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Rogoff’s basic message is that in order to insure long-term economic health, we must crash the world economy now. It would be a hard to find a more impoverishing and absurd plan of action.

A Keynesian of the first order, Rogoff sees economic growth only in demand terms. Apparently unfamiliar with the classical economic principle that supply is demand, Rogoff views the latter as the cause of inflation. In that sense, and probably many others, he would feel very much at home within the hallowed walls of the Federal Reserve where similar views are held.

Unfortunately, what Rogoff and the Fed believe cannot be. Rising demand on its own can in no way cause a change in the price level. That is so because if excess demand makes a commodity such as oil or gas dear for consumers, those same consumers have less money to buy other goods. The broad inflationary impact is by definition zero.

Secondly, if we ignore for a moment the real reason commodities are expensive, we must conclude that economic growth is the solution to the problem of expensive goods. Indeed, growth is always and everywhere the result of productive work effort that attracts more capital for being productive.

If so, as in if demand explains what Rogoff deems “commodity price inflation,” it’s essential to have a booming world economy in order to fix the problem. In short, growth attracts capital, and it will be capital that funds the work effort that will either unearth more in the way of commodity supplies, or alternatives to the commodities very much in demand so that consumers can achieve price breaks on their purchases.

On the other hand, the slower economy that Rogoff advocates implies a destruction of wealth that would starve the very innovators intent on making commodities such as oil more plentiful. Rogoff’s austerity solution is charitably backwards.

Worse, while correctly explaining a worldwide run on paper currencies, Rogoff, much like the Fed once again, fails to understand why commodities are presently so expensive. As he points out, “Dollar bloc countries have slavishly mimicked expansionary U.S. monetary policy.”

The above is certainly true. Behind every commodity boom is dollar debasement whereby oil, gold and other commodities don’t so much become expensive as the greenback in which they’re priced becomes very cheap. Sure enough, thanks to a Bush Treasury that has encouraged a weak dollar in concert with a clueless Federal Reserve, commodities have risen in dollar terms, and as Rogoff correctly notes, the world has mimicked our monetary mistake. Absent worldwide monetary debasement in recent years that has led to a 250 percent rise in the price of gold versus the dollar alone, it’s fair to say that the price of oil would not be part of today’s economic discussion.

Rogoff’s failure to tie the commodity boom to currency weakness takes him down another false path given his belief that, “Absent a significant global recession, it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand.” His comment there is highly illuminating for his limited and incorrect understanding of inflation.

Owing to his view that rather than a monetary event, inflation results from too much growth, Rogoff remarkably believes that the ‘70s and this decade are examples of overly healthy economies. While stock-market returns in both decades clearly suggest a weak worldwide economic outlook, beholden to the unfortunate assumption that rising price levels are indicative of growth, Rogoff thinks otherwise. In doing so, he ignores the powerful economic acceleration that led to rising markets in the ‘80s and ‘90s, and that occurred in tandem with falling commodity prices.

Rogoff concludes that when it comes to today’s problems, “there is no easy, painless exit strategy.” And good Keynesian that he is, he suggests central banks should use their rate mechanism not to strengthen world currencies as so many strong-dollar advocates falsely presume they will, but instead he’d like rates increased to slow the world economy in order to bring down commodity prices.

Rogoff gets it wrong. Commodities are once again expensive because world currencies are cheap. Stronger world currencies and cheaper commodities would be a reward for the world economy after this decade’s ongoing inflationary outbreak, and even better, central banks need not raise rates to achieve this.

As history has shown, stable and strong currencies are consistent with low, not high rates of interest. Rather than going down Rogoff’s path to pain; a path we needlessly took in the early '80s, the U.S. Treasury should announce a stronger dollar definition in terms of gold that will provide an anchor for the rest of the world’s currencies, and that will lead to lower interest rates for the currencies that follow our credible lead.

The DCI study, coming as it did amidst growing talk of state fiscal crises around the country, is particularly revealing. Of the approximately $48 billion in accumulated budget shortfalls that the 29 states with projected deficits are facing, $33 billion, or two-thirds of the gap, is concentrated in those five states considered by corporate executives to be the least friendly to business. Meanwhile, among the five states ranked as having the best business environment, Texas and North Carolina have no projected budget gaps, and Georgia, Tennessee and Florida are facing shortfalls amounting to about $4.1 billion, or less than one-tenth of the states’ total.

An idealist would assume that those stark numbers would jump out at legislators in the most anti-business states and prompt a bracing re-evaluation of their spending, tax and regulatory regimes, as Paterson advocates. But no such luck. Paterson’s former colleagues in the state legislature are lobbying for a new tax on millionaires, while across the country California’s legislators have called for boosting the state’s top tax rate from 9.3 percent to 11 percent. Since many firms, especially small ones, are organized corporately in such a way that they pay taxes on profits at their owners’ personal income tax rate, any increase in the top rate of income taxes will hit small firms hard, to say nothing of the impact on the personal taxes of executives at big firms.

I’ve often heard people around the country say that voters in places like California, New York and New Jersey (which instituted its own ‘millionaires’ tax on those earning $500,000 or more a year several years ago) get what they deserve. But beware. States that have taxed and spent themselves into a bind want everyone else to pay for their excesses. Even as Gov. Paterson excoriated his former colleagues in the state legislature for failing to recognize the magnitude of New York’s budget problems, last week he traveled to Washington, D.C., to urge the federal government to help bail out the state. Paterson argued creatively that the rest of the country should come to his aid because the Empire State is home to the country’s financial markets and thereby contributes disproportionately to the America economy--although I can imagine that there are many states that would gladly take those financial institutions off of New York’s hands if the governor considers them such a burden.

Paterson also contended that states like New York deserve aid because they send more in taxes to the federal government than they receive in return in spending. This is an old argument that one often hears from pols not only in New York, but in New Jersey, California and Massachusetts. Based on an annual ‘balance of payments’ study sponsored by former Sen. Daniel Patrick Moynihan from 1977 through 1999, the study found that certain states were always big losers. But even Moynihan realized that those states were mostly responsible for their own plight, because their federal legislators had led the way in constructing a tax system that not only redistributed income from the rich to others, but also redistributed income regionally.

For instance, a study of the 1993 Clinton tax increase, which included a sharp rise in top income tax rates, found that the legislation cost the residents of California and New York $60 billion in additional taxes in the first year, mostly because of all those rich Wall Street and Hollywood types who got hit harder. Residents of one New York congressional district alone, on the East Side of Manhattan, paid more in additional taxes than taxpayers in any other district in the country—an increase of $3.4 billion, or 700 percent, in one year. And yet the congresswoman representing that district, Carolyn Maloney, and the majority of California’s and New York’s congressional delegations, voted in favor of the tax increase, which had been heavily advocated by economic advisor to the president and New Yorker Robert Rubin.

By contrast, most of the New York congressional delegation voted against the 2003 Bush tax cuts that saved New Yorkers $36 billion in federal taxes in the first year alone, according to a study by the Manhattan Institute’s E.J. McMahon. The difference, of course, is that the tax cuts left money in the private economy, not in the coffers of government, where the likes of Maloney could get their hands on it.

As the fiscal problems of some states increase, we are likely to hear more about how the federal government must bail them out. It’s the failings of the federal government (that is, the Bush administration), that are responsible for state budget woes, so the argument goes. But any look at the states with the biggest deficits reminds us that governors and legislatures are largely the authors of their own problems, and that the biggest trouble some of them seem to have is that their taxing and chronic overspending have made them toxic to the business community. Don’t ask the feds to fix that.

The latest round of talks in Geneva has once again failed to produce an agreement. Judging by what the financial press and some economists say, the stakes could not be higher.

Conclude this so-called “development round” successfully, and you will lift hundreds of millions of farmers in poor countries out of poverty and ensure that globalization remains alive. Fail, and you will deal the world trading system a near-fatal blow, fostering disillusionment in the South and protectionism in the North. And, as the editorialists hasten to remind us, the downside is especially large at a time when the world’s financial system is reeling under the sub-prime mortgage crisis and the United States is entering a recession.

But look at the Doha agenda with a more detached set of eyes, and you wonder what all the fuss is about. True, farm-support policies in rich countries tend to depress world prices, along with the incomes of agricultural producers in developing countries. But for most farm products, the phasing out of these subsidies is likely to have only modest effects on world prices — at most a few percentage points. This is small potatoes compared to the significant run-up in prices that world markets have been experiencing recently, and it would in any case be swamped by the high volatility to which these markets are normally subject.

While higher world farm prices help producers, they hurt urban households in developing countries, many of which are also poor. That is why the recent spike in food prices has led many food-growing countries to impose export restrictions and has caused near panic among those concerned about global poverty.

It is hard to square these fears with the view that the Doha trade round could lift tens, if not hundreds, of millions out of poverty. The best that can be said is that farm reform in rich countries would be a mixed blessing for the world’s poor. Clear-cut gains exist only for a few commodities, such as cotton and sugar, which are not consumed in large quantities by poor households.

The big winners from farm reform in the US, the EU, and other rich countries would be their taxpayers and consumers, who have long paid for the subsidies and protections received by their farming compatriots. But make no mistake: what we are talking about here is domestic policy reform and an internal redistribution of income. This may be good on efficiency and even equity grounds. But should it have become the primary preoccupation of the World Trade Organization?

What about industrial tariffs? Rich countries have demanded sharp cuts in import tariffs by developing countries such as India and Brazil in return for phasing out their farm subsidies. (Why they need to be bribed by poor countries to do what is good for them is an enduring mystery.) But here, too, the potential benefits are slim. Applied tariff rates in developing countries, while higher than in advanced countries, are already at an all-time low.

According to World Bank estimates, complete elimination of all merchandise trade restrictions would ultimately boost developing-country incomes by no more than 1 percent. The impact on developed-country incomes would be even smaller. And, of course, the Doha Round would only reduce these barriers, not eliminate them altogether.

