Friday, July 16, 2010

The Dirty Dozen of Economic Mismanagement

I thought I got a lot of flak from my Republican friends about my opinion that Bush was incompetent. (I also got some flak from my Democrat friends about my opinion that Bush was well-intentioned.)

However, even a lot of Republicans would agree once I had set out my opinions about Bush - There's a difference between idea and execution, and you don't have to oppose the idea of going to war in Afghanistan or Iraq in order to oppose his particular mismanagement of that war. Some would agree, some wouldn't, but they'd listen.

The level of vitriol I get for my opinions about Obama, however, is on another level of magnitude. The mainstream media reports a great deal on fringe Republicans who believe anything bad said about any Republican is an excoriable heresy, but certainly personally, where I know a lot more fringe Democrats than fringe Republicans, I know a lot more Democrats who are unable to hear anything contrary to Progressive ideology and respond to it reasonably.

Setting aside the psychology of group creation and unreasonable in-group vs out-group response, however, an outline of the exact reasons for my opinions on Obama starts to tell a story that looks a lot like the Bush story, with the economy as the backdrop instead of war - maybe he means well, but the economy cares about Progressive economic ideals about as much as the climate cares about Conservative energy ideals, and in dealing with the actual economy, he is stunningly, historically incompetent.

I will deal with the twelve steps that have concerned me most (hence "the dirty dozen") step by step, with sources listed as necessary in each step.

1) Healthcare reform.

The US seems to have divided itself into two camps: the pre-2010 system supporters and government healthcare supporters (including Obamacare). This dichotomy has never made any sense to me, because as with a war in Afghanistan and Iraq, there's a difference between concept and execution when it comes to universal healthcare - you can oppose Obamacare and still support universal healthcare. Healthcare is also not a unitary good - you don't "have healthcare" or "not have healthcare", you have different levels of healthcare, which makes defining "universal healthcare" more difficult than it appears. The only way healthcare is unitary is if everybody needs to have exactly equal healthcare access, but this is suboptimal - if I have 1000 dollars and you have 100 dollars, it doesn't help you if I burn 900 dollars to make us equal. The goal should have been "give everybody a baseline level of healthcare, and subject to that constraint, minimize the difference between desired level of healthcare and actually given level of healthcare". This doesn't lend itself to a centralized system. What should have been fortunate is that there are plenty of ways to provide a baseline level of healthcare to everyone and kill pre-existing conditions, and not all of them require a centralized bureaucracy.

Still, with Democrats in power, we got a centralized system anyway (RIP Wyden-Bennett), which I've written about at length (footnotes 1.1, 1.2 and 1.3 are the highest-level looks at the healthcare system).

Nobody seriously thinks that healthcare reform is going to reduce healthcare spending - every structural piece, every known economic theory and the experiences of Massachusetts healthcare (and Florida hurricane insurance, as well) indicates that healthcare costs will accelerate, and the government will consolidate more insured onto their books at great expense. The CBO came out and admitted this two weeks after the bill passed - they acknowledged that it almost certainly increases the deficit and definitely doesn't bend the cost curve.

Employers thus face a triple whammy: 1) prospective significant healthcare cost increases per employee, 2) prospective significant tax increases to offset the increased deficit, and 3) the uncertainty of another healthcare bill in the next 10 years to try and fix the problems this bill was supposed to fix, which puts them in limbo. What's the logical response? Hire less employees (shifting from labor to more tax-advantaged depreciable capital when possible), and tax shelter as much of your operations as you can by shifting as much investment as possible from the US to abroad. This harms employment, this harms spending, and leads to cash pileup on balance sheets. Anyone noticed any of these things recently?

1.3 What healthcare reform should have looked at

2) Financial reform

This one's insidious because most people don't understand what they're looking at, at all. The bill is not outright destructive the way healthcare was, but it does increase overall uncertainty (what's the next big unpredictable reform the Obama administration is going to come up with?), and more to the point, it is completely useless. The financial reform bill doesn't address a single thing that could cause this crisis or any other. It's an excuse to shepherd consumer protection laws through (most of which aren't terrible, theyr'e just orthogonal to serious reform, though there's a case for the idea that the interchange fee regulation is bad - see footnote 2.1 ) and to bash banks with buzzwords like "swaps" and "derivatives".

