Lesson in Economics for the National Deficit Commission

Lesson in Economics for the National Deficit Commission

October 27, 2010

The French statesman Georges Clemenceau famously called war “too serious a matter to entrust to military men”; and in the same spirit, national budgets in a democracy are too important to leave to economists.  But no sensible government would wage war without listening to generals and admirals, and the National Commission on Fiscal Responsibility and Reform — aka the National Deficit Commission — would be equally well served to consider basic economics more carefully.  This week’s leaks from the Commission include reports that its members are leaning towards cutting back the deductions for mortgage interest and employer health insurance payments.  This approach could certainly raise a lot of money in the short run.  But for an economy suffering as ours is from weak demand, a fragile housing market, and a decade of slow hiring and income gains, these proposals are economically illiterate.

Listen up, National Deficit Commission.  This is the wrong time — maybe the worst time — to target the mortgage deduction.  Falling housing values have been the single largest force holding down consumer demand, and with it investment and growth, because their decline leaves the 70 percent of Americans who own their homes poorer.  That has created a classical, negative wealth effect which dampens spending.  On top of that, these falling housing values sharply raise the ratio of most people’s debts to their assets, moving most people to reduce their debt.  And that has meant fewer large purchases and less credit-card buying.

Cutting the mortgage interest deduction would only intensify these dynamics, because the value of that deduction is incorporated or “capitalized” in housing prices.  When prospective home buyers try to figure out whether they can afford the monthly payments on a particular house, they naturally factor in the value of the deduction.  Buyers are willing to pay more than they would without the deduction — and sellers demand more than they could without it.  Reduce the deduction, and buyers will be able to afford less, sellers will have to accept less, and housing values will fall further.

There are reasonable arguments for paring back this deduction, since it channels so much investment into housing.  Of course, that’s its explicit intention, so home ownership can be part of the American dream.  And yes, a smaller deduction would raise considerable revenues.  But doing it would inescapably further drive down housing values, and doing it now could lock in years more of slow economic growth.

This is an equally ill-timed moment to cut back the deduction for employer-provided healthcare insurance.  Once again, there are reasonable arguments for rethinking this deduction, but shrinking the deficit under current conditions isn’t one of them.  Limit this deduction for employers, and hiring costs will go up at a time when job creation is already historically weak.  Worse, the change would raise the cost of retaining people working today, creating new pressures for more layoffs.  The Commission may be talking about taxing workers, not businesses, on some share of the value of their employer-provided health insurance.  That seems no more sensible economically at this time, since it would reduce most people’s after-tax incomes at a time when their consumer spending is historically weak. 

The truth is, this is not the time for any short-term deficit reduction.  We tried fiscal tightening in 1937, at the early signs of recovery from the Great Depression, and it bought us four more years of slow or negative growth.  Japan tried it too in the mid-1990s, during the early stages of their recovery from a financial meltdown, and it set off another half-decade of economic stagnation.  Now Britain’s new conservative-coalition government is trying budget austerity, and the results almost certainly will be similar. 

Yet, it also would be foolish for the Commission to squander this rare public support for deficit reduction, so long as its members focus on the long term and consider the economic fallout from their various brainstorms.  The place to begin is with the two forces driving the long-term deficits — prospective, fast-rising entitlement spending, and taxes that raise sufficient revenues only when the economy booms.  On the spending side, Social Security could be the relatively easy part, because its budget gap remains comparatively small for many years — if Americans are prepared to accept smaller benefits down the line.  Experts figure, for example, that we could close one-third of that gap by using the CPI for the elderly, rather than the higher overall CPI, to calculate future cost-of-living adjustments.  And much of the rest of the problem would fade away if we tied the annual increase in people’s initial benefit to a combination of wage gains and inflation, rather than just wage gains.   

The harder part involves Medicare and Medicaid costs.  As with Social Security, the main difficulty lies not in figuring out how one could slow annual cost increases in health care, but rather in marshalling majority support for such measures.  In fact, the President’s health care reform already included a catalogue of approaches to slow the growth of medical costs, albeit on a limited scale or in weak form.  The Commission could urge Congress to scale up and strengthen those measures.  If those reforms work, they not only would generate large budget savings down the line.  The same approaches also would support jobs and incomes, since fast-rising health care costs have significantly slowed job creation and wage progress.

The Commission purportedly has agreed to use additional revenues to close one-third of the long-term deficit.  Assuming that additional taxes would go into effect only once the economy fully recovers, higher taxes for wealthy Americans would raise revenues without severely damaging demand, since they don’t spend nearly all that they earn.  The same idea could even be applied to industries which, by economy-wide standards, earn abnormally high profits.  By this measure, the leading candidate is finance.  A small tax on financial transactions, for example, would raise substantial revenues for the deficit with little adverse effect on the overall economy if other advanced countries follow suit — and Germany, France and the United Kingdom all have indicated interest.

