The Big Picture on Debt Part III. The Oracle of Omaha Speaks

Posted on August 12, 2014 by jackheidel

“I could end the deficit in 5 minutes. You just pass a law that says anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.” Warren Buffett, 1930 –

Mr. Buffett made this quip in a recent interview with CNBC. Since the economy has historically grown at a rate of about 3%, Mr. Buffett is saying that we’ll be alright as long as economic growth exceeds deficit spending. This is generally correct but, as Mr. Buffett well knows, the situation is more complicated than this.
A very good, and nontechnical, discussion of this whole subject can be found in the newly published book, “The Death of Money: the coming collapse of the international monetary system” by the financier James Rickards. Look at Chapter 7, “Debt, Deficits and the Dollar.”
Simplifying Mr. Rickards’ approach a little bit, and keeping it in Mr. Buffett’s framework, for a stable economy we need to have
G > D
where the nominal growth G = real GDP + I (I is the rate of inflation) and the deficit D = S – T (S is spending and T is tax revenue). I have included interest paid on the debt as part of total spending. As long as the left hand side is greater than the right hand side, the economy is growing faster than the deficit and the accumulated debt will shrink as a percentage of GDP. Notice that the rate of inflation affects the left hand side of the inequality while the interest rate is part of the right hand side.
Negative inflation is deflation which is clearly undesirable. The Federal Reserve’s current target for inflation is 2%. The challenge for the Fed is 1) to keep inflation high enough and interest rates low enough so that G > D, while at the same time, 2) to make sure that inflation does not grow so high as to destabilize the markets.
Given our underperforming economy with low real GDP growth, and huge deficits, Mr. Rickards is pessimistic that the Fed can continue successfully “in the position of a tightrope walker with no net … exuding confidence while having no idea whether its policies will work or when they might end.”
Thus the gloomy title for his book.

The Big Picture on Debt II. Why It Is So Alarming

Posted on August 10, 2014 by jackheidel

My last post, “The Big Picture on Debt,” used a chart from a recent Congressional Budget Office report (pictured below) to look at the history of U.S. debt. It is worse now than at any other time except at the end of World War II. But after 1945 massive military spending ended rapidly, the economy started growing briskly and debt as a percentage of GDP shrunk rapidly.
The light purple section at the right hand side of the chart portrays CBO’s debt projection for the next 25 years. As the report itself makes clear, CBO is using favorable economic assumptions in this projection. Without these favorable assumptions, our future debt will be much worse than this. And the same trends continue indefinitely into the future beyond the 25 year window.
Right now our huge debt is almost “free” money because interest rates are so low. But this situation cannot last much longer without setting off an inflationary spiral. As interest rates eventually resume their historical average of about 5%, interest payments on our accumulated debt will skyrocket and therefore increase the size of the annual deficits.
There are only three ways to shrink debt as a percentage of GDP: 1) cut spending, 2) achieve faster growth and 3) raise tax revenue. Let’s look at each in turn:

Government spending as a percentage of GDP is not shrinking but actually growing. Primarily this is because of the massive growth of the big three entitlement programs: Social Security, Medicare and Medicaid. All other government spending is subject to Sequester limits. This is a crude and insufficient way to control discretionary spending.
GDP growth, averaging 2.2% annually since the end of the Great Recession five years ago, is much slower than the overall average growth of 3.3% since the end of WW II. Major tax reform at both the individual and corporate levels, with lower tax rates offset by closing loopholes and shrinking deductions, would give a big boost to economic growth. But there is resistance to cutting tax deductions.
Raising taxes will in principle decrease deficit spending but the trick is to do it without hurting economic growth. Both individual and corporate tax reform could accomplish this if done in the right way. See here and here for specific proposals.

Conclusion: there are concrete ways to find solutions to get our massive accumulation of debt under control and shrinking as a percentage of GDP. But the prospects for action are gloomy.

