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April 1, 2009

What Would Bloggers Do For Recovery?

How to Fight the Recession?

When asked which type of government policy would be most effective at fighting the recession, two were clearly favored: a banking rescue and a fiscal stimulus plan. At the same time, a strong consensus also warned that both policies ran significant risks of causing long-term damage to the economy: moral hazard (in the case of the banking rescue) and higher interest rates and/or inflation in the future (because most believed that much of the economic stimulus would permanently increase the federal deficit).

The attendees also favored other policies, not yet adopted, to continue the fight against the recession: a payroll tax cut (with 75 percent support) and package of reforms aimed at removing barriers to entrepreneurship. Only one policy had zero votes against it: removing barriers to entrepreneurship.

Our survey then sought to identify the importance of “entrepreneurship” and “innovation” relative to seven other things frequently mentioned as good for the economy, namely “Free trade, Labor unions, Big business, Small business, Job creation, Manufacturing, and Economic growth.” Of all these, innovation was considered the most important to the economy’s health. Economic growth, Job creation, and Entrepreneurs rate as “very important” by more than 75 percent of respondents. The things considered least important were labor unions, manufacturing, and big business. Although the survey did not ask about bailouts for auto manufacturers, you can guess the sentiment. And when it comes to evaluating these things in terms of job creation, the results were almost identical. Notably, over half of the respondents think labor unions are unimportant for creating jobs.

Experts and voters increasingly recognize the importance of entrepreneurship, but so far policy-makers in Washington don’t quite get it. Check out the 119,000 word Recovery Act recently passed and signed into law, and you’ll find the word “entrepreneur” never appears once. The Obama Administration and the Fed have recently extended the Fed’s lending facility to purchase loans backed by the Small Business Administration, but easier debt financing for small firms is not the same as creating a growth environment for entrepreneurial firms. Only a small portion of new, small businesses grow into being the innovative forces that drive economic growth, like Microsoft, Intel, Apple, Google, and the wide range of successful bio-tech start-ups.

So what should Washington do to stimulate the entrepreneurial economy? The survey asked a number of questions to find out. Respondents feel that the biggest barriers that hinder would-be job creators are the loss of benefits like health care and pension if they leave their current employers, the risk of losing money, and the high levels of paperwork and bureaucracy. High taxes and legal complexity are two other barriers considered somewhat important. The barriers considered least important – with 50 percent or more responses of “not very important” and “unimportant” – are lawsuit risk and lost leisure time. Phrased differently, government red tape got the most votes (23 of 39) as one of the biggest barriers to startups. Only two other things receive votes from over 50 percent of respondents: the weak economy and the broken health care system.

When we asked, “What change would encourage more people to start a business here in America?” it allowed respondents to vote for positive policies rather than barriers to be removed. Keeping health benefits got votes from 25 of the 39 respondents. A close second is a call for lower and simpler taxes. This response stands out because it is rated higher than the other tax option of targeted tax breaks for entrepreneurs. Less important policies were mentoring, lowering lawsuit risks, and better business training.

Threatening the Sources of Innovation

Understanding innovation should help policy-makers focus on the right sectors in order to generate higher rates of economic growth. The main finding is that all of the potential sources of innovation identified are considered “very important” or “somewhat important” by almost the entire panel. However, small start-up firms stand significantly above the others, even venture-financed firms. Also, all three R&D institutions (government, university, and corporate) received relatively low marks, and government R&D had twice as many negative votes as the next worse source.

The survey also sought to identify which scenarios would be most damaging to innovation. Frankly, we anticipated bland scenarios, in contrast to the alarmism in mainstream media. The actual results were surprising. About 60 percent of respondents consider a continued credit freeze will be likely to cause a major slowdown in technological innovation, and another 30 percent think it will cause a minor slowdown. The other three scenarios – trade war, much higher unemployment, and depressed aggregate demand – were also considered serious threats as well.

The bottom line is that the consensus of economics bloggers is that the risks to growth from the current recession are serious. The good news is that some of the best ideas for growing the American economy are about unleashing entrepreneurs, not spending more tax dollars.

First the Politicians Come After the Rich...

One reason this is happening is because politicians who campaign on a platform of taxing the wealthy are usually beholden to constituencies who won’t let them restrain the growth of government. So everyone, not just the rich, gets sucked into the budgetary vortex. In New York State, for instance, formerly liberal state senator David Paterson found out when he became governor that some of his oldest friends and former neighbors in Harlem had left the state because they “can't pay the taxes” anymore, as Paterson explained it. So naturally Paterson began this year’s budget negotiations adamantly opposed to proposals for a millionaires’ tax, claiming the problem was not that the rich weren’t paying their fair share, but that the state chronically overspends.

But Paterson’s own party in New York is so beholden to big-government groups that they just rolled over him. Earlier this week, New York announced tax and fee increases of $7 billion to support a budget that will grow by an astonishing 8.7 percent next year. Among the increases is a surcharge on those earning more than $200,000 a year—which is considerably less than a millionaires’ tax. Apparently, state policy makers realized that, with the financial sector shrinking rapidly in New York, there aren’t nearly enough millionaires left to finance the spending sprees that their supporters demand. So the once-resistant Paterson and legislative leaders simply redefined ‘millionaire” downward--way downward.

The increasingly common phrase “millionaires’ tax” that is now employed in budget debates is one of those slick political slogans, like “compassionate conservatism,” that sounds so good that hardly anyone could be against it, until you see what it actually means in practice. In 2004 California passed a millionaires’ tax whose rationale sounded so reasonable: Increase the burden moderately on the rich to finance more services for the mentally impaired. Who could object? Yet four years after the tax passed an audit found that only $726 million of the $3.2 billion in new funds had been allocated for mental health services. Most of the rest sat unused in bank accounts because the state’s mental health agencies haven’t figured out how to spend the money. Now California is again raising its income tax rates to help solve its current budget woes, giving the state the highest top tax rate in the country.

It’s difficult to find a millionaires’ tax that has accomplished what it was supposed to. New Jersey’s tax on those making $500,000 (bizarrely dubbed a millionaires’ tax by its proponents) was designed to finance property tax rebates for everyone else in the state. Advocates of the levy even called it a ‘fair share’ tax, implying that somehow the rich weren’t paying theirs. Since the tax passed, the state’s budget has been in a free-fall and the property tax rebate program financed by the half-millionaires’ tax has now been suspended for every household earning less than $75,000 annually. Still, the state is once again raising its half-millionaires’ tax to help finance its current deficit.

More such taxes are certainly on the way. Maryland instituted a millionaires’ tax in 2008 and still continues grappling with among the steepest budget deficits in the nation. The Democrats who control Minnesota’s state legislature have introduced their own version of a millionaires’ tax, but some members of the legislature want the tax to apply to everyone earning $250,000 or more. That’s not a good sign, if the debate on your millionaires’ tax starts out at one-fourth that number.

But as politicians define wealth downward the collateral damage grows. New York’s public sector unions put a lot of resources behind the campaign to raise taxes on the wealthy—advocating tax increases starting at $250,000 per family in annual income. That provoked a rebuke from some union members who noted irately that two public school teachers married to one another can earn that much money in New York these days. Previously, no one in New York seemed to consider that taxing the rich meant taxing public school teachers. Politicians, everyone assumed, were just gunning for those bonus babies at AIG. Now, instead, a lot of people are going to be very surprised.

Mark-to-Market Accounting Needlessly Destroys

One might then ask: But what if banks should be using fair value accounting anyway? Isn’t the “fair value” of an asset its real value? If so, then isn’t the government just making banks do what they should be doing anyway, because doing otherwise is fraud?

To answer this, one must consider the implications of adopting fair value as the universal accounting standard. Fair value is supposed to represent the market value of an asset. In reason, this value should be a readily accessible concrete market price. However, fair value supporters state that fair value cannot simply be reduced to a price on an electronic exchange. One marvels at the audacious hypocrisy of a viewpoint that holds as valid the modeling of fair value when objective facts are unavailable, but derides as “myth” the modeling of values from readily available facts like cash flow.

At any rate, in application, fair value accounting requires banks to value assets in accordance with a secondary fact: What market participants say an asset is worth. This say-so is hypothesized to be accurate by the very fact that markets always discover the correct price. There is an obvious problem with the notion of adopting a number whose accuracy you cannot logically verify. Why is a successful bidder’s valuation right, but not yours? How do you know?

One might then argue that whether the price is right or wrong, investors need to know how much they could get in the event of a forced liquidation of assets. This would not be a reasonable argument, because the basic assumption of a business is that it will continue existing. An accounting philosophy that holds corporate death as a metaphysical premise is unfit for the real world.

Another obvious problem of valuation by means of such second-hand information is that the next buyer/seller pair has to set their bid/ask not in accordance with objective facts about the profitability of the asset, but by how they think the next set of buyers and sellers will set their prices. The entire market becomes a case of everyone trying to game everyone else’s decisions in advance, not trying to identify profitable opportunities in accordance with objective facts. Those who think that market prices will be rational and reflect the nature of the assets under mark-to-market rules do not take seriously enough the Darwinian concept of competition for resources.

Should we then take the market on faith? Can the market be wrong? If so, how?

This brings us to the ultimate conceptual flaw of fair value rules. Recall that banks “print money” via extension of credit under a fractional reserve system or other leveraging authorization. If all banks are marking assets to market, then the first time the market retraces significantly, all banks take write-downs, or a loss in equity, which means that there is a general credit contraction. Since there is a credit contraction, there is less money in existence, and prices must drop. When prices drop, there are more write-downs. The price of an asset is pegged to a negative self-reinforcing cycle. Fair value accounting rules are like a Ponzi scheme in a nightmare anti-universe where every new transaction serves not to prolong the scheme, but to bring it one step closer to its destruction.

The destruction has been extensive. By the time the financial crisis came to a head in the fall, there had been an estimated $500 billion in write-downs. This amounts to over $5 trillion in credit, or one-third of the GDP. The supporters of the mark-to-market rules have yet to offer an explanation of how credit contraction of this magnitude can result in anything but economic disaster.

The very size of this money destruction also brings up constitutional questions. Article I Section 8 of the U.S. Constitution grants Congress the power to “coin Money” and “regulate the Value thereof.” If one-third of the money supply is erased by means of accounting rules, this amounts to a de facto regulation of the money supply and its value by the Executive branch (which has delegated this power to a private entity acting under the aegis of the SEC).

It is disturbing to consider that the economies of the world have been so beholden to a fatally flawed notion for several quarters, but bad news does not get better with age. The accounting rules should be rescinded in their entirety, and government should refrain, and be restrained, from setting accounting rules for the private sector in the future.

April 2, 2009

Charity Begins At Home

The revenue gained would fund universal health care, Mr. Obama proposed in his March budget. He would make the 28 percent cap on the tax saving for contributions take effect in 2011, when he contemplates letting the Bush 2001 tax cuts for upper-income people expire.

The combination of higher rates and a 28 percent cap on the value of deductions for charitable contributions (and mortgage interest) seems certain to diminish giving to charities, religious institutions, anti-poverty groups, universities, health research, and the arts. Cutbacks on charitable giving would be more pronounced among the well-to-do because their tax rates would rise at the same time as their deductions would be limited.

Mr. Obama’s proposal has resulted in unusual agreement between charities and Republicans and Democrats in Congress: all are opposed.

Rabbi Shmuel Herzfeld of Washington D.C.’s National Synagogue told me in a telephone conversation, “The people who are going to be hurt most are the poor people who benefit from charities. There has to be some better way of getting money for health care than from the charities.”

According to Senate Finance Committee Chairman Max Baucus, a Montana Democrat, in a hearing on March 4, “I’m a little – especially concerned about the 28 percent limitation, which has nothing to do with health care… I’m wondering about the viability of that provision.”

Senate Republican Leader Mitch McConnell of Kentucky said, “This plan to disincentivize charitable giving is wrong. And many of us on both sides of the aisle will be working hard to make sure it doesn’t become law. Congress should preserve the full deduction for charitable donations and look for additional ways to encourage charitable giving, not discourage it.”

Under the law now, if a taxpayer in the 35 percent federal tax bracket gives $1,000 to charity, he can subtract the $1,000 from his taxable income, reducing his total tax bill by $350. The after-tax cost of his gift is $650. (Relief from state income taxes might bring the net cost still lower.)

If the value of the deduction is limited to 28 percent, then the after-tax cost of the gift rises to $720. The net result will be diminished giving.

In a March 24 news conference Mr. Obama argued that his change would add fairness to the tax system. He said, “When I give $100, I’d get the same amount of deduction as when some, a bus driver who’s making $50,000 a year, or $40,000, gives that same $100. Right now he gets…to write off 28 percent. I get to write off 39 percent. I don’t think that’s fair.”

No matter that the bus driver would be in the 15 percent tax bracket if married, and the 25 percent bracket if single, the president’s point is that the tax saving for those in the 33, 35 or 39 percent brackets should not exceed the saving for people taxed at 28 percent.

Research has shown that charitable contributions are price sensitive, and the gifts of higher-income taxpayers are more sensitive to price than are the gifts of those lower on the income scale, according to George Washington University economics professor Joseph Cordes. So shrinking tax savings will curtail giving, especially for health, education, and the arts.

In 2007, Americans gave $306 billion to charity, of which 88 percent came from individuals, and the remainder from foundations. That makes us the most generous nation in the world. As a percent of GDP, we give twice as much as the British, and over ten times as much as the French. The tax code plays a major role in this generosity.

Without undiminished deductions, the government would gain billions in tax revenue, but charities and others would lose. That would lessen the ability of charities to help the neediest, not what the president intended.

In fact, on February 5, in an executive order expanding the role of President Bush’s Office of Faith-Based Initiatives, Mr. Obama stated that “few institutions are closer to the people than our faith-based and other neighborhood organizations. It is critical that the Federal Government strengthen the ability of such organizations and other nonprofit providers in our neighborhoods to deliver services effectively.”

But tax policies that channel funding away from charities and towards the government would hurt those very institutions that Mr. Obama said he wanted to help. The full deductibility of charitable deductions enhances our national generosity—let’s leave that provision alone.





The Fallacious Notion of Job Creation

But when considering work, it should first be said that it always exists wherever there are people. Given the basic human need for the necessities of life, absent an ability to draw on the gains or productivity of others, people must necessarily work in order to consume.

In that sense the word “unemployment” is a logical falsehood. Individuals aren’t so much out of work because there are no jobs as they’re unemployed for failing to supply their labor at the going market rate. Better yet, people are frequently unemployed owing to the belief that available jobs aren’t worth their time, or worthy of their skill set.

One certain way to foment a rush into new employment would be for politicians to abolish welfare and other forms of employment insurance. Both are anti-work because they make it easier for the unemployed to stay on the sidelines. Without financial backstops provided by the government, the need for employment would become far more pressing and many new workers would be added to payrolls. The work of politicians with regard to job creation would be done.

And for those who buy into the illogicality that unemployment results from too many people chasing too few jobs, one way for legislators to create more would involve them simply outlawing productivity enhancements such as the ATM or the tractor. If so, millions of new jobs would quickly materialize. Jobs themselves are the easy part because if that which makes us more efficient is abolished, lots of new work is created.

To this day drivers in New Jersey and Oregon are not permitted to pump their own gas. Even though the majority of Americans today drive up to the self-service bay at filling stations nationwide, in these two states “self-serve” at gas stations is against the law. As a result, a lot of their residents are employed at gas stations.

Years ago politicians in France abolished the 40-hour work week as a job creation measure. At first such a measure might have seemed a winner for new work popping up that was previously completed by a lower number of laborers. But despite this legislation, the measured rate of unemployment did not drop.

Indeed, the problem with these public policies is that they fail to acknowledge the role of capital when it comes to job creation. Adam Smith observed in the Wealth of Nations that money “cannot long remain in any country in which the value of the annual produce diminishes.” Simplified, without capital there are no wages. And if rules meant to lower worker productivity are put in place, wage-enhancing capital that is mobile will go elsewhere.

This is important when we consider some of the solutions that are presently being floated in Washington to fix our economy. As has been shown by the Cato Institute's Alan Reynolds in the Wall Street Journal, part of the Obama stimulus plan involves the government spending $214.5 billion in order to create 330,400 government jobs.

Sadly, however, that’s only the seen. The unseen in this equation has to do with the government effectively taking over 300,000 potentially productive workers from the private sector in order to place them in unproductive work created by the government. In this case the private economy loses the human capital that might work in productive ways if not employed by the federal government.

And in order to make existing jobs more secure, there's been discussion about attaching “Buy America” provisions to spending bills. This will principally apply to infrastructure projects, and firms that receive government contracts will be required to buy materials from U.S.-based companies.

At first glance it’s easy to see the major problem here, and it’s one that does not bode well for all-important job creation. Simply put, we can’t be sellers if we’re not buyers. So if we subsidize American companies at the expense of their foreign competitors, we’ll be impoverishing some important customers. And if our trading partners are hurt by our unproductive obsession with job creation, any gains made through “Buy America” will be lost thanks to lower demand for our goods overseas.

Worse, and this is where capital comes into the equation, if government largess essentially supports stateside work that could be done overseas, the investment necessary to pay workers in the U.S. will dry up. Much as government jobs frequently misuse what is limited human capital, so do employment subsidies place workers in the wrong kind of employment that repels capital.

Where jobs and wages are concerned, the only sure path to wage gains involves a process whereby industrious individuals constantly enhance their work output in ways that attract capital. More to the point, capital seeks out industrious workers, and when government programs subsidize work that could be done better by others, this eventually shows up in a falling prevailing wage.

The paradoxical truth is that the best way for companies to create new jobs is for them to shed the ones that over time prove superfluous. It can’t be stressed enough that jobs themselves are not output. Instead, it is when businesses are operating most efficiently that investors supply the very capital that funds the creation of new jobs to replace those made obsolete. Absent this essential process there will still be jobs for those who desire work, but the work will surely pay less.

April 3, 2009

MTM Relaxation Makes Market Sense

The so-called FAS 157 rule, which the public took little notice of, was imposed on the banks in 2007. It forced them to take what are long-term assets and mark them down as if they were short-term ones, based on current market conditions.

It might be coincidental, but this was about the same time that banks and other financial firms began suffering problems that have since left the world economy gasping for air.

In a time when markets around the world have been battered by the fiscal crisis, mark-to-market has made things worse. It has severely damaged banks' balance sheets, forcing them to shrink capital and rein in lending.

For capital adequacy purposes, bank assets have had to be marked down to market value even if loans are being paid on time.

This is an inversion of long-standing banking practice. As economists Brian Wesbury and Bob Stein of First Advisors recently wrote, "The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans."

Bingo. From the late 1930s to 2007, the U.S. banking system was reasonably stable, with a few exceptions. One big reason for this is the absence of mark-to-market.

The change of heart from FASB on mark-to-market was largely due to Congress. We're happy to report that bipartisan pressure undid the bad rule — a rare thing these days.

Mark-to-market rules, while well intended, have historically been a problem. During the Depression, Nobel-winning economist Milton Friedman noted, mark-to-market rules caused many banks to fail. That's why FDR repealed them in 1938. Those rules had remained dead until two years ago, when they were reimposed as part of a frenzy of ill-considered financial reregulation.

While we applaud Congress, Democrats and Republicans alike, for undoing this, there's still more to be done.

One important move would be to loosen the Sarbanes-Oxley rules that have burdened so many businesses with extraordinarily costly compliance requirements in the interest of "transparency."

In fact, SarbOx has hampered U.S. companies' competitiveness and sent companies seeking to raise capital overseas to float their shares on stock exchanges where the rules are far less strict.

In 2007, when FAS 157 was first passed, one economist estimated it would shrink bank capital by at least $100 billion. Add to that the estimated $35 billion cost of SarbOx, and you have a pretty big regulatory hit to companies' balance sheets in just the last two years — and an even bigger hit to the economy, since corporate and bank capital is leveraged many times when it comes to investments.

We're glad to see some sensible deregulation when the economy needs it most. We hope this is just a start.

Self-Protectionism: The Politics of Trade

At some level everyone now understands that money isn’t the best measure of wealth or well-being. But the public conversation about trade proceeds as if it is. From a political standpoint, exports are good (they bring money back home); imports are bad (money goes out the door); and more exports than imports is a terrible thing, presumptively showing that someone is behaving unfairly to produce that awful result. When politicians talk about “unfair” trade, they strictly mean trade that increases our imports or decreases our exports. It’s unfair because someone else winds up with more of our money and we just wind up with more things.

Trade politics stands ordinary sense on its head. As with the grocery store, things are what we want – they’re what we work to have. In the same sense, nations export to earn money to pay for imports (something less obvious in a country accustomed to borrowing vast sums from other people’s savings). But politicians’ desire for more exports is what moves them. The threat of reciprocal trade restrictions haunts discussions of the steps nations should take to combat the current economic crisis, with a 1930s style global trade contraction (trade fell by two-thirds in just five years) as the nightmare scenario no one wants to repeat. World leaders’ desires to keep markets open for their own export industries prompts somber warnings of the risks protectionism entails, most often in joint pronouncements like the one issued after last November’s G-20 meeting and again this week at the G-20 summit in London. But few of the leaders mean quite what they say in group settings like this, and fewer yet will take the hard steps needed to back up their rhetoric. The same leaders who warn that protectionist measures could risk sparking a global tit-for-tat of trade restrictions also promote or tolerate a wide variety of protectionist measures at home because they truly don’t appreciate the core case for open trade and truly do appreciate its political consequences.

Trade is the ultimate form of competition. Centuries of experiments have driven home the lesson that competition brings benefits no other system has been able to match. That message is scant comfort, however, to anyone forced to make difficult, sometimes personally devastating, changes to adapt to competition, and political forces almost everywhere tilt to protecting against those changes, especially when competition has a foreign face. In addition to tariffs – visible trade barriers still used by many developing nations to protect favored domestic industries – both developed and developing nations impose special licensing requirements on imported goods, tailor technical standards to disadvantage market-leading foreign products, and use competition law regimes to discourage competition by strong foreign firms. They encourage exports through rebate programs, impose health and environmental standards that lack scientific support, limit protections for the intellectual property of innovative firms, and exploit other regulatory and financial tools to favor domestic producers over more efficient foreign competitors.

Far from evaporating in the face of financial distress, the protectionist instinct shows every indication of growing stronger. The World Bank found that, in the first few months following agreement among G-20 leaders to eschew protectionist measures so they could combat the global economic crisis together, at least 17 of the 20 nations imposed new protections for domestic industry and agriculture. Argentina imposed new licensing requirements on auto parts, toys, and leather goods. Indonesia limited imports of clothes, shoes, electronics and food to just a few ports. The United States adopted a “Buy American” provision, though less sweeping than originally proposed, as part of its most recent stimulus plan. Russia placed new tariffs on auto imports. China banned Irish pork imports and limited other food imports. India banned toys from China. Both India and China increased export subsidies. France made it harder for foreign firms to take over French ones. And nearly every nation has given subsidies to industries to stave off the effects of the downturn, with finance and auto industries prominent recipients of new state aid.

As governments invest vast amounts of public resources in propping up weak businesses and trying to end the downward spiral of deleveraging, credit contraction, job losses, and reduced consumption, leaders face both popular anger at perceived misuse of taxpayer funds and intense pressure from domestic constituencies – not least, workers who see their jobs at risk. Both groups want money spent where it will be most effective, and, even more, where it will have the greatest prospect of coming back to them. Neither has much sympathy for spending that advantages foreigners. The public isn’t clamoring to cut off trade, much less to spark a trade war, but both the broader public and intensely interested groups strongly support measures that look to tilt the public money their way. The Buy American provision and President Sarkozy’s call for French auto makers receiving government funds to safeguard jobs in France are examples. With governments increasingly intertwined with once private firms, new requirements at odds with open trade – even if not boldly violating international legal obligations – inevitably will proliferate.

Judging by recent evidence, world leaders will boldly decry trade restrictions in general and even stand up to a popular domestic initiative on occasion, but few will be eager to give up protections that substantially advance their own political interests. The hard work for those who care about national success is to make political leaders understand why trade should matter so much to ordinary people, to workers whose jobs depend on letting markets work, to those who benefit directly from open trade and to those who benefit in a thousand less visible ways from the increased choices, improved products, and reduced costs that competition spurs. More than 230 years after Adam Smith, this remains a challenge far more serious than getting a good press statement at a summit. As the G-20 heads of state leave London, it takes real audacity to hope they will make good on what they’ve promised – again.

April 4, 2009

Atlas Shrugged Sales Overturn Policy Calculations

Looking at Amazon bestseller lists in narrower categories, Atlas has been steadily in the top ten in Literature & Fiction (briefly hitting #1 during the past week) and has been switching between the #1 and #2 spot in Classics, routinely beating out lesser works like The Federalist Papers, Nineteen Eighty-Four, and To Kill a Mockingbird. Heck, the Cliffs Notes to Atlas Shrugged rank in the top 20, outselling The Grapes of Wrath.

This reflects a general cultural "buzz" about Ayn Rand and Atlas Shrugged. As someone who has been an Objectivist—an advocate of Ayn Rand's philosophy—for more than 20 years, I've never seen anything like it. Commentators on the right have recently been debating whether we should respond to Obama's tax increases by "going Galt"—a reference both to the mysterious hero of the novel and to its main plotline. Columnists have begun referring to the novel; Rush Limbaugh and Glenn Beck have recommended it; and the phenomenon has even trickled down to the pop culture level, with Ayn Rand becoming the subject (or target) of sketches by late-night hosts Jimmy Fallon and Stephen Colbert. Just today, I was sitting at lunch and heard a man at the next table say that he was planning to read Atlas Shrugged "because it's back on the bestseller list after 60 years."

Has it ever happened before that a book hits the bestseller list after it is first published—and then rises back to the bestseller list a half century later, purely through word of mouth?

What no one seems to have realized yet is that all of this upsets some of the basic calculations being made at the top level of American politics.

In particular, it ought to give the folks in the Obama administration a sense that the ground underneath them is not as firm as they thought. President Obama and the Democratic leaders in Congress clearly believe that the financial crisis discredited capitalism in the eyes of the public, leaving the American people open to a lurch toward some version of European socialism—because that's worked so well for the French. Obama has dismissed free-market economics as a "worn-out dogma" and as an "old, discredited Republican philosophy," while Barney Frank has openly exulted that the 2008 election gave the Democrats a mandate for vastly expanded government control of the economy.

But the sales figures for Ayn Rand's magnum opus tell us an opposite story. In the midst of this crisis, hundreds of thousands of people are turning to a book that glorifies capitalism.

Meanwhile, where are all of the socialist books on the bestseller lists?

Thus, while Obama has launched the de facto nationalization of two whole industries—finance and automobiles—his administration remains oblivious to the depth and strength of public resistance to socialism in America.

They may be about to get a reminder. A new website, go-galt.org—which has the delightfully non-slick look of a true grassroots undertaking—urges pro-capitalists to send copies of Atlas Shrugged to the White House and to their congressmen. The idea—and I think it is a brilliant tactic—is that stacks of hundreds or thousands of thick pro-capitalist novels piling up in the offices of our elected representatives would really get their attention, demoralizing the advocates of big government and emboldening defenders of the free market.

And the left should be demoralized. Six months ago, they had grounds to believe that the financial crisis, given the appropriate "spin," could be exploited to give capitalism a bad name. It was a dishonest attempt, given the role of the Federal Reserve, the US Treasury, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and a whole constellation of federal alphabet agencies in causing the crisis and making it worse. The sales of Ayn Rand's novels are by far the strongest indication that the attempt to pin the crisis on the free market isn't working.

Instead, many people are convinced that the current crisis is a real-life parallel to the events in Atlas Shrugged, in which the power-hungry villains are always blaming businessmen for the disastrous results of the politicians' own interventions into the economy. The public reaction is similar to that of a businessman who recently sent me a note about Tim Geithner's grab for wider powers to seize businesses: "These guys are sounding like the villains from an Ayn Rand novel." Similarly, a blogger recently recounted his conversation with a fellow lawyer who is shutting down his successful independent firm because of the new taxes planned for him by the Obama administration. Referring to the signature catchphrase of Atlas Shrugged, he concluded: "Who is John Galt? Why, it looks as if we all are."

So rather than rejecting capitalism, a significant minority of the American people has sought out a better defense of capitalism, and everyone from Rush Limbaugh on down has told them where they can find it: Atlas Shrugged.

Boy, are they going to find it. As I wrote on the novel's 50th anniversary, Ayn Rand "saw the dramatic potential in asking a single question: what would happen if the innovative entrepreneurs and businessmen—after decades of being vilified and regulated—started to disappear? The disappearance of the world's productive geniuses provides the novel's central mystery, both factually and intellectually…. The philosophical question raised by this plot is: what is the role of the entrepreneurs and innovators in a society? What motivates them, what are the conditions they need in order to work, and what happens to the world when they disappear?"

What is really radical about the novel is Ayn Rand's answer to that question—a thorough philosophical defense of individualism, including a defense of the virtue of selfishness. As one of her characters puts it: "For centuries, the battle of morality was fought between those who claimed that your life belongs to God and those who claimed that it belongs to your neighbors—between those who preached that the good is self-sacrifice for the sake of ghosts in heaven and those who preached that the good is self-sacrifice for the sake of incompetents here on earth. And no one came to say that your life belongs to you and the good is to live it." That's precisely what Ayn Rand came to say—and to dramatize in the pages of her novel.

