Barack Obama has now come clean about his thinking on why his administration has decided to focus first on reducing the deficit and next on jobs. He fears a double-dip recession will occur if foreigners lose confidence in the U.S. dollar, causing interest rates to spike. 

This is nonsense and it demonstrates how much at odds Obama’s economic thinking is with reality. This is the clearest indication that the Obama Administration doesn’t understand how modern money works. In fact, by focusing on deficit reduction, he has increased the chances of a double dip instead of decreasing them.

If he wants to reduce deficits, knowing it will precipitate a double dip and would decrease malinvestment. Fine. That’s not my solution, but it is accurate view of the economics.

What Obama actually said

At issue is whether the federal government’s enormous debt burden in the U.S. could cause investors to lose confidence in the U.S. government and shun its debt.

In an interview on Fox News today, the President said the following:

I think it is important though to recognize that. If we keep on adding to the — Even in the midst of this recovery that at some point. People could lose confidence in the US economy in a way that could actually lead to a double dip recession.

Is this really true though?

How deficits really work

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector.  Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus.  Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

Scott Fullwiler has a good graph depicting how the private sector surplus/deficit moves in concert with the public sector deficit/surplus, the difference being the current account deficit:

We can look historically at how these sector financial balances have moved over time. Figure 2 shows how closely the private sector surplus and the government sector deficit have moved historically, which isn’t surprising given they are nearly the opposing sides of an accounting identity. The difference between them, more visible starting in the 1980s, is the current account balance.

Figure 2: Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP

Below, I am now providing figure three from Fullwiler’s post at reader request, as it shows the current account deficit as the missing link since the 1980s.

Unless the increasing current account deficit switches direction violently, this can only mean that reducing the government’s deficit reduces the private sector’s surplus. Net-net, the government’s decreased deficit spending will decrease savings in the private sector. And no deleveraging can occur if savings in the private sector are reduced.

Is that what we want? Reduced private savings means continued high private sector leverage. In the U.S., the private sector has much greater debt burdens relative to the size of the economy than the federal government does. You would think we want the private sector to reduce leverage more than the public sector.

Long-term deficit reduction

What I have suggested is long-term deficit reduction.  If the President is concerned about deficits as far as the eye can see, he might want to look at retiree healthcare costs.  In June I said:

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence.  The reality is that President Obama faces political constraints in Washington right now in regards to budget deficits.  He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook.  In my view, this necessarily means changes to Social Security and/or Medicare.

But, of course, President Obama is not going to do that because this would mean cutting Medicare benefits, a political loser.

This looks like Hoover more every day

The President just doesn’t seem to understand how the economy works frankly. Reducing deficits by cutting spending or raising taxes decreases aggregate demand. And it is a decrease in aggregate demand which would induce a double-dip recession. So, the President’s logic just doesn’t work.

But what about a strike on U.S. government debt?  As you probably surmised from the above, if the U.S. private sector is increasing its savings, there is automatically a greater domestic bid for U.S. treasury securities.  So, it is a misnomer to say the U.S. is dependent on foreigners, thinking that this must continue. If the private sector saves more, a larger percentage of government bonds will be bought with domestic savings. In Japan, interest rates did not spike when the government increased deficit spending for this very reason.

The only question we have to ask ourselves is whether we want to reduce debt by:

1. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
2. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.

As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:

• The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

Obama: Debt Could Fuel ‘Double-Dip Recession’ – FOXNews.com

Related posts:

• Minsky: Turning neoclassical economics on its head
• The choice is between increasing or decreasing aggregate demand
• I am now moving from multi-year recovery to a double dip baseline
• Barack Obama as Herbert Hoover
• Japan does not demonstrate the failure of stimulus

Nouriel Roubini, writing in the New York Daily News , said on Sunday that “unemployed Americans should hunker down for more job losses” given the likelihood of a job less recovery. This was as gloomy a piece as I have seen from Roubini in the past few months. He has clearly become more downbeat about the long-term picture for the U.S. economy.

The article begins:

Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%…

…we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back.

This sounds dire. As a result, Roubini goes on to call on the Obama Administration to take direct action on jobs. Extending unemployment benefits is not going to cut it.  Roubini says we need:

a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

With statistics showing that the rate of long-term joblessness is at the highest since the Great Depression, Roubini joins an increasing number of economists who are calling on the Obama Administration to take the employment situation more seriously.

Paul Krugman has said that we are now in a liquidity trap. Therefore, we need to subsidize jobs and promote work sharing as Germany is doing.

I have made similar arguments about quantitative easing for the past year. Monetary policy is effectively useless – and is merely creating bubbles.

The Obama Administration is moving into deficit hawk mode at the wrong time as this will only worsen the jobs situation and lead to a double dip recession. Instead, I have called for a payroll tax cut or a job subsidy.

Randall Wray, a professor at the University of Missouri-Kansas City, has also offered a unique job solution.

All of this is urgent, as Roubini indicates:

Based on my best judgment, it is most likely that the unemployment rate will peak close to 11% and will remain at a very high level for two years or more.

The weakness in labor markets and the sharp fall in labor income ensure a weak recovery of private consumption and an anemic recovery of the economy, and increases the risk of a double dip recession…

The damage will be extensive and severe unless bold policy action is undertaken now.

The Obama Administration is taking an ‘indirect’ approach. They do so for three reasons. First, they are afraid of being boxed in politically by taking more direct measures. They also see a need to defend their previous policy decisions.  But, Mark Thoma thinks part of the resistance to more direct measures is ideological.  In a post earlier today, he says:

Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers’ remarks reflect this type of thinking.

The Obama Administration’s approach of focusing on deficit reduction without enough direct job measures is sure to keep unemployment elevated. In looking at the politics of economics I said recently:

I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

The Obama Administration is doing the opposite. They seem to have received the ‘deficit reduction comes first takeaway’ from recent state elections in Virginia, New Jersey, and New York instead of the ‘jobs come first takeaway.’ That is bad news for Democrats and it is also bad news for the hopes of a sustained recovery.

Source

The worst is yet to come: Unemployed Americans should hunker down for more job losses – Nouriel Roubini, NY Daily News
Job Losses Mount, Enduring and Deep – Floyd Norris, NY Times (the long-term unemployment image is also from this story)

Related posts:

• Comprehensive unemployment rate is 17.5%
• 467,000 jobs lost in the U.S. in June 2009
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• 10.2% unemployment, 190,000 jobs lost
• Unemployment rate to 9.7%, 216,000 jobs lost

Today, I want to run a few thoughts by you courtesy of John Mauldin.  In his recent weekly newsletter, he makes a number of points I have made here over the past few weeks and comes to a similar conclusion about the weakness of recovery and the likelihood of a double dip recession.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let’s look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we’re in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter’s creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won’t know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen’s Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we’ve lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let’s see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish’s very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let’s look at his assumptions:

• Job losses are likely to continue for a minimum of another year.
• When job gains start, they will be very slow at first, then pick up.
• An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
• A falling participation rate (boomers retiring) will continue to mask reported unemployment.
• Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
• The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let’s start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike’s blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let’s look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let’s be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn’t look like that will be the case. So, let’s quickly see what a double-dip scenario might look like. Let’s be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it’s getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I’ve noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Related posts:

• Comprehensive unemployment rate is 17.5%
• Payroll data mixed despite the bullish headline job loss figure
• Are jobless claims pointing to structurally high unemployment?
• Unemployment numbers still point to partial recovery
• US unemployment hits 5-year high of 6.1%

The motivating factor?  this article in Politico:

President Barack Obama plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 – and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.

The president’s plan, which the officials said was under discussion before this month’s Democratic election setbacks, represents both a practical and a political calculation by this White House.

The article, while couched in the language of fiscal responsibility and political tactics, is really an ode to the likelihood of spending cuts, tax increases or both. I see tax increases and I will tell you why later. Either way, these measures will choke off aggregate demand, making a double dip a much more likely scenario.

Below is the associated video from Politico, talking about the political calculus.

Get ready for 1937 redux – it’s coming. I warned against this before Obama even took office. But, no one in the White House is listening.

From an article here on 20 November 2008:

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted…

Just as in the two previous periods of asset deflation, we are dealing with massive amounts of debt and leverage combined with severe declines in standards of living for average citizens. In both previous cases, government thought we were out of the woods and raised taxes in order to return to fiscal prudence. On both occasions, the result was a severe recession and stock market meltdown.

Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.

I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger.

Maybe the presence of so many Clinton Administration officials is skewing this Administration’s understanding of the magnitude of the problem facing us. I don’t know. But, the White House seems to think this IS the early 1990s and we are reliving a repeat of the Clinton days. It is clearly not.

I have a lot of sympathy for the Austrian school view, although I have grave misgivings due to the likelihood of geopolitical tension and civil unrest. John Mauldin simplifies the view in a recent post:

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

And Mauldin is right. Barack Obama is not focusing on deficits in order to “get all your pain at once." This is not a Libertarian solution. The President is trying to reduce the deficit to please deficit hawks, all while perpetuating the bailout culture we have become addicted to.  This is the Japanese solution and it will not work.

Witness recent comments from Arnold Kling, who is an Austrian school economist at George Mason:

In my view, the current Administration is pro-business and anti-market–the worst possible combination. By pro-business, I mean that it likes businesses that survive on the basis of subsidies and regulatory advantages.

