Let me make no bones about it, Mr.Freud,
I have wracked my brains,
To know where you are coming from.
Where I am from, Mr. Freud,
Your subtleties and your caveats,
Your thousand insights into specifics,
Your bold assertions about generalities,
Sound like fairy-tale excursions into diseased minds.
I hear about the bride
Burned for dowry
By the surface monkey.
Thousands of brides
Burned by thousands of surface monkeys
In thousands of homes.
And horrific pictures from the war front,
Wars started by thousands of surface minds
That will give Cinderella to starving kids
And overlook the cinders of lost dreams.
Where is the magic wand
That can stop this malaise ?
Charity,
Like an inscrutable goddess,
Almost like a precious specimen in a museum
Show-cased to inspire awe,
Emerges in sporadic spurts of munificence,
To spreads her arms.
There’s my sculpture.
She is fully clothed.
That’s charity !
The dungeons of the mind
Carry wonderful gifts indeed !
Amidst the dread of hunger
And the nagging persistence of misery,
How do you coax archaic behemoths
To sanity ?
Tell me, and I will listen,
Let noble thoughts come to us from all sides,
Say the ancient Hindu seers.
Should we go looking for instinctual streams
That have evaporated in historical time ?
Or sift through the ceaseless refrains of our discourse,
Running in autocratic grooves,
For centers of meaning ?
by Choudhury Jayant Praharaj
The Global Analyst ( Commentary about economic, environmental, political and other topics )
Thursday, December 30, 2010
Wednesday, December 29, 2010
US Federal Reserve intervention in the Mortgage Backed Securities market
The housing market collapse about two years ago led the US Fed to step in and buy MBSs worth about one trillion dollars. Now, the Fed is planning to unload its MBS while buying Treasury bonds at the same time. As the Fed buys Treasury bonds, Treasury yields should decrease, everything else remaining same. As the Fed unloads MBSs, MBS yields should increase, everything else remaining same. Will additional MBSs be issued and sold in this environment ( in addition to the ones already on the market or in the possession of the Fed ) ? Will additional MBSs be lapped up enthusiastically by investors, as they were before the crisis unfolded ? Probably not to the same extent as before the crisis, since the risk perceptions have changed. The “fundamental” price of an MBS is based on the expected cash flows from mortgage loan repayments. Market madness and bubbles can drive the prices to levels very different from “ sane “ valuations. However, the current environment is unlikely to sustain this kind of madness. The “ fundamentals “ have once again become paramount. With high mortgage default rates and an uncertain economic environment, MBSs are no longer the prized assets they used to be before the crisis. So, there will be much less enthusiasm for any new MBS issue.
What are the current realities in the housing market ? Housing starts are depressed. Sales of new houses are low. And all this while mortgage rates have fallen through the official recession and even after the end of the official recession. People’s affordability perception for new homes has changed due to the current economic difficulties. Therefore, the effective ( economic ) demand for new mortgages has most likely gone down, driving the market mortgage rates lower.
Moreover, the ability to repay a mortgage is very much a function of the interest rate on the mortgage, in addition to the individual’s expected income levels and assets. The market may have gone into a mode where the mortgage-issuers are issuing new mortgages only to individuals with high credit-worthiness and at interest rates that ensure repayment. It is difficult to gauge from the available literature if this is a factor or not.
Also, the higher default rates and the previous crash of the MBS market means that investors will be less interested in buying new MBSs. Therefore, much less new money will be available for lending on the housing market. The fact that interest rates have gone down despite this dynamic means that one or both of the factors described in the previous two paragraphs are applicable to the current housing market.
So, back to the original question. Will the Fed’s unloading of 1 trillion dollars ( at current, pre-unloading valuation ) worth of MBSs over a year or a year and a half or over whatever length of time the Fed wants to do it lead to a second housing surge, if not a boom ? In other words, is the stage being set for a mini-boom ? In ideal environments, the value of an asset should reflect the actual expected cash-flow from holding the asset. The fact that the Fed was able to distort this process by buying the MBSs in the first place is cause for concern. Now, the Fed is going to distort the prices by making MBSs artificially more attractive than the fundamentals warrant. Either investors will respond to this madness or they won’t. If they do, the stage may well be set for the issuing of new MBS, a mini-bubble and a possible second financial crisis. If they don’t, the Fed MBS sales will not be worth 1 trillion dollars. The Fed will then adjust the amount of its Treasury bond purchase to keep the total cash injection to the 600 billion dollar value it announced. Hopefully, fundamentals will carry the day in the MBS market.
