US: New economic policy

The incoming Obama administration bears the burden of two often-contradictory drivers in formulating its economic policy: its campaign rhetoric for “change” and the need for a pragmatic program to deal with a growing economic slump. Obama must fashion policies that deal with the current economic distress while not dashing the hopes his campaign engendered for a vast reordering of economic and social priorities. Only a successful restart of the economy can lead to the promised changes.

The underlying credit mechanism that governs financial flows in the economy is in terrible shape. Business loans are hard to come by, the interbank lending market has revived only through credit guarantees, the commercial paper market is functional only to the extent that the monetary authorities have buttressed it with substantial guarantees; and financing of auto sales, retail sales, credit cards and even student loans is tenuous at best. Day-to-day business credit is largely paralyzed, yield spreads in the corporate sector are at historically high levels, and the IPO market for financing young companies is moribund. The Fed has driven the Federal funds rate to zero by resorting to quantitative easing to forestall any hint of a banking collapse.

Still, these funds have not easily flowed into the household and business sector. Confidence has waned and business is now cutting back inventories and fixed investment, intensifying the collapse in consumer spending produced by diminished employment prospects. What was initially seen as a recession appears to be verging into a much more serious economic downturn, perhaps approaching that of the 1930s.

A steep recession or worse?

Harvard professor Gregory Mankiw has pointed out that in the early days of the Roosevelt administration, the basic economic outlook was one of sharp cyclic decline, not a gripping worldwide, decade-long depression. Yet, despite a legion of New Deal reform measures, the US did not pull out of the Great Depression before World War II.

Today’s prevailing consensus - that this recession is likely to be the most severe economic setback of the postwar period, but that another “great depression” is unlikely - could be wrong. As each wave of policy response falls short, the call for even stronger measures will dominate policy choice. The Obama policy team is likely to recommend even more severe measures than what now appear in the offing for fear of “falling short.”

This means a much larger hand for government in the management of US economic affairs. It also means that defining an exit strategy for policies to treat the current malaise will become both more difficult and more delayed. That will make Obama’s longer-run economic strategy more difficult to predict.

Strategy in an economic emergency often resembles strategy in a military crisis and fails for similar reasons. First, a clear definition of the objective is required. Then, a rational assessment of respective forces must be made. Next, the means of achieving the chosen objective must be specified. Finally, a careful parsing of an exit strategy is required. As calls for more government assistance increase, the capability to define an exit strategy becomes more remote. Ignoring the need to clearly define an exit strategy in this economic emergency could mean snatching defeat from the jaws of victory, just as in military affairs.

It is surely the case that Obama-led policy measures will substantially increase the Federal Government’s involvement in the economy. The dilemma for Obama policymakers is acute. First they must use enough government measures to stop the decline and resume growth. At some point, unless the economy is to be totally socialized, they must pull these measures back and allow markets to function once again. There is no clear science to determine the precise amount of government intervention that can achieve restoration of economic growth. That has meant that discussion of an agreed upon course of action to return the economy to its primary market orientation is on a back burner. But without a clear specification of the role of government in the economy going forward, what are we to make of the campaign promises to take care of the middle class?

“Change You Can Believe In”

The Obama campaign used the mantra of “change you can believe in,” a slogan that encompassed a profound reordering of domestic and international economic goals. He made the needs of the middle class a top priority and coded that priority by the distinction he drew between benefits to “Main Street” and “Wall Street.” The distinction is confusing at best and disingenuous at worst. This distinction has the power to push the organization of the economy into paths from which it can never emerge.

The immense loss of confidence that is readily apparent in credit markets and the resulting flight to safety has pushed treasury yields below zero. This condition will tempt policymakers to apply even more severe economic intervention and possibly delay the ability of the private economy to resume normal economic activity. There is a point down the road of government management in economic affairs where the path back to economic normality can be essentially blocked.

Resumption of strong economic growth will require the repair of our financial system. It is unclear how monetary and fiscal measures now deployed and likely to be expanded can be easily retracted and a return to a normal state of economic management resumed - i.e., with the primacy of the private economy.