Now, what I fail to understand is how the Administration believes it can cut the deficit and add stimulus. James Pethoukoukis, who writes in Reuters says we are likely to see more stimulus initiatives:

How much money are we talking about? Alec Phillips of Goldman Sachs calls $250 billion over three years a “conservative” estimate. And what might be in the bill? Look for more highway spending, more aid to state and local governments and some sort of business hiring tax credit.

The only way to both add stimulus and reduce the deficit is to increase taxes – on whom is the only question. Obviously, adding stimulus while increasing taxes sounds a lot like ‘tax and spend’ and opens the door to all manner of attacks from the right. This is a huge tactical error that will be both politically damaging and unlikely to actually stimulate the economy. I see this as a potentially catastrophic outcome for Democrats. It is all too predictable although Obama is rushing ahead with this even earlier than I suspected he would.

Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

I understand the why of this i.e. the need to provide cover for moderate democrats in 2010. But the “tax and spend” onus during a period of weakness will have people talking about shifts to the left and Jimmy Carter’s presidency – both of which are poison to moderate Democrats.

If the Administration really wants to provide cover for Moderates, a payroll tax cut or a tax break for any firm that hires X % more employees will be more targeted to the jobs problem and will avoid both the more taxes and the more spending labels.

Donald Tsang is right; America is doing exactly what Japan did last time – not just on monetary policy but on fiscal policy too. It didn’t work for Japan and it won’t work for the United States either.

Sources

After spending binge, White House says it will focus on deficits – Politico

Obama eyes domestic spending freeze – AP

Related posts:

• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”
• Beware of deficit hawks
• The Great Depression II meme
• Japan does not demonstrate the failure of stimulus
• A brief philosophical argument about the role of government, stimulus and recession

L. Randall Wray has a post up at New Deal 2.0 which puts forward an idea which is pretty innovative. I would label it a private sector replacement for unemployment insurance. It’s the kind of thinking that might bring Obama out of a policy cul-de-sac as the economy hemorrhages jobs.

Let me present an excerpted version and mention a few concerns one might have with this idea. The link to the full post is at the bottom:

The latest jobs report shows that the official unemployment took a huge jump to 10.2% –15.7 million jobless workers. If we add to those numbers involuntary part-time workers, plus those who have given up looking for work, the unemployment rate is 17.5%. Even that seriously undercounts those who would be willing to work if decent jobs at decent pay were readily available–a number I put at 25 to 30 million…

I am advocating… a universal job guarantee available through the thick and thin of the business cycle. The federal government would ensure a job offer to anyone ready and willing to work, at the established program compensation level (including wages and a healthy benefits package). To keep it simple, the program wage could be set at the current federal minimum wage ($7.25 an hour), and then adjusted periodically as that is raised. The usual benefits would be provided, including vacation and sick leave, and contributions to Social Security.

Let’s call this the Job Guarantee (JG) program.

… A permanent and universal JG program should be decentralized, with projects created and administered locally–where the workers are, and for the benefit of their communities. The federal government would provide the wages, plus a portion of capital and supervisory expenses (perhaps capped at 25% of total wages paid for each JG project). Local governments and nonprofits would propose projects and cover the rest of the expenses. State unemployment offices would be converted to employment offices, helping to match workers and projects.

Project proposals would be submitted to regional councils and, if approved, would be evaluated by state councils and then by a federal council. Wages and benefits would be paid directly to workers (using Social Security numbers and direct bank deposits) to minimize fraud. Organizations submitting proposals would be prevented from replacing paid workers with JG workers. For-profit business would be excluded, because the temptation to substitute would be too great. At the same time, businesses would be protected from unfair competition because all JG projects would have to demonstrate they’d fulfill unmet public purposes. If at some future date, a for-profit firm decided to provide services that a JG project is performing, the JG project could be phased out. There is neither need nor desire for the JG program to compete with the private for-profit sector.

…JG workers will be gaining useful work experience and training, making them more appealing to other employers. When firms hire, they will recruit from the JG program, offering a slightly higher wage.

At the same time, the program’s fluctuation allows it to act as an employed “buffer stock”-or “reserve army of the employed”-helping to attenuate the business cycle while maintaining full employment without setting off a wage-price spiral. An economic boom will shrink the size of the JG program; in a recession the program will grow.

Thus, an effort like the Job Guarantee program I am proposing would act as an automatic stabilizer — a feature most would agree is desperately needed in our current rollercoaster economy.

This is definitely outside the box thinking. It is basically a decentralized counter-cyclical works program to largely replace the unemployment insurance program we presently have.

The benefits I see are that it maintains full employment by putting to work those that would be idle and collecting unemployment insurance.  We have an enormous number of unemployed people who are drawing significant social welfare payments (five million are drawing unemployment insurance according to my latest post). Why not use a lot of that same money and deploy them.

This approach also would employ a huge slew of longtime unemployed workers that have benefits expire and skills languish, making them harder to employ and increasing structural unemployment.  The job guarantee could then reduce the level of structural unemployment that results from a steep downturn (see Mark Thoma’s recent piece on structural unemployment for a cogent explanation of that issue).

In my view, full employment is compatible with free market capitalism. In this approach, a job guarantee is there for anyone who wants it. Any structural unemployment will be largely voluntary.

Here are my questions. I am going to present what I consider the standard questions using the standard terminology – not because these are the exact questions I have but because these are the questions I would anticipate. I have run these same questions by a few economists to generate some answers. I have incorporated most of their answers. But, I still would like to hear your thoughts as well.

1. Isn’t this just an attempt to expand the state i.e. be a move toward big government? Why shouldn’t we expect ‘mission creep?’ Since the idea is designed to fluctuate with changes in the economy, it seems less of a concern. Yes, this is the not-for-profit private sector. But, we would still need to flesh out the safeguards to make sure that it didn’t crowd out investment in the for-profit sector. (You should expect this program to increase the pie and expand investment in aggregate, so that certainly mitigates these concerns as well.)
2. Won’t this misallocate resources and create malinvestment?  Since it is designed to be an automatic stabilizer i.e. countercyclical, it doesn’t necessarily appear so. But, it still might create misallocations by increasing the propensity to spend excessively on infrastructure. Infrastructure spending in the U.S. is probably too low at present.  But, at some point in the future, this will be a concern. The fact that much of it can be administered in the private sector locally is important in this regard.
3. How much will this cost? How do we pay for this? As I understand the idea, it is designed to replace unemployment insurance entirely – and that means we will recoup in taxes lost output from cyclical and structural unemployment. But, as the Federal Government is paying not just wages but benefits, it does not seem to be a deficit neutral strategy in a employer-provided health-insurance world. If health insurance became detached from employers that would be less of an issue. But, that’s not going to happen. (I should also point out criminality and imprisonment associated with lack of job opportunities would be reduced, so that certainly decreases any costs – both social and monetary).

Personally, I am not especially keen on the ‘New Deal’ terminology in the original piece.  That goes to political/philosophical predisposition. So I have stripped it of that language here.

As an aside, of 1920s and 1930s Democrats, I find Al Smith, the Governor of NY and 1928 Democratic Presidential candidate, far more interesting than FDR. Smith and Roosevelt had a very antagonistic relationship in no small part due to FDR’s co-opting of all of Smith’s 1928 ideas for FDR’s 1932 run. Al Smith was a first-generation Irish Catholic who grew up poor on the lower East Side of Manhattan and owed his rise to Tammany Hall. Prejudice is a big reason he lost to Hoover in 1928. Roosevelt was a blue-blooded Harvard-educated Aristocrat who was much more palatable to early 20th-century Americans. Try “Al Smith and His America,” or better yet “Empire Statesman,” for a good read on Smith.

I suspect Wray’s idea will gain more traction if it can be examined it in a politically-neutral frame.

Economists I have talked to who have studied this idea inform me all studies indicate the proposal has a 1-2% of GDP price tag.

Right now, President Obama seems like he is banking on a recovery that will bring unemployment down. But, this may not end up being so. From a purely political perspective, Wray’s suggestion is the direction Obama should go if he wants any traction on the unemployment issue should recovery not bring unemployment down.  But, Wray’s idea also deserves more discussion irrespective of the political ramifications because it keeps a buffer stock of skilled, employed people ready to hand for the for-profit private sector to employ.

Source

Navigating the Jobs Crisis: Time for a New ‘New Deal’ Jobs Program – L. Randall Wray

Related posts:

• Jobless claims dip in most recent week
• ADP Report: 697,000 jobs gone in February
• US unemployment hits 5-year high of 6.1%
• Irish unemployment gaps up by most in 40 years
• Spain: “we need to go back to 2000 wages and prices and start again”

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners. You can reach the firm by email at info@arpllp.com.

This post on taxes and budget deficits should remind one of three recent posts here which take varying views of the fiscal position in Japan. See "Marshall Auerback’s "Japan does not demonstrate the failure of stimulus" and “The new Japan, domestic consumption, and the neo-liberal thought machine “ and my “Japan: stimulus without reform leads to a policy cul de sac.”

While I am personally no fan of supply-side economics or Arthur Laffer (actually, in full disclosure, I have to admit to being generally anti-Reagan/Thatcher as well – in large part due to a lax regulatory environment on both counts and some heinous racial politics in Reagan’s case), I do favour lower taxes as a way to stimulate the economy (through a payroll tax cut, for example).