Which raises the question, why does the Fed need to unload the MBSs at all ? Since its cash injection aim can be achieved through purchase of Treasury bonds, why distort the MBS market yet again ? Hopefully, the MBS market will go by the “fundamentals” rather than by factitious momentum created by the Fed.
Also, it may be high time for debates into market failures in laissez-faire economies. A money-printing entity that responds to the failures of economic entities encourages moral hazard in different shapes and forms. However, as long as the mechanisms to prevent such market failures do not exist, these interventions will continue to be a necessary evil. Regulation over overly complicated derivatives is one way of preventing the market from losing touch with reality. Also, some optimists will argue that the simplest fix to the problem is to make sure that lending euphoria is curbed by strict evaluation of credit-worthiness. Why did this strict evaluation not happen prior to the last crisis ? Is it because the lenders weren’t careful enough ? Or is it because their calculations were thrown off by the impact of the recession on the cash flows of families ? The timeline shows that the slump in the housing market happened before the beginning of the official recession. So, most likely, the methods used to evaluate credit-worthiness were themselves flawed. The public still does not have a clear answer as to whether the housing glut was created due to the inability to implement good credit-worthiness criteria for extending loans.
Feasibility analyses may need to be done on possible insurance schemes that help cover for such exigencies. If reasonable and affordable insurance schemes cannot be devised, then it may be necessary to completely revise economic paradigms in order to prevent this kind of failure.
What are the current realities in the housing market ? Housing starts are depressed. Sales of new houses are low. And all this while mortgage rates have fallen through the official recession and even after the end of the official recession. People’s affordability perception for new homes has changed due to the current economic difficulties. Therefore, the effective ( economic ) demand for new mortgages has most likely gone down, driving the market mortgage rates lower.
Moreover, the ability to repay a mortgage is very much a function of the interest rate on the mortgage, in addition to the individual’s expected income levels and assets. The market may have gone into a mode where the mortgage-issuers are issuing new mortgages only to individuals with high credit-worthiness and at interest rates that ensure repayment. It is difficult to gauge from the available literature if this is a factor or not.
Also, the higher default rates and the previous crash of the MBS market means that investors will be less interested in buying new MBSs. Therefore, much less new money will be available for lending on the housing market. The fact that interest rates have gone down despite this dynamic means that one or both of the factors described in the previous two paragraphs are applicable to the current housing market.
So, back to the original question. Will the Fed’s unloading of 1 trillion dollars ( at current, pre-unloading valuation ) worth of MBSs over a year or a year and a half or over whatever length of time the Fed wants to do it lead to a second housing surge, if not a boom ? In other words, is the stage being set for a mini-boom ? In ideal environments, the value of an asset should reflect the actual expected cash-flow from holding the asset. The fact that the Fed was able to distort this process by buying the MBSs in the first place is cause for concern. Now, the Fed is going to distort the prices by making MBSs artificially more attractive than the fundamentals warrant. Either investors will respond to this madness or they won’t. If they do, the stage may well be set for the issuing of new MBS, a mini-bubble and a possible second financial crisis. If they don’t, the Fed MBS sales will not be worth 1 trillion dollars. The Fed will then adjust the amount of its Treasury bond purchase to keep the total cash injection to the 600 billion dollar value it announced. Hopefully, fundamentals will carry the day in the MBS market.
Which raises the question, why does the Fed need to unload the MBSs at all ? Since its cash injection aim can be achieved through purchase of Treasury bonds, why distort the MBS market yet again ? Hopefully, the MBS market will go by the “fundamentals” rather than by factitious momentum created by the Fed.
Also, it may be high time for debates into market failures in laissez-faire economies. A money-printing entity that responds to the failures of economic entities encourages moral hazard in different shapes and forms. However, as long as the mechanisms to prevent such market failures do not exist, these interventions will continue to be a necessary evil. Regulation over overly complicated derivatives is one way of preventing the market from losing touch with reality. Also, some optimists will argue that the simplest fix to the problem is to make sure that lending euphoria is curbed by strict evaluation of credit-worthiness. Why did this strict evaluation not happen prior to the last crisis ? Is it because the lenders weren’t careful enough ? Or is it because their calculations were thrown off by the impact of the recession on the cash flows of families ? The timeline shows that the slump in the housing market happened before the beginning of the official recession. So, most likely, the methods used to evaluate credit-worthiness were themselves flawed. The public still does not have a clear answer as to whether the housing glut was created due to the inability to implement good credit-worthiness criteria for extending loans.
Feasibility analyses may need to be done on possible insurance schemes that help cover for such exigencies. If reasonable and affordable insurance schemes cannot be devised, then it may be necessary to completely revise economic paradigms in order to prevent this kind of failure.
