AMERICAN FUTURE

Juicy excerpts from the published transcript.

On his 9-9-9 tax plan:

MR. GREGORY: . . . So you’re acknowledging this morning, which I haven’t heard you do before, that there are individuals who are going to pay more in taxes.

MR. CAIN: There are some, yes.

MR. GREGORY: And you think those people are going to rally around tax reform where the wealthy play***(as spoken)***less and middle-class and lower income folks pay more.

MR. CAIN: Yes.

MR. GREGORY: You think that’s going to create a grassroots support for this.

MR. CAIN: Oh yes, because, if they do the math, do the math on your individual situation, people are going to benefit several other ways other than whether they pay more in taxes.  The fact that they’re not going to have the cost of filing and compliance.  That’s a $430 billion bill for all of us every year.  So if they do the math on their individual situation, I believe that they–more people are going to see it’s advantageous.

I wonder how much of that $430 billion comes from lower and middle-class taxpayers.

On liberals:

MR. GREGORY: You’ve talked as well about liberals in the country.  You gave a speech in February where you didn’t mince words.  This is what you said.

(Videotape)

MR. CAIN: The objective of the liberals is to destroy this country.

(End videotape)

MR. GREGORY: To destroy this country.  How so?

MR. CAIN: Economically.  Look at this economy.  David, the engine of economic growth is the business sector.  We are growing at an anemic 1, 1 1/2 percent.  If we allow this economy to continue to go down, it would destroy our economic capability.  And, as a result, we are now looking at how much in defense we can cut.  That’s destroying it.  It…

MR. GREGORY: You think liberals actually seek to do that, that that’s their mission, to destroy the economy?

MR. CAIN: I–that’s the conclusion that I have drawn.

MR. GREGORY: Not mismanagement.

MR. CAIN: No!

MR. GREGORY: But it’s their mission.

MR. CAIN: It is their mission.  Because they do not believe in a stronger America, in my opinion.  Yes.

If you think that our government is dysfunctional and our society is polarized now, just imagine what things would be like if Mr. Cain were president.

The website of the Republican members of the Joint Economic Committee (JEC) links to and recommends the reading of just one external website — The Library of Economics and Liberty.

The Library of Economics and Liberty includes a blog called ECONLOG. The title of the most recent post on ECONLOG is “The Top 1 Percent Includes You.” Here’s what it’s author, David Henderson, says:

But if you take a wider and longer view, you reach a striking conclusion: virtually every American who has heard John Kerry or Al Gore speeches is in the top one percent. This includes the middle-class family from Indiana, the barber in Florida, the K-mart clerk in Oregon, and the Virginia junkyard worker.

Here’s why. Carl Haub, senior demographer at the Population Reference Bureau in Washington, D.C., has estimated that 106 billion humans have been born since Homo sapiens appeared about 50,000 years ago. That means that the richest one percent in history includes 1.06 billion people. There are currently 6.2 billion humans alive, leaving approximately 100 billion who have died. Who among the dead was rich by today’s standards? Not many. Royalty, popes, presidents, dictators, large landholders, and the occasional wealthy industrialist, such as Andrew Carnegie and Leland Stanford, were certainly rich. All told, it is difficult to imagine more than 20 million of these people since ancient Egyptian times. This leaves 1.04 billion wealthy alive today, or 17% of the world’s population.

The poor in the United States, by contrast, live on up to $23.50 a day. Except for the few hundred thousand who are homeless, the Americans whom the U.S. government defines as poor live exceptionally rich lives. In most ways, their lives are better than those of kings and queens just 200 years ago. Consider the quality and quantity of our food, clothing, refrigerators, televisions, washing machines, stereo systems, and automobiles. King Louis XIV of France had a greenhouse so he could eat oranges. The poor in this country can eat an orange every day, regardless of season. King Edward III of England could summon the royal musicians to play music. The poor in this country have a wide variety of music at their command, 24 hours a day, played note-perfect every time. Edward III lived in a dark, smelly, cold castle. Even the worst houses in this country are more comfortable and have electric lights, too. Care to live without showers and flush toilets? The kings of England and France had to. Next time you see a Shakespeare play in which kings and princes cavort, remember that royalty in Shakespeare’s day had rotten teeth, terrible breath, and body odor that would make you keel over.

