Foreign Income Rising

In Converging on the Horizon (courtesy of John Mauldin), Ed Easterling explains that pre-tax corporate profits as a percentage of GDP are expected to set new record highs in 2012. As reported earnings per share (EPS) are also significantly above normalized EPS based on both Crestmont’s and Shiller’s methodologies. Continuing strength in these figures plays a major role in buoying bullish viewpoints and frustrating bears. Easterling does a wonderful job using historical evidence to support his view that mean reversion of corporate profits is likely nearing. Agreeing with Easterling’s basic outlook, attempting to understand the reasons behind this profit levitation seems a worthwhile endeavor.

Various explanations currently circulate within investment and economic research regarding the superb corporate margins. One theory points to an increasing share of profits accruing to corporations instead of employees. Stagnating wages, a less unionized workforce and regulations increasing barriers to entry all support this notion. Another consideration holds that strong emerging market growth has made up for weak economic growth in developed markets. While probably true to some degree, with U.S., U.K., EU and Japan’s (50%+ of world GDP) growth flat-lining, it’s hard to foresee this trend continuing. A less widely discussed topic deserving attention is the growing percentage of foreign income being deferred from US corporate income taxes.

Over the past several weeks publicly held corporations have been filing their second quarter reports. While firms continue beating expectations at a strong clip (this happens during bear markets too), the reasons behind stronger earnings appear to be changing. During the first portion of this recovery, cost cutting through layoffs boosted margins. As Russ Winter points out in Corporate Tax Avoidance (courtesy of Zero Hedge), diverging effective tax rates are more recently producing larger margins. Just last week Microsoft reported a 7% decline in their effective tax rate as foreign income rose to 68% of the quarter’s total. That’s correct, based on income Microsoft is primarily a foreign company and they’re not alone.

Apple, darling of US investors and techies alike, is only slightly more American than Microsoft. During the most recent quarter, 33% of Apple’s reported income came from the US. The following section from their quarterly filing explains the decrease in effective tax rate (emphasis mine):

“The Company’s effective tax rate for the three- and nine-month periods ended June 25, 2011 was approximately 24%, compared to approximately 24% and 26% for the three- and nine-month periods ended June 26, 2010, respectively. The Company’s effective rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S..” (Apple, 10-Q, 2nd qtr 2011, p.33)

As stated by Apple, an increasing portion of their earnings are never intended to be reinvested in the U.S. through higher wages, larger dividends or any other manner.

While Apple and Microsoft represent only a minute sample of U.S. corporations, my presumption is that further research focusing on large multinationals will find similar patterns of decreasing effective tax rates and increasing undistributed foreign earnings. For investors, the pertinent question is whether or not effective tax rates will remain or continue moving lower. Investors should also recognize that a significant portion of cash on these companies balance sheets is held abroad and cannot be reinvested in the U.S. without incurring income taxes. A broader concern of this tax policy focuses on its potential long-term economic impact.

In 2004, the U.S. allowed domestic corporations to repatriate undistributed foreign profits at significantly reduced tax rates. Congress hoped this “one-time” tax break would result in firms spending their extra cash to increase domestic jobs. Data largely implies that the special tax break had no visible effect on employment. Unsurprisingly, a more direct effect appears to have been a growing number of firms and percentage of earnings being classified as undistributed foreign profits. With unemployment remaining high, large U.S. multinationals are once again pressing Congress to allow repatriation of foreign profits at a minimal tax rate (5%). Despite historical evidence, several Democrats have supported the proposal. As companies become more confidant in another “one-time” tax break, undistributed foreign profits may experience another surge.

Congress is currently struggling to compromise on a debt limit deal that cuts future spending and reduces deficits for the next decade. Given this debate, a good question regarding corporate taxes would be “why are domestic companies allowed to avoid corporate taxes with undistributed foreign profits?” Jesse’s Café Américain (courtesy of The Big Picture) directs us to ten charts from the Center for American Progress displaying the vast decline in corporate tax revenues:



Corporate tax revenue this year (1.3% of GDP) is near all time lows despite record corporate profits and a supposedly uncompetitive corporate income tax rate of 35%. As chart 9 shows, the effective tax rate for U.S. corporations is only 13.4%, well below most OECD countries. Tax breaks and loopholes not only reduce tax revenue, but heavily favor large corporations. Rather than consider more tax breaks, Congress would be well advised to focus on corporate tax reform.