But note that Ayn Rand didn't just oppose the Marxists; she also rejected the idea that your life belongs to God. She was an atheist who named her philosophy "Objectivism" to highlight her defense of reason and her rejection of all forms of subjectivism and mysticism.

It is this secular moral message that is likely to upset a few political calculations on the right.

Fifty years ago, William F. Buckley's National Review published an infamously savage review of Atlas Shrugged in an effort to eject Ayn Rand and the Objectivists from the right. Earlier this month, National Review Online made a repeat attempt, publishing a "symposium" on Atlas Shrugged whose upshot, as expressed by religious right spokesman Joseph Bottum, was that "William F. Buckley, Jr., and National Review did the world a favor, all those years ago, by throwing the…Randians overboard. Do we really have to let them climb back on the ship now?"

The presumptuous assumption in this analogy is that the religious right is steaming along under its own power, and we Objectivists are trying to hitch our pathetic little dinghies to their ocean liner. But what is actually going on is the opposite. The "fusionism" championed by Buckley was an attempt to take the real power behind the right—a patriotic love of liberty and of America's distinctive political institutions and attitude toward life—and to hitch onto that powerful ocean liner the dilapidated old galleons of religious traditionalism.

But when the time comes to defend American capitalism, does the rank and file of the right turn to the ideas of Pat Robertson and Jerry Falwell? Are they snapping up copies of 50-year-old books by William F. Buckley? No, because Buckley and the religious right never produced anything like Ayn Rand's defense of American individualism. So the rank and file is realizing that she is the thinker they need to help them cope with today's political crisis.

If enough of these new readers take Ayn Rand's underlying philosophy seriously, that could deal a permanent blow to the religious right's would-be monopoly on the moral foundations of Americanism.

And that's the other shoe waiting to drop. If the sales of Atlas Shrugged indicate a pre-existing popular support for capitalism, what will happen when hundred of thousands of new readers—or, at this rate, millions—make their way through Atlas Shrugged? How many will be influenced by Ayn Rand's philosophy? How many will become active advocates of that philosophy? How many will be won over to the capitalist cause, or be re-confirmed and emboldened in their advocacy of free minds and free markets?

The Ayn Rand Factor in American politics is only beginning.

April 6, 2009

China Engages In Dollar Deception

It may surprise Americans that, up to a point, his analysis is correct. The dollarized world economy developed huge instabilities -- vast trade imbalances (American deficits, Asian surpluses) and massive, offsetting international money flows. But Zhou's omissions are equally revealing. To wit: China is heavily implicated in the dollar system's failings. By keeping its currency artificially depressed -- as an aid to exports -- China abetted the imbalances it now criticizes.

The Chinese denounce American profligacy after promoting it and profiting from it. Low prices for imported goods (shoes, computers, TVs) encouraged overconsumption. From 2000 to 2008, the U.S. trade deficit with China ballooned from $84 billion to $266 billion. China's foreign exchange reserves are now an astounding $2 trillion.

It's not just that exchange rates were (and are) misaligned. American economists have argued that a flood tide of Chinese money, earned from those bulging trade surpluses, depressed interest rates on U.S. Treasury securities and sent investors searching for higher yields elsewhere. That expanded the demand for riskier securities, including subprime mortgages, and pumped up the housing bubble. So China's policies contributed to the original financial crisis, though they were not the only cause.

For decades, dollars have lubricated global prosperity. They're used to price major commodities -- oil, wheat, copper -- and to conduct most trade. Countries such as Thailand and South Korea use dollars for more than 80 percent of their exports. The dollar also serves as the major currency for cross-border investments by governments and the private sector. Indeed, governments hold almost two-thirds of their $6.7 trillion in foreign exchange reserves in dollars.

But overreliance on the dollar can also backfire, as it now has. It is not just that countries have suffered declines in exports to a slumping U.S. economy. They've also lost dollar loans needed to finance trade with third countries. "When the crisis hit, U.S. banks cut back on dollar credit lines to foreign borrowers," says David Hu of the International Investment Group, an investment fund specializing in trade finance. The extra loans endorsed at last week's summit aim to offset these losses.

Given the dollar's drawbacks, why not switch to something else, as Zhou suggests? The trouble, as even he concedes, is that there's no obvious replacement. The attraction of an international currency depends on its presumed stability, what it will buy and how easy it is to invest. The euro (27 percent of government reserves) and the yen (3 percent) don't yet rival the dollar. As for China, it hasn't made its own currency (the renminbi, or RMB) automatically convertible for Chinese investments.

We're stuck with the dollar standard for a while. To work, it requires that countries with huge trade surpluses reduce the export-led growth that fed the system's instabilities. The Chinese increasingly recognize this. "They're very aware of the need to promote consumer spending," says economist Pieter Bottelier of Johns Hopkins University. In November, China announced a 4 trillion RMB ($586 billion) "stimulus." In addition, says Bottelier, the government is improving health and pension benefits to dampen households' need for high savings.

But China also has a default position: promoting exports. It has increased export rebates; engaged in currency "swaps" with trading partners (the latest: $10 billion with Argentina) to stimulate demand for Chinese goods; and stopped the RMB's slow appreciation. China seems comfortable advancing its economy at other countries' expense. Zhou's pronouncement provides a political rationale for predatory behavior: If we're innocent victims of U.S. economic mismanagement, then we're entitled to do whatever is necessary to insulate ourselves from the fallout. Down this path lies growing mistrust.

The larger point is that the world economy is suspended between the lofty rhetoric of last week's summit and the gritty realities of national politics. Protectionism is rising. A World Bank study found that 17 countries in the G-20 have recently adopted discriminatory policies. Though still modest, they "open the door for a lot of other opportunistic measures," says Gary Hufbauer of the Peterson Institute. And the deeper the recession, the greater the danger.


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Carbon Cap and Trade: Banking On Invisible Gas

The solution that is simplest to administer, hardest to game, easiest to adjust, and smoothest to introduce is a broad-based carbon tax. So, of course, that solution is completely off the table. Why should Congress give up the opportunity to entangle itself in every business in the land, reward friends, punish enemies, and empower alternative energy charlatans all while collecting campaign “contributions” that allow “advocates” to gain “access” to the allocators of this new license to stay in business?

So brace yourself for Cap and Trade, a bonanza for both Washington and Wall Street - as if anyone can tell the difference any more.

Congress plans to sell permission slips to businesses whose carbon footprint has attracted its attention. Some of these permission slips might be auctioned off and others might be given away to favored industries. Who gets what and who needs what will be based on “baseline” estimates of past carbon emissions, an interesting accounting challenge given that most tail pipes and smokestacks don’t come equipped with carbon dioxide meters. Sorting out the starting parameters using the scientific process of Congressional log rolling is just the beginning. Wait until the new federal carbon police begin tracking demon molecules upstream to assess the total emissions impact of production at whatever random point in the supply chain Congress decides to erect a toll booth.

If you think it’s challenging figuring out the FAS 157 fair market value for your illiquid assets, try calculating the total carbon emissions of your business. Or arguing with a carbon auditor who disagrees. Or putting a carbon footprint label on your product, which will surely be mandated as the green economy grows. “6.9 pounds of carbon dioxide was released in the manufacturing of these cornflakes.” Not counting the heavy breathing of all the audit committee members trying to stay out of Sarbanes Oxley prison.

At least our unemployment problem will disappear when armies of carbon accountants and certified greenhouse gas auditors fan out to monitor the invisible gasses that leak from the growing number of industries captured by Congress once it starts lapping up the revenue flow from this unbounded intrusion. Got Milk? Not without a cow fart permit, you don’t.

But wait, there’s more! Congress is going to reward favored companies and institutions that promise to soak up invisible gasses, or not emit them to begin with. Carbon Offsets, they’re called, yet another financial instrument that can be introduced into the mix. Al Gore buys them to assuage his guilt for burning up all that electricity he needs to warm his heated swimming pool.

How long do you think it take for the Wizards of Wall Street to cook up derivative contracts that slice, dice, and securitize these permission slips into incomprehensible combinations designed to generate fees that can be used to reignite the bonus engine? How much would you pay to short the middle tranche of the Midwest Power Producers Promise to emit less invisible gas November permissions contracts? Only your broker knows for sure.

This is much more fun than simply taxing a barrel of oil or a ton of coal, huh?

At least we’ll be in familiar territory. Remember when Congress “solved” the homeownership crisis by creating giant fishy mortgage cesspools at Fannie Mae and Freddie Mac? And then those long-term thinkers on Wall Street rushed in to build casinos on top of the mess so hedge fund speculators could bet on when the whole thing would collapse around their ears? Well yeeha, we’re going to do it again. Only this time we’re not just saving the less credit worthy from the indignity of renting. We’re saving the planet from thermal annihilation!

April 7, 2009

Larry Summers Already Took a Pay Cut

Summers is clearly one of these people. D.E. Shaw paid him $5.2 million last year to meet with important clients. In addition, he lent the firm his expertise as a crack economist, and it, in turn, provided him with an idea of how a wildly successful hedge fund works. At the same time, Summers made around $2.7 million in speaking fees from other organizations and companies. He was, to use a technical (micro) economic term, on easy street.

Yet he chucked it all for an office on the street of broken dreams, Pennsylvania Avenue. So did national security adviser James L. Jones, who was earning about $2 million a year. David Axelrod, who had been running public affairs firms before going into the White House, kissed away at least the $1.5 million he earned last year and sold his stake in his companies. Other members of the Obama team similarly unburdened themselves of excess wealth, spare time and privacy, proving that money is not everything.

This is the dirty little secret of Washington. I don't mean to characterize these or other administration aides as the functional equivalent of Trappist monks, since they enjoy the attention, the power and -- above all -- the action. They are doing something substantive, important -- sometimes making life-or-death decisions and gaining, if they are lucky, a mention in a history book. It is not a life without any compensation.

There are few among us who would take a multimillion-dollar pay cut. Yes, you could say, someone like Summers could make it back, but that's not really -- or always -- the case. Take Tom Daschle. Here was a man who was not trying to build a career. He is 61, and his career is largely behind him. Yet he was willing to give up a lucrative lobbying practice to go back into government as secretary of health and human services. It turns out he cared more about reforming health care than he did about building a fortune. He didn't make it into the Cabinet, foiled by a humiliating spot of trouble about taxes that he could have avoided just by staying where he was and raking in the money.

In Ronald Reagan's famous formulation, "government is not the solution to our problems; government is the problem." This statement, at the very heart of the so-called Reagan Revolution, denigrated government and the people in it. Reagan's statement withdrew John F. Kennedy's invitation to the intellectually gifted to come to Washington and see what they could do for their country. Reagan sent a different message. Government service is for the lame, the cautious. If you really want to do something for your country, shun Washington and make money. It was morning again in America -- whatever that meant.

It is to Barack Obama's immense credit that he has reversed Reagan's reversal. Washington crackles with people on a mission. Brains are once again in vogue, if only because Obama has them in abundance. Not for him the aw-shucks affectation of the previous eight years, when instinct was extolled and ideology trumped analysis. We are in a mess, and one of the reasons is that people who might have noticed or done something about it had been told to stay out of government.

In our scandal-soaked culture, it is de rigueur to denigrate public officials and to search for the inevitable conflict of interest. But here are people, such as Summers, who have put aside wealth and lavish perks for government service. They have their reasons, sure, but whatever they are, we -- not they -- are the richer for it.

Why Won't Geithner Take TARP Repayments?

By refusing repayment, the government can keep the leverage it bought with the bailouts. Banks that still "owe" would not be in position to reject the administration as a "partner."

This reminds us of mobsters making a small "investment" in a family-owned shop, which is not always wanted by the owners, and then using it to justify taking over the business.

Joseph DePaolo, president and CEO of Signature Bank in New York, one of the four banks making TARP repayments last week, said his company wanted to return $120 million it received because, in part, it wasn't comfortable with legislation passed that would limit compensation for salespeople. Those limits, he explained, would make it hard to recruit top professionals.

And then there's the fact that the bank didn't actually need the money. But, as we have learned, need is not relevant in the era of the bailout.

Andrew Napolitano reported last week on Fox News that he had spoken to the head of a $250-billion bank the night before who said Washington forced him to take TARP funds last September.

Napolitano said this bank "has no subprime loans, it has no bad debts, wasn't involved in credit default swaps. It didn't need any money. It didn't ask for the money and didn't want it. . . . officials from both the Federal Deposit Insurance Corporation and the Treasury said if you don't take this money, we will conduct a multi-year public audit of you."

The Fox News analyst said the bank's "board was forced to issue a class of stock just for the federal government. The federal government owns 2% of this huge bank."

That was done under the Bush administration. Enter the Obama White House. Last month, Napolitano said, Treasury told the bank "we own 2%, we're going to tell you how to run the place."

"As a result of that minority ownership, they now want to control salaries. They want to see his books, and they want to tell him who he can do business with," Napolitano reported.

Before his trip to Europe, President Obama, according to Politico, told a group of financial institution CEOs who were unhappy with the federal war on executive salaries and bonuses, "My administration is the only thing between you and the pitchforks." At the time, that sounded like nothing more than exaggeration.

An incident at the same meeting in which Geithner declined to take a fake $25 billion TARP repayment check from JPMorgan Chase CEO Jamie Dimon also seemed to be meaningful.

Later, says Politico, "Dimon also insisted that he'd like to give the government's TARP money back as soon as practical . . . But Obama didn't like that idea — arguing that the system still needs government capital."

Looking back, these are small signs that reveal the administration's desire to seize command of the nation's financial system. The bigger, unmistakable sign is the reluctance — or is it outright refusal? — to take $340 million from four banks trying to be responsible and operate on their own.

This shouldn't be happening in this country. The private sector and the state are not to be mixed. The American financial system is best directed by markets, not politics. Prosperity and liberty suffer when the latter excludes the former.

New Media vs. Gnostic Bureaucracies

The implications of the inundation of new media for political communication are huge. Up until recently, one of the doctrines of political communication and indeed most public relations was that “broadcast follows print.”

Political and corporate flacks (I was one of them) used to craft and pursue strategies like this: First, “message development,” then the “predicate” story or opinion column planted in a leading newspaper. Next, popular resonance of the message through radio and television – optimized by a strenuous effort to maintain “message control.” Finally, success (or sometimes disappointment) in the public policy contest.

Soon broadcast no longer will be able to follow print. And the broadcasting industry is not much healthier than the newspaper business. At the end of the 18th century, Edmund Burke, recalling the demise of France’s old regime and its “three estates,” is said to have coined the term “Fourth Estate” for the rising, independent power of the press. Today this Fourth Estate is being liquidated, not by Jacobins but by geeks.

Not too many years ago when I was a press secretary for a Member of Congress, on the evening of the State of the Union Address, my mission was to get coverage for my boss on network TV. In the lobby outside the House Chamber, I had to deal with reporters and producers and technicians who had sophisticated equipment connecting us with their networks, which employed thousands of people and billions of dollars in capital investment.

There was a surreal quality to President Obama’s first speech, just a few weeks ago, before a joint session of the United States Congress. While the President spoke from the podium, a number of Members of Congress employed their handheld devices to send Twitter messages to their constituents or anyone else out there in Tweetville who might have been tuning in. The commentary, whether irreverent or too reverent, was childish, undignified – to an old fuddy-duddy like me, absolutely appalling.

But as Ronald Reagan wrote in 1988 in his profoundly realistic National Security Strategy of the United States, we must “deal with the world as it is, not as we might wish it to be.”

Both the late Marshall McLuhan and his son and intellectual collaborator, Eric, saw James Joyce’s weird experimental book, Finnegans Wake, as insightful, visionary, and even prophetic as regards electronic communications media. The shadowy protagonist of the book is someone called “H.C.E.” – signifying, among other things, “Here Comes Everybody.”

The McLuhans say that electronic media dealt a devastating blow to the alphabetic, linear way of thinking and communicating that had dominated Western society since Gutenberg’s invention of moveable type and printing became a mass medium. For five centuries, the Gutenberg technology was turbo-charged by Descartes’ extreme rationalist ideology of being and knowing – what the 20th-century philosopher Frederick Wilhelmsen, McLuhan’s great friend, called “modern man’s myth of self-identity.”

Today, aural and even tactile ways of perception are regaining dominance, as had been the case before the visual age of print. Radio, as McLuhan said, is a “hot” medium. If you doubt this, consider how during the past two decades talk radio – mostly of the flavor of right-wing populism as distinct from intellectual conservatism -- did its part to turn the calm, linear, rationalist politics of the United States of America envisioned by Jefferson and Madison into a hot cacophony of electronic pow-wows for distinct but allied tribes.

Newly ascendant left-wing Democrats are flirting with legislation to curb the free expression of right-wing radio. But broadcast radio’s days may be numbered anyway. Now all the hierarchies for the distribution of information are breaking down.

A year ago I attended a program at the National Press Club in Washington, celebrating the centennials of both the Press Club and the world’s first School of Journalism, that of the University of Missouri. The luncheon speaker was a very intelligent and accomplished man – formerly editor of the Wall Street Journal Online and director of Yahoo! News.

I anticipated his speech as a kind of revelation of a Holy Grail, tearing away the veil to signify how the online news media were going to operate profitably. But his speech failed to indicate anything – not one single thing -- about a profitable or even coherent future for online news media. I had paid a princely sum of $28 to hear the speech and I wanted my money back. I do not mean in any way to belittle or criticize this man but instead to indicate the magnitude of the maelstrom all of us are in.

Clay Shirky of New York University, one of the keenest observers of the revolution in media, has a new book, called, wouldn’t you know, Here Comes Everybody. Last month on his blog, www.shirky.com, he noted:

When someone demands to know how we are going to replace newspapers, they are really demanding to be told that we are not living through a revolution. They are demanding to be told that old systems won’t break before new systems are in place. They are demanding to be told that ancient social bargains aren’t in peril, that core institutions will be spared, that new methods of spreading information will improve previous practice rather than upending it. They are demanding to be lied to.

Eric McLuhan’s latest observations are similar to Shirky’s but with the hopeful note that the media revolution has elements of a renaissance – the sort of thing that recurs in Western Civilization, like one of those over-the-top Mississippi floods, every 400 or 500 years. In a speech in Rome last month, he described several characteristics of renaissances, all in operation today:

• A renaissance is always invisible to those living through it.

• A renaissance is always a side-effect of something else, some new medium that reshapes perception: in our case, we have the spectrum of electric technologies from the motor to the MP3, from the telegraph to the satellite, the radio to the Internet. The Grand Renaissance married the printing press and the alphabet.

• A renaissance is always accompanied by a revolution in sensibility.

• A renaissance is always accompanied by a major war. In our case, we have had World Wars One and Two and the Cold War (among other wars), and now we are embroiled in the first of the Terrorist Wars. At the speed of light, the front is gone, the battleground is the outward globe, and that (much larger) paysage intérieur.”

We are at one of those crossroads in human civilization where it is scarcely possible to see any road at all. Of all people, the über-optimist and risk-taker Rupert Murdoch, should know that corporate executives come and go. About a month ago, Murdoch’s deputy at his News Corporation resigned. The world will little note nor long remember who Murdoch’s Second Banana was or what he did, but it should take note of what Murdoch said.

Instead of treating the event as a routine transition, Murdoch spoke in almost apocalyptic terms. He said, “We are in the midst of a phase of history in which nations will be redefined and their futures fundamentally altered. Many people will be under extreme pressure and many companies mortally wounded.”

That sounds a lot more like Aleksandr Solzhenitsyn than the Rupert Murdoch we all have known and loved – or, as the case may be, feared.

I am betting against the pessimists and for a renaissance. Rebirths, like births, always involve bleeding and pain, but afterwards the joy of new life.

The World Wide Web provides the world’s greatest library and the platform for the world’s most complex and far-reaching, yet potentially intimate, communications. These are resources for our renaissance. The new media can help free men and women consign bureaucratic statism to the ash-heap of history.

Sixty-five years ago Marshall McLuhan in his doctoral dissertation on the classical Trivium of grammar, dialectics, and rhetoric, deplored the Cartesian imbalance of overemphasizing dialectics to the neglect of “grammar.” McLuhan explained, “The grammarian is concerned with connections; the dialectician with divisions.” And he said, “Grammarians distrusted abstraction; dialecticians distrusted concrete modes of language.”

In terms of politics, McLuhan said Cicero – a proponent of the natural law -- was perhaps the greatest grammarian. Machiavelli was a “consciously anti-Ciceronian” dialectician. In the intelligence profession, the grammar of the Trivium is known as pattern recognition.

News media enterprises today are subject to market forces and are facing consequences – the destruction of many recently prosperous enterprises and types of enterprises.

But the modern nation-states – and the supranational organizations like the United Nations -- are stiflingly bureaucratic. They are less subject to market forces than are businesses, and in reaction to the current economic panic – a crisis of abundance, not of scarcity – the big governmental and intergovernmental bureaucracies are opportunistically seizing more power.

The bureaucracies have a shifting parasite-host relationship with the social engineer, the “international development professional,” and the other types of soulless technocrat whom the late Samuel Huntington called “Davos Man” and Frederick Wilhelmsen called “the egomaniac, lusting gnostically to dominate all existence.” Just contemplate what has taken place in Washington the past two months, and at the Group of 20 Summit in London last week, where Chinese totalitarians, Russian authoritarians, cosmopolitan eugenicists, and Western “democratic” socialists strained to stitch together a Frankenstein monster from the jumble of formaldehyde jars holding the maimed remains of capitalism.

In 1945, C.S. Lewis wrote a novel envisioning the death-over-life power of today’s gnostic technocratic bureaucracy; he called it That Hideous Strength. It is the fictional companion to Lewis’s famous treatise, The Abolition of Man.

Marshall McLuhan’s very first published article appeared when he was a 25-year-old graduate student. The article was about a writer whom young McLuhan admired, G.K. Chesterton. The year was 1936, a moment when Big Government statism was in vogue from Washington to Berlin to Rome to London to Moscow. McLuhan praised Chesterton’s “inspiriting opposition to the spread of officialdom and bureaucracy.” He called Chesterton “a revolutionary, not because he finds everything equally detestable, but because he fears lest certain infinitely valuable things, such as the family and personal liberty, should vanish.”

The new media are on a collision course with Big Government. They are not immune from gnosticism, but they are inherently anti-bureaucratic. They will serve us and serve our freedom if we understand them, and if we understand ourselves. We can and should make the new media our instruments, our allies, in recovering and strengthening infinitely valuable things such as the family and personal liberty.

The Abundant Good Of a Dollar Alternative

In the aftermath of World War II, arguably the most powerful reason for worldwide economic recovery had to do with the world being on a dollar standard, while the dollar’s value was tied to gold at 1/35th of an ounce. With currencies stable, investment was far more certain and country economies from Europe to the Orient boomed.

By the late 1960s, U.S. dollar policy changed for the worse. And with the Nixon administration greatly influenced by monetarists who believed the dollar should have no definition alongside protectionists who felt a weak dollar would drive exports, President Nixon decided to close the gold window. Lacking a golden anchor, the dollar declined, and its decline led to worldwide inflation due to the fact that central banks no longer had a credible currency to peg theirs against.

If there was a positive to all this, it had to do with the Soviet Union. While communism never worked in economic terms, the Soviet economy was able to muddle along thanks to the Ruble’s implicit peg to the formerly stable dollar. Absent the peg, the Five-Year Plans set by the Soviets proved even more unworkable, so it should be said that Nixon’s mistaken decision to leave gold at the very least hastened the Soviet Union’s decline, albeit while boosting the rise of the formerly toothless OPEC countries.

The lost, inflationary decade of the 1970s was thankfully righted with Ronald Reagan’s election in 1980. A strong dollar advocate, the dollar rose as his election became more certain, and continued to strengthen once he was in office.

If there was a problem, it had to do with Reagan’s inability to get the nation back to the stability formerly offered by the gold standard. So with the dollar’s rise continuing unchecked, and with manufacturers and farmers making a great deal of noise about the overly strong dollar, the heads of the G5 countries met in New York in September of 1985 for what is now called the Plaza Accord. The latter succeeded in driving up non-dollar currencies versus the dollar.

Japan in particular complied with the above thanks to protectionist entities stateside who felt a much stronger yen was necessary in order to make U.S. manufacturers more competitive. Simplified, Japan was given the choice of U.S. tariffs or a stronger yen, and it accepted the latter. This is important when we consider the Japan’s two lost decades since. Irresponsible, protectionist currency policy from the United States forced a deflation on Japan that it still struggles to recover from.

Moving to the ‘90s, the arrival of Robert Rubin as President Clinton’s Treasury secretary heralded a move away from the sometimes protectionist policies of the Clinton administration vis-à-vis Japan earlier in the decade. Indeed, as Stanford professor Ronald McKinnon observed, once Rubin was in control the jawboning from Treasury about the value of the yen ceased.

So while the above was a major positive, the dollar’s rise in the late ‘90s proved problematic to certain countries with dollar pegs. In particular, the greenback’s unchecked rise led to currency crises in South Korea, Malaysia and Thailand, and later on in both Argentina and Russia. Simplified, the dollar’s continued strength made those currency pegs tenuous, and as such, it should be said that dollar policy stateside claimed its latest victims.

When dollar policy this decade is considered, all three Bush Treasury secretaries communicated to the markets their desire for a weaker greenback, and markets complied. The dollar’s decline led to a housing boom in the U.S. that eventually occurred around the world as central banks mimicked our monetary mistakes. Absent irresponsible policies in the U.S., it would be hard for anyone to credibly argue that we would be where we are today. Indeed, the inflationary real estate boom that was would never have been, along with the inevitable bust.

All this brings us to recent comments from Chinese and Russian officials about how it’s necessary for the world to replace the dollar as its reserve currency. It’s hard to fathom considering the dollar’s outsized (90% +) role in world currency markets, not to mention that nearly 70 percent of all central bank reserves are denominated in dollars.

Still, judging by history since 1971, U.S. monetary authorities have irrespective of party shown how unsuited they are to overseeing what is the most important price in the world. In that sense, it should be hoped that Euroland joins up with England, or perhaps China joins with Japan in creating a currency not used for protectionist reasons, but instead one founded on the notion of currency stability.

World economies would surely benefit from currency stability, and so would the United States. Indeed, what some call “bubbles” are nothing more than currency mistakes created by the U.S. Treasury, and some would say, the Fed. If the dollar were replaced, or better yet, forced into stability thanks to currency competition from elsewhere, this would bring amazing benefits to our economy.

Not only would investment be more rational thanks to currency instability being removed as an economic variable, it’s also true that if the dollar lost its role as world currency that the U.S. economy would benefit from lower government spending; spending presently made easier thanks to the dollar’s unwarranted stature. This isn’t to say there wouldn’t be company failures (failure is as much a part of capitalism as success is) under stable currency values, but it is to say that much of the malinvestment that frequently has its origins in bad currency policy would disappear.

All that, plus the popularity of Americans around the world might grow. No longer foisting horrific currency policy on our friends, we might instead resume our role as the world’s growth engine thanks to currency stability. In that sense, we should welcome the dollar’s replacement as a way of saving us from ourselves.

April 8, 2009

Obama and the Reawakening of Corporatism

But we are entering quite a different age right now, one in which the President of the United States and his hand-selected industrial overseers fire the chief executive of General Motors and chart the company’s next moves in order to preserve it. Conservative critics of the president have said that the government’s GM strategy is one of many examples of an America drifting toward socialism. But President Obama is not a socialist. If his agenda harks back to anything, it is to corporatism, the notion that elite groups of individuals molded together into committees or public-private boards can guide society and coordinate the economy from the top town and manage change by evolution, not revolution. It is a turn-of-the 20th century philosophy, updated for the dawn of the 21st century, which positions itself as an antidote to the kind of messy capitalism that has transformed the Fortune 500 and every corner of our economy in the last half century. To do so corporatism seeks to substitute the wisdom of the few for the hundreds of millions of individual actions and transactions of the many that set the direction of the economy from the bottom up.

Corporatism periodically re-emerges precisely because it is an appealing political formulation, seeking as it does to present a middle-of-the-road alternative to socialism on the one hand, and capitalism on the other. It was the search for just such a third way that prompted Pope Leo XIII to outline the notion of corporatism in his 1891 encyclical, Rerum Novarum (Of New Things). Leo confronted a world in transition, like ours, in which technological advances had created an industrial revolution that was reshaping society, setting off mass migrations and creating wealth and pockets of new urban poverty at the same time. The Catholic Church worried about the rise of socialism--an ideology that rejected religion and preached seizing private property (a particularly distasteful notion to Europe’s biggest property owner) in response to the industrial revolution. But the Church was also distrustful of capitalism, with its overtones of survival of the fittest. That the most successful capitalist countries of the time were overwhelmingly Protestant didn’t reassure Leo XIII either. His corporatism was not rule by capitalists, but rather enlightened guidance from medieval-style guilds and associations or other such collaborative bodies.