Tuesday, December 28, 2010
The American public debt and the fairness question
Whenever there is a large build-up of public debt, the question of inter-generational fairness becomes paramount. Actually, it is slightly more complicated than that. In addition to inter-generational fairness, it raises questions about the kind of society we want to have, that is, the question of intra-generational fairness also becomes relevant. Specifically, the level of egalitarianism in society is an issue that cannot be avoided if one wants to address this question seriously.
Let us address the second issue first. One has to answer the question – why do we have a welfare system at all ? Several answers can be given. It should be a no-brainer that the desire to have a humane society should be a major motivator for having a welfare system. However, given the paralysis of the system when it comes to making welfare systems solvent or strong now and for the future, one wonders whether, as a matter of statistics, these humanitarian instincts are dominant or not in a country like the United States. Other more cynical-sounding reasons can be proffered, like economic efficiency reasons. Different societies have different emphases when it comes to this question. The fact that Congress after Congress in the United States, Republican and Democrat, have gone along with the current kinds of levels of public spending is proof that the democratic system has voiced its opinion that the current welfare system is something desirable.
Next, let us address the question of inter-generational fairness. At small levels of public debt relative to GDP or to tax revenue, inter-generational fairness is not a burning issue. However, at high levels of public debt like we have currently in countries like the United States and Japan, inter-generational fairness becomes a crucial question. Most reasonable people will agree that, as far as possible, current generations should pay for current expenses. Because if they do not, and if the public finances have to be made solvent in the future, then future generations will have to shoulder the burden. An exception may be made for developing economies, which tend to have much higher growth rates, and which often have urgent needs for building infrastructure. When the government of a developing country goes for a large spending spree on infrastructure and accumulates a huge debt, it is typically done with the justification that the growth resulting from these projects will raise more than enough future revenues to pay back the debt. The same argument does not apply to developed economies, which tend to have much lower rates of growth. Therefore, with current realities, it is impossible to justify a large build-up of public debt and a large shortfall of tax revenues if one cares about inter-generational fairness. Even in a developing country, a government must be held accountable if it goes for excessive build-up of public debt without at the same time creating the conditions necessary for rapid future growth.
Are these issues intertwined ? To some extent, but not so much as to confound public policy in a country that cares for fairness, humaneness and stability. So, this article ignores the question of how these issues, the one of humaneness, the one of economic efficiency and the one of fairness, are interlinked. It does little to add any further clarity to the discussion, especially in a situation of debt-to-GDP ratios that approach 100% or higher.
Optimists are incorrigible when it comes to their optimism. I am sure there are some who will think along lines like this – since the current rich, who are not paying enough taxes to cover current expenditure, will most likely bequeath a part of their wealth to their progenies, some amount of fairness will be restored due to the inheritance tax. This argument will work only if the current rich want to and will indeed bequeath a substantial part of their wealth to their progenies. If instead, the current rich spend most of the wealth that they get to keep due to the elitist tax cuts of the last decade, then inheritance tax will be unable to restore the balance in the public finance. No one in their right minds will entrust the future health of the public finances to such questionable sources of revenue. Inter-generational fairness is unlikely to be restored by this method.
The question of how deep tax cuts should be if they are implemented in response to recessions is something that has not be subjected to careful analysis. In addition, there is the question of how long deep tax cuts should continue, especially when they threaten to lead to a huge build-up of public debt. Neither the question of intra-generational fairness nor the question of inter-generational fairness will become such big headaches if more carefulness is observed when cutting taxes. Similarly, neither of these questions will assume the level of exigencies if the political system can muster the will to reverse deep and prolonged tax-cuts when common sense dictates so.
Let us address the second issue first. One has to answer the question – why do we have a welfare system at all ? Several answers can be given. It should be a no-brainer that the desire to have a humane society should be a major motivator for having a welfare system. However, given the paralysis of the system when it comes to making welfare systems solvent or strong now and for the future, one wonders whether, as a matter of statistics, these humanitarian instincts are dominant or not in a country like the United States. Other more cynical-sounding reasons can be proffered, like economic efficiency reasons. Different societies have different emphases when it comes to this question. The fact that Congress after Congress in the United States, Republican and Democrat, have gone along with the current kinds of levels of public spending is proof that the democratic system has voiced its opinion that the current welfare system is something desirable.
