TOPICS IN POLITICAL ECONOMY

THE ECONOMY: NOTES ON A PRETTY GOOD YEAR . . .

Considering the gloom, doom and uncertainty facing the U.S. economy at the beginning of 2009, one has to conclude that things turned out reasonably well. 

The recession appears to have ended in the third quarter (as we suggested a year ago), corporate profits turned out better than analysts expected and the stock market confounded most forecasters with 20% plus gains.  As we were expecting, the unemployment rate rose to 10% even as the economy began to pick up.

In short, the economy followed the traditional downside leg of a business cycle - with above-average amplitude in the swings of production and employment. We should be thankful that 2009's  2.5% drop in gross domestic product is modest compared to countries like the U.K. and Japan with drops of 4.5% and 5.4% respectively.

To Whose Credit? Should we give credit to anyone for turning the corner toward renewed growth? Probably not. Outside of thanking the Treasury Department and the Federal Reserve for stopping the run on the banking system, and averting an even deeper "bottom" to the cycle, we should be very cautious in handing out any kudos. 

While the income tax rebate checks of 2008 may have had a slight "bottom cushioning" effect, survey studies suggest only about one-third of the rebate money was spent, the rest being saved.  With only a little over one-quarter of the Obama Administration's $787 billion spent as of November, its impact to date has similarly been modest. Programs such as the "cash for clunkers" simply change the timing of consumer expenditures for the most part; by one estimate only 18% of the 690,000 cars sold under the program were truly "stimulated" purchases. "Clunkers" also had the perverse effect of destroying substantial wealth. (It mandated the destruction of seven hundred thousand automobile engines, many of which would normally have been recovered by scrap dealers for spare parts, refurbishing or export.) 

Business cycles have their own self-correcting features - inventories run down and eventually have to be replaced, returns to investing in new technology appear increasingly attractive, profits recover under the impact of cost-cutting, and lenders' appetites grow to make new loans instead of investing in Treasury bills with minimal returns. These have been the driving forces in the economy in the closing months of 2009, supplemented by some modest Federal stimulus spending.  

Looking Ahead. The biggest threats to a continuation of the recovery are the higher taxes, deficits, and rules/regulations likely to flow from Obama Administration legislation dealing with healthcare,  energy/climate change, and a major expansion of the financial regulatory regime.   To this list should be added the Administration's continued very public bad mouthing of bankers' compensation and lending practices. (We thought the primary lesson of the financial crisis was too much lending, not too little.)

Such factors are of more than usual importance in sustaining a decent recovery. Thanks to past excesses, home building is likely to be of little help, in contrast to its traditional leading role in an economic upturn. Similarly, debt-financed consumer spending is unlikely to be a recovery leader. Clearly, consumers have learned their lesson from the financial crisis of the past two years: "We borrowed too much."  Savings rates have rebounded dramatically; credit card balances are shrinking and prepaid or debit cards are very much in fashion.  According to the Federal Reserve, consumer credit has declined by $100 billion since the third quarter of 2008.

Exports have been and should continue to be a solid plus for the economy.  Even if the U.S. dollar were to strengthen somewhat, U.S. manufacturers, service providers, and agricultural and raw material producers should continue enjoy reasonably strong demand from abroad. Business investment in inventories should remain strong for the near-term, and capital spending shows signs of strengthening.  

However, it is business investment outlays that is most vulnerable to ill-conceived actions by Congress and the Administration. Such actions run the risk of dampening business confidence, increasing uncertainty and sabotaging the recovery. They will be coming in the middle of Federal Reserve efforts to withdraw substantial amounts of the credit it has extended the financial system over the past year and heightened concern about financing massive deficits.

Beware the Law. In short, the Law of Unintended Consequences could be very much in evidence over the next 12 months - with unpleasant results. Politicians and pundits: be careful what you wish for.   

CAN WE CONTROL THE FEDERAL DEFICIT?

An action event is in the offing: 

Congress will need to increase the debt ceiling limit before the end of the year.  When this legislation comes up, the budget hawks in the House and Senate will attempt to add legislation which would appoint a powerful commission to specify cuts in spending/tax increases to reduce the massive deficits in the offing from Medicare, Medicaid, and Social Security - not to speak of the massive unfunded outlays implicit in both House and Senate health care reform legislation.  (If you know of a better mechanism to deal with the issue, please let me know.)

Read how the major players in Washington are trying to deal with this issue in today's Wall Street Journal. Don't be surprised if Nancy Pelosi thinks this is a bad idea. 