Variations on Leo’s ideas soon became a common part of the political discourse. We see hints of corporatism in America’s Progressive Reform movement of early 20th century America, with its notion that the country could be governed by an enlightened, technocratic, nonpartisan elite, which culminated in the presidential election of Woodrow Wilson--a political scientist who specialized in the study of public administration.

But a version of corporatism also emerged in the 1920s in Fascist Italy, where Mussolini conceived of syndicates in numerous industries composed of labor leaders and businessmen helping direct the Italian economy in the service of Fascism. Hitler’s solution was more thorough, to eliminate those organizations and associations within Germany that opposed him and to smother individualism by instituting a corporatist regime of forcible coordination among trade unions and business groups.

As chilling as these authoritarian versions of corporatism sound today, in the 1930s they found admirers in the U.S., where the ravages of the Great Depression provoked public longing for a safer, more thoroughly planned economy without as much resistance and debate from recalcitrant business leaders or opposition party members who opposed the New Deal. Even today one occasionally hears a longing for a benign version of this elaborately planned economic world in phrases like “getting the trains running on time,” or in a recent column in the New York Times which suggested that Hitler’s wartime buildup amounted to a successful government stimulus in Depression-era Germany.

Today, some American conservatives will argue that we never put aside the corporatism of the U.S. during the New Deal. They can point to any number of initiatives, from Lyndon Johnson’s Great Society to Richard Nixon’s wage and price controls, as evidence of continued drift. Progressives, by contrast, will argue that America has been governed over that same time by a corporatist regime of big business conspiring with government against the middle and lower classes so that only the rich benefit.

The facts belie both versions. If corporations have been running our economy for their own purposes, or in tandem with big government, they haven’t been doing an awfully good job of protecting their interests, considering how quickly U.S. firms rise and fall and how the Fortune 500 turns over. And if only the rich are getting richer someone needs to tell Bill Gates, a kid from a middle class background with no college degree, or Warren Buffett, who grew up working in his grandfather’s grocery store, that they need to return the billions they’ve somehow acquired to the Rockefellers, the Astors, the Vanderbilts and other once-rich families whose fortunes have long been in decline.

Still, great economic dislocations bring out the corporatist, which is why we now have a government board overseeing General Motors, and the Treasury Department has issued the first car warranty program in its history. It’s why some banks were pressured to accept bailout money they didn’t need and have been pressured not to return it to get out from under federal micromanagement. And it’s why the federal stimulus package contains such chestnuts as money to build out our broadband infrastructure, which comes with all sorts of strings attached by the Federal Communications Commission, because we somehow can’t rely on our phone, cable or internet companies to provide customers with the bandwidth they demand in networks that will suit our economy.

Corporatism is especially attractive to politicians, public intellectuals who serve as policy makers, and Nobel Laureates because it is ultimately a world managed by the few, the elect, through the state. If we are told enough times that nothing, even technological innovation, is possible anymore without significant contributions and directions from the state, maybe we’ll eventually come to believe it, although the inventors of the printing press, the steam engine, the light bulb, the telephone, and internal combustion engine and other game-changing technologies might wonder how they accomplished what they did without government.

Corporatism is not about regulating capitalism better as markets evolve. It is several steps beyond. It is instead about those who believe in “the beauty of pushing a button to solve problems,” as the economist Paul Krugman recently described his attraction to the social sciences. Some people worry about what happens when the regulators take charge of our economy. But the real concern is what happens when the button pushers take charge, for the button pushers are the corporatists.

April 9, 2009

Unequal Protection Under the Law

One symptom of the breakdown of the law is the rise in gang violence. The U.S. Department of Justice estimates that the number of gang members reached 1 million last year, up from 800,000 in 2005—and these are only the ones that can be counted. The number of U.S. communities affected by gangs rose to 58 percent in 2008, up from 52 percent in 2005.

The misnamed Employee Free Choice Act, introduced last month in Congress, would permit unions to bypass a secret ballot and organize based on collected signatures on open cards. Union officials would be able to visit workers at home and pressure them for signatures, subjecting them to intimidation without recourse to the police. Think school bullies on the playground and you get the idea.

Guatemala suffers not only from a lack of law and order, but from their selective application. And that painful lesson is no less true in the United States.

Take taxes, for instance. Most Americans assume that failure to pay taxes would put them out of consideration for Senate-confirmed positions. Not so for President Obama’s appointees, at least five of whom had problems with unpaid taxes. Although Tom Daschle withdrew, Treasury Secretary Timothy Geithner, U.S. Trade Representative Ron Kirk, and Labor Secretary Hilda Solis (whose husband owed taxes) were confirmed. Kansas Governor Katherine Sebelius is set to become Secretary of the Health and Human Services Department later this month.

It’s hard to remember prior Cabinet nominees with tax problems of similar magnitude being confirmed. Indeed, President Clinton’s two nominees for Attorney General, Zoe Baird and Kimba Wood, withdrew from consideration when tax problems were discovered.

It’s not just high-ranking American government officials who benefit from the seemingly arbitrary and discriminatory application of government programs. Two small banks, Old National Bancorp of Indiana and Signature Bank of New York, are among those who have been allowed to return the Treasury funds that they received from the Troubled Assets Relief Program.

Yet other institutions, such as Goldman Sachs, Morgan Stanley, J.P. Morgan, and Bank of America, were reportedly pressured to keep the funds in a March 27 White House meeting with President Obama. A government that can decide to pressure banks to do something not required by law is engaged in extra-legal activities. A government that decides to pressure some institutions and not others is inherently discriminatory.

The government’s treatment of executive compensation bonuses, standard in many industries, has also been capricious. Some executives working in banks that received TARP funds were paid their bonuses without a peep from Washington. Others, notably those working at AIG, were demonized both by press and government. Some returned the money.

President Obama has attacked those who received bonuses, saying that only his administration is standing between the bankers and the populist “pitchforks.” Yet he has not criticized his own staff. Michael Froman, President Obama’s deputy national security advisor for international economic affairs, received a $2.25 million bonus from Citigroup, a recipient of TARP funds. Other White House aides, such as Larry Summers, received millions in compensation from financial institutions.

Whereas banking executives are being asked to return bonuses, politicians, including Mr. Obama, who received contributions from those same companies are not offering to return them. Uncle Sam has decided that it’s not OK to pay employees bonuses, but it’s OK to pay politicians campaign contributions.

The discretionary application of government power can be seen in the choice of companies that qualify for bailouts. Newspapers, retail outlets, hotels, construction, airlines—all are in trouble, and the unemployment rate is 8.5 percent, the highest in 25 years. However, the only non-financial companies selected for bailouts are domestic auto companies.

Within the auto companies, the Obama administration decided that Robert Nardelli, chairman and CEO of Chrysler, could keep his job. Yet GM chairman and CEO Rick Wagoner was forced to leave, along with many GM directors. Not only was this arbitrary, but it was done without any consultation of Congress.

The $787 billion stimulus funds are similarly based on decisions made by federal government agencies. Some businesses will receive large sums from government; many more will receive much less; and the vast majority of the millions of American businesses will receive absolutely nothing.

One of the greatest strengths of the United States has been the uniform and predictable application of laws. If we lose that, we lose much that we hold dear. To see such consequences, just visit Guatemala.

Game Theory Exposes PPIP As Fraudulent

This is a microcosm of what the Public-Private Investment Program (PPIP) is intended to do: create an incentive for investors to pay $90 for a bet that is only worth $50. It is bad economics and bad public policy and it is probably fraudulent. Congress should act pre-emptively to halt Treasury Secretary Tim Geithner’s latest scheme.

In the gaming example above the lender has a bet where he gets $80 or zero with equal odds. The value of that bet is $40. Since he paid $80 for it, he has an expected loss of $40. The PPIP puts the taxpayer, via the Federal Deposit Insurance Corporation, in a similar position. The details are only slightly more complicated. A full analysis would include the diversity in the pools of loans, the interest rate charged by the lender, and the opportunity cost to the lender for a similarly risky bet.

We don’t have enough information from the FDIC about what it intends to charge for the 84% of the PPIP it is guaranteeing and we don’t know the exact mix of assets. But once these are revealed, the analysis becomes straightforward, and the expected loss to the FDIC can be estimated with a reasonable degree of certainty.

Why is this particularly interesting? Many commentators have pointed out the obvious: that the PPIP is another welfare program for the big banks, funded by the taxpayer.

It is interesting because the legislation governing the FDIC does not allow it to take expected losses above its capital base, and that capital base is now just $30 billion. Against a $500 billion PPIP, it only requires a 6% overpayment to wipe out the FDIC’s capital.

The New York Times’ Andrew Ross Sorkin pressed the FDIC’s Shelia Bair on this point and she apparently claimed that the accountants “signed off on no net losses.” But we are now in zero sum territory. There are only the assets, the banks, and the government. The windfall to the banks is offset by the expected loss to the government. Convincing one’s accountants that a transaction with a high expected loss has no expected loss is fraud.

Here is where the over-engineered PPIP begins to raise troubling questions. Recall that in the initial announcement of the PPIP in March, Geithner made much of the auction process that would be used to price the assets. This auction, where five of the top asset managers in the country would bid against each other, was meant to ensure the fairness of the process.

In his Wall Street Journal editorial announcing the program on May 23, Geithner assured us that “private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.”

One suspects that the accountants for the FDIC were convinced that the loans would be purchased at a fair price because they would be sold through an auction mechanism. But if every bidder in the auction has the same incentive to overbid, it is no longer a fair auction. A naïve accountant might equate “auction” with “fair” and ignore the distortion built in to the process.

Jeffrey Sachs did a fine job pointing out that the incentive is actually to massively overbid, and perhaps even collude. Paul Krugman pointed out that the plan is a “disguised way to subsidize purchases of bad assets.” Josef Stiglitz commented that Geithner’s plan “only works if the taxpayer loses big time.”

Against Sachs, Krugman and Stiglitz, in a straightforward exercise in game theory, who is on the side of government accountants?

“No net losses?” The most likely outcome for PPIP is expected losses to the FDIC. In fact, game theory can be used to predict what the expected losses will be. One simply has to work the game backwards. Once we know the clearing price of the auction, we can calculate how much the government overpaid.

In our example above, if we know the auction cleared at $90, we can demonstrate the fair price was $50. If the auction cleared at $85, the fair price was $25. It’s a form of price discovery, but probably not what Geithner had in mind.

It is disturbing that the Treasury Secretary’s long awaited plan to solve the toxic assets dilemma relies on an overly contrived scheme to obscure its risk to the taxpayer. Either the disguise is intentional or it has not occurred to the Secretary that the plan jeopardizes the soundness of the FDIC. Neither answer is acceptable.

More Financial Regulations, More Financial Failures

This is notable considering the global response to the financial problems in our midst. Politicians and the regulators they oversee, seemingly unconcerned by how unequal they were to those they regulated this past decade, see the failure of all manner of financial firms as reason to enhance, not reduce regulations.

Indeed, among the major decisions made at last week’s G20 confab in London concerned financial oversight, and the desire among G20 leaders to create a global regulatory framework. Simply put, when government regulators fail, unlike businesses they can keep trying, albeit on the dime of the taxpayer.

The move toward global regulation is not insignificant. Much like moves afoot to achieve worldwide tax harmonization that would effectively trap corporations and individuals in tax sameness, global financial regulations will retard the process whereby individual countries serve as laboratories for regulatory concepts. If financial regulation is harmonized, bad rules will be imposed on everyone.

Some might say this is a good thing, that finance companies ensnared in a global web of regulations will not be able to operate outside of them, and major failures will be reduced. It’s a nice thought, but once again this kind of thinking presumes that someone taking a relatively paltry government paycheck might be able to outsmart the more enterprising minds in the private sector. Good luck.

Instead, regulations and regulators at first blush play right into the hands of the Bernie Madoffs of the world. Once they know the rules they must get around, not to mention the regulators they need to please, their jobs are easy. Indeed, it’s far easier to trick someone with no skin in the game than it is to trick a customer. Regulators allow customers to be lax in their oversight, and that’s why con artists always thrive when the role of the state is large.

Much the same applies to big banks seeking to operate in an above-board way. Not only do regulations serve the interests of big institutions for suppressing new entrants, they also create opportunities for sharp minds within banks to figure out legal ways around the rules put in place. They get paid to do just that. Think about it: banks are presently regulated by no less than the Federal Reserve, the Comptroller of the Currency and the FDIC on the federal level, and they also face myriad regulators on the state and local level. Despite this seemingly impressive oversight, banks once again were able to overextend themselves in ways that supposedly have us experiencing the “worst financial crisis since the Great Depression.”

The above should be remembered in light of G20 talk suggesting that hedge funds are next when it comes to massive oversight. If regulators can’t control the relatively prosaic world of banking, is it remotely credible to assume that truly bright hedge fund managers will somehow meet their match in Bonn, Paris or Washington? Not very likely.

Sadly, however, more financial regulations will have a deleterious impact on the very taxpayers they were meant to protect. Indeed, once a firm or sector is regulated, the regulatory bodies overseeing them are frequently on the hook for failures. This is why the failure of S&Ls in the ‘80s and ‘90s, and banks/investment banks this decade have proven so costly. Compare this to the aforementioned decline of Internet companies earlier this decade, and the reality that taxpayers weren’t forced to cough up a dime.

Treasury secretary Geithner feels he can solve the problem of bank failure and its broader impact by corralling the “too big to fail” banks into some form of “super-regulatory” system. The obvious problem here is that sharp minds will once again game the Geithners of the world in seeking to figure out who’s important, and who isn’t. It shouldn’t be hard to figure out, and once the mystery is solved, the supposed “key” financial institutions benefitting from their governmental patrons will possess an unfair competitive advantage not gained through skill, but thanks to being too large. For the federal government to crown one or many corporations with the tag “too big to fail” is for that same government to author future financial crises caused by the firms it deems essential to our financial health.

What’s not been discussed enough is how much better off we would all be if regulators here and around the world were to recognize their limitations, and let those with actual money at stake regulate those they’ve invested with. If so, it’s fair to assume that investors would be far more aggressive when it comes to making sure those they’ve entrusted their money with are operating in ways that don’t risk the capital they’ve committed. Put another way, who might regulate a big bank more effectively: a smart money manager with hundreds of millions invested in said bank’s future, or an over-degreed SEC newby possessing little to no financial experience with no money on the line?

Beyond that, the surest way to reduce the number of financial failures would paradoxically be for our federal minders to make plain that bailouts from the government are not a future option. If so, it would be well known that faulty decisions would be met with bankruptcy, and this reality alone would insure that banks, heavily regulated by their investors, would be far more prudent when it comes to deploying the capital they’ve been entrusted with.

Absent that, more in the way of regulations to fix past problems misses the point, and it insures more financial failures in the future. The financial system doesn’t suffer from too little regulation, but it does suffer from investors over-reliant on governments to do their work for them combined with a bailout culture that says government won’t countenance failure. On the other hand, if governments get out of the way, we’ll achieve the very best kind of regulatory situation whereby those with money at stake will oversee those they’ve entrusted it with.

April 10, 2009

Why Should We Defend Rich Heirs?

The House has passed this measure as part of the budget. In the Senate, there's trouble. Ten Democrats have joined the Republicans in calling for a $10 million exclusion and a 35 percent rate. This is amazing. The number of people who leave estates of even $7 million is minuscule. The number leaving more than $10 million is smaller still. Yet to save these very few very wealthy people a small fraction of their estates, these senators are willing to hand their party's president an embarrassing defeat. Why on earth?

Oh, small business blah blah blah. For the umpteenth time: Big businesses (such as General Motors) are mostly owned by people of small means (workers through their pension funds, 401(k)s and so on). To be affected by the estate tax, a business must be owned by someone of large means: at least $7 million. Small businesses come and go. Yes, they create jobs disproportionately. They also eliminate jobs disproportionately. There's nothing wrong with small businesses, but there is no reason of fairness or efficiency that they deserve special treatment.

There are philosophical arguments against the estate tax that aren't contemptible, though they also aren't convincing. My favorite is that money is only one advantage that parents can pass on to their children. If you reduce the role of money in determining where people end up, you aren't leveling the playing field. You're just tilting it in favor of other inherited qualities such as talent or intelligence. Why not tax these things, Arthur Laffer asked in the Wall Street Journal the other day.

Laffer invented the famous "Laffer Curve," which did so much fiscal damage over the past generation by convincing people that tax cuts can pay for themselves. His reason was that taxes discourage the activity being taxed; cut the income tax, and people work harder. But this, surely, is an argument in favor of a tax on inherited wealth (if you accept the premise that we've got to tax something or other). Lowering a tax triggered by your death is not likely to pay for itself by encouraging you to die sooner, or more often.

But why the populist fury over those AIG bonuses of a few million dollars while no one seems to care much about billions being transferred through inherited wealth? The obvious answer -- that there's a difference between what people do with our hard-earned money and what they do with their own hard-earned money -- isn't actually as persuasive as it seems.

Perusing the Forbes 400 list of America's richest people, it's striking how few of them made the list by building the proverbial better mousetrap. The most common route to gargantuan wealth, like the route to smaller piles, remains inheritance. The ability to pass money along to your kids may motivate many a successful executive or investor to work harder, but it can't possibly motivate those kids to inherit harder in order to pass it along once again.

Dozens of Forbes 400 fortunes derive from the rising value of land or other natural resources. These businesses are fundamentally different from mousetrap building. Land does not need to become "better" to increase in value, and that value increase doesn't produce more land. Yet other fortunes depend directly on the government. The large fortunes based on health care and pharmaceuticals would not exist if not for Medicare and Medicaid. The government hands out large fortunes even more directly in forms as varied as cable-TV franchises; cellphone licenses; drilling, mining and mineral rights; minority small-business loans; and other special treatment.

Most important, every American selling anything benefits from doing so in the world's richest market. An American doctor earns many times what the same doctor would earn in, say, India. This is not because he or she works many times harder. It's not even primarily because our government doles out hundreds of billions for health care each year. It's because we are a richer society, for reasons the American doctor had nothing to do with.

The debate over whether the estate tax should start at $7 million or $10 million is largely symbolic. That makes the push by those 10 Democratic senators for the higher amount even more mysterious.

kinsleym@washpost.com

Reagan's Legacy: Our 25-Year Boom

On the nations' campuses and even in some of its boardrooms, people were talking about capitalism as a failed system.

Some advocated a "third way" between socialism and capitalism, as in Europe, which would include heavy doses of government intervention in markets to bring them back to life. Still others took up the call in E.F. Schumacher's best-seller, "Small Is Beautiful," to downsize expectations. Live frugally, they said. Inhabit small houses. Drive small cars. Don't use oil. Rein in your ambitions.

One man didn't agree with this: President Ronald Reagan, elected in 1980 amid a wave of voter disgust at his predecessor's failures.

It was Reagan who brought America's capitalist economy roaring back to life, ending energy price controls, slashing income tax rates by 25% and dramatically reducing tax rates on capital gains.

Americans had been told for years — as they're now being told again — to expect diminished standards of living. Then they watched as the Reagan years set in place one of the most durable and remarkable booms in incomes and wealth in history.

Yet the media and academia rarely credited Reagan for his accomplishments — especially on the economy, where "Reaganomics" became a term of opprobrium among the intelligentsia.

But it's a fact. As the nonpartisan National Bureau of Economic Research once declared, we lived in the "longest sustained period of prosperity in the 20th century" from 1982 to 1999 — one big boom, the NBER said, set off by Reagan.

Reagan's magic was simple. He wanted to lower interest rates, slash inflation, cut unemployment and boost economic growth. These things, at the time, seemed impossible. But he did it.

The so-called misery index — that is, unemployment plus inflation — hit 21% as Reagan was elected in 1980. By the time his terms were over, it had plunged to around 9%.

Interest rates likewise plunged — contrary to the predictions of many pundits, who boldly predicted that the budget deficits which emerged in the 1980s would send rates spiraling upward. From a stratospheric 21% in 1980, the prime rate fell to 7% by decade's end.

During the 1970s, many Americans for the first time saw incomes shrink. But from 1981 to 1989, median real household income rose by $4,000. The poorest Americans, who saw their incomes fall 5% in the 1970s, watched their incomes rise 6% in the 1980s.

After the staunchly free-market Reagan, things got a bit rocky.

President George H.W. Bush's four years included some mistakes and questionable moves — a record rise in regulations, for one, and the infamous breaking of his "no new taxes" pledge that, after 1991's mild recession, handed the 1992 election to Bill Clinton.

President Clinton won largely because he promised change. He had also promised a middle-class tax cut, among other things.

But his popularity plunged when, instead of cutting taxes, he raised them by a record amount. That tax hike contributed to one of the slowest economic recoveries from a recession since WWII.

The young Arkansan president looked like a one-termer.

But things changed. Slashing defense spending after the collapse of communism (another Reagan victory), Clinton and the new GOP Congress in 1994 started to shrink the deficit. Clinton sounded Reaganesque declaring: "The era of big government is over."

Meanwhile, after raising interest rates in 1994, Fed chief Alan Greenspan began cutting them as inflation and the deficit fell. The economy and the stock market soared. Budget surpluses emerged.

The Reagan era's star companies begat the Internet boom; they helped save Clinton's presidency. Two stand out: In 1993, Intel unveiled its Pentium chip. In 1995, Microsoft released Windows 95.

By 1996, the economy was rocking and so was the stock market. Employing his famous policy of "triangulation," Clinton wisely signed welfare reform into law, bringing millions of people off the dole and into the productive work force, many for the first time.

A year later, and with much less fanfare, Clinton signed into law a tax bill produced by the Republican Congress to cut capital gains tax rates. The result was the record boom of 1997 to 2000, the result of which was an unprecedented expansion of wealth.

Indeed, this 25-year Reagan boom was the most profoundly democratic era of capitalism ever. In 1980, just 16% of all workers owned stock. By 2000, that had expanded to 52%. Stock ownership moved from Wall Street to Main Street.

Even so, President George W. Bush inherited a mess in 2000. The Nasdaq was at the tail end of a record plunge — which began in 1999 after the Fed aggressively raised rates to quell inflation and end "irrational exuberance." As Bush entered office, the economy was already in recession. Job growth was nil. The 9/11 attacks that killed 3,000 cast a pall over the nation's spirit and the economy.

Still, Bush managed to push through two major tax cuts. The second one, in 2003, helped set off a five-year growth spurt that went all but uncovered by the nation's media.

What's more, as a backdrop to the Reagan boom, the world's economy likewise moved strongly in a free-market direction, adding more output in the last 25 years than in all of history. In 1980, world GDP was just $11 trillion, World Bank data show. By 2007, it had soared to $54 trillion, the greatest economic surge in history.

Hundreds of millions of people were pulled from abject poverty into something resembling a middle-class existence.

Today the question is: Can Reagan's free-market miracle survive? Or was it just a brief interlude of history?

President Obama has presided over the greatest expansion of government in history. Spending on the various bailouts and stimulus programs now totals $4 trillion — about a third of our total national output. And it looks to grow even bigger.

He has proposed new taxes and new rules that will put the government's hand into our lives as never before. Expanding government spending from the 50-year average of 20% of GDP or so to as much as 25% will require sweeping new taxes — and not just on the rich.

A shocking new Rasmussen Poll shows that just 53% think capitalism is superior to socialism — despite the fact that socialism, wherever it's been tried, has brought misery and poverty.

So is Reagan's dream of free-market capitalism dead? Or is it just sleeping, as in the 1970s, waiting for a new champion to emerge?

April 13, 2009

Spend More, Get Less: Obama's Mirage

What Obama proposes is a "post-material economy." He would de-emphasize the production of ever-more private goods and services, harnessing the economy to achieve broad social goals. In the process, he sets aside the standard logic of economic progress.

Since the dawn of the Industrial Age, this has been simple: produce more with less. ("Productivity," in economic jargon.) Mass markets developed for clothes, cars, computers and much more because declining costs expanded production. Living standards rose. By contrast, the logic of the "post-material economy" is just the opposite: Spend more and get less.

Consider global warming. The centerpiece of Obama's agenda is a "cap-and-trade" program. This would be, in effect, a tax on fossil fuels (oil, coal, natural gas). The idea is to raise their prices so that households and businesses use less or switch to costlier "alternative" energy sources such as solar. In general, we would spend more on energy and get less of it.

The story for health care is similar, though the cause is different. We spend more and more for it (now 21 percent of personal consumption, says Brookings economist Gary Burtless) and get, it seems, less and less gain in improved health. This is largely the result of costly new technologies and the unintended consequence of open-ended insurance reimbursement that encourages unneeded tests, procedures and visits to doctors. Expanding health insurance might aggravate the problem. Many of today's uninsured get health care for free or don't need much because they're young (40 percent are between 18 and 34).

Together, health care and energy constitute about a quarter of the U.S. economy. If their costs increase, they will crowd out other spending. The president's policies might, as he says, create high-paying "green" or medical jobs. But if so, they will destroy old jobs elsewhere. Think about it. If you spend more for gasoline or electricity -- or for health insurance premiums -- then you spend less on other things, from meals out to home repair. Jobs in those sectors suffer.

The prospect is that energy and health costs may rise without creating much gain in material benefits. That's not economic "progress." Rebating households' higher energy costs (as some suggest) with tax cuts does not solve the problem of squeezed incomes. Given today's huge and unsustainable budget deficits, some other tax would have to be raised or some other program cut.

And collective benefits?

What defines the "post-material economy" is a growing willingness to sacrifice money income for psychic income -- "feeling good." Some people may gladly pay higher energy prices if they think they're "saving the planet" from global warming. Some may accept higher taxes if they think they're improving the health or education of the poor. Unfortunately, these psychic benefits may be based on fantasies. What if U.S. cuts in greenhouse gases are offset by Chinese increases? What if more health insurance produces only modest gains in people's health?

Obama and his allies have glossed over these questions. They've left the impression that somehow magical technological breakthroughs will produce clean energy that is also cheap. Perhaps that will happen; it hasn't yet. They've talked so often about the need to control wasteful health spending that they've implied they've actually found a way of doing so. Perhaps they will, but they haven't yet.

We cannot build a productive economy on the foundations of health care and "green" energy. These programs would create burdens for many, benefits for some. Indeed, their weaknesses may feed on each other, as higher health spending requires more taxes that are satisfied by stiffer terms for cap-and-trade. We clearly need changes in these areas: ways to check wasteful health spending and promote efficient energy use. I have long advocated a gasoline tax on national security grounds. But Obama's vision for economic renewal is mostly a self-serving mirage.

Making Sure the Poor Are Always With Us

Perhaps the mystery can be solved if you ask what ought to be a simple question: What is poverty? Alas, the answer is poisonously divisive.

Pick a level of material well being - any level - and define poverty as having less than that. For example, a roof over your head, enough food to eat, warm clothes in the winter, access to basic medical care, education for your children, air conditioning, cable TV, cell phones, Nintendo, whatever - you can make up your own list. Under this definition, winning the War on Poverty can actually be an achievable goal. You can measure progress and, one great day, declare victory.

Everyone’s list will differ, but no matter what you put on yours can you deny that the poor have made tremendous and unprecedented material progress over the past 100 years? This despite periods of war, depression, stagflation, and all the bumps in the road that mark the fitful course of western civilization. By any objective measure, progress since the War on Poverty was first declared in the 1960s has been stellar.

But what happens if you define poverty as anyone living in or passing through the lowest quintile of income distribution? Progress becomes meaningless and victory unattainable because it is, mathematically, impossible. Absent authoritarian dictatorship enforcing draconian redistribution, some people will always make less than others, even as everyone’s level of material well being rises. And as society becomes wealthier as a whole, the absolute gap between the richest and poorest will always statistically grow, as it has since we lived in caves. The only way to eliminate inequality is to eliminate progress.

The Federal Government tells us that 37 million Americans now live in poverty. Isn’t that a shocking number considering we are the richest country on earth? Yet reality belies stock images of Okies sweltering in Hoovervilles. Did you know that three quarters of today’s poor have air conditioning, VCRs or DVD players, microwave ovens, and even their own cars - sometimes two? Almost half own their own homes. And although homeownership amongst the poor soared then dipped thanks to the mortgage fiasco, the average poor American still has more living space than the average middle class citizen in most European cities.

What about food and nutrition, the most pressing condition of poverty? On average, children growing up poor in America today eat so well that they are one inch taller and 10 pounds heavier that the average GI who stormed the beaches of Normandy in World War II. In fact, obesity is on the short list of self-inflicted problems that bedevil the poor.

Can these radically different perspectives on poverty be reconciled?

Spend a few hours on the web sites of the U.S. Census Bureau and the Department of Health and Human Services and try to make sense of what you find. There is a large and growing amount of data on income distribution and inequality. There is hardly a peep about the absolute standard of living enjoyed by a person at the government defined poverty line and how that has improved over time. Why is that? As a people, don’t you think we’d be proud to document the progress we’ve made?

Now, take a look at the long and growing list of government income redistribution programs whose eligibility depend on the official declaration of the poverty line. Here lies the answer to what motivates government policy. We have adopted a policy that guarantees the poor will always be with us, along with the millions of poverty industry professionals whose livelihood depends on serving them.