Every American (with the exception of the few hundred thousand homeless) is then rich by historical standards. By God, even the poorest among us can eat an orange every day, can listen to readily available music, and possess heated homes, electric lights, showers and flush toilets. And they live this lavish lifestyle — by historical standards — on an annual income of $8,577.50. Their problem is that they fail to recognize how well-off they are. My problem is a sneaking suspicion that I wouldn’t be able to find a single person having all these “comforts” with that income.

But that’s almost besides the point. My real problem is with the Republican Party asserting that the 99 percenters (against whom this post is obviously targeted) should be comparing their quality of life with those of their ancient ancestors, rather than with today’s wealthiest one percent. If only they would do so, they would be happy with their present lot in life. And if that were true, they wouldn’t see anything wrong with today’s income and wealth inequalities and the Republican policies having as their intent the sustaining or widening of those inequalities.

If this year were 1789 instead of 2011, the Republicans slogan would be to let the 99 percenters eat cake.

It’s time to update Richard Hofstadter’s Anti-Intellectualism in American Life, which won the 1964 Pulitzer Prize in non-fiction and remains in print to this day.

Grover Norquist, president of the Americans for Tax Reform, a group having as its claim to fame the soliciting of pledges from politicians to oppose tax increases of any type for any reason at any time, opposes Herman Cain’s 9-9-9 tax plan. In light of the regressiveness of that plan (as I’ve documented elsewhere), you might expect that I’d applaud his stance.

If that were all there were to it, I would. But there’s more. After telling a reporter from The Hill that he would be “much more comfortable taking the present mess and chipping away at it like an ice sculpture to get it down to what you want,” Norquist goes on to say this:

The good news is the next Republican president only needs a forefinger and then pen and the capacity to hold a pen, he doesn’t need to come up with ideas. We have a Republican House, we will have a Republican Senate, they will fix the tax code and send them stuff to sign. He can fly around in a cool big plane and hang around the White House and he can sign the legislation that [House Speaker John] Boehner and [Senate Minority Leader] Mitch McConnell send him, and we’ll be fine. [My emphasis]

A president without ideas? Why bother to have a president at all?

Then there’s Rich Lowrie, the wealth management consultant who crafted Mr. Cain’s plan. When asked by the Washington Post‘s Jennifer Rubin whether 9-9-9 would “sock it” to the poor and middle class, Lowrie said it’s just “Washington thinking” to look at whether modest-income Americans will wind up shouldering much more of the tax burden. In addition, says Rubin, “[h]e repeatedly refused to say how much more of the tax burden would be borne by the poor and middle class than under the current system.”

Alas, for Lowrie and, by implication, Cain, Washington is filled with people who think too much. While Norquist opposes 9-9-9, he agrees with Lowrie that “thinking” is the problem.

And here I thought that the problem was a lack of thinking! I guess I’ll have to somehow “disenlighten” myself. If only I were enlightened enough to find a way.

The title of this post is a quote from the overview section of Edward Kleinbard’s (a former chief of staff of the nonpartisan Joint Committee on Taxation) 17-page analysis of Mr. Cain’s tax plan. As summarized in the following abstract from his paper, Kleinbard’s conclusions are essentially the same as those of Bruce Bartlett’s:

Presidential candidate Herman Cain has proposed replacing current law’s income, payroll and estate taxes with his “9-9-9 Plan”– a 9 percent “individual flat tax,” a 9 percent “business flat tax,” and a 9 percent sales tax. This essay analyzes the components of the 9-9-9 Plan. Contrary to casual impressions, the Plan could be expected to raise substantial amounts of revenue, but does so largely by skewing downwards the distribution of tax burdens when compared to current law.

