Relevant and even prescient commentary on news, politics and the economy.

Fiscal Policy: Forty Years of Free Lunches

The Free-Lunch Supply-Side crowd seems to be playing Barbra Streisand’s Memories of late. For example, Greg Kaza traces Federal Reserve articles as far back as 1981 – each noting that incentives matter. Of course, mainstream economists have never doubted this proposition, but we also note that there is something called the law of scarcity, which in macroeconomic speak becomes the crowding-out effect – as in when “giving the people their money back” to consume more without cutting government purchases means less savings and investment.

The good news is that those Google alerts from the Kerry economic advisors still come to my inbox on occasion with one linking to a Jude Wanniski discussion of the 1964 tax cut:

The biggest reason, I think, is that since Jack Kemp began promoting Kennedy-type tax cuts in 1976, the Democratic Establishment has been rewriting history to show that the JFK tax cuts were demand-side, Keynesian stimulants to the economy … In proposing the tax cuts in late May of 1962, Kennedy cited the incentive effects, not the income effects that a Keynesian would argue. And when the legislation was introduced by Rep. Wilbur Mills of Arkansas, then chairman of the Democratic House Ways Means Committee, his floor speech was all “supply-side,” actually written by the late Norman Ture, an economic consultant to Mills.

Wanniski accuses Democrats of rewriting history when it is his crowd that so misrepresents the discussions of macroeconomic policy some forty years ago. About 20 years ago, I listened to Richard Rahn try to convince us that the 1964 tax cut was Lafferian supply-side effects only to hear him quote the Kennedy-Johnson CEA talk about multipliers and aggregate demand effects. I had the delight of meeting Richard Musgrave who chuckled as he said this was the Keynes-Laffer effect and not some supply-side magic.

At other points, I have had the delight of hearing two CEA members discuss a December 1965 meeting with President Johnson where they advised the President that the combination of tax cuts, rising transfer payments (the Great Society), and rising defense spending (Vietnam) would put the Federal Reserve in a difficult situation. The FED’s first response was to run tight money leading to the 1966 Credit Crunch – classic crowding-out. When the President ignored the CEA’s advice and jawboned the FED, inflation accelerated.

The Wanniski never mentions this history as they wish to blame the Keynesian economists at the CEA for the acceleration of inflation, but in truth the blame goes to Norman Ture – who was indeed the forerunner to Art Laffer. Johnson told his economists that politically he would need the assistance of Congressman Mills to push for a tax increase. Ture told Mills that we should not worry about excess demand in much the same way modern proponents of this free-lunch branch of the supply-side school scoff at real economists.

We should remember the real lessons of history as modern fiscal policy is cutting taxes as transfer payments and defense spending have risen. And the Greenspan FED is showing signs that it will raise interest rates, which will crowd-out investment. This trip down memory lane by the free lunchers reminds me all too much of the mistakes made two generations ago.

Hit tip to Lawyers, Guns, and Money for a discussion of the changing rhetoric from this free-lunch crowd.

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George Will Supports a National Sales Tax as He Flunks Math

Will’s latest Washington Post oped:

He would erase the federal income tax system – personal and corporate income taxes, the regressive payroll tax and self-employment tax, capital gains, gift and estate taxes, the alternative minimum tax, and the earned-income tax credit – and replace all that with a 23 percent national sales tax on personal consumption … And his bill untaxes the poor by including an advance monthly rebate for every household equal to the sales tax on consumption of essential goods and services, as calculated by the government, up to the annually adjusted poverty level.

Will does note that passing a national sales tax might reduce government spending dictated by K Street. He also suggests a lot of other (dubious) effects from replacing the income tax with a sales tax. But could someone donate a few dollars so Mr. Will might take a remedial math class as 23% of the tax base Mr. Will is discussing comes nowhere close to providing for total Federal spending including Social Security benefits.