Next, let us address the question of inter-generational fairness. At small levels of public debt relative to GDP or to tax revenue, inter-generational fairness is not a burning issue. However, at high levels of public debt like we have currently in countries like the United States and Japan, inter-generational fairness becomes a crucial question. Most reasonable people will agree that, as far as possible, current generations should pay for current expenses. Because if they do not, and if the public finances have to be made solvent in the future, then future generations will have to shoulder the burden. An exception may be made for developing economies, which tend to have much higher growth rates, and which often have urgent needs for building infrastructure. When the government of a developing country goes for a large spending spree on infrastructure and accumulates a huge debt, it is typically done with the justification that the growth resulting from these projects will raise more than enough future revenues to pay back the debt. The same argument does not apply to developed economies, which tend to have much lower rates of growth. Therefore, with current realities, it is impossible to justify a large build-up of public debt and a large shortfall of tax revenues if one cares about inter-generational fairness. Even in a developing country, a government must be held accountable if it goes for excessive build-up of public debt without at the same time creating the conditions necessary for rapid future growth.
Are these issues intertwined ? To some extent, but not so much as to confound public policy in a country that cares for fairness, humaneness and stability. So, this article ignores the question of how these issues, the one of humaneness, the one of economic efficiency and the one of fairness, are interlinked. It does little to add any further clarity to the discussion, especially in a situation of debt-to-GDP ratios that approach 100% or higher.
Optimists are incorrigible when it comes to their optimism. I am sure there are some who will think along lines like this – since the current rich, who are not paying enough taxes to cover current expenditure, will most likely bequeath a part of their wealth to their progenies, some amount of fairness will be restored due to the inheritance tax. This argument will work only if the current rich want to and will indeed bequeath a substantial part of their wealth to their progenies. If instead, the current rich spend most of the wealth that they get to keep due to the elitist tax cuts of the last decade, then inheritance tax will be unable to restore the balance in the public finance. No one in their right minds will entrust the future health of the public finances to such questionable sources of revenue. Inter-generational fairness is unlikely to be restored by this method.
The question of how deep tax cuts should be if they are implemented in response to recessions is something that has not be subjected to careful analysis. In addition, there is the question of how long deep tax cuts should continue, especially when they threaten to lead to a huge build-up of public debt. Neither the question of intra-generational fairness nor the question of inter-generational fairness will become such big headaches if more carefulness is observed when cutting taxes. Similarly, neither of these questions will assume the level of exigencies if the political system can muster the will to reverse deep and prolonged tax-cuts when common sense dictates so.
Taxes or spending ?
Whether the 1.4 trillion dollar US budget deficit should be balanced by increasing taxes or by decreasing spending is a question that is likely to be at the forefront of public policy discussions for quite some time to come. Republican intransigence will make it difficult to raise taxes. As for spending, the Republicans had control of the White House and of the Congress during the George W. Bush years. Yet even they could not cut spending to the level that could have balanced the budget, thereby proving that most of the spending is needed direly. The extra spending due to the wars started in the wake of the 2001 attacks is another matter. There can be different opinions about how necessary they were. But the build-up of the debt due partly to these wars has happened, and will create increasing strains on public finance in the future.
As for increasing taxes, there is what appears to be a conspiracy of inaction on this question. Any kind of excuse is brought forth about this. If there is a mild recession or a deep recession, then many pundits argue that increasing taxes is not a good idea. The justifications are often unclear. The usual argument goes like this. If, say, corporate taxes are raised, companies will invest less since their future profits will be taxed at a higher rate. This argument has serious problems. In a capitalistic economy, where most companies have strong competitors for most of their products, innovating and investing are necessary for competition. That my future profits will be taxed at a higher rate does not mean that I will stop innovating and investing and give my competitor a free run. Unless there is collusion between companies, a large-scale investment freeze due to higher tax rates is difficult to understand in a free market competitive environment. A large-scale investment freeze due to depressed economic sentiments makes more sense than one due to tax rate increase. When the public debt is not very burdensome, this kind of efficiency arguments can carry force. However, during times of high debt levels, this conventional wisdom may need to be challenged and subjected to scrutiny. Also, corporate tax revenues do not constitute that large a percentage of the total revenue. The historical data shows an increase of 100-200 billion per year in corporate tax receipts from lower corporate tax rates. However, this is small compared to the deficits.
Right now, companies are holding on to large amounts of cash. Whether they are doing it due to uncertainty about tax rate policy, or whether they are doing it due to a general environment of negative economic sentiments and depressed demands, is not clear. Once again, in a competitive environment, and in a world where new products need to be introduced almost as a matter of routine, the tax-policy component of this lack of investment enthusiasm is difficult to make sense of since any particular company and its competitor will face the same tax rates.