Beat your drum and cross your fingers.

TWO BIG HOLES IN FINANCIAL REFORM LEGISLATION

Financial regulatory reform draft legislation is making its way through the Congressional sausage factory: 253 pages in the House version and 1,136 pages for the Senate's (Senators tend to be more wordy than Representatives).

But, despite their weight, there are two gaping holes in both versions: not a word dealing with the biggest bad actors in the mortgage market (Fanny Mae and Freddy Mac) or with the financial sector that posed the biggest threat to a nationwide financial panic - money market funds.

While there are plenty of issues to debate within the draft legislation, let's focus here on the two missing chapters.

Fanny and Freddy. According to the Washington Post, the federal government's seizure of these two government-sponsored housing agencies  has cost the taxpayers $121 billion.  And more dollars are likely to be needed to keep them afloat. And then there's the issue of the original federal housing agency, the FHA, which now looks like it, too, is going to need a multi-billion bailout.

If Congress and the Treasury can't confront the underlying problems arising from federal intervention in the residential mortgage market (making it too easy for high risk borrowers to get government-subsidized  credit), they clearly haven't addressed one of the principal factors in the credit crisis of the past two years. Of course, that would be a lot harder to do, politically, than beating up on bankers.

Money Market Funds. For some reason, outside of Paul Volcker's vigorous warnings and substantive proposals from The Group of 30, almost no one at the center of policymaking in Washington appears to be seriously concerned about the role poorly designed money market funds (MMFs) played in the credit crisis.

Promising to hold MMF share prices to $1.00, helped by SEC regulations permitting questionable accounting to maintain that price, and acquiescing in SEC mandates to use credit rating agency marks on all their holdings, the MMF sector literally "blew up" last September. That was when one of the oldest and biggest funds, The Reserve Fund, "broke the buck" thanks to its $785 million investment in Lehman Brothers highly-rated commercial paper. 

The money market fund sector has evolved into a trillion dollar "shadow" banking system - but it is regulated by an SEC that is subservient to the investment companies that sell and manage MMFs and is generally clueless about banking issues (and how to catch Barney Madoff). 

While the SEC has requested comments on various proposals dealing with possible MMF reforms, the likelihood of serious, fundamental changes is very dim without a legislative directive.

Bottom Line. It would be most constructive if some of the heavy hitters in the Washington sausage factory could add a little more substance to the financial regulatory reform package that is currently moving down the production line.

THE HEALTHCARE DEBATE: THE PUBLIC OPTION

Bob Samuelson, the sharpest economic columnist in the country (at the Washington Post, no less), has written an incisive and devastating analysis of the "public option" proposal in pending healthcare legislation. 

He calls it "an exercise in political avoidance: it pretends to control costs and improve access to quality care when it doesn't." 

If you are at all interested in how this major policy debate is going to be settled, read Bob's column - and send it around to others.

WHERE ARE THE TRUE REFORMERS?

The real problem in Washington, Holman Jenkins reminds us in a grim column in today's Wall Street Journal, is: 

. . . the giant riverboat gamble that Washington can save the economy by doing what comes naturally—spending money carelessly, creating massive new entitlements without funding them, dishing out cheap credit to politically favored sectors, telling business people where and how to invest.

Current healthcare legislation working its way through the Congressional sausage factory is described by Jenkins as "the equivalent of climbing aboard a train about to plunge into a canyon and deciding what it really needs is a bomb on board," thanks to the expansion of coverage paid for largely with flimsy assumptions about "cost savings."

Jenkin's wishes that Larry Summers and Ben Bernanke would step up and try "to steer Team Obama off its suicide mission."  

I would note that Council of Economic Advisers Chair Christina Romer recently observed, there is a "budgetary catastrophe looming for our children and grandchildren."  Was the White House listening?

There are plenty of good, robust proposals for real reform ready for implementation, Jenkins reminds us:

The hopper is hardly barren of ideas, like raising the retirement age, enacting the Breaux Commission's Medicare proposals, instituting a flat tax and eliminating the tax distortions that every serious economist knows contributed to the housing bubble and the health-care bubble.

 

Anybody listening?

 

 

PRESIDENT OBAMA AND THE COLA: PANDERER IN CHIEF

On October 5th, I commented - critically - on the legislation moving through Congress to award Social Security recipients a special $250 payment.  Due to a small projected decline in inflation for 2009, there will be no cost-of-living  (COLA) increase in Social Security monthly stipends for 2010.