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Soft Landing or Hard: Rip van Winkle Wakes Up

While Brad DeLong provides a nice summary of the debate through yesterday, Kash has been very busy this morning. I shared a question over at David Altig’s blog that simply queries what would Rip van Winkle think if he woke up from a nap that began in 1985. In 1985, the debate centered on the “Twin Deficits” – the fiscal irresponsibility during Reagan’s first term and the large current account deficit caused in part by a massive dollar appreciation. Rip might be happy to have learned that Reagan’s second term saw a strong recovery even as the dollar devalued and reversed the slide of the current account. Rip might next ask what is different in 2005 versus the situation 20 years ago. I’ll toss a few items and simply solicit comments.

The first item comes from the fact that the reasons for the current account deficit now are quite different from the reasons for the current account deficit during Clinton’s second term. By definition, the current account deficit is the difference between investment and national savings. During Clinton’s second term, national savings was higher than the pitifully low levels we have been witnessing since 2001. During Clinton’s second term, we were enjoying an investment-led boom but we suffered an investment-led slump that started just as George W. Bush was taking office.

Interest rates were quite high in 1985 and are low today. Of course, one would expect low interest rate during a period of weak investment demand. As investment demand is picking up, the Federal Reserve is reversing its easy monetary policy.

Much of the hard landing camp is noting that much of today’s current account deficit is being financed by Asian Central Bank mercantilism. The old Mundell premises about floating exchange rates may be good macroeconomics for the 1980’s, but we may indeed have entered Bretton Woods II. If these Asian Central Banks abandon their current form of mercantilism, an analysis of the effects would have to go beyond these particular Mundell premises.

However, I still hold to some of the critiques of Reagan fiscal irresponsibility from Thomas Sargent that Rip likely read before his nap. Sargent held out the possibility that policymakers in the 1980’s were not insanely devoted to spend and borrow but were rather playing a transitional game of chicken as to how to restore fiscal sanity – as in slashing spending versus raising taxes. Fiscal sanity in fact was restored in the 1990’s with a combination of tax increases and defense spending reductions. If markets are forward-looking, what are they expecting future fiscal policy will be given that the ruling party has the courage to neither slash spending nor raise taxes. If private agents 20 years ago held hope for fiscal sanity, but private agents today have no such hope, how does this affect our analysis as to the soft v. hard landing debate?


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The Savings Rate

The US’s abysmally low personal savings rate has to start rising at some point. There’s no getting around that fact. But we clearly have not yet reached that point. Today’s release of the February personal income and spending data from the BEA shows no inclination for US households to start saving more.

Personal income increased $33.2 billion, or 0.3 percent, and disposable personal income (DPI) increased $29.6 billion, or 0.3 percent, in February, according to the Bureau of Economic Analysis. Personal consumption expenditures (PCE) increased $46.6 billion, or 0.5 percent.

…Personal saving — DPI less personal outlays — was $52.7 billion in February, compared with $71.6 billion in January. Personal saving as a percentage of disposable personal income was 0.6 percent in February, compared with 0.8 percent in January.

Other than the exceptional month of December 2004, when Microsoft paid out a massive dividend that sharply raised personal income for that month, the household saving rate in the US has not been above 1% of income in the past 8 months.

I fear that every month that this continues, my soft landing scenario (see below) becomes a bit more difficult to believe.


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A Tale of Two Landings: Part I

The best of times, or the worst of times: what will the US’s eventual current account (CA) adjustment entail?

As some of you have perhaps deduced by now, I have bravely staked out a position of indecision about whether I find the hard landing scenario or the soft landing scenario more compelling. As I alluded to in my last post on this subject, in the past I have generally argued that the US’s CA adjustment will be sharp and painful (see here for an example). But recently, as I’ve slightly rephrased the relevant question to myself (“Will Asian CBs ever find the cost of maintaining BWII to be larger than the very significant costs they will incur if they end BWII?”), I’ve come to wonder if the soft landing scenario isn’t more likely than I had previously thought.

So partly as a way to see how convincing each scenario really is, let me test them out by constructing a possible story for each one. First comes the story of the soft landing; in the next post (below) the hard landing will rear its ugly head. You can decide which part of my tale you find more compelling.

