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September 17, 2010

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Latest Posts from Economist's View


Paul Krugman: The Tax-Cut Racket

Posted: 17 Sep 2010 01:05 AM PDT

Republicans are playing a dangerous game with the economy as they attempt to preserve tax cuts for "their wealthy friends":

The Tax-Cut Racket, by Paul Krugman, Commentary, NY Times: "Nice middle class you got here," said Mitch McConnell, the Senate minority leader. "It would be a shame if something happened to it."
O.K., he didn't actually say that. But he might as well have, because that's what the current confrontation over taxes amounts to. Mr. McConnell, who was self-righteously denouncing the budget deficit just the other day, now wants to blow that deficit up with big tax cuts for the rich. But he doesn't have the votes. So he's trying to get what he wants by pointing a gun at the heads of middle-class families, threatening to force a jump in their taxes unless he gets paid off with hugely expensive tax breaks for the wealthy. ... Politics ain't beanbag, but there's a difference between playing hardball and engaging in outright extortion...
How did we get to this point? The ... Bush administration bundled huge tax cuts for wealthy Americans with much smaller tax cuts for the middle class, then pretended that it was mainly offering tax breaks to ordinary families. Meanwhile, it circumvented Senate rules intended to prevent irresponsible fiscal actions ... by putting an expiration date of Dec. 31, 2010, on the whole bill. And the witching hour is now upon us. If Congress doesn't act, the Bush tax cuts will turn into a pumpkin at the end of this year, with tax rates reverting to Clinton-era levels.
In response, President Obama is proposing legislation that would keep tax rates essentially unchanged for 98 percent of Americans but allow rates on the richest 2 percent to rise. But Republicans are threatening to block that legislation, effectively raising taxes on the middle class, unless they get tax breaks for their wealthy friends.
That's an extraordinary step. Almost everyone agrees that raising taxes on the middle class in the middle of an economic slump is a bad idea... So the G.O.P. is, in effect, threatening to plunge the U.S. economy back into recession unless Democrats pay up.
What kind of political party would engage in that kind of brinksmanship? The ... same kind of party that shut down the federal government in 1995 in an attempt to force President Bill Clinton to accept steep cuts in Medicare, and is actively discussing doing the same to Mr. Obama. So,... the tax-cut fight is ... ultimately about a radicalized Republican Party, which accepts no limits on partisanship.
So should Democrats give in?
On the economics..., the G.O.P. plan would add hugely to the deficit — about $700 billion over the next decade — while doing little to help the economy. On any kind of cost-benefit analysis, this is ... not worth considering. ...
On the politics, the answer is also a clear no. Polls show that a majority of Americans are opposed to maintaining tax breaks for the rich. Beyond that, this is no time for Democrats to play it safe: if the midterm election were held today, they would lose badly. They need to highlight their differences with the G.O.P. — and it's hard to think of a better place ... to take a stand than on ... big giveaways to Wall Street and corporate C.E.O.'s.
But what's even more important is the principle of the thing. Threats to punish innocent bystanders unless your political rivals give you what you want have no legitimate place in democratic politics. Giving in to such threats would be an economic and political mistake, but more important, it would be morally wrong — and it would encourage more such threats in the future.
It's time for Democrats to take a stand, and say no to G.O.P. blackmail.

Financial Regulation: The Empire Strikes Back

Posted: 17 Sep 2010 12:42 AM PDT

If banks are too big for politicians to ignore, is it possible to break them up?:

The Empire strikes back, by Avinash Persaud, Vox EU: There are two remarkable aspects of the consensus around international financial regulation emerging in the run up to the November G20 meeting in Seoul. The first is that there is a consensus. International regulators are agreed that banks must set aside much more capital for risky assets; be less dependent on the whims of money markets; constrain the maturity mismatches between their assets and liabilities and set aside capital for holding complex derivatives where there may be settlement and clearing risks. They also agree that capital adequacy should move counter to the economic cycle and that banks should not be "too big to fail". Getting an international consensus around action that is sensible – save for the emphasis on "too big to fail"- is no mean achievement.
The second is that despite appearing to be down and out, the banking lobby has struck back, successfully making the case that all of these initiatives should be postponed or phased-in between 2015 and 2019. By then the pressure for regulatory reform could be a distant memory. Financial regulation veterans will be experiencing déjà vu. In each of the last seven international financial crises, plans for a radical shake up of international regulatory or monetary arrangements made surprising progress, only to be tidied away and stuffed in the bottom drawer once the economy recovered. Many of the new initiatives being proposed today have been pulled out of that same drawer, dusted down and updated.
The argument that the banking system is too broken and the world economy too fragile, to support more onerous regulations, is seductive for politicians desperately trying to boost consumer demand. But it is suspect. It highlights that attempts to make banking regulation more counter-cyclical have not gone far enough. The point of counter-cyclicality is to loosen the constraints to lending in times of recession like today and to tighten them when growth and optimism have returned and the worse credit mistakes are being made. Counter-cyclicality needs to be at the heart of the new regulatory regime and not an optional extra. As Professor Charles Goodhart of the LSE and I have said before, crashes will not be avoided if we continue to feed the booms. The methodology of counter-cyclicality is complex and given that economic cycles are more national or regional than global, it makes for greater host country regulation and national ring-fencing of bankers' operations. International banks do not like that. To counter they appeal to the "right"-sounding notion of level playing fields.
The other problem of kicking regulatory initiatives into the long grass is that as long as the prospect of new profit-squeezing regulation is out there, uncertainty will limit the one thing everyone is agreed the banking system needs more of – capital from investors. It is one of those delicious fallacies of composition that what banks want individually is often not in their collective interests. I recall writing in October 2002, what the FT headline writers presciently captured as "Banks put themselves at risk in Basel".
Competitive finance is critical to the development of a robust and dynamic economy – locally and globally. But the lesson currently being repeated is that regulatory capture – subtle, sophisticated, and seductive – has the power to stops us from developing a financial industry that serves the economy rather than the other way around.
Tackling regulatory capture head on is the better argument for limiting bank size. The notion that smaller institutions will make the financial system safer ignores history. The UK Secondary Banking Crisis of 1973-75, for example, had a bigger impact on property prices and the stock market than the current one. The principal avenue of financial contagion is the panic-stricken search for institutions that look similar to the one that has just failed. Moreover, a large number of small institutions doing the same dangerous thing is just as toxic, if not more so, than a small number of large institutions engaged in the same activity. But smaller institutions invest less in political lobbying. A politically less powerful financial system has a better chance of being reassuringly boring.
The way to make the financial system safer is to break up institutions not by the porous boundaries of "narrow" and "wholesale" banking, but by the more fundamental boundaries of risk capacity. To create systemic resilience we need a systemic approach to capital adequacy requirements across the entire financial system, one that pushes different financial risks to wherever across the entire financial there is greater capacity for those different risks.
This is simpler than it sounds. There are three major types of risk: credit risk, market risk, and liquidity risk. Their differences can be found by the different ways in which these risks can be hedged or absorbed. The capacity to absorb liquidity risk comes from having time to sell an asset because liabilities, like promises to pay a pension in twenty years, are long-term. The capacity to absorb credit risk comes from having access to a wide range of uncorrelated credit risks to pool together, like a loan to an international oil company and another to a local wind farm. A financial system in which liquidity risks were held by young pension funds because of the capital required to set aside maturity mismatches, and credit risks by large consumer banks, because of the capital required to set aside for concentrated credit risks, would be far safer than one with twice the amount of capital but where the banks fund illiquid private equity investments and pension funds hold credit derivatives because regulators and accountants treated risk as if all that mattered was price volatility not risk capacity. Limiting risk taking to risk capacity would limit the size of banking institutions. It would create opportunities for new players with different risk capacities.
But the odds of a systemic approach to systemic risk appear slim. It's politics, stupid!

The last point is something I've talked about as well, but in more general terms. Essentially, if we break up the big banks into a bunch of "mini-me's," then a shock that would bring down a big bank would likely also cause widespread failure among its smaller clones. But if the small banks pursue heterogeneous strategies, e.g. as described above, then the impact of the shock may not be as wide.

From an earlier post on this, I'm skeptical about how well this would work, partly because the institutions may still be highly interconnected and hence subject to cascading failure:

... One argument against breaking up large banks, one I've given myself, is that it won't necessarily eliminate systemic risk. A shock that pushes a large bank into bankruptcy could just as easily cause a large number of smaller firms engaged in the same business to fail. This could create just as much trouble for the financial system as the failure of a single bank encompassing the smaller entities. In fact, it could be even harder for regulators to figure out how to address the failure of, say, one hundred small firms rather than just one large firm. Thus, breaking up large banks may do little to reduce systemic risk, but, as the argument goes, there is a chance that efficiency will fall. If so, then this is not a good policy.
But I think there are several counterarguments to this. First, there may be some shocks that would take a single, large bank down, but might not do the same to the smaller banks derived from it. The key here is that the smaller banks pursue diversified strategies so that only some of them are vulnerable to a particular type of shock. If they all do the same thing as the large bank did before it was broken up, then they will still face common risks. However, even with diversified strategies, I'd still worry that there is not that much safety from breaking banks up, i.e. that most shocks that would take down large banks will also take down enough small banks to create similar problems. ...

