AMERICAN FUTURE

If there were any doubts regarding the ultimate intentions of the European Central Bank, this speech delivered on November 24 by José Manuel González-Páramo, a member of the Executive Board of the ECB,  should eliminate them. Midway through his address, after asserting that a “misplaced faith in market discipline” (by the way, Greenspan said much the same thing during his testimony before a congressional hearing soon after Lehman’s collapse) has been importantly responsible for the eurozone’s crisis, González-Páramo said that

“we cannot completely delegate governance to financial markets. The euro area is the world’s second largest monetary area. It cannot depend solely on the opinions of ratings agencies and markets. It needs economic governance arrangements that are preventive and linear. This underscores my central point that a much more comprehensive approach to economic governance is now the priority for the euro area. And this means more economic and financial integration for the euro area, with a significant transfer of sovereignty to the EMU [European Monetary Union] level over fiscal, structural and financial policies.”

What does it mean that it will take “a significant transfer of sovereignty” to end the crisis?  There are two possibilities: either (1) the resolution of the crisis will be a long, drawn-out, multi-year process during which the politicians in each of the 17 member countries are successful in persuading their respective publics that sacrificing sovereignty is worth it, or (2) an indeterminate number of current member states — those whose politicians are less than persuasive — will secede from the eurozone.  The principal risk in the first possibility is an extraordinarily long period of extreme uncertainty; in the second, it’s the unforeseeable, cascading consequences of a partial collapse of the currency union.

From the beginning of the “European project,” its opponents have complained about a “democratic deficit” — that unelected Brussels bureaucrats were having a bigger say and more power than elected national representatives. If, as the ECB maintains, crisis resolution requires much-diminished sovereignty, it’s safe to predict that this complaint will be voiced more widely and more stridently than ever before. There will then be a tipping point at which the current economic and financial crisis metastasizes into a political and social crisis. This outcome is avoidable only if the ECB’s analysis, which some will view as a rationale for usurping power, is shown to be unnecessary. That, of course, means that an alternative, at least equally convincing, solution to the crisis involving something less than a “significant” transfer of sovereignty must be conceptualized, offered and widely accepted.

Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.

How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?

Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression.  Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care:  ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.

Fiscal Policy: Tightened

With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.

The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.

It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector.  The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.

If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome.  But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase.  If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.

Monetary Policy: Loosened

Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.

The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.

Overnight Interest Rates, 2008-2011

During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance  particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.

Chart 1.

Chart 2.

Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:

Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.

For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.

The Problem — And the Solution

The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.

By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.

We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.

The arguments against fiscal stimulus and my counter-arguments are as follows:

• Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package.  Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,

The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.

Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.

• Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).

Chart 3.

• The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.

Chart 4.

At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.

To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.

Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?

Chart 5.

This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.

With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.

There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.

Political Realities

I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another.  The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.

“Our flag was still there”

Sixty years separate the two Days of Infamy our nation has endured. The death counts on December 7, 1941, and September 11, 2001 were remarkably similar. So was the sense of national unity in the immediate aftermath of the attacks on those days.

That’s where the similarity ends.

Others may disagree, but, to my mind, the Japanese attack on Pearl Harbor was the seminal event of the twentieth century — for the world, not just for America. Before the bombs and torpedoes struck the Arizona and the other ships lined up in Battleship Row, America was an inward-looking nation wanting nothing more than to be left alone in a world that had succumbed to the fantasies of totalitarian regimes in Germany, Japan, and Italy.

Less than five years later, our country had been transformed beyond recognition. With our homeland unscathed, we emerged from World War II as the world’s dominant economic, political and military power. We didn’t withdraw into a shell, as we had done after the First World War. Instead, we waged a more than forty-year-long cold war against our ideological opposite. We won that war. Depending on who’s doing the counting, victory came either in 1989, when the Berlin Wall fell, or in 1991, when the Soviet Union collapsed. During the first half on the Cold War, national unity was maintained.  Then came the Vietnam War, which started the disintegration of the American consensus.