The Soft Landing

Relatively strong growth in the US propels this year’s CA deficit to around $750bn, or over 6% of GDP. Yet private capital flows into the US slow because of fears of further dollar depreciation. Asian CBs must therefore buy even larger quantities of dollar assets in 2005 than they did in 2003 or 2004. However, they continue to choose to do so because they calculate that the cost of not doing so is even greater.

Gradually, as US interest rates continue to rise in 2005 and 2006 and the long-awaited dollar depreciation still fails to materialize, private capital flows to the US pick up, allowing Asian CBs to slowly reduce their dollar accumulation. There may be some gradual depreciation of the dollar, but so long as the big Asian CBs keep affirming their fundamental support for the dollar then such depreciation would be limited and orderly.

Simultaneously, higher interest rates in the US cause the US economy to gradually slow. The US’s housing market will cool, imports will become more expensive, and households will do less consumption and more saving (including repayment of debts). The US government’s budget deficit will also gradually improve as a percent of GDP, even under pretty pessimistic assumptions about future tax and spending changes.

Within a few years, say by 2008, the end to the housing market boom and higher interest rates will have slowly pushed the US’s household savings rate from around 1% today to perhaps 2.5-3%. Over the same period, the budget deficit will have improved from about 4% of GDP today to perhaps 2.5% of GDP by 2008. These are not dramatic changes when spread over three or four years, but they may be enough. Absent a major boom in business spending, the US’s national borrowing needs will have eased to a relatively modest 3% of GDP from over 6% today. A CA deficit of that size should be easy to finance purely from private sources, particularly with higher US interest rates, and so by then the Asian CBs will be able to slowly unwind their dollar positions and shrink the pile of their dollar reserves to a more reasonable level, if they so desire.

What about the things that could go wrong with this story? For example, suppose that one of the smaller Asian CBs defects from the de facto BWII cartel. This would almost certainly send a tremor through international financial markets, and lots of international investors who have dollar assets would try to sell them. In addition, the defecting CB may be selling dollars. The dollar will surely depreciate, possibly dramatically, against the defecting country’s currency. There would also be some upward pressure on US interest rates.

However, the larger Asian CBs (i.e. Japan and China) will still have an incentive to keep the system stable, and will still have the means to do so. They can still buy enough additional dollars to keep their own exchange rates steady. Note that they have a literally unlimited ability to do so, since there’s no limit to the amount of domestic currency they can issue to buy dollars. Yes, such an event would raise the cost to them of maintaining the BWII system – in particular, the money supplies of China and Japan would have to grow faster than they would have otherwise – but it’s not self-evident that this would be enough to change their decision.

What if some other event causes private investors to dump (or start shorting) dollars en masse? Again, the Asian CBs face no limit in how many dollars they can buy, and this will put a floor under the dollar that will curtail speculation against the dollar. After all, the CBs have the ability to be long in the dollar in greater quantities and for longer than individual investors can short the dollar. Yes, if massive numbers of private investors all moved simultaneously against the dollar, the amount of dollars that the Asian CBs would have to accumulate in a short period of time could be breathtaking. But they could still do it – and as soon as that becomes apparent, lots of private investors will start betting that the short-sellers will be wrong, making CB action less necessary.

When all is said and done, what does this soft landing scenario imply? 1) A couple of years of somewhat high interest rates in the US. 2) A few years of modest economic growth in the US, but no outright recession. 3) A gradual depreciation of the dollar, much as the dollar has experienced on average over the past 35 years. 4) A slow but steady improvement in the US’s CA deficit as a % of GDP, as US import growth slows. 5) Net foreign debt that rises to 40-45% of GDP by 2008 or 2009 (from close to 30% today), but then more or less levels off. 6) Continued economic growth in the Asian economies. This is welcome in Japan, less so in China… but even in China this is still preferable to the alternative, which is a contraction and possible severe economic dislocation.

Now let me add my disclaimers. I’m still not quite convinced by this soft landing scenario. It seems quite possible… but there are a few necessary conditions and assumptions embedded in the story above that I’m somewhat skeptical of. You can judge those for yourself. Tell me what’s wrong with my soft landing story. And then read part II of this tale, which follows immediately below.


