Punishing the Victims of the Financial Crisis

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As the new Obama administration prepares to enact the mother of all “stimulus” packages, it seems that some still can’t get straight what caused the current worldwide recession. Outgoing Treasury Secretary Hank Paulson still believes the problem was caused by Asians saving too much.

In a recent interview with the Financial Times, Paulson blamed the credit crisis on global imbalances. Specifically, he repeated a storyline popularized by Alan Greenspan and Ben Bernanke: that a global savings glut (otherwise known as an imbalance) pushed interest rates down around the world and drove investors toward riskier and more leveraged investment activities.

If we live in a global economy, and I think everyone would agree that we do, don’t some of the planet’s inhabitants need to be savers? If no one saved, where would the capital come from for future growth? Is there some magic percentage of income above which savings becomes a vice rather than a virtue? If so, who should decide what that percentage should be? Hank Paulson? Ben Bernanke?

American policy makers just can’t seem to come to grips with the fact that it is the US that caused this problem. It was not caused by Asians saving too much or because the Chinese held down the value of their currency. It wasn’t a savings glut that pushed interest rates down and drove investors toward riskier assets. It was caused by the obvious, if sometimes unofficial, policy of the US government. The Fed held interest rates artificially low while the Treasury pursued a weak dollar. The result was savings and investment being redirected to real assets such as housing and commodities in an attempt to preserve purchasing power. With savings and investment diverted from more productive uses, it should not be surprising that we now face a nasty recession.

Americans are now saving more and some interpret that to mean the recession will be extended since in their view it is consumption that drives growth. These pundits have it exactly backwards. The fact that Americans save more during recessions is what makes US recessions shorter than would otherwise be the case. Others are trotting out the old canard about the “paradox of saving”, but frugality is not a virtue only when practiced by a small number and is suddenly transformed into a vice when more people participate.

Savings today is the fuel for growth tomorrow. Families that are saving more are merely shifting their time preference. Due to circumstances and fear of the future, they are foregoing consumption today in favor of consumption tomorrow. The Fed is doing everything it can, by suppressing interest rates, to counter that shift, but that is a losing game for the Fed. Individuals will do the right thing regardless of Fed policy. Luckily, the dollar has risen during the crisis which should give Americans even more reason to save and invest in productive assets.

This focus on the short term reveals the Fed as the political entity that it has always been. Politicians who must face voters periodically have no incentive to enact economic policies that are in the long-term interest of the nation. Theoretically, the Fed should be able to ignore these short term pressures and set monetary policy in a way that is beneficial to the long-term health of the economy. The reality is obviously different as the Fed governors must please the political masters who appoint and confirm them. The Fed and Treasury Department have always been used by politicians to avoid making the hard choices that are required for long-term growth and price stability. Manipulating interest rates and exchange rates are not substitutes for good policy.

This week the Obama administration released some details of its stimulus plan, which is now being touted as heavy on “tax cuts”. But the “good policy” within is notable only by its absence. These “tax cuts” are not tax cuts in the traditional sense.

The largest of the business tax cuts will allow companies to use current losses to offset profits as far back as five years. There are even proposals to provide tax “rebates” to companies that have never turned a profit (think ethanol). Thus, companies that have lost money recently will be rewarded while those who managed their businesses profitably will be forced to support their competitors. Accelerated depreciation is also part of the package and will allow companies to shorten the schedule for investments made over the next two years. This has been tried before and had little effect on investment. The temporary nature of the cut renders it ineffective. Companies will just use the cut to expense already planned expenditures. Changing the depreciation schedule permanently could have an effect on long-term investment, but that isn’t being considered.

Most of the other “tax cuts” are actually tax credits that should be classified as income subsidies. While there may be social benefits to a negative income tax and it is certainly more efficient than traditional forms of welfare, tax credits shouldn’t be confused with anything that will drive future economic performance. It is just another attempt to prop up consumption at the expense of savings.

Higher taxes on the most productive will be used to supplement the income of the less productive. Money is merely transferred from those with a high propensity to save to those with a high propensity to consume. It is just another attempt to borrow from the future to fund consumption in the present. We may forestall a deeper recession today, but only at the expense of a weaker economy in the future.

And those who believe that only government spending can save us can’t even bring themselves to embrace these limited, temporary and ineffective tax cuts. Paul Krugman has already taken to the pages of the New York Times to wonder aloud whether Obama is depending too much on tax reductions:

"I don’t know yet. But news reports this morning certainly raise questions.

Let’s lay out the basics here. Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over."

Recent studies have shown that tax cuts are actually more stimulative than deficit financed government spending. Deficit financed government spending shocks produce an effect similar to tax hikes. The taxes to pay for the spending may be in the future, but the effect is felt today as people adjust their behavior to prepare for those higher future taxes. Any stimulus from the spending is mostly offset by the expectation of higher future taxes.

With a deficit financed tax cut, even if it is saved to Krugman’s doubtless horror, at least people will have the dollars to pay higher future taxes and the present change in behavior is limited. And does Krugman really believe that if the tax cuts are saved (and therefore fund private investment) there is no benefit? Why is it that only “investments” made by his preferred politicians produce returns?

The actions of the Federal Reserve and soon the actions of the new Obama administration amount to punishing the victims of the financial crisis. The victims are the everyday Americans who saved and invested their hard earned dollars and didn’t consume beyond their means, but who will be forced to pay the tab for those who did.

Other victims are the companies that managed their businesses conservatively, only to be forced to subsidize companies that were managed recklessly. The victims are the retired Americans who must try to survive on interest rates that are artificially suppressed to rescue those who overindulged.

The question at this point is when will the prudent be rewarded? When will creditors be treated with the same deference as debtors? When will we get economic policy that is effective rather than just politically correct? When will we again trust the market to sort winners from losers rather than allowing politicians to rescue the well connected?

Joseph Calhoun is CEO of Alhambra Investment Partners in Miami, Florida. He can be reached at jyc3@alhambrapartners.com

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