The Doha Round was constructed on a myth, namely that a negotiating agenda focused on agriculture would constitute a “development round.” This gave key constituencies what they wanted. It provided rich-country governments and then-WTO Director General Mike Moore with an opportunity to gain the moral high ground over anti-globalization protesters.

It gave the US a stick with which to tear down the EU’s common agricultural policy. And it was tailor-made for the few middle-income developing countries (such as Brazil, Argentina, and Thailand) that are large agricultural exporters.

But the myth of a “development” round, promoted by trade officials and economists who espouse the “bicycle theory” of trade negotiations — the view that the trade regime can remain upright only with continuous progress in liberalization — backfired, because the US and key developing countries found it difficult to liberalize their farm sectors. What ultimately led to the collapse of the latest round of negotiations was India’s refusal to accept rigid rules that it felt would put India’s agricultural smallholders in jeopardy.

More importantly, the fears underlying the bicycle theory are wildly inflated.

We live under the most liberal trade regime in history not because the WTO enforces it, but because important countries — rich and poor alike — find greater openness to be in their best interest.

The real risks lie elsewhere. On one side is the danger that today’s alarmism will prove self-fulfilling — that trade officials and investors will turn the doomsday scenario into reality by panicking. On the other side is the danger that a completed “development round” will fail to live up to the high expectations that it has spawned, further eroding the legitimacy of global trade rules over the longer run. In the end, it may well be the atmospherics — psychology and expectations — rather than the actual economic results on the ground that will determine the outcomes.

So don’t cry for Doha. It never was a development round, and tomorrow’s world will hardly look any different from yesterday’s.

Dani Rodrik is Professor of Political Economy at Harvard University’s John F. Kennedy School of Government. His latest book is "One Economics, Many Recipes: Globalization, Institutions, and Economic Growth".

Each year AFG hosts a client conference in Las Vegas. As part of the proceedings, the clients in attendance fill out a survey which asks them to make various market and political projections for the year ahead. Given the relevant information that often reveals itself through the aggregated wisdom offered by crowds, it seems worthwhile to analyze some of last year predictions, all the while detailing some of what the AFG clientele foresee in the year ahead.

Last year, 47 percent of those surveyed said they were less optimistic about the equity markets going forward, 27 percent were neutral, and 24 percent were bullish. The large crowd of bears was proven somewhat correct in that year-over-year, the S&P 500 fell 10.27 percent. Of note, less than a percent surveyed last year felt a greater than 10 percent S&P correction lay ahead, but just that and more (if market turmoil from the summer is factored in) has materialized.

41 percent of the attendees felt the S&P would handily outperform the Russell 2000 in the year ahead, and while outperformance wasn’t of the 5 percent variety that was assumed, the Russell did fall 11.88 percent compared to the S&P’s aforementioned decline of 10.27 percent. With large cap stocks presumably better situated to weather economic uncertainty, the S&P projections from ’07 jibe with a clientele that was bearish in its posture.

On the oil front, 64 percent of those surveyed said oil would more likely hit $80/barrel before it touched $50, and this proved wildly corrrect. Where it gets interesting is that 72 percent said a weaker dollar would be good for stocks. This paradox was noted last year in that with oil’s price largely a function of the dollar’s direction, the twin assumptions were somewhat contradictory.

Indeed, the inflation that is a function of a weak currency is a retardant for stocks as evidenced by equity returns from 1966 to 1982. Notably, oil as mentioned does best when the dollar is weak. The dollar’s continued fall since last year has shown up in oil prices that at one point reached $145/barrel, and this has occurred alongside broad weakness in the equity markets.

In the political space, to show how quickly things change, twenty percent said Rudy Giuliani would be our next president, while 36 percent said Hillary Clinton would ascend to the Oval Office. Since these predictions were largely guided by the political punditry paid to comment on same, the faulty predictions there are perhaps an indictment of pundits who seek to crown winners before the votes are cast.

Looking at this year’s predictions, while the attendees almost overwhelmingly believe the U.S. still offers the greatest economic opportunity, there’s a decidedly bearish sentiment when it comes to the economy and the stock markets. These bearish feelings seem to be tied to projections about who will be our next president. 53 percent feel Barack Obama’s policies will be bad for the economy, and 68 percent feel he'll be our next president.

Asked to predict what will be the most significant challenges for the economy in the next twelve months, oil/energy (15.5%) and inflation (21%) got the most votes, while the credit crisis (9.5%), Democrats (9.5%) and housing (14%) rounded out the top five. And with inflation the number one risk, it’s not surprising that 50 percent of those surveyed are less bullish about stocks than they were last year.

30 percent think the S&P 500 will outperform the Russell 2000 by more than five percent this year, while another 46 percent believe the S&P will beat the Russell by less than 500 basis points. Only a fifth of those surveyed think the Russell will outperform the large cap index, so these numbers surely jibe with the generally bearish and conservative outlook held by the attendees.

And while a majority forecast a higher oil price last year, this year 67 percent think we’ll see $100 oil before it reaches $170/barrel. With oil down to $119/barrel, so far this prediction is proving correct. Either way, as in if oil moves back up above $130, 62 percent polled think the economy will continue to grow if so.

Despite a consensus view that the price of oil will decline, 55 percent of those surveyed still believe the economy will enter a recession this year. As for housing, 84 percent think troubles in that space will harm the economy. What’s unknown is why. Indeed, stocks rallied in the aftermath of an even greater moderation of home prices in the early ‘80s, so while housing’s problems are viewed as problematic, it could be that many think the interventionist governmental response to housing problems will be what hurts the economy the most.

A whopping 92 percent feel the dollar will appreciate against the euro this year, and contrary to last year’s consensus that a weak dollar would help equities, 83 percent think a stronger dollar will help the economy over the next five years. If equities are the truest barometer of our economic health, and it says here they are, this year’s sentiment suggesting a stronger dollar will aid the economy is a good one. All one need do to confirm this view is to look at the strong-dollar decades (‘50s – S&P +245%, ‘80s +121%, ‘90s +208%) since World War II versus the weak-dollar decades (‘60s – S&P +54%, ‘70s +17%, and -2% since Jan ’01) to see that economies embrace strong currencies while retreating during periods of money enervation.

73 percent of those polled think most Americans are happy, and this consensus conforms with the groundbreaking studies done by Arthur Brooks at the American Enterprise Institute. An even greater percentage believes the typical American worker is happier than his or her German/French counterparts, and this too is confirmed by Brooks’s research. Coddled workers are evidently not as happy, and who can blame them considering the higher levels of unemployment in Europe?

Given the choice to trade economic opportunities with workers in countries ranging from China to the U.K. to Brazil, heavy majorities said they would not make the trade. What fascinated this writer is that while China (17%) and India (22%) are lionized by most media for their blindingly bright economic futures, both polled behind Brazil (35%) among attendees in terms of countries they would prefer to work in.

Looking ahead to the elections, 40 percent think the country is on the right track, while 50 percent think it’s not. Importantly, 64 percent think equity prices will decrease if capital gains taxes are increased in 2009.

For those looking to position their portfolios ahead of November, 68 percent think Barack Obama will be elected president in 2009. Obama is presently of the mind to increase the capital gains levy, so investor beware. Notably, 82 percent think John McCain will be good for the economy, while only 46 percent think Obama will do a creditable job.

James Surowiecki, author of the 2005 book The Wisdom of Crowds, says "groups are remarkably intelligent, and are often smarter than the smartest people in them." Looking ahead, it will be interesting to see if Surowiecki's thesis holds when it comes to the successful investors who gathered in Las Vegas in June. Their aggregated wisdom seems to suggest that the stock market isn’t necessarily a great place to be going forward thanks to a potentially worsening policy outlook from Washington. As was written at this time last year, if the collective wisdom offered up by AFG’s clients proves accurate, investors should once again watch presidential polling to divine the future of stock-market returns.

A year ago, however, with the subprime mortgage meltdown of August 2007, I became certain. The situation had to resolve itself within a year – or else. Either central banks would manage somehow to thread the needle and guide exchange rates and asset prices back to some stable and sustainable equilibrium configuration, or the chaos and disruption in financial markets would spill over into the real economy and a major global downturn would begin. The odds heavily favored the second outcome: global macroeconomic distress.

But I was wrong. Here we are, fully a year later, and things are still balanced on the knife’s edge.

Let me stress that I have no complaints about the policies implemented by the United States Federal Reserve, which has had the main burden of responsibility for “managing” the crisis. I wish – as the Fed does – that some way could have been found to make financial-sector equity holders bear an even larger share of the losses that are coming down the road than they have borne so far or are likely to bear. But I agree with Fed Vice Chairman Donald Kohn that it is not wise to focus on teaching financiers lessons about moral hazard when doing so risks collateral damage in the form of the destruction of millions of jobs.

The Fed’s first priority is to try to keep the American economy from dropping too far below full employment, and to try and avoid a US meltdown contaminating other economies. If employment and incomes in America crash, US demand for imports crashes – and not just America but the whole world will slide into recession.

Employment in construction and related industries is collapsing, as Americans and foreigners recover from their fit of irrational exuberance over housing prices. Less enthusiasm about housing means that manufacturing firms will no longer be squeezed when they seek capital to expand. It also means a lower value for the dollar, and thus more opportunities for US-located firms to export and supply the domestic market. Jobs are moving from construction (and related occupations) into tradable goods and services production (and related occupations).

But if the system of financial intermediation collapses in universal bankruptcy, producers of tradable goods will be unable to get financing to expand. And if housing and mortgage security prices don’t just fall but collapse, everyone should remember that construction employment falls faster than employment in tradable goods can grow.

That would not be good for America or the world.

And so far, so good, at least on the real side of the US economy. Of course, US unemployment is rising, but if the American economy is in recession, it is the mildest recession ever. On the financial side, however, the magnitude of the chaos is staggering: mammoth failures of risk management on the part of highly leveraged financial institutions that must be first-rate risk managers in order to survive.