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A Tale of Two Landings: Part II

And now for the other, darker side of my tale: the hard landing for the US’s CA imbalance. I envision the hard landing to be triggered by some sort of shock to the system. One of the problems with the soft landing story is that there are many, many different possible shocks to choose from – some economic and some political – all of which could jeopardize the BWII system. Without specifying the initial shock, here’s what I imagine all of those hard landing scenarios would have in common.

The Hard Landing

For whatever reason, international investors start to think that the dollar will finally fall against the major Asian currencies, presumably because the BWII cartel is seen to be breaking up or losing its resolve. Private investors start to dump dollars en masse. Contrarians who are willing to bet that the Asian CBs will continue to maintain the BWII system are few and far between, so that the only major buyer of dollars left in the market are those Asian CBs. The quantity of dollars that they must buy is enormous: tens of billions of dollars per day is not out of the question.

The Asian CBs blink. They balk at the prospect of such massive intervention. They realize that if they don’t intervene there will be severe consequences… but for whatever reason they don’t have the stomach to buy dollars on such a massive scale. So they stop buying dollars altogether.

As a result, the dollar drops against those Asian currencies. It drops far and fast – perhaps a 30% depreciation, perhaps more, in a matter of days. Interest rates on US bonds rise just as fast, perhaps by a full percentage point, perhaps more. Around the world, stock markets fall just as fast as interest rates rise.

Thanks to suddenly expensive imports, there’s a spike in US inflation. Business and consumer confidence plummet, business investment spending dries up, house prices begin to fall, consumers curtail their spending, and the US economy screeches to a halt. A recession ensues. Recessions also grip many of the Asian economies, due to their own higher interest rates and sharply lower US imports of Asian goods.

Note that higher interest rates in the US and the end of the danger of a major dollar depreciation will probably entice private investors back into US assets before too long, so that the US will still be able to obtain a sizeable amount of foreign lending. In that sense, markets will do what they typically do, and as a result the US CA deficit will not need to disappear overnight. But it will shrink, and rather rapidly, as consumption falls in the US.

So what do I envision as the end results of this hard landing scenario? 1) Interest rates in the US will move sharply higher over a period of days or weeks. Stock markets decline substantially as a result. 2) The dollar will depreciate by a substantial amount against the major Asian currencies. 3) Inflation in the US will jump upward very quickly, though perhaps only temporarily. 4) Household wealth in the US will fall significantly, due to the falling stock market and the bursting of the house price bubble. 5) The US economy will experience a rather sharp contraction, which I imagine to be deeper than either of the past two recessions… perhaps similar to the 1974-75 recession triggered by the first oil shock. 6) As households quickly retrench and reduce consumption, US imports fall, causing a fairly rapid fall in the US CA deficit over the course of a year or two. 7) Most of the Asian economies will also experience recession, with particular economic dislocation in their export industries.

Needless to say, this is not a happy story. But that has never really been in doubt. The important questions are this: is it a plausible story, and is it a likely story? Are the implicit assummptions and conditions that make this story possible more realistic than those in the tale of my first landing? In trying to answer that question I come back, again and again, to the crux of the matter: what will the two big Asian CBs do if confonted with suddenly increased pressure on the dollar?

I still find the answer to that question to be elusive.


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Social Security: Tanner v. Krugman and Marshall

The Club for Growth’s Soc. Sec. blog had been previewing a debate on March 15 between Michael Tanner and Paul Krugman forgetting to mention that Joshua Marshall was also invited to speak. Via Joshua comes the transcript.

Michael Tanner led off trying to claim that the Trust Fund has $12 trillion in debt right now and then he opened the door with this:

So, think of the single mother working maybe two jobs to try to make ends meet, paying 12.5% of her income in Social Security taxes, and at age 59 or 60, she dies, and her children are over the age of 18, so they’re not eligible for survivors benefits, what happens to all of the money that she has paid in to Social Security over the course of her lifetime? It’s simply gone. Lost. None of that money is passed on to her children, that they could use to go to college or start a small business.