Also, if I am an owner of stocks, I and everybody else who has expendable money to buy stocks will face the same tax rates. Also, as a stock owner, to what extent will I forego the opportunity to buy additional stocks in a company that has an excellent innovation that it intends to incorporate in a new product ? Also, if I have money to buy stocks, and if the capital gains taxes are raised, will I buy more or less stocks ? It is a complicated question, and the response to higher capital gains taxes can be to buy more stocks or to buy less stocks depending on the circumstances of the individual.
How about income taxes ? What happens when income taxes on high income earners are decreased by a lot ? This is most likely to lead to a re-allocation of income towards luxury good compared to basic goods. If high income earners tend to save a larger fraction of their retained earnings, then it can also lead to an increase in savings available for investment. This can spur growth and create new jobs. However, it has to be correctly quantified lest its effect is exaggerated. Also, the question arises, why did this factor not lead to high enough revenue increases during the George W. Bush years to offset the effect of lower tax rates on the revenue ? In fact, if one compares the trend of income tax receipts as a percentage of GDP through the 1990s and the first decade of this century, it is quite clear that, depending on which year of the Clinton period is compared with which year of the George W. Bush period, income tax receipts as a percentage of GDP remained either the same or decreased from the 1990s to the middle of the last decade. If one compares the middle of the Clinton years with the middle of the George W. Bush years, which were non-recessionary periods, the income tax receipts were almost the same as a percentage of GDP. If one compares the highest income tax receipts of the Clinton years with the highest income tax receipts of the George W. Bush years, then they decreased from about 10% of GDP to about 8% of GDP. Also, GDP growth was no better during the George W. Bush years than during the Clinton years.
Even when the economy is out of a recession, there is paranoia about increasing taxes. Again, many of the same arguments are given, often without any cogent logic to them. High tax rates have existed in the past, and have had a positive effect on public finances. This is consistent with some of the arguments outlined above about competing companies, about the response of investing entities to increases in corporate or capital gain taxes and about the fact that GDP growth rates do not respond to tax decreases so drastically as to offset the effect of lower income tax rates.
What about a situation that involves a combination of deep recession by historical standards and also an alarming level of public debt, like now ? Even here, the paranoia about higher taxes may well need to be challenged. Actual historical effects of tax rates on GDP growth and on investor confidence need to be quantified. The bigger evil has to be identified. Excessively alarmist sentiments about higher tax rates can prove fatal. It may be better to have lower GDP growth rates if the reward is the avoidance of crisis-like situations like a debt default in the future. What about unemployment ? Is it better to risk lower growth and higher unemployment to make the system solvent now, or is it better to wait for the economy to recover ? The question is a difficult one, and I have not come across deep quantitative studies that address this trade-off. The instinct of this writer is that it is better to restore some of the higher income tax rates on the super-wealthy. The economy is growing according to official statistics even though unemployment numbers have stayed at >9.5% for more than a year. This is a better time to judiciously fix the revenue side than to wait for a crisis like a sovereign debt crisis. If a debt default occurs, all the trade-offs will become more difficult. Also, the reality is not encompassed by the efficiency aspect alone, as is often made out to be the case in debates. There is a fairness aspect also that tends to get overlooked. Alarmist sentiments can be justified only so much and not more. Judiciously identifying areas where taxes can be increased without affecting growth very negatively will be one of the tests of a mature administration and a mature Congress. Employment generation, growth and identifying ways to increase revenue are things that need to be addressed simultaneously, and not in sequence.
European countries typically tend to have high income tax rates and high payroll tax rates. This may be a good model to adopt in America as well. With such a distribution of tax rates, a lot of the problems facing the American economy now could have been avoided. The corporate profit plough-back component of investment is not affected directly by these tax rates. The stock ownership component, as argued above, can move in either direction, in response to higher income taxes. Whether such a judicious approach to revenue restoration will be followed may well determine if a bigger future crisis can be averted in America.
As for increasing taxes, there is what appears to be a conspiracy of inaction on this question. Any kind of excuse is brought forth about this. If there is a mild recession or a deep recession, then many pundits argue that increasing taxes is not a good idea. The justifications are often unclear. The usual argument goes like this. If, say, corporate taxes are raised, companies will invest less since their future profits will be taxed at a higher rate. This argument has serious problems. In a capitalistic economy, where most companies have strong competitors for most of their products, innovating and investing are necessary for competition. That my future profits will be taxed at a higher rate does not mean that I will stop innovating and investing and give my competitor a free run. Unless there is collusion between companies, a large-scale investment freeze due to higher tax rates is difficult to understand in a free market competitive environment. A large-scale investment freeze due to depressed economic sentiments makes more sense than one due to tax rate increase. When the public debt is not very burdensome, this kind of efficiency arguments can carry force. However, during times of high debt levels, this conventional wisdom may need to be challenged and subjected to scrutiny. Also, corporate tax revenues do not constitute that large a percentage of the total revenue. The historical data shows an increase of 100-200 billion per year in corporate tax receipts from lower corporate tax rates. However, this is small compared to the deficits.
