyone can get rich.

To speak of these priorities in these terms is to see how facially incompatible they are. That's simply because ideologues of the right or the left will consider one of the two priorities to be the only one which matters, and the other one will take care of itself.

The mistake that people on the right make is that markets, left fully free, will automatically take care of everyone's material needs, and that government's most valuable contribution will be to get out of the way. On the left, people assume that social justice is a simple matter of redistributing wealth from those who earned it to those who deserve it, and there's more than enough wealth to go around.

So it's perhaps novel to speak of achieving both of these priorities together, given that so many people are so firmly committed to one at the expense of the other. But we stand at a moment in history when it's critical to hold both opposing ideas firmly in mind, to see how they interact, and to see how we can indeed achieve both.

Since the beginning of the economic crisis Paul Krugman has been the loudest advocate for a down-the-line, damn-the-torpedoes Keynesian approach. He continues to press this point in his latest op-ed column at the New York Times, which I would link except that it requires a registration.

Krugman knows his economics (and if you forget about that, his Nobel Memorial Prize will remind you). He's been writing cogently and presciently since nearly the beginning of the financial crisis (which long predates the economic one) about the clear and present danger of falling into a deflationary spiral.

Paul Krugman knows how mathematical models work as well as anyone. His problem is that he has a much more pedestrian understanding of how people work. This problem typifies the whole Obama Administration, which pays close attention to Krugman at his perch in Princeton, and professes to revere data rather than ideology.

In his latest column, Krugman cites an analysis by the Congressional Budget Office to the effect that over the next three years, the US economy will underperform its capacity by $2.9 trillion. (Of course, no color on the methodology or the approach of the study, but he's writing an op-ed piece, not an academic paper.) Let's take that large number on faith. It works out to about 7 percent of GDP.

This is the starting point from which Krugman goes on to call for government stimulus spending of about an equal size. Let's deconstruct the thinking a bit.

Something very important has been missing from the debate about fiscal stimulus. There are two really good reasons to oppose the Obama stimulus bill.

First, it's got be to just about the most hasty and poorly thought-out piece of legislation ever to come out of the US Congress. (Isn't it ironic that it also happens to be the biggest expansion of government spending ever?) This bill is so full of waste, earmarks and pork-barrel spending that Obama will have to use all his charm and deception to blow it past the American people.

Second, and this is what you hear from a lot of Congressional Republicans, the bill expands the Federal deficit tremendously.

It's being suggested by many sharp observers that global investors (like the Chinese) will be unwilling to fund this stimulus package, and will demand much higher interest rates on US debt.

Not quite. This deficit will be a lot easier to fund than many people think. It's what comes later on that we have to worry about.

Barack Obama has been very consistent about several elements of his storyline. It has three basic parts: First, the financial system just needs a little confidence. Second, the economy just needs a huge dose of spending on left-wing priorities. Third, and key to the point here, tax cuts don't work.

Obama always frames the point about taxes in a political context, something like: "the last eight years have proven that tax cuts are bad for the economy." So by taking him at his word, I'm at risk of misreading statements that may be meant only to shift blame for the difficult economy onto the Republicans. But here goes, anyway.

The great and abiding fear of Obama and his advisers, is a deflationary spiral, in which wages and prices fall, and people who owe money find it harder and harder to get by. (Debt-service generally consists of periodic payments of fixed size, so if the real value of the payments increases as overall prices fall, then debtors start defaulting more.)

And history suggests when you get a deflationary spiral, you can't get out of it, and it sticks around for years. What history? The Great Depression, and the "lost decade" in Japan. (Shockingly, Obama even mentioned the lost decade in his press conference the other night. Aren't Presidents supposed to avoid talking about worst-case scenarios?)

Unfortunately, there are several big problems with Obama's approach. First, he really doesn't know what he wants to do about the problem, other than spend nearly a trillion borrowed dollars to increase funding for a vast array of government programs, many of which are priorities of the political left wing.

Second, the President is profoundly misreading the mood of the country. The other night on national television, he repeated almost literally the conventional wisdom that the economy suffers when people save more money. (Confusingly, he also warned us that the era of debt-financed consumption and investment is over.)

I just noticed this news story. This is very important. Large employers are now starting to impose large and widespread cuts in wages and salaries.

This is a classic sign of a deflationary spiral, and it's going to be deeply frightening to a lot of people. Especially people in the Administration.

Why? Because sustained deflation is exactly what Obama is talking about when he says that we face the potential for an economic decline that we can't recover from. But there are good reasons to be encouraged by this news.

I live in New York City. I talk to a lot of businesspeople, investors, and Wall Streeters. I don't talk to all that many ordinary people.