No doubt, the safety net does good things for the desperately needy. Can you imagine living in a society without one? And in the larger scheme of things, programs for the poor represent a minute fraction of the money consumed by runaway middle class entitlements like Social Security and Medicare. But it’s not hard to see how this safety net might entangle those who are ready to graduate from poverty while crowding out private charitable actors who may have a different approach to encouraging behaviors that reduce long term, multi-generational dependency.

April 14, 2009

Taxpayers Get Really Tea-Ed Off

If that is the message heard loud and clear from this unprecedented national movement against the liberal Democratic rule in Washington, and if Republicans endorse those tax-reducing principles, then this grass-roots uprising could succeed.

What the tea parties aim to accomplish is really a much taller order than gaining independence from a tyrannical monarch and far-away parliament two centuries ago.

They are trying to persuade Congress and the states to reject what comes perfectly naturally to them: the opportunity to fritter away a fortune in other people's money, and the idea that we should spend our way out of this economic downturn.

That is not the tried-and-true means of lifting ourselves out of distress. When America suffered the worst recession since the Great Depression at the beginning of Ronald Reagan's first term of office more than a quarter-century ago, the president spurred Congress to cut income taxes across the board.

The longest, strongest expansion in history soon began, extending well beyond Reagan's two terms in office.

And when our country, already suffering from a shaky economy, was in 2001 hit by the first attacks on domestic soil since Pearl Harbor, President George W. Bush similarly rallied Congress to cut the rates of everyone who paid income taxes, as well as investment taxes.

The result was the same: a recovery generating many millions of new jobs.

But the ideology now dominating Washington sees those successful steps as capitalistic greed. As such, it was not Reagan or John F. Kennedy or Bush 43 who had it right when they cut taxes. Rather, it was Franklin Roosevelt, who may well have extended a bad recession into a full-scale collapse by using it as the rationale for a massive expansion in the size and scope of the federal government.

Or so the statists on the left believe.

In the case of today, the notion that "we have nothing to fear but fear itself" as trillions of taxpayer dollars are about to be spent is not being accepted by one and all.

Standing on the floor of the Chicago Board of Trade in February, CNBC commentator and former financial trader Rick Santelli told viewers the reality of what Congress was doing.

The government was rewarding bad behavior, having American taxpayers pay their neighbors' bad mortgages, he pointed out.

And it was Santelli who, as traders cheered him on, suggested a repeat of the famous Boston Tea Party in 1773, in which cases of British tea on ships in Boston Harbor were dumped by colonists dressed as Indians in protest of new British taxes on the beverage.

Millions saw computer postings of the Santelli clip. The result is that Wednesday's protests will see armies of protesters from sea to shining sea wearing, burning or mailing tea bags to politicians in a 21st-century version of the colonial protest.

Can it work?

Howard Jarvis' Proposition 13 movement to cut California's property taxes started small, then expanded to other states in the Midwest and Northeast, and even helped inspire the Reagan tax cuts.

There is an opportunity here for Republicans to bring some fiscal integrity back to their tarnished brand.

GOP senators and House members can appear at their local tea parties and apologize for squandering more than a decade of control of Congress because they wouldn't resist the spending impulse any more than Democrats would. Or they can sit in their offices and hope the storm of anger passes them by.

If Republicans commit to becoming a new "Grand Tea Party," this week's demonstrations could be as consequential as the events in Boston that inspired them.

A Coordinated Global Stimulus Is Needed

This global crisis requires a global response, but, unfortunately, responsibility for responding remains at the national level. Each country will try to design its stimulus package to maximise the impact on its own citizens – not the global impact.

In assessing the size of the stimulus, countries will balance the cost to their own budgets with the benefits in terms of increased growth and employment for their own economies. Since some of the benefit (much of it in the case of small, open economies) will accrue to others, stimulus packages are likely to be smaller and more poorly designed than they otherwise would be, which is why a globally co-ordinated stimulus package is needed.

This is one of several important messages to emerge from a UN Experts Commission on the global economic crisis, which I chair – and which recently submitted its preliminary report to the UN.

The report supports many of the G-20 initiatives, but it urges stronger measures focused on developing countries. For instance, while it is recognised that almost all countries need to undertake stimulus measures (we’re all Keynesians now), many developing countries do not have the resources to do so. Nor do existing international lending institutions.

But if we are to avoid winding up in another debt crisis, some, perhaps much, of the money will have to be given in grants. And, in the past, assistance has been accompanied by extensive “conditions,” some of which enforced contractionary monetary and fiscal policies – just the opposite of what is needed now – and imposed financial deregulation, which was among the root causes of the crisis.

In many parts of the world, there is a strong stigma associated with going to the International Monetary Fund, for obvious reasons. And there is dissatisfaction not just from borrowers, but also from potential suppliers of funds. The sources of liquid funds today are in Asia and the Middle East, but why should these countries contribute money to organizations in which their voice is limited and which have often pushed policies that are antithetical to their values and beliefs?

Many of the governance reforms proposed for the IMF and the World Bank – affecting, most obviously, how their heads are chosen – finally seem to be on the table. But the reform process is slow, and the crisis will not wait.

It is thus imperative that assistance be provided through a variety of channels, in addition to, or instead of, the IMF, including regional institutions. New lending facilities could be created, with governance structures more consonant with the twenty-first century. If this could be done quickly (which I think it could), such facilities could be an important channel for disbursing funds.

At their November 2008 summit the G-20 leaders strongly condemned protectionism and committed themselves not to engage in it. Unfortunately, a World Bank study notes that 17 of the 20 countries have actually undertaken new protectionist measures, most notably the US with the “buy American” provision included in its stimulus package.

But it has long been recognised that subsidies can be just as destructive as tariffs – and even less fair, since rich countries can better afford them. If there was ever a level playing field in the global economy, it no longer exists: the massive subsidies and bailouts provided by the US have changed everything, perhaps irreversibly.

Indeed, even firms in advanced industrial countries that have not received a subsidy are at an unfair advantage. They can undertake risks that others cannot, knowing that if they fail, they may be bailed out. While one can understand the domestic political imperatives that have led to subsidies and guarantees, developed countries need to recognize the global consequences, and provide compensatory assistance to developing countries.

One of the more important medium-term initiatives urged by the UN Commission is the creation of a global economic co-ordinating council, which would not only co-ordinate economic policy, but would also assess impending problems and institutional gaps. As the downturn deepens, several countries may, for example, face bankruptcy. But we still do not have an adequate framework for dealing with such problems.

And the US dollar reserve-currency system – the backbone of the current global financial system – is fraying. China has expressed concerns, and the head of its central bank has joined the UN Commission in calling for a new global reserve system. The UN Commission argues that addressing this old issue – raised more than 75 years ago by Keynes – is essential if we are to have a robust and stable recovery.

Such reforms will not occur overnight. But they will not occur ever unless work on them is begun now.

Joseph Stiglitz is professor of economics at Columbia University.

TARP the Life Insurers? This Is Nuts

If Team Obama ignores this uprising, it has a political tin ear.

While commercial banks of all sizes are increasingly profitable and want to pay back their TARP money, the Treasury Department is now proposing to extend bailout funds to life-insurance companies, most of which are in no danger of failing. And for those that are in danger, surely it’s time for a bankruptcy proceeding instead of more taxpayer money.

We are already on the hook for banks, GM and Chrysler, and lube jobs for guaranteed government-backed GM warranties. And the banks themselves may go to war against an Obama administration that wants to maintain control over the big-bank sector and prevent these financial institutions from paying down TARP. It’s as if Team Obama is saying, “Don’t worry about the taxpayers. Just keep expanding government control over the economy.”

And now comes life insurance. But when will this country stop saving losers and start rewarding winners?

Meanwhile, no one has proven that life-insurance companies constitute true systemic risk to the financial system. No one. This is nothing but a bailout. Actually, it’s a precautionary bailout, since none of these insurers has failed.

Despite the stock market rally and proliferating signs of an economic comeback, a new TARP regime is being prepared in case insurers lose more money in their stock portfolios, or their bond investments, or their residential- and commercial-mortgage purchases. (By the way, corporate bonds -- which are heavily owned by life insurers to pay out retirement contracts -- are rallying big time, with prices rising and yields declining.)

But for those insurers who may lose money on their investments, tough luck. A lot of these insurers own variable annuities, which are retirement products that guarantee minimum returns no matter what happens to the stock market. Most of these products won’t come due for ten years or more. And the break-even point is something like 600 on the S&P 500 index, which is now above 850 and rising.

Not all life insurers would be eligible for bailout funds -- only those that own federally chartered banks or thrifts, like Hartford Financial, Genworth, Prudential, MetLife, and Lincoln National. But a recent Wall Street Journal article indicates that a number of life insurers are doing very well and still have triple-A gilt-edged ratings. These include MassMutual, New York Life, Northwestern Mutual, and TIAA-CREF.

A senior executive at a large Midwestern insurance company e-mailed me to say he’s against an insurance-industry TARP: “Those that are in trouble, including Conseco, Genworth, Phoenix, The Hartford, etc., should go the way of the dodo bird. Imagine some Treasury bureaucrat investing your 401(k) or retirement-plan money, or worse setting prices on your insurance policy.”

A recent Bloomberg accounting of the federal financial-rescue package puts the grand total at $2.5 trillion for taxpayers on the hook. That’s a lot of future debt. And that total does not include the Federal Reserve’s $1.7 trillion, which is about to grow by at least another $1.5 trillion. It’s unclear right now how much money the life insurers might get from TARP. And with members of Congress on recess -- and undoubtedly hearing a mouthful from constituents who are fed up with bailout nation -- it remains to be seen if our elected lawmakers will actually back up the Treasury’s life-insurance bailout.

But is there any limit to this administration’s intentions to interfere and perhaps control large swaths of our economy? And do these life-insurance mavens know what they’re getting into by going on the hook to Congress? And does anybody remember that free-market capitalism is about success and failure?

Just say no to expanded TARP for insurance companies or anybody else. That’s the real message of the homegrown tea-party revolts against bailout nation and the higher taxes, deficits, and debt being used to finance it. Folks are trying to tell Washington on the April 15th tax day that enough is enough. They can’t take it anymore.

More Than Ever, We Need Currency Leadership

In an article from February of 2008, it was questioned whether commodity currencies are actually bolstered when commodities themselves show nominal strength. What was found is that with periods of commodity strength merely a function of dollar weakness, commodity currencies have historically weakened in real terms, while showing relative strength against a greatly debased dollar.

Similarly, it was found that in periods of dollar strength like 1997-2001, commodity currencies didn’t so much move into inflationary territory as become less strong than the dollar. In each instance gold was used as the objective benchmark.

So when gold is factored in today, another scenario reveals itself; albeit similar to those previously mentioned. Dollar strength against other paper currencies is simply masking weakness among them all. Indeed, in the six months from the end of August to the end of February, the dollar has gained against the euro, sterling and Canadian dollar, but when gold is factored in, we find that while gold has risen 14 percent in dollars, it has risen 32 percent in euros, 37 percent in Canadian dollars, and 46 percent measured in pounds.

Bloomberg financial writer Michael Sesit recently damned the dollar with faint praise by suggesting that the greenback is the “Looker” in an “Ugly-Currency Parade.” His assessment was correct. The dollar is wilting and, as has historically been the case, relative currency movements have whitewashed over this reality.

Russian premier Vladimir Putin has lately suggested that the world’s reliance on the dollar is “dangerous”, and he called for an “irreversible switchover” to a system of multiple reserve currencies. Putin doubtless has a point given the dollar’s mismanagement, but the sad fact is that the dollar remains the only currency possessing worldwide stature.

At present the dollar factors into 90 percent of all trades in what is a $3.2 trillion currency market. And nearly two-thirds of the world’s central bank reserves are held in dollars. Furthermore, the dollar remains the go-between currency for the great bulk of cross-border transactions between countries with thinly traded currencies.

So while it might comfort us to think about another country taking on the currency leadership that we’ve abdicated, none can dispute the dollar’s widespread use. Most troubling is what this potentially tells us about the future.

The dollar price of gold has shown its most impressive strength going back to the third week of January, when the confirmation hearings for then Treasury Secretary-designate Tim Geithner were held. After mouthing the familiar line that a “strong dollar is in the national interest,” Geithner later added that “President Obama—backed by the conclusions of a broad range of economists—believes that China is manipulating its currency.”

What’s interesting here is that while all three of George W. Bush’s Treasury secretaries needlessly hectored China about the yuan to the dollar’s detriment, all of them stopped short of formally accusing China of “currency manipulation.” This is important because while sentient minds know all currencies are manipulated, this public accusation communicated to the markets a clear statement that the new administration (like the old one) would prefer a weaker dollar.

That is the case because probably more than any cabinet position, newly nominated Treasury secretaries are coached with great care when it comes to what they’ll say publicly. With the U.S. Treasury the mouthpiece for what is the most important currency in the world, it’s easy to move world markets with ill-expressed or ill-timed statements. Notably, the dollar plummeted one day in 2001 when then Treasury Secretary Paul O’Neill simply suggested that a “strong dollar” meant very little in policy terms.

For the same reason, it’s no surprise that gold jumped $70/ounce within two days of Geithner’s comments about the yuan. Put simply, Geithner would never have uttered such clear words about the yuan’s alleged “manipulation” unless they were meant to announce the Obama administration’s position on the matter. Just as the Bush administration made a weak dollar its implicit policy to the detriment of the president’s popularity, it seems the Obama administration intends to go down the same mistaken path.

Especially as we’re in the midst of a crisis, it would be hard to imagine a worse stance for the Obama administration to take. More than ever the world needs currency leadership, yet Geithner seems eager to abdicate at a time of market peril. Looked at from an historical perspective, it is hoped that Geithner gathers his thoughts and changes his tune.

Back in 1931, with the world economy falling into what is now known as the Great Depression, Britain finally departed from the gold standard. This destabilizing decision, made when the pound was still the world’s reserve currency, had a worldwide impact. As Chase economist Benjamin Anderson observed at the time, after England’s departure from gold, “Fear gripped the world regarding the value of every currency.”

And in much the same way, uncertainty about the dollar at the moment has led to a run on non-dollar currencies worldwide. The price of gold has been the big winner amid broad currency declines, and as its rise foretells a further flight to real goods, this bodes ill for economic growth here and elsewhere. That is so because if the “credit crunch” is as dire as is presumed, capital will become even more scarce as money flows into tangible items, rather than the entrepreneurial economy.

Looking ahead, we can only hope that Barack Obama’s economic brain trust, one that includes former Fed Chairman Paul Volcker, will set the Obama Treasury on a surer path. As history has regularly made clear, the words of the Treasury secretary matter a great deal. It’s essential that Secretary Geithner reverse course and talk up the dollar in such a way that confidence grows among investors with regard to all currencies.

If not, and the dollar’s continued decline is ignored due to its illusory strength versus other paper currencies, it’s fair to say that world inflation has the potential to get much worse. To quote Anderson yet again, when currency values are uncertain, there “is no worse fear than this, from the standpoint of economic functioning.”

Right now currencies aren’t functioning properly, and as they are the lubricant for all economic activity, it’s essential that a renewed trust is developed in each. More than anyone, this is a job for Treasury Secretary Geithner. What’s still unknown is if he’s equal to the task.


April 15, 2009

Politicians Love the Tax Code We Hate

The second conversation, however, doesn’t seem so controversial. Nearly everyone agrees that our tax system is too complicated for just about all filers. And yet, ironically, Washington is far more likely to pass legislation that either raises or lowers tax rates than it is to do anything to make our system less complex. Why? Because legislators of all stripes like the code the way they now use it. They have turned it into an agent of cultural change which they employ to make political promises and payoffs, in the process making simplification unattractive to them and the tax code ever more painful to us.

About the complexity of the code there is little debate. In a recent Wall Street Journal opinion piece Nina Olson, the IRS’s taxpayer advocate, noted that 80 percent of all filers now require some help, either using paid tax preparers or software, to complete their forms, and as a country we spend (waste) an extraordinary 7.6 billion hours on tax compliance, which now costs us nearly $200 billion annually. So complex is the system that it’s becoming increasingly difficult to judge whether inaccuracies on forms are intentional efforts to cheat or legitimate errors. Even the percentage of forms signed by paid preparers which have mistakes on them is growing rapidly, something that should be a source of embarrassment and concern to the profession.

What’s worse is that we’re going in the opposite direction from the rest of the world. A survey of the 30 member nations of the Organisation for Economic Co-Operation and Development found that most enacted some type of simplification of their tax systems in the current decade. We haven’t simplified ours in 23 years. That’s one reason why another study ranked the U.S. as 122nd in tax complexity out of 175 nations.

Most countries opt for simplification by flattening out their tax code, that is, by reducing the number of tax rates and eliminating most, if not all deductions and credits, so that it’s much easier to figure out your taxable income. Reforms of this sort also involve lowering tax rates because the new code exposes much more income to taxation.

Why does the U.S. continue to go in the opposite direction and make our code ever more complex? Because it is through deductions and credits that legislators manipulate the system. When you hear a politician touting a cause these days--whether it is making us more energy efficient, getting more kids to go to college, expanding educational opportunities in inner cities, or increasing home ownership--you can assume he intends to pursue his cause at least in part through changes in our tax code.

Credits and deductions are also a way for office holders to pay back the always-growing number of rent-seekers in Washington, from lobbyists to advocacy groups, by crafting adjustments in the tax code favorable to their industry or constituency. That’s one reason for the 3,125 changes in the tax code since 2001, an average of more than one a day. Imagine what a loss most politicians would be at on the campaign trail or in K Street meetings with lobbyists if we had a tax code that didn’t permit deductions and credits.

It’s only going to get worse in the near-term. The first Obama budget makes a series of adjustments to the code that the administration claims will make our system fairer, but at the price of even more complexity. Nothing is more illustrative of the problem than Obama’s proposal to reduce the value of the deduction for charitable contributions made by those in the top tax bracket, whom the administration argues benefit disproportionately from their giving. To do this the government must add yet another calculation to the process of determining a tax bill which treats charitable donations at a different rate from a filer’s other deductions. If something as benign as charitable donations get this treatment, you can be sure that many other deductions will soon be similarly indexed. The potential for slicing and dicing the system when you think this way is never ending, so that soon every deduction may have its own rate schedule.

Ironically, this approach makes the tax system more inequitable, not less. That’s because the cost of increasing complexity falls heaviest on the lowest-income filers. A 2001 study by the Tax Foundation estimated that individuals who earn under $20,000 annually spend the largest percentage of their income on preparation and compliance of any group—an average of 4% at the time of the study.

Another problem with complexity is the cost of unintended consequences in a system where change is so common. Exhibit A is the Alternative Minimum Tax, enacted in 1969 to target 155 high-income filers whom news reports said were benefiting from huge deductions. The original AMT raised just $122 million in income (the equivalent of $671 million today) by capping the value of certain deductions, according to the Tax Policy Center. But because the AMT was not indexed to inflation and has progressively applied to more and more taxpayers, some 3.8 million filers now must pay it, to the tune of $30 billion. In two years, that sum is projected to rise to $100 billion. The AMT has grown so large that Washington can no longer afford simply to repeal it, even though it was never designed to operate as it now does.

Faced with this mess, we can derive many benefits from simplification: It would produce savings for most Americans without an actual tax cut. The largest gains would accrue to lower-income filers. Simplification would cut down on mistakes by filers and make IRS audits much simpler.

There’s only one reason not to change the system. The pols love it.

Reshaping the U.S. Regulatory System

Today’s regime, which developed piecemeal, was created for a world that barely resembled the financial environment we inhabit. It makes sense to step away and revisit the regulatory bodies. Many of the agencies that still oversee banks and investment firms date back in history. For example, the Office of the Comptroller of the Currency (OCC), which supervises commercial banks, was set up in 1863, during the Civil War; the Federal Reserve was established as the central bank in 1913; the Federal Deposit Insurance Corporation (FDIC) was created to insure depositors’ account in 1933, during the Great Depression; and the Securities and Exchange Commission was founded the following year to protect investors. It is no wonder that many firms have cropped up subsequently, which no longer fit the original concepts behind the licenses and charters.

At the same time, gaping holes were left. Egregious examples, such as the subprime lenders, or AIG’s credit default swap business, became visible last year. The seeds were, in fact, sown many years ago during the free market heyday of the 1990s and before. The Commodity Futures Modernization Act of 2000 carved out an exemption for over-the-counter derivatives (see graph, p20), and left them unsupervised by the CFTC, then considered to be the most obvious and appropriate regulator for those products.

Ben Bernanke, the chairman of the Federal Reserve, has called for a “macroprudential” approach, to regulate on a more holistic basis. That, presumably, would encompass off-balance sheet entities, which currently make a mockery of prudential practices. Moreover, “non-banks”, such as financing companies, also slip through the net. David Brown, an attorney with Alston & Bird in Washington DC, points to the hedge funds, affiliated through partnerships with major investment banks, such as Bear Stearns. “They shared liabilities, so when the hedge funds got into trouble, the banks had to bail them out,” says Brown.

In a global network, cross border banking poses tough challenges. But even on a domestic level, interconnectedness proved viral in the complex mechanisms. Counterparty risks, it turned out, tied far flung entities together and exposed them to chain reactions. As Lehman failed, and AIG tottered, markets recognised the need to support those institutions consider­ed systemically significant. The buzz is no longer “too big to fail”, but, rather too intertwined.

In an interlocking world, how should we recognise which organisations are truly pivotal? Geithner has laid out a preliminary set of characteristics that may define whether a firm is systemically important. Features, he said, may include the following: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding and its role as a source of credit and liquidity for households, businesses and governments.

There has still not been much discussion about how to improve and empower regulators. This might entail some straightforward reforms, such as equalising pay scales for attracting and retaining talented staff. Henry Paulson, a former Treasury Secretary, has urged that the entire regulatory architecture be “modernised.” He has drawn attention to the uneven capabilities and jockeying among agencies, which blights the current framework, on top of the jurisdictional gaps.

Among structural solutions, a favoured suggested is the creation of an űberregulator with authority to preside over the whole system.

Even a year ago last March, before the full impact of the credit storm hit, Paulson’s Treasury was proposing a Blueprint for a Modern Financial Regulatory Framework. The Treasury then contemplated an optimal division of authority among three primary regulators: one to maintain regulatory stability across the financial spectrum, one to ensure the soundness of banking institutions, and one to protect consumers and investors.

A year later, Bernanke has been calling again for Congress “to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential risks”.

So who should this overarching ombudsman be? Should it be a new organisation, similar to Britain’s Financial Services Authority? Or should it be an existing regulator, in which case most eyes turn to the Fed? “The central bank would be the logical solution,” says Carol Beaumier, executive vice president of global industry programs at Protiviti, a consultancy firm. “Already, it has been creative in its approach to controlling the shots. What’s more, it has a history of stepping up and taking a leadership role, going back to crises such as Long-Term Capital Management.”

Politicians are debating whether the Fed should get the job. Barney Frank, who is the powerful chairman of the House of Representatives Financial Services committee, would like to see that happen. However, his Senate counterpart, Chris Dodd, has been more cautious about vouchsafing the Fed added powers that might compromise its vital function of monetary independence.

“In any political structure, there will be compromises, but the goal remains a unified system that will allow regulators to see across multiple lines of business, in whomever’s kingdom they belong,” says Scott Mosley, owner of independent investment firm Mosley, in Madison, Wisconsin.

Before the dust settles, the new order must address charter shopping. Right now, a jumbled patchwork of agencies holds sway, depending on whether a firm is chartered at a state or federal level, or owned by a holding company. What is worse, the numerous diversified firms look to multiple regulators. Thus, many are supervised by a combination of regulators and can nimbly switch the nature of the components in the firm’s family. “We need a more consistent approach to avoid regulatory arbitrage,” says Beaumier. “If financial institutions are doing the same things, they should be supervised by the same rules.”

There is a logic to having a single regulator for an entire institution, rather than parsing out responsibility according to functions. Until now, firms with diverse activities adroitly seek out the most beneficial oversight. “If I were king,” says George Simon, at attorney at Foley & Lardner, “I’d have a functional regulator to look after the details of an industry, and that in addition to an overall risk regulator. We need to look at what you do, and not just where you put it.”

Insurance, particularly post AIG, has become the elephant in the room as a candidate for streamlining and rationalisation. (AIG, of course, was brought down by an overseas holding company.) The industry is currently regulated separately in 50 states and has “become a crazy beast, applied to consumer, retirement and employer-sponsored benefits markets at the same time,” says Mosley. You might find the same entity managing a variable annuity, a hedge fund, a mutual fund or separate accounts. Although they are wrapped up in different formats, the same activities are involved. Mosley says, “that should be taken away from the 50 states and brought into the SEC.”

It will not be easy to reshuffle along functional lines. Paul Architzel, also an attorney with Alston & Bird, explains how “most of the regulatory agencies have different goals and purposes”. For example, the Fed is invested with central bank duties, and is also a bank regulator. “Throughout its history, the Fed has displayed a schizophrenic attitude to bank lending,” says Architzel. As a regulator, it should want to promote prudence, while, in steering monetary policy, it may want to accelerate lending. At certain times, which hat is it wearing? Or consider how the FDIC is both a prudential regulator and a deposit insurer.

On another front, bank regulators’ approaches differ from that of the SEC. The latter has tended to concentrate on customer protection, whereas bank regulators focus on ensuring the safety and soundness of their institutions and banking system.

First in line as likely candidates for merger are the OCC and the OTS, the Office of Thrift Supervision, which acts as the primary regulator for savings and loan banks, in the thrift (home mortgage) industry. As the number of thrifts dwindles, a consolidation between them has emerged as the easiest path to reduce duplication. Both bureaus are agencies of the Treasury, with the same reporting structure.

“The OCC is typically viewed as a strong regulator,” says Beaumier, who worked as an examiner with the agency for 11 years and also served as an executive assistant to the Comptroller and a member of the OCC’s senior management team. “The advantage,” she adds, “is that the OCC has historically examined the larger institutions and its examiners are used to dealing with problems related to innovative products”. The OTS, on the other hand, supervises savings and loans (such as buildings societies), with their special mission to create housing loans. There is no longer a need, Beaumier argues, for a standalone agency.

The next marriage under frequent discussion is one between the SEC and the Commodities Futures Trading Commission (CFTC). “For years, people have been calling for their unification and all know it is the right thing to do, with huge areas of overlap and fungible products,” says Simon.

Nicolas Morgan, a Los Angeles-based attorney with DLA Piper, gives a hypothetical example. Suppose you were to start a fund called, say, ‘Commodities Trading Fund’ to structure it as a limited partnership and to sell it to 100 investors. On the surface, it sounds like an SEC issue. But what are you doing with the money? Investing in commodities and futures. Suppose you misrepresent your annual return, which agency should be disciplining you? Or why, in another instance, should we have S&P futures regulated by the CFTC, while individual stock futures are under the SEC?

There are, in fact, some valid reasons. Commodities markets, which are primarily driven by professionals, have far fewer investors than those in equities. Although the value of commodities contracts can be substantial, the number of participants is small. The CFTC mandate, historically, has been to protect professionals, preserving free and open markets, less able to be cornered or manipulated. In contrast, the SEC protects multitudes of investors by enforcing corporate disclosure and transparency. Moreover, the two industries exhibit different risk profiles. Futures are more highly leveraged, but mark portfolios to market on a daily basis.

“From a political view, it could be a tall mountain to unify the agencies,” Simon predicts. In the US Congress, the Banking Committee oversees the SEC, while the Agricultural Committee is in charge of the CFTC. “Neither wants to give up jurisdiction, which leads to a stalemate or turf war,” he says.

Despite years of discussion about combining agencies, a merger may be less likely.

The SEC, which is the larger agency, would normally dominate in a merger; its staff numbers about 3,500, versus only 500 at the CFTC. But the SEC is seen as having been ineffectual during the recent crisis and further tainted by the Madoff scandal. The CFTC, however, “can boast of not having taken one dime of public money”, says Brown.

Nevertheless, the CFTC has been on the defensive against charges that it failed to curb excessive speculation in oil and agricultural prices, enabling those sectors to run up to destructive levels during the summer of 2008.

Further, some profound philosophical differences would make a mix more challenging. The CFTC takes a more principles-based approach, akin to the FSA. The SEC leans toward a more prescriptive style.

Whoever ends up regulating whom, across the board from banks to securities firms, reforms will highlight a similar set of principles.

First, regulators must define prohibited activities. Beaumier muses, “Do you put added restrictions on what those types of firms can do,” she asks, “such as no proprietary activities and more plain vanilla?”

Along with restrictions may come a new roster of obligations, such as enhanced risk management. Consider the case of subprime products. It is only with hindsight we recognise that without understanding the products, purchasers could not manage the risks.

David Thetford, a consultant at Walters Kluwer Financial Services, envisions a new, required role of chief risk manager. It will be enforced, he predicts, just as that of chief compliance officer became mandatory for investment advisers a decade ago.

The main issue, however, looks to be capital adequacy. Here, the debate centers on pro-cyclicality. The current rules, derived from accounting principles, discourages banks from setting aside extra reserves during profitable periods, as a buffer to tide them over for a rainy day. The tension is that accounting rules have been designed to prevent featherbedding and stuffing the cookie jar. “But what is appropriate for accounting may not necessarily be so for the economy,” Brown points out. Now, capital adequacy demands are compelling banks to plump up their capital cushions, just when they have been taking massive hits.