The 9-9-9 Plan functions as an effective 27 percent payroll tax on wage income. By imposing an effective 27 percent flat tax on wage income, the 9-9-9 Plan would materially raise the tax burden on many low- and middle-income taxpayers, who today face little or no tax under the income tax, and a 15.3 percent effective payroll tax burden. The Plan apparently offers lower tax rates (17.2 percent) for labor income attributable to owner-employees of firms, because they can extract their labor earnings as returns to capital.

The Plan operates as an ersatz variant on standard consumption taxes with respect to capital income, exempting normal returns on equity from tax and imposing tax at an effective 17.2 percent rate on economic rents. Finally, the Plan’s sales tax acts as a one-time tax on existing wealth. The relative undesirability of that consequence depends on what one chooses as the current-law comparable.

Here’s Kleinbard’s paper:

While Republicans oppose raising taxes on the wealthy, they don’t favor raising taxes on the less-than-wealthy. During their next debate, it will be interesting to see which — if any — of Mr. Cain’s adversaries take him to task for proposing a tax plan that would penalize the middle class and whether his popularity among Republican voters will drop as rapidly as it has recently risen.

Where did the 9-9-9 plan come from? Click here to find out.

I don’t know whether it’s surprising or not, but House Budget Committee chairman Paul Ryan “loves” 9-9-9.

“Even allowing for the poorly thought through promises routinely made on the campaign trail, Mr. Cain’s tax plan stands out as exceptionally ill conceived.”

Today’s Economix blog in the New York Times has an analysis of Herman Cain’s tax plan by Bruce Bartlett, who held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul.

Every week, there’s a different Republican frontrunner. If nothing else, this indicates that the preference of Republican voters is based on the emotion of the moment, not on knowledge of the policy intentions of each of the candidates. Based on Mr. Bartlett’s analysis, I can’t believe that Mr. Cain’s policy intentions reflect the desires of more than a minute fraction of Republican voters. How many of them want a regressive tax system? 9-9-9 is a catchy slogan; if it became law, it would be a ‘gotcha for the overwhelming majority of Americans.

Here’s what Bartlett has to say:

Little detail has been released by the Cain campaign, so it’s impossible to do a thorough analysis. But using what is available on Mr. Cain’s Web site, I’m taking a stab at estimating its effects.

First, the 9-9-9 plan is actually an intermediate step in Mr. Cain’s plan to overhaul the tax system and jump-start growth. Phase 1 would reduce individual and business taxes to a maximum of 25 percent, which I assume means reducing the top statutory tax rate to 25 percent from 35 percent.

No mention is made on the site of a tax cut for those now in the 10 percent, 15 percent or 25 percent brackets. This means that the only people who would get a tax rate cut are those now in the 28 percent, 33 percent or 35 percent brackets. According to the Joint Committee on Taxation, only 4 percent of taxpayers pay any taxes at those rates.

As for corporations, Mr. Cain’s proposal is primarily going to benefit those with revenues of more than $1 million a year, because they account for 98.7 percent of all receipts by C corporations. (A C corporation is a legal entity separate and distinct from its owners that is taxed as a corporation; its shareholders pay taxes individually on their gains.) Those companies with receipts over $50 million account for 88.8 percent of total receipts.

Other business entities — sole proprietorships, S corporations (which have between 1 and 100 shareholders and pass through net income or losses to shareholders) and partnerships — would not benefit because they are not taxed on the corporate schedule. But they represent 92 percent of all businesses.

Second, Mr. Cain would eliminate all taxes on profits earned by multinational corporations outside the United States. It’s hard to know the impact of this provision, but according to Martin Sullivan, an economist with Tax Analysts, the 50 largest corporations in the United States generated half of their profits in other countries.