Corporate tax reform that eliminates breaks and loopholes, while reducing rates, holds the key to several issues plaguing Congress and the current administration. Small businesses, which typically create the most new jobs, will benefit from lower tax rates. Federal tax revenue will increase as far greater sums of income are taxed. Consumers will likely benefit as increased business competition drives down prices and encourages innovation. Although this idea seems simplistic, it has a unique benefit of being both a market-oriented solution (for the right) and more progressive tax system (for the left).

Unfortunately these type of drastic overhauls rarely occur outside a crisis and are in direct opposition of numerous parties with invested interests (as well as significant cash to spend on lawyers and political contributions). Regardless, moving in the opposite direction by allowing another “one-time” tax break is almost certain to hurt economic growth, employment and federal debt in the long run. Hopefully after the senseless debt limit debate ends, the country will begin discussing more valuable issues including tax reform.  

Basic Math Predicts EU Defaults

In his weekly market comment, John Hussman (Hussman Funds) explains why the “Simple Arithmetic” of European sovereign debt forecasts necessary defaults. Hussman demonstrates the severely large portion of Greek GDP simply used to pay interest on sovereign debt given current outstanding amounts and interest rates. While some form of Greece default is now widely accepted, the size of outstanding Italian debt makes it increasingly clear how close interest rates are to rendering principal repayment nearly impossible. Italy announced today that it would forgo planned debt issuance in August due to concerns about prevailing market rates. If interest rates remain heightened in September, we could be looking back on July as the last time Italy had access to credit markets.

Despite focusing on Europe in this week’s comment, Hussman makes a very poignant remark about the maturity of outstanding US debt. Hussman states “it's precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can't be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues.”

Recent efforts by the Fed through quantitative easing have further shortened the average maturity of outstanding debt. Regardless, many economists and investors argue for betting on long-term inflation because of the US debt burden. As Hussman makes clear, unless the US actively extends the maturity of outstanding debt, attempts to inflate away the problem will more likely exaggerate the risks.

Personally I remain of the view that US inflation is likely to be subdued (below 2%) for several years, with greater potential risk of deflation than high inflation. Long-term treasuries therefore remain a good value at current yields (4.3%) for investors with 3-5 year time horizons.

EU Steps Forward, Still Much More Needed

As the debt ceiling debate continues on this side of the Atlantic, over in Europe the EU and ECB have apparently agreed upon a plan to end Europe’s sovereign debt crisis. Since early 2010, each bailout of Greece (we’re now on number 3), Ireland and Portugal has witnessed enthusiasm in financial markets through a stronger Euro and massive stock rallies. Needless to say, had any of the previous plans been successful, the current conversation would not be taking place.

Several highly regarded Economist's responded to Economix’s questions on recent efforts to save the euro. Simon Johnson, Carmen Reinhart and Laura Tyson each offer insightful thoughts, but Tyson’s responses appear most spot on. Overall the answers display much less enthusiasm than financial markets have for the likely outcome. I certainly recommend reading the entire article (Economist Q. & A. on Europe’s Debt Accord) but wanted to offer my own responses to several of the posed questions.

“Q. What effect is the European accord, including “selective default,” likely to have on Greece’s economy as it tries to recover?”

Tyson offers the most comprehensive answer, highlighting similar themes being argued by proponents of MMT and Keynes. Up until now, Greece’s presumed liquidity crisis has been treated with bailouts providing temporary loans at below market rates. Although these loans reduce the present value of Greece’s debt burden, the actual amount of outstanding debt remains unaffected. In reality, Greece represents a solvency crisis with minuscule hope of ever repaying existing debt in full. The decision to include “selective default” portrays acceptance of a solvency crisis, marking a significant step forward toward an actual solution.