In a speech on March 2, John Dugan, Comptroller of the Currency, told the Institute of International Bankers that, “loan loss provisioning has become pro-cyclical, magnifying the impact of the downturn”. While urging his audience to ask some “hard questions” about provisioning, Dugan described how the ratio of loan loss reserves to total loans went down rather than up, during the booming part of the economic cycle. “Perversely”, he added, “even though there was a broad recognition that the cycle would soon have to turn negative.”

How could a more counter cyclical effect be achieved? New bank debt might convert into equity capital, automatically in the event of deteriorating financial ratios; or gov­ern­ment could intervene as a response to a downturn. The same impetus should operate in reverse, suggests Haag Sherman, chief investment officer at Salient Partners in Houston. “People would scream, but whenever we see credit begin to expand, the logical reaction should be to raise capital requirements,” he says. Sherman reflects that European banks, in particular, have been following the opposite course in recent months. “They are making a push to increase capital requirements, just when that should be pushed into the future.”

Another key principle may be a push toward more prescriptive, even formulaic requirements. There may be more scrutiny of underlying assumptions used in financial models; not to say that the models will be abandoned, but that assumptions must be shown to be sensible and not just algorithms. “In my early days as an examiner in the late 1970s, we looked at unique institutional circumstances and moved away from formulas,” says Beaumier. “Now we see a tendency to return to hard and fast rules. Human nature almost demands that, after a crisis, we want to be more prescriptive.”

All these reforms could strengthen and reinforce the American regulatory framework. All the same, in a world economy, prohibited activities do not work. That was one of the limitations of the 1933 Glass-Steagall legislation, which separated investment and commercial operations in America. Decades later, in Europe and elsewhere, banks were thriving under a universal model.

The more promising approach, Simon urges, is to “assess the risk and force companies to hold reserves.” The alternative is to act like an ostrich, by ignoring off-balance sheet risks and letting firms bury them out of sight. In other words, we must look at each company holistically. Then, and only then, will today’s crisis lead to the foundations for an improved system.


April 16, 2009

Recovery's Coming

In fact, virtually all the data now out show either a bottoming or slight upturn in activity. As the year goes on, that will gather steam.

Even banks, which we've been told hold the key to our future prosperity, are doing much, much better. Wells Fargo and Goldman Sachs both reported record earnings in the last two weeks.

The data being called "grim" or "troubling" — like Wednesday's report that industrial output shrank 1.5% and year-over-year consumer prices fell for the first time since 1955 — actually show improvement, not deterioration.

fuelforthefuture.pngTake industrial output. It fell largely because businesses late last year panicked. They cut output to slash inventories, getting lean and mean. As a rebound comes, even a mild one, they'll ramp up fast to meet demand.

Or take consumer prices. Deflation is a scary thing. But March's drop in prices reflects the dramatic plunge in oil since last year — which will act like a giant tax cut this year, boosting consumption.

A flood of freshly printed money makes a rebound all but inevitable. The Fed has cut rates to zero. As the chart shows, M2 money supply is rising at close to a 10% rate now. Going back to WWII, a 10% rate of money growth has always led to economic growth.

Then there's the Fed's own best predictor, the spread between 10-year Treasuries and 3-month T-bills. At a current 2.65%, that spread shows virtually no chance of recession by year end.

Add to this the fact that U.S. stock markets have added nearly $2 trillion in value since bottoming on March 9. As investment adviser Barton Biggs noted last week, "there have been 40 upticks in key indicators of economic activity around the world."

So the recovery is coming, ready or not. It's just a matter of timing. Even the Fed's own beige book survey of economic activity, also out Wednesday, saw signs of "stabilization."

We shouldn't be stampeded by fearmongers into passing more foolish and unnecessary "stimulus" and spending packages that will saddle future generations with trillions in unneeded debt.

Choose Tax Cuts for Economic Recovery

It includes income tax hikes for upper-income Americans and increases in prices of energy-intensive products, increases to be paid by all consumers.

Fair Warning: tax increases would prolong the recession and discourage employers from hiring. This was shown by Mr. Obama’s chair of the Council of Economic Advisers, Christina Romer, in a paper coauthored with her husband David Romer last November when both were professors of economics at the University of California at Berkeley.

Yet Mr. Obama has proposed new limits on carbon emissions, known as “cap-and-trade.” This is projected to raise $646 billion in revenue over the next 10 years, a significant tax increase that would impose a drag on the American economy. Manufacturers and utilities would receive an allocation of permits to emit carbon (the “cap”), and would have to purchase additional permits from other firms or the government, or pay penalties for noncompliance, if their emissions exceeded their permitted cap (the “trade”).

In addition, Mr. Obama would have the two top income tax rates rise, from 33% to 36%, and from 35% to 40% in 2011. That would affect singles making more than $172,000 in taxable income and couples making more than $209,000. And that would be a blow to many unincorporated small businesses.

Upper-income taxpayers would also face limits on their deductions—for example, for charitable gifts and mortgage interest. That would be an additional, thinly-disguised tax increase.

Raising taxes, whether now or in 2011, is exactly the wrong way to help America recover from the recession, because higher taxes cramp economic growth.

The Romers’ paper is entitled “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks.” The innovative feature of the paper is to distinguish between the effects of tax changes arising from legislation and those tax changes that occur automatically, for instance as individuals move into higher tax brackets or stock prices change.

Looking at data from 1947 to 2006, and studying the legislative record behind the tax changes, they conclude that legislated tax changes have far more effect than automatic tax increases. They write, “Our estimates suggest that a tax increase of 1% of GDP reduces output over the next three years by 3%.” A major reason is that higher taxes have a markedly negative effect on investment.

Arizona State University Nobel Prize-winning economist Edward Prescott, looking at tax rates over major industrialized countries, has shown that the higher the levels of taxes, the lower are the hours of work. In highly-taxed France, for example, people on average worked only three-fourths of the American workweek. In the early 1970s, when American taxes were higher, the French worked more than the Americans. Mr. Prescott’s results also hold for countries as diverse as Japan, Chile, and Italy.

Rather than raise taxes, Wisconsin Representative Paul Ryan, ranking Republican on the House Budget Committee, has introduced a bill, H.R. 6110, that would lower all income tax rates and reform the complex tax code by simplifying it, together with spending cuts that halve the 2019 deficits projected by the Obama White House.

People could elect to pay their taxes on a postcard, with only two rates. If they chose the card, couples would pay 10% of their first $100,000 of taxable income, and then 25% on any earnings above that. There would be no itemized deductions, only a refundable credit to help with the purchase of private-sector health insurance. The rate on capital gains and dividends would be 15 percent, and the rate on interest would be zero.

The system would be progressive due to retention of standard deductions and personal exemptions, so that a family of four would start paying tax only after earning $39,000.

Under Mr. Ryan’s proposal, those who prefer the present system, with the 2003 tax rates and complex scheme of deductions, could continue to file as they did this week. In sum, there would be two parallel systems of taxation in place, to minimize the opposition to abandoning one and adopting another. Mr. Ryan would limit the number of times a tax payer could switch between the two systems to minimize gaming the tax code.

The primary objective of Congress and the White House should be to put our economy back on track. That’s why Congress should be debating how to lower taxes and government spending, rather than how to raise them.

Whatever GDP's Path, Don't Expect a Bull Recovery

In much the same way, other commentators see recovery as something around the corner thanks to strong increases in the supply of money. To believe this is to put the proverbial cart before the horse. Money creation is itself not wealth. Instead, money is a concept, and when it’s stable in value, productivity increases. At present there’s no stability in the value of a dollar that remains very weak, so the idea that Nirvana awaits thanks to the creation of more in the way of weak greenbacks seems destructive at best.

On the GDP front, it’s easy to see why some might presume a recovery that won’t be, but that will show up in this most Keynesian of economic measures that presumes real output can be measured within country borders. Indeed, government spending will surely increase this measure of output, but as most intuitively understand, governments cannot create economic growth. More realistically they can rob the economy of growth thanks to taxing and borrowing money from the private sector. No growth will occur, probably the opposite, but unreliable GDP figures will suggest recovery.

Even more problematic when it comes to GDP is the faulty way in which it measures trade. When massive amounts of imports reach our shores, meaning the trade “deficit” is increasing, this is one of the surest signals of economic growth. That’s the case because production and consumption are ultimately identical, and when imports flow our way, that’s a sign that we’re being rewarded for our productivity with more imports. But with our trade deficit at a 9-year low, meaning imports are declining, this unfortunate signal of our wilting productivity will paradoxically add to GDP growth. In short, what so many economists deem “recovery” in fact signals the opposite.

To develop a sense of what economic “recovery” will feel like, it would be best to look back to Jimmy Carter’s presidency. With the dollar regularly testing new lows alongside weak imports and heavy government spending, the U.S. economy experienced under Carter what author William Greider described as “one of the longest and most expansive periods of economic growth in postwar history.” It’s also true that percentage job growth under Carter hit postwar records.

So while job and GDP measures of growth showed expansion under our 39th president, markets saw something entirely different. Not fooled by Keynesian measures of output, investors bid up shares during Carter’s presidency a paltry 24 percent. And in real terms, investors lost a great deal of ground given the inflationary dollar that paradoxically added to GDP growth.

More modernly, job growth under President George W. Bush was similarly impressive, plus he regularly pointed to a 52-month expansion in GDP terms as a way of talking up the economic portion of his presidency. The problem there was that neither the markets nor voters were fooled, just as they weren’t under Carter. The S&P fell 36 percent during Bush’s presidency.

In truth, the dollar was in steady decline throughout his two terms, and as Carter’s term in office proved, GDP statistics can’t whitewash over the economic realities wrought by currency decline that effectively robs voters while retarding economic growth. Notably, the dollar’s debasement was a boon for firms in the energy sector, and it was energy sector health that made the total market look healthier than it actually was.

Indeed, as of last May, when the S&P was 40 percent higher than it is at present, profits within S&P firms were the worst they’d been in a decade. If not for the earnings of ExxonMobil, Chevron and ConocoPhillips, S&P profits would have shown their biggest declines since Bloomberg data analysts began compiling earnings data. By last year the energy sector accounted for 15 percent of the S&P’s total capitalization, and this explains why a relatively high S&P average of 1473 coincided with a great deal of unhappiness among the electorate.

The broader lesson from all this is that stocks do well when the dollar is strong and gold is falling, and they do really well when the dollar is strong and stable. At present the dollar is weak and gyrating, so no matter what the faulty measures of GDP may suggest in the coming quarter, any future recovery is something investors and workers alike should curb their enthusiasm about.

Inflation rarely if ever correlates with strong stock markets, and worse, the chance for a noticeable economic recovery was most likely stolen from us last fall. It was then that the federal government stepped in to block out the very company failures (and resulting unemployment) that if allowed to occur, would have authored a greater recovery. As awful as unemployment and bankruptcy are, both are economically cleansing for allowing debased assets and capital to reach better overseers, all the while creating a happy process whereby healthy firms are able to hire skilled workers on the cheap.

Instead, Congress and both the Bush and Obama administrations foisted bailouts on a country whose voters did not want them. The alleged “security” offered us has shown up in growing government oversight of the banking sector that promises to politicize the latter while giving American citizens a form of economic paralysis.

So while esoteric data may well point to economic recovery beginning in the fall, the reality will likely feel a lot different. In short, we’ll only feel economic recovery through rising market indices and in ways intangible once the toxic asset that is the dollar is strengthened alongside a humble Washington that steps aside and allow markets to work. Absent that, what some deem recovery will be the kind of growth that shows up in government statistics, but that most won’t notice.


YouTubing Rubin, The Economic Godfather

Bottom line: This is a powerful man with an extensive Rolodex. It’s worth understanding how the economic godfather thinks.

Research Edge CEO Keith McCullough and I both attended the presentation with two Yale Law School students. I was undoubtedly the least intelligent (except for maybe Keith) in our group, with very likely the most partisan Republican views. And yet, despite widely varying political beliefs among our four person Rubin lecture watching cohort, we all arrived at the same conclusion: Rubin was radically underwhelming. It is scary to think that not only was he at one point one of the most powerful economic policy makers in the world, but that he still wields significant influence today.

In lieu of actually transcribing his comments, I figured I’d just go ahead and “YouTube” various quotes from his lecture as I recorded them:


Rubin: “No one saw the extreme confluences of events that led to this recession.”

Research Edge: Actually, we went to 96% cash in September 2008 and were hardly alone in this call.

* * *

Rubin: “Everyone missed it.”

Research Edge: Everyone who owned Citigroup stock, or was on their Board, definitely missed it.

* * *

Rubin: “The most important academic experience for my career in finance was my first year class at Harvard in Greek Philosophy.”

Research Edge: Not a lot of quantitative analysis was taught in Greek Philosophy as I recall from my first year Greek philosophy class.

* * *

Rubin: “I do not believe there are bad assets.”

Research Edge: So there are only good assets? What about highly levered banks that ostensibly have no equity value . . . bad assets?

* * *

Rubin: “I called for more regulation on derivatives in my 2003 book.” (He said this about 4x)

Research Edge: What did you DO when you were in those board meetings at Citi?

* * *

Rubin: “There is no risk of any defaults on sovereign debt globally.”

Research Edge: History tells us that sovereign defaults will likely increase dramatically in the coming months.

* * *

Rubin: “A key problem in our Democracy is that our electorate is not informed.”

Research Edge: My mom didn’t go to Harvard, Yale Law School, or work at Goldman Sachs, but I’d consider her very informed. She also does math.

* * *

Rubin: “I ran the whole bloody thing (sales and trading) at Goldman Sachs, so I think I understand a thing or two about markets.”

Research Edge: I guess experience at Goldman makes any opinion valid.

* * *

Rubin: “Psychology changes (and thus markets) move for no reason.”

Research Edge: This is an interesting comment for a guy that ran sales and trading at Goldman for so long.

* * *

Rubin: “I think there is something in human nature that causes euphoria in markets.”

Research Edge: Gee, thanks Ruby.

* * *

Rubin: “The criticisms of the Clinton years major economic policies, repealing of Glass-Steagall, lack of regulation of derivatives, and the creation of the CRA, as contributing factors to this crisis are unwarranted.”

Research Edge: We don’t necessarily blame Rubin or Clinton, but certainly they are far from blameless. A little accountability could be a start.

* * *

Rubin: “That little group (referring to President Obama’s Economic Recovery Advisory Board) is having good meetings.”

Research Edge: This “little group” includes Paul Volcker, David Swenson, Bill Donaldson, and John Doer, to name a few.

* * *
Parting thoughts. Arrogance is scary in its own right. But it can be downright dangerous when it is a defining characteristic of a person possessing real influence. Perhaps Mark Twain summed it up best when he said: “The offspring of riches: pride, vanity, ostentation, arrogance, tyranny.” The minute any of us believes that our resume, wealth, position or power makes us impervious to criticism is a dangerous time indeed. Especially when that person is as powerful as Mr. Rubin.

Continue reading "YouTubing Rubin, The Economic Godfather" »

April 20, 2009

Our Great Depression Obsession

Anyone who wants to know why should read this engrossing book. Ahamed, a professional money manager, attributes the Depression to two central causes: the misguided restoration of the gold standard in the 1920s and the massive inter-governmental debts, including German reparations, resulting from World War I.

His story builds on the scholarship of economists Milton Friedman, Anna Schwartz, Charles Kindleberger, Barry Eichengreen and Peter Temin. But Ahamed excels in evoking the political and personal forces that led to disaster. His title refers to four men deeply implicated in the era's perverse policies: Montagu Norman, governor of the Bank of England; Benjamin Strong, head of the New York Federal Reserve Bank; Émile Moreau, head of the Banque de France; and Hjalmar Schacht, head of Germany's Reichsbank. Their determination to reinstate the gold standard -- seen as necessary for global prosperity -- brought ruin.

Under the gold standard, paper money was backed by gold reserves. If gold flowed into a country (normally from a trade surplus or a foreign loan), its money and credit supply were supposed to expand. If gold flowed out, money and credit were supposed to contract. During World War I, Europe's governments suspended the gold standard. They financed the war with paper money and loans from America. The appeal of restoring the gold standard was that it would instill confidence by making paper money trustworthy.

Unfortunately, the war damaged the system beyond repair. Britain, the key country, was left with only 7.5 percent of the world's gold reserves in 1925. Together, the United States and France held more than half the world's gold. The war had expanded U.S. reserves, and when France returned to gold, it did so with an undervalued exchange rate that boosted exports and gold reserves. Meanwhile, German reparations to Britain and France were massive, while those countries owed huge amounts to the United States. The global financial system was so debt-laden that it "cracked at the first pressure," writes Ahamed.

That came after a rise in American interest rates in 1928 forced other countries to follow (no one wanted to lose gold by having investors shift funds elsewhere) and ultimately led to the 1929 stock market crash. As economies weakened, debts went into default. Bank panics ensued. Credit and industrial production declined. Unemployment rose. Weakness fed on weakness.

Sadly, this tragedy has modern parallels. Like the 1930s, a worldwide credit collapse is a danger. Global stock, bond and bank markets are interwoven. Losses in one may prompt pullbacks in others. Money flowing to 28 "emerging market" countries in 2009 will drop 80 percent from 2007 levels, projects the Institute of International Finance. Currency misalignments have, as in the 1920s, distorted trade. China's renminbi is clearly undervalued.

Still, striking differences separate now from then. The biggest is that governments -- unencumbered by the gold standard -- have eased credit, propped up financial institutions and increased spending to arrest an economic free fall. The Federal Reserve and the International Monetary Fund have made loans available to emerging-market countries to offset the loss of private credit. Nor is there anything like the international rancor that followed World War I and impeded cooperation: In 1931, the French balked at rescuing Austria's biggest bank (Creditanstalt), whose failure triggered a chain reaction of European panics.

When countries left the gold standard -- the United States effectively did so in 1933 -- their economies began to recover. Some indicators now imply that the present decline is ebbing ("glimmers of hope," says President Obama). China shows similar signs of improvement. All this diminishes the dreary comparisons with the Depression. But if these omens prove false, a more somber conclusion could emerge.

The mistakes of the Depression were rooted in prevailing economic orthodoxies, which had been overtaken by new realities. The present policies likewise reflect today's orthodoxies. But what if they, too, turn out to be misguided because the world has moved on in ways that become obvious mostly in retrospect?

Political Opportunists vs. Technology Innovators

Does the media-pundit complex give a hoot that startups that survive infancy can no longer exchange their venture investments for the broader pools of capital found in public markets, allowing risk dollars to be recycled?

Venture Capital investment in this country is spiraling down just when we need it most, hitting an eleven year low. How will the unemployed ever be put back to work if fresh new companies can't rise to replace dead old ones? Where is the next Apple, Microsoft, Dell, or Google supposed to come from if today’s young Steve Jobs, Bill Gates, Michael Dell, or Sergey Brin can’t get their unorthodox ideas financed? We’d better think about this if we’re counting on growth rather than inflation to retire those ballooning deficits we’re racking up.

Maybe I missed the vote where Congress was declared the Solver of All Great Problems. Now that they’ve done such a great job handling the banking crisis, they’re getting ready to “invest” unlimited mountains of taxpayer money in almost every key field that is supposed to drive our innovation economy. That would be a pretty hilarious proposition if it weren’t so frightening.

Has one Congressman in a hundred, regardless of party, ever actually started and run a business? How many do you think have engineering or science degrees, or served as product managers for a new launch? Have they ever done serious due diligence on an emerging technology to figure out whether it's remotely feasible, much less economically viable? Is a single one of them putting a penny of their own money at risk alongside the billions they’re gambling with?

Clean energy, electronic health records, broadband connectivity, fuel efficient cars, bullet trains, a cure for cancer – have career politicians really convinced us that they can legislate these goodies into existence? Who do they think is going to show up in Washington to collect the handouts nominally earmarked for this growing list of pet projects? Which would you guess – lobbyist laden megacorporations who can point at the hundreds of people they employ in the congressional districts of key committee chairmen or some geek who just graduated from MIT or Stanford that may have solved a holy grail physics problem but has no idea how to bundle campaign donations?

Modern day carpet baggers are gearing up for flush times. But what will become of classic market entrepreneurs when they’re boxed out of the beltway then starved of start-up dollars after what’s left of the Venture Capital community has been squeezed dry between Sarbanes Ox-gored IPO markets and punitive tax policies obsessed with gutting the rewards of success?

Shame on the Wall Street casino culture for bringing the wrath of know-nothing populism down upon us all. But please don't paint our business or the entrepreneurs we back with the same brush. We're not in it for the bonuses, we're in it for a share of the capital gains we create. We spend our days building real companies, not flimsy transaction pyramids. My partners are engineers, not finance alchemists. We live with the companies we back for seven, eight, nine years helping entrepreneurs iron the bugs out of their businesses, we don't package them into opaque securities so fast-talking snake oil salesmen can shuffle them out the door before they implode.

While stimulus dollars may create the illusion of recovery by constructing field-of-dreams demonstration projects that can’t hope to pay their own way, what are we going to do when the subsidies inevitably run out? One look at Federal ethanol policy- a cascading economic and environmental fiasco – tells the story of where we are headed if we let Congress play Venture Capitalist with our money. Perhaps we should catch our breath after the banking crisis moves off the front page before we plunge into a publicly financed malinvestment binge driven by clueless barking heads who can’t see pass the next election.

Continue reading "Political Opportunists vs. Technology Innovators" »

April 21, 2009

Save the Whales, Kill the Economy

The plan was vacated, the panel ruled, because of allegedly insufficient environmental review because its "environmental sensitivity rankings are irrational."

What is irrational is that despite a more than three-decade long record of environmental sensitivity at Prudhoe Bay and elsewhere, and despite booming polar bear, caribou and fish populations, the fiction that oil exploration and environmental protection are somehow incompatible and will decimate Arctic wildlife remains enshrined in law.

The Bush administration had started the process of auctioning off leases in the Chukchi and Beaufort Seas, Cook Inlet and in the North Aleutian basin. Shell Oil, which spent more than $2 billion to acquire some of the leases, and its partner ConocoPhillips had planned to start drilling in the Chukchi Sea in 2010.

The stakes are enormous. Alaska's Outer Continental Shelf by itself may hold 27 billion barrels of oil and 132 trillion cubic feet of clean-burning natural gas.

That oil is important in its own right, but as Alaska Gov. Sarah Palin told Interior Secretary Ken Salazar when he visited Anchorage, without it the Alaskan pipeline may have to shut down due to reduced flow.

The trans-Alaska oil pipeline now carries only a third of the 2 million barrels a day it carried from Prudhoe Bay and Alaska's North Slope in 1988. "Once the pipeline shuts down, it will mean the end of oil production from the North Slope," Palin said. Trans-Alaska oil pipeline throughput is slipping by about 7% per year.

Alaska's economy is over 80% dependent on oil activity. Aside from keeping the pipeline open, a recent study predicted that OCS activity in the Beaufort and Chukchi seas could produce around 35,000 jobs.

Environmental groups argue drilling would interrupt whale migration, affect native peoples who hunt to live, risk oil spills devastating to the local ecosystem and further threaten polar bear populations already threatened by climate change and melting Arctic ice.

Each year millions of square miles of sea ice melt and refreeze. The amounts vary from season to season. Despite pictures of floating polar bears taken in summer, data reported by the University of Illinois' Arctic Climate Research Center show global sea ice levels the same as they were in 1979 when satellite observations began.

As for the polar bears, they're doing fine. Dr. Mitch Taylor, a Canadian polar bear expert, notes they evolved from grizzly bears about 250,000 years ago and developed as a distinct species about 125,000 years ago when natural climate change occurred. He recently put the population currently at around 24,000, up 40% since 1974.

Similar arguments were made when Prudhoe Bay opened in the 1970s. It would hurt all manner of critters, we were warned. Except it didn't.

The caribou herds have thrived. Oil platforms offshore have in effect become condos for fish and all forms of marine life. This argument is currently being used to block development in the frozen tundra of ANWR.

Writing recently in Foreign Affairs, Scott Borgerson, an international affairs fellow at the Council on Foreign Relations, noted: "The U.S. Geological Survey (USGS) and the Norwegian company StatoilHydro estimate that the Arctic holds as much as one-quarter of the world's remaining undiscovered oil and gas deposits."

A recent study by the American Energy Alliance found that developing all our offshore oil resources, including Alaska's, would in coming years add $8.2 trillion in additional GDP, generate $2.2 trillion in total new state and federal tax revenues, create 1.2 million new jobs at high wages, and provide $70 billion in added wages to the economy each year.

But it looks like we're going to have a whale of a time getting it.

April 22, 2009

Public Pension Funds Become Political Playthings

The abuse in Hevesi’s office is symptomatic of a growing problem as public employee pension funds housing trillions of dollars in assets become political toys under the control of elected officials or politically appointed boards. The New York AG is making the case that Hevesi’s operatives crossed the line into blatant, illegal pay-for-play. Other cases in Ohio, Illinois and California have similarly focused on kickbacks and extortion among trustees of public pension funds.

But even in instances where there has been no overtly illegal activity, fund trustees have used these public sector assets for troubling political and personal advantage. Their actions represent an abandoning by the trustees of their fiduciary duty to public employees and to taxpayers, who are ultimately responsible for the cost of pensions if the funds face shortfalls because of mismanagement.

Public pension funds have long been subject to political uses, going back to disinvestment by some funds in companies that did business in South Africa during apartheid. These days, however, the investment decisions of pension overseers are a lot more self-interested, with nothing as grand as defeating apartheid as their aim.

In 2003, for instance, the board of advisors of the California’s Public Employees’ Retirement and State Teachers’ Retirement Systems (Calpers), a group composed of state public sector union officials, voted to reduce holdings in companies that run operations for local governments because public officials were turning to these companies during the recession to reduce spending. One could argue that investing in such businesses, not dumping their shares, during a recession makes lots of sense, but Calpers’ decision was motivated by a desire to pressure these businesses and drive down their shares at a time when local governments were looking for ways to outsource work.

Similarly, New York City’s public sector pension fund, whose trustees include two elected officials, stopped making investments several years ago in firms specializing in privatization services because these firms potentially eliminate public sector jobs by allowing governments to outsource work. Thus the fund, composed of taxpayer dollars, was actively working against taxpayers, who benefit when governments reduce costs.

To justify their machinations with public money, trustees often resort to a tortured logic of the marketplace. Back in 2004, for instance, Hevesi used the state pension fund’s holdings in Sinclair Broadcast Group to threaten the company as it was about to broadcast a documentary critical of Democratic presidential nominee John Kerry. Hevesi, a Democrat, claimed that Sinclair’s plans to air the documentary would undermine the value of the company’s stock because advertisers might boycott the program. A political science professor who had spent most of his life in public office, Hevesi had apparently quickly become an expert on the bottom line of the broadcasting industry once the presidential nominee in his party faced unfavorable coverage from Sinclair.

As pension funds become politicized, they have emerged as a convenient way for trustees to reward allies and campaign contributors. After reform legislation in 1995 made it more difficult for trial lawyers to file so-called ‘strike’ lawsuits against a corporation when its share price declines, public pension trustees cordially stepped into the game and started partnering with the class-action firms as lead plaintiffs in new rounds of lawsuits. Milberg Weiss, a firm which eventually went out of business after several former partners pled guilty to paying kickbacks, was especially active with its contributions in New York and California. It poured $137,000 into Hevesi’s campaign for New York State comptroller and later represented the state pension fund in a big lawsuit against pharmaceutical giant Bayer.

Nor was Hevesi the only abuser. Louisiana’s teachers pension fund was a serial litigant against big corporations, prompting a federal judge to brand the fund a “professional plaintiff” in one ruling denying it class action status.

Over time it becomes difficult to determine whose interests are being served in such cases—taxpayers and employees, or the officeholders and trial lawyers. Under Hevesi, for instance, New York took the lead in filing third-party lawsuits against financial firms like Citigroup that did business with Enron or WorldCom, claiming the financiers enabled corporate malfeasance. The litigation raised eyebrows because at the time New York was a major shareholder in several big financial firms, with a $1 billion stake in Citicorp, for instance. In the end, this third party litigation cost New York more than it earned because the settlements against the firms hammered the price of stocks that the pension fund owned. But the trial lawyers, who had contributed $121,800 to Hevesi’s campaign, did quite well, earning tens of millions of dollars in fees.

Trustees run few risks in such cases because most state constitutions guarantee employee pensions. That means taxpayers will make up any shortfall in investment returns when trustees let political or personal considerations dominate their investment decisions.

There’s no easy solution to this problem because the size of the public sector pension pot is enormous and the money is tempting. Some states have gone to boards rather than sole trustees, but boards can become politicized too, as the infamous (and infamously ineffective) Calpers has demonstrated.

The ultimate solution is to put the investment decisions of public workers in the hands of investment managers selected by the workers themselves, through decentralized 401k-style plans. In such a system, public trustees can only influence the selection of a menu of investment advisers—mutual fund companies, index-fund managers and the like—to serve workers, who would retain individual control over their investments. Such accounts can be designed with limits on risky investments, providing employees with a menu of investment options that made it impossible for workers to place too much of their retirement money in speculative assets, but nonetheless keeps the money in workers’ hands, not trustees.

