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June 1, 2009

Boom Times Are Back, Outside the U.S.

But a funny thing happened on the way to a global depression. Once the panic that seized all global markets abated—because it became clear the world was not going to end—there began a fascinating and disparate recovery. The American stock market, after six plummeting months, has rebounded, so that the S&P 500 is roughly where it started the year, as is the London FTSE. Japanese stocks have fared better, up nearly 7 percent.

Around the globe, though, markets are humming. China's Shanghai index is up 45 percent, India's Sensex is up 44 percent, Brazil's Bovespa is up 38 percent and the Indonesia index is up 32 percent. Now, stock markets don't tell the whole story, but the reason many of these are rising is that the underlying economies of most of these countries are still registering significant growth. The evidence abounds. In April, India's car sales were 4.2 percent higher than they were a year prior. Retail sales rose 15 percent in China in the first quarter of 2009. China is likely to grow at 7 or 8 percent this year, India at 6 percent and Indonesia at 4 percent. These numbers are not just robust but astonishing when you line them up against those in the developed world. The U.S. economy contracted at an annual rate of 6.1 percent last quarter, Europe by 9.6 percent and Japan by a frightening 15 percent, something that truly does begin to rival the 1930s.

Compare the two worlds. On the one side is the West (plus Japan), with banks that are overleveraged and thus dysfunctional, governments groaning under debt, and consumers who are rebuilding their broken balance sheets. America is having trouble selling its IOUs at attractive prices (the last three Treasury auctions have gone badly); its largest state, California, is veering toward total fiscal collapse; and its budget deficit is going to surpass 13 percent of GDP—a level last seen during World War II. With all these burdens, even if there is a recovery, the United States might not return to fast-paced growth for a while. And it's probably more dynamic than Europe or Japan.

Meanwhile, emerging-market banks are largely healthy and profitable. (Every Indian bank, government-owned and private, posted profits in the last quarter of 2008!) The governments are in good fiscal shape. China's strengths are well known—$2 trillion in reserves, a budget deficit that is less than 3 percent of GDP—but consider Brazil, which is now posting a current account surplus. Or Indonesia, which has reduced its debt from 100 percent of GDP nine years ago to 30 percent today. And unlike in the West—where governments have run out of ammunition and are now praying that their medicine will work—these countries still have options. Only a year ago, their chief concern was an overheated economy and inflation. Brazil has cut its interest rate substantially, but only to 10.25 percent, which means it can drop it further if things deteriorate even more.

The mood in many of these countries remains surprisingly upbeat. Their currencies are appreciating against the dollar because the markets see them as having better fiscal discipline as well as better long-term growth prospects than the United States. Their bonds are rising. This combination of indicators, all pointing in the same direction, is unprecedented.

The United States remains the richest and most powerful country in the world. Its military spans the globe. But from the Spanish Empire of the 16th century to the British Empire in the 20th century, great global powers have always found that their fortunes begin to turn when they get overburdened with debt and stuck in a path of slow growth. These are early warnings. Unless the United States gets its act together, and fast, the ground will continue to shift beneath its feet, slowly but surely.

Wither the Dying Newspaper Business?

Sounding the alarm after years of denial, newspaper publishers are rallying to defend what they believe is their constitutional prerogative to herd us into passive masses so they can tell us what news to read, how to read it, and what we should think about it. Lotsa luck.

Pundits and politicians are horrified at the prospect of losing their captive channel. Defenders of diversity and the richness of multiple voices unsullied by corporatism recoil from the thought that this could happen in the news business. Watch as calls for government intervention grow.

Right on cue, congressmen are proposing government subsidies, changes in tax and copyright laws, and most recently suspension of antitrust regulations so the beleaguered industry can cartelize and fix prices. How else can politicos maintain their cozy relationships with their purported watchdogs?

King Canute would be proud.

With few exceptions, most notably the Wall Street Journal, the newspaper industry fell into the classic trap of underestimating the power of the internet. Not only can the internet do a better and more timely job distributing news but it demolished barriers to entry for news gatherers, editors, and commentators. Who can feign surprise? Go check out the price difference between a web server and a block-long printing press feeding a fleet of trucks.

Publishers failed to prepare and most will fail to adapt. Shielded behind bulletproof classes of supervoting stock, newspaper family oligarchs ran their web sites like vanity press, preferring to marinate in the dwindling prestige of the antique paper product they inherited. Meanwhile the economic lifeblood of newspapers, namely classified ads, fled to the web. In that fertile soil classifieds harnessed the power of interactivity unencumbered by the economics of physical distribution.

So what now? The world of the written word will always need news gatherers and news editors. And the market for commentators has never been better. But there is no reason to believe that news practitioners have to be employees of vertically integrated corporations housed in antiquated factories run by industrial-age guilds squirting black pigment onto bleached tree slices. Trying to keep that broken business model alive is a fool’s game. Speaking of which, how much fun was it to watch the New York Times face down the guaranteed-job-for-life crew at the Boston Globe as management struggled mightily to free itself from the curse of organized labor that it wishes on every other industry?

But what about professional journalists, you ask? Who will pay their keep if not vertically integrated newspapers? Don’t they deserve special consideration?

Check any public opinion poll and you will see that journalists have largely worn out their welcome. Long gone are the days when reporters were trained to stick to the who, what, when, and where of a story. Rare is the reporter that even bothers to get the facts straight, absorbed as they are promoting their point of view. Anyone who has actually been interviewed by a reporter only to watch their words get twisted to fit a pre-conceived agenda knows that “journalistic integrity” is a cultural myth. And when was the last time you found an editor that restricts editorials to the editorial page?

Breaking the present system and allowing it to rebuild itself as an interconnected ecosystem of independent full and part-time news agents, specialty aggregators, and freelance commentators is the best thing that can happen to the news business. Writers, editors, and commentators such as myself will always be over-produced commodities. There will be plenty of us to feed the machine even as we watch our compensation drop from $1.50 per word to zero, as mine has.

Like much of my generation, I still read the Wall Street Journal and the New York Times in their paper editions, though who knows how much longer. The new WSJ reader on my BlackBerry is so superb that I no longer get frantic if the paper copy doesn’t arrive on time. I’ve not yet bought a Kindle but it’s just a matter of time before Moore’s Law makes portable e-Readers attractive to the masses. Reading on a small screen is certainly different than perusing a broadsheet, and content producers and aggregators will have to adapt. Articles have to be read by active selection rather than serendipity. This will surely have consequences. For example, would you go out of your way to read Maureen Dowd's vapid twitterings if your eyes weren't already in the neighborhood? Ditto display ads.

Life will go on and business models will adapt. Old players will disappear under the waves and new ones will arise from unlikely places. Yet news will continue to be gathered and distributed long after paper newspapers pass the way of the town crier.

June 2, 2009

When the Government Determines Success

How's that compare with the other "stakeholders?" For spending $50 billion to bail out GM, the government will get 60% of the equity in the new GM; the UAW, which along with other unions gave millions to Democrats, will be repaid for its loyalty with 17.5% of the stock for $10 billion of unsecured debts.

So the government, with roughly two times what private bondholders have on the table, gets a stake five times bigger. And the union, with about a third as much "invested," gets a 70% bigger stake. Even the Canadian government, with its $9.5 billion "invested," ends up with 12%.

They call it "restructuring." We call it theft. Never in our memory has there been a more thorough, systematic effort to disenfranchise the shareholders and bondholders of a major American firm.

It will make investors — domestic and foreign alike — think twice about investing in an American stock or bond in the coming years. Why invest if your money and rights as an investor can be arbitrarily stripped from you, as they were in GM's case?

But our real issue with this isn't that people will lose money. It's that we don't believe the government's actions are even legal.

The White House has basically been manipulating GM into bankruptcy since early this year, putting 31-year-old Brian Deese, a Yale law student, in charge of GM's restructuring. "It is not every 31-year-old who, in a first government job, finds himself dismantling General Motors and rewriting the rules of American capitalism," the New York Times said with tongue in cheek (we think).

It used to be that the "rules of American capitalism" came from 200 years of U.S. case law, the Constitution and legitimate federal regulation. But no more. Instead, the job's been given to someone not yet out of law school. This shows shocking contempt for GM, once the world's pre-eminent industrial company, for American capitalism and the rule of law.

We don't think this travesty passes constitutional muster and hope to see it vigorously challenged in federal court soon.

Our Constitution is very specific. It limits the executive branch's rights to those enumerated therein. The rest it grants to the people and the states. It also requires due process under the law, especially when government "takings" are involved.

That's why in 1952, when President Harry S. Truman tried to seize control of the U.S. steel industry during a debilitating strike, the Supreme Court made him back down. And Truman had a real emergency on his hands: the Korean War.

We pored over Article II of the Constitution, known as the Executive Powers Clause. Nowhere is the White House granted the right to override the time-tested bankruptcy process, to use Treasury money raised by taxing Americans to buy or bail out companies, to fire CEOs, to micromanage corporate policy, or to abrogate lawful contracts made by private parties.

Yet, our government has done these things and more — leading to a corrupt GM bankruptcy. The damage to our system of corporate capitalism and the rule of law is severe. Next stop: Federal court?

The Hidden Purposes of High Finance

So does the ability of households to borrow and lend in order not to be forced to match income and expenditure every day, week, month, or year.

But what use is "high" finance?

Economists’ conventional description depicts high finance as providing us with three types of utility. First, it allows for many savers to pool their wealth to finance large enterprises that can achieve the efficiencies of scale possible from capital-intensive modern industry.

Second, high finance provides an arena to curb the worst abuses by managers of large corporations. Managers’ fear that if the stock price drops too low they will be out on their ears provides a useful restraint.

Finally, high finance allows for portfolio diversification, so that individual investors can seek high expected returns without being forced to assume large, idiosyncratic risks of bankruptcy and poverty.

But these are the benefits of high finance as they apply to the ideal world of economists — that is, a world of rational utilitarian actors who are skilled calculators of expected utility under uncertainty, who are masters of dynamic programming. We do not live in such a world.

Economists have spent their lives attempting to evolve theories that would account for how salient features of reality might emerge if we did live in their ideal world, but since we don’t, their theoretical enterprise is of doubtful utility. It is like describing how one could bake a delicious wedding cake using only honey, bicarbonate of soda, and raw eggplant.

If we take the world as it really is, we see that high finance performs two further tasks that advance our collective welfare. It induces us to save, accumulate, and invest by promising us safe, liquid investments even in extraordinary times.

It is a fact that we are much happier saving and accumulating, and that we are much more likely to do so when we think that the resources we have saved and accumulated are at hand. It is also true that when we invest our wealth — in Pfizer’s intellectual property, factories in Shenzhen, or worldwide distribution networks — it is not, in fact, at hand. Our invested wealth can only be made to appear liquid, and only if there is no general shift in our collective desire for liquidity.

And it is also a fact that we are happier saving and accumulating if we receive positive and negative feedback on our decisions on a time scale that allows us to believe that we can do better next time by altering our strategy — hence marketwatch.com and CNN/Money.

Of course, investors who believe that their wealth is securely liquid, and that they are adding value for themselves by buying and selling are suffering from a delusion. Our financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...."

Moreover, for Keynes, "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...."

It is for these reasons that we have seemed frozen for the past generation or two whenever we have contemplated reforming our system of financial regulation. And it is why, even in the face of a severe financial crisis, we remain frozen today.

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

Continue reading "The Hidden Purposes of High Finance" »

Mankiw & Rogoff: Why We Don't Need Economists

At first glance it’s easy to pick out the many problems with their analysis. While it’s certainly true that inflation drives cash-holding individuals to consume in the near-term, what neither economist has accounted for is that governments can at best reschedule consumption. If a weak dollar moves heavy consumption into the present, the economy will suffer from a dearth of consumption later on as debts come due.

It also has to be remembered that consumption is an overrated economic God. Broken down to the individual, we can see that if individuals consumed every dollar of every paycheck, they wouldn’t be well off; instead they would be living paycheck to paycheck. Since most big ticket items (think cars, houses, medical care) require more than one paycheck to finance, irrational consumption would put much of what we want out of reach altogether. Most important is the basic truth that any economy relies on entrepreneurial innovation in order to grow and attract more investment. If individuals are driven to consume with reckless abandon, entrepreneurs and businesses reliant on investment in order to grow will have a smaller pool of capital from which to draw from.

Inflation does help debtors as Mankiw and Rogoff suggest, but sadly, that’s only the seen. The unseen is the certain truth that lenders don’t sit idly by when central banks devalue the unit of account which they lend. Instead, they demand a higher rate of interest on money borrowed to account for the devaluation of the currency.

Rogoff thinks 6 percent inflation is the answer, but what he fails to acknowledge is that 6 percent inflation would double the admittedly worthless price level in twelve years. Put more simply, inflation always steals the benefits of devaluation because the cost of goods must rise to account for the weaker currency. Economists love to talk up devaluation, but their advocacy is naïve. The owners of my apartment could redefine what a square foot is tomorrow and my apartment would double in size, but I would still be cramped in the same apartment. Why economists don’t think this applies to money and the cost of goods will remain one of life’s enduring mysteries.

In the real world, however, devaluation does once again increase the cost of goods, so while Americans might be more eager to move up their spending in the near-term, longer term the value of their paychecks would shrink in concert with higher prices across the board. To clarify this, think of prices at the pump this decade. As is always the case, they rose when the dollar weakened. For Rogoff and Mankiw to suggest that a resumption of $4/gallon gas would be good is something they should be forced to explain in greater detail.

Sadly, the true ravages of inflation don’t end there. Indeed, when investors consider committing capital to anything, assumptions about inflation play a big role. They must due to the simple truth that inflation erodes the value of investment returns. If it’s assumed that the money they’re committing will be reduced in value by governmental mischief, it’s a certainty that they’ll invest the capital in a place where it will be treated better.

Notably, the above calculation greatly impacts the wages of the very individuals that Mankiw and Rogoff suggest they want to help. Simplified, there are no wages without capital, and capital providing investors naturally hate inflation. If the advice of Rogoff and Mankiw is followed, not only will Americans face higher prices in the future, but they’ll suffer those prices amid an investor strike as capital goes elsewhere, or into hard assets like property, gold and art.

