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January 29, 2008

Economist's View - 5 new articles

"A Helpful Suggestion for the Fed"

Willem Buiter:

A helpful suggestion for the Fed, by Willem Buiter: It is now clear beyond a reasonable doubt that the Fed wants to prevent sudden sharp drops in the stock market. ... I propose that the Fed put its money where its heart is by engaging in outright open market purchases of US stocks and shares.

By intervening through the purchase of the most broadly-based value-weighted index of US stocks, e.g. the Wilshire 5000 Total Market Index, any unlevelling of the playing field between listed stocks can be avoided. I would prefer the Fed to acquire only non-voting shares, or to put any shares it acquires in a blind trust... On January 25 the Wilshire 5000 index stood at 13,423.62. The 52-week peak was on October 7, 2007 at 15,806.69. Let's split the difference and request the Fed to put a floor below the Wilshire 5000 at, say, 14,500.00. ...

What I propose is effectively the same as the Fed attaching a free put option to every equity share in a US-registered and-listed enterprise. It would put paid forever to all those jokes about the Greenspan put and the Bernanke put.

Let's do it!

Barry Ritholtz also has a letter to Ben. My view hasn't changed and is similar to Mark Gertler's. Update: Another view:

Ben Bernanke under fire, Times Online: ...Robert Shiller ... told The Times yesterday that Paul Volcker, the Fed's chairman during the Carter and Reagan administrations, would have made a better job of spotting the consequences of the housing recession and credit turmoil on the American economy than Mr Bernanke. ...

Paul Krugman: Lessons of 1992

There are lessons to be learned from Bill Clinton's 1992 presidential campaign and what happened after he was elected:

Lessons of 1992, by Paul Krugman, Commentary, NY Times: It's starting to feel a bit like 1992 again. A Bush is in the White House, the economy is a mess, and there's a candidate who, in the view of a number of observers, is running on a message of hope, of moving past partisan differences, that resembles Bill Clinton's campaign 16 years ago.

Now, I'm not sure that's a fair characterization of the 1992 Clinton campaign... Still, to the extent that Barack Obama 2008 does sound like Bill Clinton 1992, here's my question: Has everyone forgotten what happened after the 1992 election?

Let's review the sad tale...

Whatever hopes people ... had that Mr. Clinton would usher in a new era of national unity were quickly dashed. Within just a few months the country was wracked by the bitter partisanship Mr. Obama has decried...

No accusation was considered too outlandish: a group supported by Jerry Falwell put out a film suggesting that the Clintons had arranged for the murder of an associate, and The Wall Street Journal's editorial page repeatedly hinted that Bill Clinton might have been in cahoots with a drug smuggler.

So what good did Mr. Clinton's message of inclusiveness do him?

Meanwhile,... Mr. Clinton ... did avoid some conflict by being strategically vague about policy. In particular, he promised health care reform, but left the business of producing an actual plan until after the election.

This turned out to be a disaster... Mr. Clinton didn't deliver legislation to Congress until Nov. 20, 1993 — by which time the momentum from his electoral victory had evaporated, and opponents had had plenty of time to organize against him.

The failure of health care reform, in turn, doomed the Clinton presidency to second-rank status. The government was well run (something we've learned to appreciate...), but — as Mr. Obama correctly says — there was no change in the country's fundamental trajectory.

So what are the lessons for today's Democrats? First, those who don't want to nominate Hillary Clinton because they don't want to return to the nastiness of the 1990s ... are deluding themselves. Any Democrat who makes it to the White House can expect the same treatment: an unending procession of wild charges and fake scandals, dutifully given credence by major media organizations...

The point is that while there are valid reasons one might support Mr. Obama over Mrs. Clinton, the desire to avoid unpleasantness isn't one of them.

Second, the policy proposals candidates run on matter. I have colleagues who tell me that Mr. Obama's rejection of health insurance mandates — essential element of any workable plan...— doesn't really matter, because by the time health care reform gets through Congress it will be very different from the president's initial proposal anyway. But this misses the lesson of the Clinton failure: if the next president doesn't arrive with a plan that is broadly workable..., by the time the thing gets fixed the window of opportunity may well have passed.

My sense is that the fight for the Democratic nomination has gotten terribly off track. The blame is widely shared. Yes, Bill Clinton has been somewhat boorish (though I can't make sense of the claims that he's somehow breaking unwritten rules, which seem to have been newly created for the occasion). But many Obama supporters also seem far too ready to demonize their opponents.