“Selective default” involves restructuring Greek debt to actually reduce the total amount outstanding. Two primary options will likely be available to creditors for restructuring current holdings. One option offers creditors new 15 or 30 year bonds at par (face value) with interest rates around 4-5%. The other option provides new 15 year bonds with slightly higher interest rates but requires a principal reduction of 15-20%. It’s clear that Greece's existing debt is only reduced by creditors selecting the second option.

A significant portion of outstanding Greek debt is held by the ECB and European banks, whom are not bound by mark-to-market accounting standards. As noted in Avoiding Default Protects Phony Asset Valuations, these creditors are largely valuing current holdings at par despite market prices. Choosing an option that includes principal reduction will therefore force banks to realize losses on current holdings. Potential for large realized losses and previous reluctance to dispose of current holdings probably removes any consideration of voluntary options involving principal reduction for these creditors. Regardless of the options selected by remaining creditors, the actual reduction in outstanding Greek debt will be minimal.

Apart from including "selective default," the European accord requires Greece to enact even greater austerity measures. Similar to previous measures, these requirements will reduce the chances of an economic recovery already being hindered by a strong Euro. Further economic contraction combined with a reduced willingness to pay taxes will continue undermining efforts to meaningfully reduce the deficit and debt burden. Despite taking a step in the right direction, the European accord appears severely inadequate to aid Greece's economic recovery or reduce the likelihood of future default.


“Q. What are likely to be the challenges in carrying out the European plan?”

The European plan was made especially urgent by recent rises in yields of Spanish and Italian sovereign debt. Greece, Portugal and Ireland have already been effectively locked out from issuing new debt. An initial resolution to these countries losing access to credit markets involved creation of the European Financial Stability Facility (EFSF). The EFSF issues triple-A (AAA) rated debt guaranteed by financially stronger euro zone countries and uses those funds to provide loans well below market rates. To maintain its AAA rating, only about 270 billion euros of the 440 billion guaranteed are currently available for loans. The new accord expands the EFSF’s abilities to include purchasing bonds on the secondary market, providing loans supporting European banks and backing losses by the ECB. Although these are meaningful steps, the EFSF is vastly underfunded for its expanded role.

An Alliance Bernstein report (provided by Zero Hedge) discusses the inadequacy of the EFSF going forward.
Apart from minor measures related to Greece, the European accord fails to reduce existing debt burdens for any other overly indebted nation. After a brief calm, markets are likely to once again test the resolve of politicians and central bankers. Since the EFSF was not granted the breadth necessary for funding Spain and Italy, it becomes all the more probable that EU/ECB commitments will be tested.

Under the EFSF guidelines, countries requiring loans from the facility are unable to guarantee the facility’s debt. Given the sheer size of Spain and Italy, if both countries become locked out of credit markets, the EFSF’s lending capacity will need to be expanded from 440 billion to nearly 2.5 trillion euros. Without debt guarantees from Spain and Italy, the responsibility will fall primarily on Germany, and to a lesser degree France. Based on Alliance Bernstein’s estimates, Germany will need to guarantee 790 billion euros, which equals 32% of Germany’s current GDP.

Maintaining the EFSF’s AAA rating is imperative for ensuring loans are provided at the greatest discount. Expanding the EFSF becomes further complicated by France’s significant amount of existing debt. If France’s credit rating were downgraded due to extra debt guarantees, Germany’s share could conceivably become nearly 1.4 trillion euros. Whether or not Germany could retain its AAA rating while providing such a massive guarantee remains an open question. Even before that question needs addressing, Germany and France will probably face the tougher challenge of selling the new proposal to their citizens. Despite all the hype, significant challenges remain in approving and implementing the European plan.


“Q. What does this move portend for the euro zone?”

Probably the most certain effect of the European accord is that it buys more time. The euro zone is suffering from over-indebtedness that has rendered several nations and banks insolvent. While prospects for growing out of debt remain a pipe dream, reality almost always involves either restructuring existing debt, devaluing currency or generating inflation. Recently the ECB has been vigilant in maintaining its mandate for stable money by raising interest rates to quell inflation. This policy has also encouraged a stronger Euro. With currency devaluation and inflation off the table, restructuring debt becomes the only feasible option.