This explains why the weak dollar era of the ‘70s, not to mention this decade, coincided with a great deal of economic unhappiness among the electorate. Inflation is death by a thousand cuts. Alongside the rising prices that it by definition generates, individuals suffer wages that can’t keep up with devaluationist policies thanks to investors fleeing to where currency oversight is responsible.

In truth, the currency policy we need today is the exact opposite of that which Mankiw and Rogoff advocate. Economies don’t just deteriorate, instead they descend when capital is treated badly. Inflation is the ultimate destroyer of capital, so if recovery is what we want, policy must center on strengthening our already weak dollar first, followed by stabilization of that same dollar; preferably in terms of gold.

If Rogoff and Mankiw get their way, what many term the greatest economist crisis since the Great Depression will intensify. Worse, and maybe this is a good thing, the reputation of conventional economists will plummet even more than it already has.

June 3, 2009

Militant Unions Raise Muni Risk

But today’s world is very different. Public employee groups have accumulated so much power in recent years that governments are having trouble trimming budgets, especially burgeoning employee costs, while tax increases on an already-shrinking economy aren’t producing the revenues needed to close budget gaps. That’s created budgetary gridlock in places like California and is one reason why imposing figures like Warren Buffett have started to worry whether the old, reliable municipal bond market isn’t heading for turmoil. “Insuring tax-exempts…has the look of a dangerous business,” Buffett wrote to shareholders earlier this year.

Buffett isn’t alone in worrying about munis. Although the municipal business has always been considered a plain-vanilla market— dependable bonds issued to conservative investors—it has also had its troubling, controversial side. As former Securities and Exchange Commission head Arthur Levitt recently observed in a Wall Street Journal opinion piece, the muni market has long been plagued by allegations of ‘pay-to-play’ in which firms win business not based on expertise but after making contributions to politicians. Legislative efforts to limit the role of political influence in the business have been halfhearted, perhaps because it’s such a gravy train for both politicians and investment bankers.

This intersection of finance and politics has resulted in a steady increase in local debt and, more disturbing, an increase in offerings that circumvent state and local legislative debt limits. States and cities have created a bevy of public authorities and other bodies that they use to issue debt that’s officially off-the-books but still leaves taxpayers on the hook. Several years ago an audit in New York State found that public authorities there had issued some $43 billion in so-called ‘backdoor debt,’ that is, debt not approved by voters--one reason why the state will spend nearly $5 billion this year just to service its debt.

These growing liabilities wouldn’t be half so troublesome except that, as Levitt pointed out, the market isn’t very transparent and reliably produces some controversial “Enron moment” every decade or so. In the 1970s, that moment belonged to New York City, which nearly reneged on its debt obligations under the weight of an unprecedented social welfare spending spree, until the state and the feds bailed out the city. In the 1980s the Washington Public Power Supply System, a municipal corporation created to build power plants in the Northwest, defaulted on $2.25 billion in bonds used to build nuclear plants that never operated (the debt vehicles became known as “Whoops bonds”). In 1994, Orange County in California filed for bankruptcy after it invested some $2 billion of borrowed money in risky derivative instruments that wracked up big losses. In 2006 the city of San Diego settled fraud charges with the SEC after admitting it hid growing pension shortfalls and misled investors about the extent of benefits it had promised to city employees. Tellingly, the city had granted rich benefits enhancements to city employees under the belief that a rising stock market, not taxpayers, would finance the new obligations, and eventually under the weight of those obligations the city declared bankruptcy.

Defenders of the muni market point out that such incidents are rare and that tax-exempt bonds have a far greater repayment rate than corporate bonds.

But if ever there were a market that seemed ready for what Nassim Nicholas Taleb calls a ‘black swan” moment, that is, a big, rare event outside the scope of past experience, it may be the muni market. Levitt observes that the market is far more opaque than investors believe, with inconsistent accounting standards and no central regulator watching over it, which raises the question of whether more San Diego-style surprises will emerge as budget woes intensify.

Meanwhile, Buffett worries that growing political pressure on elected officials—who are getting squeezed between irate taxpayers on the one hand and powerful public employee groups on the other—might prompt a few places to test the idea of reneging on their debt. That, he fears, could lead to a cascade of defaults that would overwhelm insurers who back these bonds: “If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow.”

Concerned about just such a gusher of bankruptcy filings, California’s state legislature is now considering controversial legislation that would require a municipality to get approval from a state commission to file Chapter 9, which is how governments go bankrupt. Muni investors can’t be heartened by the prospect of a rash of such municipal bankruptcies considering the way bondholders have been treated by government in the Chrysler and General Motors filings. I can just hear some politician browbeating muni holders about how they must do their part to help troubled cities out of their fiscal woes by taking 30 cents on the dollar.

For decades the claims of municipal bondholders have been considered the immovable obligations of government finance. But now their interests are in conflict with the new irresistible force of local politics, the public employee unions.

Geithner Takes His Act to China

Maybe that explains what Leno's writers have been doing since his final show last Friday.

Equally risible were these comments from Geithner shortly before departing for China: "No one is going to be more concerned about future deficits than we are," he told reporters as he prepared for two days of talks with concerned Chinese finance officials.

Obviously, he was showing off his comedic chops, since even that line was delivered deadpan.

He also insisted the U.S. is "committed to a strong dollar" — not exactly apparent when you look at the U.S. budget.

The problem with all this is obvious — and actually, quite serious. As of last Friday, the Merrill Lynch & Co. Treasury bond index was off 5.1% so far this year, its worst performance since the index was created in 1977. The dollar likewise is down — a double loss for the Chinese, who hold an estimated $770 billion in U.S. Treasuries.

Of course, we'd like them to buy more. That's the reason for Geithner's trip in the first place. Indeed, in March, Premier Wen Jiabao asked the U.S. to "guarantee the safety of China's assets."

But China's finance officials, many of them educated at the best U.S. business schools, can do the math. And it isn't very pretty.

Next year, the U.S. runs a deficit of $1.8 trillion — or nearly 13% of GDP. Last year's deficit was $455 billion. The deficits will slowly come down from that $1.8 trillion, but not by much, according to the White House's own forecasts. Geithner says he hopes to slash the deficit as a share of GDP from 13% to 3% by the end of the decade.

But those projections of declining deficits depend highly on the rosy scenario cooked up by the White House for the economy. They expect the economy, for instance, to expand 3.5% next year, 4.4% in 2011, 4.6% in 2012 and 3.8% in 2013. They might be right, but if they are, they'll be in the minority. Virtually no private sector forecaster expects the economy to grow that fast.

Over the next 10 years, the U.S. will rack up another $9 trillion in deficit spending — money that will have to be borrowed from someone — perhaps the Chinese, or maybe strapped and overtaxed U.S. consumers.

Another $1.1 trillion is planned as a possible down payment on nationalized health care. Add to that the $2 trillion at least that the Federal Reserve is spending, and government is on the hook for close to $13 trillion.

Given that the White House has built into its projections just $989 billion in added taxes, its clear the deficits will get big and stay that way for years.

One trip to China by our top bond salesman may not be enough.

As Bloomberg.com reported, 17 of 23 Chinese economists polled before Geithner's visit said the country's holdings of U.S. Treasuries pose a "great risk" for the economy.

Still, on Tuesday, Chinese officials responded with polite reassurances. Geithner said they expressed "justifiable confidence in the strength and resilience and dynamism of the American economy."

Maybe so. In fact, the U.S. fiscal problem really isn't so intractable, when broken down into parts.

Summed up, the U.S. is spending way too much on bailouts and bogus "stimulus" packages that haven't stimulated anything. And it's expanding the reach of government into areas it has no business being in — such as running auto companies and banks.

We have far too many regulations, not too few. We need to embolden entrepreneurs and small businesses, the backbone of economic and job growth in this country — not spend hundreds of billions on corporate losers with political clout.

Geithner's future sales pitches to the Chinese and other potential investors would be helped by a less radical U.S. fiscal approach.

Instead of spending wildly and taxing to the hilt, we should slash outlays, kill plans for nationalizing health care and lower taxes for all Americans, rich and poor. Such moves would restore U.S. growth and make all our investors, foreign and domestic, happy.

June 4, 2009

We Face Major Healthcare Choices

But the Democratic president now sounds willing to limit, and perhaps repeal, the existing exclusion from income tax for employer-paid premiums. When his Republican opponent proposed doing that during the campaign for the purchase of private health insurance, Mr. Obama accused Senator John McCain of raising taxes.

Now Mr. Obama seems to admit that the tax exclusion for the premiums, which are part of an employee's compensation, is destructive in two ways. It has limited development of the private insurance market, and curtailed labor mobility by creating incentives for workers to stay with their existing employer, since new insurers generally exclude coverage of “pre-existing conditions.”

The more sensible view is that workers should be able to keep their health insurance when they change jobs, just as they keep their car and home insurance.

The $250 billion a year of additional revenue that would be raised by taxing premiums has undoubtedly tempted the president to break his promise of not raising taxes on those who earn under $250,000. An extra $250 billion, or part of it, would give him a share of the $634 billion health care fund that his budget projected without identifying specific sources.

Democrats are proposing to earmark the fund for a public health-insurance plan for people without employer-paid insurance underwritten by Washington. Republicans oppose the public plan as unfair competition for the private sector and as a possible step towards a costly national, single-payer health-care system that might mean the end of private insurance, just as Medicare drove plans out of business in the 1960s.

Rather than raising taxes, Republicans want to transfer the tax deduction for employer-provided health insurance to the individual. Individual tax credits to purchase health insurance are a crucial feature of the leading Republican health care proposal, “The Patients’ Choice Act of 2009.” Sponsors include Wisconsin Representative Paul Ryan and Oklahoma Senator Tom Coburn, a physician who goes home and delivers babies on Mondays.

The refundable tax credits would be worth $2,300 for individuals and $5,700 for families, with an extra $5,000 for poor families, enabling many families now on Medicaid to choose their own plans. ("Refundable" means the credit would be paid in cash to the extent it exceeded an individual's or a couple's tax bill.) In addition, monthly contribution limits for tax-free health savings accounts would be increased.

Health insurance plans could include high deductible plans combined with health savings accounts, or more traditional managed care or fee-for-service plans. Those with chronic illnesses, such as hemophilia or diabetes, would be assigned to special plans designed to avoid high-penalty premiums

Such a system would encourage Americans to shop around for the best plan as they do for auto and home insurance. Just as medical procedures that are not covered by health insurance, such as laser eye surgery and cosmetic surgery, have seen declines in prices over the past decades, so health care costs are likely to decline also as people become more aware of deductibles and copayments.

The administration's goals for health reform go beyond insuring the uninsured. Mr. Obama declared in his White House meeting, “What we've got to figure out is how do we create the incentives in terms of how we are reimbursed, how we deal with getting doctors to work together more effectively, how we're working on prevention and wellness so that we're driving down costs across the board.”

In other words, the administration hopes to revamp the way doctors practice medicine, possibly with metrics that purport to compare the effectiveness of different treatments. It seeks to trim 1.5 percentage points from the annual rate of increase in the country's total health-care spending, not through increased competition and shopping around, but through regulation, even though the disastrous deficits of Medicare prove that this hasn’t worked in the past.

A new Council of Economic Advisers report entitled The Economic Case for Health Reform suggests the creation of a national insurance exchange to regulate the operation of health insurance markets. The exchange would coordinate health plan participation; negotiate premiums with employers; disseminate information about different plans; and facilitate enrollment.

State exchanges are a crucial feature of Dr. Coburn’s Patients’ Choice Act, but they would fulfill a different function, acting as portals where Americans could take their tax credits and choose private insurance. All insurance plans licensed in a state could participate in the state exchange, and premiums would be set unilaterally by the different companies.

In the months ahead Americans will be presented with a choice between expansion of private insurance, modeled after auto or home insurance, or a Medicare-type government plan combined with more regulation. The result will affect the cost and quality of health care for years to come.

It’s the Printing Presses, Stupid

This monetary explosion explains what’s really driving the dollar down and Treasury rates up (alongside rising gold and oil prices). It’s not huge budget deficits, but the growing fear that a less-than-independent Fed will keep pushing new money into the financial system in order to fund Obama’s liberal spending policies.

This week, German chancellor Angela Merkel launched a broadside against the Fed, saying she views the Fed’s powers “with great skepticism.” It was an important rebuke. Here’s the elected leader of a major country actually telling a central bank to stop the printing presses and avoid creating yet another inflationary bubble during the next recovery cycle. In other words, it’s the printing presses, stupid.

Rising inflation and interest rates are always a monetary problem. When Dick Cheney said a few years ago that deficits don’t matter, he was basically right. There is no clear relationship between budget deficits, inflation, and interest rates. In fact, for most of the’80s and ’90s, and much of the 2000s (excepting the 2003–05 bubble), interest rates and inflation fell while deficits averaged over $200 billion a year and got as high as 6 percent of GDP at some points. This is because Paul Volcker and Alan Greenspan restrained money-supply growth in a non-inflationary manner.

Now surely today’s $2 trillion deficit — which is 13 percent of GDP and likely to remain very high — is a shocking number. But if the Fed refuses to monetize the deficit, inflation will stay low and long-term interest rates will normalize. Conventional economists and most politicians do not understand that excess money is the root cause of inflation, spiking rates, and a bad, unwanted dollar.

Unfortunately, with the Fed purchasing Treasury bonds, mortgage-backed securities, and other asset-backed bonds, the growing suspicion is that Bernanke & Co. is too entangled in Obama economic policy. Therefore, a timely Fed exit strategy is just as unlikely as a timely fiscal exit strategy to remove unnecessary budget spending and TARP money.

With clear signs of economic recovery on the horizon, some are now calling for an end to the unnecessary stimulus package and a de-TARPing across-the-board. Along with a big rise in the money supply, there’s been a rebound in commodities, a stabilization in housing, falling unemployment claims, a booming stock market, narrowing credit spreads, and rising ISM manufacturing reports. All this is telling us that additional stimulus is unnecessary.