What the Democrats should do is get back to talking about issues ... and about who is best prepared to push their agenda forward. Otherwise, even if a Democrat wins the general election, it will be 1992 all over again. And that would be a bad thing.

The New Laffer Curve Logic and the Lack of Evidence for It

After being shown again and again that tax cuts don't increase revenues, those who make the Laffer curve argument stopped making the claim generally and shifted the argument to say that while it may not be true across the board, there is evidence that it is true for the very top rates. Now, as Lane Kenworthy discusses below, the argument has shifted again. But even after all of this reformulation of the argument to try and make it work somehow, somewhere, the evidence is still pretty shaky:

The New Laffer Curve Logic, by Lane Kenworthy: "When you cut the highest tax rates on the highest-income earners, government gets more money from them."

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled "The Tax Threat to Prosperity" (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original "Laffer curve" argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The "supply-side" problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the amount of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here. This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via "tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures." When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households' incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let's consider them in turn.

1. Tax reform in 1981 reduced the top marginal rate from 70% to 50% beginning in 1982. Few exemptions and loopholes were closed. The fact that the effective income tax rate on the top 1% of households fell only slightly in the ensuing years appears to support Laffer's argument.

But there are two important qualifications. First, the drop in the top marginal rate is misleading. As Eugene Steurle points out in his book, Contemporary U.S. Tax Policy, "Even before 1981, high-income individuals often avoided a top tax rate of 70 percent through a special provision of the tax code that limited the tax rate on earnings, or income from labor, to a maximum of 50 percent." Furthermore, in 1982, 1983, and 1984 additional tax reforms were enacted that reduced loopholes and enhanced tax compliance and collection via expanded reporting requirements and heightened penalties.

2. Tax reform in 1986 reduced the top marginal rate from 50% to 39% in 1987 and 28% beginning in 1988. The effective rate on the top 1% actually increased slightly in the following years. This, however, is fully explained by the fact that the 1986 reform dramatically reduced loopholes and exemptions. This wasn't a case of high-income households deciding to hide less of their income because the top marginal tax rate had been lowered. They had no choice.

3. Tax reform in 1993 raised the top marginal rate from 31% to 40%. The effective rate on the top 1% increased from 21% in 1992 to 24% in the latter part of the decade. Did the hike in the marginal rate of 9 percentage points encourage tax avoidance? Possibly, but if tax avoidance increased, it was more likely due to the massive rise in incomes among the top 1% that occurred in the second half of the 1990s. The next chart shows this. Average pretax income in this group nearly doubled between 1993 and 2000, soaring from $750,000 to $1,450,000.

4. Tax reform in the early 2000s reduced the top marginal rate by four percentage points, from 39% in 2002 to 35% in 2003. In this case the effective rate on the top 1% of households fell by exactly the same amount, from 24% in 2002 to 20% in 2003.

None of this is to suggest that tax avoidance doesn't occur or isn't worth worrying about. Far from it. But the notion that lowering the top marginal tax rate dramatically reduces such avoidance appears to be wishful thinking.

Update: See also Do capital gains tax cuts increase revenues?, by Justin Fox.

Fed Watch: Sometimes It Is the Path, Not the Destination

Tim Duy tries to figure out what the Fed and the economy will do next. All I can say is good luck:

Sometimes It Is the Path, Not the Destination, by Tim Duy: I spent much time this weekend – as is often the case – considering the path of economic activity over the next year, as well as the Fed's role in defining that path. The Fed has come under widespread criticism for a seemingly awkward communication strategy that culminated with last week's surprise rate cut. I think the last rate cut had the unfortunate appearance of a panicked effort to prop up equity markets. That said, I think the criticism is likely too severe – it is easier to be bitter with the Fed than to admit you just weren't reading the situation correctly.

Of course, it is likely the Fed was not reading the situation correctly as well. But what part of the forecast was in error? We have heard repeatedly of Fed expectations that the economic downturn would be largely limited to the first half of 2008, followed by a gradual reacceleration to trend growth, albeit the anemic trend of roughly 2.5%. We do not yet know that this forecast is fundamentally in error. Indeed, I have argued in the past that it is consistent with the story told by a one-year ahead forecast derived from the yield curve, specifically the 10-2 spread:


Looking at the more recent history more closely:


The depth of the inversion of the yield curve in November 2006 signaled a 50% percent chance of recession in November 2007 – remarkably accurate, in retrospect. But this is where the path vs. the destination becomes important. In December of 2006, I told a business group that the then current recession hysteria would be short lived, but would return at the end of 2007. I, however, didn't fully know the path to that point – I said it would likely reflect the washing out of the housing market. For that particular group, I don't think the path was particularly important. For financial markets, both the destination and the path are important. The permabears, who were aggressively predicting a recession in early 2007, largely had the path right (financial market meltdown stemming from a faltering housing market), but were a year ahead on the timing.