“The only thing worse than rescuing the system would have been not to do so.”   – Martin Wolf

Welcome to the third letter in our four letter series about major trends defining the future of the world we live in. I kicked off back in September with a piece on energy supplies and last month I took a closer look at the demographic outlook. This month my focus will be on government and why our leaders need to think outside the box to solve the crisis we find ourselves in. I have found this topic particularly difficult to handle – probably because I am somewhat outside of my comfort zone. I sincerely hope you enjoy it anyway.

Let me introduce the main characters: First, the banks which are veering out of control (again!). Next, our central bankers and regulators who are doing a better job than broadly perceived; however, they lack the political support to tackle a financial system which thrives on excesses. And, just to complete the picture, we are up against a political system which is institutionally corrupt and politicians who are hopelessly narrow-minded and unable to look beyond the next election.

Less means more

Since the early 1980s, we (or at least those of us living in an Anglo-Saxon country) have lived in a world where less has carried the meaning of more. Reagan and Thatcher both genuinely believed in small government. Fundamentally, they shared the view that people respond to economic incentives, but it was not only about tax. The public sectors in both countries were slimmed down and much red tape removed. Even the City of London underwent drastic transformation – the so-called Big Bang. The economy reacted favourably in both countries and stock markets began a journey which lasted more than two decades and delivered the most powerful bull market of all times.

But, as we all know now, it ended in tears. Like children in a candy shop, we couldn’t control ourselves. Greed took over and whatever control mechanisms there were in place failed miserably when we needed them the most. It is therefore perfectly understandable that both regulators and politicians want more control. I just wish that our elected leaders would put their self-interest to the side for once and do what is right for the country. Unfortunately, that is about as likely as the sun not rising tomorrow morning.

Too big to fail or…?

Central to the discussion is the role of our banks. Are some banks really too big to fail or are they just too politically connected to fail? Following last year’s near Armageddon, most banks desperately need fresh capital and our monetary authorities – with plenty of encouragement from our Government – have created an environment which has handed banks a license to print money. In a budget constrained world, such a policy was always considered a more palatable way to re-finance the banking sector than the alternative – pumping more hard earned tax payer money into the banking system. So far so good.

Unfortunately, little seems to have been learned from the excesses of recent years. As we have seen time and again, easy money leads to carelessness, paving the way for future bubbles, and why should it be any different this time? A system where profits are privatised and losses socialised is destined to fail. It is the old moral hazard argument all over again and it encourages extreme risk taking. It is nevertheless the system which is being practised all over the world at the moment. And if politicians believe they can solve the problem by capping bonuses, they are less intelligent than even I thought.

In a recent article in the Financial Times, Willem Buiter made some interesting observations on this subject:

Will things be different during the next boom/bubble?  The next credit and asset market boom will generate massive profits and generous tax revenues.  The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government.  New and exciting financial instruments – superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecedented potential for diversifying, sharing and extinguishing risk.  It will be different from every other boom in the past.  It will be a truly sustainable euphoria – a high for humanity.  And the regulators/supervisors will be convinced, seduced, intimidated or co-opted.

Bank of England Governor Mervyn King recognises the problem:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.

As a possible solution, King has proposed a re-introduction of the rules which used to be in place, prohibiting retail and investment banking activities under the same roof. For speaking his mind, he was publicly reprimanded by the Prime Minister, who deemed such a policy response “simplistic and out-of-date”. Perhaps I should mention that banks are amongst the largest contributors to the political parties in this country. So much for integrity.

It is time to move on

A friend of mine attended an investment conference recently, where one of the speakers was the CEO of a world famous investment bank. When the talk turned to bonuses, the CEO stated flatly that “it is time to move on” (no prizes for guessing which bank). Perhaps it is time to move on, but not in the direction he wants to go. When US tax payers were forced to cough up $185 billion last year to save AIG which in turn saved an entire industry bar Lehman Brothers, the man on the street would be forgiven for expecting a touch more humility and sensitivity from those running our banks.

I am not for one second arguing that bonuses should be regulated. It is simply the wrong way to address the problem. But society is faced with a much broader problem when bankers carry on living in their ivory towers whilst the canyon between them and the rest of society grows bigger and bigger. “Take risks and you will be amply rewarded; fail and the tax payer will bail you out” is about the only lesson they seem to have learned from the past two years. The solution? Force banks to take less risk. It is absurd that many of our banks are still levered 30, 40 and some even 50 times. With less risk, their profits in good times will be much lower (and their losses in bad times correspondingly smaller), and the reduced profits will automatically drive down bonuses.

Here in the UK, two banks (Royal Bank of Scotland and Lloyds Banking Group) are being forced to break up their businesses. If you are too big to fail, you are too big to exist, seems to be the philosophy. However, the government deserves little or no credit for that decision. It is in fact the EU Commission which is forcing the government to take this draconian step. Who said nothing good comes out of Brussels? It is a much more constructive move than the pathetic focus on bonuses, but it doesn’t address the basic problem – banks must reduce their gearing.

The Laffer curve

Regulating banks more effectively is only half the story, though. As already alluded to, governments all over the world are faced with rising debt, threatening to bankrupt many countries. Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.

Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.

  Chart 1:  The Laffer Curve

Source:

http://www.heritage.org/research/taxes/bg1765.cfm

It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).

Chart 2:  US Marginal Tax Rates

Source: http://www.heritage.org/research/taxes/bg1765.cfm

Compelling evidence

So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented, US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.

Table 1:  US Tax Revenues around Major Income Tax Cuts

Source:  http://www.heritage.org/research/taxes/bg1765.cfm.

All numbers are inflation-adjusted.

Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling.

Other factors to be considered

It is not always one-way traffic, though. In his first term as President Clinton actually increased taxes in 1993 and what followed? One of the biggest economic booms of all times. Other factors impact tax revenues as well. In the case of Clinton, he presided over an economy which benefited immensely from globalisation and an IT boom, the likes of which had never been seen before.

Here in Europe, total tax revenue as a % of GDP is, on average, much higher than it is in the United States (chart 3). Whilst European growth rates have, admittedly, been modestly below US growth rates in recent years, there is no evidence to suggest that the higher tax rates have done significant damage to European growth. If that were the case, Denmark and Sweden should suffer the lowest growth rates amongst developed nations. In fact, the two Scandinavian countries have enjoyed comparatively high economic growth in recent years.

Also, corporate earnings have been as strong here in Europe as is the case in the US, and European stock markets have actually vastly outperformed the US market in recent years. So it is hard to drive the argument that lower taxes always lead to higher economic growth and stronger stock market performance. However, it is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?

The canary in the coal mine?

One thing is sure, though. Given the rapidly rising public debt all over the OECD area, economic growth must be secured at any price. Anything else will be devastating longer term. Japan stands out as the black sheep with public debt-to-GDP reaching 218% this year. Japan has tried many things to drag itself out of the quicksand but to no avail.

Chart 3:  Total Tax Revenues as % of GDP (2006)

Source: OECD

Its stimulus programme has been very Keynesian with a multiple of public spending projects over the past couple of decades, most of which have been a terrible waste. Now, 20 years later, Japan is falling into the precise trap our economic adviser Woody Brock is warning so vehemently about. GDP growth is slow or non-existent. Debt continues to grow rapidly and sticky deflation makes an already difficult situation almost impossible to deal with.

So far, Japan has just about gotten away with it because they have had easy and cheap access to credit. But what will happen if (when) that changes? It is no longer inconceivable that Japan will default on its sovereign debt at some point over the next decade. Ambrose Evans-Pritchard has written an excellent piece in the Daily Telegraph recently about Japan’s predicament, which you can read here.

Woody Brock did a study earlier this year where he pointed out the danger of allowing public debt to grow much faster than GDP for an extended period of time. As is evident from chart 4, should the United States (or any other nation for that matter) fall into that trap, the implications could be very dire indeed. Think Zimbabwe. Therefore, given the large escalation of public debt, policy makers should aggressively pursue a pro-growth policy. Anything else could have fatal consequences.

Chart 4:  US Federal Debt Outlook

Source: www.sedinc.com

Cut income taxes! 

Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite. And the Swiss will be laughing all the way to the bank as more and more disenchanted people in this country flee Britain and Gordon Brown’s strait jacket to start a new life in Switzerland.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance.  Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009
• A Country for Old Men and a Bit of Samba – Oct 2009

Related posts:

• Japan does not demonstrate the failure of stimulus
• Obama takes middle road on stimulus and taxes that leads nowhere
• Are US corporations feeding at the trough of low taxes?
• Japan: stimulus without reform leads to a policy cul de sac
• A note on Japan’s experiment with quantitative easing

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

It is refreshing to read the foreign press because they have decidedly different takes on issues.Whether you agree or not, it is important to hear those views.

The Swiss are very negative on the U.S. and their tax fight against UBS. This has them dredging up pass legal skirmishes. Here’s an article from the Swiss daily Tagesanzeiger – a media outlet that is not considered a establishment paper – about Marc Rich.  Remember him?  He’s the wealthy man living in exile who created a scandal when he was pardoned by U.S. President Bill Clinton at the urging of Rich’s ex-wife.  Here’s what the paper had to say (my translation):

U.S. law takes precedence: thanks to this principle and massive financial penalties, the United States has also forced Marc Rich on his knees.

The American oil dealer Marc Rich, living in Zug, got into the crosshairs of the U.S. authorities in the beginning of the eighties. The United States accused him of profiting from untaxed income of 100 million U.S. dollars at his Swiss company, and therefore claimed 48 million U.S. dollars in tax payments.