In stark contrast, the post-9/11 unity lasted for only a few weeks or, at most, months. Some of us opposed taking military action to destroy the terrorist camps in Afghanistan. More of us opposed the invasion of Iraq. While these two wars were raging, we learned about eavesdropping by the National Security Agency and actions by the CIA, including waterboarding and rendition, that went against the American grain.

9/11 did more than destroy our belief that we are physically secure. Instead of uniting us, it divided us.

Now, our belief that we are economically secure has evaporated. The divisiveness that was so pronounced during the Bush years has carried over into the Obama years. A vocal minority was certain that Bush was a closet fascist. Now, an equally loud minority is sure that Obama is a closet socialist. Bush wasn’t and Obama isn’t.

In a single decade, we’ve lost both physical and economic security. What’s left?

Freedom — the most precious gift of all.

God bless America.

Marc Schulman, September 11, 2011

Every so often, something happens that reminds me why I’ve always been an Independent (or, if you prefer, a Moderate). Since starting this blog a little over two months ago, I’ve had some harsh words to say about Conservatives — in particular, the Tea Party. This may have led to the inference that I’m a Liberal. It’s time to dispel that impression. The New York Times has provided me with an opportunity to do so.

In today’s editorial, the Times is highly critical of President Obama’s decision not to proceed with stronger air-quality standards governing ozone.

In a terse, three-paragraph statement Friday morning, the president said he did not want to burden industry with new rules at a time of great economic uncertainty, and he pledged to revisit the issue in two years. But since the proposed rules would not have begun to bite for several years, his decision seemed driven more than anything else by politics and his own re-election campaign . . . there is still no excuse for compromising on public health and allowing politics to trump science.

No excuse? The Times has been outspoken in its concern about the dismal employment situation and would certainly agree with the president that this is a time of great economic uncertainty. One would think, then, that it would be against policies that would heighten uncertainty. But, in at least this instance, it isn’t. By ignoring the fact that business decisions made today take into account expectations regarding the future (“the proposed rules would not have begun to bite for several years”), it jumps to the ill-considered conclusion that the president’s decision is based on political, not economic, considerations. Accordingly, there’s “no excuse for compromising on public health.” The Times is oblivious to the possibility that two admirable objectives can be in conflict. This blindspot enables the Times to avoid making a choice. It believes that you can have it all.

What makes this editorial stance even more remarkable is that it flies in the face of the Times’ news article on the president’s decision:

The E.P.A., following the recommendation of its scientific advisers, had proposed lowering the so-called ozone standard of 75 parts per billion, set at the end of the Bush administration, to a stricter standard of 60 to 70 parts per billion. The change would have thrown hundreds of American counties out of compliance with the Clean Air Act and required a major enforcement effort by state and local officials, as well as new emissions controls at industries across the country. [My emphasis]

At a time of severe budget squeezes, where would the “hundreds of American counties” find the money to restore their compliance with the Clean Air Act? Would they find it by laying off still more teachers, policeman, and fireman? At a time when corporations are hoarding cash, would not the added cost of new emission controls prompt them to stuff even more money into their mattresses?

I don’t like dirty air. But I like our current economic travails even less. The Times doesn’t recognize the trade-off. I do.

. . . I’m better off than most. Yes, I worked hard for many years. But hard work isn’t the only reason that I’m financially comfortable. I was fortunate to have been at the right place, at the right time. Being at the right place at the right time was not something over which I had any control. Had the time and place not been right, I would be like millions of other Americans who are struggling to make ends meet. I can truthfully say “there but for the grace of God lay I.”

Recognizing this, I have no problem with paying higher taxes so that the meat cleaver doesn’t have to be taken to government programs that aid those less fortunate than I am.

Just in case you missed it, this is the link to Buffett’s oped.