The actual benefit of Mr. Cain’s proposal would be much greater to many of them, because, according to Mr. Sullivan, while some of these 50 companies have no foreign operations, others derive 100 percent of their gross profits in foreign countries. In 2010 these included Philip Morris, Pfizer and Abbott Laboratories.

Third, Mr. Cain would abolish all taxes on capital gains. Such taxes typically generate more than $100 billion in federal revenue annually, according to the Tax Policy Center. According to the Joint Committee on Taxation, two-thirds of all capital gains are reported by those with incomes over $1 million.

Mr. Cain says these three proposals, which he would put into effect immediately without offsetting the lost revenue, will jump-start economic growth. He offers no evidence for this assertion; it is simply put forward as self-evident. But the experience of the George W. Bush administration was that cuts in tax rates on the wealthy and on capital gains had no effect whatsoever on growth, according to the Congressional Research Service.

And this is only Phase 1 of the Cain plan. In Phase 2, the payroll tax would be eliminated, causing more than $800 billion in revenue to evaporate. The estate and gift tax would be abolished, further reducing taxes on the wealthy. And the 9-9-9 plan would be implemented.

It’s important to understand that the 9 percent rates on personal and business income would apply to very different tax bases than now exist. For individuals, the tax would apply to gross income less only the deduction for charitable contributions. No mention is made of a personal exemption.

This means that the 47 percent of tax filers who now pay no federal income taxes will pay 9 percent on their total income. And elimination of the payroll tax won’t even help half of them because the earned income tax credit, which Mr. Cain would abolish, offsets both their income tax liability and their payroll tax payment as well.

Additionally, everyone would now pay a 9 percent sales tax on all purchases. No mention is made of any exemptions from this tax, so we may assume that it will apply to food, medical care, rent, home and auto purchases and a wide variety of other expenditures now exempt from state sales taxes. This would increase their cost of living by 9 percent while, at the same time, the poor would pay income taxes.

The business tax in the Cain plan bears no resemblance to the present corporate income tax. The tax would apply to gross sales less dividends paid and all purchases from other companies, including investment goods. Thus, there would be no deduction for wages.

How benefits would be treated is unclear, because purchases of things like health insurance might constitute a purchase from another company and remain deductible. If so, what is to stop a company from paying its employees by leasing their cars and homes for them and even buying their food and clothing? That would reduce their taxable revenue.

The abolition of any deduction for wages is likely to raise the cost of employing workers, even with abolition of the employers’ share of the payroll tax. And since the dividend deduction doesn’t appear to be related to profitability, companies could borrow to pay dividends and still get the deduction. Even a novice tax lawyer could easily make a tax shelter out of that.

And here’s the kicker in the Cain plan. Phase 2 is merely a transition to yet another fundamental tax reform. In Phase 3, the United States would adopt the so-called Fair Tax, which would replace all federal taxes with a 30 percent sales tax on all goods and services. In a previous post, I explained why the Fair Tax is a bad idea. I went into more detail in testimony before the House Ways and Means Committee on July 26.

Whatever one thinks of the Fair Tax, it makes not the slightest bit of sense to have a plan that requires fundamental changes to the federal tax system twice to achieve its objective.

Veterans of tax reform attempts in the United States know reform is very difficult and time-consuming even once. If the Fair Tax is a good idea, Mr. Cain ought to just do it, without confusing the issue with his unnecessary and highly complicated 9-9-9 plan. After all, one of the prime selling points of the Fair Tax is its simplicity, and the 9-9-9 plan is far from that.

Because so little detail exists, it’s hard to do either a proper revenue estimate or distributional analysis of the Cain plan. It’s obvious, however, that Phase 1 would represent a huge tax cut for the wealthy at a time when federal revenues are at a historical low as a share of the gross domestic product and the economy’s fundamental problem is a lack of aggregate demand.