The Big Picture on Debt

Posted on August 7, 2014 by jackheidel

Most observers agree that the Congressional Budget Office is a reliable source for detailed, objective and nonpartisan information about the federal budget. Its frequent reports are cited by all sides in budget debates. Today I refer to the recent CBO publication, “The 2014 Long-Term Budget Outlook in 26 Slides.” In particular, one of its graphs entitled “Federal Debt Held by the Public” (pictured here) has a striking message.
Throughout history, the U.S. has had relatively large debt following each of its major wars, especially after World War II. But the debt has always declined relatively quickly, as a percentage of GDP, as the economy recovered and grew briskly. But now, in 2014, we are stuck with a huge debt which is projected (by CBO) to not shrink but rather to keep getting much worse. And furthermore, the so-called “Extended Baseline Projection” in the graph, is an optimistic projection which disregards several long-term trends such as mortality decline, possibly slower productivity growth, higher interest payments and likely growth of federal healthcare spending.
How in the world will this huge debt problem be resolved in a favorable manner? Republicans don’t want to raise taxes and Democrats don’t want to cut spending, especially on entitlements. The only action taken in the last few years, under threat of not lifting the federal debt limit, was to implement a Sequester on discretionary spending. This helps but not nearly enough.
Recent budget agreements are not auspicious for future progress. A five year farm bill was passed last spring without significant cuts to either farm subsidies or food stamps. Highway spending was extended for a few months with a gimmick when what we really need to do is increase the federal gasoline tax. A $17 billion (over three years) increase for veteran’s health has just been approved when what we really need is an extensive overhaul of the Veterans Administration.
There are deficit hawks in Congress, on both sides of the aisle, but their numbers are too small to be effective. It is just very hard to vote no on spending measures when the pressure coming from special interest groups on all sides is to vote yes.
I am an eternal optimist by nature but I have a hard time visualizing a favorable outcome to our fiscal dilemma. I am arranging my own affairs accordingly.

Five Sectors to Blame for Economic Weakness

Posted on August 5, 2014 by jackheidel

Several of my recent blog posts have addressed various issues relating to our slow growing economy. In particular I have proposed a simple way to speed up economic growth: namely, broad-based tax reform at both the individual and corporate levels. The idea is to lower tax rates across the board, paid for by closing loopholes and shrinking deductions. At the individual level this could have the effect of putting as much as $250 billion per year in the hands of the middle and lower income wage earners who will surely spend most of it, thereby giving the economy a big boost. The U.S. corporate tax rate is not internationally competitive.
In today’s New York Times the economics writer, Neil Irwin, has an article “Why Is the Economy Still Weak? Blame These Five Sectors.” The five sectors are, in order of magnitude of effect: housing, state and local governments, durable goods consumption, business equipment investment, and federal government. See the chart below.
Let’s look in turn at each of these top five barriers to faster economic growth:

Housing. Not at all surprising with 24 million people either unemployed or underemployed. Young people especially cannot afford to buy their first home today.
State and Local Governments. These governmental units have to balance their budgets. When people have more money to spend, tax revenues will increase and so will public spending.
Durable Goods Consumption. These same 24 million people aren’t buying much new furniture or many new cars either. It makes complete sense.
Business Equipment Investment. Lower corporate tax rates will incentivize our multinational firms to bring their foreign profits back home for reinvestment.
Federal Government. Unfortunately nothing can be done about this category! Federal deficit spending is way too high as it is and must come down.

Conclusion: Using broad-based tax reform to put a large amount of money in the hands of middle and lower-income wage earners, and also reforming corporate taxes, will boost spending for four of the five main barriers to faster economic growth. Why don’t we do it?