Economic blogger Scott Grannis says “recall the stimulus.” Prof. Russell Roberts of George Mason notes that only $36 billion of the stimulus has been spent through May, out of a total $787 billion. And USA Today reports that $209 billion in countercyclical automatic safety-net stabilizers — which is apart from the stimulus package — has already been spent on unemployment insurance, food stamps, Medicaid, and early Social Security retirements.

On the eve of recovery, with all this prior spending, why on Earth do we need more?

Policy analyst Dan Clifton tells me that the $200 billion spending increase scheduled for 2011 to 2019 should definitely be rolled back from the Obama stimulus package, before it’s built into the current-services spending baseline. And let’s not forget that the Obama Democrats already passed a $400 billion omnibus spending bill for 2009. So anybody in Washington who is serious about spending and deficits can save hundreds of billions of dollars by rolling back the stimulus package and TARP. The financial system is healing, and banks want to pay TARP down anyway.

Here’s the moral of this story: Excessive Fed pump-priming and over-the-top federal spending is what matters, not the budget deficit. If we keep paying people not to work by piling on more transfer payments and government subsidies, economic growth will suffer mightily. And if the Fed keeps buying bonds issued by Uncle Sam, inflation will ratchet higher.

Republicans, are you listening? Rollback the unnecessary stimulus and restore the Fed’s independence.

Card-Check Threat Alive And Well

Besides denying workers a right to a secret ballot, "card check," as it's known, also forces federal arbitration onto companies for union contracts, ensuring that either unions dictate the wages they want or a federal bureaucrat will step in and do it for them based on politics, not economics.

It's a formula for disaster. This still-undead bill will shut plants, drive jobs abroad and ensure that few new jobs are ever created. Little wonder the public has turned a thumbs-down on it, and Congress has backed away. A recent Pew poll shows that 61% of Americans think labor unions have gotten too powerful.

But it hasn't stopped Big Labor. Card check remains its top goal, and instead of dropping a bad idea, it's switching tactics.

Card-check supporters have begun a new lobbying effort that targets a few wavering senators including Democrats Dianne Feinstein, Arlen Specter and Mark Pryor. The idea is to put the squeeze on Congress instead of taking the case to voters.

It may be one reason why card check has morphed into new incarnations, the latest a "compromise" bill from Feinstein. She has proposed a mail-in card-check format, which still amounts to a denial of secret ballot. Curiously, Feinstein backed away from her own compromise Thursday, raising questions as to whether she was being manipulated and wanted out.

The other prong of the card-check lobby has set up a supposed "grassroots" group as a fig leaf for the same old Big Labor interests.

A new group calling itself "Business Leaders for a Fair Economy" has gotten press for its novelty value as a 1,000-member business group that actually favors card check. Its Web site says it's paid for newspaper ads in The Hill, Politico and Wall Street Journal, all closely read by the political set, urging Congress to pass card check.

"What is good for workers is good for business," its chairman says.

But at its Web site, not all its 1,000 members are identified, the way, say, members of a chamber of commerce might be.

Instead, there's a moving slide show of randomly identified, highly eclectic companies with a distinct countercultural tinge: "Boulder's Best Organics," "Ukush Handmade for Fair Trade," "Mother Earth Reverence Farms," "Justice Clothing," "Loughmiller's Pub," "Central Montessori School," "Montana Vintage Clothing," "DaMane's Hair Studio," "If Jesus Can't Fix It, Neither Can We," and "Swanton Berry Farm."

While we value entrepreneurs of all sorts, few are major employers or industry leaders, and wouldn't be affected by card check under most versions of the bill.

There are some radical foundations and trial lawyers on board, too. But among these mostly small enterprises, one heavy hitter stands out: Trillium Asset Management of Boston, which manages $1 billion in assets in "socially responsible" investments.

Trillium's site says its clients include foundations and nongovernmental organizations, and some of its employees are alumni of the AFL-CIO. Apparently, we're supposed to think Trillium and all its pals in the dog grooming business somehow spontaneously joined to endorse card check.

Both the lobbying effort on the narrowly targeted Senators and the sudden appearance of a "business group" that inexplicably supports card check suggest that the card-check lobby has shifted tactics from getting public support to quieter tactics of squeezing individual legislators instead.

If the right muscle is applied, they win. But card check won't be a truly democratic mechanism.

It underlines that unions are still supporting a bill that plainly repels the public. That card check hasn't been dead and buried long ago, but is now re-emerging in new forms, suggests a quieter and more lethal strategy to get it through Congress.

June 8, 2009

Deflation or Inflation? Or Both?

The lesson for today: Psychology matters. What economists call "expectations" shape how workers, managers and investors behave. If they fear inflation, they act in ways that bring it about. The converse is also true, as the late 1940s remind. The lesson provides context for today's debate. Are the Federal Reserve's easy-money policies laying the groundwork for higher inflation? Or will these policies prevent deflation -- a broad decline of prices -- that would deepen the economic slump?

The questions arise from the Fed's strenuous efforts to contain the economic crisis. It has cut the overnight Fed funds rate almost to zero. It has made loans when private lenders wouldn't -- in the commercial paper market, for instance. To lower long-term interest rates, it has pledged to buy $1.25 trillion of mortgage securities backed by Fannie Mae and Freddie Mac and $300 billion of long-term Treasury bonds. All these measures are without modern precedent.

Precisely, say the inflation worriers. Once the economy recovers, the easy money and credit will spawn inflation. Cheap loans will bid up prices; wages may follow. Low interest rates will encourage spending and deter saving. The Fed will be "under pressure from Congress, the administration and business . . . to prevent interest rates from increasing," warns economist Allan Meltzer of Carnegie Mellon University. With huge budget deficits, the White House and Congress will want to hold down borrowing costs. Inflation psychology will emerge.

Nonsense, say deflation worriers. Inflation results mainly from too much demand chasing too little supply. Today, too much supply chases too little demand. High unemployment and slack business capacity (idle factories, vacant office suites, closed mines) impede wage and price increases. If the Fed doesn't maintain cheap credit, shrinking demand might cause prices and wages to spiral down. "Deflation, not inflation, is the clear and present danger," retorts Princeton economist and New York Times columnist Paul Krugman.

It seems impossible for both arguments to be correct, but they may be. As Krugman notes, inflationary pressures are almost nonexistent. In the past year, the Consumer Price Index has been roughly stable. In May, unemployment rose to 9.4 percent from 8.9 percent. A survey by Challenger, Gray and Christmas found that 52 percent of firms had frozen or cut salaries. GM's bankruptcy is but one indicator of excess industrial capacity. The surplus is worldwide, finds a study by Joseph Lupton and David Hensley of J.P. Morgan. Inflationary expectations are low.

All this gives the Fed maneuvering room. Expectations matter; inflation won't burst forth instantly. Even Meltzer doesn't see an immediate surge. "When will it come? Surely not right away," he writes.

Still, Meltzer's warning remains relevant. The Fed has often overdone expansionary policies and fostered inflationary expectations. In the 1960s and '70s, that occurred through excess demand and a classic wage-price spiral. The danger now might emerge through exchange rates and commodity prices. Inflation fears could raise prices of commodities (oil, metals, foodstuffs) and depress the dollar. Imports would become costlier, allowing domestic producers to raise prices. Once inflationary practices take hold, high inflation and unemployment can coexist: dreaded "stagflation." In 1977, both inflation and unemployment were about 7 percent.

There's evidence (better housing and auto sales, stronger growth in "emerging markets") that the danger of a deflationary economic free fall is ebbing. Someday, the Fed will have to raise interest rates. Fed Chairman Ben Bernanke has pledged to preempt high inflation. Will the Fed get the timing right and resist contrary political pressures? Will the pledges reassure markets?

One reason they might not is that Bernanke's term as chairman expires in January. Any replacement named by President Obama would be seen, fairly or not, as more beholden to the administration. The president could eliminate that perception by offering Bernanke -- who has performed well in the crisis -- a second four-year term now and, if he accepts, announcing the reappointment. That would not settle today's deflation-inflation debate. Only time will do that, but it would remove a needless uncertainty.

Only Moore's Law Can Save Big Pharma

Economically, Big Pharma continues to deliver less and less for more and more. A new blockbuster cancer drug is almost never a cure. The “good” ones have no effect on most patients besides making their hair fall out while helping some “fortunate” subset die in 15 months instead of 12. For some advanced biologics, this pathetic result comes with a sticker price of $100,000. The only reason there are any customers at all for products this bad is that someone else is paying the bills.

Scientifically, the classic drug discovery paradigm has reached the end of its long road. Penicillin, stumbled on by accident, was a bona fide magic bullet. The industry has since been organized to conduct programs of discovery, not design. The most that can be said for modern pharmaceutical research, with its hundreds of thousands of candidate molecules being shoveled through high-throughput screening, is that it is an organized accident. This approach is perhaps best characterized by the Chief Scientific Officer of a prominent biotech company who recently said, “Drug discovery is all about passion and faith. It has nothing to do with analytics.”

Does this sound like science to you?

The problem with faith-based drug discovery is that the low hanging fruit has already been plucked, driving would be discoverers further afield. Searching for the next miracle drug in some witch doctor’s jungle brew is not science. It’s desperation.

Hence the attraction to political fixes. The problem, however, with buying senators and congressmen is that they don’t stay bought. Plus our legislators are on the payroll of so many other industries right now that they don’t need extra campaign cash. They know they can win more points with voters by vilifying drug companies, not larding them with subsidies.

The only way to escape this downward spiral is new science. Fortunately, the fuzzy outlines of a revolution are just emerging at the edges of the startup community. For lack of a better word, call it Digital Chemistry.

Drug companies of the future will be built around drug design, not discovery. Scientists cross trained in engineering will run product development teams with productivity levels comparable to other industries. Compare this to today’s chemist, who can spend an entire career at a pharmaceutical company without ever working on a drug that gets to market. This is not just scientifically embarrassing, it’s economically indefensible.

Tomorrow’s drug companies will build rationally engineered multi-component molecular machines, not small molecule drugs isolated from tree bark or bread mold. These molecular machines will be assembled from discrete interchangeable modules designed using hierarchical simulation tools that resemble the tool chains used to build complex integrated circuits from simple nanoscale components. Guess-and-check wet chemistry can’t scale. Hit or miss discovery lacks cross-product synergy. Digital Chemistry will change that.

But modeling protein-protein interaction is computationally intractable, you say? True. But the kinetic behavior of the component molecules that will one day constitute the expanding design library for Digital Chemistry will be synthetically constrained. This will allow engineers to deliver ever more complex functional behavior as the drugs and the tools used to design them co-evolve. This is not a new idea. After all, that’s what nature did when it invented DNA – a comparatively simple, kinetically constrained molecular machine whose actions reliably control the myriad metabolic processes we call life.

How will drugs of the future function? Not by gumming up target proteins the way small molecule drugs do, often sticking to the wrong places causing nasty side effects. Rather, intracellular microtherapeutic action will be triggered if and only if precisely targeted DNA or RNA pathologies are detected within individual sick cells. Normal cells will be unaffected. Corrective action shutting down only malfunctioning cells will have the potential of delivering 99% cure rates. Some therapies will be broad based and others will be personalized, programmed using DNA from the patient’s own tumor that has been extracted, sequenced, and used to configure “target codes” that can be custom loaded into the detection module of these molecular machines.

When it arrives, the transition to Digital Chemistry will be similar to the revolution set in motion when engineers began using transistors as switches instead of amplifiers. Over the succeeding 40 years, the semiconductor industry used the simplest of components to design increasingly more sophisticated integrated circuits whose complexity now rivals that of many of the metabolic disease pathways we hope to control.

Only Moore’s Law can save Big Pharma, not Rent-a-Congressman law. We better hope it arrives soon.

June 9, 2009

America's Socialism for the Rich: Corporate Welfarism

It has long been recognized that those America's banks that are too big to fail are also too big to be managed. That is one reason that the performance of several of them has been so dismal. When they fail, the government engineers a financial restructuring and provides deposit insurance, gaining a stake in their future. Officials know that if they wait too long, zombie or near zombie banks - with little or no net worth, but treated as if they were viable institutions - are likely to "gamble on resurrection." If they take big bets and win, they walk away with the proceeds, if they fail, the government picks up the tab.

This is not just theory; it is a lesson we learned, at great expense, during the Savings & Loan crisis of the 1980s. When the ATM machine says, "insufficient funds," the government doesn't want this to mean that the bank, rather than your account, is out of money, so it intervenes before the till is empty. In a financial restructuring, shareholders typically get wiped out, and bondholders become the new shareholders. Sometimes, the government must provide additional funds, or a new investor must be willing to take over the failed bank.

The Obama administration has, however, introduced a new concept: "too big to be financially restructured". The administration argues that all hell would break loose if we tried to play by the usual rules with these big banks. Markets would panic. So, not only can't we touch the bondholders, we can't even touch the shareholders - even if most of the shares' existing value merely reflects a bet on a government bailout.

I think this judgment is wrong. I think the Obama administration has succumbed to political pressure and scare-mongering by the big banks. As a result, the administration has confused bailing out the bankers and their shareholders with bailing out the banks.

Restructuring gives banks a chance for a new start: new potential investors (whether holders of equity or debt instruments) will have more confidence, other banks will be more willing to lend to them, and they will be more willing to lend to others. The bondholders will gain from an orderly restructuring, and if the value of the assets is truly greater than the market (and outside analysts) believe, they will eventually reap the gains.

But what is clear is that the Obama strategy's current and future costs are very high - and so far, it has not achieved its limited objective of restarting lending. The taxpayer has had to pony up billions, and has provided billions more in guarantees - bills that are likely to come due in the future.

Rewriting the rules of the market economy - in a way that has benefited those that have caused so much pain to the entire global economy - is worse than financially costly. Most Americans view it as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending to payments of outsized bonuses and dividends. Tearing up the social contract is something that should not be done lightly.

But this new form of ersatz capitalism, in which losses are socialized and profits privatized, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity - and, with the Federal Reserve making funds available at near-zero interest rates, there are ample funds to do so.

Some have called this new economic regime "socialism with American characteristics." But socialism is concerned about ordinary individuals. By contrast, the United States has provided little help for the millions of Americans who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most lose their health insurance, too.