Now President Obama has come out in favor of this $13-$14 billion post-Christmas present (financing unspecified by the White House), thus joining the pandering politicians in Congress at throwing money at what might be called "the grasping geezers." 

The original legislation which provided for COLAs said that upward adjustments in COLA would always be made (my social security check went up 5.8% this year), but if prices declined (as in 2009, for the first time since the COLA was instituted) downward adjustments were ruled out. Talk about a sweetheart deal.  But not sweet enough, apparently, especially for frequent voters. 

The White House says that seniors are among those "hardest hit by this recession."  In a class with automobile workers??  The  Presidential statement points to the decline in home values, but ignores the reality that, so long as seniors stay in their current residence, the fluctuation in home values has no impact on them - only their heirs. Yes, maybe their retirement savings accounts have fallen in value - but so have those of "juniors."  And juniors didn't get a 5.8% increase in Social Security stipends this year.

Now that the President has endorsed it, the $250 pandering payment is probably unstoppable in Congress, despite a growing sense that Federal spending is on a suicidal track. Only a resolute, far-sighted leader in the White House could have mustered the political courage to derail a craven, populist proposal.

But we don't have a lion in the White House; we have a free-spending fox. 

SOCIAL SECURITY COLAS: THE PANDERING POLITICIANS AT WORK

Here's a letter I have just sent one of my Senators.  The leaders of this classic example of the mob at work are Senator Sanders from Vermont and Congressman Pete DeFazio of Oregon.  The official title of the legislation is The Emergency Senior Citizens Relief Act (H.R. 3597 in the House, S. 1685 in the Senate). If you agree with the thoughts, send something similar to your Senators and Congressman - or, better yet, your newspaper.

Dear Senator Casey:

I understand you are a co-sponsor of legislation to provide a one-time payment of $250 to all Social Security recipients, since there will be no cost-of-living (COLA)  increase for them this year.  Your proposal would increase federal outlays by $14 billion.

I am one of those potential recipients. And I strongly oppose your proposal. The reason there is no COLA this year is because consumer prices have declined. When consumer prices increase, my Social Security check increases; but it doesn’t decrease if prices decline. That was the deal when Congress wrote COLA into the Social Security System in 1975.  A lot of working people would say that’s pretty good deal – if they’re still working.

You argue that medical costs keep going up.  But most Social Security recipients are on Medicare, which insulates them from the bulk of such cost increases.

My bus fare hasn’t gone up in years: I pay nothing, thanks to my senior pass.

You say you will make up the $14 billion in handouts by increasing Social Security taxes on the working rich.  Sounds very familiar: robbing Peter at work to pay Paul at home.

Seniors have been insulated from economic hardship more than any other age group during this economic recession.

Senator, stop pandering to us.

  Sincerely,

    James B. Burnham

THE BIG, BAD ENERGY BILL: H.R. 2454

1. If you think the world is getting warmer . . . and

2. If you think that carbon dioxide emissions are a factor in such trends . . . and

3. If you think that human activity is a sufficiently significant generator of such emissions . . . and

4. If you think a warmer world has a net "bad" impact on humans . . .

Then you certainly shouldn't be supporting the massive Waxman-Markey energy bill making its way through the Washington DC sausage factory on Capitol Hill.

The reason is simple: if you want to reduce consumption of energy sources that contribute to carbon dioxide emissions with minimal impact on output and with maximum stimulus to innovation, you need to increase the relative cost of such energy. The current energy bill tries to avoid doing this - mainly by creating valuable licenses to pollute that will mainly distributed by elected politicians.  There is no better design for a political cesspool than such a mechanism. 

The gory details of the current draft can be found at http://www.thomas.gov/cgi-bin/query/z?c111:H.R.2454, but at roughly 900 pages I am sure you don't have the time (nor do I - or any Congressman or Senator) to go through it. But the basic thrust should make the Al Gore crowd very happy - and amply substantiates Vaclav Klaus's summing up of the knee-jerk environmental gang:  "the biggest threat [today] to freedom, democracy, the market economy and prosperity [is] ambitious environmentalism."

H.R. 2454 is, simply put, a "command and control"  vehicle  which is intended to promote a massive expansion of Federal government power to determine how Americans should live.

The alternative, a straightforward tax on carbon emissions, with revenue used to reduce taxes, is fairer, provides the right incentives to consumers and producers of alternative energy sources, stimulates innovation without government subsidies and provides far fewer playing fields for lobbyists seeking to game the system for their clients. 