This move represents the first step toward allowing restructuring of existing debt. However, the current scheme only applies to Greece and is doubtful to make a significant impact. Any considerations of allowing or forcing more significant restructuring are probably defeated by fears of a modern day bank run (think Lehman 2.0). Within a short time, interest rates on Spanish and Italian debt will likely start pushing through recent highs. At that point, the insufficiency of the EFSF will become widely apparent.

Although politicians may wish to kick the can down the road forever, each countries’ citizens remain a wild card concerning their patience. Greece is effectively experiencing a depression at this moment, yet being asked to sacrifice more. Ireland’s citizens are enduring a recession in return for bailing out banks. Germans' have benefited enormously from creation of the EU, but may be asked to accept enormous risks to maintain the current alignment. One can only imagine the fallout if France and Germany guarantee loans for Spain and Italy, only to watch those nations willingly default on their obligations.

As described in Time is Running Out on the EU, the true conclusion to the euro zone crisis still lies in either greater fiscal unity or some number of defections. While the current accord provides measures for increased fiscal unity, the troubled nations remain stripped of means for recovery. Potential resolutions still remain numerous, but time for implementation is ticking down. If the Middle East uprising last year taught us anything, the whims of desperate people can change in an instant. Allowing a euro zone resolution to be ultimately dictated by public uprisings will certainly bring about a more chaotic end. The European accord is certainly a step forward, but much more will be necessary to ensure a peaceful and prosperous outcome.   

Nonpartisan Interventionism

Tyler Durden at Zero Hedge directs us to a wonderful op-ed in the WSJ today by John Taylor. While I haven't read much from John Taylor previously, his op-ed resonates with my recent thinking. Over the past several months I’ve engaged in various discussions relating to where countries or political parties fall on spectrum concerning various economic and political policies. These discussions initially attempt to label opposing groups as pertaining to opposite sides of a spectrum. For example, many people may associate Republicans with smaller government and Democrats with larger government. Although this basic assumption seems logical, is it correct? Clearly political parties frequently support different policies, but must they be in opposition on the size of government? Comparing the parties views on democracy versus communism would surely find both parties on the former end. Any spectrum must have opposing ends but groups seemingly need not fall on differing sides.

Stemming from this vantage point is questions regarding the validity of the initial example above. Republicans and Democrats assuredly disagree on many policies, yet political actions suggest government intervention is not one. Taylor’s piece highlights the interventionist policies of the 1970's and 2000's, as well as less interventionist policies of the decades between that gained support from both political parties. Using a game theory perspective, this mutual “understanding” supports both parties in assuring their overwhelming government majority compared to other political parties.

Recently a number of Democrats, including Congressmen, have pointed out quotes and legislation enacted by Ronald Reagan supporting their debt limit debate efforts. Meanwhile, several Democrats and even some Republicans have begun to acknowledge that proposals offered by President Obama reflect a moderate Republican stance from an earlier age. The point is not to imply that Reagan was truly a Democrat or President Obama is a covert Republican. The intended takeaway is that an Administration’s or Congress’ stance toward government intervention typically reflects the current consensus rather than any political affiliation.

Shared practices based on majority opinion demonstrates a strength of democracy however, the glacial pace of change portrays a weakness. Taylor notes the “damaging wage and price controls of the ‘70s” that helped create destabilizing inflation throughout the decade. This interventionist period ultimately ended with a deep recession in the early ‘80s that pushed unemployment into double digits. In an oddly similar fashion, the recent interventionist period has resulted in another decade of weak real economic growth, major recession and almost equally unbearable unemployment. Despite these similarities, the Great Recession appears to have actually spurned desire for even further government intervention from both sides.

This is not to say that the government should have no role or power in society. Many people forget that both Milton Friedman and F.A. Hayek, renowned economists and libertarians, believed government should provide means for public education and accepted some means of redistribution. More important to both though was the government’s role in maintaining the rule of law. Maybe surprisingly to some, both men also suggested that efforts to expand government would be approached with good intentions. The ultimate fear both men expressed was that government power would be exploited by concentrated groups of society fighting to maintain or gain a greater share of the pie.