Request denied

Rich denied the claim. Then a district court judge in New York asked Marc Rich & Co. AG to submit all business documents concerning the oil deals. There were hundreds of thousands of pages. Rich refused. The judge, therefore, punished him with a fine of 50,000 dollars per day. For a full year, the oil dealer transferred a check on Monday and Friday to the U.S. – a total that came to over 20 million U.S. dollars in the U.S.. Only then was Rich ready to deliver the documents to the court.

And as a result, he fell into the crosshairs of the Swiss judiciary. The Office of the Attorney General seized all the remaining documents. An investigation into Rich was opened because of the economic news agency.

100 million U.S. dollars blocked

In the U.S. as well, the then-Attorney General Rudi Giuliani stepped into action, bringing charges against Rich and blocking his assets in the U.S. (real estate, pension funds, etc.). Their value was estimated at around 100 million U.S. dollars.

But that was not enough. Banks which had been associated with Rich in business were put under pressure. They were warned not to receive any money from Rich or to pay out money to him – including his own. Beside U.S. companies, non-American banks with branches in the U.S. became entangled in the wider net of the judge’s ban. "It was this pressure which forced him to capitulate," said "Weltwoche» journalist Daniel Ammann, who in October will publish a biography of Marc Rich ( "The King of Oil," St. Martin’s Press, New York). Under these conditions, Rich could no longer do business transactions. He signed to pay a re-imbursement in U.S. court, although he has always denied the allegations.

According to Ammann, Marc Rich is said to have paid 200 million U.S. dollars, which for 1984 was a huge sum. Did the U.S. win? Ammann: "In the Rich case, the U.S. has not won. They were not not able to get Rich before a court and never were able to obtain the desired documents. But they got the money. "The Americans could have gone through the legal route. This way was just too slow," said Ammann. He calls this attitude of the U.S. in his book "legal isolationism."

While you might abhor Rich and think the Swiss banking system is built on a bunch of tax dodging, this account regarding “legal isolationism” has the ring of truth to it.  Certainly, these same issues are at play in the detention of enemy combatants at Guantanamo Bay.  I would argue they are also at play in the Swiss tax law cases as well. And despite the Obama’ Administration’s claims to break from the past, don’t expect a change in America’s sense of “legal isolationism” any time soon.

Source

Wie die USA den Ölhändler Marc Rich weichklopften – Tagesanzeiger

Related posts:

• UBS is too big for Switzerland
• GM gets the green light on its section 363 bankruptcy
• Did JP Morgan cause Lehman’s bankruptcy?
• Judge stops BofA deal with the SEC
• Bloomberg wins Freedom of Information lawsuit against Fed

The U.S. has been using the weakness of the UBS banking franchise to shake down the organization for the names of American clients suspected of using the bank to dodge taxes in the United States. As far as the Swiss government is concerned, this would set a bad precedent in the Swiss banking community where Swiss banking secrecy is part and parcel of the attractiveness to foreign clients.  As a result, the government has moved to prevent UBS from handing over names to the IRS.

The Swiss government is arguing that handing over the client details would breach its national bank secrecy rules.

UBS is refusing to release data on 52,000 Americans that hold Swiss bank accounts to US tax authorities who accuse them of tax evasion.

Switzerland’s largest bank, UBS faces a court hearing in Miami on 13 July.

In a case brought under civil law, it stands accused by the US of hiding close to $15bn (£9.33bn) in assets in secret accounts.

‘International conflict’

Back in February, UBS did hand over the details of 250 US clients to American authorities to avoid a criminal case, but it is continuing to refuse to pass on data on the further 52,000.

Back on the first of the month, included in the daily links was an article in the Swiss daily Le Temps, which indicated the precedent set by UBS with the U.S. tax authorities was furthering the passing of data by Credit Suisse to French tax authorities. Clearly, as the economy has faltered, governments are looking to maximize revenue and are cracking down on suspected cases of tax evasion. Below is my translation of the publicly available bits of the French-language article on Credit Suisse:

Fearing retaliation, the [Credit Suisse] group is requiring its customers allow it to transmit their identity to the French tax authorities. The measure applies to all holders of French-traded securities.

Fifteen days after the signing of a new tax treaty between Switzerland and France on 11 June, Credit Suisse is taking unusual steps to avoid falling into the focus of the French tax authorities. Fearing new prosecutions of customers not reporting.. the bank plans to close the accounts of customers who do not have the ‘smell of holiness’ with the French tax authorities.

Clearly, things are getting out of hand as far as the Swiss government is concerned because Switzerland is losing its status among wealthy private clients.  In fact, Bank of America, through its acquisition of Merrill Lynch, recently dethroned UBS as the top dog in Private Banking.  UBS has been shrinking in share due to its financial woes and the uncertainty about bank secrecy. This is why the Swiss are fighting back now.

I should also point out that the Germans are getting in on the more aggressive policing of tax dodging. It seems as if everyone is using this economic crisis to try and pry open Swiss banking secrecy laws.  The 13 July hearing in Miami regarding UBS is the next important date in this effort.

Related posts:

• Swiss citizens think a large Swiss bank will fail
• Credit Suisse and UBS have hands out for more capital
• UBS reports Tuesday: brace yourself
• FDIC Friday Night: Silverton Bank is seized
• SunTrust Bank receives insured deposits of Omni National Bank

Here’s a good segment from CNBC with an interview from two city mayors, the mayor of El Centro, CA that has 26.9% unemployment, the highest in the nation, and the mayor of Flint, MI, which is imploding due to the decline in the U.S. car industry.

Interestingly, CNBC has another article on its website showing that joblessness is rising EVERYWHERE.  California is one state that is getting hit hard.  Its jobless rate is now at record highs (hat tip Judith).  If you are investing in municipal bonds, despite the happy talk, especially by Flint’s mayor, none of this should leave you feeling particularly comforted.  As a taxpayer or receiver of services in states like California, Michigan, Oregon, Rhode Island and South Carolina, get ready for tax hikes, service cuts or both.

Related posts:

• State tax revenue down 26% in 2009
• Everyone wants in on the bailout gravy train, cities too
• California is to begin handing out IOUs tomorrow
• Warren Buffett: we have to be sure all debt liabilities of Citigroup are met
• Text of Schwarzenegger letter to Paulson

It’s not just California.  Tax revenue is falling everywhere.

State income-tax revenue fell 26% in the first four months of 2009 compared to the same period last year, according to a survey of states by the nonprofit Nelson A. Rockefeller Institute of Government.

The report, conducted by the public-policy research arm of the State University of New York, is one of the most up-to-date measures of how deep the recession is digging into Americans’ wallets and, consequently, state coffers.

States are required by law to balance the budget, so lower tax revenues will translate in service cuts, rather than red ink. Already states such as Kansas are slowing the payment of income-tax refunds and delaying payments to local school districts, according to the report.

This is a point I have highlighted in the past: when state taxes fall, services get cut.  And the fact that states are constrained unlike the U.S. government because they have no printing presses is one reason I said in January that the President’s stimulus package was not going to get it done. Time will tell whether U.S. government largesse is countered by state and local government cutbacks. And it is local government services you probably care most about: schools, police, garbage collection, swimming pools, libraries.

Related posts:

• State and local government weighed down by housing
• Kansas and California and the race to U.S. state insolvency
• State and local governments: budget cuts likely
• Will federal largesse be countered by state and local cutbacks?
• GDP: imports, inflation and local government are the story

As understandable as the Congressional response to the AIG bonuses was, the reality is that this does create a number of disturbing precedents. We have a stupid Congress mindlessly lashing out to compensate for its own complicity in political corruption (Congress has long been a major recipient of Wall Street largesse, including AIG) It all goes back to Tom Ferguson’s analysis in “The Golden Rule”. (Golden Rule: The Investment Theory of Party Competition and the Logic of Money-Driven Political Systems (American Politics and Political Economy Series))

That said, I hate the bill the House introduced for five reasons:

1. The law is being pushed through quickly and the old warning about “legislate in haste, repent at leisure” appears to apply here;
2. It is retroactive, and we should always discourage laws that are retroactive;
3. It is clearly politically motivated and applies to a very small number of people (who will be next? liberal bloggers?); as a general rule, we should discourage laws that are not general in application;
4. It is, at least in part, motivated by a punitive impulse that isn’t necessarily the best thing for our politics; and, 
5. Most obviously, it attacks the symptoms, rather than the disease. Maine style political reforms which introduce public funding into our politics, and an independent commission which constructed real Congressional constituencies rather than these absurd exercises in gerrymandering, would do much to deal with the problem of political corruption at the top.

I also take Steve Waldman’s point in Interfluidity, “If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly.”

Anyway, I see that one of the kings of late night television, Jay Leno, agrees with me:

President Obama took to Jay Leno’s stage and compared life in Washington to “American Idol,” where ‘”everybody’s got an opinion.” The appearance on “The Tonight Show with Jay Leno” was itself a sign of just how much the culture has changed in America, where comedy and politics often mix.

From there, he went on to pitch his long-stated proposals to change the tax code by increasing taxes on all upper-income Americans, specifically families earning more than $250,000 a year and individuals earning more than $200,000 annually.

“The important thing over the next several months is making sure that we don’t lurch from thing to thing, so we try to make steady progress, build a foundation toward long-term economic growth,” he said. “That’s what I think the American people expect.”

Mr. Leno was even more negative to the House plan, saying it “kind of scared me.”