The Obama policy team surely knows that without resumed economic growth, there can be no successful address to the middle-class issues that they have championed. Resumed economic growth will require a functioning credit system, and it is impossible to see how the private credit system can be repaired without the efforts of Wall Street and other financial centers. Main Street and Wall Street are not separate policy options. To repair Main Street will require the repair of Wall Street, unless we assume Government is going to be the central finance mechanism of the future.

To the extent that excessive risk behavior of financial institutions was the core of the problem, that risk posture was enhanced by a long period of easy credit in an (unfamiliar) environment of global finance, insufficiently restrained by suitable corporate governance. If and when the economy is restored to health, monetary authorities will have to address the moral hazards they may have unleashed during the past decade. That is neither a partisan issue nor is it one that Main Street will find easy to understand.

Demonizing Wall Street excess will not help us to understand needed corrections. Similarly, creating a better system of corporate governance - no easy task - is likely to fall to the bottom of a priority list devoted to restarting the economy. Pillorying Wall Street is not a step on the road to understanding the dilemma that full-employment policies create. Nor are corporate governance issues confined to Wall Street - we see them in Detroit and elsewhere.

Policy moves limited by international considerations

Obama has made clear that he is committed to reordering the U.S. distribution of income and wealth, using expenditure and taxation measures to further that redistributive aim. He has also evinced a nearly religious dedication to environmental issues. Efforts to confront climate change were tied closely during the campaign into his national energy, security, regulatory, as well as tax and expenditure policies. Environmental issues transcend national boundaries and cannot be remediated solely by domestic policy measures. Slowing down climate change will require an international consensus that does not yet exist.

The world’s nations do not agree on the priorities embedded in the Obama climate message, and negotiations on these issues are likely to be lengthy and less than satisfactory. Moreover, given the current economic situation, dramatic improvements in global environmental policies will surely rank behind restoring economic growth.

As Obama enters office, he has to deal with domestic and world economies that are declining rapidly. Interdependence rules in bad times as well as good. That recognition must inform the Obama administration if it is to avoid “beggar thy neighbor” policies that damaged recovery attempts during the Great Depression. Meanwhile, pragmatic efforts are required to rekindle economic growth here at home. How artful a politician he is will be measured by how successful he is in restoring this country to economic health while still holding onto to his mantra of “change.”

Financial crisis and beggar-thy-neighbor appeals

Clearly, the overriding theme of the present disturbance is a massive global financial crisis. In a global context, “beggar thy neighbor” remedies become more dangerous in spite constituent pressure to benefit the middle class. Trade policy provides a clear example. During the campaign there was much talk that trade agreements must be modified to encompass “fair” rather than “free” trade.

Restricting international trade for domestic political concerns was tried by the previous administration, but the Obama administration would be wise to avoid this tactic. The fair trade/free trade dichotomy posits a false option for policymakers similar to the Main Street/Wall Street distinction. Fair trade policies that punish foreign exports to the US will surely trigger restrictions on our own export industries.

Furthermore, as our financial system tries to rebuild, fair trade measures will undoubtedly redound to the disadvantage of our financial institutions. The Clinton years’ focus on free trade was wise, and adoption of that same attitude will give Obama a larger purchase from which to rebuild international cooperation in foreign policy.

Ironically for a country that has always led the fire brigade when financial contagion threatened to burn down the world economy, the current US financial meltdown is at the center of a world financial crisis. It is first and foremost a home fire, and extinguishing it here will help the entire global economy. The rest of the world has levitated to financial events here and will continue to do so for years to come.

To gain traction in correcting financial issues here is paramount to resurrecting the financial institutions abroad that are needed for a full global recovery. The danger is that the new government will forget this maxim and begin once again trying to hector others on their own economic domestic policies. That would only divert our attention from what we can do for ourselves. It creates the illusion that only if others adopt our recommended policies for themselves will it be possible for us to recover.

A case in point is our economic stance toward China. If we begin by attacking Chinese exchange-rate policies, we will weaken our connection to a major trading partner. Publicizing them to the American electorate in order to demonstrate concern for the “middle class” will create risks on the slippery slope of economic nationalism. The Chinese are already aware of the problems that over-reliance on exports has created for their economy, and their exports are actually now declining. Banging the drum on Chinese exchange rate policy is a modality that Obama needs to avoid.