Today, billions of dollars are spent each year by corporations lobbying for and against legislation. The extension of government involvement in the economy is probably best depicted by the approximately 100,000 pages of the Federal Register. Significant economic instability caused a substantial policy shift in the ‘80s, but the recent decade of bubbles and busts has yet to bring about a rival change. My hope, and likely Taylor’s too, is that even greater economic pain is not necessary to relearn lessons of the past. Only time will tell...

From Zero Hedge

John Taylor's Must Read Op-Ed Calling For The Great Reset

John Taylor, the "Fed Chairman who should have been", has penned a terrific op-ed in the WSJ. Must Read.

(emphasis ours)

The End of the Growth Consensus

America added 44 million jobs in the 1980s and '90s, when both parties showed they had learned from past mistakes. The lessons have been forgotten.

By John Taylor

This month marks the two-year anniversary of the official start of the recovery from the 2007-09 recession. But it's a recovery in name only: Real gross domestic product growth has averaged only 2.8% per year compared with 7.1% after the most recent deep recession in 1981-82. The growth slowdown this year—to about 1.5% in the second quarter—is not only disappointing, it's a reminder that the recovery has been stalled from the start. As shown in the nearby chart, the percentage of the working-age population that is actually working has declined since the start of the recovery in sharp contrast to 1983-84. With unemployment still over 9%, there is an urgent need to change course.

Some blame the weak recovery on special factors such as high personal saving rates as households repair their balance sheets. But people are consuming a larger fraction of their income now than they were in the 1983-84 recovery: The personal savings rate is 5.6% now compared with 9.4% then. Others blame certain sectors such as weak housing. But the weak housing sector is much less of a negative factor today than declining net exports were in the 1983-84 recovery, and the problem isn't confined to any particular sector. The broad categories of investment and consumption are both contributing less to growth. Real GDP growth is 60%-70% less than in the early-'80s recovery, as is growth in consumption and investment.

In my view, the best way to understand the problems confronting the American economy is to go back to the basic principles upon which the country was founded—economic freedom and political freedom

Economic policy in the '80s and '90s was decidedly noninterventionist, especially in comparison with the damaging wage and price controls of the '70s. Attention was paid to the principles of economic and political liberty: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform led to lower marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. And with strong economic growth and spending restraint, the federal budget moved into balance.

As the 21st century began, many hoped that applying these same limited-government and market-based policy principles to Social Security, education and health care would create greater opportunities and better lives for all Americans.

But policy veered in a different direction. Public officials from both parties apparently found the limited government approach to be a disadvantage, some simply because they wanted to do more—whether to tame the business cycle, increase homeownership, or provide the elderly with better drug coverage.

And so policy swung back in a more interventionist direction, with the federal government assuming greater powers. The result was not the intended improvement, but rather an epidemic of unintended consequences—a financial crisis, a great recession, ballooning debt and today's nonexistent recovery.

The change in policy direction did not occur overnight. We saw increased federal intervention in the housing market beginning in the late 1990s. We saw the removal of Federal Reserve reporting and accountability requirements for money growth from the Federal Reserve Act in 2000. We saw the return of discretionary countercyclical fiscal policy in the form of tax rebate checks in 2001. We saw monetary policy moving in a more activist direction with extraordinarily low interest rates for the economic conditions in 2003-05. And, of course, interventionism reached a new peak with the massive government bailouts of Detroit and Wall Street in 2008.

Since 2009, Washington has doubled down on its interventionist policy. The Fed has engaged in a super-loose monetary policy—including two rounds of quantitative easing, QE1 in 2009 and QE2 in 2010-11. These large-scale purchases of mortgages and Treasury debt did not bring recovery but instead created uncertainty about their impact on inflation, the dollar and the economy. On the fiscal side, we've also seen extraordinary interventions—from the large poorly-designed 2009 stimulus package to a slew of targeted programs including "cash for clunkers" and tax credits for first-time home buyers. Again, these interventions did not lead to recovery but instead created uncertainty about the impact of high deficits and an exploding national debt.