How to Increase Growth and Decrease Inequality at the Same Time II. A Concrete Example

Posted on August 3, 2014 by jackheidel

The United States has two fundamental economic and fiscal problems at the present time. First of all, the economy is growing too slowly to create enough new jobs. In fact, there are now 24 million people either unemployed or underemployed. Secondly, federal tax revenue is not sufficient to pay the bills. Of course, these problems are interrelated. If the economy were growing faster, more tax revenue would be generated and deficit spending would be lower.
At the same time, changes in society, such as globalization and technological progress, are creating higher levels of inequality. Economic inequality is inevitable in a free society but too much of it will create resentment. The best way to minimize such resentment is to make sure that incomes are rising for all. In other words, first speed up growth. If inequality can also be reduced, so much the better.
A few days ago my post “How to Increase Growth and Decrease Inequality at the Same Time!” presented such a plan. The idea is to enact broad-based tax reform, whereby tax rates are lowered for everyone, offset by shrinking tax deductions. The 64% of taxpayers who do not itemize deductions will receive a big tax cut. Since they are the lower and middleclass wage earners with stagnant incomes, they will tend to spend their tax savings, thereby giving the economy a boost. But this means that the 36% of (wealthier) taxpayers who do itemize deductions will, on average, end up paying higher taxes. Overall, this represents a shift from the wealthy to the less wealthy and therefore lessens inequality.
Here is a concrete example to illustrate the magnitude of what can be accomplished:

Individual tax deductions total about $1 trillion per year.
Let’s suppose that these deductions are cut in half to $500 billion per year.
Let’s further suppose that half of this amount, or $250 billion per year, is cut from the taxes of the 64% who do not itemize deductions.
If these 64% spend just 2/3 of their new income (instead of saving it or paying off debt), this will total $170 billion which is 1% of GDP.
This would increase the rate of growth of GDP from the 2.2% average, since the end of the Great Recession, to 3.2%. This represents an enormous boost to the economy and would return average GDP growth to about its 3.3% average since 1947.

I emphasize that this is an oversimplified illustrative example to demonstrate what can be achieved with a plan of this nature. Hopefully it will be more thoroughly analyzed by an expert economist, which I am not!

How to Increase Growth and Decrease Inequality at the Same Time!

Posted on July 31, 2014 by jackheidel

The Department of Commerce has just reported basic economic data for the second quarter of 2014. As the chart below shows, the economy gradually lost steam from 2004 – 2008, sunk badly in 2008 and 2009, and has now grown at a slow but steady rate of about 2% during the period 2010 – 2014.
One of my favorite journalists, the New York Times’ economics reporter Eduardo Porter, has just written again on the topic of inequality, “Income Inequality and the Ills behind It.” He quotes the economist Tyler Cowen as saying “The right moral question is ‘are poor people rising to a higher standard of living?’ Inequality itself is the wrong thing to look at. The real problem is slow growth.” The economist Gregory Mankiw is quoted as saying that “Policies which address the symptom (of inequality) rather than the cause include higher taxes and a more generous safety net. The magnitude of what we can plausibly do with these policy tools is small compared to the size of the growing income gap.”
What Mr. Cowen and Mr. Mankiw are both suggesting is that we can’t effectively attack income inequality without also increasing economic growth. I believe that it is possible to address both problems at the same time by implementing broad-based tax reform as follows:

Individual income tax rates should be lowered across the board, paid for by closing loopholes and shrinking deductions, in a revenue neutral way.
The 64% of all taxpayers who do not itemize deductions will get a significant tax cut. Since they are largely the middle and lower-income wage earners with stagnant incomes, they will tend to spend their tax savings, thereby giving the economy a big boost.
At the same time the 36% of taxpayers who do itemize their deductions will, on average, see their income taxes go up. But these are, on the whole, the wealthier wage earners who can afford to pay higher taxes.
A plan such as this represents a shift of net after-tax income from more wealthy people to the less wealthy. It therefore reduces income inequality.

If we can cut tax rates, increase economic growth and reduce income inequality all at once, why can’t our national leaders come together and act along these lines?