This bill does not address moral hazard at ALL (you don't wanna deal with moral hazard when its time to pay out, you wanna deal with it before the bad behavior can be undertaken - as in, now). The bill also seems to follow the logically incomprehensible dictum that (i'm paraphrasing one of the NY Times columnists here) "the establishment never caught this crisis, so let's make it more powerful and rely on it EVEN MORE next time." You see no market-distributed risk assessments (contingent convertible debt for banks, for example), you see no specific new incentives for banks to self-regulate (my idea of an accelerating bailout tax for banks), you do see a lot of very skirtable rules on capital requirements (which they had to do, but are hard to do perfectly), you see some odd and likely counterproductive restrictions on how banks are able to offload risk with derivatives (because everyone assumes that derivatives are to pad a bank's bottom line, not to offset risk - sometimes true, but just as often not true), and you increase uncertainty with the condition that the government can seize any firm deemed to be a systemic risk, as designated by some council of regulators with no guidelines at all. Isn't that what crushed the market after Lehman and Fannie/Freddie failed (that's on Paulson/Bush, not Geithner/Obama)? People thought they knew what would happen to their securities (in this case, a government bailout), then they get surprised by Lehman's equity getting wiped out and the completely useless evisceration of Fannie/Freddie's preferreds, and everyone decides to offload everything because it's too uncertain to own anything but cash anymore? Isn't certainty a good thing? Also, as another note, why are they auditing the supposed-to-be-independent Fed? I appreciate the importance of transparency (I will be talking more about this at length in my discussion on housing below), and I suppose from that perspective it's a good thing, but if it gives Congress license to shove the Fed around for political aims, then it's a really, really bad idea.

(EDIT: I didn't realize this bill still held the ratings agencies legally liable for their ratings. That is a TERRIBLE idea. See 2.3 below)

Let's put it this way: I don't claim to know comprehensively what should go into financial reform, but there are a number of features which I know would have helped - maybe more things were needed, but these ones would all be helpful, I think. Of that list (footnote 2.2), which had 19 things, there were perhaps 4 that got implemented. There were also some things which I thought would be explicitly harmful. Of the things I thought would be harmful (a list of 5 things), 3 were implemented.

 2.3 Holding the credit ratings agencies legally liable for ratings raises the cost of capital.

3) Stimulus and the prospect of uncertain future taxes

It is my opinion (I haven't seen it elsewhere) that the decision rule for government spending should fulfill a pretty basic hurdle rate formula (footnote 3.1). The economic impact of any spending should be greater than the combined effect of interest payments on the debt used to fund it, the crowding out effect impact, and the effect of raising taxes later to pay off that debt. Even relaxing that to make it practical, you can justify ignoring the latter effect (effect of later taxes) if there is some unmeasurable but definitely-bad effect of a particularly deep downturn today - in other words, if the range of outcomes could get really bad now because you're in a collapse, you can justify redistributing future economic benefit to today to be safe. Still, that means you need impact to exceed your own interest costs - not just present interest costs, but all interest costs you will incur on that debt before paying it off.

Now, in a downturn crowding out is minimal, but interest costs, while presently low, have to have some of the long term rate incorporated in, or else you'll end up spending a ton now with low interest costs and get CREAMED when you have to refinance.

Which brings us to stimulus. Again, we look at "idea vs execution". We absolutely needed a stimulus bill, there's no question about that. However, it was important that if we were threatening the US credit situation, we needed to get bang for our buck - in other words, maybe you'll create uncertainty and bond worries, but you'll be using the money to such great effect that the effect is outweighed.

Instead, we got an absolute atrocity of a bill.

It was protectionist (sparking serious trade concerns, which is exactly what we DIDN'T need at that point - I'll talk about trade again later, as well). It required only union labor, which is way more expensive and got us significantly lower stimulus efficiency. Going line-by-line through the stimulus, about a third of it was total pork, fulfilling a Democratic wishlist. (The exact number I got was 36.5%, but I also understand that a lot of issues could have gone either way, and even now, there are elements I would have changed my tone on.).