Right now, companies are holding on to large amounts of cash. Whether they are doing it due to uncertainty about tax rate policy, or whether they are doing it due to a general environment of negative economic sentiments and depressed demands, is not clear. Once again, in a competitive environment, and in a world where new products need to be introduced almost as a matter of routine, the tax-policy component of this lack of investment enthusiasm is difficult to make sense of since any particular company and its competitor will face the same tax rates.
Also, if I am an owner of stocks, I and everybody else who has expendable money to buy stocks will face the same tax rates. Also, as a stock owner, to what extent will I forego the opportunity to buy additional stocks in a company that has an excellent innovation that it intends to incorporate in a new product ? Also, if I have money to buy stocks, and if the capital gains taxes are raised, will I buy more or less stocks ? It is a complicated question, and the response to higher capital gains taxes can be to buy more stocks or to buy less stocks depending on the circumstances of the individual.
How about income taxes ? What happens when income taxes on high income earners are decreased by a lot ? This is most likely to lead to a re-allocation of income towards luxury good compared to basic goods. If high income earners tend to save a larger fraction of their retained earnings, then it can also lead to an increase in savings available for investment. This can spur growth and create new jobs. However, it has to be correctly quantified lest its effect is exaggerated. Also, the question arises, why did this factor not lead to high enough revenue increases during the George W. Bush years to offset the effect of lower tax rates on the revenue ? In fact, if one compares the trend of income tax receipts as a percentage of GDP through the 1990s and the first decade of this century, it is quite clear that, depending on which year of the Clinton period is compared with which year of the George W. Bush period, income tax receipts as a percentage of GDP remained either the same or decreased from the 1990s to the middle of the last decade. If one compares the middle of the Clinton years with the middle of the George W. Bush years, which were non-recessionary periods, the income tax receipts were almost the same as a percentage of GDP. If one compares the highest income tax receipts of the Clinton years with the highest income tax receipts of the George W. Bush years, then they decreased from about 10% of GDP to about 8% of GDP. Also, GDP growth was no better during the George W. Bush years than during the Clinton years.
Even when the economy is out of a recession, there is paranoia about increasing taxes. Again, many of the same arguments are given, often without any cogent logic to them. High tax rates have existed in the past, and have had a positive effect on public finances. This is consistent with some of the arguments outlined above about competing companies, about the response of investing entities to increases in corporate or capital gain taxes and about the fact that GDP growth rates do not respond to tax decreases so drastically as to offset the effect of lower income tax rates.
What about a situation that involves a combination of deep recession by historical standards and also an alarming level of public debt, like now ? Even here, the paranoia about higher taxes may well need to be challenged. Actual historical effects of tax rates on GDP growth and on investor confidence need to be quantified. The bigger evil has to be identified. Excessively alarmist sentiments about higher tax rates can prove fatal. It may be better to have lower GDP growth rates if the reward is the avoidance of crisis-like situations like a debt default in the future. What about unemployment ? Is it better to risk lower growth and higher unemployment to make the system solvent now, or is it better to wait for the economy to recover ? The question is a difficult one, and I have not come across deep quantitative studies that address this trade-off. The instinct of this writer is that it is better to restore some of the higher income tax rates on the super-wealthy. The economy is growing according to official statistics even though unemployment numbers have stayed at >9.5% for more than a year. This is a better time to judiciously fix the revenue side than to wait for a crisis like a sovereign debt crisis. If a debt default occurs, all the trade-offs will become more difficult. Also, the reality is not encompassed by the efficiency aspect alone, as is often made out to be the case in debates. There is a fairness aspect also that tends to get overlooked. Alarmist sentiments can be justified only so much and not more. Judiciously identifying areas where taxes can be increased without affecting growth very negatively will be one of the tests of a mature administration and a mature Congress. Employment generation, growth and identifying ways to increase revenue are things that need to be addressed simultaneously, and not in sequence.
European countries typically tend to have high income tax rates and high payroll tax rates. This may be a good model to adopt in America as well. With such a distribution of tax rates, a lot of the problems facing the American economy now could have been avoided. The corporate profit plough-back component of investment is not affected directly by these tax rates. The stock ownership component, as argued above, can move in either direction, in response to higher income taxes. Whether such a judicious approach to revenue restoration will be followed may well determine if a bigger future crisis can be averted in America.