The steepening of the yield curve signaled by the middle of 2007 that the risks of recession would be dropping dramatically by the middle of 2008. Interestingly, this fit nicely with the Fed's forecast of late last year. The Fed could see the destination – the other side of the downturn, and this was able to make statements such as that of the October 30/31 meeting:

Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

The problem, however, is again the issue of the path to the destination. We can assume that Fed forecasts were largely based on a "constant policy" assumption. They saw the destination, but misjudged the path – the steepening in the yield curve was signaling that the Fed had a significant role in leading the economy to that destination. And that role was aggressive rate cutting (not academic tinkering with the discount rate), rather than holding policy constant. The Fed was trying to focus market participants on the medium term outlook, market participants were telling the Fed they need to do something more to ensure that outcome. Needless to say, confusion reigned.

Is the Fed's forecast still viable? I think so. The yield curve is a good predictor of economic activity – note how the permabears no longer discuss the yield curve; it no longer fits in their paradigm. But I see the path unfolding over the first half of this year. The aggressive rate cutting by the Fed is forcing central banks around the world to continue and even accelerate their purchases of dollar denominated assets, especially those that limit or prevent the appreciation of their currencies. This supports a capital inflow to the US to offset the collapse in the asset backed commercial paper markets and keeping the US financial markets more liquid than they would be otherwise (Brad Setser continues to repeatedly educate us on this topic. See here and here.) The general tendency toward lower rates across the yield curve tends to have a stimulative effect – eventually, mortgage rates drop low enough to help some homeowners. Not all of us are underwater, and could benefit from refinancing.

The US government further supports this process with a temporary stimulus package, issuing debt that foreign central banks are forced to buy, turning the proceeds over to consumers, many of whom are sure to boost spending. Those economies that choose to hold monetary policy constant, such as the European Central Bank, support the US economy by allowing their currencies to appreciate against the dollar, internalizing the US weakness.

All of these stimulating forces are coming to bear over the next six months. But will they be lasting effects? It depends on what you define as "lasting." This story is one in which strong economic growth in the US depends critically on a sustained capital inflow. Capital inflows supported the tech bubble. When that story ended, a few years of subpar growth occurred until capital inflows could find a fresh asset bubble, housing. Where will the next bubble be? Will it even be in the US? Without that consistent, and growing inflow, I suspect the US will suffer a protracted period of subpar activity as the economy is weaned from reliance on foreign production. Or a steady stream of "temporary" stimulus packages forced upon global central banks for financing, until the world is finally saturated in dollar denominated assets. Or a steady stream of monetary easing? Or…? This is something I am still thinking about.

Bottom Line: The amount of stimulus, largely monetary, but also fiscal, coming on line in the next six months suggests that the worst part of the downturn will be relatively short lived, limited to the first half of this year. But the other side of the downturn is likely to be anemic, similar to the wake of the 2001 recession. Lasting growth of the kind we are accustomed to, I fear, depends on capital inflows to support a fresh US asset bubble.

Postscript: Obviously there is a Fed meeting this week. Market participants are expecting 25 or 50bp, most likely the latter. I see that as the most likely result, especially since it is clear that the Fed deems the health of the equity markets as critical (note, this fits into the above story, as a weaker dollar will entice foreign capital into the equity markets - the foreign currency price is lower - as long as equities are not set for a precipitous drop). But, every call is something of a toss-up right now.

Post-postscript: I just realized that if I follow the argument through, my opening statement about the Fed's cut last week merely having the appearance of an effort to prop up equity markets is overly charitable. Perhaps it was simply a straight forward effort to prop up the equity markets to keep foreign players in the game.

Another postscript: It occurs to me that the US is doing the opposite of everything it advised in the Asian Financial Crisis.

Am I currently placing too much weight on the importance of capital inflows? Feel free to comment.

[Tim starts with "I spent much time this weekend ... considering the path of economic activity..." Here's something else Tim did this weekend. This is what happens to Fed watchers when economic conditions get like they are now. Tim is on the left.]

links for 2008-01-28

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