Breaking up the big banks and then imposing heterogeneity is certainly worth a try. If nothing else it may reduce their political influence. But it's unlikely to be enough by itself, and we should also be sure to reduce system vulnerabilities through other means such as leverage limits, orderly resolution for troubled banks, improved monitoring of system/network risks, the elimination of incentives to take on excess risk, and so on.

Update: I just posted something related at MoneyWatch: Will Basel III's Capital Requirements Make the Financial System Safer?.

links for 2010-09-16

Posted: 16 Sep 2010 11:02 PM PDT

Poverty and Redistribution

Posted: 16 Sep 2010 09:45 AM PDT

Here are two links:

And an argument for redistribution:

Superstars & redistribution, by Chris Dillow: Alex Tabarrok explains how increasing inequality can be due to "winner take all" superstar effects. This raises an issue. Insofar as this is a reason for higher top incomes (and it is only part of the story), mightn't it strengthen egalitarians' arguments for redistribution?
I mean this in three senses.
1. It increases the force of Rawls' claim that the distribution of talents is "arbitrary from a moral perspective" because "no-one deserves his place in the distribution of native endowments." The essence of winner-take-all economics is that  small differences in skills can mean large differences in returns. Even if you think Rawls was wrong on this, and that there is a moral element in the distribution of skills - say, insofar as these arise from differences in effort - one must, surely, be inclined to think that small differences in skill are largely arbitrary.
This is especially true because not all superstar earnings arise from even slightly superior skills. As Alex says, people like to read the books that others read. But this can generate Adler superstars - people who become rich simply because they arbitrarily become the focus of attention. Is Dan Brown's superstar income really the result of him leveraging his superior intellect? Or is he just a mediocre writer who got luckier than comparable writers?
2. It reduces the relevance of the self-ownership thesis. Even if we concede the Nozickian point, that people own their own talents, this does not suffice to justify leaving superstar salaries untaxed, because such salaries are a joint product. They arise from an interplay of talent (or luck) with socio-technical forces: globalization; a negligible marginal cost of production; copyright laws; and so on. No superstar can claim a right to these factors, which are an accident of history. And insofar as these are social factors, it might be reasonable for the incomes arising therefrom to be socialized.
3.  It undermines Laffer curve arguments. Imagine you're the impoverished J.K.Rowling writing her first Harry Potter novel, and that taxes on high incomes are very high. Do you think: "I'll not bother writing, but become a waitress instead?" It's about as likely as Wayne Rooney preferring to work in McDonalds than play football.
Because only a tiny minority become superstars - and they do so at least in part through luck - hardly anyone with rational expectations would anticipate becoming a superstar. Superstar salaries, then, are not needed to induce people to become writers, musicians or sportsmen. Instead, they consist very heavily of rents. And rent is a reasonable subject for tax.
Against all this stands Nozick's famous Wilt Chamberlain story. But is this really a compelling counter-argument?

I've always liked the principle of equal marginal sacrifice as a basis for progressive taxation, but it's not the only foundation for a progressive tax structure.

Update: The CBPP notes that even though poverty rates hit record levels in 2009, without automatic stabilizers it could have been even worse:

The headline story in today's Census Bureau report is the large jump in the poverty rate in 2009. But an exclusive Center on Budget and Policy Priorities analysis of the new survey data shows that unemployment insurance benefits — which expanded substantially last year in response to the increased need — kept 3.3 million people out of poverty in 2009.

In other words, there were 43.6 million Americans whose families were below the poverty line in 2009, according to the official poverty statistics, which count jobless benefits as part of families' income. But if you don't count jobless benefits, 46.9 million Americans were poor.

Update: More on the poverty report from Economix:

...Race continues to play a huge factor in poverty and income inequality. Median per capita income for non-Hispanic whites was $30,941, down 0.8 percent from a year earlier. Among blacks, median per capita income was less than two-thirds of the white median income, at $18,135....

Age is also a factor. Households led by someone 65 or older actually saw their median income rise 5.8 percent to $31,354. That was largely because of Social Security payments. But households maintained by someone aged 15 to 24 saw their income drop 4.4 percent, and those led by someone 35 to 44 fell 2.6 percent.

One of the most striking statistics released Thursday was the number of people aged 25 to 34 who are living with their parents. That number rose 8.4 percent to 5.5 million from 5.1 million in the last two years. We knew that recent college graduates were moving back in with their parents, but the fact that even older adults are doing so because they can't make it on their own is a sign of the difficult economic times.

Had those people not been living with their parents, their poverty rate, officially reported as 8.5 percent, would have been a 42.8 percent.

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