If you had asked me a year ago whether this degree of financial chaos was consistent with a domestic US economy not clearly in recession, I would have said no. If you had asked me a year ago whether a year could pass without either a restoration of confidence in financial institutions or widespread nationalizations and liquidations, I would have said no. Unstable and unsustainable configurations must come to an end.

Rudi Dornbusch was right: imbalances can last for longer than economists believe possible. But that does not mean that the water will not eventually run down the hill.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former Assistant US Treasury Secretary.

Mail out "tax rebate" checks. This is not a "tax cut" even though it might be labeled a "tax rebate." The label is unimportant. Functionally, it is a "government check in the mail" no different than Social Security or welfare payments. The effects are very transient. Also, this tends to cost a lot of money.

Devalue the currency. This can provide some short-term effects which might seem positive, but the end result is further impoverishment. You can't devalue yourself to prosperity.

"Cut interest rates." Interest rates would fall naturally, in something like a gold standard system, to reflect the overall lower return on capital during a recession. This impulse to "cut interest rates" via artificial means is typically a masked desire to devalue the currency.

Raise taxes. This is typically to "close the budget deficit." Some states are considering this right now. The federal government is going to effectively raise taxes, by "phasing out" the Bush tax cuts. This "raise taxes to close the deficit" was a major cause of the Great Depression, and also many other economic blowups throughout history into the 1990s. Usually, government budget deficits aren't really that big a deal. The tax hikes to "close the deficits" can be a big deal, however. Ironically, the tax hikes often cause so much economic deterioration that tax revenues fall rather than rise, and the deficit gets bigger! This is especially true when the recessionary effect of the tax hikes causes further pressure on the government for welfare-type spending.

Welfare spending. Today's welfare spending, such as food stamps or unemployment insurance, are usually welcome in an economic downturn. However, they typically do little to resolve whatever caused the economic problem in the first place. Also, the combination of increased spending and depressed tax revenues (due to recession) tends to lead to a bigger deficit, and thus calls for higher taxes.

Public works spending. Military-related spending often ends up in this category as well. The idea is to create jobs via government funding. This is a welfare-type activity, and typically does little to resolve the underlying cause of the economic difficulties. Also, it tends to be very, very expensive, which results in "raise taxes to balance the budget" arguments. The effects are usually transient.

Reduce government spending. Usually governments are rather bloated anyway, and what better excuse to go through a downsizing than a recession? If there is a problem with this, it is that it piles government unemployment on top of private-sector unemployment. It would be much better to slim down the government during the boom (OK, that never happens), when government workers could easily find new employment in the private sector. Maybe if a government reduced spending policy were paired with something positive, like a tax cut.

So, you see, what else are you going to do besides cut taxes? A tax cut, in a recession, has some advantages:

If the recession was caused by a tax hike, at least in part, a tax cut is an excellent solution. Herbert Hoover raised the top income tax rate in the United States from 25% to 63%, plus additional taxes on inheritances and businesses. This definitely made the situation worse. Much worse! A good solution for Roosevelt would have been to go back to 25%. Yes -- sometimes it is that obvious. In 1997, Thailand's government was pushed by the IMF to raise its sales tax to 10% from 6%, to reduce the looming budget deficit. (Thailand's government had run budget surpluses for years, and had very low debt, but the economic crisis caused by the currency crisis affected revenues. The IMF knuckleheads keep pulling the same Herbert Hoover routine over and over.) This produced no positive results, so the Thai government thought about it a bit, and moved the sales tax back to 6% in 1998. See -- it's not really that hard.

If the economic problems have a weak-currency component, a tax cut would help the currency to rise. Especially in emerging markets, where a lot of financing can be in foreign currencies, economic problems often have currency weakness as a component. A significant tax cut -- such as the East European-style flat taxes -- would have a meaningful currency-supportive effect, in addition to their positive effects in allowing greater economic expansion.

If the economic problems have little to do with taxes, a tax cut would still be one of the most effective ways of inducing a stronger economy. The present problems in the U.S. don't really have a tax hike component, although they may in 2009 once there is Democratic leadership in Washington. However, if we look at the list of options above, I would say that a meaningful permanent tax cut is one of the best options a government has to create more economic activity. What would the U.S. be like if we enjoyed a Hong Kong style tax system, with a 15% top income and corporate tax rate, and no taxes on interest income, dividends, capital gains, or inheritances? It would probably be a lot more healthy economically. If something is good for an economy in the long run, like a sensible tax system, then it is probably good in the short run as well. Vladimir Putin passed Russia's 13% flat tax in 2000, the depths of a decade-long economic catastrophe. The result: POW! Galloping economic growth -- the most since before the First World War! -- and galloping tax revenues. This was no fluke, since many other moribund FSU countries did much the same thing in 2001-2008, with much the same results.

It was fashionable in the mid-1990s for mainstream economists of nearly all stripes to recommend capital account liberalisation as an essential step in the process of economic development. Indeed, in September 1997, the governing body of the International Monetary Fund sought to make “the liberalisation of capital movements one of the purposes of the IMF and extend, as needed, the IMF’s jurisdiction …regarding the liberalisation of such movements.” The East Asian financial crisis of the late 1990s, where even seemingly well-managed countries like South Korea were engulfed by massive capital outflows and tremendous currency volatility, raised questions about the wisdom of developing countries opening their capital accounts, and certainly ended all discussion about giving multilateral organisations more of a mandate to push for liberalisation.

Ten years have passed and it is worth re-examining the benefits of openness to international financial flows, now that time has quelled passions and intervening research can shed more light on the debate. Moreover, the increasing desire of investors to look beyond their national borders for higher returns and diversification, as well as the increasing asymmetry in cross-border trade flows, necessitating corresponding financing flows, suggest that this is a particularly apt time to reconsider the issue.1

The subtleties of financial openness

Recent research suggests that the primary benefits and costs of financial openness are not what most thought they were. For instance, one benefit was seen to be the role foreign capital inflows could play in helping poor countries grow by expanding investment. It is very hard to conclude from the available studies that financial openness has a robust positive association with, let alone a causal effect on, the growth of non-industrial countries. More generally, some economists now believe the key benefit of financial openness is not the greater availability of financing. Indeed, recent studies show that non-industrial countries that rely on domestic savings rather than foreign capital do not have worse growth outcomes in the long run.2 This suggests that domestic savings are not the primary constraint on growth in these economies, as is implicitly assumed in the benchmark neoclassical framework. Moreover, access to international capital markets hasn’t helped emerging market economies to share their income risk more efficiently, a presumed benefit of financial globalisation.

At the same time, it has been difficult to conclusively pin the blame for the financial crises of the last two decades on open capital accounts by themselves. There is also some recent research showing that capital controls can distort investment decisions, though this literature remains tentative at best. So the case for capital controls is quite weak as well.
Though there is little evidence for either the main supposed benefits of financial openness or the main supposed costs, economists do not believe the debate over it is irrelevant, because they now see that the benefits and costs may both be more subtle than earlier thought. In particular, there is mounting evidence that financial openness catalyses indirect benefits that, in turn, can have a significant positive effect on growth. These indirect benefits include financial market development, improved governance, and incentives for greater macroeconomic policy discipline. Some of the newer literature based on microeconomic (firm- or industry-level) data provides evidence that is supportive of these channels. Analysis of such data has also been helpful in understanding how capital controls raise the effective price of capital and have distortionary effects on investment decisions of domestic and foreign investors.

A complication is that there appear to be certain “threshold” levels of institutional development that an economy needs to attain before it can get the full benefits and reduce the risks of financial openness. This suggests that a country should focus on building up its institutional capacity and strengthening its financial markets before opening up its capital account. However, while financial openness is clearly not a prerequisite for attaining the thresholds, it is equally clear that it can greatly facilitate the process. This creates a trade-off for developing countries. Without opening their capital accounts, the process of improving domestic institutions may take far longer. With underdeveloped institutions, however, the country will not realise the full benefits of financial openness and may indeed suffer costs. The question then becomes how to manage the risks during the transition to an open capital account if the preconditions are not fully in place.

Trending towards financial globalisation

Notwithstanding these complications, there are two arguments for why it increasingly makes sense for countries to shift their focus to how they will manage the process of capital account liberalisation rather than whether they should liberalise at all. First, capital accounts will become more open so long as there are strong incentives for cross-border flows of capital. Increasing global financial flows, the rising sophistication of international investors, and the expansion of international trade – which can serve as a conduit for disguising capital account transactions – will inevitably result in de facto opening of the capital account, irrespective of the capital control regime. Hence, it may be best for policymakers in emerging market economies to take steps to actively manage the process of capital account liberalisation – rather than just try to delay or push back against the inevitable – in order to improve the benefit-cost trade-off. Otherwise, policymakers may be stuck with the worst of all possible worlds – the distortions created by de jure capital controls and the complications of domestic macroeconomic management that are a consequence of increasing cross-border flows.

Second, given the balance of risks will vary over time, the global economic environment and the circumstances of individual countries may create windows of opportunity for countries to pursue capital account liberalisation. For instance, private capital flows in the last few years are increasingly taking the form of foreign direct investment or portfolio equity flows, both of which are less volatile and more beneficial than portfolio debt flows. A number of emerging market economies have accumulated large stocks of foreign exchange reserves and have also become more open to trade, which has substantially reduced the risks related to sudden stops or reversals of capital inflows and also mitigated risks of contagion. A country that has shifted the terms of the debate to “how” from “whether” can take advantage of these windows of opportunity to press for further liberalisation.

None of this is to say that the risks of financial openness have evaporated and that countries should rush headlong into it. Indeed, one of the main lessons of the financial crises of the 1980s and 1990s is that, once the taps are opened to capital flows, it can be very difficult to shut them off. Moreover, allowing capital account opening to get too far ahead of other policy reforms – especially domestic financial sector reforms and greater exchange rate flexibility – could have potentially devastating consequences if there were to be sudden shifts in international investor sentiment. There are also substantial inefficiencies in international financial markets, which remain far from complete in terms of the range of available instruments for sharing risk and are still beset by informational asymmetries, herding behaviour and other such pathologies. This suggests the need for creative approaches to capital account liberalisation that allow countries to undertake liberalisation in a controlled way, helping them enjoy some of the indirect benefits without exposing themselves to substantial risks.