If you're going to create the prospect of substantial future taxes while increasing the US interest payments and debt servicing burden, you need to get bang for your buck. This is especially true if it's the one shot you have, because the debt markets would clearly not support another stimulus of that size at this point. Social safety net provisions are important, but this stimulus needed to be designed to impact the economy absolutely maximally, not fulfill 8 years of pent-up Democratic angst. Even the classically good stimulus provisions were misimplemented - high speed rail lines are a decent investment if done in the right place (though many would argue that buses are a better focus of public transport), but the high speed rail lines being installed are going through areas with no population density and will never earn back their cost (the best measure of economic impact). They should have been built in Southern California and the Northeast Corridor, but political payoffs dominated smart stimulus design.

Was the stimulus too big or too small? It's hard to tell, when the impact of the trillion dollar stimulus was probably what you would have gotten out of a better-designed stimulus half the size. The sad thing is that there are plenty of areas we really do need to upgrade spending on (the electricity distribution grid is in critical need of major upgrades just to avoid brownouts and blackouts, to say nothing of handling a more variable solar/wind load, the highway system is a disaster, etc), but the focus on "shovel-ready" projects meant all of the projects were crappy. Implement the better, slower projects, cut the pork and pay it out as a payroll tax cut, NEXT YEAR. That way, employers don't fire as many people (this upcoming year, employees will cost less) and by the time that wears off, you'll have projects gearing up. This wasn't that hard to design, but Democratic supermajority killed any prospect of a bipartisan compromise (which is what this would have resulted from).

4) Unemployment extensions

I mentioned earlier that the economy cares about progressive ideals about as much as the climate cares about conservative energy ideals, and this is particularly apparent here. Yes, it'd be nice if we could give everyone as much unemployment as they needed without disincentivizing them from retraining for new work or finding a new job. It'd also be nice if we could burn coal forever and not worry about climate change. It's been estimated that unemployment extensions have added between a percentage point and a percentage point and a half to the unemployment rate. Certainly, I don't buy into the right ideology that unemployment makes people just coast on the government forever, but the left ideology that unemployment benefits are so low that nobody would not find a job because of them is just as incorrect. The most plausible condition on this, to me at least, is that people look, but are way more selective about what jobs they'll take until their unemployment is about to run out. That's not a good thing in high unemployment conditions - if people take a worse job, and then when employment is higher find the job of their dreams, it costs less for everyone and they themselves are more marketable (long unemployment makes you less marketable).

The sad thing is, there's a happy medium. I had the idea of starting unemployment at a higher rate and decreasing the payout weekly, so people don't wait to find a new job. Scott Sumner suggested unemployment be paid as a lump sum. But ideology won out over pragmatism here, and unemployment suffers as a result of it.

There's another problem here that people talk about less. Businesses pay an unemployment tax per worker based on the level of unemployment benefits provided by the government, so increased unemployment benefits actually serve as a disincentive to hiring. So all of these unemployment extensions actually increase unemployment by destroying jobs.

5) expiration of the Bush tax cuts

The prospect of a future tax increase makes people save more of their current salary in the presence of partial (or, heaven forbid, full) Ricardian equivalence. Of course, the paradox of thrift is that we need people spending now, not saving. We also need people producing as best as we can, and increasing tax rates on high-income people to that extent also disincentivizes work. Finally, taxes on dividends are going back up to 40%. This encourages businesses to just stockpile cash on their balance sheets to wait for a good time to buy back stock, instead of paying out cash as dividends that would actually get spent by recipients.

It's unbelievable to me that people actually are excusing the fact that Obama and the Democrats are allowing income taxes to go up in the MIDDLE OF A RECESSION/DEPRESSION. I say only half-jokingly that this alone should be enough to impeach for incapacity. The deficit is really important (lord knows I talk about it a lot) but you don't focus on the deficit in the middle of a recession, you focus on convincing people now that the deficit will be fine later, so they don't need to save for higher future taxes. This literally looks to me like Obama is saying "this is the only possible way I can raise taxes without causing an uproar, so timing be damned, I'm raising income taxes!" It is ideological petulance at its worst - if he wants to raise taxes on private incomes/spending (which seems to be the lazy and inefficient way out, relative to cutting the much more wasteful government spending), he could at least extend the Bush cuts by 2 or 3 years. That keeps the long-term fisc relatively the same (taxes still are going up), doesn't cut government spending (sigh) but doesn't RAISE INCOME TAXES IN THE MIDDLE OF A DEPRESSION.