Since starting this blog a month ago, most of my criticism has been reserved for the Republicans. If you’ve inferred that this means I’m a card-carrying Democrat, you’d be wrong. I’m a lifelong (and, at this point, it’s a pretty long life) independent. As for the issues currently at hand — the debt ceiling and the budget deficit — I strongly back President Obama’s position, which satisfies neither the Democrats’ left-wing nor the Republicans’ right-wing. At the risk of over-generalizing, any policy that’s opposed by both political extremes is almost certainly better than is one that makes either of the extremes happy. Now to the post—-

Among conservatives (the old-fashioned kind) in the U.K., Theodore Dalrymple is a well-known writer who also happens to be a physician. In the current issue of the Manhattan Institute‘s City Journal, he sets forth the conservative viewpoint on the economic malaise in the U.K. (and, by my inference, in the U.S.). It’s the best depiction of that point of view that I’ve run across, so I decided to bring it to your attention.

He starts his article with an apt analogy:

Deficits are like smoking: difficult to give up. They can be cut only at the cost of genuine hardship, for many people will have become dependent upon them for their livelihood. Hence withdrawal symptoms are likely to be severe; and hardship is always politically hazardous to inflict, even when it is a necessary corrective to previous excess. This is what Britain faces.

This sounds very familiar:

When the new coalition government, led by David Cameron of the Conservatives and Nick Clegg of the Liberal Democrats, came into power last year, the economic situation was cataclysmic. The budget deficit was vast; the country had a large trade deficit; the population was among the most heavily indebted in the world; and the savings rate was nil. Room for maneuver was therefore extremely limited.

[...]Britain was living on borrowed money, consuming today what it would have to pay for tomorrow, the day after tomorrow, and the day after that; the national debt increased at a rate unmatched in peacetime; and when the music stopped, the state found itself holding unprecedented obligations, with no means of paying them. Without aggressive reforms, it was clear, Britain would soon have to default on its debt or debauch its currency. Both alternatives were fraught with dire consequences.

In the end, the new government chose to attack the deficit from both ends: by cutting spending and by increasing taxes. As many commentators noted, this approach risked a reduction of aggregate demand so great that short-term growth would be impossible and a prolonged recession, even depression, would be probable. Domestic demand would plummet . . . [I've frequently made this argument]

This doesn’t:

Since the end of World War II, the British have grown accustomed to the idea that the money in their pockets is what the government graciously consents to leave them after it has taken its share. When (as rarely happens) the chancellor of the exchequer reduces a tax instead of increasing it, even conservative newspapers say that he has “given money away,” as if all money came from him in the first place. The wealth is the government’s and the fullness thereof: where such a belief is prevalent, no tax increase will seem either illegitimate or oppressive.

Opponents of a single-payer medical insurance program will like this:

From 1997 to 2007, the number of people employed by the NHS rose by a third, with the number of doctors employed by it doubling and overall remuneration for personnel increasing by 50 percent per head. Yet it became ever more difficult for patients to see the same doctor twice, even during a single hospital admission; the standard of medical training declined, according to 99 percent of surgeons in training, while senior surgeons admitted that they wouldn’t want their trainees operating on them; and a government inquiry found that productivity in the NHS—admittedly, not easy to measure—had declined markedly.

Opponents of  “big government”  and public-sector unions will love this:

Wherever one looks into the expanded public sector, one finds the same thing: a tremendous rise in salaries, pensions, and perquisites for those working in it. In Manchester, for example, the number of city employees earning more than $85,000 a year rose from 68 to 1,746 between 1997 and 2007. In effect, a large public service nomenklatura was created, whose purpose, or at least effect, was to establish an immense network of patronage and reciprocal obligation: a network easy to install but hard to dislodge, since those charged with removing it would be the very people who benefited most from it.

One of the Labour government’s gifts to public employees was overly generous pensions. While Gordon Brown raised taxes on pensions funded by private savings, he increased pensions for public-sector workers. In many cases, these government pensions, if they had not been paid for with current tax receipts and (to a growing extent) borrowing, would have required funds of millions of dollars to support. In other words, Brown was Bernard Madoff with powers of taxation. I leave it to readers to decide whether that makes him better or worse than Madoff.