Capital account liberalisation in reform strategies

We do not view capital account liberalisation as an appropriate policy objective for all countries in all circumstances. For poor countries with weak policies and institutions, it may not be a major priority, although even some poor but resource-rich countries have to deal with capital inflows and their mixed benefits. Having a strategy for managing an open capital account, rather than just coping in an ad hoc way with the whims of international investors, may be relevant even for these countries. Indeed, a key lesson from country experiences is that an open capital account works best in a supportive environment when other policies are disciplined and not working at cross-purposes. An open capital account is hardly an end in itself and generates adverse outcomes when implemented in isolation without due heed to domestic conditions and to complementary policies such as trade liberalisation. The same is true on the flip side, however. Imposing capital controls to try to mitigate the costs of other distortionary policies (such as financial repression or fiscal profligacy) often makes things worse.

Ultimately, capital account liberalisation can be much more effective if seen as part of a broader reform process. The objective of a fully open capital account can offer a unifying development goal that can help structure and sequence essential policy reforms and evaluate progress towards those reforms. There is also an important political economy argument to be made that a time-bound framework towards an open capital account can help build a consensus around that goal and make the political path for reforms smoother. In sum, capital account liberalisation may best be seen not just as an independent objective but as part of an organising framework for policy changes in a number of dimensions.

Eswar Prasad is the Tolani Senior Professor of Trade Policy at Cornell University.

Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business.

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1 This column draws on our article “A Pragmatic Approach to Capital Account Liberalization” forthcoming in the Journal of Economic Perspectives, Summer 2008. For a detailed survey of the literature and a description of the analytical framework used in that article, see M. Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei “Financial Globalization: A Reappraisal” NBER Working Paper No. 12484, 2006.
2 See, for instance, Eswar Prasad, Raghuram Rajan and Arvind Subramanian, “Foreign Capital and Economic Growth,” Brookings Papers on Economic Activity, 2007:1, pp. 153-209.

Looked at over a longer timeframe, from 1970 to 1981 the price of gold rose 1,219 percent, versus a rise in the price of oil 1,291 percent. This wasn’t coincidental. With gold and oil both priced in dollars, and with gold serving as the best proxy for the latter’s value, a jump in the gold price neatly foretold the oil “shocks” of the 1970s that were merely dollar shocks.

Given the strong price correlations between the two commodities, many economic commentators wrote of the gold/oil relationship in terms of a 15/1 ounce/barrel ratio. As the late Warren Brookes wrote in his 1982 book, The Economy In Mind, “In 1970 an ounce of gold ($35) would buy 15 barrels OPEC oil ($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels of Saudi oil ($32/bbl).

More modernly, in March of 1999 The Economist predicted $5/bbl oil in the future because “the world is awash with the stuff, and it is likely to remain so.” Instead, with the gold/oil ratio of roughly 25/1 historically out of whack, crude proceeded to rally beyond the 15/1 ratio; reaching $24/bbl by September of 2001.

Since 2001, gold has rallied powerfully owing to the dollar’s debasement over the same period. Unsurprisingly, oil has skyrocketed too. With many commentators on both sides of the political spectrum unfamiliar with the relationship between the dollar, gold and oil, apocalyptic notions of shortages and “limits to growth” have revealed themselves much as they did in the ‘70s.

More realistically, the oil “shocks” of this decade were rooted in dollar shocks that were bound to make oil dear in dollar terms. As of last month, oil since 2001 had risen over 380 percent in dollars versus 160 percent in euros. Though the numbers were different in the late ‘70s, this was not unlike oil’s 43 percent rise in dollars from 1975 to 1979; a “shock” that did not register in deutschemarks, yen and Swiss francs where oil rose 1 and 7 percent in deutschemarks and yen, versus a 7 percent fall in francs.

Last month, gold rose at one point to nearly $1,000/ounce, and oil hit an all-time high of $147/barrel. Since then, oil has fallen roughly 23 percent against a 17 percent drop in gold. So as is always the case, a large reason for oil’s current weakness has to do with a dollar that presently buys 1/827th of an ounce of gold, as opposed to nearly 1/1000th a month ago.

Still, oil has fallen further, and while rumblings of greater supply reaching the market due to presumption of liberalized drilling rules might explain some of the disparity, another realistic explanation lies in the aforementioned gold/oil ratio. As of last month, the ratio was roughly 6.8/1, so if history is any kind of indicator, oil was and is due for an even greater fall versus gold given the longstanding relationship between crude and the yellow metal. Looking ahead, no matter the direction of gold, oil has room for further weakness given a ratio that as of this writing is roughly 7.3/1.

What explains the dollar strength that has revealed itself in lower commodity prices? To some degree we can tie it to the coupled world economy that had never “decoupled” in the way so many pundits suggested. Simply put, dollar debasement regularly leads to world currency debasement, and with economies around the world struggling under the inflation that bats 1.000 when it comes to economic uncertainty, the severely weakened dollar has perhaps paradoxically been seen by investors as a safe haven in these treacherous times.

More interestingly, polls and market-based measures of political outcomes such as Tradesports.com point to a Barack Obama victory in November. Whatever his many policy faults, Obama recently met with strong-dollar advisors Paul Volcker and Robert Rubin, and not long after told a gathering of potential voters in Ohio that a strong dollar would help reduce the cost of fuel.

Obama’s new position dovetails nicely with a recent Forbes.com interview of McCain advisor, Douglas Holtz-Eakin. Holtz-Eakin talked up the value of a strong dollar, and this is very important for putting the dollar in play as a campaign issue. Looking past November, the markets are perhaps pricing in better dollar policy ahead, regardless of the winner of the presidential contest.

It’s also notable that Treasury Secretary Henry Paulson a few weeks back termed a strong dollar “very important.” The latter is a not insignificant improvement over his “the strong dollar is in our nation’s interest” comments that the markets understandably did not take seriously. Investors of course ignored Paulson’s boilerplate statements given the Bush administration’s anti-dollar stance that has revealed itself through a true policy of "benign" dollar neglect, tariffs on steel, lumber and shrimp, not to mention frequent jawboning of China over the value of the yuan.

If the long neglected dollar’s collapse is permanently reversed, look for lower commodity prices across the board. And while many commentators will say this is evidence of a weakening world economy, don’t be fooled.

Since 1971, all commodity “shocks” have been dollar shocks; the dollar’s debasement real inflation that has revealed itself through more expensive commodities and a weaker economic/investment outlook. Conversely, commodity weakness has regularly resulted from dollar strength that enhances the value of the money we earn, all the while leading to greater investment for inflation not destroying the returns gained from that same investment.

Put simply, the nascent bear market for commodities is a bullish economic turn for it signaling a resumption of dollar strength. If commodities continue to fall, this will be more evidence of better dollar policy that will occur alongside rising equity prices and a more economically confident electorate.

Perhaps one reason union leaders believe this, though it’s so contrary to the facts, is because their opponents in corporate boardrooms seem to believe it, too. How else to explain the absolute frenzy in management circles about labor issues at the hands of a prospective Obama administration? Ever since Obama’s nomination became assured, business groups and corporate managers have been painting doomsday scenarios in whispered meetings and off-the-record talks with reporters and columnists. They’re worried about a host of labor initiatives that might become a reality, from legislative changes that would make it easier for disabled workers to sue employers to a bill that would reclassify many supervisors as union members.

But what worries management most of all is a bill co-sponsored by Sen. Obama that would give unions the right to organize workers without a secret election--the inaccurately named Employee Free Choice Act. The legislation, previously discussed mostly at union rallies and in Congressional hearings, burst onto the presidential campaign when the Wall Street Journal reported two weeks ago that Wal-Mart has been warning its store managers and supervisors that a Democratic victory in November would assure passage of the bill, which allows labor to declare victory in a union drive merely by garnering the signatures of more than half of employees, rather than submitting to a contested election in which the results are determined by secret ballot.

I can understand why businesses in some industries that are more heavily unionized than others—like Cintas, the large uniform supplier, for instance—might aggressively lobby against such legislation. But it’s worth noting that the long decline in union participation in this country isn’t about to be reversed by a few federal laws. Indeed, despite a lack of success in Washington promoting card-check legislation, labor has been winning legislative victories for years at the state and local level, where they’ve been able to pass bushels of labor-friendly laws which nonetheless have had no discernable impact on their membership.

Today, for instance, some 32 states have so-called prevailing wage laws that require companies in certain industries that do business with government, especially construction firms, to pay their workers essentially what union members make. These laws are aimed at making it uncompetitive for government to hire non-union shops, thereby slowing their rise. Some of these laws can be quite elaborate and specific. Connecticut, for instance, publishes tables listing the required rate of pay for hundreds of jobs covered by prevailing wage, with pay rates varying by region. And some of these laws have been expanded over the years to encompass just about every service that government contracts for, including leases on stores in government-owned airports or agreements with maintenance firms that clean government buildings.

Sympathetic legislators have also come up with new wrinkles as they’ve expanded wage laws. In more than 100 localities, unions and their allies have passed so-called ‘living wage’ laws that are like prevailing wage on steroids. Though nominally meant to give workers a ‘living wage,’ the laws are often explicitly aimed at undercutting nonunion shops. In some places, these laws even require companies to abide by ‘neutrality agreements’ in labor negotiations, meaning that they cannot contest organizing drives. Gradually labor’s legislative allies have extended these laws to include anything government touches, even forcing businesses that receive tax-exempt financing provided by government, as in public/private partnerships, for instance, to abide by a host of union-friendly guidelines.