Sunday, December 26, 2010
Need a debt to revenue ratio metric - the dangers of inducing complacency and creating economic time-bombs
There is a lot of talk about the exploding debt to GDP ratio of the United States. In fact, the situation is dire around the world, with major economies like Japan sitting on mountains of debt. The official Chinese debt to GDP ratio is most likely misleading because it does not include debts of provinces and other government obligations. It is not clear if the official figure includes Chinese sterilization bonds. Japan has a debt to GDP ratio of over 200%, probably a record for advanced peacetime economies.
In this kind of situation, it is imperative to switch to other kinds of metrics that really characterize the true seriousness of the situation. Taxes cannot be increased or raised overnight because of political realities. Thanks to right-wing politicians and decades of intellectual brainwashing by right-wing economists, raising taxes to meet public finance needs is an uphill task. A debt-to-revenue ratio is a better metric for capturing the true urgency of the debt problem.
The public is often not aware of the dangers of exploding debt. Right-wing politicians talk glibly about balancing the budget by cutting spending, forgetting ground socio-economic realities. Public welfare systems provide much-needed and often indispensable assistance to those in distress. Also, doing away with too much of the welfare spending can easily have a negative impact on economic recovery during these difficult times. Even during good economic times, drastic welfare cuts can induce economic panic and recessions.
The United States gave a large tax cut to the wealthy and to corporations as it entered into major war spending around the world. Wars are supposed to be periods that require economic sacrifice. And common sense dicates that the rich, who have most to gain from security, should sacrifice more during wars. Just the opposite happened. And the community of economists were unable to highlight this incongruity to any significant extent. Right-wing economists of different colors and stripes are naturally enthusiastic about tax cuts. Left wing economists lacked clout in the right-wing Bush administration. War co-existed with a domestic picnic in the form of low tax rates for the wealthy and a booming housing market. I wonder what Mr. Tom Brokaw has to say about this generation - the most selfish generation ?
The battlelines have been drawn. Today's rich refuse to shoulder the burden of war expenditures and the burden of a much-needed welfare system. The stage is being set for significant economic distress for future generations. There may be a sovereign debt default by Japan and the US down the road, thereby constraining the ability of these governments to raise the debt necessary to meet their deficits. Given that the public is not well-versed in the nitty gritty details of public finance, politicians will not try to increase taxes due to their unpoularity. They will try to take the easier way out and try to do drastic cuts in public spending.
The United States had high tax rates in the 1990s with no deleterious effect on economic growth or corporate enthusiasm. A surplus was turned into recurring deficits due to decade-long tax cuts in the wake of a mild recession in the early 2000s. Throughout this decade, figures like Alan Greenspan called for reducing the deficit, always revealing their preference for spending cuts rather than reversing elitist tax-cuts. The damage has been done. It is very difficult to arouse the public will or the political will to raise taxes and to set the fiscal house in order during times of distress.
Future generations in these countries may well have to bear the major brunt of this mismanagement. Will social disturbance become the norm rather than the exception in these circumstances ? One is reminded of a poem by Langston Hughes, written in a different context and a different time, but which may hold lessons for this situation.
What happens to a dream deferred?
Does it dry up
like a raisin in the sun?
Or fester like a sore--
And then run?
Does it stink like rotten meat?
Or crust and sugar over--
like a syrupy sweet?
Maybe it just sags
like a heavy load.
Or does it explode?
Will a future society, groaning under an unmanageable public finance, and faced with the prospect of having to deal with new problems like green investment, explode in reaction to the fundamental and inherent inequities in the system ?
If a sovereign debt default does happen, will Japan, or the United States for that matter, have to go for shock-therapy-like steps involving drastic welfare spending reductions ? Will the tens of millions of Americans who depend on these payments and who have made significant contributions to the economy take such measures lying down ? At what level of economic pain will the public begin to lose faith in the rhetoric about efficiency ? What will the reaction be towards a political class that has mismanaged the public finances to such an extent ? Will the public take kindly to the rich of today, many of whom have lobbied Washington for tax cuts, and who have not showed a spirit of sacrifice when the country needed it ? Why will the class that supplies the majority of the war dead live in a spirit of compromise with the rich elites who do not sacrifice now for the country, and do not intend to sacrifice in the future for the country, if the welfare system becomes badly damaged due to deficits ? Rich innovators and rich entrepreneurs depend on a complex economic web that supports them and provides the conditions under which they are able to create wealth. As public finances become stressed, the poorer people will begin to question the value and utility of such innovations. Society itself may have to re-examine its priorities. National groups like Japan and the United States may have to re-examine what exactly it means to be a nation. At what level of economic parochialism does national cohesion becomes a meaningless thing ? What is the breaking point beyond which the public loses patience with the lack of a spirit of sacrifice on the part of the rich ?