[...] it does not follow from the existence of immense waste in the public sector that budget cuts will target that waste. After all, most of the excess is in wages, precisely the element of government spending that those in charge of proposed reductions will be most anxious to preserve. It is therefore in their interest that any budget reduction should affect disproportionately the service that it is their purpose to provide: cases of hardship will then result, the media will take them up, and the public will blame them on the spending cuts and force the government to return to the status quo ante.

I’m in full agreement with these words, which come near the end of his article:

. . . since taxes are increased incrementally—and everyone is already accustomed to them, anyway—but jobs are lost instantaneously and catastrophically, with the direst personal consequences. Thus those who oppose tax increases and favor government retrenchment will seldom behave as aggressively as those who will suffer personally from budget reductions. Moreover, when, as in Britain, entire areas have lived on government charity for many years—with millions dependent on it for virtually every mouthful of food, every scrap of clothing, every moment of distraction by television—common humanity dictates care in altering the system.

Since I started this blog a month ago, I’ve studiously avoided adding my two cents worth on the debate (if that’s the right word) over raising the debt ceiling and reducing the budget deficit. I did so with the expectation that an agreement would be reached by now. I saw little point in posting a blow-by-blow, day-by-day commentary. Having just listened to President Obama and Speaker Boehner, I’ve decided to break my silence.

If you took an economics course in college on public finance, you may recall that there are two types of taxes. Regressive taxes, as exemplified by sales taxes, are those taxes that impose a heavier burden on the less economically-fortunate than on the more economically-fortunate. For example, in any given jurisdiction, the sales tax rate is the same for all. The sales tax is a consumption tax — the more you buy, the more tax you pay. The poorer you are, the higher the percentage of your income that is apportioned to spending and the lower to saving. It’s for this reason that the sales tax is a regressive tax.

In theory, the income tax is a progressive tax, as it takes a bigger bite out of larger incomes than out of smaller incomes. In practice, of course, the income tax, as a result of the myriad of deductions that are of little avail to lower income individuals, isn’t very progressive.

I have a reason for insulting the intelligence of those of you who know everything I’ve thus far said.

The reason is that any plan to reduce the budget deficit that relies entirely or almost entirely on cutting spending is regressive. If you favor any of the various Republican proposals, including Speaker Boehner’s, you should be aware that you’re supporting regressive pain. The comfortable among us — a category that includes me — are far less dependent upon government spending to maintain our standards of living. I can’t support any proposal that imposes more pain on those who have the least pain tolerance.

There’s another topic I may as well cover in this post. Calling any of the proposals, regardless of their source, “deficit reduction” proposals is, in my view, to be guilty of a misnomer. Rather, they are spending decrease and tax increase proposals having as their objective the reduction of the deficit. Whether or not the cuts reduce the deficit depends on their impact on the GDP growth rate. Because there is no guarantee that their GDP impact will be positive, there can be no certainty that the cuts will reduce the deficit. The only thing that the government can control is spending. It can’t control the impact of spending reductions on the level of economic activity; accordingly, it can’t control the impact of the reductions on tax revenues. One need only go back to the late 1990s — when it was projected that there would be budget surpluses into the indefinite future  — to see how faulty estimates can be.

All I’ve done since starting this blog is to complain and to worry. What I haven’t done is to say what I would do to make things better. What follows is my proposal.

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What would make sense to me would be to have the magnitude of budget reductions pegged to the performance of the economy. An index could be constructed based on various measures of recent and forecasted economic performance — real GDP growth, employment growth, etc. The higher the value of the index, the larger the budget reduction in the forthcoming period. I think Keynes would approve, as this approach is anti-cyclical and is in marked contrast to pro-cyclical policies, some of which have been proposed and others of which have been implemented. These pro-cyclical policies (as in Greece) are making it harder, not easier, to set the economic world right.

A further and no less important advantage of pegging fiscal actions to an index is that, once the relationship is defined, it results in a high level of automaticity, which would reduce the influence of politics on economics. Of course, there would still be efforts to change the structure of the index and/or to change the mapping of the index onto fiscal policy. Not since the gold standard of the late 19th and early 20th century has politics been almost completely divorced from economics. Still, what I’ve proposed here comes a lot closer to separating the two than does what we have now.