And if the Commission wants to tackle broader tax reform, the top candidate should be a carbon-based fee on energy.  A tax on greenhouse gas emissions not only would restore U.S. leadership on climate change.  It also could turbo-charge the development and deployment of green fuels and technologies, a potential source of exports; and reduce our dependence on foreign oil and the consequent distortions in our foreign policy.  And if Congress set a carbon tax high enough to sharply reduce CO2 emissions, a good share of the revenues could go to reduce payroll taxes, spurring job creation and income gains. 

These approaches may not satisfy the balance-the-budget-at-all-costs crowd.  But sound deficit reduction requires a larger economic frame.  At a time of serious economic stress and frustration, the National Deficit Commission should embrace real economic thinking.

Are We Better Off Now than We Were Two Years Ago?

October 19, 2010

To borrow a construction from the Sherlock Holmes mysteries, there’s a dog that hasn’t barked in this election.  In a campaign dominated by the economy, Republicans have never invoked some version of Ronald Reagan’s devastating query from 1980, “Are you better now than you were four years ago?” It turns out, there’s good reason for their reticence:  By every basic economic measure — GDP growth, corporate profits, business investment, the stock market, incomes, wages, and jobs — Americans actually are quite a bit better off now.  That’s the inescapable conclusion after comparing the economy’s performance over the first six-to-seven quarters of Barack Obama’s presidency with its performance during the last six-to-seven quarters under George W.  Bush. 

Let’s start with overall growth.  The Bureau of Economic Analysis (BEA) tells us that from January 2009 through June 2010, the first six quarters of the Obama presidency, the country’s real GDP grew by more than 2.8 percent.  That may not be strong growth by the standards of the Clinton or Reagan eras.  But it leaves Americans considerably better off compared to the last six quarters of George W.  Bush’s term, when the economy’s output shrank by 2.1 percent. 

Business leaders complain a lot that President Obama unfairly bashes them.  Yet, the data suggest that they should thank him, because American business is clearly a lot better off under Obama.  The BEA reports that corporate profits grew 62 percent in the first six quarters of his term, rising from an annual rate of $995 billion in the first quarter of 2009 to $1,425 billion in the second quarter of 2010.  That’s a complete turnaround from the last six quarters of Bush’s term, when the annual rate of corporate profits fell 34 percent, from $1,501 billion to $995 billion.  It’s the same story for gross domestic investment by American businesses, which fell at an annual rate of 14.2 percent over the last six quarters of the Bush presidency, but has turned around under Obama to increase by 17.5 percent over his first six quarters. 

Given this record, it’s no wonder that American investors also are much better off today.  Standard & Poors reports that over the first 21 months of the Obama presidency, their benchmark index, the S&P 500, rose more than 46 percent, from 805.22 to 1,176.19.  The healthy gains under Obama have wiped out the miserable record of the last 21 months of the Bush presidency, when the S&P 500 sank 43 percent, from 1,495.4 to 850.1.

Political scientists say that the most powerful economic measure, for affecting elections, is what happens to people’s incomes.  The BEA has issued six quarters of personal income data since Obama took office.  Again, the contrast is clear.  From January 2009 through June 2010, the real per capita income of Americans rose 0.7 percent, from $32,780 to $33,009.  That’s not much, but it’s nearly twice the gains seen over the last six quarters of the Bush presidency, when real per capita income rose 0.4 percent, from $32,681 to $32,810.  The hourly wage data from the Bureau of Labor Statistics (BLS) tell the same story.  Adjusted to 2010 dollars, hourly wages over the first 19 months under Obama increased 1.0 percent, from $22.45 to $22.67.  Again, that’s not great progress, but it’s considerably stronger than the wage gains over the last 19 months of the Bush presidency, when the real hourly wage grew 0.7 percent, from $22.18 to $22.33.

Finally, we come to jobs.  A few months ago, I calculated that 92 percent of all private-sector job losses in this period occurred under Bush or during the first six months of Obama’s term, before his policies took effect.  Even if we don’t draw that fine distinction and compare the jobs record of the President’s first 19 months in office with the last 19 months under his predecessor, Americans again are clearly better off under Obama.  BLS reports that total non-farm employment in September of this year was 130.2 million or 2.0 percent lower than the level in January 2009.  That’s a marked improvement from the much sharper job losses over the last 19 months under George W.  Bush, when total non-farm employment shrank 3.5 percent, from 137.7 million to 132.8 million jobs.

