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May 12, 2010

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Feldstein: Extend the Bush Tax Cuts—For Now

Posted: 12 May 2010 12:24 AM PDT

Martin Feldstein says we shouldn't allow Bush tax cuts to expire for high income households as the administration is proposing, we should keep them in place for another two years:

Extend the Bush Tax Cuts—For Now, by Martin Feldstein, Commentary, WSJ: This is not the time for a tax increase. But unless Congress acts, under current law the existing income tax rates will rise sharply at the beginning of next year. Congress should vote now to extend all of the current tax rates for two years, including the tax rates on dividends, interest and capital gains. Limiting the resulting tax-rate cuts to two years would reduce the projected future fiscal deficits. The sooner Congress acts, the stronger our prospects for continued economic recovery.
A tax increase next year could easily derail the current fragile expansion. ... A 2011 tax increase that reduces economic incentives and household spending would raise the risk of a new economic downturn.
President Obama proposes to increase tax rates on high-income households while making the existing tax rates permanent for taxpayers below the top tax brackets. While the increase would hit only a relatively small fraction of all households, that group represents a large share of total taxes and of private spending. Raising their tax rates would be a substantial blow to overall spending and therefore to GDP growth. ...
Although it is important to avoid increasing the current tax rates until the recovery is well established, the enormous budget deficits that are now projected for the rest of the decade must not be allowed to persist. ...
It would be wrong therefore to commit to the permanent reduction in tax rates for all taxpayers below the top brackets that is called for in the Obama budget. ...
Such a limit on the future tax cuts should be combined with policies to slow the growth of spending. ... If Congress cares about future deficits, it will prevent that unprecedented rise in government spending. It will also do more to deal with the spending programs that are hidden in the tax law like the health-insurance subsidy, the child-care credits, and the deductibility of local property taxes.
Failure to cut future deficits would mean a weaker recovery and slower long-term growth. ...
The fragility of the economic recovery means that it would be dangerous to allow any taxes to rise in 2011. The inherent uncertainty about the out-year deficits means that it would be unwise to enact tax cuts that stretch beyond the next two years. Congress should move quickly to reassure taxpayers and financial markets that the current tax rates will be preserved for two years but that further tax cuts will depend on the future fiscal outlook.

We could always shift the tax burden, i.e. allow the tax cuts to expire at the upper end of the distribution and replace them with cuts at the lower end (for the two year period or even beyond). That would make the overall distribution of taxes more progressive, something that's needed, and it would get money into the hands of people who need it. Shifting the tax cuts to people who are more likely to spend the extra money rather than put it into savings would provide an even larger boost to the economy.

It's also worth noting that if the worry is about the effect on the economy and the deficit, it would also be possible to allow the tax cuts to expire and then replace the missing demand with additional temporary government spending, say for two years. Since the spending is temporary -- it only lasts for two years just like the tax cuts -- the long-run impact on the deficit would be the similar. The point isn't that we should do this, or that we shouldn't, it's that there's no necessity in keeping the tax cuts in place at the upper end of the distribution to preserve aggregate demand. A tax increase can always be offset by tax cuts in other places or by additional government spending. One argument is that any policy that involves increasing taxes on the wealthy is inherently inefficient, e.g. that it lowers productivity, but I don't find the empirical evidence for that argument to be very compelling (and even if some categories of taxes are inefficient, that doesn't meant that, say, a capital gains tax can't be replaced with some other type of tax with more desirable properties).

links for 2010-05-11

Posted: 11 May 2010 11:04 PM PDT

Europe's "Political Trilemma"

Posted: 11 May 2010 04:50 PM PDT

Dani Rodrik uses his idea of a political trilemma (e.g. see this from 2007), i.e. that "economic globalization, political democracy, and the nation-state are mutually irreconcilable," to analyze recent events in Europe:

Greek Lessons for the World Economy, by Dani Rodrik, Commentary, Project Syndicate: The $140 billion support package that the Greek government has finally received from its European Union partners and the International Monetary Fund gives it the breathing space needed to undertake the difficult job of putting its finances in order. The package may or may not prevent Spain and Portugal from becoming undone in a similar fashion, or indeed even head off an eventual Greek default. Whatever the outcome, it is clear that the Greek debacle has given the EU a black eye.
Deep down, the crisis is yet another manifestation of what I call "the political trilemma of the world economy": economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance.
The history of the world economy shows the trilemma at work. ...[gives examples]...
[One way around] the trilemma is to do away with national sovereignty altogether. In this case, economic integration can be married with democracy through political union among states. ... Think of this as a global version of federalism. The United States, for example, created a unified national market once its federal government wrested sufficient political control from individual states. ...
The crisis has revealed how demanding globalization's political prerequisites are. It shows how much European institutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in other parts of the world: either integrate politically, or ease up on economic unification.
Before the crisis, Europe looked like the most likely candidate to make a successful transition to the first equilibrium – greater political unification. Now its economic project lies in tatters while the leadership needed to rekindle political integration is nowhere to be seen.
The best that can be said is that Europe will no longer be able to delay making the choice that the Greek affair has laid bare. If you are an optimist, you might even conclude that Europe will therefore ultimately emerge stronger.