Thus the Cain plan would increase the budget deficit without doing anything to stimulate demand, because rich people can already spend as much as they want and are unlikely to spend more even if their taxes are abolished.

The poor and the middle class might increase their spending if they could keep more of their earnings, but they will unquestionably pay more under Phase 2 of the Cain plan. With no tax on capital gains, the rich would pay almost nothing, while elimination of all deductions and credits, as well as imposition of a national sales tax, must necessarily raise taxes on everyone else, especially those not now paying income taxes.

At a minimum, the Cain plan is a distributional monstrosity. The poor would pay more while the rich would have their taxes cut, with no guarantee that economic growth will increase and good reason to believe that the budget deficit will increase.

Even allowing for the poorly thought through promises routinely made on the campaign trail, Mr. Cain’s tax plan stands out as exceptionally ill conceived.

There’s another Republican debate this evening. These are the economic questions the Wall Street Journal (no link) would like the candidates to answer:

1. The unemployment rate is stuck at 9.1%. The U.S. isn’t adding enough jobs to keep up with the growth of the labor force. What’s done is done — the fiscal stimulus, the Federal Reserve’s quantitative easing, etc. What specific policies would you adopt today to quicken the pace of economic growth and hiring?

2. If raising taxes would be bad for the economy, how would cutting spending and eliminating government jobs now be good for the economy?

3. Housing remains a major drag on the U.S. economy. About one in five Americans with a mortgage owes more than the value of his or her house. More than half Americans with equity in their home have a mortgage with an interest rate above 5%, but hasn’t refinanced. Home-building is at historic lows. Can government policy do more to rescue housing? If so, what?

4. Several of you have expressed displeasure with Federal Reserve Chairman Ben Bernanke. Who would you prefer to see in that job?

5. Will the middle class have to bear some of the burden — either in higher taxes or fewer government benefits — to bring the federal deficit under control?

6. Are there any tax increases of any kind that you would accept over the next decade?

7. What’s the best way to slow the growth of health care costs in the U.S. over the next quarter-century?

8. Mitt Romney backs the imposition of U.S. tariffs on Chinese imports if China doesn’t allow its currency to float freely on international markets. The Senate is taking up similar legislation. Do you support the pending Senate bill?

9. The living standards of our children and our grandchildren’s generation depend on investments we make today that pay off in future productivity later. What, if anything, should the government spend money on today with that objective in mind?

10. How specifically, if at all, should government policy respond to the persistent widening of the gap between winners and losers in the U.S. economy?

Here’s how I think all of them will answer:

1. Get the government out of the way.

2. Get the government out of the way.

3. No.

4. It’s a hypothetical question.

5. No.

6. No!

7. Get the government out of the way.

8. It depends.

9. Nothing.

10. Get the government out of the way.

What’s your guess?

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.

That’s not me talking. It ‘s the conservative Weekly Standard’s Bill Kristol reacting to Thursday’s Republican debate:

THE WEEKLY STANDARD’s official reaction to last night’s Republican presidential debate: Yikes.

Reading the reactions of thoughtful commentators after the stage emptied, talking with conservative policy types and GOP political operatives later last evening and this morning, we know we’re not alone. Most won’t express publicly just how horrified—or at least how demoralized—they are. After all, they still want to beat Obama—as do we. And they want to get along with the possible nominee and the other candidates and their supporters. They don’t want to rock the boat too much. But maybe the GOP presidential boat needs rocking.

The e-mails flooding into our inbox during the evening were less guarded. Early on, we received this missive from a bright young conservative: “I’m watching my first GOP debate…and WE SOUND LIKE CRAZY PEOPLE!!!!” As the evening went on, the craziness receded, and the demoralized comments we received stressed the mediocrity of the field rather than its wackiness. As one more experienced, and therefore more jaded, observer wrote: “I just thought maybe it’s always this bad…they’re only marginally worse than McCain and Bush.”