There is no doubt that Americans are disappointed and angry that the jobs and incomes picture hasn’t improved more.  But elections involve choices.  How the early-term Obama economy stacks up against the late-term Bush economy may help explain why, as my NDN colleague Simon Rosenberg has acutely argued, we may not be headed for a GOP wave this November.  At least, it’s now obvious why Republicans aren’t asking Americans if they’re better off now than they used to be.  The mystery is why more Democrats aren’t using Ronald Reagan’s famous question to frame their own campaigns.

The Troubling View from the IMF Meetings

October 12, 2010

The International Monetary Fund held its annual Washington meeting last weekend, so I spent a balmy Sunday discussing the potential pitfalls for the U.S. and world economies. I attended as an American representative on the IMF’s advisory board for the Western Hemisphere; and in that group and beyond, almost no one could see a clear path to worldwide prosperity. Yet, few delegates seemed open to their own countries accepting any costs to enhance the prospects of global growth or even to protect the world from another meltdown.

The weekend’s favorite topic was the slow growth unfolding in the United States, Europe and Japan — too slow, that is, for the large developing countries that depend on us to buy their exports and so support their employment. The upshot is new concerns about a “currency war” breaking out in the developing world, and perhaps beyond. Already, many countries are intervening to keep their currencies relatively cheap and so make their exports more price-competitive than their neighbors. Of course, the only certain way for a country to keep its exports competitive is to produce better goods and services than its rivals. But that can involve reforms in investment, education and business-formation policies, all much harder to pull off politically than temporarily managing an exchange rate. The catch is that when everyone tries to keep their currencies cheap at the same time, no one ends up better off — and the next step is protectionism. If that sounds far-fetched, consider that one of the first orders of business in the new Congress will be legislation to punish Beijing for its cheap currency by slapping new tariffs on Chinese imports.

Forgotten in all these machinations is the supporting role that artificially cheap currencies played in the financial crisis. The strong dollar, compared to almost everyone else’s currencies, made Americans outsized consumers of everyone else’s exports — in 2007, U.S. imports totaled $2.2 trillion, or more than the entire GDP of all but five countries. But most of the dollars we spent on imports came back here, since the United States is the only place where dollars are the legal currency to buy stocks or companies. Those dollars helped swell the liquidity that financed the reckless leveraging by mortgage lenders and Wall Street, which all came crashing down in 2008. And when economists today say we have to redress “global imbalances” to avoid another crisis, they’re talking about the same dynamics. Yet, today’s competitive currency devaluations put us right back on the same path.

The weekend’s next favorite topic was the current political fashion for tight budgets, especially in the advanced countries. Since those are the same countries with slow growth, the talk turned to technical moves by the Federal Reserve and perhaps other major central banks — so-called “quantitative easing” — to expand credit even as interest rates already are near zero. This cheap new credit, of course, could someday be the kindling for the next bubble.

Moreover, it was hard to find anyone at the meetings who believes that the financial reforms taken thus far, here and around the world, are enough to avoid another meltdown. The good news is that the Financial Stability Board — that’s a rule-setting body for the major central banks — is set to issue another set of requirements for big finance, which will go well beyond what anyone else has done so far.

Of course, it’s unlikely that the world’s big banks will accept significant restrictions from the FSB, following their success in watering down new limits everywhere else. And even if they did, those rules won’t help contain the current flash point in the global capital system, the sovereign debt problems of Greece, Spain, Portugal and Ireland. A default by Spain, for example, would leave major French and German banks insolvent. They also would be unable to meet their obligations to U.S. and British banks, setting the stage for another financial meltdown.  Now, even if Greece goes down, as most financial experts privately expect, Spain and the rest may still avoid the worst. But if the worst does happen, the EU-IMF contingency bailout program might well not stem the tide. At least, that’s the current judgment of global investors, who have bid down the prices for Greek, Spanish, Portuguese and Irish bonds to levels near those before the EU and IMF announced their program months ago.

Behind all of these problems, the core issue remains the persistent slow demand and growth across much of Europe, Japan and the United States. The unavoidable fact is that the financial crisis has left countless tens of millions of households in the advanced countries poorer, and therefore reluctant to spend like they used to. The only recourse is to help people rebuild their incomes and wealth through direct measures to stabilize housing prices (the source of most people’s wealth) and to induce employers to hire more people. As usual, the world’s dominant economy and its President will have to take the lead. And that, I suspect, was the main topic of discussion this past weekend at the White House, just a few blocks down the street from the IMF meetings.