Stopping Corporate Tax Dodgers

Posted on July 29, 2014 by jackheidel

Several large U.S. companies have recently announced that they are planning to merge with foreign companies and move their corporate headquarters to a low tax country such as Ireland or Great Britain. The Obama Administration proposes to disallow such “tax inversions” by requiring that after such a merger at least 50% of the stock of the new company would have to be foreign owned. Otherwise the firm would still be considered American for tax purposes. Such a technical fix is unlikely to solve a much more fundamental problem.
As the latest issue of the Economist, “How to stop the inversion perversion,” makes clear, “America’s corporate tax has two horrible flaws. The first is the tax rate, which at 35% is the highest among the 34 mostly rich-country members of the OECD. … The second flaw is that America levies tax on a company’s income no matter where in the world it is earned. In contrast, every other large rich country taxes only income earned within its borders (a so-called ‘territorial system’). Here, too, America’s system is absurdly ineffective at collecting money. Firms do not have to pay tax on foreign profits until they bring them back home. Not surprisingly, many do not: American multinationals have some $2 trillion sitting on their foreign units’ balance sheets.”
A relatively simple solution to this glaring problem would be to lower the corporate tax rate to 25%, the OECD average, and shift to a territorial system. Revenue losses would be offset by closing loopholes and deductions.
A better, but likely more controversial, solution would be to completely eliminate the corporate income tax and then tax dividends and capital gains at the same rate as earned income. This would avoid the double taxation problem whereby profits are taxed first at the corporate level and then again for individuals as dividends and capital gains.
The overall goal in this entire endeavor should be to boost the economy, thereby creating more jobs, and additionally to raise the tax revenue needed to pay our bills. Fairness is important but growth is even more important!

How to Improve America’s Welfare System

Posted on July 27, 2014 by jackheidel

Several months ago I had a post entitled “A Balanced and Sensible Antipoverty program,” describing four characteristics of effective antipoverty programs: work requirements, work incentives, supporting married, two-parent families, and supporting business growth.
The Budget Committee of the House of Representatives has just released the outline of a new plan, “Expanding Opportunity in America,” designed to implement the above basic principles of welfare reform. The introduction states that “Fifteen percent of Americans live in poverty today – over 46 million people. … A key tenet of the American Dream is that where you start off shouldn’t determine where you end up. … Of all Americans raised in the bottom fifth of the income scale, 34% stay there and just 38% make it to the middle class or above (see the chart below).”
The idea is to let selected states experiment in consolidating separate means-tested programs such as SNAP, TANF, child-care and housing assistance programs, into a new holistic Opportunity Grant program. The purpose is to make these programs more effective in lifting welfare recipients out of poverty. Here is how the program is envisioned to work:

Each participating state will approve a list of certified providers who are held accountable for achieving results such as moving people to work, out of poverty and off of assistance.
Needy individuals will select a provider who will conduct a comprehensive assessment of that person’s needs, abilities and circumstances.
The provider and the recipient will develop a customized plan and contract both for immediate financial needs and also for long term goals towards self-sufficiency.
Successful completion of a contract will include able-bodied individuals obtaining a job and earning enough to live above the poverty line.

The U.S. is currently spending over a trillion dollars a year on welfare programs for low income families and individuals. A good way to increase both the efficiency and effectiveness of federal programs is to shift them over to state control. The Opportunity Grant program proposes to do this on an experimental basis. It makes good sense to try it!

How Likely Is Financial Collapse?