The results of these hundreds of laws and backdoor deals are hardly impressive. Take construction, the one industry most affected by such laws—and an industry that, unlike manufacturing, can’t be outsourced overseas. Even though government controls about 25 percent of all construction in the country, in the last 30 years, according to research by economists David Macpherson and Barry Hirsch, unionization in the construction industry has declined by nearly two-thirds to just 14 percent of all workers, from 38 percent. The decline has been relentless through Democratic and Republican presidential administrations.

States with the friendliest and most pro-union legislation, including elaborate prevailing wage laws, haven’t fared very well. In California, which not only has some of the most detailed statewide laws protecting unions as well as dozens of local ordinances in left-leaning municipalities, the portion of the construction industry that’s unionized has slumped in 25 years to 17 percent from 41 percent. In New Jersey, where union-friendly legislators have made it a felony for a company to violate prevailing wage laws (in most states it’s a civil violation publishable by fines), union rates in construction are down to 23 percent of all workers, from 38 percent.

Broader statistics on unionization in all industries are even bleaker, and nationally, of course, just 7.5 percent of all private sector workers now belong to unions.

Even so, labor leaders and their allies hold out hope that an Obama-led legislative drive would revive not only unions, but the entire Left in this country. Nothing illustrates the giddiness of these folks more than an unintentionally hilarious pro-union piece in the Chronicle of Philanthropy entitled How the Employee Free Choice Act Would Help Colleges, which observes that “the labor movement is still the most effective political force for electing liberal candidates” and that pro-labor politicians would also support “the environment; the civil rights of women, homosexuals, and minority groups…universal health insurance…affordable housing…and funds for public schools and higher education.” Never has so much been riding on one simple bill.

I can certainly understand why critics object to the federal check card legislation. If this bill passes, I sympathize with workers who don’t want their companies unionized, because they will come under unprecedented pressure once they are deprived of the right to a secret ballot. Indeed, one study of companies that willingly agreed not to oppose union organizing efforts found that more than half of all labor campaigns failed anyway. (Imagine having no opposition and still batting less than .500). However, the study also found that when labor negotiated not only neutrality, but also to have the process determined by signature cards rather than a secret vote, nearly 80 percent of campaigns were successful. Deprived of a secret vote, in other words, some workers went along with the union when they apparently wouldn’t otherwise.

But beyond the injustice to workers and the headache it will certainly cause a few management teams, Obama’s support of card check and other union friendly legislation will mostly accomplish one thing: ensuring that he gets the maximum campaign effort out of organized labor, which has pledged some $100 million to see him elected.

On the other hand, a more union-friendly attitude in Washington will have little impact on the historical trends undercutting organized labor in this country, because in most American workplaces these days, unionization isn’t even an issue. A union movement which grew in response to the industrial revolution and succeeded because laborers were fighting for basic rights is simply no longer relevant to the vast majority of today’s workers. And the huge chunk of their members’ dues that labor leaders now spend supporting Left-wing causes, ranging from environmentalism to subsidized housing to anti-war efforts, has made labor’s message less palatable even to employees in industries still prone to unionization.

Faced with a flood of pro-union sentiment from Washington, most workers will simply yawn and say, that’s change we can do without.

Although there are significant differences between the current economic environment and the 1970s, there are also significant similarities. As then, the current high price of oil has little to do with the supply and demand for that commodity. The problem then and the problem now is the supply and demand for US dollars. Soon after Reagan’s inauguration in 1980, the dollar started a rise that continued until the Plaza Accord of 1985. The trade weighted dollar rose roughly 50% and the price of oil fell by a similar amount. That rise was no accident. It happened because of the tight monetary policy of Paul Volcker and the growth promoting tax policies of Ronald Reagan. After the Plaza Accord and the coordinated effort to devalue the dollar, oil prices responded as one would expect, doubling by 1990.

Politicians are currently locked in a battle over energy policy which ignores the real cause of the problem and therefore offers no solution. Those on the left alternately argue that we haven't had any energy policy, or that current policy is a result of the Bush administration rewarding its oil industry benefactors. Politicians on the right argue that a lack of domestic production, due to environmental policy, is to blame. Both claim that enacting an energy policy is a matter of national security.

These arguments are all incorrect and largely irrelevant.

Regardless of politicians’ high regard for their own abilities, the high price of oil has little to do with any energy policy that was enacted, or not enacted, by a previous Congress. The ban on offshore drilling and in the ANWR region merely reduced domestic production while having little effect on the amount of oil being placed on the market. If we had increased production here over the last 30 years, it is logical to assume that producers outside the US would have decreased production to maintain prices at acceptable levels.

The real culprit in the rise in oil prices has been a monetary policy more concerned with growth than inflation. The successive bubbles in stocks, real estate and now commodities are prima facie evidence that monetary policy has been driving asset prices. Yes, there has been an increase in demand from China and other emerging markets, but the oil industry has met that demand, over time, with capacity to spare. New discoveries are adding to known reserves regularly. New technology is making previously unrecoverable oil, well, recoverable. It is not a lack of supply that is driving the price of oil.

The distortions caused by bad monetary policy are now creating a sense of urgency on the part of lawmakers. For now Congress is in recess, something for which we can all be thankful. But they will eventually return. I don't expect them to accomplish anything in the lame duck session since expecting Congress to actually pass meaningful legislation in an election year is like expecting Michael Jackson to become normal. But with a new administration, the danger increases that they will pass legislation that will not only fail to reduce oil prices but also damage the economy as a whole.

There are obviously other factors which influence the price of oil and other commodities, but it is also obvious that the value of the US dollar is the major factor. A reduction in demand due to high prices has contributed to the recent decline in the price of oil as has in increase in supply from Saudi Arabia and the potential for increased supply from more domestic drilling.

Furthermore, the recent strength of the dollar would seem to be more of a tallest midget phenomenon rather than a result of any overt policy change by the US. The decoupling thesis, where the rest of the world continues to grow even as the US slows, has been proven as wrong as every other “it’s different this time” thesis.

Ultimately, the value of the dollar is determined by the supply of and demand for US dollars. The current credit contraction is reducing the supply of dollars despite the best efforts of the Federal Reserve. In a world of fractional reserve banking, the Fed’s control over the supply of dollars via interest rate manipulations is limited at best. Any increase in demand for the dollar is not a result of good policy here but rather worse policy abroad. These factors have pushed the dollar higher for now, but if it is to be sustained, good policies must be enacted to support the demand for dollars.

Congress should enact pro-growth policies that act to increase the demand for dollars. Increasing capital gains taxes and marginal tax rates are not policies that will achieve that goal. A windfall profits tax on oil companies is not a policy that will achieve that goal. A cap and trade system to limit carbon emissions, endorsed by both candidates for President, is not a policy that will achieve that goal. Pro-growth policies would favor lower marginal tax rates, lower capital gains taxes (or better, none), less regulation, lower corporate tax rates (or better, none) and deficit reduction through lower government spending.

While Congress can and should enact pro-growth tax policies, a much more important task is to reform the Federal Reserve. The fist step should be to clarify the Fed’s mandate. Now, the Fed is tasked with maintaining growth and minimizing inflation. The only way for the Fed to truly accomplish the first goal is to concentrate exclusively on the second. It should also be made clear that inflation is defined as an expansion of the money supply and not a rise in price of an arbitrary basket of goods. The best way to accomplish currency and price stability is to adopt a gold standard but in the absence of political will for such a policy, a single mandate is a good first step.

We cannot drill our way to lower oil prices nor can we tax our way to prosperity. Growth cannot be created through policies that encourage consumption over savings and investment. The Fed needs to act to reduce and then stabilize the price of gold (increase the value of and then stabilize the dollar). Congress needs to act to create an environment that promotes growth through private investment. That’s what Ronald Reagan and Paul Volcker did in the early 80s. It worked then; it’ll work now.

Well, okay. But in 1997 the capital-gains tax was cut from 28 percent to 20 percent. That provided an 11 percent increase in retained income for the extra dollar put at risk by investors. In 2003, President Bush reduced the cap-gain levy to 15 percent, providing another 6 percent incentive.

With Sen. Obama’s 20 percent rate on investment, investors would suffer a 6 percent incentive loss on their cap-gain incomes and another 5.5 percent incentive drop on dividends. The cost of capital would rise under Obama and investment returns would decline by more than 11 percent. Uncle Sam will keep more and investors will retain less, all while the economy is languishing.

The McCain folks say a weak economy is no time to raise taxes. It’s a strong point, isn’t it? Former undersecretary of the Treasury John Taylor, a senior McCain advisor, notes that raising investment taxes will undermine business and lessen new job creation, which is the ultimate source of consumer incomes and spending power.

The Obama people counter that their middle-class tax credit of $1,000 per family is much more powerful than Sen. McCain’s plan to double the child exemption. In the Journal piece, Messrs. Furman and Goolsbee argue that McCain’s larger dependent exemption skips 101 million families with no children or dependents.

But tax credits are an inefficient source of stimulus because of various income-thresholds that determine eligibility. Phasing-in these credits provide temporary relief, but phasing them out as earners gain higher incomes actually raises marginal tax rates and provides a work disincentive for the extra dollar earned.

Another glitch in the Obama plan is the difference between the $200,000 income limit for individuals and the $250,000 threshold for two-earner families. If two singles each earning $200,000 get married, one will have to surrender over half of what he or she earns to the government. And raising the top income-tax rate from 35 percent to 39.6 percent is a work deterrent of roughly 7 percent. The extra dollar earned leaves only 60.4 cents take-home pay at the 39.6 percent tax rate compared with 65 cents at the current 35 percent rate. At the margin, this work disincentive can really matter.

Nonetheless, it appears the Obama people acknowledge at least some effects from supply-side incentives. And perhaps they are implicitly recognizing the likelihood that higher tax rates on cap-gains and dividends will generate lower revenues and a higher budget deficit.

It also seems clear that the Obama tax plan is not a growth policy, but a social policy that uses tax fairness as a means of redistributing income. There’s a long history of failed redistributionism, and this is where the Obama plan falls apart.