6) Budgets and the prospect of neverending deficits above a sustainable (~2%) rate

Obama used accounting sleight of hand in his most recent government budget. He treated the short-term (by government standards) military expenses of Iraq and Afghanistan as permanent spending, so that government expenditure does not have to come down at all when Iraq and Afghanistan costs go down. The funny thing is that liberals EVISCERATED Bush for spending that much on a war, but excuse Obama trying to spend that much forever.

Even so, Obama has found enough other various avenues of spending that his long term budget deficits are 50% higher than Bush's ever were going to be, assuming Obama's own very rosy economic forecasts (which everyone has criticized as being too optimistic, and the last year has borne that out).

7) Even allowing chatter of things like a VAT

Business leaders respond to anticipated laws - they have to - so allowing chatter of a VAT is a TERRIBLE idea in a recession, along the same cardinal problem as allowing income taxes to go up in a recession/depression. If you're a business, and you're looking at the prospect of a VAT, and looking at how fast it swelled to a high rate in the rest of the OECD, why on earth would you hire a single worker or build a single factory here if you could avoid it? Wouldn't anyone even remotely close to the "US or Foreign production?" margin either just build abroad or decide to wait until this has shaken out?

A competent leader would have come out and unequivocally said "I will veto any attempt to create a VAT for the foreseeable future" and left it at that. Setting aside the fact that a VAT is way worse than a national sales tax because it is a logistical nightmare and a recipe for political favoritism and political footballs (look up how a VAT is calculated in the rest of the OECD and you'll see why), even if you intended rolling one out, you shouldn't let a WHISPER of it out right now.

8) Pledging to double exports, ignoring/misunderstanding the dynamics of why our trade deficit is the size that it is

Up until Obama's pledge to double exports, I had thought he was ideological but never got the sense he's incompetent. I understand part of it is political, but if he's promising to double exports, he's going to look like an idiot when real exports drop (A strong possibility. I have no idea what nominal exports will do because I have absolutely no idea whether to expect inflation or deflation right now, and that's the Fed's fault - I'll get to this in a bit, also). The fact that he thinks it's POSSIBLE to double exports in the current world trade system indicates a fundamental misunderstanding of what actually is affecting the economy.

Trade is subject to a pair of very simple, intrinsically related identities - the current account balance and the capital account balance. If China exports one widget for $1 to the US, then China has a $1 current account surplus (net exporter of goods) and the US has a $1 current account deficit (net importer of goods). That dollar goes from the US to the  Chinese, which means the US is a net exporter of capital (they're sending a dollar to China) and China is a net importer of capital. In essence, the capital account is a claim on future current account - if I am China and I import capital on a net basis now, it means that later on, I have the money to import more goods on a net basis.

It should seem obvious on this micro scale that the sum of all of the current account surpluses and deficits in the world must equal 0. Similarly, the sum of all of the capital account surpluses and deficits must equal 0.

In a free trade environment, these surpluses and deficits should tend towards 0. If the US wants more goods from China than China wants from the US, then in the absence of intervention, what should eventually happen is that demand for the Yuan drives the Yuan to strengthen vs the dollar, and the relative overavailability of dollars drives the dollar to weaken, and the exchange rate shifts until demand for Yuan and demand for dollars is balanced, which happens when neither country has a trade deficit or surplus. In real life, all sorts of exogenous shocks and time-lagged responses mean there would be a cycle of surpluses and deficits, but they would be small, and over time, one would expect them to balance.

However, we don't operate in a free trade world.

There are two large regions that have imported a great deal of goods over the last decade on net (and exported a lot of capital) - the US and Southern Europe. There are two large regions that have exported a great deal of goods over the last decade on net - China/Japan/East Asia and Northern Europe.

Furthermore, as Michael Pettis (the single best blogger alive right now, in my opinion) points out, Northern Europe and Southern Europe have largely balanced each other out. The US has mostly offset China and Japan, and the world stays in balance.

Well, southern Europe is screwed - Greece, Portugal, Spain, Italy - and they will have trouble importing nearly the same amount as they have been.