Paul Krugman led off thusly:

Let me just first say what Social Security is, and just repeat – it is not a pension fund. It is not an investment project. It’s a social insurance program. It is a – it’s something that is there to protect people against misfortune. Now, it’s a big social insurance program. It is in fact the principle source of retirement income for many, many people in the United States. But it’s – you need to think of it always as, in fact, being social insurance. Now, it fulfills that function very well. Michael Tanner talks about the 59-year-old person whose children are adult who receives nothing if she doesn’t – if she passes away, and this is true. There’s a reason for that, which is those are 18 – those are children who are working age. They can take care of themselves. We might like them to have more, but, you know, this is not what the program is for. Think, instead, about the 35-year-old working man with a traditional family, wife hasn’t worked, hasn’t paid into the system, several, maybe many children, is hit by a bus.

Paul also dismantled Tanner’s $12 trillion fraud. Joshua Marshall mainly discussed the politics but also got in:

Over the years, I think that many Republicans, and President Bush particularly, decided that this was a popular reform, and the way they did that was by doing basically what Michael just did: put the best case forward for what you get. You have ownership. You can pass, you know, equity you build up to your heirs and so forth. Michael never mentioned benefit cuts, cuts in your guaranteed benefits. And when you say that, support for the whole thing drops, drops rapidly.

I guess we now know why Le Club has not yet mentioned the actual debate in the last couple of weeks.

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Santorum Exposes His Own Dishonesty

My only opinion about the Terri Schiavo issue is that this is a private matter so the politicians have no right to intervene. With that said, I have to admire the discussions from Aaron Brown. Aaron interviewed Rick Santorum last night and the Senator proved over and over how dishonest he can be. First of all, the GOP leadership told us all they wanted was a Federal review – something Barney Franks has challenged:

SANTORUM: No. Yes, the court shall consider this case. It was required — they were required to do so, and they were required to have a de novo trial. That’s exactly what the bill said, and this judge simply ignored it and snubbed his nose at the Congress.
BROWN: Senator, did the bill say may or shall? This seems to be hanging on one word. Because it’s been my impression for a week — you tell me I’m wrong, I’m wrong.
SANTORUM: It’s a misimpression there.
BROWN: It won’t be the first time.
SANTORUM: You are absolutely wrong. The bill said “He shall hold a de novo trial.” That’s what the bill said.

Exactly what Congressman Franks said! But this interview got better:

SANTORUM: And I think that’s – I would general agree with that. I think they should be family decisions, first and for most. And secondly, when you have a dispute, as you do in this case. that the courts, unfortunately, have to get involved in these decisions. And what I think we see here is a court that got involved and did so erroneously.

Santorum wants us to believe that he respects the separation of powers – but then only when the Courts rule the way he wants them to. But the end of this had to leave the Democrats just chomping at the bit:

SANTORUM: I think there’s a — look, these are issues that one of the things I’ve found out and I think we’ve all learned, is these issues are far more common than I think most of us envision. I sometimes I’ve got to tell you, I get chills listening to doctor after doctor getting on talk shows and television shows saying, Oh, I would easily pull the plug on this case. Or I’d easily remove a feeding tube here. I mean, we do it all the time. I don’t think most Americans realize how callous we’ve become in dealing with people who are of diminished capacity and who otherwise would live if given simple hydration and food, and are simply not allowed to live. That to me is something that we need a public policy discussion on, as to how we’re going to treat those that are the least among us.

Least among us? As in those with no financial means except for the public assistance that the GOP leadership desires to cut?

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Bush’s Backdoor Employment Tax Increase: Does Kevin Hasset Agree with Me?

Via Jesse Taylor comes Kevin Hasset:

To what extent are Social Security taxes really “taxes” in the traditional sense? Do the lines in the sand make sense? The question is not as odd or revolutionary as it may sound, and the answer has a significant impact on all sorts of debates. For example, opponents of President Bush’s first-term tax cuts often included payroll taxes in their incidence calculations.

Jesse provides the shorter version of Hassert’s theme:

Kevin A. Hassett attempts to make the argument that payroll taxes aren’t taxes … because you eventually derive a benefit from them.