Plus, the world’s changed since the 1990s. The flat-tax revolution coming out of Eastern Europe has slashed marginal rates on individuals and corporations, resulting in strong growth and big revenue gains that keep budget deficits down.

Sen. McCain’s plan to maintain the Bush tax cuts and move toward a lower corporate tax rate will leave the U.S. in a much more competitive position in the global race for capital and labor. But I still believe the best tax reform is a flat tax that would end the multiple tax on saving and investment by doing away with taxes on capital gains, dividends, and estates. Corporate tax rates also should be slashed and all forms of corporate welfare, subsidies, and loopholes should be eliminated. This would put K Street lobbyists out of business and put tremendous torque behind our future economy.

But Team Obama’s small shift toward the supply-side remains a positive development.

The McCain folks are now slamming Obama’s credibility on tax hikes and other issues. They infer that the young Illinois senator is a flip-flopper. Well, that’s true. But some flip-flops are better than others. Sen. McCain flip-flopped on the Bush tax cuts and drilling. Bravo for that. And if Sen. Obama is flip-flopping toward lower investment taxes, so much the better.

It used to be thought that wars were good for the economy. After all, the Second World War is widely thought to have helped lift the global economy out of the Great Depression. But, at least since Keynes, we know how to stimulate the economy more effectively, and in ways that increase long-term productivity and enhance living standards.

This war, in particular, has not been good for the economy, for three reasons. First, it has contributed to rising oil prices. When the US went to war, oil cost less than $25 a barrel, and futures markets expected it to remain there for a decade. Futures traders knew about the growth of China and other emerging markets; but they expected supply to increase in tandem with demand.

The war changed that equation. Higher oil prices mean Americans (and Europeans and Japanese) are paying hundreds of millions of dollars to Middle East oil dictators and oil exporters elsewhere in the world rather than spending it at home.

Moreover, money spent on the Iraq war does not stimulate the economy today as much as money spent at home on roads, hospitals, or schools, and it doesn’t contribute as much to long-term growth. Economists talk about “bang for the buck” — how much economic stimulus is provided by each dollar of spending. It’s hard to imagine less bang than from bucks spent on a Nepalese contractor working in Iraq.

With so many dollars going abroad, the US economy should have been in a much weaker shape than it appeared. But, much as the Bush administration tried to hide the costs of the war by misleading accounting, the economy’s flaws were covered up by a flood of liquidity from the Federal Reserve and by lax financial regulation.

So much money was pumped into the economy and so lax were regulators that one leading US bank advertised its loans with the slogan “qualified at birth” . In a sense, the strategy worked: a housing bubble fed a consumption boom, as savings rates plummeted to zero. The economic weaknesses were simply being postponed to some future date; the Bush administration hoped that the day of reckoning would come after November this year. Instead, things began to unravel in August last year.

Now it has responded with a stimulus package that is too little, too late, and badly designed. To see the inadequacy of that package, compare it with the more than $1,5-trillion that was borrowed in home equity loans in recent years, most of it spent on consumption. That game, based on a belief in ever-spiralling home prices, is over.

With home prices falling , and with banks uncertain of their financial position, lenders will not lend and households will not borrow. So, while the additional liquidity injected into the financial system by the US Federal Reserve may have prevented a meltdown, it won’t stimulate much consumption or investment. Instead, much of it will find its way abroad. China, for example, is worried that the Fed’s stimulus will increase its domestic inflation.

There is a third reason that this war is economically bad for America. Not only has the US already spent a great deal on this war — $12bn a month, and counting — but much of the bill remains to be paid, such as compensation and healthcare for the 40% of veterans who are returning with disabilities, many of which are very serious.

Moreover, this war has been funded differently from any other war in America’s history — perhaps in any country’s recent history. Normally, countries ask for shared sacrifice, as they ask their young men and women to risk their lives. Taxes are raised. There is a discussion of how much of the burden to pass on to future generations. In this war, there was no such discussion. When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, two centuries ago, America has had to turn to foreigners for financing, because US households have been saving nothing. The numbers are hard to believe. The national debt has increased 50% in eight years, with almost $1-trillion of this increase due to the war — an amount likely to more than double within 10 years. Who would have believed that one administration could do so much damage so quickly? America, and the world, will be paying to repair it for decades to come.

Joseph Stiglitz is Professor of Economics at Columbia University. His most recent book, co-authored with Linda Bilmes, is 'The Three Trillion Dollar War: The True Costs of the Iraq Conflict.'

In the above sense Obama is making plain that “we’re all Reaganites now.” Nowhere in his plan does he say we should return to the confiscatory rates weathered under Nixon, Ford and Carter in the ‘70s, or for that matter rates experienced under Ronald Reagan up until 1986. Reagan’s ideas about incentives and taxation seem to have positively infected both political parties to varying degrees, and this means there’s reason for moderate optimism no matter who wins in November.

Still, Obama’s tax plan is unfortunate because it flies in the face of his own objectives. Indeed, as Furman and Goolsbee noted, “Sen. Obama believes that one of the principle problems facing the economy today is the lack of discretionary income for middle-class wage earners.”

But if that’s the case, Obama won’t help the middle class by penalizing the wealthy. This is so because wages can only rise when the amount of available investment capital increases. Simply put, without capital there are no wages.

So while Furman and Goolsbee argue that “Obama’s middle-class tax cuts are larger than his partial rollbacks for families earning over $250,000,” they misunderstand the origin of middle-class comfort. In short, a 10% rate cut on income of $250,000 and up frees up far more capital than a tax cut on income of $50,000.

And that’s why it’s so essential to keep the rate of taxation on high earners as low as possible, perhaps the lowest rate of them all. From a revenue standpoint it’s empirically true that top earners footed a much greater portion of federal revenues in the 1920s, ‘60s and ‘80s despite a reduction in top rates, but more important is the impact on wages for those not wealthy.

Sure enough, logic tells us that if top earners are penalized less, they can either consume non-taxed income or they can save. If they consume we should consider their spending a non-Washington form of “stimulus” whereby the rich transfer wealth to workers through the purchase of life’s necessities and frivolities.

Even better, however, is what happens if the rich choose to save and invest the income that the government doesn’t confiscate. Invariably, money saved is lent to businesses and entrepreneurs reliant on capital in order to grow. For the middle class this is a big deal because the savings either fund new forms of employment, or additional remuneration. When Obama’s concerns about discretionary income are considered, the single best way to increase middle-class income is to reduce the success penalty on those in possession of the greatest amount of capital. That is the rich.

The above in mind, Furman and Goolsbee oddly maintain that the tax-rate cuts advocated by McCain “would take money from the middle class,” but as economic logic dictates, their assumptions are backwards. Any legislation that expands the dollar amount of non-taxed capital will automatically accrue to middle-class earnings. In short, don’t be fooled by candidates who say they’ll help the poor and middle class by taxing the rich. When politicians say the latter, what they’re really saying is that they’ll reduce the earnings of all those not yet rich.

And when we consider the blessings we all receive from the vital few who start businesses, it’s essential to remember that many of tomorrow’s corporate behemoths are presently small. According to Furman and Goolsbee, the “vast majority of small businesses would face lower taxes” under Obama’s plan, but this is deceptive. More realistically, many small businesses pay individual rates of taxation on profits, so while the Obama tax plan allegedly favors them, the reality is that an increase in the top tax rate will harm the very firms that Obama seeks to elevate.

Even worse, when Obama contradicts his alleged like of small business with proposals of higher taxes for same, he shows an impressive ignorance of how hard it is to make what is small, large. Indeed, the “seen” in the U.S. economy is the various economic success stories such as Microsoft and Google. What’s unseen is how many small businesses over the years have ceased to exist. With many reliant on the smallest of earnings margins to stay in operation, higher individual rates of taxation could constitute what is often the slight difference between success and failure.

The late Warren Brookes once noted that envy “is the single most impoverishing attitude of thought.” While the Obama tax plan in no way heralds future bread lines, it misses the point for needlessly furthering the politics of envy. Increased taxes on the rich will serve no helpful policy objective, but those taxes will weigh on the incomes of those who would one day like to be rich.

Other advanced economies or emerging markets (the rest of the euro zone; New Zealand, Iceland, Estonia, Latvia, and some Southeast European economies) are also nearing a recessionary hard landing. When they reach it, there will be a sharp slowdown in the BRICs (Brazil, Russia, India, and China) and other emerging markets.

This looming global recession is being fed by several factors: the collapse of housing bubbles in the US, the United Kingdom, Spain, Ireland and other euro-zone members; punctured credit bubbles where money and credit was too easy for too long; and the severe credit and liquidity crunch following the US mortgage crisis; the negative wealth and investment effects of falling stock markets (already down by more than 20% globally).

Some other contributing factors are: the global effects via trade links of the recession in the US (which still counts for about 30% of global GDP); the US dollar’s weakness, which reduces

American trading partners’ competitiveness; and the stagflationary effects of high oil and commodity prices, which are forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and financial stability.

Official data suggest that the US economy entered into a recession in the first quarter of this year. The economy rebounded – in a double-dip, W-shaped recession – in the second quarter, boosted by the temporary effects on consumption of $100 billion in tax rebates. But those effects will fade by late summer.

The UK, Spain, and Ireland are experiencing similar developments, with housing bubbles deflating and excessive consumer debt undercutting retail sales, thus leading to recession.
Even in Italy, France, Greece, Portugal, Iceland, and the Baltic states, frothy housing markets are starting to slacken. Small wonder, then, that production, sales, and consumer and business confidence are falling throughout the euro zone.

Elsewhere, Japan is contracting, too. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now, exports to the US are falling while the yen has strengthened. Moreover, high oil prices in a country that imports all of its oil needs, together with falling business profitability and confidence, are pushing Japan into a recession.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices, but its GDP shrank in the first quarter, owing to the contracting US economy. Indeed, three quarters of Canada’s exports go to the US, while foreign demand accounts for a quarter of its GDP.