“If the government decides they don’t like a guy, all of the sudden hey we’re going to tax you, and, boom, and it passes, that’s seems a little scary,” he said. “It was frightening to me as an American that Congress or whoever could decide I don’t like that group, let’s pass a law and tax them 90 percent.“

Sources
On ‘Tonight Show,’ Obama Urges Steadiness in Face of Crisis – WSJ
HR 1586: Not a good tax clawback – Steve Waldman

Related posts:

• The Paulson plan is not going to make it
• Bush: ever the opportunist, lifts oil drilling ban
• AIG: worst damage yet to come
• S&L crisis chronology and accounting rules
• The House defeats the bailout plan and shares plunge

California’s problems are well-known. They have been in the making for sometime. When I predicted a U.S. state would go bust this year, California was very much on my mind. But, frankly, Kansas was nowhere on my radar screen. Now both states have gotten my attention.

First Kansas (hat tip Marshall):

State tax refunds, Medicaid reimbursements and payments to local schools are all on hold because of a political showdown between Kansas legislative leaders and Gov. Kathleen Sebelius.

The Kansas Finance Council was to meet at 1 p.m. today to vote on whether to borrow $225 million from healthy state funds to cover expected payments to schools, state workers and taxpayers. The state did the same thing last December when it ran into a cash-flow problem.

But Republican leaders said they wouldn’t authorize the new loans until Sebelius, a Democrat, signs legislation designed to erase the state’s current year budget deficit. That bill, passed Thursday, cuts statewide school funding by $32 million and makes millions more in cuts to other state agencies.

If you recall, Kathleen Sebelius gave the Democratic rebuttal to the 2008 State of the Union Address. She was tipped as a potential running mate for Obama. And her name had surfaced after Tom Daschle withdrew his name for the post at Health and Human Services. Her ambitions for national office are not looking very good.

Update: Sebelius got the deal done and is decamping to DC as head of HHS. President Obama has faith in her skills. This is a great outcome.

But, then there is California. If they don’t get revenue up or spending down, bankruptcy is certain. They are looking to raise taxes in the teeth of a downturn to prevent a bad outcome — not exactly a good way to jump-start the economy. Note the highlighted section below.

California’s legislature adjourned from a marathon budget debate after falling one vote short of a $40 billion package of tax increases, spending cuts and borrowing aimed at reducing a record deficit.

Lawmakers went home at 9 p.m. yesterday after spending 28 hours in session while Republican Governor Arnold Schwarzenegger and Senate leaders worked to secure an additional Republican vote for the package of 27 bills. Schwarzenegger made rare appearances at closed-door party caucuses and urged a quick solution to the impasse.

“We are just searching for that one more vote that we need in order to get that budget done,” Schwarzenegger told reporters after the meeting.

Failure of the package would prolong a four-month stalemate over how to counter a record $42 billion deficit that drained California of cash, left it with the lowest credit rating among U.S. states, forced officials to delay paying bills totaling $3.7 billion and halted $3.8 billion of bond-financed construction on schools, roads and other public works.

The draft bills include plans to raise the state sales-tax rate to 8.25 percent from 7.25 percent; boost vehicle license fees to 1.15 percent from 0.65 percent of the value of an automobile; add 12 cents to the per-gallon gasoline tax; reduce the dependant-care tax credit to $100 from $300 and impose a surcharge on income taxes of up to 5 percent.

If you are investing in municipal bonds, you might want to do some serious due diligence on the creditworthiness of the issuers. The state and local bankruptcies are coming.

Sources
Kansas budget crisis: State tax refunds on hold – Kansas City Star
California Lawmakers Fail to Pass Budget Package by One Vote – Bloomberg.com

Related posts:

• California is to begin handing out IOUs tomorrow
• Is the State of California bankrupt?
• California starts issuing IOUs as bankruptcy nears
• State tax revenue down 26% in 2009
• California impasse ends as Schwarzenegger reaches agreement

This is pretty funny actually (Hat tip Michael Turk).  Well, at least the guy in the advert is laughing!

Maybe a Geithner ad is next.

Related posts:

• Saturday Night Live Grades the Stress Tests
• Dilbert on the asset-based economy
• Video: Barack Obama finally gets angry
• Young Hillary Clinton
• Application for the Federal Bail Out Program, 2008-2009

There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption.  In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.

But, in the United States, there is a bit of a problem: state and local governments.  They will not, and often cannot, spend.  In fact some will be cutting.  Will local government budget cuts undercut federal fiscal stimulus?

To answer that question, we need to know why local governments in the U.S. are not spending more money.  The answer is two-fold.  First, state and local governments don’t have access to a printing press.  It’s not like they can tell their teachers, “wait a minute, let me just run out back and print off a few dollars to pay you.”   The federal government intends to do exactly that – print money.  This is what is commonly known as inflation, now given the hifalutin designation of quantitative easing.  So inflating one’s way out of crisis is not an option o the table for municipalities.

On the other hand, they are even more hamstrung by their own self-imposed rules.  In recent years, state governments have tried to exercise fiscal resonsibility by balancing the budget.  Politicians are so eager to put their hand in the till that legislatures were forced to enact balanced budget amendments that forbade deficit spending to keep spending down.

Here’s how the National Conference of State Legislature puts it:

The Nature of State Balanced Budget Requirements

Some states have strict, explicit balanced budget requirements that force policy makers to ensure that expenditures in a fiscal year are within the cash available for that fiscal year. In other states, the requirement is derived from a constitutional limitation of state indebtedness or some other budgetary provision such as Virginia’s constitutional requirement that the governor keep spending within revenues, and may lack a binding enforcement mechanism. In some states, of which Michigan is an example, constitutional provisions that are designed to prevent budget deficits allow unavoidable deficits to be carried to the next fiscal year for resolution. Vermont , uniquely, has no constitutional or statutory requirement for a balanced budget.

Not all states have constitutional language that clearly requires a balanced budget and many even lack explicit statutory requirements. The General Accounting Office has commented that “some balanced budget requirements are based on interpretations of state constitutions and statutes rather than on an explicit statement that the state must have a balanced budget.” GAO’s observation is supported by appendix B, which prints the language that legislative staff in 49 states have identified as the constitutional and statutory balanced budget requirement. The link between the constitutional or statutory language and a balanced-budget requirement can be obscure.

Whatever the source of the requirement-constitutional, statutory, or traditional interpretation-there are three general kinds of balanced-budget requirements, with differences of detail within each kind:

• The governor’s proposed budget must be balanced;
• The enacted budget must be balanced;
• The budget must be balanced at the end of a fiscal year or biennium (no deficit can be carried forward).

That is a problem now because tax revenue is imploding.  Sales tax revenue is down.  Income tax revenue is down.  Property tax revenue is down.  And when falling revenue and balanced budget amendments collide, the only remedy is budget cuts.  So, state and local governments in the United States are about to cut spending just as the worst recession since the 1930s hits.

What to do?  Ask for a bailout from the Federal Government, of course.  Here’s what Politico says about this:

A group of Democratic governors warned Friday that without as much as $1 trillion in federal assistance, many states will not be able to pay their bills in the next year.

“There are states that are talking as California has of not being able to meet their financial obligations in the coming months,” New York Gov. David Paterson (D) said on a conference call with reporters. California announced in December that all state employees would be forced to take two days of unpaid leave.

Paterson was joined by New Jersey Gov. Jon Corzine (D), Massachusetts Gov. Deval Patrick (D), Ohio Gov. Ted Strickland (D) and Wisconsin Gov. Jim Doyle (D) in warning that states across the country will be forced to make drastic budget cuts in the face of unprecedented deficits.

“We are not crying wolf, this is one of the worst situations our states have faced,” Strickland said. “This is a real crisis. These are real problems. And if we don’t get some significant assistance many of those in our states will suffer greatly.”

Strickland added that the situation facing the state of Ohio is so dire that in order to balance his state’s budget he would have to fund every state program at 75 percent of its current level. “If I were simply to flat fund the operations of this government I’d end up with $7.3 billion in deficit,” he said. “We’re just trying to keep afloat.”

In order to make up for the shortfalls, Corzine said the incoming Obama administration and Congress will need to free up $1 trillion in federal spending for state assistance. “We’re all going to be Herbert Hoovers if we’re not careful here,” he said.

The $1 trillion the governors are seeking would be spent to prevent cuts in social services and education, as well as “shovel ready” infrastructure projects that could begin with 18 months. The group has presented their plan to the transition team and congressional leaders. The New Jersey governor said both have been receptive to the idea.

“There is a need for the federal government to step in to bolster the social safety net,” Patrick said. “We’re really talking about a bridge from where we are and where we think the economy will be in two years.”

With the automakers and the banks already receiving handouts en masse and with the Obama Administration committed to massive fiscal stimulus, one can see that the United States is in for some trillions of dollars of deficits.

The question is whether states and municipalities should be welcome on the bailout gravy train as well. California is on the verge of bankruptcy and I have predicted at least one state will default and go bankrupt. Do we want that? Do we want teachers, police officers going without pay, firefighters being let go or trash collection being curtailed?

This is a predicament that was easily predicted as a result of the housing bust. However, with its consequences looming, there are no easy answers.

At a minimum, cutbacks at the state and local level would be very much working at cross purposes with federal stimulus. Ostensibly, state governors could play chicken with the Federal Government if they don’t get some bailout money. How the Obama Administration chooses to tackle this problem will be a contentious issue going forward.

Stay tuned.