However, the exporting countries are largely structurally dependent on exports. Germany, Japan and China have all significantly favored their export production businesses and artificially kept down consumption (I encourage you to click on either of my Chinese Currency footnotes or anything Pettis has ever written on his blog, if you're interested). Thus, in order to not shock their economies, China and Japan are working to ensure their export balances stay high to keep their businesses healthy, because otherwise consumption would not really be able to ramp fast enough to offset the rapid reduction in exports. Germany and the rest of northern Europe are doing that, also, and they also benefit as exporters by the weakening of the Euro caused by their southern neighbors.

We know we need balance, and everyone's exports are staying high. Who do you think is going to be importing more?

Thus, as southern Europe collapses, the US will probably be importing more than ever. Who exactly would absorb the doubling of exports? The US is still (I believe) the third largest exporter in the world (behind.... China and Germany!). There's not enough import capacity in the entire world to double exports. It's not happening.

I understand that Southern Europe wasn't quite as acute a problem when Obama made that promise, but he still had a team who had to see this coming, plenty of economists did. A country as large as the US, Japan or China should not have a structural deficit or surplus, and only because we've been anesthetized by 20 years of reversing our strong prior export record did we miss this.

The reason this relates to economic mismanagement and wasn't just a political promise or a misunderstanding was that this particular arrangement means that in essence, China, Japan, Germany and the rest of Northern Europe are exporting their unemployment to the US. China, especially, routinely violates WTO dictums to keep their export balances high. This is not a trivial problem for China, and it's a sensitive issue, but the complete lack of attention to this in favor of more ideological bills (healthcare, consumer financial protection, etc) is a massive, massive problem for Obama's economic record. It's the equivalent of fiddling while Rome burns.

What SHOULD he be doing? I talk about it in the footnote 8.3, but the Warren Buffett proposal for import certificates is one that I can get behind - in essence, tax imports the exact percentage required to balance the trade deficit. As the trade deficit drops, the tax drops. This would have to get past the WTO, but other countries would have a lot of trouble retaliating because there are no other large importers in the world right now. If there were other large importers, you could just not tax goods from that country.

He's also done a terrible job of framing energy as a trade issue. Oil is a third of our imports, and getting gasoline out of the car fleet would increase employment by quite a lot (as well as having beneficial effects on the climate and arguably security).

Finally, it's impossible to cut the trade deficit with a persistent government deficit, because the government deficit is high enough that it can't be financed at a low interest rate internally, so foreign countries currently finance the govenrment deficit (Chinese and Japanese especially, right now). In a recession, this isn't such a big deal because interest rates are low, but Obama needs to credibly show now that he will reduce the government budget deficit beyond a couple years from now in order for employment to really rebound with any strength.

9) R&D tax credit expiration and uncertainty about whether it's coming back

Can someone explain to me why it's a good thing to let an R&D tax credit expire, ever, and especially in a recession? R&D is how companies find new products (essential for GDP, employment, etc), and higher corporate taxes aren't good. This is simple, but it's so dumb, and it gets ignored. Not only should the R&D credit have been extended, companies should have had the option of capitalizing it on their balance sheets. That way, R&D spending gets cut less in the recession, more researchers stay employed, and companies have more of an incentive to use R&D because they can tax-deduct the depreciation as well (essentially, double tax crediting R&D)

10) Property rights enforcement (auto bondholders got shafted by the government, and financial reform gives government leeway to seize firms without guidelines)

One of the more harmful and less talked-about actions taken by the Obama administration happened early, when he was working on a bailout for the automakers. Without commenting on the actual automaker bailout (on the one hand, those companies were slaves to unions, horrifically mismanaged and should have been allowed to die, but on the other hand, saving them is the cheapest way on the planet to save 2 million jobs for now), I should point out that Obama arbitrarily forced senior bondholders to take a haircut in a way that was a) unconstitutional and b) established an early "anti-business" reputation. The move significantly increased the required interest rates on distressed debt, because of the risk that things would get bad enough that the government would step in and haphazardly decide for political reasons who takes haircuts (bondholders and hedge funds) and who doesn't (the unions, or at least not nearly enough of one). There is very little worse for capital markets than highly uncertain risk, and capital markets feed back into the real economy, as we've found with the credit crisis.