When California Gov. Arnold Schwarzenegger proposed just such a change several years ago, officials at Calpers brought public pension fund managers together from around the country to wage a ‘national movement’ against the governor. A Calper’s official called the governor’s plan, “part of a concerted effort to break apart the powerful voices of public pension funds." That tells you exactly what these trustees think of public pensions. To them, this is not workers’ money, but leverage that trustees can use for their political causes and ambitions. Nothing will change until we take that leverage out of their hands.

The Folly of 'Green' Job Creation

Or is it the case perhaps that this problem is to be taken as an opportunity for even greater gains in employment? This might be achieved if, in all those times when the wind does not blow or the sun does not shine, human beings are employed in rotating copper-clad generator shafts, in a manner similar to that of rotating a grindstone in a gristmill, only in the presence of surrounding magnets, so that electricity can be produced by the rotation. (I don’t know how much, if any, electricity might actually be produced in this way. But it would keep people employed in the attempt.)

Indeed, if we’re realistic, environmentalism is capable of creating a virtually limitless number of jobs. Big-rig trucks and their “polluting” emissions might be done away with by replacing them with human porters who would carry freight on their backs. Ocean-going ships and their emissions might be done away with by replacing their “dirty engines” with the clean labor of banks of oarsmen. (Sails would be a substitute too, but they are no match for oarsmen when it comes to the number of workers needed.) Automobiles and their emissions might be replaced by sedan chairs and teams of litter bearers.

And if all that is not enough, then think of the jobs that might be created in making coal in the ground absolutely safe. At present there are outcries over the release of trace amounts of mercury, arsenic, and other heavy metals from above-ground accumulations of coal sludge. Yet these metals are found in nature-given, below-ground deposits of coal as well, and could not appear in coal sludge if they had not first been present in below-ground coal. While perhaps a smaller threat to human health so long as they are locked in below-ground coal, they must undoubtedly represent some threat, if only at the level of parts per billion or parts per trillion.

Since one can never be too safe, it follows that if job creation is the goal, a green case can be made for extracting all known coal deposits and then, instead of using any of that coal for such environmentally “destructive” purposes as producing electricity or heating homes, simply reburying it. But this time in repositories lined so as to prevent any possible leakage of heavy metals into the surrounding environment.

And finally, think of all of the jobs that a program of environmental “stewardship” might make available. Thus each patch of desert, each rock formation, each clump of grass, and each tree stump, might have assigned to it one or more “stewards” whose job would be to watch over it, protect it, and “preserve it for future generations.” To carry out this valuable work, there could be a whole corps of “stewards.” They could be dressed in special uniforms displaying various ranks and medals, all gained in “service to the environment” and the defense of nature and its resources from the humans.

Indeed, once we put our minds to it, nothing is easier than to think of things that would require the performance of virtually unlimited labor in order to accomplish virtually zero result. Such is the nature of all job-creation programs. Such is the nature of environmentalism. Such is thought to be the path to economic recovery by most of today’s intellectual establishment.

The Death of Democratic Capitalism?

So while some investors believe Tim Geithner backed away from the prospect of government-controlled banks, it’s really not clear that he did so.

The issue at hand is the possible conversion of the TARP money now held by banks in the form of non-voting preferred stock into common stock with full voting rights. White House and Treasury officials have spoken of this possibility in recent days, and it plainly raises the issue of government ownership and backdoor nationalization of the banks -- or at least the major banks.

To wit, Goldman Sachs and JPMorgan look to be recovering their health. They want to de-TARP, and perhaps Geithner will let them. But if he doesn’t, these institutions might be forced to convert their preferred TARP shares into common stock, thereby giving Team Obama tremendous sway over their operations. As for the less-healthy big banks, one suspects the government will increase its 36 percent ownership in Citigroup and take a new ownership position in Bank of America.

The results of the government’s economic “stress tests” -- due early next month -- will complicate these calculations. And at the end of the day I think Team Obama will interpret the stress tests in whatever manner serves its larger purpose, which I suspect is backdoor nationalization.

Just to confuse matters more, the congressional strings attached to TARP might not only apply to the banks, but could apply to participants in TALF and PPIP -- the new government-lending programs designed to detoxify bank balance sheets. I don’t know this is the case, but it could well be the case.

This is why most private investors have stayed away from the two early TALF auctions. And JPMorgan CEO Jamie Dimon says his bank won’t play in PPIP because “we’ve learned our lesson.” He calls TARP a “scarlet letter.” But what he’s really saying as America’s leading banker is that he doesn’t want his bank or shareholders to be run by the government.

An old friend e-mailed me this week about how to characterize Obama’s economic interventions into the banking and auto sectors (with health care next on the list). He says it’s not really socialism. Nor is it fascism. He suggests its state capitalism. But I think of it more as corporate capitalism. Or even crony capitalism, as Cato’s Dan Mitchell puts it.

It’s not socialism because the government won’t actually own the means of production. It’s not fascism because America is a democracy, not a dictatorship, and Obama’s program doesn’t reach way down through all the sectors, but merely seeks to control certain troubled areas. And in the Obama model, it would appear there’s virtually no room for business failure. So the state props up distressed segments of the economy in some sort of 21st-century copy-cat version of Western Europe’s old social-market economy.

So call it corporate capitalism or state capitalism or government-directed capitalism. But it still represents a huge change from the American economic tradition. It’s a far cry from the free-market principles that governed the three-decade-long Reagan expansion, which now seems in jeopardy. And with cap-and-trade looming, this corporate capitalism will only grow more intense.

This is all very disturbing. For three decades supply-siders like me and my dear friend Jack Kemp talked about democratic capitalism. This refers to the small business that grows into the large one. It means necessary after-tax incentives are being provided to reward Schumpeterian entrepreneurship, innovation, and risk-taking.

At the center of this model is the much-vaunted entrepreneur who must be supported by a thriving investor class that will provide the necessary capital to finance the new economy. But also necessary for the Schumpeterian model is a healthy banking and financial system that will provide the necessary lending credit to finance new ideas.

Do we truly believe that raising tax rates on investors and moving to some sort of government-controlled banking system will sufficiently fund the entrepreneur and sustain democratic capitalism? Do we really believe that a federal-government-directed economic system will generate a sufficient supply of capital and credit to produce a strong economy?

I doubt it.

The Stunning Level of TARP Waste, Fraud & Abuse

And why has this happened? The Troubled Assets Relief Program, or TARP, said Barofsky, is "inherently vulnerable to fraud, waste and abuse, including significant issues relating to conflicts of interest facing fund managers, collusion between participants, and vulnerabilities to money laundering."

Not bad for a program alive for just six months that still has $135 billion to spend. Barofsky's 250-page report to Congress also notes that taxpayers have been exposed to huge losses under TARP, with no guarantee that the funding will do what it's supposed to do.

All told, the unique "public-private" partnerships of the Treasury, Fed and private companies buying back many of the bad assets on banks' balance sheets could cost taxpayers a total of $2 trillion.

While private investors stand to make the bulk of the profits, taxpayers will in some cases be saddled with more than 90% of the risk, since the Treasury and Fed — that is, you the taxpayer — will be lending them the money.

Next year, you can expect a rash of stories about "massive fraud" in the TARP. It's inevitable.

When that happens, please remember this: The TARP's inspector general has formally advised the Treasury Department to force all TARP recipients to account for how they use TARP money. And the Treasury has refused. It's an open invitation for further fraud.

Remember all the calls last year for "greater transparency" in the banking industry? Now, the government won't even take its own advice on that.

Already, TARP has become a money-losing boondoggle for Congress. Elizabeth Warren, who heads the Congressional Oversight Panel for TARP, estimates that the government has already lost $104.2 billion on the TARP program.

It did so, basically, by paying $1 for assets worth only 66 cents.

It doesn't end there. TARP has proved a tempting source even for members of Congress who should know better.

Take Rep. Barney Frank, D-Mass. In January, the chairman of the House Financial Services Committee unveiled the TARP Reform and Accountability Act of 2009. Its goals: to "strengthen accountability, close loopholes, increase transparency, and require Treasury to take significant steps on foreclosure mitigation."

All laudable. Except, according to a January article in the Boston Business Journal, Boston's smallish OneUnited Bank earlier got a $12 million cash infusion from federal funds after "gaining influential support from" Frank.

Frank denies any impropriety. But with little or no transparency in this program, how are we to know?

Then there's the case of Sen. Dianne Feinstein, D-Calif.

On the first day of Congress this year, Feinstein unveiled legislation to push $25 billion into the Federal Deposit Insurance Corp. It was a strange move since, as the Washington Times noted, she doesn't even sit on the Senate Committee on Banking, Housing and Urban Affairs, which oversees the FDIC.

Shortly after Feinstein put forward her legislation, CB Richard Ellis Group, the commercial real estate firm, won a major FDIC contract. CB Richard Ellis' chairman of the board is Feinstein's husband, Richard Blum.

During last summer's debate over the bailout and stimulus packages, we warned of the potential for fraud in such massive government spending. Sadly, it's turning out to be true. And given the stunning level of corruption so far, don't be surprised when further revelations of fraud and fiscal malfeasance emerge.

April 23, 2009

Job Loss By Millions, Tax Hikes By Billions

The 648-page bill, cosponsored by Mr. Markey and fellow Democrat Henry Waxman, Chairman of the House Energy and Commerce Committee, has been the subject committee hearings this week. It would set new limits for greenhouse gas emissions, potentially bringing in over $1 trillion in revenue, and prescribe radically new standards for energy production and use.

These requirements would come at substantial costs to producers that would be then be passed on to consumers. Homes, cars, household goods, and energy would become more expensive and people would buy less, leading to layoffs and a worsening recession.

Over 100 legislative pages are spent on measures to reduce greenhouse gases—deep, rapid reductions. The bill requires greenhouse gas emissions in 2012 to be no more than 97 percent of 2005 emissions; 58 percent in 2030; and 17 percent in 2050. This last target, four decades into the future, is incompatible with our present standard of living—and illustrates the arrogance of a legislature that thinks it can fine-tune the huge, variegated American economy far beyond anyone’s capacity to foresee events.

The mechanism for this is a "cap-and-trade" program, proposed by President Obama, under which allowances to emit greenhouse gases would be issued by the Environmental Protection Agency at a steadily declining rate through 2050. When a firm’s emissions exceeded its allowance, or cap, it would have to purchase more from the government or other firms, a tax under another name, driving up costs that would be passed on to consumers.

Shifting costs to consumers is the hidden theme of the Democratic bill. There’s no transparency because until the allowances are distributed and auction mechanisms are specified, the Congressional Budget Office cannot calculate the official cost.

Representative Joe Barton of Texas, ranking Republican on the Energy and Commerce Committee, offered his version of candor at yesterday’s hearing, with estimates based on previous cap-and-trade bills. “With a cap-and-trade scheme like that proposed by Chairmen Waxman and Markey," he said, "households can expect energy cost increases up to $3,128 per year. Your electricity bill will increase by 77 to 129 percent. Filling up your gas tank will cost anywhere from 60 to 144 percent more. The cost of home heating oil and natural gas will nearly double.”

The Obama March Budget acknowledged revenues of $646 billion over eight years from cap and trade. Yet National Economic Council deputy director Jason Furman told Senate Finance Committee staffers, according to news reports, that the figure could reach $1.3 trillion to $1.9 trillion over the same period.

In addition to higher costs to consumers, cap-and-trade would give government officials practically unlimited scope to play favorites in the allocation of permits, an invitation to political influence peddling, if not outright corruption.

At the discretion of government officials, firms could meet 30 percent of their 2012 greenhouse gas reduction obligations, increasing to 60 percent by 2050, by buying “offsets” to reduce greenhouse gas emissions elsewhere. Half of these offsets can take place abroad.

As drafted, the bill allows firms to shift economic activity abroad to countries with laxer emissions standards, further damaging U.S. job creation. A plant’s emissions might exceed its U.S. allowances, yet its technology might produce lower emissions than the norm in a developing country, thereby allowing the relocation to count as an offset.

Cap-and-trade is only one of many parts of the bill that would drive up prices. Consider energy production, among others. The bill would require doubling in three years of the share of electric utility output that comes from renewable sources—wind, solar, geothermal, biomass—from three percent now to six percent in 2012. In a further leap of central-planning hubris, the bill would raise that standard in stages to 25 percent in 2025.

Sounds good? Maybe, but the technology to do it doesn’t exist. Nor do transmission lines to deliver wind energy from where it is likely to be produced, in the central states, to the population centers on the coasts, where it would be consumed.

The most surprising word in the 648-page bill is the one that isn’t there, not even once. That word is “nuclear.” To discuss clean energy and security without mentioning increased development of nuclear energy, now powering 20 percent of America’s electricity with no greenhouse gas emissions, shows that Chairmen Waxman and Markey are not taking the issue seriously. They’re just trying to raise taxes on Americans and enhance the power of Congress and the agencies it oversees.


Geithner's Protections Are Banking Opportunities Lost

The Administration’s reasoning on the above was laid out last Sunday by Lawrence Summers, President Obama’s NEC chairman, on NBC’s Meet the Press. Summers said “We want people to be paying back the government. But we don’t want people to be paying back the government in ways that will put themselves back in trouble and leaving themselves with inadequate capital.” Translated, the Obama administration would prefer a process whereby it could turn the federal government’s preferred shares in banks into equity stakes. Nationalization, here we come.

This serves the Administration’s main purpose in propping up the banks, which is to socialize banking activities. While it pines for a healthy banking system out of one side of its mouth, the Administration speaks with a forked tongue. Indeed, it wants ownership in banks so that interest rates charged customers can be regulated more heavily, loans for strapped customers can be reduced or forgiven, future loans can be directed toward preferred constituents, not to mention that hiring can be restricted at times to those possessing U.S. citizenship. In short, banks will take on the prosaic nature of utilities and other industries given security in the past by government.

While this should properly scare anyone with a basic understanding of markets, it has to be remembered that owing to the Keynesian orientation of many in the Obama regime, spending is spending. Keynesians believe that government spending is investment in much the same way that Microsoft’s $240 million investment in Facebook was. In that sense, if Geithner et al can exercise a greater form of control over banks, government-directed loans will pack just as much economic punch as privately-driven loans, and even better, the money will reach preferred constituents. While sentient minds in the real world would heartily disagree, many in the Obama camp don’t draw a distinction about where money goes so long as it’s being lent.

This perhaps explains Geithner’s argument in favor of banks holding onto the TARP funds. As he noted in an interview with the Wall Street Journal, “You can’t have economic recovery without a financial system.” And without “a financial system you have no credit, which means higher unemployment, lower production capacity and a higher number of failing institutions.”

Nice rhetoric from Geithner for sure, and it’s even the kind of rhetoric that some on the Right bought into last fall in defense of the Bush administration’s imposition of bank bailouts on a country that did not want them. Without well capitalized banks, wouldn’t the financial system implode followed by the rest of the economy?

The above would be true if sources of finance were limited to what we see as the banking system. The happy problem there is that within capitalist economies new substitutes regularly reveal themselves such that industries as we define them regularly take new shapes. Schumpeter was writing about the retail sector, but as he observed, “the competition that matters arises not from additional shops of the same type, but from the department store, the chain store, the mail-order house and the supermarket which are bound to destroy those pyramids sooner or later.”

Indeed, Blockbuster Video was not crushed by a like competitor along the lines of Movie Gallery, but instead by Netflix. When we consider finance, for years retailer Wal-Mart has been panting to get into banking only to be thwarted by many of the same banks presently on life support. Quicken began as a company peddling personal finance software, and ETrade low-cost stock trades, but now both are very much in the loan business. Most in the U.S. think of British retailer Tesco as a retail behemoth, but its lending arm is growing by leaps and bounds.

Looked at from the perspective of banks, it’s quite simply not true that finance would have dried up had one or many big U.S. banks failed. Instead, and as Thurow made clear, their failure would have created an opportunity for substitutes to fill in where their predecessors failed. So while it’s seemingly settled “logic” on both sides of the political aisle that we must empower to an even greater degree the very regulators who proved so unequal to the crises before us, and that occurred on their watch, it seems the better answer is less regulation so that well-run companies inside and outside the financial sector can do what gasping banks could not.

Thurow concluded long ago that “demands for protection” arise due to the abandonment of “belief in the virtues of a competitive, unplanned economy.” His words describe today’s economic environment very well, and as long our federal minders keep offering us false security, the alleged economic recovery will be stillborn thanks to a bipartisan lurch away from the very competitive economic principles that made us so prosperous to begin with.


April 24, 2009

What Will the Stress Tests Mean?

So, if you could just find a way to recapitalize the banks, they’d start lending again, and consumers would start buying cars and homes and student loans again. Right?

There are so many things wrong with that statement, but let’s stick to stress tests. The Treasury has two choices: they can nationalize the banks altogether (as Sweden did in the early Nineties), and then force them to either find new capital or go out of business. Or they can “encourage” private investors to step up and put some new capital into the banks, without an explicit nationalization.

I’m an investor. If someone asked me to put new capital into most of the large zombie banks, I’d probably ask him if I look like I have rocks in my head. There are so many reasons for a sane investor to avoid this, but Geithner is focusing on only one of them: ”How do I know I’m not throwing my money down a rat hole?”

That’s the whole idea behind the stress tests. If you can show that a given bank will have no problems weathering the worst economic storm you can reasonably imagine, then you can also say that the bank’s existing equity actually is worth more than zero. And that would provide a rationale (and a baseline price) for a private investor to buy in.

For complex reasons I won’t trouble you with, it’s almost never rational to buy equity in a bank that may fail. The bottom line is that if you do so, you’re not actually acquiring value in full measure to your investment. Rather, you’re transferring value to the bank’s existing bondholders, who of course are thrilled to see you do that.

That’s the calculus that Geithner wants to modify. He figures that if a stress test can show that banks are healthy, they won’t have trouble attracting private capital. This is a great potential outcome for him, because it allows him to avoid doing what no one seems happy about, which is a full nationalization. (For the record: nationalization doesn’t scare me, and it shouldn’t scare you either, but that’s another story.)

Here’s where it gets messy: the stress tests are likely to show that many of the largest banks are in very deep trouble. On top of that, the economic assumptions being made in the stress tests themselves are said to be not all that dire, so the results could well be understating the potential problems. (Remember, this is the Administration that, ridiculously, is counting on a 4% economic recovery next year.)

If the stress testing has come up clean, then we’ll have a great big press conference with grins and TV cameras, and a big relief rally in the stock-market. But what if it doesn’t?

Now, if you’re Geithner, you’ve got a big problem, and it’s hard to imagine he didn’t see this coming. Let’s say the stress testing has turned up major problems across the universe of very large banks. (Small and regional banks are a totally different situation, and I’ll get to them in a moment.)

Now what does he do? If he suppresses or candy-coats the results, everyone will smell a rat. For one thing, he’ll totally cement that case that private capital should avoid large banks like the plague, which wipes out the whole point of the exercise. Far worse, he’ll also create so much brand-new uncertainty that financial markets will take another dive, and the economy will also suffer.

What if he comes totally clean, exposing the raw data, the methodology, and the interpretations?

If that happens, you’ll see a whole blizzard of blog posts from people like me, taking issue with everything about the results. You’ll also see an instantaneous sorting of the large banks, in order from the best to the worst. The handful at the top will be the winners. It will be assumed that all the non-winners are roadkill. And if you were watching the last weeks of the lives of Bear Stearns and Lehman Brothers, you know that when a financial institution is even rumored to be in trouble, the end comes swiftly.

In my opinion, that’s exactly what Geithner should do. The resulting bloodbath would eliminate a large amount of overcapacity in the banking system, and make room for some new players to come up, which will happen rapidly.

Why don’t I think the cataclysm would be fatal for the economy? Because the large zombie banks aren’t contributing anything to the economy now. Let Citigroup and a handful of others go away, and let the good parts of their businesses pass into other hands. Geithner is wrong if he thinks that he can return these companies to the way they used to do businesses.

But what is Geither likely to do? He’s not likely to let a whole raft of B players face the meat grinder. He’ll have no choice but to nationalize them. After all this talk of avoiding the “N” word, that’s going to make him look like a fool.

Now, what about the regional and community banks? Based on my information, these are generally a whole lot healthier than the large, wholesale banks with heavy exposure to leveraged mortgage securities.

The problem is that smaller banks tend to regulated by the mid and low level apparatchiks at the Fed and the FDIC. And those people are so incredibly risk-averse right now, that they’re overdiscounting perfectly good capital and underrating perfectly sound assets. It’s gotten to the point that even solidly run, well-capitalized smaller banks with clean operating histories can’t expand lending activities even if they wanted to. Which in many cases, they do.

That’s a story you’re not going to hear on the evening news. This whole crisis still has a long way to go, no matter what Geithner does.

Glaring Groupthink In Financial Markets

I don’t think American economic history has ever seen such a powerful level of groupthink in her financial markets. This, of course, is primarily a supply issue. In terms of participation, The New Reality is that there has never been more people willing to get in this game. Whether it’s an oversupply of manic media, money management firms, or the 34 million plus online brokerage accounts in this country, no matter where you go this morning, there they all are…

Being in my seat provides an interesting vantage point. To get here, I drive through the “make money” mecca of Stamford in the wee hours of the morning and see that most of my sell side competition’s lights are off. By the time I get to New Haven, my inbox is lit up like a Christmas tree with people who agree/disagree with my firm’s points of view. While I don’t spend my time with group-thinkers, I am privy to plenty enough of their thoughts. Short Starbucks, long McDonald’s anyone?

Do I have baggage in this business? Don’t we all?...

After having a great run being overly compensated in the hedge fund business, remember that I was basically fired at the end of October 2007 for being “too bearish”… so, pardon the pun, but I BEAR the cross of my own experience in not trusting the “established authorities” in this business. If it comes across as my having an axe to grind, I apologize for my inability to communicate – I’m grinding alright… grinding to be right.

So away from John Mack and “The Masters of Herd Island” that I went off on in yesterday’s note, what are the most glaring groupthinker points of view I have staring at me from my notebooks this morning?

1. “we’re overbought”

2. “the consumer is never going to be the same… its over…”

3. “earnings are going to kill the market, watch…”

4. “Ivy is bearish on housing, haven’t’ you looked at foreclosures”

5. “we’re overbought”

6. “Meredith is saying this bank is going to… that will be a disaster”

7. “China really looks good now… this is how you should play it”

8. “Tech has moved to far too fast… its over…”

9. “we’re overbought”

Are we overbought? Even Cramer went live with the Doug Kass call on that front last night. But are we really overbought or just getting ready to rip this line of groupthink up and into the right of into its final crescendo?

There is a big difference between stock market operators and stock market commentators. Most pundits, including those regulating US markets, say that market timing is not possible. In fact, on the Series 65 exam, you must check the box that says market timing is BAD, or you get the question wrong…

Understanding that not doing macro or not managing your market exposure around a macro call implies a massive amount of systemic risk in your portfolio is one thing. Understanding that the art of managing money is having a narrative fallacy of an investment process that provides you money to manage is completely another.

So what if you could be more right than you were wrong in calling markets? Would you use it? Is it any different than using the Master of Herd Island “one on one” approach to trading around a stock? Is the perceived edge associated with having sat across from a CEO in one of Wall Street’s finest hotel conferences any different than understanding a mathematically relevant market correlation that begins to dominate?

The New Reality is that there is edge in understanding the behavioral side of markets and the glaring groupthink that’s embedded therein. Next time someone tells you that we’re “overbought”, ask them at what price. Like the answers to the aforementioned 9 considerations, I am sure you’ll find the specificity of the answer enlightening…

At the beginning of this week, I said China was overbought on the Goldman call – the Shanghai Composite Index closed down again last night, locking in her 1st down week in the last six. I’ll say that, in the immediate term, that the SP500 will be overbought at the 874 line, and I’ll refresh my risk management model every 90 minutes of trading so that my answer to the question changes as the cold hard facts do.

The “established authorities” aren’t allowed to put these kind of a calls in print – making market calls isn’t what they tell their clients they do, even though that’s what they are doing more and more here every day…

Looks like great weather for a BBQ!

Have a great weekend with your families,

KM

Continue reading "Glaring Groupthink In Financial Markets" »

Corporate Taxes, and Their Real Impact On Small Business

Every dollar we have paid in corporate income taxes has been a dollar we haven’t been able to use to grow our business – whether through new hires or additional investments. Retained earnings are the reward for a company well run. These earnings represent capital for future growth and corporate income taxes quite simply decrease (steal?) these funds that could otherwise be used to benefit the business. How much faster would Capterra have grown had we held on to all of our earnings and invested them into our firm? Furthermore, less money to invest in our future has an impact beyond our own ability to grow.

It means lower employment since we cannot afford to hire as many people.

It means less opportunity for other businesses since we don’t have as much to invest in external services or products.

It means less potential for wage increases for our current employees.

The list could go on indefinitely. All of these factors represent unintended consequences of a tax that ends up being highly regressive since it impacts all of society, regardless of income.

A secondary point worth acknowledging: when you essentially penalize a company for what it is supposed to be striving for, namely profits, it creates additional costs and misdirected behavior for that business. One obvious example is that companies will hire consultants and similar service providers to reduce tax costs. Money spent on these initiatives is not available to provide a better customer experience and can’t be used to grow the business.

Many companies will take it a step further and invest in tax havens and other schemes that only make sense due to the presence of the taxes, but that are an otherwise poor use of resources.

A less obvious example is the complexity that results when tax implications are considered as part of the true cost of a new expenditure. For example, a company is on track to generate $1,000,000 in profit and is considering a $100,000 ad campaign. This campaign will reduce the company’s profit by $100,000 and its corporate income taxes by $33,000, so is the real cost actually $67,000? The answer depends upon, among other things, other initiatives that may also reduce profits. This complexity requires the time and effort of valuable employees - time that would be better spent growing the business.

A common counter-argument is that small, high-growth companies should immediately reinvest all profits back into the business so as to avoid being taxed. I believe there is some validity to this argument, but I disagree with the use of the word “all.”

Capterra reinvests most of its profits, but not “all” for three reasons. First, we are saving for future investments that are too large for just one year’s left-over profits. Second, not all revenue and costs are entirely predictable in time to spend accordingly. And third, it is prudent to save some cash for the possibility of a downturn. It is risky for any business to re-invest “all” of its profits. We did that in the early years of Capterra when we were just getting started. Now that we have hired employees and it’s more than just the founders’ livelihoods on the line, it is prudent to have a cushion to rely on during a downturn.

Since it is the citizens of a country who are ultimately responsible for paying taxes, and since it is those same citizens who effectively pay corporate income taxes, why not abolish them entirely, given the reality of the additional costs that they incur? More pointedly, since “companies paying their fair share” is just a political campaign myth that serves to confuse citizens, what is the benefit to society of taxing its citizens in such a backdoor way that reduces transparency and results in such obvious additional costs?

April 27, 2009

Selling the Green Economy

Re-engineering the world energy system seems an almost impossible undertaking. Just consider America's energy needs in 2030, as estimated by the Energy Information Administration (EIA). Compared with 2007, the United States is projected to have almost 25 percent more people (375 million), an economy about 70 percent larger ($20 trillion) and 27 percent more light-duty vehicles (294 million). Energy demand will be strong.

But the EIA also assumes greater conservation and use of renewables. From 2007 to 2030, solar power grows 18 times, wind six times. New cars and light trucks get 50 percent better gas mileage. Light bulbs and washing machines become more efficient. Higher energy prices discourage use; by 2030, oil is $130 a barrel in today's dollars. For all that, U.S. CO2 emissions in 2030 are projected to be 6.2 billion metric tons, 4 percent higher than in 2007. As an example, solar and wind together would still supply only about 5 percent of electricity, because they must expand from a tiny base.

To comply with the House bill, CO2 emissions would have to be about 3.5 billion tons. The claims of the Environmental Defense Fund and other environmentalists that this reduction can occur cheaply rely on economic simulations by "general equilibrium" models. An Environmental Protection Agency study put the cost as low as $98 per household a year, because high energy prices are partly offset by government rebates. With 2.5 people in the average household, that's roughly 11 cents a day per person.

The trouble is that these models embody wildly unrealistic assumptions: There are no business cycles; the economy is always at "full employment"; strong growth is assumed, based on past growth rates; the economy automatically accommodates major changes -- if fossil fuel prices rise (as they would under anti-global-warming laws), consumers quickly use less and new supplies of "clean energy" magically materialize.

There's no problem and costs are low, because the models say so. But the real world, of course, is different. Half the nation's electricity comes from coal. The costs of "carbon capture and sequestration" -- storing CO2 underground -- are uncertain, and if the technology can't be commercialized, coal plants will continue to emit or might need to be replaced by nuclear plants. Will Americans support a doubling or tripling of nuclear power? Could technical and construction obstacles be overcome in a timely way? Paralysis might lead to power brownouts or blackouts, which would penalize economic growth.

Countless practical difficulties would arise in trying to wean the U.S. economy from today's fossil fuels. One estimate done by economists at the Massachusetts Institute of Technology found that meeting most transportation needs in 2050 with locally produced biofuels would require "500 million acres of U.S. land -- more than the total of current U.S. cropland." America would have to become a net food importer.