Policies for a global age

Whatever its ultimate outcome, this is the most global financial crisis since the Great Depression. In some ways, it is far more severe at this stage of its development, precisely because world financial interdependence has grown so large. The share of traded goods in world output has grown markedly over the past sixty years, indicating that world trade has grown far faster than world output. Financial linkages have grown even faster than the markets for goods, and financial ties are now deeper than ever before. What Washington chooses to do on economic policy will affect the entire global economy.

To be successful internationally, Obama must become an effective spokesperson for international cooperation. There is great power in this interdependence, but there is also great danger. If poor policies are chosen, the consequences will be felt not only on Main Street, but on Every Street throughout the globe.

Policy has to start from the presumption that this slump can get worse if not appropriately treated, and from the knowledge that the bigger the slump here, the greater the impact around the world. Because the global economy is a fact of life, the Obama administration needs to avoid framing the policy alternatives in overly domestic terms. Policy focused only on the difficulties of America’s Main Street will ignore this country’s role in an interdependent global economy.

To come out at the end of this dark passage, the US cannot afford to use too little economic weaponry, nor can it fail to set sensible ground rules for the longer-term financial health of the nation. As noted above, those ground rules must include a defined exit strategy.

The main presumption of the Obama policy team is that fiscal policy is the sine qua non for economic recovery. Some economists disagree, believing that aggressive monetary policy, particularly quantitative easing measures, will ultimately restore our credit economy.

An added benefit of using monetary measures is that they can be scaled back as recovery occurs without leaving a permanent imprint on the financial sector. Unfortunately, that argument is now probably moot.

The predominant view of Obama’s policy advisors is that a vast expansion of fiscal measures is required to restore aggregate demand. Our own history during the 1930s should caution us about the efficacy of this view, but it probably will not. The fire alarms are ringing and the engines are already racing out of the station.

Even if it is assumed that fiscal measures are required, if the goal is sustainable economic growth, then permanent changes in tax policies are likely to be far more effective than transitory assistance to personal disposable income. If government expenditures are deemed necessary to confront sagging aggregate demand, the Obama team needs to be quite clear what they are wishing for: an expansion in demand or a selected set of bridges to finance. Once fiscal actions, particularly expenditure moves, are set, they are very hard to reverse.

Obama also wishes to use tax policy as a redistributive force. That is likely to produce not only more of the same tinkering that has made a shambles of any rational tax policy, but also to concatenate the goal of tax reform and tax fairness to the detriment of both objectives. The root issue is that the US income tax code is a scandal in its own right. It is the result of constant pressure from separate interests to gerrymander the fiscal regime for their own benefit. The result is tax policy that is inconsistent and counterproductive.

We need taxes on consumption rather than on factor income, which would be a monumental change in the American economy. However, this would mean giving up various shibboleths of Democratic Party tax policies of the past. It would mean treating the corporation for what it is, a legal fiction, and focusing on the detrimental aspects of the corporate tax.

Most economists are aware that the corporate tax falls significantly on labor (roughly in the proportion that labor makes up in total value added - approximately 70 percent). The candidate of “change” could use the bully pulpit to make a strong effort to educate the citizenry about the fallacy of the burden of the corporate income tax. It falls most heavily on the “middle class” that elected Obama. It mistakenly taxes the “good guys,” although it is always portrayed as just the opposite, and it illustrates why policies that try to excoriate the “rich” and be “fair” to the poor often result in just the opposite outcome.

By the same token, taxing labor at the payroll level may be an ingenious way of collecting taxes, but it creates perverse incentives for an economy wishing to add employment. The fairest tax regime would be to abolish both the income tax and the payroll tax and move straight to a consumption tax. That tax can be made progressive, if demands for “fairness” require it, but the key is to make it broad and inescapable.

Finally, because the long-term fiscal health of this country depends upon raising national savings, abolishing the capital gains tax and becoming totally dependent upon a consumption tax regime would be a huge change for the better. Unfortunately, it is not one we are not likely to see. Capital gains are associated with the “rich,” even if we now have the largest ever participation in the stock market by individuals.

The financial crisis of 2007/2008 has decimated American private wealth. Personal household savings, pension plans, 401(k)s, equities, bonds and real estate have all been severely damaged. It will take years to cure these losses. Ending taxes on capital gains would immeasurably help that recovery and should be applauded by everyone. To do that would be a raw act of political courage requiring a vast education of the voting public. The scope of the current crisis brings forth opportunities for drastic change; the question is whether there is sufficient leadership to support it.