11) Housing price prop up to avoid foreclosures

Quoting Arnold Kling: "Everyone knows that the housing market and the mortgage market are artificial. The mortgage market is being propped by by Fannie, Freddie FHA, and the Fed. The housing market is being held in a state of suspended animation by government attempts to stave off foreclosures. This policy is keeping the foreclosure crisis in front of us rather than putting it behind us.
If it had been up to me, I would have put in place policies to accelerate getting people out of houses where they don't belong. I would have given subsidies to underwater borrowers to move, and I would have given them bonuses for leaving houses in good condition. I think that if we had a housing market with a reasonable relationship between where people live and what they can afford, then the economy would be humming by now."
My note: I think that's probably an exaggeration, but it certainly would have credit flowing better by now, which is a critical step to recovering. Debt levels probably would be much lower, as well, as banks would just be forced to eat credit losses instead of having an elaborate shell game between the government, banks and consumers, hiding who is solvent and who is not. There is a major timing effect (you want to have the economy starting to recover as the level of government spending drops, which it has been doing for a few months now) which anti-foreclosure efforts have been harming. Finally, there's also a major uncertainty factor - when people don't really know how much housing is supposed to cost, a lot of decisions get delayed or avoided. Mortgages are harder to get, producers of building materials have trouble hedging and thus don't spend on capital improvements or labor, and people wait to buy houses because housing prices could drop and at the very least will stay low for a while. This is a MAJOR demand sap.

11.1 Why housing prices are prolonging the recession

12) minimum wage increases and union card check

I pair these as part of a backwards-looking labor policy. Almost every economist agrees that minimum wages increase unemployment more than they help people who receive the higher wages, and hit the uneducated, teens and minorities particularly hard. Notice who is bearing the brunt of this recession the worst of everyone? see 12.1

Similarly, union card check and other pro-union policies (Adam Stern was Obama's number one visitor in his first year, with 23 white house visits) increase the cost of labor and decrease employment. Unions had their uses (more in footnote 12.2) but right now, just decrease employment and decrease corporate efficiency (and incentivize companies to move production elsewhere).

and the two factors over which as president he could possibly influence but are also partially out of his control (I don't talk about these much because these would require some very nifty legislation on commodity production or more intervention at the Fed than may be appropriate).

13) commodity price pressure from China, and the complete lack of any addressing of it

Commodities should not be this expensive right now. A weaker dollar than 10 years ago is part of it, but there's also the "China is using a lot of commodities and stockpiling even more" factor. Stimulating domestic production would help a great deal (subsidy, tax credits, etc), but it'd be hard to avoid subsidizing overcapacity. Legislation would have to be pretty carefully constructed, but also would help if executed well. Note that things like grid upgrades or natural gas storage/transport subsidy or highway improvements could have this effect and also be stimulatory.

14) focusing on pulling the stops out on the fiscal side but ignoring some very legitimate, much better monetary options

Scott Sumner has talked a great deal about Nominal GDP targeting, which is one option, and there are certainly other monetary options that don't require fiscal damage. All would increase inflation, but many of them could still keep inflation controlled (inflation targeting or ngdp targeting) and many others are adjustable back down when inflation stops being a good thing, as it is right now (Fed paying nontrivial interest on bank reserves, discouraging lending). Deflation is the biggest risk right now, and deflation is WAY worse than controlled inflation a little higher than what we've seen over the last 20 years. I highly recommend for all sorts of details on this stuff.

1 comment:

  1. The VAT logistics issue is an interesting one. Here in Canada, the federal VAT rate has actually been cut from 7% to 5% since its inception in the early 1990s. Many provinces also impose a separate non-VAT sales tax on top of it (the rate is 8% in Ontario). As far as businesses were concerned (at least from what I could tell from the recent tax harmonization debates in Ontario and BC), the VAT was preferable to the non-VAT sales tax because the VAT on business inputs could be deducted from taxable profit, whereas provincial sales tax couldn't be. The federal VAT also has (I'm told) a much simpler exemptions regime than provincial sales tax in Ontario. That said, I agree with you that implementing one in the US would probably not be done very competently.

    I love the rest of your post. Many of the "dirty dozen" could be characterized as increasing business uncertainty, which is probably the one big thing killing job creation. I can't help but wonder how many subsequent proposed economic solutions will only make this uncertainty worse. After all, weren't health care and financial reform (and energy reform, etc.) supposed to "create jobs?"