In truth, models have a dismal record of predicting major economic upheavals or their consequences. They didn't anticipate the present economic crisis. They didn't predict the run-up in oil prices to almost $150 a barrel last year. In the 1970s, they didn't foresee runaway inflation. "General equilibrium" models can help evaluate different policy proposals by comparing them against a common baseline. But these models can't tell us how the economy will look in 10 or 20 years because so much is assumed or ignored -- growth rates; financial and geopolitical crises; major bottlenecks; crippling inflation or unemployment.

The selling of the green economy involves much economic make-believe. Environmentalists not only maximize the dangers of global warming -- from rising sea levels to advancing tropical diseases -- they also minimize the costs of dealing with it. Actually, no one involved in this debate really knows what the consequences or costs might be. All are inferred from models of uncertain reliability. Great schemes of economic and social engineering are proposed on shaky foundations of knowledge. Candor and common sense are in scarce supply.

Developing Government Into a Cult of Personalities

This bank is too big to fail. That bank must go. This industry must pay to save the world from global warming. That industry gets a free ride. This credit card rate is too high. That company must fire its CEO. Does this sound like the operation of a constitutional republic of enumerated powers or a cabal of fractious nobles jostling with the King?

As blue tribe elders and their chosen apparatchiks press the limits of power, red tribe legislators have shrunk to such invisibility that The New York Times can’t even finger a credible bogeyman. The media elite have been reduced to railing against Limbaugh, Cheney, Gingrich, and Rove. Last time I checked, these bloviating has-beens were neither government officials nor party leaders. They are straw men selected for their ability to frighten little children.

Does that make us the little children?

Perhaps it’s the fawning of the partisan press that creates the worry that this last election marked not just a normal changing of the guard to rebuke a party that overreached but a permanent shift in the relationship between government and citizen. Maybe, unreported in the background, thoughtful deliberations are taking place among elected legislators mindful of the separation of powers defined in the constitution, respectful of the nondelegation doctrine designed to constrain the executive, and infused with humility knowing that the complex problems we face can easily be made worse by the application of hasty fiat.

Maybe. But I wouldn’t bet on it.

Are you satisfied by the argument that the economic crisis – the most severe since the Great Depression! - is so profound that our dear leaders must do “whatever it takes" acting “right now” to save us from calamity? Didn’t we just go through that when the last administration was faced with a security crisis - the most severe since Pearl Harbor! – and responded by trampling the constitution? So, how’d that work out for the country?

Regardless of what tribe you swear fealty to, what happens when these "emergencies" become a persistent state of affairs? When does the permanent campaign of our hyper-politicized culture metastasize from a technique to win office into a tool for aggrandizing power once elected? Whether you’re inclined to attend a tea party or a celebration of the first 100 days, aren’t you at least a little disturbed by the ends-justifies-the-means ideology that has taken hold of our so-called public servants?

As dangerous as this is in arenas like foreign policy, consider the damage that can be done by command-and-control diktats seeking to fine tune the millions of economic outcomes required to deliver happiness to vocal constituents whose approval is the mother’s milk of power. What is the right level of home ownership? How much credit card debt should a household in the fourth quintile shoulder, and at what rate of interest? How many car brands and dealers should a publicly subsidized car company have? Who gets an MRI and who doesn’t? What’s the right amount of carbon dioxide the aluminum industry can emit? If you think its hard to figure out the best product mix for a small company, imagine trying to “optimize” a fifteen trillion dollar economy.

This can’t be what the founding fathers had in mind. As well meaning as he may be, what makes Barack Obama different than Hugo Chavez if either can take over entire industries with the stroke of a pen as rubber stamp legislatures sing hosanna and media enablers plaster el Magnifico’s smiling face on posters across the land?

Democracy is not about the outcome, it’s about the process. What makes the United States exceptional is the unique method of government we were bequeathed, which elected officials take an oath to preserve, protect, and defend. The rule of law is the common interest that trumps all special interests. Sacrifice that common interest, surrender the rule of law to feed pressure groups with benefices, and that uniqueness evaporates along with the freedoms we once held dear.

Creative Destruction In the Legal Industry

But these numbers do not reflect the pain that is now coming. Most industry observers predict a precipitous drop in revenues by the end of 2009, likely in the 15% to 30% range. This will lead to significant downsizing even within some of the most storied and profitable practices. Latham & Watkins, the second largest US firm by total revenues, just recently announced a 21% decline in its client business from the previous year and outlined plans to lay-off 190 attorneys in 2009. More extreme are the cases of Wolfe Block and Heller Erhman, who were forced to close their doors permanently. Similar stories are fast becoming the standard.

To be fair, not much can be done by firms to counteract weakening demand for legal services. It is being driven by market forces largely beyond their control. But what is making some firms more vulnerable than others is the rigidity in their billing structures. Right now clients have all of the leverage in the system to shop for better services and cost. But unlike previous downturns in the economy, the unusual severity of the distress ripping through the nation is creating newfound demand for lasting alternatives that go beyond the basic billable hour methodology. And because the motivation for change is coming from the client side, not the attorney side, there is a unique opportunity for consumers of legal services (and especially general counsel’s of major US businesses) to create the solutions that best fit their objectives.

Law firms caught off guard by this shifting paradigm should be concerned, but not surprised. A major report published by the American Bar Association in 2002 (ABA 2001-2002) sounded the alarm on the billable hour by citing its tendency to produce spiraling per hour costs, overbilling, loss of client control over work-product, misalignment of interests, lack of collaboration and mentoring between attorney’s, as well as upset in the work-life balance. Six years later these risks are deeply rooted in the system, so much so that prominent senior practitioners are joining the chorus for change.

Evan Chesler, the presiding partner at Cravath, Swaine & Moore, told BusinessWeek in an interview last month that he is on a “mission to make the billable hour irrelevant,” even for lawsuits. Chesler’s comments are significant not just for their content, but also because of the pressure they place on New York-based and other elite law firms to follow his firm’s example. Chesler argues that the move to alternatives isn’t just recession driven, but rather a reality of where the industry is going longer-term.

This shifting paradigm is offering clients their greatest opportunity yet to bring systemic change to billing structures, which if done properly, should result in better legal services at the same or lower cost to businesses. This should be welcome news to executives struggling to make ends meet with fewer and fewer resources. Achieving this outcome, however, will require at least two key weaknesses of the current billable hour to be addressed by clients.

First, clients need to ensure that new billing structures have better quality control mechanisms. Success fees, even if only representing 10% to 20% of the total compensation in a client matter, more closely tether the objectives of the client with the attorney’s work-product. It also confronts the soft logic that effort by itself, even if unsuccessful, merits equal compensation.

Second, clients need to use billing alternatives as a way to control spiraling costs. Pricing inefficiencies today are rooted in the perverse incentives created by the billable hour, which often lead to work-product that goes beyond a client’s needs or desires. As a standard practice, firms write-down 15% to 25% of the bill at the end of a case to avoid client outrage. This type of institutionalized overbilling is uncommon within professional industries such as the law and clients need to respond to it by demanding cap and flat fee alternatives. The protection afforded by these alternatives not only will ensure that lawyers do more with less, but that longer-term cost spiraling tendencies are keep in check when markets correct.

When economic bubbles burst, there is chaos and distress. One of the few positive developments to rise from the ashes has typically been innovation and opportunity. New business ideas – and new ways for running old businesses -- are informed by what went horribly wrong in the past. Customers of legal services have just as much right to benefit from this process of creative destruction as customers of any other industry. Ensuring that this occurs will be a positive step for businesses on their path to economic recovery.

April 28, 2009

Ax the UAW's 'Jobs Bank', Save GM

The latest restructuring includes shedding GM's Pontiac unit and offering the government a controlling stake in GM's stock. It would also give the UAW shares in exchange for pension relief.

The nation's biggest automaker is living on $15 billion in government loans, and hopes to get another $12 billion in bailout money to avoid bankruptcy.

UAW contracts helped put GM on this road to ruin. The UAW Jobs Bank has cost the company billions, acting as a major drag on earnings.

Still, the union is fighting to keep the program, though it recently agreed to allow management to suspend payments into the massive fund until the company can regain its footing.

"To give up the jobs bank is to give up everything the union fought decades to win," said a UAW boss in Flint, Mich.

The Jobs Bank was created as GM made its plants more flexible and automated to compete with the Japanese. As GM became more efficient, it no longer needed as many workers to run a plant. The union demanded that it keep paying workers displaced by the new technology.

The UAW argued that if workers knew they had job security in spite of the advances in automation, they might embrace the new methods.

Of course, the UAW got its concessions and then some, while still fighting the plant closings. The Jobs Bank became little more than a welfare system for laid-off workers, who are still paid most of their wages and benefits.

Many of the Flint job-bankers, for example, worked in a plant that no longer exists: the huge Buick City factory that closed 10 years ago. Yet GM has paid them up to $85,000 a year. They also still enjoy health care coverage, while continuing to collect years of service toward their pensions.

Rewriting labor contracts is not what the Obama administration is looking for in a restructuring plan. It wrongly assumes that GM's foray into the gas-guzzling SUV market sealed its fate.

And it wants the nation's largest automaker to roll out more eco-friendly hybrids, even though SUVs were for years a cash cow — and could be again, now that gas prices have settled back down. Hybrids are once again viewed as the expensive joke that they were.

The unreported, unspoken reason that GM is careening toward bankruptcy is the crushing labor mandates it's had to fund each year.

In addition to the billions spent on the Jobs Bank, GM has spent $103 billion during the past 15 years funding its pension and retiree health care obligations, according to industry analysts. That's nearly $7 billion a year — more than GM's capital spending budget for new models this year.

Meanwhile, Honda and other nonunion companies didn't have to bear such costs. Japanese automakers even built cars inside America with relatively young nonunion labor that, unlike their UAW counterparts, quickly learned to adapt and thrive in the leaner assembly systems that Japanese companies operated.

You won't hear President Obama or House Speaker Nancy Pelosi or Senate Majority Leader Harry Reid mention this in their analysis of the auto industry's woes from their driver's seats in Washington.

If GM and Chrysler don't survive this recession, blame the unions, not SUVs.

To Recover, We Must Abide By Classical Principles

Nearly all of Washington believes that spending drives the economy – that “demand” drives “supply.” But central to classical economics is the more subtle idea that demand and supply have a mutual interdependence like the two inseparable sides of a coin. To keep the economy moving, both must fire simultaneously. The fuel is effort and enterprise, including management talent, innovation and risk-bearing. It is not money or credit. These are akin to lubrication, only a minimal amount of which is necessary for the economic machine to operate. The economy does not grow proportionately with the amount of money or credit in the system.

According to classical economics, the necessary economic fuel is not threatened by a credit crisis; but uncertainty and fear keep it from finding its best use. State initiatives tend to increase uncertainty and were exactly what the early classical economists distrusted, influenced by scientific discoveries of equilibrium systems in nature. John Stuart Mill pointed out that economies heal themselves following violence and destruction. So does the human body. Good physicians know their job is to facilitate self-healing, not to thwart it.

Public-sector interventions elicit adjustments in the private economy that reduce or nullify their purpose. Indeed, economic systems automatically resist outside disturbances as do physical and chemical systems. They go by LeChatelier’s Principle: “A change in one of the variables that describe a system at equilibrium produces a shift … that counteracts the effect of this change.” This is exemplified by two classic economic phenomena: “crowding out” and substitution. The scope for substitution is often ignored in modern discussion; one example is the fear that banking is an irreplaceable pillar of the economy. More realistically, if money and credit are not forthcoming from the banks, other pools of capital will spring up as substitute sources.

Fear for bank solvency has motivated researchers to try to estimate the “lost wealth” due to the crisis, and from that they derive a prognosis for the economy. Will the world’s banks have to write off $2 trillion ultimately, as officially estimated? Or is the loss closer to $3.6 trillion, as suggested by some who forecast a sustained economic collapse?

Yet the presumption that lost wealth depresses economic activity flies in the face of a common-sense idea embodied in the following question: Do you make people work harder by making them richer – or by making them poorer? The answer, surely, is by making them poorer.

Another false assumption is that any problem can be solved if enough money is thrown at it. The classical, and wiser, observation is that the more money lavished on a problem, the bigger that problem is liable to get. The Romans eventually succumbed to the barbarians they tried to buy off.

Just as classical economics was spawned in the Enlightenment by revulsion to autocracy, conventional macroeconomics derives from the desire to place the State back in economic control. Following World War I and the onset of the Great Depression, John Maynard Keynes deprecated market forces, and the intellectual case he reintroduced for government intervention and management was seized enthusiastically.

Keynes caused a rift between modern macroeconomics (the theory of aggregate income, employment and money) and standard economics (price theory). Students of both often admit to a feeling of schizophrenia. In standard economics markets clear through the adjustment of prices, and equilibrium is constantly being regained. But according to modern macroeconomics, prices don’t adjust. The markets for income and employment stagger from one disequilibrium to another, periodically requiring redirection by government.

Keynes’ critics pointed out that government spending in the 1930s did not succeed in normalizing unemployment, which was still over 17 percent in the US in 1939. Nevertheless classical economics was thought to have failed. Keynesian ideas and teaching tools eventually acquired a near-monopoly in the classroom.

The premise for today’s policies is that the Depression resulted from a banking crisis that the Federal Reserve failed to address. This requires us to believe that non-bank firms are unwilling or unable to substitute for banks compromised by the threat of insolvency. True, it takes trust for new credit relationships to develop; that could explain a recession, but not a depression. Surely the explanation for the Depression lies elsewhere.

Classical economics does not, in fact, rule out sustained slumps. An act of government that hamstrings the price system, deters the private sector from exercising enterprise, or curbs its freedom to trade will hold the economy down until such policies are changed.

According to yet another classical precept, the size of an economy depends on the scope of the market that its participants can reach. Globalization increases that scope, while protectionism cuts it back. Thus sustained closure of world trade could be enough, by itself, to hold the world in depression.

The mystery about the Depression is why it began when it did and why it ended so abruptly. In the Wall Street Journal more than thirty years ago, the late Jude Wanniski pointed out that the 1929 Crash occurred at the same time – to the day – that President Hoover decided to sign the Smoot-Hawley tariff. Following large-scale retaliation on the part of US trading partners, world trade collapsed. Sustained peacetime growth did not return until 1945 – shortly after the Allies agreed to restore free trade at Bretton Woods.

Financial Crisis and the Panic of 2008

After failing to predict a slow-down, let alone a panic, the International Monetary Fund finally issued a scary forecast on March 19 — just in time for the G-20 meeting. This forecast allowed the IMF to peddle its prescriptions. Once the G-20's communiqué was released, doom and gloom were temporarily swept aside. The political classes had just struck a mother lode.

The G-20 winner was the IMF. The IMF's managing director Dominique Strauss-Kahn — a seasoned French socialist politician — could hardly believe the IMF's good fortune. At a press conference on April 2, Strauss-Kahn had this to say:

"Maybe some of you were in the IMF press conference at the end of the Annual Meeting last October. And if some of you were there, then you may remember that what I said at that time is that IMF is back. Today you get the proof when you read the communiqué, each paragraph, or almost each paragraph — let's say the important ones — are in one way or another related to IMF work."

If the G-20 summiteers come through with their pledges, the IMF's resources will be increased by over $750 billion (USD).

To put that in perspective, consider that the IMF's credits and loans outstanding at the end of 2008 were only $27 billion. As politicians confront a new crisis, the opportunists are playing the system and exploiting it for their own ends.

Much of the growth of government in the US and elsewhere occurs as a direct or indirect result of national emergencies such as wars and economic slumps. Laws are enacted, bureaux are created and budgets are enlarged. In many cases these changes turn out to be permanent.

As Robert Higgs verified in his 1987 classic, Crisis and Leviathan, crises act as a ratchet, shifting the trend line of government's size and scope up to a higher level. History provides many illustrations of how damaging this fallout can be.

Take the Great Depression. At that time, the organized farm lobbies, having sought subsidies for decades, took advantage of the crisis to pass a sweeping rescue package, the Agricultural Adjustment Act, whose title declared it to be "an act to relieve the existing national economic emergency."

Seventy-six years later, the farmers are still sucking money from the rest of society and agricultural policy has been enlarged to satisfy a variety of other interest groups, including conservationists, nutritionists and friends of the third world. Indeed, even though agricultural prices hit record highs last year, the river of government farm subsidies kept flowing.

Then, during the second world war, when government accounted for nearly half the US's gross domestic product, virtually every interest group tried to tap into the vastly enlarged government budget.

Even bureaux seemingly remote from the war effort claimed to be performing "essential war work" and to be entitled to bigger budgets and more personnel.

Even smaller crises have sent the opportunists into feeding frenzies. Let us return to the classic case of ever-opportunistic IMF. Established as part of the 1944 Bretton Woods agreement, the IMF was primarily responsible for extending short-term, subsidised credits to countries experiencing balance-of-payments problems under the postwar pegged-exchange rate system.

In 1971, however, Richard Nixon, then US president, closed the gold window, signalling the collapse of the Bretton Woods agreement and, presumably, the demise of the IMF's original purpose. But since then the IMF has used every so-called crisis to expand its scope and scale.

The oil crises of the 1970s allowed the institution to reinvent itself. Those shocks required more IMF lending to facilitate, yes, balance-of- payments adjustments. And more lending there was: in the 1970-1980 period, IMF lending increased by 123%.

With the election of Ronald Reagan as US president in 1980, it seemed the IMF's crisis-driven opportunism might be reined in. Yet with the onset of the Mexican debt crisis, more IMF lending was "required" to prevent future debt crises and bank failures.

That rationale was used by none other than President Ronald Reagan, who personally lobbied 400 out of 435 congressmen to obtain approval for a US quota increase for the IMF. IMF lending ratcheted up again, increasing 108% in real terms during Reagan's first term in office. With the fall of the Soviet Union in 1991, the IMF reinvented itself again. According to the IMF, a temporary lending facility was needed "to facilitate the integration of the formerly centrally planned economies into the world market system."

The 1990s ended with the Asian Financial crisis (among others) — one that was misdiagnosed and made worse by the IMF's medicine. Never mind. The Asian crisis was yet another justification for more funding. During the 1990- 1999 period, IMF lending increased by 99% in real terms.

Not surprisingly, the events of September 11, 2001 did not catch the IMF flat-footed. On September 18, Paul O'Neill, the then US Treasury Secretary, had breakfast with Horst Kohler, the then IMF's managing director, to discuss the financial needs of coalition partners.

The IMF received a bit of a post-September 11 bounce. Then the IMF experienced a free fall, when the Federal Reserve (along with other central banks) pushed interest rates to record lows. The flood of new global credit was drowning the IMF until the credit bubble burst. That is when the IMF seized its opportunity.

The ratchet, of course, has many deleterious dimensions that reach well beyond public budgets. For example, on the same day the G-20 met in London, the US Financial Accounting Standards Board caved in to pressure exerted by the US Congress and altered the accounting rules for banks and other financial institutions.

Instead of valuing assets at prices they can fetch in the market (mark-to-market), banks will be allowed to use their own valuation models to value assets.

This accounting change brings to mind the fallout from another panic — the US panic of 1873. It was then that the publication of bank statements was suspended on the hope that "what you don't know won't hurt you."

Let's hope the current tidal wave of interventionism fades and a modicum of reason kicks in.

The Choice Between Capitalism and Socialism

"I came here," he said, "because of my son." His son is ten years old, and he moved to the US ten years ago. I thought perhaps this meant that his son had some rare medical condition that could be better treated in America. But that wasn't it. He came here, he said, because "they won't change"—by which he meant that Russia's culture had not fundamentally changed after the collapse of the Soviet system. I asked if he left because of Vladimir Putin, who has spearheaded the effort to re-impose an authoritarian political system in Russia. But he replied, "Putin is nothing. It is the system."

You can get by in the system and have a decent life, he explained, if you know the rules—that is, if you know which wheels to grease and which authorities to please, if you know the right things to say and the things you aren't allowed to say. "I grew up in the system, so I learned the rules," he continued. "But you ask yourself whether you want your child to learn the rules." That is a profound and courageous observation. It is not just the material effect of living under a corrupt, bureaucratic, tyrannical system that he feared; it was the soul-destroying psychological effect of having to learn and internalize the rules of that system.

His overall summary of Russia's culture of authoritarianism is that "They do not value human life." This was his introduction to the subject on which he was most passionate: socialized medicine. A major part of the reason he left Russia was because socialized medicine is just as intolerable for doctors as it is for patients.

Socialized medicine, he stated flatly, "doesn't work." Why doesn't it work? He explained that a doctor works for the state—not for his patients. So he spends much of his time filling out forms. "As long as the forms are filled out, no one cares what the patient says," how he is doing, or whether he survives.

He then went out of his way to point out that the current administration wants to move us toward socialized medicine. "If they move us just a little bit, it will not be so bad. But if they move us a lot, it will be a disaster." Keep that in mind during the coming debates over President Obama's plans for the de facto nationalization of our medical system.

After our conversation, I shook his hand warmly and told him we were happy to have him here. But that one question he asked kept haunting me. "Do you want your child to learn the rules?"

It struck me that this is not just the question he had to ask himself when he decided to leave Russia. It is the question we Americans ought to be asking ourselves right now. Do we want to live in a society where the state has such a predominant role that you get live a decent life if you know the rules? Do we want our children to learn those rules—the rules they will have to follow to show their proper subordination to the power of the government and those who run it?

That is what socialism is about.

But America is cherished the world over as the place where no one has to learn the rules. We have traditionally been a country where the average person can speak his mind and plan his career path without having to think twice about the arbitrary rules that might be imposed on him by some government authority. And when it comes to informal rules about social customs or the way things are done in the business world—well, we pride ourselves on being people who break the rules. The key to our dynamic society and our enormous productivity is that we are constantly rearranging "the way things are done"—and we are rewarded for doing so.

That is what capitalism is about.

Fundamentally, America is a place for independent men—which is why it attracts independent thinkers from around the world. But the current push toward a dominant role for government in our economy—with the government running automakers, hospitals, universities, banks, and who knows what else—threatens to change our culture at the deepest level, converting us into a population of compliant rule-followers.

So that's the choice we face, and you are going to have to decide where you stand. Do you want your children to learn the rules? Or do you want them to grow up as free men?

The Specter of Arlen: Is Cloture on Card Check in Play?

In a major about face from his stance less than one month ago, Senator Arlen Specter, Republican from Pennsylvania, announced that he is switching parties earlier today. The literal implications of this are that, assuming Al Franken from Minnesota gets confirmed, the Democrats will have 60 seats in the Senate, which is a filibuster-proof majority.

In the statement announcing his decision, Specter said the following:

“Since then, I have traveled the state, talked to Republican leaders and office-holders and my supporters and I have carefully examined public opinion. It has become clear to me that the stimulus vote caused a schism which makes our differences irreconcilable.”

After voting in favor of Obama’s stimulus package, one of three Republicans that did so, and then travelling his state and talking to members of his own party, it became clear to Specter that his nomination for the Republican party in Pennsylvania 2010 would be at risk. Coincident to this, Pat Toomey, head of the anti-tax Club for Growth, stepped down from that post in mid-April with the intention of running in the 2010 primary. In 2004, Specter barely beat Toomey in the primary by 17,000 votes out of a million cast. Undeniably, that margin would have shrunk or gone away with Specter’s support of the Obama stimulus package and polls showed Toomey ahead by double digits versus Specter, which made Specter’s decision that much easier.

Specter now has to appeal to a different constituency in the Pennsylvania primary. He can do this in both promises, as to Mencken’s quote above, or in actions. Quite frankly, if I were a Democrat in Pennsylvania I would want to see some actions from Specter in the next 18 months to prove his party allegiance before I would cast my vote for him in the primary. Even in the most recent congress, he voted over 61% of the time with his Republican colleagues. That number will shrink, likely below 50%.

That said, in his statement today, Specter did hedge himself in order to assert his independence when he stated:

“My change in party affiliation does not mean that I will be a party-line voter any more for the Democrats that I have been for the Republicans. Unlike Senator Jeffords' switch, which changed party control, I will not be an automatic 60th vote for cloture. For example, my position on Employees Free Choice (card check) will not change.”

Given that Specter had previously voted for cloture in 2007 on Employee Free Choice, before he spoke out against it (if you will), I would consider this issue very much in play, among many issues, despite his referencing it in the quote above.

Now my Dad was a former labor leader in Canada, so I do not have a bias either for or against unionization, but it is reasonable to assume that the passage of this act will increase unionization as union representatives will no longer be selected solely by a secret ballot based NLRB election. Under the Employee Free Choice Act, the NLRB would be required to certify a bargaining representative if the majority of employees sign cards, which obviously introduces the factor of peer pressure in determining representation as union members collect these signatures from their colleagues. As was stated in Supreme Court decision NLRB versus Gissel Packing: “A secret ballot election is the most satisfactory — indeed the preferred — method of ascertaining whether a union has majority support.” Indeed.

Unionization obviously has differing impacts on different segments of the economy, but for those businesses that are dependent on labor, the rise in labor cost could be dramatic. According to estimates by the Economic Policy Institute, if 5 million service workers join unions they would “get an average raise of 22%”, which would add up to “$34 billion in total new wages”. While this is obviously a positive outcome for the service worker, assuming they’re able to keep their jobs, the impact on the margins of their employers can only be negative.

Make no mistake about it, the balance of power in the United States has officially swung to the left and as a result we should analyze both risk and reward accordingly with this new geo-political input.

Continue reading "The Specter of Arlen: Is Cloture on Card Check in Play?" »

April 29, 2009

The Extortion Economy

Welcome to the extortion economy. With the financial crisis as cover, the federal government has spent the past eight months dictating terms to American business – terms that defy common sense, economic logic, and moral justification. And they’ve been doing it with brass knuckles.

In testimony made public last week, Bank of America CEO Ken Lewis alleged that the government’s ultimatum to his company was even more menacing than the Credit Suisse shakedown. Lewis claims that then-Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke pressured Bank of America into buying the distressed financial firm Merrill Lynch, even after it became apparent that Merrill was set to post massive losses (the eventual total was over $15 billion) in the fourth quarter. When Lewis raised the prospect of BofA cancelling the deal, Paulson reportedly told him that the acquisition would continue apace and Bank of America shareholders would be kept in the dark about Merrill’s cratering value … or the federal government would fire Lewis and his entire board of directors.

Of course, a “crisis” generally gives Washington carte blanche to indulge in “emergency measures” that stop just short of ritualized human sacrifice. And indeed, those who were on the front lines last autumn claim that any overreach on behalf of the federal government stemmed from a good-faith effort to prevent the nation from economic disaster. But long after the prospect of a complete meltdown has passed, the government’s pistol-to-the-ribs style remains.

Just last week, for instance, Treasury Secretary Timothy Geithner put up roadblocks to responsible banks that want to pay back their TARP debts and free themselves from government control. Geithner told a congressional committee that while he welcomed repayment from TARP-weary institutions like Goldman Sachs and J.P. Morgan Chase (two firms that would have never been brought into the program if it wasn’t for government strong-arming in the first place), releasing them would be contingent on the health of “the system as a whole”. In other words, successful firms will remain indentured to Washington as long as necessary to obscure the failures of their wayward counterparts.

Not content to limit the thumbscrews to the banking sector, the Obama administration – following what is apparently its default urge – is socializing the pain across American industry.

Last week, news leaked that the President’s Auto Task Force was pressuring General Motors to jettison its popular GMC truck line – an unintelligible decision given that GMC is one aspect of GM’s business that is actually profitable. What GMC’s heavy-duty trucks are not, however, is “green”. In the new Democratic zeitgeist, that tends to be a capital offense.

Accordingly, Obama’s Environmental Protection Agency announced in the same period that it is assuming new powers to regulate greenhouse gases. The Administration hopes it can use the specter of crushing EPA regulations to get businesses to knuckle under to Obama’s ambitious program to cap and trade carbon emissions. Given the choice between erratic regulatory pain and predictable statutory pain, their bet is that industry will pick the more digestible poison.

Having already hamstringed the banking, automobile, and energy industries, Obama concluded last week with a Roosevelt Room meeting with executives from the nation’s credit card companies. As the President outlined his support for legislation that would limit the card issuers’ ability to change interest rates or set credit limits, one of the guests boldly ventured to challenge the push for greater regulation. Obama’s glib response was “[you are] talking to a president who still has a very fresh memory of relying on credit cards”. Given the math involved in his current budget, this may be the least revelatory bit of autobiography in presidential history.

Obama’s attempt to run the credit card industry from the West Wing is illustrative of the practical drawbacks of such massive government intervention. Though it may be difficult to convince a public that believes he can multiply loaves and fishes, President Obama cannot change the laws of the marketplace. If he robs credit card companies of the ability to price risk through interest rates, he will see the supply of available credit dry. If he attempts to build a “green economy” by taxing current energy suppliers into penury, he will eliminate more wealth than he creates. And if he forces Detroit to make vehicles that are designed for the preferences of Al Gore rather than the tastes of the market, he will make an already fading industry comatose.