Big government has proved to be a clumsy manager, and it did not stop with monetary and fiscal policy. Since President Obama took office, we've added on complex regulatory interventions in health care (the Patient Protection and Affordable Care Act) and finance (the Dodd-Frank Wall Street Reform and Consumer Protection Act). The unintended consequences of these laws are already raising health-care costs and deterring new investment and risk-taking.

If these government interventions are the economic problem, then the solution is to unwind them. Some lament that with the high debt and bloated Fed balance sheet, we have run out of monetary and fiscal ammunition, but this may be a blessing in disguise. The way forward is not more spending, greater debt and continued zero-interest rates, but spending control and a return to free-market principles.

Unfortunately, as the recent debate over the debt limit indicates, narrow political partisanship can get in the way of a solution. The historical evidence on what works and what doesn't is not partisan. The harmful interventionist policies of the 1970s were supported by Democrats and Republicans alike. So were the less interventionist polices in the 1980s and '90s. So was the recent interventionist revival, and so can be the restoration of less interventionist policy going forward.

Time is Running Out on the EU

Nouriel Roubini offers a detailed solution for the continually worsening Eurozone problems. Roubini is one of the smartest minds today regarding credit related issues and his ideas here should be taken seriously. One of the most notable facets of his plan involves extending maturities on Greek debt without forcing banks to write down losses. Despite the laughable stringency of the recent EU bank stress tests, the need for significant additional capital was readily apparent. Considering the large sell off in bank stocks currently taking place, imposing realized losses could make obtaining further capital nearly impossible.

Another major part of his plan involves the ECB reversing recent interest rate hikes, supporting a devaluation of the Euro. While the periphery nations would become more competitive globally, some significant headwinds face this option. Unlike the Federal Reserve, the ECB’s only mandate is to maintain price stability, effectively through low inflation. Inflation has been picking up in Europe recently with Germany in particular feelings the effects. Reversing recent policy actions would likely generate a temporary jump in inflation and appear in direct contradiction of the mandate. Germany also maintains significant power over the ECB and may not be able politically to accept the short-term pain.

Separately, any attempt at Euro devaluation would likely come largely at the dollar’s expense. Misunderstanding of QE has allowed the Fed and Treasury to support a weak dollar policy without increasing the monetary base beyond historical trends. These efforts have been focused at reducing the large US current account deficit and provided the added benefit of propping up US stock markets. If the ECB/EU were successful, a stronger dollar might undermine recent export growth, corporate profits and equity prices. It’s unclear what, if any, response US policy would take against a weak-Euro policy.
 
The EU/ECB are faced with choosing from several less than ideal options. While I think Roubini's plan is among the best, implementation and support remain concerning factors. Ultimately Roubini comes to the same conclusion as many others, either the EU becomes more fiscally cohesive or allows defections and defaults. With Spanish and Italian bond yields spiking in the last week, potential solutions are dwindling. One way or another the EU crisis may be resolved far sooner than many expect.

From Project Syndicate

The Eurozone’s Last Stand by Nouriel Roubini

America Should Focus on Budget Allocations, Not Debts and Deficits

Marshall Auerback counters President Obama's claims for progressives to favor deficit cutting. Auerback notes how many Democrats continue to recount the Clinton surpluses as an enormous achievement of that administration. As his graph shows, a significant feature of the government surpluses were the corresponding private sector deficits. For anyone that believes exorbitant debt played a major role in the recent crisis, it should be clear that the growth in private sector debt was in some ways a consequence of the government surplus.

Understanding this graph is important for progressives and conservatives alike as it makes perfectly clear the near impossibility of the US government and private sector saving at the same time. For that to occur, the US would suddenly have to export significantly more than it imports. Auerback explains why that change in the current account balance is unlikely to happen in the near future.

Progressives should currently be concerned that greater investment in education and jobs is not the main subject of discussion. Even looking past the notion that federal spending is only politically constrained, the current budget represents more than $3.5 trillion in spending and close to another trillion in tax expenditures. Many of these programs and tax breaks are highly regressive and support little, if any, economic growth. Instead of debating cutting programs, the debate should be about which current programs remain desirable and which should be replaced.