Congress and the Fed: Why the Bark is Worse Than the Bite

Posted: 11 May 2010 11:34 AM PDT

New post at MoneyWatch in reaction to today's 96-0 vote in the Senate to audit the Fed:

Congress and the Fed: Why the Bark is Worse Than the Bite

I argue that Congress should try to look like it is being very tough on the Fed, but it's not in Congress' interest to take a big bite out of the Fed's authority.

"Banks Failing to Lend is Not the Problem"

Posted: 11 May 2010 10:08 AM PDT

Dean Baker takes on the "banks not lending" explanation for the persistence of the downturn and sluggish movement toward recovery:

Banks failing to lend is not the problem, by Dean Baker: One of the big myths of the current downturn is that the reason the slump persists is that banks are refusing to lend. The story goes that because the banks have taken such big hits to their capital as a result of the collapse of the housing bubble and record default rates, they no longer have the money to lend to small- and mid-sized businesses.
We then get the story about how small businesses are the engine of job creation, responsible for most new jobs. Therefore, if they can't get capital, we can't expect to see robust job growth.
This story of banks not lending is used to justify all sorts of special policies to help out small businesses and banks. In fact, the Obama administration has plans to make a special $30bn slush fund available to banks if they promise to lend it out to small businesses.
In reality, every part of this argument is completely wrong. First, small businesses are not special engines of job growth. Small businesses do create most new jobs, but they also lose most new jobs. Half of new businesses go under within four years after being started. Jobs do get created when the businesses start, but jobs are lost when the businesses fail.
The reality is that businesses of all sizes create jobs. There is no special reason to favor small businesses in promoting job creation. We should favor businesses that create good paying jobs with good benefits and conditions, regardless of their size.
The other parts of this story make even less sense. Let's hypothesize that many banks are crippled in their ability to lend because of the large hits to their balance sheets from bad mortgage debt. Well, not all banks got themselves over their heads with bad mortgages. There are banks with relatively clean balance sheets.
If it were the case that a substantial portion of banks are now unable to issue many new loans because of their inadequate capital, we would expect to see the healthy banks rushing in to fill the lending gap. There should be accounts of dynamic banks that are taking advantage of this once-in-a-lifetime opportunity and rapidly gaining market share.
While this may be happening, there certainly have not been many accounts in the media of banks that fit this description. In other words, it does not appear to be the view among banks, including those with plenty of capital, that there are many good potential customers who are unable to borrow money.
The other missing part of the story has to do with the nature of competition between small firms and their larger competitors. We know that large firms have no difficulty attracting capital at present. They can issue bonds at near record-low interest rates. They can also borrow short-term money at extraordinarily low interest rates in the commercial paper market.
If small and mid-sized companies were being prevented from expanding due to their inability to raise capital then we should be seeing larger companies rushing in to take market share. Retail stores should be opening up new outlets everywhere. Factories should be rapidly increasing output and transportation companies should be rushing into new markets.
Of course, we don't see any of this happening. If anything, most large businesses are expanding at a slower rate than they did before the crisis. If their competitors have been hamstrung due to a lack of credit, no one seems to have told Wal-Mart, Starbucks and the rest. They have both slowed the rate at which they are adding new stores, not sped it up as the credit-shortage story would imply.
There is truth to the credit-squeeze story, but it goes in the other direction. Stores that have seen their business plummet as a result of the downturn are, in fact, worse credit risks from the standpoint of banks. Many businesses that were profitable in 2006 and 2007 are now highly unprofitable and may not be able to stay in business. As a result, the banks that were happy to lend money just a few years ago are no longer willing to lend money to the same business. This drying up of credit happens in every downturn. It is just more serious this time because of the severity of the downturn.
The moral of this story is that we should not think that "fixing" the banks will get us out of the downturn. The problem is that we have to generate demand, which means having the government spend more money to stimulate the economy. Unfortunately, the politicians in Washington are scared to talk about larger deficits, so more spending seems off the table at the moment – therefore we get this nonsense about insufficient bank lending.
But hey, at the rate we created jobs in April, we should be back at full employment in seven years anyhow. Who could ask for anything more?

This is not a supply problem, banks are sitting on mountains of excess reserves (some of which are serving as insurance against unexpected contingencies, but even so the excess reserves in the system are voluminous). But the ample supply of loans available to be loaned out at the right terms does not automatically create a demand for them.