Now there are some legitimate excuses. With nine candidates on the stage, and answers restricted to one minute, it’s hard to really show your stuff. And two of the candidates—Rick Santorum and Mitt Romney—did provide respectable performances. But no front-runner in a presidential field has ever, we imagine, had as weak a showing as Rick Perry. It was close to a disqualifying two hours for him. And Mitt Romney remains, when all is said and done, a technocratic management consultant whose one term as governor produced Romneycare. He could rise to the occasion as president. Or not.

There’s no need for me to add my two cents’ worth.

From the equally (more?) conservative Washington Examiner, in “GOP disappointed in Perry, divided over future“:

“I’m very disappointed in Rick Perry,” says Tuny, of Vero Beach.  “I was wanting to come away saying he’s our guy, and I didn’t get that.”

“I liked him when he first came out,” says Narda, of Clearwater.  “The more I hear about him, the more I think he’s just a flash in the pan.  I don’t think he’s going to make it in the long run.”

“I was going to vote for him [in the straw poll],” says George of Tampa.  “I was pretty sure I was going to go for him, and then I saw the debate.  The immigration thing really irritated me.”

These are people who approached the debate hoping to see Perry do well.  Some were unhappy with his positions on immigration — his suggestion that people who oppose him on tuition subsidies for the children of illegal immigrants are heartless rankled many here.  But others were disappointed with his performance overall, and for them, a turning point came when Perry tried to portray Romney as a flip-flopper.  Nothing wrong with that — a lot of them do see Romney as a flip-flopper. But instead of mounting a crisp attack, Perry seemed to mangle the moment.

“I thought Rick Perry, when he was going back and forth comparing Romney’s flip-flopping, it’s like he lost his train of thought,” says Myra of Fort Lauderdale.  “I was sitting eight rows from the front, and you could literally feel the energy in the room change.  It was almost like a collective, silent groan.”

“The debate last night showed more weaknesses than anything else,” says David, of Mt. Dora.  “I was disappointed in Rick Perry.  It’s like the room just turned into a vacuum when he started getting confused with his great crescendo.”

Once again, there’s no need for me to add my two cents’ worth.

Finally, the editorially-conservative Investors’ Business Daily is worried.

Unknowingly, of course, the WSJ, in an editorial titled “Twist and Sell,” defended a major point in my criticism of the Republican letter to Fed Chairman Bernanke.

We agree with that policy point, but we also think the letter was unwise. The current Fed has been too political in our view, and Republicans should be speaking up for the cause of Fed independence rather than playing tug-of-war with Mr. Frank over Mr. Bernanke.

The WSJ and I share at least one thing in common, namely, support of an independent central bank.

Having received some flack over my umbrage at the GOP’s letter, I feel it to be necessary to more fully explain my position:

• I’m a strong believer in the independence of the Fed. Being independent doesn’t guarantee that the Fed will always make the right decisions; indeed, there are numerous examples of precisely the opposite. But this is true of any human institution. The Fed’s governors, unlike the Supreme Court’s justices, aren’t appointed for life. Despite this difference, the Fed and the Supreme Court are similar in the roles that they are intended to play in our society. While neither is, nor can be, totally immune to, or oblivious of, political passions of the day, they are – and are intended to be – less subject to such influences than are the two Houses of Congress.
• The Republican letter to Chairman Bernanke — which, notably, was sent only a day or two before the issuance of the FOMC statement – is to my knowledge the most blatant public attempt by either of our political parties to influence the Fed’s monetary policy in our history. Regardless of whether one concludes that the Republicans or the Democrats (or both) should be blamed for our dysfunctional political system, the fact is that the inability of the two parties to reach a compromise is putting our already shaky economy at greater risk. The letter admonishes the Fed to forsake any action that is not in accord with the GOP’s economic policies. I view the letter as a shot across the bow. It is a warning to Chairman Bernanke that, if the thrust of the Fed’s policies is not altered and the outcome of the 2012 elections is favorable to the Republicans, he may join the ranks of the unemployed. I doubt that Bernanke will be swayed by this threat. That is not the issue. The attack on the Fed’s independence – in full public view – is the issue. It is politically motivated. The Fed, not just the Democrats, is to blame for our economic distress. In other words, only the Republicans are blameless.
• Early in the Obama administration, Senator McConnell said that his primary objective was to do everything he could to make Obama a one-term president. He said this at a time when the economy was in freefall and the financial system was on the verge of collapse. A stated willingness to work with the president under what were extremely trying conditions would have been far more statesmanlike and might have boosted confidence in the country’s ability to weather the storm.  Nearly unanimous Republican opposition to all of the president’s proposals to help the economy — specifically, the stimulus program and the GM and Chrysler bailouts — and the inaccurate, repeated Republican denials that these programs had saved a single job, along with Senator McConnell’s statement led me to conclude that the party’s game plan was to boost its electoral chances in 2012 by doing whatever it could to keep the economy weak for the duration of the Obama administration.
• In both words and deeds, at a time of great economic peril, the Republican party has given precedence to its future over the country’s future. It has been unwilling to compromise, believing that, by not doing so, its electoral prospects are enhanced. Having successfully minimized the efficacy of fiscal policy to help cure our economic wounds, it is now – as evidenced by its letter to Bernanke – attempting to do the same to monetary policy. Thus, the letter reinforces my conclusion that the Republican party has decided that the weaker the economy, the better its prospects.

American history since the founding of the Federal Reserve System in 1913 is replete with efforts to influence its actions. With this letter to Chairman Bernanke, the Republican party has taken attempts to politicize the Fed to a new high. In no uncertain terms, the letter demands that the Fed abstain from any further efforts to stimulate the economy, claiming that previous efforts — in particular, quantitative easing — have backfired. While it’s true that some responsible — and some irresponsible — individuals have made such an argument, this isn’t the majority viewpoint.

If there was any remaining doubt that the Republican party wants the economy to remain sick in what I hope and pray is a misguided effort to win control of the presidency and both houses of Congress next year, this purposely overt attempt to politicize the Fed should eliminate it.

Dear Chairman Bernanke,

It is our understanding that the Board Members of the Federal Reserve will meet later this week to consider additional monetary stimulus proposals. We write to express our reservations about any such measures. Respectfully, we submit that the board should resist further extraordinary intervention in the U.S. economy, particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.

It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. To the contrary, there has been significant concern expressed by Federal Reserve Board Members, academics, business leaders, Members of Congress and the public. Although the goal of quantitative easing was, in part, to stabilize the price level against deflationary fears, the Federal Reserve’s actions have likely led to more fluctuations and uncertainty in our already weak economy.

We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. Such steps may erode the already weakened U.S. dollar or promote more borrowing by overleveraged consumers. To date, we have seen no evidence that further monetary stimulus will create jobs or provide a sustainable path towards economic recovery.

Ultimately, the American economy is driven by the confidence of consumers and investors and the innovations of its workers. The American people have reason to be skeptical of the Federal Reserve vastly increasing its role in the economy if measurable outcomes cannot be demonstrated.

We respectfully request that a copy of this letter be shared with each Member of the Board.

Sincerely,

Sen. Mitch McConnell, Rep. John Boehner, Sen. Jon Kyl, Rep. Eric Cantor

In the early 1950s, General Motors’ “Engine” Charlie Wilson famously said that what was good for GM was good for the country. Now, some 60 years later, the Republicans are saying that what they perceive to be good for their party is good for the country. Lacking knowledge of the future, I can’t say with certainty that the economy will go to hell if the Fed, fearful of its post-2012 future, follows their advice. I am now certain that the Republicans would gladly send the economy through the wringer if  they thought that doing so would help them take over the government.