America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to automobiles, with no end in sight. In truth, this is not socialism, but an extension of long standing corporate welfarism. The rich and powerful turn to the government to help them whenever they can, while needy individuals get little social protection.

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don't break them up, then we have to severely limit what they do. They can't be allowed to do what they did in the past - gamble at others' expenses.

This raises another problem with America's too-big-to-fail, too-big-to-be-restructured banks: they are too politically powerful. Their lobbying efforts worked well, first to deregulate, and then to have taxpayers pay for the cleanup. Their hope is that it will work once again to keep them free to do as they please, regardless of the risks for taxpayers and the economy. We cannot afford to let that happen.

Joseph Stiglitz is professor of economics at Columbia University.

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Britain, America and the Global Economic Recovery

But this wasn't this week's June 6. It was June 6, 1909, a hundred years ago this week. And the President was President Taft, not President Obama.

The impetus for the story was a controversial speech on trade by William Taft's Secretary of the Treasury, Franklin McVeagh, made here in Chicago. Trade was a hot topic even then.

The issues in the newspaper a hundred years ago are strikingly contemporary: the proper role of government in regulating markets; the proper role of government in creating and protecting jobs.

I'd like to concentrate today on how these issues are playing out as Britain and America strive for recovery from the severe downturn that began almost two years ago.

In a little over three months from now, in Pittsburgh, the G20 leaders will meet for the third time in a year. The previous two G20 Summits - one in Washington and then one in London in April - played an important role in setting out a clear and comprehensive international policy response to the economic crisis.

It's easy to dismiss international summitry as political theatre. But that would be unfair to these Summits. Last autumn one of the symptoms of the crisis was an apparent collapse of international co-ordination. We lacked a framework for working on a multi-faceted international response. The UK always believed it to be vital that national measures, aimed at restoring lending and repairing the financial system, did not encourage a retreat into domestic financial markets. The way forward was more, not less, co-operation.

The outcomes of the Washington and London summits emphasised the benefits of working together and that a global crisis required a global response.

The London Summit not only agreed the need for urgent action to support the global economy. It also agreed on additional resources for the international financial institutions to help those countries that would otherwise be overwhelmed.

The Summit also looked ahead. It made the first steps towards a framework for the future of the world economy such as through the new Financial Stability Board.

The next step after London is going be the tough part: Implementation. I want to highlight two particular areas where - as they say - the proof of the pudding will be in the eating: Financial regulation and trade.

On financial regulation, we must ensure that policies are put in place that restore confidence and renew financial markets for the future.

It's difficult to argue in black and white terms that lack of regulation as such caused the financial crisis. After all, the most affected sector has been the banks - the most regulated part of the financial system. Instead, low interest rates encouraged financial institutions to increase borrowing and to invest in new highly complex products. With hindsight, it is now clear that there was insufficient understanding and monitoring of the resulting risks by the private sector and others.

Until the crisis struck, our approach was based on an overt philosophy that markets are in general self-correcting. That market discipline is effective. And that management and boards are better placed than any regulator to identify business system risks.

But, as Alan Greenspan testified to Congress in October last year, this model was flawed.

Learning the lessons of the crisis, our watchwords for the future should be better and smarter regulation, and not regulation for the sake of it. Better oversight of banks. Smarter capital requirements. Better checks on the system as a whole.

Smarter regulation means creating incentives so that executives pursue long-term gains, not short-term profits. It means establishing a system of international co-ordination to spot potential issues before they blossom into crises.

At the global level, we need to ensure that institutions like the IMF have the robust independence to do excellent macro-prudential analysis and to criticise, if necessary, the policies of major economic powers, and to challenge conventional wisdom.

The challenge with global banks is that we have a global financial system but no global government. And that mismatch is not going to entirely disappear. But we need to ensure as much global co-ordination and co-operation as possible. As the Governor of the Bank of England has noted: "Firms are international in life but national in death."

One positive to emerge from the crisis has been the opportunity to have an honest debate about the kind of capitalism we want in the future. I'm optimistic that we will be able to take advantage of this once-in-a-generation chance. And optimistic that the innovation and industry at the heart of our economies will enable us to bounce back.

International trade is vital to the prospects for recovery. The G20 leaders recognised this, pledging to promote global trade and investment and to reject protectionism.

Trade binds nations together, and there is no better example than the United States and the United Kingdom. Our two countries enjoy one of the strongest bilateral trade and investment relationships in the world and a uniquely strong political alliance.

In trade, the U.S. is the United Kingdom's top export destination and its second-largest trading partner. The UK is the United States' sixth-largest trading partner.

In terms of investment, British companies are the largest foreign investors in the U.S. British investment supports nearly one million American jobs with average pay over 30% above the U.S. average. These are high-value jobs. Similarly the U.S. is the largest foreign investor in Britain, where American companies employ more than one million people.

But these are tough economic times. The recession has cut consumer demand around the world, leading to a severe drop in trade flows. The World Trade Organisation estimates that trade will decline by 9% this year, which is the single largest year-on-year contraction in the post-war era.

Falling global demand is bad enough. But it is in danger of being compounded by protectionist sentiment. There are pressures around the world to build barriers to trade or other forms of protectionism, which become so much stronger during a downturn. As my Prime Minister wrote in the Wall Street Journal in May, there is a danger that "a banking crisis has become a trade crisis."

Much of this has to do with what the experts call ‘water' - the difference between legally binding tariff levels and actual applied tariffs, which are often considerably lower. Because there has been no WTO world trade deal for more than a decade, many countries could raise the tariffs that they have lowered over the last ten years. This would not technically violate their trade commitments, but it would quickly cost the global economy billions of dollars. One estimate suggests by as much as 700 billion dollars.

An even bigger concern is the wide range of hidden, or non-tariff barriers, that countries can be tempted to introduce in times of trouble. According to the World Bank, since the London Summit 2 months ago nine G20 countries have imposed or are considering twenty-three new protectionist measures. These are on top of at least forty-seven trade-restricting measures imposed around the world after the G20 Summit in Washington in November.

These have taken the form of subsidies and other support packages rather than old-fashioned tariffs. What is more, the use of so-called ‘trade remedies', such as safeguards and antidumping policies, to restrict imports has grown. In the first quarter of 2009 we saw a 15% year-on-year increase in the imposition of duties related to trade remedy investigations and a 19% increase in new investigations. These figures are likely to continue to increase though 2009.

I highlight these facts to remind you that wealth creation via our globalised economy has not come about by accident. It is the result of a collective choice for openness. Now more than ever, we have to resist. Protectionism doesn't protect. In the long run it just makes things worse.

It is imperative that the G20 countries, which together comprise 85% of the global economy, think internationally as they act nationally to help their economies through the downturn. In London, G20 leaders made important commitments to shore up international trade.

They committed to refrain from raising new barriers to trade or investment. To refrain from imposing new export restrictions. To refrain from implementing measures which are inconsistent with WTO rules to stimulate exports.

Part of the downturn in trade flows can be explained by a lack of available credit to finance international trade transactions. To this end, leaders at the London Summit agreed to provide $250 billion in trade financing over the next two years. And we must be ready to go further if more money is needed.

The WTO was mandated by the G20 to monitor and report quarterly on countries. This has undoubtedly helped. But as I have mentioned there remain causes for concern.

No one is blameless - the EU's recent re-imposition of export subsidies for dairy products was a regrettable step. Here in the United States, there are some worrying signs too.

Let me start with the controversy over ‘Buy American'. It is clear from the Congressional language that British and other European companies, together with those from other developed countries like Canada and Japan, should be free to compete for contracts in each of the 37 US states which have signed the Government Procurement Agreement. However, the danger is that some officials interpret the ‘Buy American' provisions as simply banning all foreign companies or foreign-made goods. We will be monitoring this issue very closely and will want to see federal, state and local authorities held to account, to give US citizens, and UK businesses, the best deal.

We have no equivalent ‘Buy British' requirements for government procurement in the UK. Shutting out foreign competition sends a bad message on how open markets are valued in the United States and will often end up with taxpayer money going less far. Building one fewer school. Two fewer bridges. It all adds up.

The US also stands to lose much from international retaliation over government procurement rules. According to an editorial in the New York Times last week, ‘Buy American' provisions protect about 9,000 jobs. But foreign government procurement of US products supports 650,000 jobs - jobs that could be lost if other countries implement their own ‘Buy National' provisions.

I want to finish by going back to 1909. A hundred years ago, President Taft was having a tough time of it. He tried to square too many circles, pleasing no one. He ended up signing the Payne-Aldrich Tariff Act of 1909 that kept tariffs high.

Taft's Presidency coincided with the final hurrah of the first period of globalisation. It was, after all, only a small step away from an open and global approach. But those small steps and departures continued for twenty years, until a more notorious tariff act, one written by Senator Smoot and Representative Hawley, helped pushed the US and the rest of the world further into recession and then depression.

The damage done by Smoot-Hawley took a long time to undo. Everyone now agrees that "protectionism" is a bad thing. But, like Taft, some today would bend an ear to those who claim they are "seeking to destroy" this or that industry. It is clear that eternal vigilance will be the price of open markets. We cannot let those who would restrict trade and investment be the loudest voices heard in this debate. We must not retreat behind national borders and move to "deglobalisation" precisely at a time when we need the benefits of openness more than ever.

Geithner Brings the Laughs In China

For this alone, it’s hard to be optimistic about the dollar’s future prospects. When Treasury heads exhibit total ignorance about its value, and in Geithner’s case a sanguine countenance, this is a signal that the greenback is being ignored and that further weakness will be accepted.

Worse if that’s possible is Geithner’s stance on the very inflation that the above dollar weakness represents. As he told U.S. reporters last week, the Chinese “understand and have confidence in the Fed’s capacity to keep inflation low and stable over time.” Implicit in a statement pregnant with meaning is that Geithner shares the Fed’s absurd view that inflation is an economic growth concept that can be controlled through interest-rate machinations that supposedly fine-tune economic activity.

What this means is that true inflation, something that is always and everywhere the result of declining currency values, will be ignored in favor of central management over the economy. That economic growth of any kind has nothing to do with inflation doesn’t seem to trouble our Treasury secretary. Instead, he’ll apparently accept the dollar’s inflationary decline while allowing the Fed to make interest rate guesses that frequently end in tears. Is it any wonder that investors are growing increasingly skeptical about our private capacity to support the debt issued by Washington?

Rising Treasury rates suggest investors are growing very skeptical, and further statements by Geithner offer clues as to why. Sure enough, he mimicked his Treasury predecessors in the Bush administration with his comment that “We…welcome their commitment over time to move to a more flexible, market-determined exchange rate.”

Translated, Geithner underscored his untroubled conscience about the dollar’s decline with his statement about flexible exchange rates. What he actually meant was that China’s manipulation of the yuan doesn’t bother him so long as its value increases relative to the dollar. The Chinese currency can rise versus the dollar either through a strengthened yuan, or, and this is more likely the case, thanks to an even more debased dollar. In short, Geithner talks about sound U.S. assets out of one side of the mouth, and then out of the other he accepts further dollar decline that will necessarily make them less valuable.

More broadly for the economy, his currency stance points to a stagnant one. That’s the case because inflation invariably fosters an investment climate whereby capital moves away from the growth and wage economy, and into hard assets that by their nature can’t make us more productive. In order to expand, businesses need capital, but Geithner’s “benign neglect” of the dollar means that investors will seek safe haven from concepts whose returns will be eroded by inflation.

Concerning his view that the yuan should float against the dollar rather than be pegged to it, it’s best to conduct a thought experiment: Do individuals in California engage in more or less in the way of wealth enhancing trade with Arizonans thanks to the dollar being the lone currency in both states? If the answer is more, and that’s really the only answer, we must then ask how trade between Tucson and Torrance is any different than trade between San Francisco and Shanghai. It is not.

That the dollar is the only currency within our fifty states logically ensures more trade because a single currency greatly reduces the very currency risk that makes transacting across borders so difficult to begin with. The reality is that ever since China pegged its currency to the dollar in 1994, trade between individuals in the two countries has skyrocketed. This has of course accrued to the economic health of both countries in that workers in each have been able to specialize their labor. Absent this tight currency arrangement, it’s a near certainty that some transactions will never be, and the comparative advantage that lifts all economic boats will be compromised.

Perhaps silliest of all, Geithner made plain his desire that the Chinese “strengthen domestic demand” in order to stabilize the international financial system. He got it exactly wrong. Production itself is demand, and even if the Chinese choose to bank their monetary gains rather than spend them, the money saved will be lent out to others (including capital starved U.S. firms) who will demand what Chinese citizens presently do not. In the end entrepreneurs can’t be entrepreneurs without capital, and Geithner’s policies applied ensure that there will be less capital available for those eager to innovate.

It’s likely a testament to the world’s overall economic health that at least for now, foreigners and Americans alike can laugh at the musings of a Treasury secretary who’s so clearly not up to the job. The problem here is that the dollar remains the most important price in the world, and its decline is no laughing matter. Tim Geithner surely ignores its falling value to the detriment of the world economy, and if his indifference continues, we’ll soon enough not be laughing.

June 10, 2009

Why Inflation Is So Scary

To the Germans this is not merely a theoretical discussion, and maybe it shouldn’t be to us, either. Although few people in Germany actually “remember” the Weimar years because not many were alive then, the lessons of that era (and perhaps the notion of the pain the country experienced) have been repeated over and over again until they have been seared into Germany’s national consciousness.

By contrast, we’ve largely forgotten our most recent brush with raging peacetime inflation, the 1970s. Although nothing like Germany’s in the 1920s, ours was nonetheless powerful enough to be more dispiriting and more transformative of our culture than any stretch of post-World War II recession has been. It’s probably not a coincidence that America began its long transformation from a nation of savers to one of consumers and debtors just after the inflation of the 1970s. That’s what can happen when money seems to be “crumbling to dust in your hands,” as Fortune magazine described the inflation of that era.