Posted on July 24, 2014 by jackheidel

The financial crisis of 2008 was the biggest shock to our financial system since the Great Depression of the 1930s. It caused a deep recession from which we are still recovering. To aid the recovery the Federal Reserve launched an unprecedented expansion of the money supply, referred to as quantitative easing, as well as keeping short term interest rates near zero. As explained by James Rickards, a portfolio manager at West Shore Group, in his new book, “The Death of Money, the coming collapse of the international monetary system,” such a severe recession would normally have caused a corrective period of deflation. Quantitative easing has warded off deflation and, so far, without igniting inflation.
We are now in a catch-22 situation. Congress could and should adopt several policy changes to speed up the recovery as I described several days ago in “The Federal Reserve Cannot Revive the Economy by Itself.” But, if and when the economy does start growing faster, it will require great skill by the Fed to exit from its current policies without harm. If it contracts the money supply too quickly, it risks a sharp rise in interest rates. If it contracts the money supply too slowly, it risks a sharp rise in inflation. Mr. Rickards doubts that the Fed will be able to accomplish this fine tuning without another major crisis. Here are his Seven Signs of what to look for:

The price of gold ($1300 per ounce today). A rapid rise to $2500 will anticipate inflation. A rapid decrease to $800 signals severe deflation.
Gold’s continued acquisition by Central Banks. Large purchases by China, for example, will announce inflation.
IMF governance reforms, e.g. towards more voting power for China, will be an inflation warning.
The failure of regulatory reform, i.e. reinstatement of Glass-Steagall in addition to the Volcker Rule, will increase the chances of systemic failure.
System crashes, resulting from high-speed, highly automated, high volume trading. An increasing tempo of such events will cause disequilibrium which could close markets.
The end of QE, could give deflation a second wind and lead to a new round of QE.
A Chinese collapse (predicted by Rickards), will lead first to deflation and then inflation.

We all hope that the Federal Reserve can steer clear of a new, and much deeper, financial crisis. But it doesn’t hurt to have guideposts and Mr. Rickards knows what he’s talking about.

Bush Was a Disaster; Obama Is Merely Ineffective

Posted on July 22, 2014 by jackheidel

As Barack Obama nears the three-quarter’s mark of his presidency, it is natural that he and George W. Bush will be compared to one another. I consider them both to be disappointing presidents but in very different ways.
First, the sins of George Bush:

The Bush Tax Cuts of 2001-2003 lowered tax rates without being offset by closing loopholes and/or shrinking tax deductions. This made his huge budget deficits much worse than they otherwise would have been and without helping the economy.
The Iraq War. Regardless of whether or not the U.S. was justified in invading in 2003, the current ISIS uprising of Sunnis is likely to result in a worse outcome than existed before the U.S. invasion. This will come to mean that Iraq was a mistake.
Medicare Part D (2003). The Prescription Drug program now costs the federal government about $100 billion per year. It makes the unsustainable cost of Medicare that much worse.
The Financial Crisis of 2008. This represents an even bigger stain on his record. He appointed all of the key players such as Ben Bernanke, Tim Geithner and Henry Paulson who failed to see it coming. He also appointed Sheila Bair as head of the FDIC in 2006. She did see it coming but it was too late and she didn’t have enough clout.

Mr. Obama is very bright and articulate. But he has made many serious mistakes including:

His total immediate attention in 2009 should have been on reviving the economy. Instead he and the filibuster-proof Democratic Congress pushed through the Patient Protection and Affordable Care Act. The employer mandate of Obamacare, even though postponed by the administration, has slowed down the economic recovery by making it more expensive for businesses to hire full time employees.
For all of his nonpartisan campaign rhetoric about “change we can believe in,” he has been one of the most divisive and partisan presidents in many years. This has created huge animosity and distrust amongst his political opponents which makes it difficult for the two sides to negotiate differences in good faith.
The most glaring example of this is the anemic 2.2% annual growth of the economy since the Great Recession ended in June 2009. Many economists agree that cutting both individual and corporate tax rates, offset by closing loopholes and deductions, would be hugely beneficial in boosting the economy. It would put millions of people back to work and shrink our huge deficits. Why isn’t the President talking about this and leading the charge? But, of course, this was the Romney tax plan in 2012. What’s wrong with the election winner adopting the best parts of the program of the election loser? Now that would be demonstrating real leadership ability!

It Does Not Add Up

Jack Heidel's blog on fiscal responsibility