If President Obama and progressives believe education deserves greater funding, than the conversation should focus on which other programs are ineffective or tax breaks are undesirable. Creating any budget requires making choices and weighing options. Unfortunately, fear mongering about a debt crisis has overshadowed those decisions. President Obama is an incredible orator and holds an ideal position for shaping the national discussion. President Obama and progressives should reclaim the conversation and ensure that the allocation of funds is “the only thing we’re talking about over the next year, two years, five years.”

From naked capitalism

Marshall Auerback: There is No Progressive Case for Deficit Cutting – The Myth of the “Virtuous” Clinton Surpluses

By Marshall Auerback, a portfolio strategist and hedge fund manager

For once, President Obama has sought to address his progressive critics, without caricaturing them as a bunch of out of touch, irresponsible radicals. At his press conference on Friday, the President made the following argument:

If you are a progressive, you should be concerned about debt and deficit just as much as if you’re a conservative. And the reason is because if the only thing we’re talking about over the next year, two years, five years is debt and deficits, then it’s very hard to start talking about how do we make investments in community colleges so that our kids are trained. How do we actually rebuild $2 trillion worth of crumbling infrastructure.

If you care about making investments in our kids, and making investments in our infrastructure, and making investments in basic research, then you should want our fiscal house in order so that every time we propose a new initiative, somebody doesn’t just throw up their hands and say “more big spending, more government.”

It would be very helpful for us to be able to say to the American people: “Our fiscal house is in order. So, now the question is, what should we be doing to win the future, and make ourselves more competitive, and create more jobs, and what aspects of what government’s doing are a waste, and we should eliminate.” And that’s the kind of debate that I’d like to have.

You want a debate on this, Mr. President? Consider it done. In a nutshell, your proposed cuts will NOT set the stage for a “progressive agenda” going forward. The austerity measures contemplated by your Administration will suck income and wealth out of the private sector. This will cause private spending to fall, leading to yet more downsizing and unemployment. Tax revenues will decline further as corporate profitability sags, social welfare expenditures will rise as the automatic stabilizers kick in. And before you know it, we’ll be bumping up against that troublesome debt ceiling again, experiencing the same kind of political grandstanding that is characterizing today’s conflict, sort of like a nightmare version of “Groundhog Day”. The government will, in effect, be chasing its own tail. You will not “put the nation’s fiscal house in order”, Mr. President, but tear down its foundations even further.

Democrats, like President Obama, persistent invoke the halcyon Clinton budget surpluses as some kind of Holy Grail for the country. But the mythical “virtue” of the Clinton budget surpluses is one of those unfortunate pieces of misinterpreted history that continues to afflict the Democrats in regard to their conduct of fiscal policy. Implicit in this argument is the belief that somehow balanced budgets are the norm, that President Clinton’s responsible stewardship righted the fiscal ship of state, after it has been left close to “insolvent” by the irresponsible legacy of Reagan’s supply-side economic adventurism.

Well, let’s look at the history first: for the past 82 years, the US government’s budget has been in deficit of varying proportions of GDP over 80 per cent of the time. There is nothing insidious or inherently sinister about these deficits. Each time the government tried to push its budget into surplus, a major recession followed which forced the budget via the automatic stabilizers back into deficit, ultimately helping to put a floor on demand and prevent a recurrence of the Great Depression.

All debt is not created equal. The expansion before the end of the Internet bubble crash in 2001, and the subsequent recovery in the 2001-2008 period (which had its roots in the housing bubble and massive financial fraud) were both largely products of an unprecedented private sector borrowing binge. Both businesses AND households borrowed (and spent) on an unprecedented scale. If a picture is worth a thousand words, then consider this chart, courtesy of Professor Scott Fullwiler

During the Clinton years, everybody – Democrats and Republicans alike – applauded these surpluses because it meant that the government’s outstanding debt was being reduced. But Professor Fullwiler’s chart confirms that as the government budget moved to surplus during the latter years of the Clinton Presidency, the private sector’s deficit correspondingly grew larger: It was the mirror image to the budget surplus plus the current account deficit. In other words, this chart illustrates that the budget surplus meant by identity that the private sector was running a deficit.