In this kind of situation, it is imperative to switch to other kinds of metrics that really characterize the true seriousness of the situation. Taxes cannot be increased or raised overnight because of political realities. Thanks to right-wing politicians and decades of intellectual brainwashing by right-wing economists, raising taxes to meet public finance needs is an uphill task. A debt-to-revenue ratio is a better metric for capturing the true urgency of the debt problem.
The public is often not aware of the dangers of exploding debt. Right-wing politicians talk glibly about balancing the budget by cutting spending, forgetting ground socio-economic realities. Public welfare systems provide much-needed and often indispensable assistance to those in distress. Also, doing away with too much of the welfare spending can easily have a negative impact on economic recovery during these difficult times. Even during good economic times, drastic welfare cuts can induce economic panic and recessions.
The United States gave a large tax cut to the wealthy and to corporations as it entered into major war spending around the world. Wars are supposed to be periods that require economic sacrifice. And common sense dicates that the rich, who have most to gain from security, should sacrifice more during wars. Just the opposite happened. And the community of economists were unable to highlight this incongruity to any significant extent. Right-wing economists of different colors and stripes are naturally enthusiastic about tax cuts. Left wing economists lacked clout in the right-wing Bush administration. War co-existed with a domestic picnic in the form of low tax rates for the wealthy and a booming housing market. I wonder what Mr. Tom Brokaw has to say about this generation - the most selfish generation ?
The battlelines have been drawn. Today's rich refuse to shoulder the burden of war expenditures and the burden of a much-needed welfare system. The stage is being set for significant economic distress for future generations. There may be a sovereign debt default by Japan and the US down the road, thereby constraining the ability of these governments to raise the debt necessary to meet their deficits. Given that the public is not well-versed in the nitty gritty details of public finance, politicians will not try to increase taxes due to their unpoularity. They will try to take the easier way out and try to do drastic cuts in public spending.
The United States had high tax rates in the 1990s with no deleterious effect on economic growth or corporate enthusiasm. A surplus was turned into recurring deficits due to decade-long tax cuts in the wake of a mild recession in the early 2000s. Throughout this decade, figures like Alan Greenspan called for reducing the deficit, always revealing their preference for spending cuts rather than reversing elitist tax-cuts. The damage has been done. It is very difficult to arouse the public will or the political will to raise taxes and to set the fiscal house in order during times of distress.
Future generations in these countries may well have to bear the major brunt of this mismanagement. Will social disturbance become the norm rather than the exception in these circumstances ? One is reminded of a poem by Langston Hughes, written in a different context and a different time, but which may hold lessons for this situation.
What happens to a dream deferred?
Does it dry up
like a raisin in the sun?
Or fester like a sore--
And then run?
Does it stink like rotten meat?
Or crust and sugar over--
like a syrupy sweet?
Maybe it just sags
like a heavy load.
Or does it explode?
Will a future society, groaning under an unmanageable public finance, and faced with the prospect of having to deal with new problems like green investment, explode in reaction to the fundamental and inherent inequities in the system ?
If a sovereign debt default does happen, will Japan, or the United States for that matter, have to go for shock-therapy-like steps involving drastic welfare spending reductions ? Will the tens of millions of Americans who depend on these payments and who have made significant contributions to the economy take such measures lying down ? At what level of economic pain will the public begin to lose faith in the rhetoric about efficiency ? What will the reaction be towards a political class that has mismanaged the public finances to such an extent ? Will the public take kindly to the rich of today, many of whom have lobbied Washington for tax cuts, and who have not showed a spirit of sacrifice when the country needed it ? Why will the class that supplies the majority of the war dead live in a spirit of compromise with the rich elites who do not sacrifice now for the country, and do not intend to sacrifice in the future for the country, if the welfare system becomes badly damaged due to deficits ? Rich innovators and rich entrepreneurs depend on a complex economic web that supports them and provides the conditions under which they are able to create wealth. As public finances become stressed, the poorer people will begin to question the value and utility of such innovations. Society itself may have to re-examine its priorities. National groups like Japan and the United States may have to re-examine what exactly it means to be a nation. At what level of economic parochialism does national cohesion becomes a meaningless thing ? What is the breaking point beyond which the public loses patience with the lack of a spirit of sacrifice on the part of the rich ?
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