There is a greater risk, however, in this age of burgeoning industrial policy and it is a moral one. By severing the free market’s link between performance and reward, the federal government has totally undercut the ethical rationale of capitalism. For all the recent talk of “greed”, the greatest stain on our economy comes not from the imprudent executive. His fate awaits him in the marketplace. Rather, the real shame comes when the state saves the reckless and the venal at the expense of the upright and the decent.

Economists tell us you get more of what you subsidize. Perhaps that is why wholesale failure is quickly becoming America’s biggest growth industry.

Troy Senik is a former presidential speechwriter and a contributor to the Center for Individual Freedom. He can be reached at .

Yankee Stadium and the Power of Sports Monopolies

To understand what I mean about sports and demographic trends, just take a look at the way the New York metropolitan area has changed in the last 47 years, and the way baseball hasn’t. Since 1962, when the Mets joined the Yankees in New York, MLB’s capacity in the area hasn’t grown. The teams both play a home-season schedule of 81 games, as they have since ’62, and their stadium capacities are actually somewhat smaller today than 47 years ago.

But since the last time the league added capacity in New York, the population of the metropolitan area has grown by some 3 million, or by nearly a fifth. More important, the wealth of that population has increased robustly. Per capita income, after adjusting for inflation, has nearly doubled in the region. All of those extra people and the additional wealth per person mean total income in the region, after adjusting for inflation is up by 115 percent. That’s a marketplace you’d love to have more or less to yourselves, as the Yankees and Mets do.

A growing population that’s also growing richer has set off a scramble for tickets, and as tickets became more prized, businesses have jumped into the fray to compete with the ordinary fan because they can reward prime clients with something that is now scarce and get favorable tax treatment to boot. I can’t say precisely when the era of corporate ticket buying took off, but it’s a good bet that it had something to do with the soaring price of tickets to the four major sports during the 1990s. The average price of a baseball ticket alone increased 93 percent during that decade, compared to a gain of just 26 percent for the Consumer Price Index in an era of low inflation. So far this decade, the average price of an MLB ticket has risen another 60 percent, or more than double the Consumer Price Index. If baseball’s prices had instead increased at the same rate as the CPI over the past 20 years, ticket prices on average would be half of what they are today.

This isn’t by accident. Over the years, professional sports teams have had the leeway to organize and cooperate among themselves. Teams, which are individual businesses, can join together to design a single schedule among themselves and limit the number of participants in a league in order to create a championship format leading to a World Series or Super Bowl. Teams have also been allowed to create a single system of hiring players, such as a draft, and to implement salary caps, on the grounds that it’s in the best interest of the leagues—and fans—to have some sort of competitive balance within a league.

Baseball, of course, has long had more monopoly power than the other leagues thanks to a famous (or infamous, depending on your perspective) 1922 Supreme Court decision in which the court ruled that baseball was a sport, not an interstate business, and therefore not subject to federal anti-trust laws. The most noted element of baseball’s anti-trust exemption, the ability to bind players to a team for life, has slowly been whittled away over the years by court decisions, arbitrator rulings, collective bargaining, and finally by a 1998 federal legislation, the Curt Flood Act, which revoked baseball’s anti-trust exemption in labor issues.

But even as players have gained access to much higher salaries, other elements of the cartel have remained in place, most especially the ability of the league to stop teams from moving between markets and to restrict competition within markets. That means that teams can’t switch markets without approval from MLB, and can’t enter a market already occupied by someone else without approval of a local owner.

The situation hasn’t changed much over the years because there’s no genuine agent of change to force the leagues to operate differently. The only time the federal government ever raises the issue of monopoly practices in pro sports is when some congressman gets his nose out of joint because his local team is thinking of relocating, and then the debate becomes about how to placate the congressman, not how to force the leagues to operate more competitively. The courts haven’t offered much of a better solution because the few lawsuits brought against leagues for antitrust violations are usually initiated by competing leagues or wannabe owners who want to be admitted to the cartel, not bust it up.

Baseball’s owners thus congratulate themselves on the job they’ve done marketing the sport in order to sustain whopping price increases, but it’s a lot easier to raise prices when you have a form of monopoly, but not so easy otherwise. Just ask any retailer who has ever tried to compete with Wal-Mart.

Every once in a while some incurable free-market romantic argues that if the courts would just force the leagues to dump their monopoly practices fans would be better off. If, for instance, MLB couldn’t stop the financially-challenged Minnesota Twins from relocating to New York to compete for fans with the Mets and Yankees, would that moderate ticket prices? A quick look at the market suggests that, given the opportunity, the Twins would be crazy not to consider such a move. After all, one-third of the New York market still amounts to double the population and more than double the aggregate personal income of greater Minneapolis-St. Paul.

Given the success on the field that the Twins have had with meager resources, one could imagine that they would soon develop a loyal following in New York and would probably over time become at least the area’s second most popular team, considering how the poorly-run Mets consistently manage to squander the advantages they have as a big-market team. And maybe a move by the Twins would jolt Minnesota-area fans into more support for a new team. Or maybe not. That’s the way markets work.

But the real incurable romantics in sports are fans, who would dislike that kind of competitive jockeying even more than they dislike high prices. Sports fans, especially in baseball, want everything about the leagues, including their structure, to stay exactly the same because fans value tradition so much. But you can’t have that kind of long-term equilibrium and still expect low prices.

So for the foreseeable future the only economic threat most teams will face in the major sports is from lousy play, which shows that fans still have certain standards. The 1992 Yankees, for instance, with a 76-86 record, drew just 1.7 million spectators. With an expensive new park to pay for, attendance like that would be a disaster today for the Yankees, who count on drawing more than 4 million spectators. Since history has shown that after a few years of fascination with a new stadium, fans will desert a team if their performance wanes, the Yankees face considerable pressure on the field considering the cost of the new stadium.

The leagues understand this issue, of course, which is why they have all done everything they can to make as many teams seem competitive as possible, including expanding the number of teams that get into the playoffs and shrinking the size of divisions to create the illusion that virtually all teams are in contention down to the bitter end of a season.

Of course, some people would observe that sports are entertainment and thus a discretionary purchase, and so their monopoly powers do not quite jolt us the way we might be jolted by banks or supermarkets colluding with one another. To paraphrase Rick in Casablanca, the problems of a few sports fans don’t amount to a hill of beans when the global financial system is falling apart. Still, there’s something unseemly about allowing businesses to generate demand for their services and then use cartel powers to restrict supply and drive up prices. It’s un-American, actually.

Of course, one solution would be for fans to appeal to the Obama administration to nationalize the sports leagues, as it has General Motors, and run them for the public good, as Fidel Castro has done with baseball in Cuba. Then you’d only have to worry about fiddling by Washington. I’m sure it wouldn’t be long before some congressman demanded we limit the number of foreign players to give our American boys in the minors a chance to earn a major league living.

With Washington in control, the games wouldn’t be as good, but they would be cheaper.

Fix Social Security, Ease the Credit Crisis

To see how this could be done, it’s worth looking at the experience of Chile. Government officials in many other countries have looked at Chile’s reform during the 1980s as a model. The United States should take a look, too.

Nothing threatens a public pension system as much as a diminishing ratio of workers to retirees. In Chile, by the time reform began, this problem was severe. As Hernán Büchi, an economic adviser to the Chilean government at the time, notes, in 1979 there were only two-and-a-half workers to support each pensioner. “This ratio, combined with other deficiencies in the system, inevitably meant that the vast majority of workers were retiring on very low pensions,” he writes in his memoir, La transformación económica de Chile (The Economic Transformation of Chile). Clearly, the old system needed to be replaced with one that was sustainable.

The Chilean pension reform required three preparatory steps. The first involved, in Büchi’s words, “introducing some rationality into the system,” which meant doing away with major administrative inefficiencies that had plagued the system.

The second phase of reform involved “gradually reducing the tax on work that was implicit in pension contributions.” This “tax” arose out of the fact that public pension benefits bore no relation to payments made into the system, since they were largely paid via general revenues. Benefits were an unsupportable liability that threatened the finances of the entire government. Another goal of this phase was to bring these financing mechanisms under control. To do so, Büchi notes, “the tax collection systems had to be improved and government spending cut.”

The third, and most crucial, phase constituted “a top-to-bottom structural overhaul of the pension system.” The first step in this phase was to separate different kinds of benefits—old age, disability, workman’s compensation, and others—to be administered separately according to the needs of each kind of benefit.

Having reformed the framework of the pension program, Chile then moved to tap into the power and dynamism of the market. “The new pension system, with freedom as its guiding principle, is founded on the individual responsibility of each worker, reflected in his own savings capacity and his own individual account, and in the private administration of the funds by properly regulated companies,” writes Büchi.

Individual ownership of retirement benefits has helped families accumulate wealth over generations. Now parents, even of limited means, can bequeath more assets to offspring than they ever before.

Contrary to critics, the Chilean pension system does not leave low income individuals or those unlucky enough to have made poor investments adrift. The system, Büchi notes, retains a state-supported “social safety net,” that guarantees “a minimum pension at least” to workers who have not accumulated sufficient savings and who meet certain contribution requirements.

The lessons from Chile’s reforms are relevant to Americans, now that President Obama seems willing to tackle Social Security reform.

Moreover, the Chilean reform has special value given the current need to unleash capital. Büchi points out that Chile’s reform “helped create a substantial private capital market.” Money previously cycled through government agencies became available for private investment, providing entrepreneurs with needed capital and pensioners with better returns.

As the Obama administration and Congress struggle to address America’s credit crisis, they should take the Chilean experience into consideration. As the billions thrown at the nation’s economic troubles have turned into trillions, the last thing we should do is to go further into debt. Instead, we should unleash the wealth and savings creating capacities of the world’s most formidable economic engine: the American workforce

100-Day Lurch to the Left

And with Sen. Arlen Specter switching from Republican to Democrat, Obama can now move the nation even further to the left. A filibuster-proof Senate will mean even greater economic restructuring with expanded government control of health care and energy and increased unionization.

This looks very much like a war against investors, businesses, and entrepreneurs. Shareholder rights are being eviscerated. Political decisions are replacing the rule of law, the rule of bankruptcy courts, and free-market principles.

We are witnessing more spending, deficits, and debt-creation than anyone ever imagined. Bailout Nation has run amok. This started under Bush, but Obama is raising the stakes exponentially.

The latest federal budget would double the debt in five years and triple it in ten. For some perspective, that debt level is higher than the combined debt levels generated under every president from George Washington to George W. Bush. According to the CBO, federal debt held by the public as a percentage of GDP under Obama is projected to rise to 82 percent in ten years. The budget deficit itself never drops below $670 billion and closes the period at $1.2 trillion. That’s nearly a 6 percent share of the economy.

All of this will certainly lead to large tax-rate hikes that will rob incentive power from entrepreneurs, investors, and small-business owners. Just look at Britain, where the top tax rate has been raised to 50 percent from 40 percent. The Thatcher Revolution is being repealed over there. Unless current trends are reversed, the Reagan Revolution will be repealed over here.

The Obama budget already will raise taxes on overseas corporate earnings and oil-and-gas companies at home. It will elevate taxes on capital gains and dividends for investors and will lift the top tax rate for successful earners. And more is coming.

But this is the wrong direction for economic growth. Instead, business tax rates should be slashed — which, by the way, would repatriate corporate earnings for domestic investment. We need a capital-gains tax holiday. We should be flattening individual tax rates across-the-board. And all manner of loopholes and special-interest deductions should be repealed to broaden the taxable-income base.

Nowhere is the Obama vision of government interference more evident than on the banking front. The White House and Treasury are using TARP as a bullying club to force government control on the country’s financial institutions. There is no exit strategy; no endgame in sight. Quite the opposite: News reports suggest that six major banks could be subjected to government ownership, putting them in the same club as Fannie Mae, Freddie Mac, AIG, GM, and Chrysler. This reminds one of Francois Mitterrand, the former socialist president of France. It’s way outside the American economic tradition.

And TARP itself is riddled with criminal-enterprise undertones. According to Special Inspector General Neil Barofsky, the $700 billion TARP program — which has ballooned to more than $3 trillion in spending, loans, and loan guarantees — is “inherently vulnerable to fraud, waste and abuse.” Barofsky already has opened 20 separate TARP-related criminal investigations and six audits into whether taxpayer dollars are being stolen or wasted. Rest assured that they are.

Economic recovery is still likely in the second half of the year. And President Obama will claim victory for his big-spending policies. But the reality is much different. Massive Federal Reserve pump-priming is moving the economy from deep recession to some kind of recovery. Meanwhile, the combination of deficit spending and easy money increases the threat of stagflation.

Will Republicans take advantage of the wide opening created by Obama’s 100-day lurch to the left? So far the GOP has produced only fragmented policy alternatives and no central spokesperson. That’s not unusual for the party out of power. But the Specter defection underscores the GOP’s sagging fortunes.

Right now, the most promising Republican leader — at least in a policy sense — is former Vice President Dick Cheney. His attack against the release of the CIA interrogation memos and his forceful call for the release of the information gathered during those interrogations — facts that helped keep America safe after 9/11 — clearly rattled Team Obama. Mr. Cheney should now launch a counterattack on Obama’s tax-and-spend New Deal/Great Society enlargement of government power.

It would make for delicious irony, but Dick Cheney may be most effective spokesperson the GOP has.

Seeds Of Revival

But they won't. Yes, things are bad. But the fact is, even the nasty 6.1% drop in first-quarter GDP — following an even nastier 6.3% plunge in the fourth quarter — shows signs of a turnaround.

Most prominently, look at consumer spending, which makes up about 70% of GDP. It slowed in last year's final two quarters, but it rose 2.2% in this year's first.

The rebound was boosted by a hefty 9.4% jump in demand for big-ticket durable goods. Indeed, consumer spending rose in almost every segment except food — which fell slightly.

So why did the economy continue its free fall? Five big reasons.

As expected, new home construction plummeted 38%. Government spending also fell — largely due to cuts in defense and spending trims at the state and local level.

Also, business investment and inventories declined at the fastest rates since the end of World War II. Exports to the rest of the world also plunged, thanks to the global recession.

Inventories shrank $103.7 billion in the first three months, the biggest drop since records began in 1947. If not for that massive write-down, the economy would have contracted just 3.4%.

But that's actually positive news — because inventories have been slashed to the bone at most companies. So has capital investment.

With a consumer comeback in the works, businesses may have to move fast later this year to expand output and restock their depleted shelves. This could get the economy moving again, though for how long and how strong is open to question.

Even the Fed, which is about to buy $1.7 trillion in bad debt from banks, said in its most recent reading on the economy released Wednesday that the recession is starting to ease.

This optimism is bolstered by the April IBD/TIPP Poll, which rose 8.4% to 49.1, just below the 50 level that signals optimism. A look at IBD's stock market indexes shows many of the leaders since the March 9 bottom have a consumer tinge.

The Nasdaq index in a bit over a month and a half has surged 24%. Total market value has jumped $1.9 trillion in that time. Clearly, the stock market, our best leading indicator, expects a recovery.

We mention this not to be Pollyannish about the economy. We aren't. But we're seeing little gems like the following, tucked into a recent AP story on the GDP drop: "Some analysts stuck to predictions that the economy would shrink less in the current April-June period . . . as Obama's stimulus begins to take hold."

There are many reasons the economy might grow. Unfortunately, the $787 billion stimulus passed by Congress isn't one of them. Simply put, not enough money emerging from it will make any difference in the second quarter.

(Fed action is another question. The central bank has already pushed more than $1 trillion into the financial system, and stands ready to add an additional $1.7 trillion.)

So recovery is likely. Our guess is the third quarter, but who really knows? One thing is clear: When it happens it'll be thanks to the sacrifices businesses, workers and investors have already made.

Other than get in the way, the government has done little.

April 30, 2009

There Is No Time To Dither in a Meltdown

The key problem in times like these is that investor demand for safe, secure, and liquid assets - and thus their value - is too high, while demand for assets that underpin and finance the economy's productive capital is too low. The obvious solution is for governments to create more cash to satisfy the demand for safe, secure, liquid assets.

As Keynes liked to say: "Unemployment develops ... because people want the moon" - safe, secure, and liquid assets. "Men cannot be employed when the object of desire [ie, money] is something which cannot be produced and the demand for which cannot readily be choked off." The solution is "to persuade the public that green cheese [ie, the notes printed by the central bank] is practically the same thing and to have a green cheese factory [ie a central bank] under public control ..."

By buying government bonds for cash, a central bank can satisfy demand and push down the price of cash. When there is no excess demand for cash, there will be no excess supply of the bonds and stocks that underpin and finance the economy's productive capital. Thus, expansionary monetary policy via standard open-market operations by a central bank is the first item on the checklist of what to do in a financial crisis.

Three months ago, I argued that all but a tiny and unbalanced fringe of economists approve of expansionary open-market operations to keep total nominal spending constant in a downturn, and I was right.

I was also right to say that all but a tiny and unbalanced fringe of economists approve of central-bank guarantees of system stability, in order to prevent the risk of a collapse of the payments system from becoming a first-order consideration boosting the demand for cash to unnatural levels.

The problem comes when expansionary monetary policy via standard open-market operations and central-bank guarantees of orderly markets prove insufficient. Economists disagree about when, under what circumstances, and in what order governments should move beyond these first two items on the checklist.

Should governments try to increase monetary velocity by selling bonds, thereby boosting short-term interest rates? Should they employ unemployed workers directly, or indirectly, by bringing forward expenditures or expanding the scale of government programs? Should they explicitly guarantee large financial institutions' liabilities and/or classes of assets?

Should they buy up assets at what they believe is a discount from their long-run values, or buy up assets that private investors are unwilling to trade, even at a premium above their likely long-run values? Should governments recapitalize or nationalize banks? Should they keep printing money even after exhausting their ability to inject extra liquidity into the economy via conventional open-market operations, which is now the case in the United States and elsewhere?

A checklist

Three months ago, I said that there was considerable disagreement about these issues, but that two things were certain. First, we do not know enough about when, under what circumstances, and in what order governments should resort to these checklist items.

Second, trying a combination of these items - even a confused and haphazard combination - was better than doing nothing. All five of the world's major economies implemented their own confused and haphazard combinations of monetary, fiscal, and banking stimulus policies during the Great Depression, and the sooner they did - the sooner each began its own New Deal - the better.

Japan and Britain began their New Deals in 1931. Germany and the US began theirs in 1933. France waited until 1936. Japan and Britain recovered first and fastest from the Great Depression, Germany and the US followed well behind, and France brought up the rear.

The conclusion that I draw from this is that we should try a combination of all checklist measures - quantitative monetary easing; bank guarantees, purchases, recapitalizations, and nationalizations; direct fiscal spending and debt issues - while ensuring that we can do so fast enough and on a large enough scale to do the job.

Yet I am told that the chances of getting more money in the US for an extra round of fiscal stimulus this year is zero, as is the chance of getting more money this year to intervene in the banking system on an even larger scale than America's Troubled Asset Relief Program (TARP).

There is an 80 percent chance that waiting until 2010 and seeing what policies look appropriate then would not be disastrous. But that means that there is a 20 percent chance that it would be.

Brad DeLong, a former Assistant U.S. Treasury Secretary in the Clinton administration, is professor of economics at the University of California at Berkeley.

Continue reading "There Is No Time To Dither in a Meltdown" »

The Folly of 'Equal Pay' Laws

According to Mrs. Maloney, “we have considerable work left to do before women earn equal pay for equal work.” Yet a GAO report, released at the hearing, found only a seven-cent pay gap between men and women working in the federal government. This seven cent gap was calculated even without accounting for work experience outside the federal government—surely a significant determinant of income. GAO concluded that “our analysis neither confirms nor refutes the presence of discriminatory practices.”

The latest figures show that comparing men and women who work 40 hours weekly yields a wage ratio of 87 percent, even before accounting for different education, jobs, or experience, which brings the wage ratio closer to 95 percent. Many studies, such as those by Professor June O’Neill of Baruch College and Professor Marianne Bernard of the University of Chicago, show that when women work at the same jobs as men, with the same accumulated lifetime work experience, they earn essentially the same salary.

Of course, not everyone is paid the same. Some people are paid less than others because of the choices they make about field of study, occupation, and time on the job. Compared to men, women tend to choose more college majors in the lower-paid humanities rather than in the sciences, and take more time out of the workforce for child-raising.

The Equal Pay Act of 1963 already requires equal pay for equal work, and the recently-passed Lilly Ledbetter Fair Pay Act changed Title VII of the Civil Rights Act to allow workers to argue that their current compensation flows from discriminatory decisions made years back, with no statute of limitations.

But Mrs. Maloney wants still more, and she is a cosponsor of the Paycheck Fairness Act, which would allow women to sue for unlimited compensatory and punitive damages. It would encourage class actions by requiring workers who do not want to participate to opt out, rather than opt in, a radical change from conventional law and practice. The Equal Employment Opportunity Commission would collect data on the race, sex, and wages of workers to test for and prevent discrimination.

At the Joint Economic Committee hearing, University of Massachusetts economics professor Randy Albelda testified that since women pick different occupations, the government needs to raise the wages of these occupations to get rid of the pay gap, particularly wages of caregivers, such as nurses, who are employed through federal, state, and local government funds.

The American Association of University Women’s Lisa Maatz, a former Maloney staffer, testified “It’s not that we don’t want women to be nurses. But why aren’t we paying them what they’re worth?” She added, “We need to look at how we pay people, what we value and what we don’t.”

What these witnesses are saying is that the government needs to be setting wages, rather than leaving this valuable function to the private sector, because the private sector does not do the right job. It’s not fair, said Ms. Maatz, that secondary school biology teachers earn less than scientists—even though high school biology teachers get more vacation, finish their days earlier, and do not have to produce lengthy research papers as a condition of promotion.

Consider a large firm such as Chevron. Would it have to pay clerical workers, mostly women, as much as it pays refinery hands, mostly men? With such “equality,” who would be willing to work at the distant, more dangerous jobs in the refinery?

Into how many categories would the EEOC divide hospital jobs? Bank jobs? Insurance jobs? Wages change constantly and job classifications are imperfect, and can be changed. Employers might not know the race of workers—and are prevented by other laws from inquiring.

Although Congress has never enacted comparable worth, a few states, such as Washington and Minnesota, have done so on state and local government operations. The extra funding for increased women’s salaries comes from the taxpayers and does not cause the governmental entity to go out of business. Requiring private businesses to adopt comparable worth would raise costs of hiring, hurting women’s opportunities.

For better or for worse, our economic system rewards workers on the basis of how much employers willing to pay for their service. There is no other measure of a job’s "inherent value."

American women are winners, although it’s hard to believe from the Equal Pay Day rhetoric. They earn over 57 percent of BA degrees and their unemployment rate in this recession, at 7 percent, is lower than that for men, at 9 percent. Perhaps it’s the men that need help.

When Our Trade Isn't Free, Neither Is Our Work

Greenspan’s underlying point is that the trade that so many discuss in terms of countrywide imports and exports is really about individuals freely exchanging their surplus for that produced by others. In that case, all trade by definition balances.

And with the individual in mind, we can see clearly the faulty premise of protectionism. For an individual to act in ways protectionist would be for that person to live needlessly a life of deprivation. If this is doubted, imagine the living standards to which we would reduce ourselves if as individuals we relied solely on ourselves for food, clothing and healthcare, to list just a few of our wants. Assuming a long life, it would surely be one of immense poverty.

All of this is important in light of the almost monolithic move away from free trade among the G20 nations whose leaders recently gathered in London. Notably, officials of those same countries met in Washington last September, and while all promised to eschew protectionism, a new report from the World Bank reveals that in the aftermath of the September gathering, 17 of the 20 (including the United States) countries adopted no less than 47 protectionist measures.

The United States turns inward. Sadly, the numbers cited by the World Bank don’t even begin to describe what has actually occurred. If the U.S. is considered alone, our leaders have had us on a protectionist tilt of impressive proportions since last fall.

Indeed, while Washington has described the loans made to General Motors and Chrysler as simple bridge financing that will allow them to restructure their operations on the way to profitability, the subsidies have the effect of tariffs meant to give U.S. carmakers advantage against their foreign rivals. The loans have not only kept GM and Chrysler afloat, but they’ve allowed both to tempt potential customers with zero percent financing that other automakers, including Ford, have been unable to offer. More recently the Obama administration introduced a “cash for clunkers” program meant to subsidize the process whereby owners of older cars will receive a government check if they exchange their autos for new, American made cars.

And while there’s growing evidence that the Troubled Asset Relief Program (TARP) has unwittingly aided foreign banks, its imposition in the first place retarded the natural market process that would have allowed healthy banks, both domestic and foreign, to take market share from U.S.-based financial institutions made insolvent by their lending errors. Free trade also includes the free flow of human capital, but TARP recipients have seen their hiring scrutinized too, and have been told to cancel job offers made to foreign workers.

As part of the Obama administration’s stimulus package, a “Buy American” provision was inserted that would require companies receiving money for infrastructure projects to purchase most materials from U.S.-based firms. Not long after, U.S. trade officials, in a blatant violation of Nafta, re-imposed restrictions on the entrance into the United States of long-haul Mexican trucks seeking to deliver goods to American customers.

More broadly, and since 2001, officials at the U.S. Treasury have regularly decreed that markets should set the value of the dollar. This statement is pregnant with meaning, for it communicates to the markets that U.S. monetary officials would countenance a weaker dollar. A debased greenback has long but incorrectly been seen by Washington as a tool to enhance the prospects of U.S. exporters at the expense of foreigners.

Implications of our inward turn. To a certain degree, therefore, American politicians are seeking to put up barriers to the natural flow of goods. What are the implications? At its core, protectionism is the process whereby producers who are no longer meeting customer needs are foisted on those same consumers despite their desire to transact with someone else.

In that sense, it should be said that tariffs are as much a tax on work as those imposed on us by the IRS. Ultimately we all engage in some form of labor so that we can purchase what we don’t make, but when barriers to trade are erected, the very reason we work is discouraged due to our inability to buy what we want. And what we buy costs more.

Worse, when artificial barriers to trade are created, they restrict the natural expansion of the division of labor so essential to economic growth. Along those lines, we never consider the balance of trade between (for instance) the state of Washington and Texas. And for good reason. That Seattle-based Microsoft created Windows software for Texans in no way impoverishes the latter, but makes them more efficient, all the while making it possible for the rise of Dell and Compaq.

As Adam Smith’s famous observation on the pin factory made so clear, the introduction of new workers to the production process has the wonderful effect of increasing the productivity of all those participating. Conversely, when labor’s division is shrunk not only do we increase the cost of all goods, but we make all labor less efficient thanks to the duplication of work effort alongside the misdirection of capital necessary to fund less efficient work.

Barriers are based on the notion that trade is harmful rather than enriching, and that we must keep our supposed competitors in check lest they become too strong. But what’s rarely mentioned is what our economic situation would be like absent the myriad goods that reach our shores from foreign locales. No New York City financier would blink at a computer arriving from Texas in return for his or her productivity in finance; instead both the financier and the computer manufacturer are thankful for open lines of trade that allow each to do what they do best.

Looked at from an international perspective, are the individuals from whom we import competitors? Or are they the very people whose production of televisions, clothes and shoes allow us to do other, more enriching work? Not only can we not sell to foreigners if we’re not buying from them, but when we seek to retard the process whereby they export to us, we also reduce our own individual freedom to do the kind of work we want to do.

Mentioned earlier were the subsidies meant to keep dying banks, automakers and trucking firms afloat. It’s more than apparent that portions of each sector are not profitable. Would we prefer that foreign competition make unprofitable U.S. firms obsolete, or would it be better if individuals operating outside the States started competing with us in higher-margin areas?

Wages always and everywhere result from capital provided by investors. So if the policy objective from Washington is one meant to oxygenate those gasping for air, we’re merely setting the stage for capital to flow to foreigners eager to compete with us in more profitable, higher paying disciplines. Ultimately, open lines of trade free U.S. workers and capital from low-value areas so that both can be applied to industry that investors value more. As 19th century free trade advocate Nassau Senior observed, protection causes individuals “to divert their capital and industry from their natural courses.”

International implications of U.S. protectionism. The inward turn of the United States with regard to trade cannot be ignored. While economic logic would suggest that our foreign trade partners might turn a blind eye to our economic mistakes, history tells us they might do otherwise.

As H.C. Wainwright's David Ranson recently observed, news that President Hoover would eventually sign the 1930 Smoot-Hawley tariff bill was all the evidence investors needed that a worldwide trade war was looming. As the late Jude Wanniski pointed out thirty years ago, the barriers we put up to trade were met by our foreign trade partners and markets cascaded downward.

Some might respond that another trade war would never happen, that we’ve learned from past mistakes, and that there will never be another Smoot-Hawley. This is perhaps comforting to assume, but as historian John Batchelor recently observed about the 1930s in contrast with the present, “we are no smarter than our forebears, and they were no less informed than we are of the threats of trade, currency and prices.”

In short, our limping moves away from free trade are very real and, if not halted, there’s no telling what the foreign response might be. Better it would be if the United States showed leadership at a time when it’s much needed. We ought to be making plain to foreign leaders that no matter the lengths they go to offer their citizens a false form of protection, we’ll keep our markets open so that our citizens can continue to be gratified beyond their own ability to produce.

About April 2009

This page contains all entries posted to RealClearMarkets - Articles in April 2009. They are listed from oldest to newest.

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