For starters, there is a plethora of proposed federal standards - for renewable electricity, low carbon fuels, building codes, appliances, and vehicles - that are either mandated or subject to implementation by coercion, e.g. withholding federal monies raised through the sale of allowances to pollute. The bill requires that by 2012, local building codes must mandate that new buildings are 30% more energy efficient than currently. Forget local building codes that reflect local realities.

But the real "cesspool" creator is the failure of Waxman-Markey to let market forces determine the price of licenses to pollute.  Instead, in the initial year of implementation 85% of the licenses will be distribute for free under Congressionally-mandated distribution formulae, as the accompanying graphic from David Wesselman's article in the May 23 Wall Street Journal clearly shows. It reflects the efforts of more than 800 lobbyists over the past several years in wining, dining, and contributing campaign monies to your elected representatives.

 

The administration of this "cap and trade" system is full of "special reserves" and similar escape valves, the administration of which will draw in the political class like flies feast on honey, even if, as is intended the percentage of licenses auctioned off increases over the years. 

Now, let's see how President Obama responds to this monstrosity.  As he put in when he was campaigning, "If you're giving away carbon permits for free, then basically you're not really pricing the thing and it doesn't work -- or people can game the system in so many ways that it's not creating the incentive structures that we're looking for."  If he sticks to his sound analysis of this issue, he will demand that the vast majority of allowances be auctioned off immediately. And revenues accruing from the auctions will result in lower taxes for some individuals - as he also promised.

But What If . . .?    But what if any one of beliefs (1)-(4) with which I started this note are incorrect? And there are, in fact, many reputable scientists who cast doubt on at least one of the four. 

If there is legitimate doubt on these issues, then the impact of passing Waxman-Markey is likely to be similar to that of the 18th Amendment to the Constitution in 1919 establishing Prohibition. It took 14 years for Congress to grasp the magnitude of its mistake, which created millions of lawbreakers and gave rise to criminal gangs that live on today.

Waxman-Markey, in anything close to its present form, would be an even costlier piece of ill-considered legislation.

And the best that could be said for legislation that enacted a carbon tax instead of "cap and trade" is that it would do less damage.

DANGER: SAUSAGE FACTORY AT WORK

Major federal legislation dealing with our health care system is currently winding its way through the Congressional sausage factory.  Seasoned observers (and many lobbyists) feel that the probabilities of such legislation becoming law before the end of the year are considered good. 

But the legislative process is never a pretty picture in such matters, and the resulting product  could be highly dangerous to our economic health. Instead of addressing the root causes for distortions in pricing, costs, modalities in treatment and assurance of supply, Congress appears to bent on simply establishing new entitlement programs, mandates, and cost controls.

Only when there is a clear and present danger that serious economic disruption caused by the mistaken policies of the past does the Federal government seem able to identify the true underlying causes and take effective action. 

Case Study: Natural Gas Supply.  Consider the history of natural gas price regulation.  In 1954, bowing to political pressures “to protect consumers,” the Federal government began a process that eventually led to widespread shortages of gas and a costly, convoluted, Rube Goldberg pattern of market inefficiencies. The situation reached near-crisis stage in the winters of 1976-1977, when many schools and factories in the Midwest were forced to close due to a shortage of natural gas to run their facilities – while at the same time there was substantial supply in Louisiana and other gas-producing states.

As a result, finally, legislation was passed in 1978 that started the industry on the road to de-regulation, although the final lap was not completed until 1992.  There have been no significant problems with natural gas supplies since that time.

How to Create A Market Failure.  Federal tinkering with the U.S. health system has an even longer history, going back to World War II.  At that time, responding to union pressures for higher wages than allowed for by the wartime wage/price control system, the Federal government permitted employer-paid health insurance benefits to be considered nontaxable to the employees (and exempt from employers’ matching Social Security contributions). 

By 1982, Congress – and the public – were told clearly, in President Ronald Reagan’s first Economic Report, that the growing costs and inefficiencies in the health care industry “are due to inappropriate tax policy and inadequate incentives for both consumers of medical services and providers of health care to reduce costs.” Tax policy created excess demand and spending for gold-plated health insurance – and marginal medical services.  Medicare reimbursement schedules discouraged newly-minted MDs from primary care careers and enticed them into more lucrative specialty niches. Paying for hospital stays and treatments rather than patient outcomes provided perverse incentives for hospitals.