Hassert’s discussion pales in comparison to the discussion provided by Richard and Peggy Musgrave in Public Finance in Theory and Practice. Hassert also did not finish the line of thinking with respect to the 2005 Social Security debate – so let me. Bush’s Social Security proposal cuts the benefits of young workers drastically but does not reduce the payroll tax rate. In other words, it is a backdoor tax increase on young workers. The Bush fiscal agenda does appear to be tax cuts for rich older people paid for by deferred employment tax increases on young workers.

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Hard versus Soft Landing

Nouriel Roubini and David Altig debate the likelihood of a hard versus soft landing for the US’s financial imbalances in today’s WSJ econoblog. For those who aren’t familiar with the arguments, let me try to boil them down a bit. I think that Roubini’s hard landing scenario can be summarized as this:

  • The US current account (CA) deficit is being primarily funded by Asian central bank (CB) lending to the US, and is primarily driven by the US government’s budget deficit.
  • The enormous and growing CA deficit can not keep growing forever, and is probably unsustainable even at current levels. So at some point those Asian CBs will decide to stop lending additional funds to the US. They do not have to dump their current dollar assets to cause a crisis; simply stopping the accumulation of new dollar assets will suffice to cause difficulties.
  • When that happens, the US CA deficit must necessarily fall by a (roughly) similar amount over a short period of time. The only way that that can happen, particularly given continued US government deficits, is for a sharp fall in the dollar, a sharp rise in interest rates, a sharp fall in asset values, a sharp fall in consumption, and a large rise in US saving.

On the other hand, David Altig is relatively sanguine. He agrees that the CA deficit is unsustainably large, and that US fiscal policy is problematic. However, he makes the following points when arguing for a soft landing:

  • Foreign sources of funding won’t suddenly dry up. Asian CBs are not the only source of funds for the US; if they slow their lending to the US, then private foreign investors will step in as US interest rates rise and the dollar falls, making the net change in foreign lending quite gradual. Furthermore, foreign lenders will have a hard time finding investments (of similar riskiness) that pay as well as those in the US.
  • If foreign funding just slows gradually, there’s no cause for alarm. There will just be a gradual depreciation of the dollar, gradual rise in interest rates (and perhaps prices), and this will naturally reduce the US’s CA deficit by encouraging less consumption in the US. There’s no reason to think this adjustment needs to happen rapidly. Furthermore, it’s entirely possible that the US’s budget deficit will improve over the medium-term, making the adjustment happen even more smoothly.

It seems to me that there are a couple of important unresolved questions that hold the key to understanding which scenario is more likely. The first is this: how important is Asian CB lending to the US? If it were to fall or disappear, would that require a major change in the CA balance, or would other capital flows be enough to require only a small change in the CA balance? In an excellent post the other day Brad Setser argued that Asian CB lending is indeed the dominant source of funding for the US’s CA deficit. He took issue with the argument recently made by Ragu Rajan (of the IMF) that Asian CB lending is not of crucial importance to determining how the US’s CA deficit is financed.

The second unresolved (and probably unresolvable) question is this: assuming that Asian CB lending to the US is indeed a crucial determinant of the US’s CA deficit (see #1 above), will it be in the best interest of Asian CBs to stop lending additional funds to the US any time soon? The costs to those CBs of additional lending to the US are large: enormous potential capital losses when the dollar depreciates, growing inflationary pressures in their home countries (perhaps particularly in asset markets), and heightened protectionist pressures in the US.

But the costs that Asian CBs will incur if they stop lending to the US could be even greater: the sharp fall in exports to the US that would surely happen, a likely sudden rise in domestic interest rates, the crash in asset prices that would probably follow… all of which would make a recession — possibly a rather severe one — quite likely. Right now these costs are apparently greater than that aforementioned costs of continued lending to the US.

Is it likely that this calculus will ever change? I’ve generally been in the hard landing camp on this issue, but on this last question I’m not so sure. It seems entirely possible to me that the enormous downside risk of recession, asset price depreciation, and domestic economic dislocation could well outweigh any other consideration for a long time to come. If so, then Asian CBs will have every reason to only very gradually taper off their additional lending to the US — gradually enough to ensure that the hard landing scenario never happens.


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