Why is that? It is because budget surpluses suck income and wealth out of the private sector. As the budget surpluses grew, households and firms were going ever farther into debt, and they were losing their net wealth of government bonds. Even when the government went back into deficit, it was insufficient to offset the cumulative effect of huge private debt accumulation and rising trade deficits, both of which ultimately laid the foundations for the Great Financial Crash of 2008.

It is true that we could diminish our budget deficits via an improving trade account. But the trade option is highly problematic: It’s all very well to suggest that we should export more, but it takes two to tango, and if our trading partners (such as Germany, Japan or China) do not want to increase US imports, there’s very little the US can do. When I was living in Japan in the 1980s, this was a huge issue: the US tried to “force” Japan to revalue the yen (shades of China today), and pressured the Japanese into a whole host of liberalizing/deregulatory measures designed to increase US exports to Japan. Hardly any of them worked. Japan’s trade surpluses continued to expand.

There is also the issue of government restrictions at home. China would glad buy tons of our military hardware, but we restrict its sale on the grounds of national security. Since this is one of the areas where the US literally has a “cutting edge”, it makes export growth even more problematic.

Finally, you run into the old fallacy of composition argument: not every country can be a so-called “export superpower” as our President keeps urging on the US. As an example, consider Germany, which refuses to even run a current account deficit with its fellow European Union “partners” (even though this is arguably in Germany’s economic self-interest, as it would mitigate some of the strains currently being experienced in the euro zone periphery). Do we seriously expect the Germans to run big trade deficits with the US?

All things equal, then, leaves the government sector. Given our current account deficit (and the corresponding demand leakage) to sustain anything like the level of aggregate demand required to reduce unemployment, rebuild our infrastructure, etc., that means our budget deficit has to be even larger to allow our private sector to save.

To re-emphasize the point which the President should be making day in and day out: It was NOT “profligate” government expenditures that created the current fiscal state of affairs. To the extent that the US has experienced any “government profligacy” over the past 3 years, it is because of our mindless bailout of Wall Street institutions (and note how conspicuously quiet today’s fiscal hawks were during that period when the Treasury and Federal Reserve established trillions of dollars of financial guarantees to fundamentally insolvent banking institutions). The real issue is that those who are better off don’t want to have government intervention in economic affairs unless it benefits them. When the government intervenes with bailouts, Wall Street stands with hat in hand.

No one wants to bear the actual discipline of markets if that means losses. Those at the high end of income distribution aren’t against deficits when it suits them, but are frequently against it if that might make the workers stronger, or create competition for private businesses (in the case of a public option healthcare reform, for example).

Here’s the thing: deficits DO matter, but not in the way that is being formulated by President Obama. if a government spends too much after getting us to a state of full employment and higher economic growth, excessive government spending can create inflationary pressures. So to that extent, there is a limit. But acknowledging that unconstrained government spending can create inflation is not the same as arguing that it is in any way operationally constrained. Contrary to conventional “gold standard” thinking, where every dollar spent has to be ‘financed’ by an ounce of gold already in existence, our government can afford anything that it is for sale in its own currency (unless we artificially constrain ourselves via stupid self-imposed limits such as a debt ceiling – the US being the only sovereign issuer of its currency that chooses to constrain itself this way).

The debate that the President is calling for, then, should not be focused on “affordability” but on what constitutes the national priorities of our government. The political process, not a non-existent gold standard, or a foolishly imposed debt ceiling of questionable constitutionality, should determine our national priorities. Promising jam tomorrow in exchange for “eating our peas” today might make for a good sound bite, but it is predicated on a fundamentally flawed model. The whole basis of our growth over the past quarter century has been based on households borrowing and the continuation of negative saving trends. A good place to start recovery efforts, therefore, would be to change this method of economic growth toward restoring incomes and job growth, rather than propping up zombie banks and embracing “rentier economics” through this misconceived emphasis of public debt reduction. No ostensible progressive can achieve anything close to the objectives ostensibly desired by the President, if we embrace his flawed economic thinking. Concerns about government deficits and the government debt have served as a very useful way of masking the real issue, the unwillingness of conservatives to allow the government to work for the good of the population, something that a democratic government is supposed to do.