One reason that inflation can be such a powerful social force is because it affects virtually everyone. To people who’ve worked their whole lives playing by the rules, that is, to the majority of adult Americans in the early 1970s, inflation at the hands of wayward government policy seemed to be a betrayal. People who had been thriftiest watched down payments for buying a home disappear, college savings accounts shrivel, retirement nest eggs vanish, the value of monthly pension checks shrink. Harvard Business School Professor Samuel Hayes recounted the damage to a relative of his in a magazine story: “He was the epitome of the Protestant ethic. He had inherited money, he had saved, he was very frugal, had a very modest house, had part of his investment money in bonds and short-term securities, had always maintained liquidity. And he came out of the Seventies looking like a fool.”

In the 1970s, inflation turned the chronology of the American dream on its head and made our lives less predictable and more chaotic. What I remember was how our own family’s financial situation became tenser and more anxious than it had been just a half-decade earlier even though my father’s career and salary had advanced over time. This was what inflation did, taking people who thought they were building economic security and upending it.

The anxiety and confusion was not terribly surprising given that through the 1950s and 1960s Americans got comfortable with prices that rose just 21 percent and 24 percent, respectively, per decade, but then increased by 150 percent between 1970 and 1982 before Fed chairman Paul Volcker, backed by President Reagan, applied the tough medicine that broke inflation.

Still, after a 14 year roller-coaster of inflation, counting the upward surge that began in 1968, America was a different country by 1982. Subsequently, our savings rate declined and our consumer debt started rising more rapidly. Our fascination with real estate mounted, as those who had bought homes in the 1970s saw their value soar and their mortgage payments decline relative to their incomes—windfalls that transformed the way people looked at housing ownership and the amount of money they might borrow to buy a home. “Buy, buy, buy, buy” was the message of the inflationary 1970s to the average America, Fortune opined.

A new round of inflation would send some of the very same messages as in the 1970s. It would undercut those who behaved most sensibly during the recent housing bubble—who took out affordable mortgages and banked money toward their retirement-- by eroding the value of what they saved. It would significantly raise people’s anxiety about the future. How much money will we need to retire on? To buy that house that is our dream? In inflationary times, the goal line for such things keeps moving further and further away, as if someone is painting and repainting the lines on the field every day. You think the stock market has wrecked havoc on your 401(k)? Just hope you don’t get to see what inflation does to it.

In such an environment the only thing that is predicable is that calls for government to provide a greater safety net—as in increasing cost-of-living adjustments for Social Security benefits—grow stronger.

Of course central bankers, including our own Ben Bernanke, reacted to Merkel’s warning by assuring us they are ready to react to the first signs of inflation, but meanwhile have to continue battling to end the recession. Yet in their responses they create the illusion that stopping inflation is as simple as flicking a switch off (presumably on printing presses.) In fact, having put lots of money into the financial system, the Fed will have to soak it back up using a variety of methods that aren’t foolproof and may not work as advertised given the unprecedented nature of the financial interventions by central banks and governments around the world in recent months. The current financial crisis has already tested some of our basic assumptions about how markets work, yet central bankers remain confident their traditional tools for taming inflation will work.

The risk is especially high given that the academic research on stimulus and loose money suggests that the payback for our current approach in terms of net jobs created or, more controversially, “saved,” is not very great. There are probably more limited, less risky ways we could have dealt with rising unemployment—such as extending benefits for longer periods to the jobless—than juicing up our entire financial system in an effort to shorten the recession.

We’ve gone that route, I fear, because we’ve forgotten that inflation is a game-changer, a culture-changer. Let’s hope we don’t relearn that lesson the hard way.

The President's Paygo Schtick

But this is an inaccurate description of what budgeteers have dubbed "Paygo." If more money is spent, Congress doesn't have to "save" a dollar elsewhere at all — it can make up the difference by raising your taxes.

And that's what Paygo is. It's a way to increase spending now, then raise taxes later, while crying like the late comedian Flip Wilson, "The devil made me do it." Or, in this case, Paygo.

So Paygo really turns out to be a mask for the profligacy of current leaders who, based on the latest estimates, will ring up an estimated $13 trillion in deficits over the next decade and then try to fleece you through higher taxes to pay for it all.

This concept was on full display Tuesday, when the president said he wanted Paygo but that Congress would be free to rack up as much as $2.5 trillion in special budget "exemptions" over the next decade. Spending on a new $1.1 trillion national health care program would also be financed with new debt.

Such out-of-control spending will lead, inevitably, to higher taxes down the road. In fact, it could be used to rescind the Bush tax cuts of 2001 and 2003, which helped keep the economy from sinking further and which are set to expire next year.

Obama excludes the Bush cuts from Paygo. But pressures being what they are, we expect Congress to go after them anyway — using Paygo as an excuse. Paygo also can be used to justify all kinds of new taxes — from a Euro-style value-added tax to cap-and-trade levies.

Since entitlements — the fastest-growing part of the budget — are excluded from Paygo, it won't stop the inexorable growth of government. It won't even slow it down much. As Heritage Foundation analyst Brian Riedl notes, "Even if Paygo were fully enforced, entitlement spending would still grow 6% annually, and discretionary spending could grow without limit."

This is another budget gimmick that's been tried before — and failed. Indeed, Congress already has a Paygo rule in place. But since it's a mere rule, and not a law, Congress simply ignores it when it's convenient to do so, which is basically all the time.

Even the $787 billion stimulus package passed in February grossly violates Congress' own Paygo rules. After all, why let a little thing like rules stand in your way? Since 2007, Congress has added $600 billion to the deficit, with nary a peep about Paygo.

Expect Congress to become real Paygo sticklers, however, when it comes to raising taxes to pay for new programs. "We don't want to raise your taxes," they'll tell us, "but because of our soaring deficits, we have to. Paygo requires it."

If history is any guide, we're in for big trouble.

Heritage's Riedl notes that Paygo was in place from 1991 to 2002. During that time, both major parties controlled the White House and Congress. And during that time, Congress and the president added more than $700 billion to the budget deficit by simply ignoring Paygo.

Paygo serves another purpose — a political one. By dragging out Paygo and pretending to be fiscally responsible, the White House and Congress hope to convince average Americans that they've been handed this mess by the wild-spending Bush administration — that it's an "inherited" problem.

But that's utterly and factually false. In 2007 the Democrats took back Congress. Based on 10-year spending estimates made then and comparable ones this year by the Congressional Budget Office, our government will spend $5.6 trillion more over the next decade than first planned when the Democrats took over.

Sorry, but they own this mess. And Paygo won't fix it.

June 11, 2009

High-Speed Rail: A Big-Ticket Item That Drives Deficits

One such big-ticket item is high-speed rail, an expensive form of transportation that will reach only small segments of the country and that will not substitute for highways. Mr. Obama’s initial payment for high speed rail would be funded partly through $8 billion from the $787 billion stimulus plan, and partly through a separate five-year, $5 billion investment proposed in the 2010 budget.

Developing a true, nationwide high-speed rail network would cost far more than $13 billion. Building true high-speed lines—capable of speeds of 150 to 200 miles per hour—on newly-laid track, as well as incremental improvements in existing rail infrastructure, could cost between $250 billion and $500 billion, perhaps more. Mr. Obama’s initial payment would be just the first drop in the bucket.

Some Americans admire the railroads they see on trips to Europe and Japan and think America should have similar trains. But this ignores the exceptionally different demographic and economic environments.

European and Japanese population densities are high, which makes train travel more efficient, even though railroads benefit from substantial government subsidies, paid for by higher levels of individual taxation. Their fuel prices, including taxes, are higher, making driving more expensive relative to other travel options. Their land area is relatively smaller, so travel time by train is more competitive with air travel.

The administration claims that high-speed rail would be faster, cheaper and easier than building more freeways or adding to an already overburdened aviation system—but has published no supporting analysis. Potential benefits cited are job creation; decreased traffic congestion; reduced dependence on oil; increased rural development; and a potentially rich new market for rail equipment makers.

Proponents of high-speed rail have exaggerated its benefits. Transportation jobs can be created through expansion of highways, using private funding from tolls rather than taxpayer dollars. And additional high-speed rail is unlikely to ease traffic congestion, because traffic congestion occurs within cities, rather than outside them.

Evidence from Japan and Europe indicates that expansion of rail does not stop increases in road transportation and therefore would not reduce dependence on foreign oil. In fact, the opposite has occurred. Since high speed rail was built, rail has lost market share to cars.

It’s unclear how the $13 billion would be divided among the different high-speed rail initiatives that are in various stages of planning. Would it be spent in California, Texas, the Midwest, Florida, Nevada and North Carolina, or would it be focused on the Northeast Corridor, which has high ridership? What is certain is that the decision will come down to political rather than efficiency considerations.

Obstacles to high-speed rail, as well as funding, include the complex and lengthy environmental review and approval process for construction; the specific technology requirements for entirely separate rights of way for true high-speed rail; and the need to increase investment substantially in other modes of transportation.

While comparable for station-to-station travel, rail loses the "high-speed" advantage over cars when travel is suburb-to-suburb. Because steel wheels on steel rails cannot be quickly stopped, rail trains need miles of empty space in front of them. Expressways, on the other hand, can carry over 2,000 cars, or 1,000 buses, per lane per hour, so have much bigger carrying capacities.

Last year Amtrak had an operating loss of over $1 billion. The question for good government is whether expenditures on rail would be more, or less, beneficial than other governmental expenditures.

Many are comparing the development of a high-speed rail network with President Eisenhower's initiative in pushing for the interstate highway system. But this is deficient because the highway system was created to serve an evolving, growing, congested transport mode. Passenger service on fixed rails, on the other hand, is an old and outmoded technology. In addition, the highways were designed to be paid for by users, by means of a dedicated fuel charges, but rail services have to be paid for by taxpayers.

If Mr. Obama is looking for a big-ticket item that drives deficits, he need look no further than high-speed rail.

A Depression Index

Here’s the reality: Since World War Two, there have been 39 monthly reports in which the unemployment rate increased by 0.4 points or more. How many of those instances have occurred in this recession? Nine. Only two post-war recessions are comparable in severity, 1974 and 1980 (see chart). But this one is the worst. In a normal downturn, the rate of unemployment rises a net 2 or 3 points. The current spike of 4.5 points is matched only by the back-to-back recessions of the 1980s, this time in 17 months compared to 34 then.

A Sense of History
If it was macro pain alone that I wanted to measure, I would turn to the famous misery index, made famous during the 1976 presidential election by Jimmy Carter. He cited the misery index – simply the rate of unemployment plus the rate of inflation – of 13.6 as an indictment of Republican policies. Four years later, Ronald Reagan noticed the misery index was up to 22.0 (all this comes from the scandalously reliable Wikipedia.org), and asked during the only presidential debate of 1980, “Are you better off now than you were four years ago?” Today, the misery index seems mild by comparison. With no inflation to speak of, it measures a mere 9.4, same as the unemployment rate. But misery alone does not tell you how bad things are.

The real cause for alarm is how little capacity our policymakers have to fight the recession. Remember, in the 1980s the Federal Reserve was doing everything in its power to cause a downturn (and wrench out inflation), but today’s Fed is doing everything it can to stop one – with roughly the same result. The Fed was also raising interest rates before the 1974 recession. In contrast, Bernanke’s Fed has slashed the overnight fed funds rate from a monthly average of 5.25 in late 2006 to near zero. While the effect of monetary policy is known to lag, the rate gun is out of ammo.

The other policy tool, if you believe the hype, is fiscal stimulus. Although deficit spending has been used almost constantly since the mid-1960s at around 4 percent of GDP, it was never more than 6 percent until this year. The Obama administration's Office of Management and Budget (OMB) says the deficit will be 13.9 percent of GDP this year. Fair to assume that gun is “out of ammo,” also?

Index of Economic and Policy Capacity
To make the situation clear, I thought it would be useful to combine the three indicators of economic and policy capacity into a simple depression index. I define the depression index as equal to the monthly average fed funds rate plus the surplus(deficit) as a percentage of GDP minus the rate of unemployment.

In a stable economy, the depression index would probably hover around zero, rising during healthy times and dropping below zero when the economy is weak and/or fragile. For example, the index rose above zero during the late 1990s when unemployment was relatively low, the budget briefly went into surplus, and Fed funds rate was around 5 percent. During the last sixty years, this index only touched below 10 points on two brief occasions: one month in late 1992 and four months during the middle of 2003. The Fed funds rate was 1.0 that summer and the budget deficit was 5 percent of GDP, yielding a policy capacity of negative 4. Since the unemployment rate peaked at 6.3 percentage points that summer, the overall depression index measured negative 10.

This spring, unemployment is spiking and both policies are being exhausted to stop it. The effect is a depression index that is not only the worst on record, but twice as low as ever before. The depression index is now negative 23.1. A metaphor for the index is something that measures the heat of a fire and how much water the firefighters have to douse it. Our fire is raging, and the water buckets are empty.

Recovery is going to have to come from the private sector. Indeed, research shows that new firms create new jobs, as obvious as that may sound. What we need then is less emphasis on monetary policy and fiscal policy, and more on growth policy.

On that note, I suppose a third policy could be considered for inclusion in the depression index. Taxes. Lower tax rates are known to encourage economic growth, and tax rate cuts have been utilized throughout history to fight recessions. Then again, given the policy preferences in D.C. nowadays, I decided not to include average tax rates in the index. It would be too depressing.

Tim Kane, Ph.D., is a senior fellow at the Kauffman Foundation and coauthor of Growthology.org.

June 15, 2009

Chrysler's Bankruptcy Roils the National Hockey League?

Perhaps you believe that the “special circumstances” used to justify this historic taking will limit its impact. Only lenders to vital American companies deemed “too big to fail” need to be concerned, right? That was the argument when the administration’s Auto Task Force recently upped the anti in the ongoing Delphi bankruptcy. Did you notice that the president’s men are trying to throw Debtor-in-Possession (DIP) creditors under the bus in favor of a no-bid buyout offer from a well-connected Beverly Hills private equity firm?

Shafting DIP creditors! How can that be?

Easy. The auto bailout express needs Delphi. 80% of the money for the proposed buyout is coming from taxpayer-controlled GM. The Feds needed a front man to cosmetically price the offer, a discrete service that will no doubt fetch a handsome reward.