Sources

State Balanced Budget Requirements: Provisions and Practice – National Conference of State Legislatures

States seeking $1 trillion to ‘keep afloat’ – Politico

Related posts:

• State and local governments: budget cuts likely
• State tax revenue down 26% in 2009
• State and local government weighed down by housing
• Is the State of California bankrupt?
• GDP: imports, inflation and local government are the story

It sure seems like California is insolvent. Just today we heard that Arnold Schwarzenegger contacted Hank Paulson to let him know that the State is having liquidity problems (see pdf) and needs help. California ranks as the world’s 9th largest economy with a population of over 30 million people, so this is quite worrying.

The state had an economy that was going gangbusters during the boom. That certainly aided U.S. GDP growth a few years back. Now, house prices are way down in California — San Diego down 31%, San Francisco down 28%, Los Angeles down 30%. And so goes housing, so goes California. The economy is a shambles, unemployment is skyrocketing and tax revenue is plunging. One city in California has already gone bankrupt. Could the whole state be next?

I certainly think so.

California Gov. Arnold Schwarzenegger warned U.S. Treasury Secretary Henry Paulson in a letter emailed Thursday that the state might need an emergency federal loan of up to $7 billion within weeks, the Los Angeles Times reported Friday, citing a copy of the letter that the newspaper obtained.

California, among several states frozen out of the bond market by the credit crunch, is nearly out of cash to fund day-to-day government operations and can’t access routine short-term loans it relies on to remain solvent. If the state’s inability to access cash continues, Schwarzenegger aides say, payments to schools and other government entities in California could be suspended and state employees laid off.
-Real-Time Economics

If a financial services company were in this kind of shape, it would be on its way to Chapter 11. Many of us have seen this coming for some time. With property tax revenue down and income tax revenue falling as the real economy begins to suffer, this was inevitable. Other states with huge housing busts like Florida, Nevada and Arizona may be the next areas we hear about in the coming weeks.

Update 2009-01-15:  Governor Arnold Schwarzenegger called California’s huge budget deficit a “rock upon our chest”and warned this is the top priority for policy makers.

The deficit and cash shortage developed rapidly after Schwarzenegger signed the current year’s budget in September. Since then, he’s called lawmakers into three special sessions and twice declared fiscal emergencies. On Jan. 7, he vetoed the only plan that has reached his desk from those special sessions.

Schwarzenegger’s fellow Republicans have blocked his proposal to raise taxes, which can’t be done without a two- thirds vote. Democrats, who control both chambers of the Legislature, have balked at deep spending cuts and proposals to ease environmental regulations and labor rules.

Last month, Schwarzenegger proposed a mix of spending cuts, tax increases and borrowing, as well as an economic stimulus package, efforts to curb home foreclosures and streamlined government operations.

State finance officials are preparing to withhold payments to thousands of vendors and say they will likely have to issue IOUs to people who are expecting tax refunds.

Saving Money

To conserve cash, Schwarzenegger has ordered state offices shut for two days a month and all workers to take two days of unpaid leave each month. The impasse forced a state panel on Dec. 18 to halt funding for $3.8 billion of construction on schools, roads and other public works, a decision officials said might cost tens of thousands of jobs.

“So now the bulldozers are silent. The nail guns are still. The cement trucks are parked,” Schwarzenegger said. “This disruption has stopped work on levees, schools, roads, everything. It has thrown thousands and thousands of people out of work at a time when our unemployment rate is rising.”

California, the biggest borrower in the municipal market, shares with Louisiana the lowest credit ratings among the states because of perennial fiscal shortfalls and legislative gridlock. It is rated A+ by Standard & Poor’s and Fitch Ratings, the fifth-highest grade, and an equivalent A1 at Moody’s Investors Service.

Part of the problem is that some want to raise taxes here to fix the problem. Raising taxes in the teeth of a major recession is a recipe for disaster. However, California will go bankrupt if some form of revenue raising or spending cuts are not taken. The Federal Government will have to step in here with some monies or things will unravel very quickly for California and that will have very negative consequences for house prices.

Sources
Hasta la vista, baby – FT Alphaville
Schwarzenegger Warns California May Need Federal Loan – Real Time Economics
Schwarzenegger letter to Paulson (PDF) – LA Times
Schwarzenegger Says Deficit has ‘Incapacitated’ State – Bloomberg.com
Gov. Arnold Schwarzenegger’s State of the State address – LA Times

Related posts:

• Text of Schwarzenegger letter to Paulson
• Kansas and California and the race to U.S. state insolvency
• California is to begin handing out IOUs tomorrow
• California will go bankrupt
• State tax revenue down 26% in 2009

Not if you believe the figures from a University of Calgary – C.D. Howe Institute study comparing tax rates in 80 countries – remember, they’re Canadians (hat tip Stephen Gordon). In this list, which includes all the major economies, the U.S. ranks in 3rd place for the highest corporate tax rate for advanced economies (I didn’t include Chad on that list).

Am I saying we should lower taxes? No. The U.S. Government needs more income, not less. The same argument holds in the UK, although less so, as tax rates are lower for UK corporates (11th amongst advanced economies). But, when populists tell you that corporations are not paying their fair share, you have to be skeptical.

So when this housing bust has John McCain or Barack Obama and Gordon Brown dialing for dollars because of the gaping hole in American and British public finances, corporations may not be the best place to call ad get the cash.

Source
2007 Tax Competitiveness Report, C.D. Howe Institute (pdf)

Related posts:

• Quote of the day: John McCain
• FSA: Gordon Brown complicit in credit bust
• Obama sees Bush behind weak dollar
• Obama leads McCain by 2 points
• I probably can’t vote for McCain

The chart below is yet another from Perot Charts. I have no particular message in mind with this chart except to inform my readers how the government gets and uses tax monies.

One issue to note is the outsize proportion of taxes that come from individuals despite the U.S. having a relatively high corporate tax rate. Certainly, part of this has to do with tax loopholes making effective tax rates for favored industries lower. However, that issue is a debate into which I won’t wade.

Below is a related post on taxation from Amity Shlaes, taking the low tax side of the debate.

Related articles
McCain’s Tax Plan Would Block a Democrat Katrina: Amity Shlaes, Bloomberg News, 25 Jun 2008

This post is part of my chart of the day series.

Related posts:

• Chart of the day: US Federal government spending
• Chart of the day: Continuing Claims
• Chart of the day: Dow 1973-1974
• Chart of the day: Total US Debt
• Chart of the day: Jobless Claims

A friend from the UK visited me at the weekend last week. As we drove by the local Exxon, and he spotted the $4.30 marker for regular unleaded, he commented “Petrol is cheap here.” Really?

Well, in the UK, he said he was paying £1.40 a litre for diesel. With the British pound near $2 and 3.78 litres per gallon, that comes out to about $10 per gallon. Cheap indeed.

Edward Janeck over at the Investing Speculator has a blog entry that points this out. Using data from a May 6th USA today article. It shows how much less Americans pay for gas than other developed economies (although they pay next to nothing in Venezuela and Iran).

Something to think about next time you’re filling up.

Cruisin’ Where gasoline is cheapest Rank Country Price/gal 1. Venezuela 12 cents 2. Iran 40 cents 3. Saudi Arabia 45 cents 4. Libya 50 cents 5. Swaziland 54 cents 6. Qatar 73 cents 7. Bahrain 81 cents 8. Egypt 89 cents 9. Kuwait 90 cents 10. Seychelles 98 cents 44. United States $3.45

Chart Source: USA Today, 6 May 2008,U.S. gas: So cheap it hurts

No related posts.

Amity Shlaes has a good column over at Bloomberg News. Her post today is about the likely rise in taxes we are going to see in 2009 and beyond. She admonishes the Democrats for being overly complex when it comes to taxes. She says:

“The overall point isn’t that Obama has or even wants the worst economic programs. As noted here, there are intriguingly entrepreneur-friendly components to a lot of the ideas coming out of his campaign. It’s that complexity for its own sake is no substitute for virtue. A preoccupation with the political ideal of change can bring about the sort of change not even the senator himself wants.”
-Amity Shlaes, Bloomberg News, 10 Jun 2008

In the interest of full disclosure, I must admit to be being an Obama supporter Nevertheless, Shlaes does make a few good points it is worth thinking about regarding our tax future. For one, the oil windfall profit tax is a disaster waiting to happen. The other is that taxes on the higher income brackets, dividends, and capital gains are going up.

Related posts
Election means big government and higher taxes
The Windfall Profit Tax: Bad Idea

Related posts:

• Windfall profits: ‘Robin Hood’ Berlusconi to the rescue
• Chart of the day: US federal spending and receipts
• Gas Tax Breaks
• Election means big government and higher taxes
• Are US corporations feeding at the trough of low taxes?

This past week, I attended an Investment luncheon to hear Greg Valliere, the chief political strategist with the Stanford Washington Research Group. He had a number of important things to say regarding the economic implications of political decision-making in Washington and of this year’s U.S. presidential election. I agree with most of his analysis and will write the rest of this blog entry from his vantage point. Where I disagree or have a specific point to make, I will preface my comments accordingly.

His three big themes were:

• There has been a dramatic rise in the size of government, especially in regulatory agencies
• Taxes are going to rise — in particular capital gains taxes
• The election in November has big implications on investment strategy

[First, in the interest of full disclosure, I will briefly say where I stand on the political and economic spectrum. I consider myself to be a pro-free market Libertarian. I believe in a lightly regulated free-market economy with regulation as a check on market power. On politics, my Libertarian views make me closest to Ron Paul, Barack Obama and Mike Gravel of all the U.S. Presidential nominees. I admit to being partial to Barack Obama and feel he would make the best U.S. President.]