I think the problem is on both sides. Supply has tightened up due to poor economic conditions -- as noted above banks are unwilling to loan to firms who look shaky during the downturn, firms that might have looked very solid and worthy not all that long ago. But the demand for loans has fallen as well since firms have little reason to invest in such bad economic conditions. So if the goal is to generate more investment, the solution is twofold. First, the demand for loans must be present. Additional government spending as called for above can help, but so can measures such as an investment tax credit or other financial incentives for firms that undertake to new investment. Second, banks must have the money to lend and be willing to do so at reasonable terms. Available reserves are not the problem, it's the fear of losses due to poor economic conditions that is making banks hesitate. One way over this hurdle is for the government to share in losses that banks realize on these loans. With lower expected losses through the loss sharing arrangement, the banks would be more willing to part with funds.

But the big question for me is the desirability of promoting investments that the private sector does not think are a good idea. If the result of this intervention is a bunch of failed investments and wasted resources, then this is not the best way to stimulate the economy. If there's some sort of market failure that is preventing firms and banks from entering into productive deals, then there is clearly a role for government to step in and fix the problem. One could make an argument that, say, risk is artificially elevated (disconnected from its "fundamental" value) and hence some sort of intervention is needed to restore the market, and I think there's some merit to the market failure arguments. Still, rather than helping firms in this way, I'd prefer to have more help for those households suffering the most from the downturn, i.e. additional government spending, transfers, and job creation -- that means a far bigger stimulus program than we got -- and then let firms respond to the additional demand as they see fit.

Finally, this is a bit different -- it involves investment in basic research rather than investment by firms -- but some types of government intervention appear to be productive:

Federal investment in basic research yields outsized dividends -- innovation, companies, jobs, EurekAlert: How can the United States foster long-term economic growth? A new report suggests that one of the best ways is through investment in the basic research that leads to innovation and job creation. ...
"There is no question that the public benefit gained from funding basic research is exponentially greater than the initial investment," said Susan Desmond-Hellmann, Chancellor of University of California San Francisco. "The success stories highlighted in this report demonstrate that fact and are a reminder that the continued scientific and technological leadership of the United States – and our economic well-being – depends on consistent, strong funding for research." ...
These success stories include global industry leaders like Google, Genentech, Cisco Systems, SAS and iRobot, as well as relative newcomers such as advanced battery manufacturer A123 Systems; network security company Arbor Networks; AIDS vaccine developer GeoVax Labs; and Sharklet Technologies, which has developed a novel surface technology based on the qualities of shark skin to combat hospital-acquired infections.
The report illustrates the substantial economic benefits the U.S. reaps when companies are created as a result of discoveries in federally funded university laboratories. One example of this return on investment is TomoTherapy Incorporated, based in Madison, Wisconsin. A $250,000 grant from the National Institutes of Health's National Cancer Institute to two researchers at the University of Wisconsin-Madison enabled the development of ... a highly advanced radiation therapy system that targets cancerous tumors while minimizing exposure and damage to surrounding tissue. Each year the technology is used to help improve the outcomes of tens of thousands of difficult to treat cancer patients around the world.
"That original investment generates many times its value in salaries and taxes returned to both the U.S. and Wisconsin governments," says University of Wisconsin-Madison professor and TomoTherapy Co-founder and Chairman Rock Mackie. TomoTherapy employs 600 people. ...
"University-launched startups can be powerhouses for value creation, becoming public companies at a far greater rate than the average for new businesses," according to Krisztina "Z" Holly, vice provost for innovation at the University of Southern California (USC). "Higher education can play a crucial role not just in spurring pioneering ideas, but in creating entrepreneurs who turn breakthroughs into innovations." The results benefit everyone, she says. Holly points to 24 USC startup companies that currently employ 500 full-time workers, more than half of whom are in Los Angeles. Sixteen of these companies have raised at least $148 million in financing over the past two years, during the height of the recession. ...

Goldman's Winning Streak

Posted: 11 May 2010 08:25 AM PDT

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I'm not sure what to make of this:

Goldman Sachs has first quarter with no trading losses, Bloomberg News: Goldman Sachs Group Inc.'s traders made money every day of the first quarter, a feat the firm has never accomplished before.
Daily trading net revenue was $25 million or higher in all of the first quarter's 63 trading days... The firm reaped more than $100 million on 35 of the days, or more than half the time. ...
The lack of trading losses could add to the perception that Goldman Sachs has an unfair advantage in the markets, one shareholder said.
"It will reinforce the heads we win, tails you lose mentality that people think actually exists and promotes the concept of an unfair advantage," said Douglas Ciocca... "It's too politically charged not to. How is that possible that they only make money?" ...

"This is the first time we have reported zero trading loss days in a quarter," said Samuel Robinson, a Goldman Sachs spokesman. "We believe it shows the strength of our customer franchise and risk management."

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