Regulation or enforcement

That brings us to the regulatory agenda and the legacy of campaign rhetoric. Many have argued that a vast expansion in regulation is needed because the predecessor administration ignored any serious attempt at regulation. The real issue, however, is whether we need more regulation or clear enforcement guidelines that are adhered to regardless of political consequences.

The typical call for more regulation is based on a canard of high order that more regulation will prevent financial scandal. The predecessor regime created an extensive regulatory apparatus (Sarbanes-Oxley) for the public securities industry. What failed was not regulation but enforcement. The regulations already on the books would have prevented much of the malaise we are currently experiencing, if they were regularly and systematically enforced by the relevant regulatory agencies. Rather than adding to regulatory complexity with new laws, the new administration could just make it policy to uniformly enforce the regulations already on the books.

In the process of putting out financial fires, the Fed and the Treasury have created a nearly nationalized banking system and a national credit guarantee program, and are now setting mortgage interest rates by intervening directly in the mortgage market. If the auto company bailout proceeds, the government will be overseeing one of this country’s largest industries, with consequences for our entire productive structure as well as the financial underpinning of US auto production and distribution.

An institution not known for managerial capability, the US government, will become the world’s largest economic manager. That is not a prospect to be welcomed. Its running the Post Office as a monopoly supplier of first-class mail has provided no evidence that Government operates either efficiently or profitably in the business sector. Yet that is what the incoming administration will inherit and seems likely to expand. A viable plan for exiting these extreme measures would be a tonic for the economy, as it would create a blueprint for returning our financial institutions to the private sector, where they belong.

Fiscal policy dangers

During the campaign, Obama put forth a series of income tax proposals that centered on what appears to be a tax cut for broad swaths of taxpayers while adhering to some sort of “budget balancing” desire by raising taxes at the upper end of the income distribution. To do that, the Bush tax cuts of 2002 would have to be terminated and tax cuts implemented for all families below some arbitrary level (the campaign focused on income of US$250,000).

In addition, current corporate tax rates and the capital gains tax were to be raised. Circumstances now may dictate no tax increases currently. The most likely course will be to create a sizeable tax cut for the “middle class” that may involve a payroll tax rebate or holiday combined with lower income tax rates below some threshold level, while largely ignoring for the time being the resulting deficit expansion. That would combine both “transitory” and “permanent” measures.

The payroll tax rebate or holiday would generate substantial disposable income gains, which would at least allow households to both consume and save more simultaneously. The lower income tax rates would be needed to lessen the transitory savings that is likely to result and create an environment more conducive to consumption. The “equity” side of that change might well be to let the Bush tax cuts expire under their own timetables.

Similarly, the campaign focused on claimed needs for additional expenditure on infrastructure, schools, alternative energy measures and health care. For purposes of confronting the current recession, it is impractical to think that each of these policy areas is staffed for a vast increase in expenditure.

If Obama is serious in attempting to put more government expenditure to work, it is almost mandatory that this be done through block grants to states and municipalities that already have designated projects that are now tabled due to declining state and local tax resources. Because many states and localities already have balanced-budget legal machinery, any increase in their expenditures must be funded. What better source than Federal grants?

There is a downside to such a policy, however. State expenditure plans are rife with state political pork and the lobbies that support them. While increased state and local expenditure may give a fillip for the economy, they will enshrine those political lobbies with a permanent call on Federal financial support. State and local political constituencies will clamor for funding going forward and are likely to become permanently installed as pigs at the trough. It is easy to turn on the water, but it will much more difficult to turn the spigot of Federal funding off if the economy regains traction.

The Obama economic team is well versed in macroeconomic theory, but the choice is not essentially one of economics. It is the choice over the role that government is to play in the economy of the future. Catering to those who elected this administration will be a powerful force. Obama’s mandate will likely never be greater than it is now, so in the first 100 days, markets would be well advised to adopt a cautionary stance on what will ultimately prevail.

There appears to be no concern with developing an exit strategy from the huge intervention now underway, not even a minimalist attempt to set some guidelines for the future. We are rushing into a strongly interventionist future. Now is the time to be careful about what we wish. We may indeed get it.