Current Economic Situation
According to Valliere, we have just witnessed one of the biggest increases in the size of government in modern U.S. history. Now, I’m not talking about the increases due to the War on Terror — that’s been going on for nearly seven years now — but rather what’s happening right now. And it’s all because of the subprime crisis.

Basically, the U.S. Federal Reserve simply was caught asleep at the switch and was not aware of how important the subprime sector was and the potential for contagion in other asset markets. Now, we have a full blown crisis on our hands and the Fed has done what it can to contain the damage by lowering interest rates to 2%, by lending to investment banks, by taking on questionable collateral in exchange for rock-solid treasurys, and by bailing out Bear Stearns.

But, now the Fed is done. Interest rates are not going any lower because the Fed is constrained by rising inflation. They are also worried about the Dollar. Their next move — and this won’t be for another 10-11 months at least — will be up. That said, all the risks are to the downside in the economy.

My comment: what I take from these statements is that the Fed wishes it could do more given the downside risks to economic growth. But, it is constrained by the low dollar and rising inflation, especially with prices at the pump where inflation has its most visible and problematic manifestation. That means that, as much as the Fed wishes it could support the economy, it simply cannot and will not. This is not good for stock market investments, especially in cyclical companies. One needs to be as defensive as possible (consumer staples, TIPS, cash).

Valliere called the Fed an “activist Fed.” But felt this was a good thing generally. The Fed generally acted appropriately including its machinations in the JP Morgan- Bear Stearns shotgun wedding. He did not see the Bear Stearns deal as a ‘bailout,’ saying that if you thought it was a bailout, you’d have to ask Bear Stearns investors what they thought (having lost 90% of their money).

Big Government
So, with that as a backdrop, we can get into Valliere’s macro issues. The first example of big government is the housing bailout measures put forth by Chris Dodd. The pure politics of the issue means this bill will not be vetoed. This is the first example of how the subprime crisis is leading to big government.

My comment: The politics of it all means no sane politician would be caught vetoing a bill that gives millions of Americans relief on a key election issue with an election only six months away. George W. Bush may be a lame duck but he’s cares enough not to sacrifice the Republican’s chances in November by vetoing a bill that will aid millions and being seen as hard-hearted. And the tax rebate checks, while a drop in the bucket in terms of the stimulus the U.S. economy needs and likely to have no effect on the economy at $150 billion in a $14 trillion economy, will have a substantial impact on the size of the federal budget deficit. This is another sign that the subprime crisis has ushered in an era of big government.

The biggest change, according to Valliere, is in regulation. There will be a marked increase in Government regulation regardless of who’s in power in 2009. First, U.S. Treasury Secretary Hank Paulson’s regulatory proposal is “dead on arrival.” In this economic environment, much more is desired. Congressman Barney Frank will have the biggest say on this issue and he wants much more regulation and “punishment.”

My comment: This means that the de-regulation era has effectively ended. Big mergers will be eyed suspiciously. The cost of doing business will increase as red tape and regulation increases. All of this is bad for anyone looking to make a boatload of money based on capital gains in a new bull market. I happen to think that the pendulum does need to shift substantially away from de-regulation, but this will certainly mean an end to inflated asset prices in the capital markets.

As far as regulation goes, I predict a ’super-regulator’ is in the offing a la the Department of Homeland Security (DHS). This bout of big government is going to produce a federal agency akin to DHS because people are going to want to see an all-powerful federal agency formed that can effectively keep the capitalist wolves at bay when they overreach. This is a transformation that I view with some dread because I believe that, while de-regulation had swung way too far, big government is a problem, not a solution.

Valliere finished his big government theme by mentioning the enormous increase in the federal budget deficit for FY 2008. We are going from about $160 billion to $500 billion in ONE year. This is truly remarkable and his testimony to the size of the government increase.

So, that’s Valliere’s theme #1: the subprime crisis workout means big government regardless of who is in power.

Taxes
Theme #2 is taxes. Valliere said that even John McCain will not be able to withstand an invigorated Democratic congress. Bush’s tax cuts are set to expire in 2010. This means that unless some legislation is proposed, voted for by congress, signed by the new President and enacted, all of those tax cuts will expire. This gives the Democrats in general, and Charlie Rangel in particular, a lot of leverage.

First, the Top Rate on ordinary income is definitely going higher. 35% may go to it’s pre-Bush level of 39.6% McCain may have to accept a compromise at 37-38%.

Second, capital gains is a big story. If Obama wins, they are going from the current 15% to the mid-20s. And then you’ve got Dividends, which were taxed at the rate of ordinary income before the Bush tax cut and are now taxed at 15%. That’s a huge difference. Valliere does not see the rate shooting up to 39.6% but it will go up substantially as well.

Interestingly, a subject where Valliere was clear was on these tax changes being retroactive. Even if the new President gets legislation through congress quickly, we’re talking June before a comprehensive new tax bill is signed, sealed and delivered. But, this bill may well be retroactive to January 1, 2009 if it is Barack Obama as President. Retroactive bills have been done before, so this is not a novel idea. Any way you look at it 15% is history.

My comment: I agree that capital gains taxes are going up. First, Obama is on record in the last ABC debate as having said that he would raise the capital gains tax to at least 20% (where it was under Clinton, after he lowered it) if not 28% (where it was when Clinton came to the White House in 1992). McCain will be forced by a Democratic Congress to accept a deal of some sort. Remember, the Democrats have huge leverage here because these cuts are automatically going to lapse in 2010. So, absent new legislation, starting in 2010, the capital gains rate will be 20% and the dividend rate 39.6%.

As for the equity of this, that’s a whole second discussion. I feel it is equitable to somewhat equalize capital gains, ordinary income and dividend tax rates because it gives people fewer opportunities for tax arbitrage. Having widely different rates is discriminatory because it allows individuals who can earn their money through one channel to receive a vastly different effective tax rate than others earning income through different channels. The best equitable solution is a flatter rate structure near 25-30% that is tax neutral. Deficit spending is not something to be proud of, so any tax rate cuts must be accompanied by spending cuts.

The most important implication of these developments is it will mean a selling torrent in November and December as people look to lock in gains. If people expect a capital gains tax increase that is retroactive to January 1, 2009 to go into effect, they will lock in capital gains before that date. This is a guarantee. So, I see Valliere’s assessment as very troubling for the stock market come year end 2008.

Valliere also addressed the Estate Tax as well. He said that the federal government was simply not going to abandon the estate tax. He sees a rate of 35-40% with a high exemption as the likely outcome.

My comment: Estate taxes are not about revenue but equity. Estate taxes are not huge money makers for the Treasury. However, the concept of capital gains being passed between generations leads to fears of consolidating wealth and power and is alien to the American psyche. Americans will not stand for a tax policy without estate taxes on principle alone.

The AMT is a huge tax generator. According to Valliere, it’s worth $900 billion over 10 years. Therefore, given the size of the deficit, he does not see its being abolished anytime soon. More likely, it will be phased out over time.

The third rail of politics is social security and medicare. We fund social security through payroll taxes. These taxes are limited to the first $100,000 of income.

My comment: That’s not going to cut it, as the structural generational changes in the U.S. mean that social security will be in deficit soon. People are living longer and having fewer children. So that means the country is getting older.

Obama is a brave politician according to Valliere for addressing this issue. With Obama as President, he sees the payroll taxes being assessed on income up to $200,000.

My comment: we have the lowest effective tax rates on individuals in the OECD. Don’t believe anyone who implies that America is overtaxed as Valliere did. A gentlemen of 80+ in the room hit back at Valliere, implying that we get a good deal and he was proud to be an American.

The last tax issue is corporate taxes. They are going down. Even Charlie Rangel wants 31%. McCain wants 25%.

My comment: The UK is suffering a rash of corporate defections because of high corporate tax rates. There is a lot of talk in the British press about companies leaving or threatening to leave the UK as a result. The point being — we are in a global corporate world where companies can choose their base for taxation. There is a solid point in being competitive on corporate tax rates.

Politics
Valliere admits to being partial to Hillary Rodham Clinton. He thought she would be the next President and is on record as having said so in ‘07. He felt she would be the strongest President amongst the candidates. However, during his whole speech, he never mentioned her,nly referring to McCain. [I assume he did this because people inside the beltway all believe she has no shot at being nominated.] He chalked up her problems to:

• Bill Clinton, his gaffes and surprisingly poor campaigning skill
• Her positioning as an inevitability nominee
• Internal campaign problems
• Barack Obama’s being “adroit”
• Obama’s winning “a lot of states where nobody lives.”

Valliere said that he imagines someone high within the Democratic apparatus close to Clinton will pull her aside and ask her to quit after the primaries. He mentioned Rahm Emanuel, James Carville and Ed Rendell as the ones most likely to take on this role. He imagines they will tell her it is in her best interest to quit gracefully because she has three jobs to contend for:

1. Senate Majority Leader- Harry Reid is unpopular
2. Governor of New York. Spitzer and Patterson have not been stellar.
3. Nominee for 2012

He believes she will bow out gracefully by mid-June and that everyone will be singing “Cumbaya” at the Democratic Convention come August.

He sees the Democrats scoring significant victories in the Senate. They will get 4-5 seats, maybe 6. But, they will not hit the [filibuster-proof] magic number of 60. In the house, the Republicans are going to have huge problems. States of notable interest are VA, NH, MN, CO, NH, OR, and ME. All of these are at risk. The big problem is Republican retirements.