So every G7 economy is now headed toward recession. Other smaller economies (mostly the new members of the EU, which all have large current-account deficits) risk a sudden reversal of capital inflows; this may already be occurring in Latvia and Estonia, as well as in Iceland and New Zealand.

This G7 recession will lead to a sharp growth slowdown in emerging markets and likely tip the overall global economy into a recession. Those economies that are dependent on exports to the US and Europe and that have large current-account surpluses (China, most of Asia, and most other emerging markets) will suffer from the G7 recession.

Those with large current-account deficits (India, South Africa, and more than 20 economies in East Europe from the Baltics to Turkey) may suffer from the global credit crunch. Commodity exporters (Russia, Brazil, and others in the Middle East, Asia, Africa, and Latin America) will suffer as the G7 recession and global slowdown drive down energy and other commodity prices by as much as 30%.

Countries that allowed their currencies to appreciate relative to the dollar will experience a sharp slowdown in export growth. Those experiencing rising and now double-digit inflation will have to raise interest rates, while other high-inflation countries will lose export competitiveness.

Falling oil and commodity prices – already down 15% from their peaks – will somewhat reduce stagflationary forces in the global economy, yet inflation is becoming more entrenched via a vicious circle of rising prices, wages, and costs. This will constrain the ability of central banks to respond to the downside risks to growth.

In advanced economies, however, inflation will become less of a problem for central banks by the end of this year, as slack in product markets reduces firms’ pricing power and higher unemployment constrains wage growth.

To be sure, all G7 central banks are worried about the temporary rise in headline inflation, and all are threatening to hike interest rates.

Nevertheless, the risk of a severe recession – and of a serious banking and financial crisis – will ultimately force all G7 central banks to cut rates. The problem is that, especially outside the US, this monetary loosening will occur only when the G7 and global recession become entrenched.

Thus, the policy response will be too little, and will come too late, to prevent it.

Nouriel Roubini is Professor of Economics at the NYU's Stern School of Business and Chairman of RGE Monitor.

Those startling numbers should remind us that even in a strong economy there are plenty of losers—not just winners. And that should help explain what’s wrong with the press’s coverage of a Government Accountability Office study released last week, which reported that two-thirds of American corporations paid no taxes in 2005—including a quarter of big businesses. The report, commissioned by several labor-friendly Democratic Senators who pretty much knew based on previous studies what it would say, sparked a lot of manufactured outrage in political circles and produced a series of misleading stories, like one by the Associated Press that ran in dozens of newspapers under sensationalistic headlines like “Corporations Pay No Taxes.”

A number of more rational commentators have pointed out some of the ways that the pols have led the media astray on this one. Kevin Hassett, in a Bloomberg commentary, explained that most small businesses are now organized in such a way that many prefer to take their profits as an owner’s salary and pay taxes on the wages. It’s not that they aren’t paying taxes, as the headline incorrectly says, but rather that the money is not flowing to the government through the corporate levy.

Still, the report leaves open the question of larger businesses that paid nothing. The impression one gets from corporate critics is that many are prospering but exploiting loopholes in the tax code and leaving the rest of us to pick up the tab. But that criticism is based on the mistaken notion that in robust years, such as 2005, virtually all businesses do well. Nothing could be further from the truth.

Even in good times, there are plenty of losers in a dynamic economy. The BLS’ Business Dynamics Survey, for instance, shows that in 2005 there were 7.3 businesses that were contracting for every 7.6 that were expanding, including 1.3 that were closing their doors for every 1.5 that were starting up. Large businesses were hardly immune to this kind of tumult. For every 5.8 jobs added by firms with more than 500 employees, other firms that big eliminated 4.9 jobs. Among those hit hard in 2005 was General Motors, which despite $193 billion in revenues wracked up a $10.4 billion loss and cut its workforce.

It shouldn’t be necessary to remind reporters and editors who cover such matters that businesses pay taxes on their profits, not sales. But I often read stories in which a reporter confuses the two, saying that a business “made” $50 million when the writer is referring to the company’s sales. Much of the press that the GAO report received revolves around blurring the distinction between these two. As Michigan Senator Carl Levin, a frequent critic of corporations, said of the study, “Twenty-five percent of the largest U.S. corporations [those with more than $50 million in revenues] had $1.1 trillion in gross sales in 2005 and yet paid no federal income taxes.” That statement suggests that Levin is either trying to mislead us or that he has made it into the world’s most exclusive club, the U.S. Senate, without knowing the difference between earnings and sales.

The difference, of course, can be enormous. For one thing, many industries have extremely small profit margins because as soon as it gets too easy to make a buck in a free-market system, you’re sure to get plenty of competitors crowding in, driving down your margins. The average net margin in the supermarket business is just 1 to 2 percent of sales, for instance, which means that a company with $50 million in sales (to use the study’s definition of large businesses) would earn, on average just $500,000-to-$1 million annually and pay taxes on that money. Many firms in the industry, of course, would be below that average, and some would lose money in any year.

Many businesses we regard as successful operate on small profit margins. After paying $5.8 billion in taxes in 2005, Wal-Mart earned $11.7 billion—a nice chunk of change. But those earnings were on revenues of $312 billion, a mere 3.4 percent net profit margin. Exxon Mobil earned $36 billion in 2005 after paying $23.3 billion in taxes on revenues of $371 billion. Looking at that result you realize that in America today, a ‘windfall’ profit is one that amounts to less than 10 percent of revenues.

The politics behind the GAO report are transparent—to undermine the momentum that’s building to cut corporate tax rates. As I wrote several weeks ago (“In the U.S., Selectively Applied Capitalism,” July 28), the U.S. has the second highest corporate tax rate among 30 countries in the Organisation of Economic Co-Operation and Development. That matters because, as economists for the OECD recently concluded, the corporate tax is the most harmful to economic growth of all the levies most commonly used by member nations. That’s why GOP presidential nominee John McCain favors lowering it, but so does the powerful Democratic Chairmen of the House Ways & Means Committee, Charlie Rangel. The Democratic presidential nominee, Barack Obama, has also said in newspaper interviews that he would consider cutting the corporate tax, but he hasn’t made that an official part of his platform.

Now, however, labor-friendly legislators egged on by union leaders are trying to derail calls for a corporate tax cut by manufacturing outrage against U.S. businesses. That’s not hard to do when you have so many journalists reporting and commenting on these issues who can’t get behind headlines that are spoon fed to them, like the editorial writer at Newsday who found the GAO report “jaw dropping.”

Yes, it’s true that 2005 was a good year for many American companies. As I noted above, corporate profits rose 18 percent, according to the Bureau of Economic Analysis. But taxes on corporate profits that year increased 34 percent, says the BEA. Growing firms, you see, do pay more in taxes. Just don’t imagine that every business is growing whenever the American economy is.

Extreme poverty is almost synonymous with extreme isolation, especially rural isolation. But mobile phones and wireless Internet end isolation, and will therefore prove to be the most transformative technology of economic development of our time.

The digital divide is ending not through a burst of civic responsibility, but mainly through market forces. Mobile phone technology is so powerful, and costs so little per unit of data transmission, that it has proved possible to sell mobile phone access to the poor. There are now more than 3.3bn subscribers in the world, roughly one for every two people on the planet.

Moreover, market penetration in poor countries is rising sharply. India has around 300mn subscribers, with subscriptions rising by a stunning 8mn or more per month. Brazil now has more than 130mn subscribers, and Indonesia has roughly 120mn. In Africa, which contains the world’s poorest countries, the market is soaring, with more than 280mn subscribers.

Mobile phones are now ubiquitous in villages as well as cities. If an individual does not have a cell phone, they almost surely know someone who does. Probably a significant majority of Africans have at least emergency access to a cell phone, either their own, a neighbour’s, or one at a commercial kiosk.

Even more remarkable is the continuing “convergence” of digital information: wireless systems increasingly link mobile phones with the Internet, personal computers, and information services of all kinds. The array of benefits is stunning.

The rural poor in more and more of the world now have access to wireless banking and payments systems, such as Kenya’s famous M-PESA system, which allows money transfers through the phone. The information carried on the new networks spans public health, medical care, education, banking, commerce, and entertainment, in addition to communications among family and friends.

India, home to world-leading software engineers, high-tech companies, and a vast and densely populated rural economy of some 700mn poor people in need of connectivity of all kinds, has naturally been a pioneer of digital-led economic development. Government and business have increasingly teamed up in public-private partnerships to provide crucial services on the digital network.

In the Indian states of Andhra Pradesh and Gujarat, for example, emergency ambulance services are now within reach of tens of millions of people, supported by cell phones, sophisticated computer systems, and increased public investments in rural health.

Several large-scale telemedicine systems are now providing primary health and even cardiac care to rural populations. Moreover, India’s new rural employment guarantee scheme, just two years old, is not only employingmns of the poorest through public financing, but also is bringing tens of millions of them into the formal banking system, building on India’s digital networks.

On the fully commercial side, the mobile revolution is creating a logistics revolution in farm-to-retail marketing. Farmers and food retailers can connect directly through mobile phones and distribution hubs, enabling farmers to sell their crops at higher “farm-gate” prices and without delay, while buyers can move those crops to markets with minimum spoilage and lower prices for final consumers.

The strengthening of the value chain not only raises farmers’ incomes, but also empowers crop diversification and farm upgrading more generally. Similarly, world-leading software firms are bringing information technology jobs, including business process outsourcing, right into the villages through digital networks.

Education will be similarly transformed. Throughout the world, schools at all levels will go global, joining together in worldwide digital education networks. Children in the US will learn about Africa, China, and India not only from books and videos, but also through direct links across classrooms in different parts of the world. Students will share ideas through live chats, shared curricula, joint projects, and videos, photos, and text sent over the digital network.
Universities, too, will have global classes, with students joining lectures, discussion groups, and research teams from a dozen or more universities at a time.