There is no higher claim on assets – period – than DIP financing in a bankruptcy. Once but no longer known as the T-bill of bankruptcy claims, DIP financiers are the paramedics of the bankruptcy industry. They arrive after the disaster, charged with picking up the pieces in an effort to get the company back on its feet. As a precondition to continued operation, all prior creditors, secured and unsecured, must agree in advance that the DIP financier is top dog.

Not any more. Can you imagine arriving at the scene of an accident to render aid only to have the accident victim’s political cronies impound your ambulance? Welcome to the new world of Hope and Change.

Fortunately, an astute judge ordered Delphi to hold an auction to solicit competing bids. But suppose the case happened to come before a judge who valued empathy over the law? Or another who’s reasoning was based not on statute but on desired social outcomes?

Extraordinary times require extraordinary solutions, you say? The Administration must take unprecedented steps if it hopes to save the critically essential Detroit-based auto industry. Of course the auto czar has to reach down into the supply chain and do whatever it takes to keep this increasingly expensive house of cards from collapsing. After all, there are more jobs to “save or create” amongst the top tier auto suppliers than there are in the big three themselves. Given the “special circumstances,” why is it improper to ask yet another set of creditors to sacrifice for the greater good? It’s the outcome that matters not the process, right? Even the Phoenix Coyotes agree.

The Phoenix Coyotes?

Yep. The bankruptcy lawyer representing the hapless Coyotes is invoking the Chrysler “363 sale” precedent insisting that an emergency offer to buy the National Hockey League franchise must be accepted right away because … because … the NHL draft is looming! The NHL, which holds the rights to the franchise, prefers to continue funding the company to conduct an orderly sales process. Will the law protect their rights? Who knows.

Extension by analogy is how our judicial system interprets the law. Precedents invariably ripple into the future. This is why using political muscle to achieve an outcome that feels good today despite trampling the rule of law has unintended consequences tomorrow.

Don’t think creditors aren’t taking notice. Especially “good” creditors, the kind the government desperately needs to start lending again in order to “save or create jobs.” Too bad for the “greedy” creditors, you know, folks who have already lent out money expecting to get it back. Those creditors get tongue lashings from the President.

Stephen Lerner, a lawyer for a committee of Chrysler dealers, said it best when he was quoted in the Wall Street Journal. “The concern is that you have thousands of lenders, hedge funds, insurance companies who model their investments on rules and laws. How do these folks make investment decisions when they’re faced with bankruptcy courts that appear to disregard the rules?”

I’ll answer that one. They start making campaign donations. That approach sure paid off for the United Auto Workers union.

June 16, 2009

Not Everyone Guessed Wrong About Stimulus

Biden tried to rationalize the sad state of affairs, in which the jobless rate is now 9.4%, but finally just said that, "Everyone guessed wrong at the time the estimate was made about what the state of the economy was at the moment this was passed."

Anyone who guessed that Biden was wrong would have guessed right. On Feb. 18, we said: "The (stimulus) bill Congress hurried to pass late last week without anyone having read the entire 1,434 pages will in fact not stimulate much of anything."

We further noted that the $787 billion package would not be an economic stimulus but a spending bill filled with "pork and outright waste."

We were not alone. Some 330 economists signed a statement last winter saying that President Obama's claim — that "there is no disagreement that we need action by our government, a recovery plan that will help to jump-start the economy" — simply "is not true."

This statement, in an ad paid for by the Cato Institute, appeared on full pages in 24 major newspapers across the country, including the New York Times and Washington Post.

The economists were not crackpots but respected scholars, including Nobelists James Buchanan, Vernon Smith and Edward Prescott, as well as Reagan Office and Management of Budget Director James Miller, Walter Williams and John Lott.

Also opposed to the stimulus are the nonpartisan Congressional Budget Office and a core of U.S. representatives and senators, too small unfortunately to change the outcome, who saw through the smoke and weren't fooled by the mirrors.

The CBO, which makes analytical estimates, not guesses, believes that "in the longer run, the legislation would result in a slight decrease in gross domestic product compared with CBO's baseline economic forecast."

If the best the White House can do is guess as to how much unprecedented federal spending can affect the economy, then voters made a poor guess themselves last fall when they gave it their vote. Maybe from this we'll all learn that guessing has no place in the voting booth or the crafting of policy.

World War II Did Not End the Great Depression

World War II spending did not stimulate economic spirits in the U.S., but congressional pushback on New Deal legislation, a move toward freer trade and increased output on the part of the American citizenry did. To show why government spending is not the economic stimulant that many economists suggest, it’s first worthwhile to look at one downturn that occurred before economists were aware of the supposed wisdom of John Maynard Keynes.

1921-1923. Ohio University professor Richard Vedder observed at a Council on Foreign Relations symposium in March that “The 1920s downturn, although initially more severe than the Great Depression, turned out to be relatively short and weak precisely because the federal government did nothing.”

The research of Chase economist Benjamin Anderson supports Vedder’s conclusion. Indeed, as Anderson pointed out in his classic Economics and the Public Welfare, the federal government actually reduced spending from $6.4 billion in fiscal year 1920 to roughly $3.3 billion in 1923. And while taxes were reduced, it might surprise many who feel tax cuts are the answer to today’s ills that they were not reduced by very much. Tax revenues in 1920 were $6.7 billion and in 1923 they came out to $4 billion. In the crisis year of 1921 the federal government reduced public debt by $300 million, and from June of 1920 through June of 1923, public debt by $2 billion.

According to classical economics the government’s non-intervention was the proper response. Government spending is a tax, and the pullback by the federal government left more capital in the private sector to fund real economic growth rather than government consumption. Contrary to suggestions today that monetary authorities must devalue in the face of economic decline, authorities back in the early 1920s made sure to protect the dollar. As Anderson noted, the “gold standard was unshaken” despite the economic crisis.

So while the 1921 downturn was surely severe, Anderson recounted that by 1923 we had a labor shortage. All of this supports the recent arguments made by my H.C. Wainwright colleague David Ranson, who asked whether “you make people work harder by making them richer—or by making them poorer?”

Ranson’s answer was that greater work output results more from poverty (or fear of poverty) than from wealth, and this explains why recessions are frequently “V-shaped” if left alone. Fear of unemployment or poverty makes us more productive, and this same dynamic applies to companies forced to be more efficient in the face of reduced profits. And if governments spend and tax less as an added bonus, there exists more capital to fund the resumption of economic growth.

1933-1934. The early 1920s economic decline shows that economies can naturally heal after a recession. To clarify further why pump-priming by governments does not live up to its billing, it’s important now to look at what happened from 1933 to 1934. The Keynesian approach to economic growth was now much better known and, most telling, Keynes had met with President Roosevelt to make the case for more government spending.

While there’s no way of knowing how much or how little the eminent British economist affected the President’s thinking, it’s certainly true that Roosevelt chose to go on an impressive spending binge in hopes of lifting the economy out of its doldrums. Indeed, in early January of 1934 Roosevelt announced that the 1934 federal deficit would be $7 billion. Keynesianism would be tested in the United States.

Roosevelt never achieved his deficit of $7 billion, but it did rise to $4 billion by the end of fiscal 1934. Some might say that Roosevelt failed for not spending enough. But to test that assumption, we need merely ask whether the massive, but not massive enough, spending increase resulted in at least slightly greater economic activity. History says no.

By November of 1933, the Federal Reserve’s index of industrial production had fallen from 100 in July all the way to 72. Notably the index rallied from 72 to 86 by May of 1934, but as Wainwright research has regularly shown, governments can surely reschedule economic growth through spending and interest rate programs more easily than they can sustainably boost it. In this case, heavy spending on the part of the Roosevelt administration drove industrial production up in the near term, but by September of 1934, the Fed’s index had taken a round trip back to 71, slightly lower than it was when the spending program began.

The failure of 1930s Keynesian spending should in no way surprise us. Governments can only spend to the extent that they can borrow or tax from the private sector. In that sense, the economic growth that funded the spending had already occurred. To presume that productivity would multiply thanks to government largess is the equivalent of assuming that a thief could aid a convenience store by first stealing $20 from the store, then returning later in the day to spend it. Logic tells us that no stimulation results from money simply changing hands.

At best, there would be a decline in economic activity for the proverbial store owner spending less time selling products, and more time detaining thievery. In much the same way, if governments seek to tax wealth with simple redistribution in mind, the economically productive would spend less time innovating and more time on tax avoidance.

1938 and before. The 1938 elections represented a positive change in terms of Congress’s makeup. While the Great Depression was fathered by legislative mistakes in both parties, the gain of seven Republican seats in the Senate and 81 seats in the House of Representatives was a sign that going forward, FDR would experience a great deal more resistance when it came to legislation. Sure enough, the Wages and Hours Act marked what Anderson termed “President Roosevelt’s last successful effort to override a reluctant Congress.”

This is important because as history frequently shows, a divided Washington is often the right kind of environment to make bad legislation far more difficult to pass. But up until 1938, most of what came out of Congress was anti-growth, and that helps explain why unemployment was just as high in the late 1930s as it was earlier in the decade.

Looking back to the early 1930s and Herbert Hoover’s presidency, J.P. Morgan head Thomas Lamont remarked that “I almost went down on my knees to beg Herbert Hoover to veto the asinine Smoot-Hawley tariff.” GM’s European head, Graeme K. Howard, sent a telegram to Washington which said passage of Smoot-Hawley would lead to the “MOST SEVERE DEPRESSION EVER EXPERIENCED.” In one fell swoop, Washington shrank the very division of labor that enhances productivity, while the tariffs themselves greatly reduced the size of markets for U.S. firms to sell to.

With deficits in mind, Hoover raised the top tax rate from 25 to 62 percent, and then FDR eventually one-upped him by raising the top tax rate to 79 percent in concert with a reduction in rate thresholds so that more Americans could be ensnared by higher tax rates. Estate taxes were also increased, which meant that the individuals with capital were forced to become careful tax evaders rather than bold investors.

On the wage front, FDR was able to pass the National Industrial Recovery Act of 1933 which, according to Vedder, “raised wages in factory employment about 20 percent,” thus stalling recovery. This legislation was thankfully killed by 1935, but the Wagner Act followed, and as Vedder recounts, the “resulting wave of unionism led to another double digit rise in money wages, reversing the previous unemployment decline.” As a result, unemployment ticked back up to 20 percent by 1938.

Perhaps most economically crippling was the passage of the Undistributed Profits Tax of 1936. For corporations with profits of less than $10,000/yr. the tax ran from 10 to 42.14 percent, while companies earning more than $10,000 faced taxes on undistributed profits of 40 to 74 percent. The plan there was to force the distribution of profits through dividends that could be taxed as income, but what it meant in practice was that savings put aside by corporations for future growth or for future economic uncertainty would have to be handed over to the federal government.

When we consider the impact of small businesses on growth and employment, a more economically enervating tax would be hard to conceive. Large, established firms were already paying out dividends as they frequently do today, but this pernicious tax on profits doubtless strangled a lot of promising companies and jobs before they could truly be created. Thankfully this tax was repealed in the early part of 1938.

So while the Wagner Act still weighed on economic growth in 1938, the tide was turning. FDR’s court packing scheme had failed, his undistributed profits tax had been repealed, and a Congress previously eager to pass his initiatives was turning against him. In short, a New Deal that gave the U.S. a rate of unemployment in the late ’30s that was similar to the one earlier in the decade was winding down. In that sense it could easily be argued that the economy was set to recover regardless of the major war that was looming.

World War II. Mentioned earlier was the conventional account suggesting World War II ended the Great Depression. The basic argument is that government spending employed a lot of people, and the economy grew. But logic tells us that this assumption puts the cart before the proverbial horse. Once again, governments can only spend if they can tax and borrow against productive work that’s already occurred. Instead, it would be more accurate to say that a resumption of work combined with a less economically interventionist Washington did the job.

From a stock-market perspective, there’s no evidence supporting the conventional claim. While the Dow Jones Industrial Average reached 155 in October of 1939, it never regained that level until 1945, when the war was ending.

On the labor front, unemployment sat at 18.8 percent in 1938, but by 1939 it had already fallen to 16.7 percent. Amity Shlaes observed in The Forgotten Man that FDR knew a “war on business and a war against Europe could not happen at the same time,” and as has been shown, New Deal legislation so harmful to employment and capital formation was effectively halted by 1938. In 1942, FDR ordered the liquidation of the Work Projects Administration. The WPA employed 2.4 million Americans in 1939, but by June of 1943 the number was down to 42,000.

What seems to have increased national output during the war was the simple fact that Americans were working a great deal more. In this sense we might say the war was superficially stimulative because patriotic Americans felt it was their duty to work. And work they did judging by the increase in hours worked across all manner of industries. While average hours worked in the food products industry was 40 in 1940, by 1944 it had reached 45. In tobacco the number rose from 36 to 42, and in rubber products 36 to 45. FDR asked for income limits, but Congress refused him.

Not surprisingly, the extra work led to a massive increase in federal revenues. While federal receipts were roughly $6 billion in 1940, by 1945 they had risen all the way to $47 billion, an increase of nearly 700 percent. And with patriotism perhaps in mind, 90 percent of federal receipts came from individuals making less than $15,000 per year. Simplified, the government spending that many claim got us out of the Great Depression was only feasible once the government got out of the way somewhat and allowed Americans to work.

It would be hard to argue against the suggestion that the war and a desire to help the government win it stimulated work effort. But the fact remains that the government was only able to spend to extent that Americans in the private sector chose to work more, and were allowed to do so. To suggest that federal spending was the driver of work effort is to ignore the fact that federal receipts rose only when Americans became more productive. The war likely helped, but unemployment was already falling by 1939, and with FDR’s legislative assault effectively over with, productivity was set to resume either way.

To assume war is stimulative is to argue for governments that regularly wage wars or massive employment programs. How death and destruction could help any economy has never been explained, plus when the government bids for workers against the private sector, the latter sags due to a lack of human capital. Also, those who continue to suggest that the war drove the economy in ways that the private sector failed to can never explain why our economy didn't collapse once it ended.

The aftermath of World War II. Wainwright publications have long stressed that passage of the Smoot-Hawley tariff was a significant match that sparked the Great Depression. True enough, but by 1944 the tide was happily turning when it came to trade. Put simply, the very legislation that put us on the path to economic decline was reversed in a very substantial way in 1944.