But I enjoy being interviewed on live radio in other parts of the country. And when I do that, I get the chance to hear what local callers think about the economy, and more importantly, what they want.

They want to save a lot more money. This answer comes up automatically, without qualification, and without exception when you talk to ordinary folks.

When did this desire to save materialize? It was pretty sudden. If you look at official statistics (both the Commerce Department and the St. Louis Fed publish relevant ones), the personal saving rate suddenly ticked up to between 2 and 3 percent about four months ago. Remember, it had been running nearly zero before the financial crisis started. We had one month when personal savings jumped over 5%.

Curious? Sure enough, it was May 2008. That's when the tax rebate checks went out.

I won't try to explain the sudden desire on the part of consumers to start saving, after decades of dissaving, although that's certainly an interesting question. Sometimes the pendulum just has to swing the other way. If you try to associate the shift with some contemporaneous event (like an acute financial crisis, or the gasoline-price spike), you risk mistaking cause for effect.

Up tomorrow morning is the initial reading of GDP for Q4 2008. Most of the estimates are centering around contraction at an annual rate of 5.5% or a little more.

The long-term growth trendline over the last several decades has been about 2%, with the better periods running closer to 3%. This is a little better than the demographic increase. If you still believe anything Alan Greenspan says (I do), we benefited from a multi-year period of above-trend productivity improvements in the Nineties, and from globalization in this decade.

I think it's somewhat more likely that the GDP reading (which will be revised twice over the next two months) will surprise on the upside. I think a reading of minus-3% isn't out of reach. It's less likely that we'll see a surprise on the downside.

In any case, if the reading surprises, it will almost certainly change the color of the policy debate. Devotees of Macroeconomics-101, including Nobel Laureate Paul Krugman and recent convert Christina Romer, are using negative-growth expectations to scale the amount of deficit spending they think we should enact.

To spare you a lot of arithmetic and questionable assumptions, the idea is to take the expected contraction in the economy, divide by a multiplier (typically about 1.5), deficit-spend that much on anything other than tax cuts, and subsequently expect a decline in unemployment rates predicted by Okun's Law.

Some orthodox economists are calling for fiscal-deficit package of about 8% of GDP, about twice the size that Obama has proposed.

If tomorrow's GDP reading is significantly different from minus-5.5%, look for some people to revise their numerology.

Say, has anyone noticed that the stimulus projects which are getting the most negative attention from the press and the public, actually are the ones that orthodox Keynesianism suggests are the best ones to do?

I admit that striking the $600 million for condoms hurts no one but the people in China who would have manufactured the condoms. That one is a good strike, because it's transparently a giveaway to the pro-abortion lobby.

But spending $21 million to re-sod the National Mall is exactly the kind of make-work that fiscal stimulus is all about. The objective isn't to create a capital asset that will pay off in increased productivity later on, although that's often adduced as a bonus. The idea, as someone like Paul Krugman will readily tell you, is simply to reflate the economy by putting money into circulation and causing it to have a little velocity.

If you were to state this case baldly to the people, they'd probably laugh at you. What consumers want to do more than anything in the world at this point in time, is to SAVE A FEW BUCKS. But orthodox economists hate this idea because it creates no velocity, no additional GDP, and thus (according to orthodox theory) no additional employment. What all the smart people are missing is that you can't work your way out of a depression led by impaired consumer demand unless you increase consumer confidence. A major tax cut is what the people need. And it would have to have radical features to be effective, chief among them a sharp reduction in the payroll tax, not just the income tax as proposed weakly by Congressional Republicans.

And even the case that fiscal stimulus generates capital investment is suspect. You don't get much more utility out of a freshly-painted museum that no one goes to, than you do out of re-sodding the National Mall. (By the way, you can employ 1000 people at well over $10 an hour for a whole year, for $20 million. This isn't about re-sodding the Mall. It's about featherbedding.)

But we're all arguing the wrong things here. Let me tell you what the fiscal stimulus will REALLY accomplish. Except for the tax cuts (should significant ones actually materialize), the money will all be disbursed to the control of state governors and possibly some big city mayors. And what will they do with it? Yes, certainly, they'll fund some make-work ("shovel-ready") projects like bike paths, bridges to nowhere, new paint and air conditioners for government buildings, and (my personal favorite) Museums of the Great Depression.

But the thing these governors need more than anything else, is to fill in gaps in their state budgets. To a first approximation, the fiscal stimulus will be used to pay for healthcare and teacher salaries. The most direct effect of the stimulus will be to relieve states and cities of the need to raise taxes.

Don't hear anyone talking about that, do you?

For the Democrats to be willing enough to strip this stuff out under political pressure tells you that they really don't have the courage of their convictions here. This stimulus legislation is rotten to the core.