In my book The End of Poverty , I wrote that extreme poverty can be ended by the year 2025. A rash predication, perhaps, given global violence, climate change, and threats to food, energy, and water supplies. But digital information technologies, if deployed co-operatively and globally, will be our most important new tools, because they will enable us to join together globally in markets, social networks, and efforts to solve our common problems.

Jeffrey Sachs is Professor of Economics and Director of the Earth Institute at Columbia University. He is also a special adviser to the UN secretary-general on the Millennium Development Goals.

Many argue that the Fed Funds rate of 2% is too low and is producing a negative real fed funds rate. These arguments would concern us if interest rates themselves mattered.

We believe two things: interest rates don't matter, and interest rates alone do not signal that Fed policy is easy or tight. What does matter is the amount of liquidity the Fed provides - the supply and the demand for money. The fed funds target rate is merely the rate at which the Fed will add or subtract liquidity. Too much liquidity produces asset price inflation, too little asset price deflation. Investors should stop worrying about the Fed's level of interest rates and instead focus on whether assets prices are inflating of deflating.

Once the focus moves from concerns about interest rates themselves, to concerns over asset prices, the picture becomes much clearer. Asset prices are falling. The drops in house, building and stock prices have large effects on the financial system and on all of our balance sheets.

These balance sheet losses have a much more damaging effect than the income statement effects of rising inflation through higher food and fuel costs. What bothers people more, the 30% drop in their home price or paying $4/gallon for gasoline? We certainly do not support inflation, but we fear balance sheet deflation far more and think the Fed should add liquidity to stop this asset price deflation. When they do investors will want to be long U.S. stocks.

In this, we can say that federal politicians are learning from their state and local brethren. Although tax rebate programs are relatively rare at the federal level (though we’ve now had two in the past seven years), they are increasingly common at other levels of government and almost invariably now exclude certain taxpayers, namely those doing well. Although these programs are not nearly as controversial as redistributing income by raising taxes on the rich, the effect is similar. Given how politically popular such rebates have become, expect even more of them, and expect those with the highest income to bear their burden.

Unlike the federal stimulus package, one purpose of local rebate programs is to refund to taxpayers a portion of embarrassingly high budget surpluses, and thus defuse calls for tax cuts. And so, when New York City logged a budget surplus just a year-and-a-half after Mayor Michael Bloomberg pushed through the largest tax hike in the city’s history, Gotham began a rebate program that it renews each year in lieu of simply cutting taxes. The rebates allow Mayor Bloomberg and the city council to target the money where it does the most good politically by reserving it for homeowners, even though businesses paid the bulk of the additional taxes. The program also affords local pols the opportunity to announce with fanfare a new rebate each year.

Taking a similar approach, New Mexico has decided to refund some $58 million of the state’s current budget surplus to taxpayers, but households earning more than $70,000 a year will receive nothing, and those earning less will see their rebates decline as their income rises. The state’s economy and its budget have done well since Gov. Richardson cut income tax rates in 2003, but the federal stimulus package now seems to have inspired New Mexico to go the route of means-tested rebates.

Politicians seem to love such programs so much they are even willing, paradoxically, to raise taxes to support them. New Jersey began a rebate program in the late 1990s when the state was running huge budget surpluses, using state funds to offset high local property taxes. But as Jersey’s spending rose and the 2002 recession cut tax revenues, the state raised dozens of taxes, including taxes on businesses and high-income earners. Still it kept paying out the rebates, as politicians argued that in hard times the refund checks were even more important. Of course, in order to be fiscally responsible, the state eliminated the rebates for high income earners, the very same people whose taxes it had raised to keep the state’s budget afloat in the first place.

Rebate programs have become an especially popular way to defuse anger over soaring local taxes. Municipalities have long used property taxes to finance most of local government, including schools. But K-through-12 school spending in America has soared, increasing on a per-student basis about four-fold in inflation-adjusted terms over the past 50 years, according to Manhattan Institute senior fellow Jay Greene. Those increases have forced property taxes sky-high and prompted states to step in with means-tested, state-funded rebate programs. Some 18 states, for instance, now have rebate programs that employ “circuit-breakers” that stop refunds once a household reaches a certain income level, or a certain ratio of annual income to property taxes.

These programs are an easy sell because of the widespread and misleading notion that property taxes are regressive, that is, that they impact lower income households disproportionately and therefore that the rich should help to offset their cost so that ‘working families’ can stay in their homes. This notion remains pervasive even though economists concluded decades ago that property taxes are, in fact, progressive because they represent a tax on a household’s true wealth—something that’s not always accurately reflected in other sorts of taxes.

Despite claims by their proponents, most property tax rebate programs don’t really subsidize working families anyway. Most are heavily oriented toward retired senior citizen homeowners, who are reliable voters, on the spurious notion that those on a fixed income are hurt most by such a ‘regressive’ tax. Income, however, is a poor measure of household wealth. Although the typical over-65 household earns only half the annual income of a household headed by someone aged 35-44, senior households also have an average of three-times the assets of these younger families, and far fewer family members to support. Still, virtually all property tax rebate programs take tax money paid by our most productive workers and use it to relieve the burden of those who are no longer working, but who may have spent a lifetime accumulating wealth.

Even worse, rebate programs designed to ameliorate the burden of higher taxes rarely get at the underlying causes of the problem—government spending. A study a few years ago, for instance, found that municipal governments in New York State had accelerated their spending after the state instituted a rebate program to offset rising local taxes, and the higher spending prompted even faster growth in municipal taxes within a few years. Critics of rebate programs had warned that just such a thing would happen unless the state enacted spending caps, but while refund checks are popular, spending limits are vigorously opposed by public sector unions and local politicians. So, like most rebate programs, New York wound up with the worst of both worlds.

That’s a good way to describe the impact of tax rebates on businesses and high income families: the worst of both worlds. Expect these means-tested ways of redistributing income to become ever more common.

In this, we can say that federal politicians are learning from their state and local brethren. Although tax rebate programs are relatively rare at the federal level (though we’ve now had two in the past seven years), they are increasingly common at other levels of government and almost invariably now exclude certain taxpayers, namely those doing well. Although these programs are not nearly as controversial as redistributing income by raising taxes on the rich, the effect is similar. Given how politically popular such rebates have become, expect even more of them, and expect those with the highest income to bear their burden.

Unlike the federal stimulus package, one purpose of local rebate programs is to refund to taxpayers a portion of embarrassingly high budget surpluses, and thus defuse calls for permanent tax cuts. And so, when New York City logged a budget surplus just a year-and-a-half after Mayor Michael Bloomberg pushed through the largest tax hike in the city’s history, Gotham began a rebate program that it renews each year in lieu of simply cutting taxes. The rebates allow Mayor Bloomberg and the city council to target the money where it does the most good politically by reserving it for homeowners, even though businesses paid the bulk of the additional taxes. The program also affords local pols the opportunity to announce with fanfare a new rebate each year.

Taking a similar approach, New Mexico has decided to refund some $58 million of the state’s current budget surplus to taxpayers, but households earning more than $70,000 a year will receive nothing, and those earning less will see their rebates decline as their income rises. The state’s economy and its budget have done well since Gov. Richardson cut income tax rates across-the-board in 2003, but the federal stimulus package now seems to have inspired New Mexico to go the route of means-tested rebates.

Politicians seem to love such programs so much they are even willing, paradoxically, to raise taxes to support them. New Jersey began a rebate program in the late 1990s when the state was running huge budget surpluses, using state funds to offset high local property taxes. But as Jersey’s spending rose and the 2002 recession cut tax revenues, the state raised dozens of taxes, including those on businesses and high-income earners. But it kept paying out the rebates, as politicians argued that in hard times the refund checks were even more important. Of course, the state eliminated those refund checks for high income earners, the very same people whose taxes it had raised to keep the state’s budget afloat in the first place.

Rebate programs have become an especially popular way to soothe anger over soaring local taxes. Municipalities have long used property taxes to finance most of local government, including schools. But K-through-12 school spending in America has soared, increasing on a per-student basis about four-fold in inflation-adjusted terms over the past 50 years, according to Manhattan Institute senior fellow Jay Greene. Those increases have forced property taxes sky-high and prompted states to step in with means-tested, state-funded rebate programs. Some 18 states, for instance, now have rebate programs that employ “circuit-breakers” that stop refunds once a household reaches a certain income level.

These programs are an easy sell because of the widespread and misleading notion that property taxes are regressive, that is, that they impact lower income households disproportionately and therefore that the rich should help to offset their cost so that ‘working families’ can stay in their homes. This notion remains pervasive even though economists concluded decades ago that property taxes are, in fact, progressive because they generally represent a tax on a household’s true wealth—something that’s not always accurately reflected in other sorts of taxes.

Despite claims by their proponents, most property tax rebate programs don’t really subsidize working families anyway. Most are heavily oriented toward retired senior citizen homeowners, who are reliable voters, on the spurious notion that those on a fixed income are hurt most by such a ‘regressive’ tax. But income is a poor measure of household wealth. Although the typical over-65 household earns only half the annual income of a household headed by someone aged 35-44, senior households also have an average of three-times the assets of these younger families, and far fewer family members to support. Still, virtually all property tax rebate programs take tax money paid by our most productive workers and use it to relieve the burden of those who are no longer working, but who may have spent a lifetime accumulating wealth.

Even worse, rebate programs designed to ameliorate the burden of higher taxes rarely get at the underlying causes of the problem—government spending. A study a few years ago, for instance, found that municipal governments in New York State had accelerated their spending after the state instituted a rebate program to offset rising local taxes, and the higher spending prompted even faster growth in municipal taxes within a few years. Critics of rebate programs had warned that just such a thing would happen unless the state enacted spending caps. But while refund checks are popular, spending limits are vigorously opposed by public sector unions and local politicians. So, like many rebate programs, New York’s was an example of the worst of both worlds.

That’s a good way to describe the impact of tax rebates on businesses and high income families: the worst of both worlds. Expect these means-tested ways of redistributing income to become ever more common.