My comment: Two retirements are especially noteworthy. Former House Speaker Dennis Hastert (R-IL) left early to get a cushy job because he knew what was coming for Republicans in 2008. So he left while the getting was good despite the fact that he left his seat prey to the Democrats, who took it in a special election. The same thing goes for Former House Speaker Tom Delay (R-TX).

Valliere says the Democrats will take at least 12 seats in the house giving them a 50-seat majority.

My comment: This is a big story because it means Democratic control of Congress will be strengthened.

Valliere also sees a lot of headwinds for McCain. But, he thinks you have to respect a man who condemns ethanol subsidies in Iowa and tells Michigan workers jobs are never coming back. His problems are:

• Age
• Temperament
• Health

Temperament: the Democrats will hit him on his ties with Phoenix developers and lobbyists. Both of these issues could cause a McCain volcanic eruption for which he is known [My comment: McCain has been known to drop the F-bomb on even Republican colleagues when hot under the collar].

Health: he has had melanomas 5 different times and you can see that one side of his face has been fully reconstructed. Therefore, his running mate selection is crucial. Mitt Romney has to be on the short list.

Overall, these are not fatal headwinds.

My comment: this seems a fair depiction. I would also say that McCain is vulnerable on his association with Bush policies, one of many reasons Condi Rice is a non-starter as VP. And he is vulnerable as a flip-flopper given his policy stance changes since his last run in 2000. Romney being seen a flip-flopper for tacking hard right as well could present problems with moderates and independent voters.

Biggest McCain problems are:

1. The economy may not come back. Valliere believes in a 2nd-half recovery. But, will it be enough, especially on jobs, to rescue McCain? In 1992, Bush I lost because it didn’t come back in time.
2. There’s the Bush Ball and Chain. He has the approval ratings of Nixon post-Watergate and Truman during the Korean War. The next elections led to huge change in both cases. Dwight D. Eisenhower, the Columbia University president and former War hero who had never held national office became President after Truman in 1953. In 1976, Jimmy Carter, a peanut farmer, became president.
3. History: since FDR. The pattern is 8 and out. People don’t like parties to be in power too long. The only exception is Bush I.

Obama’s problems:

1. He has not been fully vetted
2. “Harvard Disease”: this is a problem of Harvard turning out smart people who don’t seem to connect because they are seen as arrogant and condescending.

The wildcard is Iran. The U.S., Israel or both could strike before Bush II leaves office. From Israel’s national security point of view, would you rather have the threat of a nuclear enemy who wants to wipe you off the map eliminated during a Bush or an Obama administration?

Investment Themes

1. Freddie and Fannie will benefit from an Obama administration.
2. Big Pharma loses with Obama because of price controls.
3. Alternative energy wins with Obama (although McCain is also lukewarm on ethanol.
4. Tax breaks for oil & gas are out with Obama, so that’s a negative for big oil
5. Hospital Stocks will rally because of McCain
6. Defense: In a contrarian call, Valliere saw McCain as bad for Defense because he is a fiscal hawk with national security credibility. The national security vulnerabilities of Obama may cause him to be more liberal on defense spending.

My comment: all interesting ideas, but not necessarily ones I agree with 100%. I think Fannie and Freddie will fail or be nationalized. And I think McCain is good for defense.

Valliere’s ideas were well-constructed and his logic was internally consistent.

Related posts:

• Marc Faber: Obama’s not going to be good for the market
• Taxes, Taxes, Everywhere
• I probably can’t vote for McCain
• Are US corporations feeding at the trough of low taxes?
• Obama sees Bush behind weak dollar

On Friday, the Spanish newspaper ABC reported that Spanish municipalities are being hit hard due to the tax revenue shortfalls emanating from the effects of the Spanish property market crash. The two local governments most affected have been Madrid and Catalonia.

“The two municipalities that earned the most from [property-related] taxes, Madrid and Catalonia, in the past year have already registered a drastic decline in income. In effect, the Catalan community saw how their income from the Tax om property sales was reduced 27% in 2007 to 1,517 million Euros, 561 million less than the previous year. Additionally, tax collection from related legal transactions fell 5% to 1,682 million Euros, 5% less than in 2006. Therefore, between both taxes, the Generalitat Catalana (Catalan Government) last year failed to take in more than 655 million Euros.

The deceleration in Madrid was somewhat less, although the decline was also abrupt. According to provided by the community’s Property Council, the collection of tax on property transactions fell 19.1% in 2007 to 1.692 billion Euros, representing a cut of 374 million Euros. Cuts in notary tax revenue has been minimal, but this area is also down. Specifically, the fall has been 1% to 1.403 billion Euros. Therefore, between both taxes, the local government of Madrid last year lost 414 million Euros in comparison to 2006.”
-ABC, 16 May 2008 (my translation)

The article saw similar slowdowns across the board: in Valencia, Andalucia, Castilla and Leon, Castilla-La Mancha, and Extremadura. These tax receipt shortfalls will have a dramatic impact on the services local governments in Spain can provide as recession takes hold. It is a caution that the US, Ireland, and the UK should also keep in mind as this housing bubble’s effects are felt globally.

Sources
La crisis inmobiliaria recorta de forma drástica los ingresos autonómicos, ABC, 16 May 2008

See also: Other posts under the label ‘Spain.’

Related posts:

• State and local government weighed down by housing
• Spanish furniture sales down on housing bust
• Spanish property market implosion
• Ireland: government blew the boom
• State tax revenue down 26% in 2009

Recently I have been toying with the idea of voting for John McCain if it became a McCain-Clinton general election. As much as I may like John McCain’s apparent straight talk, some of his recent positions seem like major flip-flops and others seem dangerous.

I will continue to gauge McCain, but I have to say that fiscal conservatives like myself are disappointed that he has taken a tax and spend position to governance like the Bush administration. In general, he is moving closer to being a continuation of the Bush Administration. Very disappointing compared to the man who campaigned in 2000.

Here is where I see him on key policy issues:

1. Foreign Policy: Gut it out in Iraq, play brinkmanship with Iran. While I was opposed to the war in Iraq, I was willing to be convinced about staying on given the right tactical argument for maintaining a limited presence without a timetable. Now, McCain’s “100 years” quote is being distorted out of all context by the Democrats. But his position on Iraq shows him to be inflexible and likely to stay the course. That’s not encouraging. Even less encouraging is his hawkish stance on Iran. While Iran was always a bigger threat than Iraq to begin with, the U.S. can ill afford to attack a third Muslim nation in its quest for hegemony, pre-emption or whatever mindless excuse we might use.

2. Civil Liberties: I am not aware that McCain has any inclination of repealing or rolling back the Patriot Act, which is a huge curb on U.S. Civil Liberties.

3. Economic Policies: Continued under-regulation. No support for homeowners. McCain defends the laissez-faire approach. Fair enough. But, this is a major crisis and laissez-faire was inappropriate for 1929. It’s in appropriate for 2008.

4. Taxes and Budget: Maintain the tax cuts for the wealthy. While I agree with the premise that lower taxes are beneficial, I am not a proponent of massive deficit spending. Moreover, if anyone needs a tax cut, it would be the middle class. Again, McCain seems to be moving into Bush territory here, a real flip flop for the former fiscal conservative.

McCain is in a tough position because he is trying to solidify his base in order to get out the vote if Obama is the Democratic nominee (he doesn’t need to worry if Clinton is the nominee because the base will be energized to defeat her.). But, in so doing, he risks alienating moderate and swing voters who liked the John McCain of 2000 a lot more than the John McCain of 2008.

Related posts:

• Hillary’s saber-rattling
• Pennsylvania goes to Clinton
• The Bush Administration steps up its secret moves against Iran
• Now Obama is back to not being good enough?
• Hillary Clinton has shown she lacks character

As the housing bubble pops, one major casualty is likely to be state and local government property tax receipts. It appears that state and local governments recklessly spent the windfall revenue that they received during the boom times and have been caught out now that the boom has turned to bust.

Not a day goes by without commentary in the newspapers or online about severe budget cuts in one municipality or another. The State of California and the City of New York are leaders among those governments likely to suffer severely during this downturn.

The question then becomes: what can we expect as taxpayers in terms of services for our hard-earned tax dollars? Charles Hugh Smith has an excellent blog on this very topic. My understanding is that much of the State and local budget is mandated and hard to cut. Therefore, cuts will occur in areas of greatest leverage: infrastructure — both human and transportation. It is a safe bet that we will get less in infrastructure and education, in particular. After incidents like the Minneapolis bridge collapse, we all know that our governments have continued to under-invest in infrastructure despite boom times. Now that revenue for local and state governments have fallen, it is to be expected that infrastructure projects will be even less likely going forward.

I expect many municipalities to enter bankruptcy. Others will be forced to make major cuts to stay viable and avoid bankruptcies. So, a likely outgrowth of the housing bubble is a decaying infrastructure and poor education. For those of us who can think of historical parallels, the United Kingdom after World War II is an apt one. There, decades-long under-investment after the crippling war left the country’s roadways and education system in a shambles from which it is still recovering over 60 years later. It wasn’t called the ‘Sick Man of Europe’ for nothing.

Let’s hope the United States does not suffer the same fate.

Related posts:

• Will federal largesse be countered by state and local cutbacks?
• State and local government weighed down by housing
• State tax revenue down 26% in 2009
• Spanish local governments struggling with bust
• Ireland: government blew the boom