Smoot-Hawley was on its face a protectionist act, as were the responses around the world. The fact that money was unstable in the ’30s served to isolate economic activity even more. With the world effectively off the gold standard in the 1930s, economist Judy Shelton wrote in Money Meltdown that through “a series of competitive devaluations, nations sought to undercut each others’ ability to sell their products in world markets.”

In that sense the looming passage of the Bretton Woods monetary agreement was highly stimulative, and is arguably the greatest reason that the world economy recovered after the war. Death and destruction wrought by conflict could in no way grow ours or any economy, but resumption of free trade together with stable currency arrangements serving to expand the worldwide division of labor would. As Bretton Woods architect Harry Dexter White observed in 1942, “the task of securing the defeat of the Axis powers would be made easier if the victims of aggression, actual and potential, could have more assurance that a victory by the United Nations will not mean, in the economic sphere, a mere return to the pre-war pattern of every-country-for-itself.”

Passage of the Bretton Woods agreement in 1944 was a signal to the Axis countries that the economic isolation of the 1930s was to be reversed such that the Allied powers would combine economic growth with military strength. Better yet, once the war was over, the bloc of freely trading nations would grow as they always do when labor is divided based on comparative advantage.

Conclusion. The governmental response to the 1921 economic downturn shows what happens when ailing economies are allowed to heal free of government help. Conversely, the federal government’s 1933 compounding of past legislative mistakes shows how ineffective government spending is when it comes to jumpstarting an economy that is unproductive.

The mistakes of the 1930s reveal for us how very unequal government is to the challenge of coping with economic decline—rather than being a facilitator of economic growth. Governments are the instigators of most recessions. It’s the height of folly to presume that they have the answers to dig us out of them.

By the late 1930s it was already apparent that the New Deal had not worked, and more legislation of its kind ceased. The war years gave us a less economically intrusive government whose relative absence made possible a great deal of productivity once the Bretton Woods monetary agreement was passed. In short, World War II and spending more generally did nothing to end the Great Depression.

June 17, 2009

Government Stimulus Consists Of Fraud and Abuse

Combing through the long list of stimulus projects, Coburn found some real winners. Projects that have won millions of taxpayer dollars include everything from a turtle crossing in northern Florida, at a cost of $3.4 million, to a guardrail near a man-made lake that no longer contains any water, with a price tag of $1.1 million.

Other doozies include:

• $1 billion for the FutureGen power project in Illinois, called the biggest earmark ever. And no one is sure it will even work.

• $800,000 to pave a runway at John Murtha Airport — dubbed the Airport for Nobody because it's rarely used.

• Money from stimulus funds for 10,000 dead people.

These and others like them sound like small potatoes, and indeed, Coburn's 100 add up to just $5.5 billion — peanuts in a $3.6 trillion budget. But expect the waste to grow as we spend more money on politically backed pork projects that local governments sensibly have refused to fund with their own money.

Worse still is the rampant fraud that goes with this out-of-control spending. Vice President Joe Biden accidentally let the cat out of the bag two weeks ago, telling business leaders in New York: "We know some of this money is going to be wasted. There are going to be mistakes made. Some people are being scammed already."

This isn't just hot air.

A report by Deloitte Touche last week said that about $500 billion of the $787 billion in stimulus will be spent through the "traditional (government) procurement network." Using past performance as a gauge, Deloitte Touche predicted as much as $50 billion will end up being fraudulently spent — or 10% of the total.

Similarly, the head of the Recovery Act Accountability and Transparency Board estimates $55 billion in waste, fraud and abuse.

We're not surprised. The whole stimulus program has been a fraud from the start, promising millions of jobs and delivering few, and playing on Americans' fears to get the stimulus passed right away, because we simply couldn't wait. So far, only 6% of the total has been spent. The "emergency" was a sham.

This may be why 45% of taxpayers in a June 10 Rasmussen Poll said they'd halt stimulus spending now vs. just 36% who want it continued. They know it's not stimulus at all. It's waste, fraud and abuse on a grand scale — almost as if it was planned that way.

President Obama's Prepared Remarks on Financial Regulatory Reform

That is why, as part of this new foundation, we are seeking to build an energy economy that creates new jobs and new businesses to free us from our dependence on foreign oil; to foster an education system that instills in each generation the capacity to turn ideas into innovations, and innovations into industries; and, as I discussed on Monday at the American Medical Association, to reform our health care system so that we can remain healthy and competitive.

This new foundation also requires strong, vibrant financial markets, operating under transparent, fairly-administered rules of the road that protect America’s consumers and our economy from the devastating breakdown we’ve witnessed in recent years.

It is an indisputable fact that one of the most significant contributors to our economic downturn was an unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess. A culture of irresponsibility took root from Wall Street to Washington to Main Street. And a regulatory regime basically crafted in the wake of a 20th century economic crisis – the Great Depression – was overwhelmed by the speed, scope, and sophistication of a 21st century global economy.

In recent years, financial innovators, seeking an edge in the marketplace, produced a variety of new and complex financial instruments. These products, such as asset backed securities, were designed to spread risk but ended up concentrating it. Loans were sold to banks, banks packaged these loans into securities, and investors bought these securities often with little insight into the risks to which they were exposed. It was easy money. But these schemes were built on a pile of sand. And as the appetite for these products grew, lenders lowered standards to attract new borrowers. Many Americans bought homes and borrowed money without being adequately informed of the terms, and often without accepting their responsibilities.

Meanwhile, excessive executive compensation – unmoored from long-term performance or even reality – rewarded recklessness rather than responsibility. This wasn’t just a failure of individuals. This was a failure of the entire system. The actions of many firms escaped scrutiny. In some cases, the dealings of these institutions were so complex and opaque that few inside or outside these companies understood what was happening. Where there were gaps in the rules, regulators lacked the authority to take action. Where there were overlaps, regulators lacked accountability for inaction.

An absence of oversight engendered systematic, and systemic, abuse. Instead of reducing risk, the markets actually magnified risks being taken by ordinary families and large firms alike. There was far too much debt and not nearly enough capital in the system. And a growing economy bred complacency.

We all know the result: the bursting of a debt-based bubble; the failure of several of the world’s largest financial institutions; the sudden decline in available credit; the deterioration of the economy; the unprecedented intervention of the federal government to stabilize the financial markets and prevent a wider collapse; and most importantly, the terrible pain in the lives of ordinary Americans. There are retirees who have lost much of their life savings, families devastated by job losses, small businesses forced to shut their doors.

Millions of Americans who have worked hard and behaved responsibly have seen their life dreams eroded by the irresponsibility of others and the failure of their government to provide adequate oversight. Our entire economy has been undermined by that failure.

The question is, what do we do now? We did not choose how this crisis began. But we do have a choice in the legacy this crisis leaves behind. So today, my administration is proposing a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.

These proposals reflect intensive consultation with leaders in Congress, including those here today: leaders like Chairmen Dodd and Frank, who along with Senator Shelby and Representative Bachus met with me earlier this year to jumpstart the discussion of reform. They also draw on conversations with regulators, including those I met with this morning; consumer advocates; business leaders; academic experts; and the broader public.

In these efforts, we seek a careful balance. I have always been a strong believer in the power of the free market. It has been and will remain the engine of America’s progress – the source of prosperity unrivaled in history. I believe that jobs are best created not by government, but by businesses and entrepreneurs who are willing to take a risk on a good idea. I believe that our role is not to disparage wealth, but to expand its reach; not to stifle the market, but to strengthen its ability to unleash the creativity and innovation that still make this nation the envy of the world.

That’s our goal. To restore markets in which we reward hard work and responsibility, not recklessness and greed – in which honest, vigorous competition in the system is prized, and those who game the system are thwarted.

With the reforms we are proposing today, we seek to put in place rules that will allow our markets to promote innovation while discouraging abuse. We seek to create a framework in which markets can function freely and fairly, without the fragility in which normal business cycles bring the risk of financial collapse; a system that works for businesses and consumers.

There are those who will say we do not go far enough, that we should have scrapped the system altogether and started again. I think that would be a mistake. Instead, we have crafted reforms to pinpoint the structural weaknesses that allowed for this crisis and to make sure that these problems are dealt with so as to prevent crises in the future.

There are also those who will say we are going too far. But the events of the past few years offer ample testimony for the need to make significant changes. The absence of a working regulatory regime over many parts of the financial system – and over the system as a whole – led us to near catastrophe. We do not want to stifle innovation. But I’m convinced that by setting out clear rules of the road and ensuring transparency and fair dealings, we will actually promote a more vibrant market. This principle is at the heart of the changes we are proposing.

First, we are proposing a set of reforms to require regulators to look not only at the safety and soundness of individual institutions, but also – for the first time – at the stability of the system as a whole.

One of the reasons this crisis could take place is that while many agencies and regulators were responsible for overseeing individual financial firms and their subsidiaries, no one was responsible for protecting the whole system from the kinds of risks that tied these firms to one another. Regulators were charged with seeing the trees, not the forest. Even then, some firms that posed a so-called “systemic risk” were not regulated as strongly as others; they behaved like banks but chose to be regulated as insurance companies, or investment firms, or other entities under less scrutiny.

As a result, the failure of one large firm threatened the viability of many others. The effect multiplied. There was no system in place that was prepared for this kind of outcome. And more importantly, no one has been charged with preventing it. We were facing one of the largest financial crises in history – and those responsible for oversight were mostly caught off-guard and without the authority needed to address the problem.

It’s time for that to change. I am proposing that the Federal Reserve be granted new authority – and accountability – for regulating bank holding companies and other large firms that pose a risk to the entire economy in the event of failure. We will also raise the standards to which these kinds of firms are held. If you can pose a great risk, that means you have a great responsibility. We will require these firms to meet stronger capital and liquidity requirements so that they are more resilient and less likely to fail.

And even as we place the authority to regulate these large firms in the hands of the Federal Reserve – so that lines of responsibility and accountability are clear – we will also create an oversight council to bring together regulators from across markets to coordinate and share information; to identify gaps in regulation; and to tackle issues that don’t fit neatly in an organizational chart. We’re going to bring everyone together to take a broader view – and a longer view – to solve problems in oversight before they can become crises.

As part of this effort, we are proposing the creation of what is called “resolution authority” for large and interconnected financial firms so that we are not only putting in place safeguards to prevent the failure of these firms, but also a set of orderly procedures that will allow us to protect the economy if such a firm does in fact go under.

Think about this: if a bank fails, we have a process through the FDIC that protects depositors and maintains confidence in the banking system. This process was created during Great Depression when the failure of one bank led to runs on other banks, which in turn threatened wider turmoil. And it works. Yet we do not have any effective system in place to contain the failure of an AIG and the largest and most interconnected financial firms in our country.

That is why, when this crisis began, crucial decisions about what would happen to some of the world’s biggest companies – companies employing tens of thousands of people and holding trillions of dollars in assets – took place in emergency meetings in the middle of the night. And that is why we’ve had to rely on taxpayer dollars. We should not be forced to choose between allowing a company to fall into a rapid and chaotic dissolution or to support the company with taxpayer money. That is unacceptable. There is too much at stake.

Second, we are proposing a new and powerful agency charged with just one job: looking out for ordinary consumers. This is essential, for this crisis was not just the result of decisions made by the mightiest of financial firms; it was also the result of decisions made by ordinary Americans to open credit cards, take out home loans, and take on other financial obligations. We know that there were many who took out loans they knew they could not afford, but there are also millions of Americans who signed contracts they did not always understand offered by lenders who did not always tell the truth. Even today, folks signing up for a mortgage, student loan, or credit card face a bewildering array of incomprehensible options. Companies compete not by offering better products, but more complicated ones, with more fine print and hidden terms.

This new agency will change that, building on credit card reforms I signed into law a few weeks ago. This agency will have the power to set standards so that companies compete by offering innovative products that consumers actually want – and actually understand. Consumers will be provided information that is simple, transparent, and accurate. You’ll be able to compare products and see what is best for you. The most unfair practices will be banned. Those ridiculous contracts – pages of fine print that no one can figure out – will be a thing of the past. And enforcement will be the rule, not the exception.

For example, this agency will be empowered to set new rules for home mortgage lending, so that the bad practices that led to the home mortgage crisis will be stamped out. Mortgage brokers will be held to higher standards; exotic mortgages that hide exploding costs will no longer be the norm; home mortgage disclosures will be reasonable, clearly written, and concise. And we’re going to level the playing field so that non-banks that offer home loans are held to the same standards as banks that offer similar services, so that lenders aren’t competing to lower standards – but to meet a higher bar on behalf of consumers.

The mission of this new agency must also be reflected in the work we do throughout the government. There are other agencies, like the Federal Trade Commission, charged with protecting consumers, and we must ensure that those agencies have the resources, and the state-of-the-art tools, to stop unfair and deceptive practices as well.

Third, we are proposing a series of changes designed to promote free and fair markets by closing gaps and overlaps in our regulatory system – including gaps that exist not just within but between nations.

We’ve seen that structural deficiencies allow some companies to shop for the regulator of their choice – and others, like hedge funds, to operate outside the regulatory system altogether. We’ve seen the development of financial instruments, like many derivatives, so complex as to defy efforts to assess their actual value. And we’ve seen a system that allowed lenders to profit by providing loans to borrowers who would never repay – because the lender offloaded the loan, and the consequences, to someone else.

That is why, as part of these reforms, we will dismantle the Office of Thrift Supervision and close loopholes that have allowed important institutions to cherry-pick among banking rules. We will offer only one federal banking charter, regulated by a strengthened federal supervisor. We’ll raise capital requirements for all depository institutions. And hedge fund advisers will be required to register with the SEC.

We are also proposing comprehensive regulation of credit default swaps and other derivatives that have threatened the entire financial system. And we will require the originator of a loan to retain an economic interest in that loan, so that the lender – and not just the holder of a security, for example – has an interest in ensuring that a loan is paid back. By setting common-sense rules, these kinds of financial instruments can play a constructive – not destructive – role.