Since starting this blog a couple of weeks ago, I haven’t put my old hat — that of a Wall Street analyst — back on. I can no longer avoid doing so.

For weeks, if not months, one of the primary issues that investors have been focusing on is whether Democrats and Republicans will reach a deal to prevent the first-ever default by the United States government. Judged by the recent trends in our equity and fixed income markets, it’s quite clear that participants in those markets are confident that a deal will be struck. If this were not so, the prices of both stocks and bonds would have been heading south.

Let’s assume that a deal is struck and that default is avoided.  What happens then? As I argued in a recent post, the immediate impact of the agreement will be to put pressure on the near-term performance of our economy. Employment will grow more slowly than it would have if maintaining the triple-A credit rating of the country hadn’t been held hostage to reducing the budget deficit. Considering how weak the recent employment reports have been, the number of Americans having jobs may even decline. In such a climate, it is highly unlikely that business — however much its confidence in the long-term outlook may be enhanced — will be more confident about the short-term outlook. If, as I have argued, the employment situation worsens, business will be even less likely to accelerate its investments in property, plant, and equipment, and more likely to continue to hoard cash as protection against a rainy day.

Why have I chosen to call this post “Be Careful What You Wish For”? Right now, the Street is wishing for a deal and is confident that one will be struck. Immediately upon the removal of that uncertainty from investors’ minds, there will be a new uncertainty: what will be the impact of the deal on the U.S. (and world) economy and, more specifically, on corporate profits. Every investment bank and every money management firm will make that assessment. If I’m right, the overwhelming majority of those assessments will be bearish.

There’s a precedent for my view. In February, according to ABC News, a confidential report that had recently been prepared by Goldman Sachs for its clients said spending cuts passed by the House of Representatives in the previous week would be a drag on the economy, cutting economic growth by about two percent of GDP. While reading the following excerpts from the report, bear in mind that Goldman was assuming that Congress would reduce discretionary spending by $25 billion from the Congressional Budget Office’s baseline for fiscal 2011, and another $25 billion (for a total of $50 billion below the baseline) for fiscal 2012. The legislation passed by the House called for a reduction of $60 billion. According to Goldman,

Both scenarios would add to the drag from federal fiscal policy on growth:

1. The modest spending cuts we assume in our own budget forecast would lead to renewed fiscal drag. Since spending cuts could be enacted no earlier than next month, when the current fiscal year will be nearly half over, $25bn in cuts would require spending in the second half of FY2011 to be reduced by $50bn at an annual rate. Since the cut would be phased in abruptly, it could result in a drag on growth in Q2 by as much as one percentage point (pp), but would quickly fade over the next two quarters as spending stabilizes at a lower level, with little effect versus current policy on the rate of real GDP growth by year end.
2. The spending cut package that passed the House of Representatives would have a deeper effect. Under the House passed spending bill, the drag on GDP growth from federal fiscal policy would increase by 1.5pp to 2pp in Q2 and Q3 compared with current law.

At an annual rate, the soon-to-be-announced budget cuts will be considerably larger than $50 to $60 billion. Would you want to bet against Goldman and others marking down their forecasts of economic and profit growth? These downward-revised forecasts will diminish — not enhance — business confidence, further lessening the prospects for reducing the unemployment rate.

Our tough times are about to get tougher. The possibility of a continuing downward spiral is growing. Fed Chairman Bernanke, in couched words, warned about this in his June 22 press conference, saying that

I think it would be best not to — in light of the weakness of the recovery, it would be best not to have sudden and sharp fiscal consolidation in the very near term. That doesn’t do so much for the long-run budget situation. It just is a negative for growth.

[ . . . ] I don’t think that sharp, immediate cuts in the deficit would create more jobs. I think in the very short run that we are seeing already a certain amount of fiscal drag coming from state and local governments, as well as from the withdrawal of previous federal stimulus. So I think in the very short run that, you know, the fiscal tightening is — is, at best, neutral but probably somewhat negative for job creation.