Clearly, not much has happened at the Federal level in the ensuing 25 years to address the problem.  Instead, it has tended to grow worse.  Economic growth and swelling tax revenues permitted politicians the luxury of adding new benefits (e.g. Medicare’s prescription drug program) without addressing the underlying problems. “No crisis?  No real problem” summed up Washington's attitude.

Current Prospects.  Two years ago, writing in this space, I was cautiously optimistic that “the laboratory of the states” was moving policy in potentially useful directions. Some of these efforts, as well as others by the Veterans’ Administration, have been bearing modest fruit and are now being imitated by others. It would be disheartening if further initiatives were put on hold or pushed aside by the prospect of “one size fits all” Federal legislation.

While the odds of new legislation that makes the current mess worse are better than even, chances appear to be brightening for at least one long overdue reform. Confronted with the costs of expanding coverage for the uninsured, the Administration uncharacteristically has told Congress that the legislation must be paid for in additional revenues. It has even intimated that it would go along with taxing employer-paid health benefits, something Obama slammed John McCain for advocating during the Presidential campaign. 

If applied across the board, eliminating this tax-free benefit would net the government well over $100 billion a year in additional tax revenues. More importantly, it would provide the incentives for individuals and their employers to rethink what kind of health insurance they really need and do away with the thicket of health savings plans based on tax avoidance dreamed up by financial advisors.  Finally, this step would eliminate the highly unfair treatment of self-employed individuals, who have to pay for their insurance with after-tax income.

It would be a pleasant surprise if, unlike the sorry history of government’s role in the natural gas supply market, the legislative sausage factory could produce one major, substantive improvement in approach to health care without the whip of a genuine crisis, presently scheduled for 2017 - when Medicare runs out of cash.

But don't bet on it.

STRESS TESTS, KEYNES AND THE BANKING SYSTEM

So, the well-meaning civil servants have dutifully ground through the numbers and their politically-attuned Treasury/White House managers have signed off on the "stress tests" of 19 major shareholder-owned financial institutions.  (Notice that the Social Security System and major public employee pension funds - e.g. the State of California's mega fund Calpers - have not had to undergo similar scrutiny.)

What do we know now that we didn't know yesterday?  Not a great deal more.  The regulators took these institutions' current balance sheets, posited a set of assumptions about future economic conditions and loan losses, and let the Excel spreadsheets generate a set of numbers and ratios. These purport to estimate the "capital buffers" each institution has to have to weather a more severe economic downturn. A fairly simple exercise for any reasonably competent MBA.

The Reality.  What has been the true purpose of this exercise?  The answer can be found in John Maynard Keynes' "The General Theory of Employment, Interest, and Money."  But it has all to do with "confidence" and nothing to do with spending and fiscal stimulus. 

The answer is in Chapter 12, "The State of Long-Term Expectation."  Long term expectations, Keynes pointed out, do not depend solely on forecasts, but also depend upon "the confidence with which we make this forecast."  The state of confidence, in turn, is critical to determining the appetite for investment and enterprise. I suspect that more than a handful of Federal Reserve governors and staffers, and a few Treasury Department types, have been re-reading this classic essay in recent weeks.

In other words, since the rating agencies have been shown to be close to useless in such matters, and the credit default swap market had been so bad-mouthed by politicians and journalists, and the regulators themselves were shown to have been clueless, a hopefully credible alternative had to be immediately established.  

Washington's "stress tests" have been one in a series of actions designed to restore confidence in the financial system and among bankers.  This is to ensure that depositors and other lenders are comfortable in entrusting their funds to such institutions, who in turn will be able to extend credit.   

The Politics. The results of the stress tests rest on fairly credible assumptions: the "more adverse" stress simulation assumed a two-year loss rate of 9.1% of total loans (the highest rate in at least 90 years) and the highest unemployment rate since the 1930s. Ten of the 19 financial institutions evaluated were seen as needing to augment their "Tier I" capital to cope with such a  downturn, but the initial reaction in the market is that this should be feasible without a major problem.

As I have suggested in this corner before, "modern money is magic." Destroy my confidence in my bank - any bank - and you destroy money, as represented by that bank's deposits, as I withdraw my deposit and turn it into currency, gold, or some other borrower's liability (Treasury bills?). The stress tests, originally announced in February, were designed and orchestrated primarily to restore confidence in major financial institutions.

In short, the entertaining saga of the "stress tests"  has more elements of a long-running, elaborate Japanese noh drama than technocratic public policy - but that doesn't mean we can't congratulate the dramatists for a useful script.