Over the past two decades, we have seen – time and again – cycles of precipitous booms and busts. In each case, millions of people have had their lives profoundly disrupted by developments in the financial system, most severely in our recent crisis. These aren’t just numbers on a ledger. This is a child’s chance to get an education. This is a family’s ability to pay their bills or stay in their home. This is the right of our seniors to retire with dignity and security. These are American dreams, and we should not accept a system that consistently puts them in danger. Financial institutions have an obligation to themselves and to the public to manage risks carefully. And as President, I have a responsibility to ensure that our financial system works for the economy as a whole.

There has always been a tension between those who place their faith in the invisible hand of the marketplace – and those who place more trust in the guiding hand of the government. That tension isn’t a bad thing. It gives rise to the debates and dynamism that make it possible for us to adapt and grow. For we know that markets are not an unalloyed force for good or for ill. In many ways, our financial system reflects us. In the aggregate of countless independent decisions, we see the potential for creativity – and the potential for abuse. We see the capacity for innovations that make our economy stronger – and for innovations that exploit our economy’s weaknesses.

We are called upon to put in place those reforms that allow our best qualities to flourish – while keeping those worst traits in check. We are called upon to recognize that the free market is the most powerful generative force for our prosperity – but it is not a free license to ignore the consequences of our actions.

This is a difficult time for our nation. But from this period of challenge, we can once again tap those values and ideals that have allowed us to lead the global economy, and will allow us to lead once again. That is how we will help more Americans live their own dreams. That is why these reforms are so important. And I look to working with leaders in Congress and all of you to see these proposals put to work so that we can overcome this crisis and build a foundation for lasting prosperity.

Thank you.

Trying to Cover the Unenthusiastic Uninsured

Why do they lack coverage, then? One reason is that some of them have simply decided to spend their money elsewhere. Among this group are people called ‘invincibles’ in industry slang, that is, well-employed, healthy twenty and thirty-something adults who think medical insurance—even just co-pays for employer-provided plans--is a waste of money.

Meanwhile others, mostly low-income uninsured, have remained ignorant of expanding government programs designed to help them—often despite extensive outreach programs by government agencies and health advocates. Others apparently can’t be bothered going through the bureaucracy to enroll in these subsidized programs. Instead, they just do what they’ve always done if they or their kids get sick--head to the local emergency room knowing they’ll get treatment that someone will pay for.

Designing a health care effort that offers newfangled options for all of these folks won’t mean much unless we actually get them to participate. And to do that we need some honest assessment of why people in this huge group aren’t insured already.

You won’t get much of that in a lot of the coverage of America’s health care woes. Most stories and commentary make passing reference to the 47 million or so uninsured and then move on to other issues. Reporting that does delve deeper typically focuses on working Americans who want insurance but can’t afford it. Their stories are often compelling, but they are not by any means the whole story.

A study two years ago by Urban Institute scholars found that 19 percent of the uninsured in America, or roughly nine million people, were in households earning more than three times the poverty level, which the study broadly defined as income high enough to afford unsubsidized insurance. About two-thirds of this group was childless adults who only needed insurance for themselves.

Another six million of the uninsured earned between 200 percent and 300 percent of the federal poverty level. While that’s not officially considered enough to afford health insurance, it is often enough to pay for health care itself, except under the worst circumstances. One study of California residents done several years ago found that half of those without insurance who were earning 200 percent or more of the federal poverty level had received care in the past year, for which they had paid out of their pocket.

Then there is the other end of the spectrum. Another 25 percent of the uninsured, or some 11 million people, are eligible for government subsidized programs but not enrolled. In particular, three-quarters of the eight million uninsured children in America are already entitled to public health care insurance but haven’t been registered in plans by their parents or guardians.

There are a number of reasons why people who fall into these groups may not have insurance. As I noted above, one group consists of ‘invincibles’ who are paying for health care when they need it out-of-pocket because they are in generally good health and don’t believe any life-threatening or costly medical condition is likely to happen to them. The numbers tell the story: Some 45 percent of uninsured adults without children who earn more than three times the poverty level are in their 20s and 30s, and 93 percent of this group report their health as good or excellent.

While most of us might consider going without insurance risky, local laws incentivize healthy people to do so. States like New York and New Jersey have ‘guaranteed issue’ laws that require an insurer to sign up anyone who requests coverage regardless of his condition. That encourages some people, especially younger people without children, to forgo insurance until they get sick—driving up everyone else’s costs in the process by depriving insurers of premiums from healthy individuals. In New York and New Jersey, for instance, the average age of an insured adult person is 44 and 37 years old respectively, while in nearby Pennsylvania, which doesn’t have a guaranteed issue law, the average age is 31 years old.

An even more confounding issue is the large number of people eligible for government programs that don’t enroll, don’t visit doctors regularly, and then show up at hospitals for expensive care. Health care advocates like to argue the problem in such cases is a lack of government outreach, but as states have expanded their subsidized programs, many have vastly increased their advertising and marketing and tried to discourage people from using emergency rooms for ordinary ailments. One measure of the effectiveness of such marketing efforts is that many lower and middle income working families have migrated from employer insurance coverage to these public plans because of the publicity surrounding them as lower-cost options. Yet at the same time, a core group of the poor have failed to enlist. The problem seems to go deeper than mere marketing, in other words.

These issues present government reformers with all sorts of thorny problems. Take the case of people at higher incomes without insurance. To make reform work, the government will have to require them to buy coverage, necessitating some type of national monitoring program and penalties for those who don’t comply (Massachusetts, which now mandates coverage, has already hiked fines once to get better cooperation from the uninsured). And once government decrees everyone must have health insurance, the feds must also decide who can afford it and then subsidize everyone else. One proposed plan, the Affordable Health Choices Act of Sen. Edward Kennedy, for instance, would help finance premiums for uninsured people in families making up to 500 percent above the federal poverty level, or more than $100,000 in annual income for a family of four.

Of course, when government requires insurance it must decide what to do with people who earn enough to buy it but still can’t afford it, including those who have gotten themselves into trouble with bad investments, unwise borrowing, too much consuming, and the like. Should government subsidize coverage of such people or allow them to go uncovered? Who will decide? And what will be the consequences? The nonpartisan Congressional Budget Office, for instance, has estimated that under the Kennedy plan about 15 million fewer people will be covered by employer-sponsored plans by 2019 because many will migrate from these plans to government-subsidized health insurance instead.

Then there is the question of low-income families. To make reform work the Obama administration is counting on expanding government run programs so that, for instance, adults earning up to 200 percent of the federal poverty level would be eligible for government-paid insurance. Some of these individuals, however, are the same people who haven’t bothered to enroll their children in existing federal-state health insurance for dependents of the working poor. Why do we think they’ll do any better for themselves?

There is an assumption in much of the coverage and commentary about health care reform that virtually all of the uninsured are desperate for coverage and counting on the federal government to come through for them. Don’t bet on it.

June 18, 2009

Is There An Oil Story Behind the Iranian Elections?

Although the answer is likely no (the price of a barrel of oil has fallen 4 percent since the elections), there are a few scenarios that might on their face impact oil supply.

The first one concerns Iranian oil exports, and whether crude will continue to flow from its ports despite internal unrest. Logic tells us that it will.

The reasons for this are basic. As much as oil lubricates our—and the world’s—economy, Iran needs foreign exchange far more than the world needs its oil. Especially considering the aforementioned internal unrest, the last thing President Ahmadinejad needs right now is a dollar shortage amid persistent questions about the veracity of the Iranian vote. Conclusion? Iranian oil will flow.

Assuming a scenario whereby violence leads to a shutdown of Iranian oil ports, is this something that should concern us? In the near-term maybe, but this wouldn’t materially impact oil prices over the long-term; the reason being that if Iranian producers bring less oil to market, other OPEC countries will gladly increase oil exports in order to fulfill their own needs with regard to foreign exchange.

But what if President Obama turns up the heat on Iran, and specifically on Ahmadinejad, over last Friday’s vote? Couldn’t Ahmadinejad retaliate by refusing to allow Iranian oil sales to U.S. interests?

The above is not outside the realm of possibility, but it’s also wholly irrelevant to the price of a barrel of oil. For one, the majority of foreign oil that reaches the U.S. comes from Canada.

Secondly, while the notion of an “embargo” is at first blush a bit scary, the greater truth is that embargoes of any kind are a major economic myth. Put simply, embargoes aren’t.

Indeed, during the mid-19th century similar fears of embargo arose in England, only in their case the product in question was food. One argument made at the time in favor of maintaining the country’s Corn Laws was that if England’s agricultural interests were decimated by free trade, there would not be food to supply its troops or its citizens in times of war. The problem, however, for those who defended the tariffs was that since 1810 England had been at war with near every European power, yet it still managed to import 1,491,000 quarters of wheat from the very countries it had been warring with.

During World War I, England’s blockade of Germany complicated the efforts of U.S. exporters to sell their wares to Germans. No problem there either. Instead of transacting with German interests, U.S. firms simply increased their exports to Sweden and other Scandinavian countries who in turn exported the U.S. goods to Germany.

Fast forward to the 1970s, when, despite the early ‘70s Arab oil embargo (Iran, as a non-Arab country did not participate) placed on the United States, America imported every bit as much oil during the embargo as before the embargo. Saudi oil minister Sheik Yamani admitted after 1973 that the embargo "did not imply that we could reduce imports to the United States … the world is really just one market. So the embargo was more symbolic than anything else."

Countries can impose all manner of selling restrictions on the items they export, but once those goods leave the port, there’s no accounting for where they end up. If every OPEC country were to place an embargo on the United States, the U.S. would still buy their oil, only from those they’d not embargoed.

Assuming Ahmadinejad restricts sales of Iranian crude to U.S. interests, those same interests will still buy Iranian oil; albeit from those the oil is sold to.

All this begs the question of why oil prices spiked in the early and late ‘70s. Conventional wisdom points to the aforementioned embargo in the early ‘70s, and unrest in Iran in the late ‘70s. History in both instances is flawed.

More realistically the oil price spiked both times because the dollar was in freefall, and oil is priced in dollars. Oil didn’t become expensive in the ‘70s, rather the dollar became cheap. Robert Bartley, the late editorial page editor of the Wall Street Journal, used to put the word ‘shocks’ in quotes when writing about the 1970’s “oil shocks.” His reasoning was sound because it once again wasn’t oil that spiked. Instead, the dollar weakened and its decline drove up the prices of all commodities, including oil.

In that sense, if there’s an oil story here it if anything hinges on the unlikely possibility that civil unrest in Iran turns into all-out war along the lines of Israel invading Iran during a time of weakness. If so, oil could realistically spike but this would mostly be due to the dollar’s decline amid a conflict that the U.S. military might not be able to avoid.

Happily, and as evidenced by the oil’s 4 percent decline since last week, the above scenario seems highly unlikely. More realistically, oil will continue to flow from Iran because irrespective of who ultimately takes control there, the country needs dollars.

A VAT Tax Is Not the Answer

Perhaps he was only practicing legislative diplomacy, but chairman Charles Rangel (D-NY) of the Ways & Means Committee, where tax bills originate, refused to rule out a VAT in recent conversations, saying “it’s been put on the table.”

To be sure, Rangel went on to acknowledge obliquely that many Democrats might not support such a tax. Nor has there been any hint from the Obama White House that the 44th president would go for a VAT.

But a 1% VAT could raise $100 billion a year, and a 5% VAT could bring in $500 billion. That may have a seductive ring in the ears of some in the White House and on Capitol Hill—a small tax yields a lot of money. Nevertheless, it is a bad idea.

The tax, on goods and services, is levied only on the value added at each stage of production. Take a hand-made guitar: When the maker buys the strings and the wood, he receives invoices that show how much value-added tax their producers have paid. By assembling the guitar into an instrument a musician can use, the maker adds value, and can sell the guitar for more than the cost of the materials. He will pay tax on his sales price, but may first subtract the taxes that suppliers have paid, avoiding double taxation. Net, he pays tax only on the value he adds.

The problem with the VAT is that it is biased upward over time, because it is so tempting for legislatures to produce more revenue by making small rate increases. When imposed in 1967, Denmark’s VAT was 10%; it is now 25%, in addition to a top income tax rate of around 59%. A year later, in 1968, Germany levied a 10% VAT. Germans are more fortunate; their VAT has risen “only” to 19%, and their highest income tax rate is “only” 45%.

Twenty-nine OECD countries have VATs, and only three— Canada , Japan , and Switzerland —apply rates under 10%. The others impose rates of 10% of more, and 12 have rates of 20% or higher. In sum, the notion that a VAT will be a small, single-digit tax is not born out by other countries’ experience. In fact, in many countries the VAT is the largest source of government revenue.

It’s politically unrealistic to expect that a VAT would be a substitute for the income tax, so it would end up being an additional levy, one that enlarges the government’s claim on the rest of the economy. Putting a VAT in the hands of Congress is like giving an alcoholic the keys to the wine cellar and saying he’s welcome to drink just one bottle. Of course, the following morning several bottles will have been consumed.

Len Burman, a liberal economist with the Tax Policy Center, suggests imposing a VAT and then rebating the revenue back to families through lower income taxes and vouchers to buy health insurance. If this complicated plan seems too good to be true, that’s because it is. The notion that Congress will reduce other taxes when it imposes a VAT strains credulity at a time when it is considering expensive “investments” in energy, health, and education.

OECD countries do not use their VATs solely for one program, such as health care. They use them to pay for a wide variety of expenditures. There’s no reason to expect it to be different in America.

Should Congress wish to move towards a consumption tax in order to encourage savings, there are better and simpler ways to do so. The best is to take the myriad of tax-free savings accounts we have now—529 college savings plans, 401(k) retirement plans, traditional Individual Retirement Accounts, Roth Individual Retirement Accounts, Health Savings Accounts, Simplified Employee Pensions, etc.—and meld them into one large tax-free savings account and place no limit on annual contributions. Income going into this omnibus savings account would not be taxed, so de facto we would have a consumption tax, since the only money subject to income tax would be money spent.

A VAT has the potential to fund all of Congress’s pet projects, such as cap-and-trade, renewable energy, electric cars, high speed rail, and, of course, health care. It’s the taxpayers who would be the losers.

About June 2009

This page contains all entries posted to RealClearMarkets - Articles in June 2009. They are listed from oldest to newest.

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