Bubbling Up...1/24/13

1) Hit the “Defer” Button, Thanks… by David Merkel @ The Aleph Blog

This is why I believe that the biggest issue in restoring prosperity globally, is finding ways to have creditors and stressed debtors settle for less than par on debts owed.  Move back to more of an equity culture from what has become a debt culture.  A key aspect of that would be making interest paid non-tax-deductible for corporations, housing, etc., while making dividend payments similar to REITs, while not requiring payouts equal to 90% of taxable income.  Maybe a floor of 50% would work, with the simplifying idea that companies get taxed on their GAAP income — no separate tax income base.  Would certainly reduce the games that get played.

Anyway, those are my opinions.  The world yearns for debt relief, but governments and central banks argue with that, and in the short-run try to paper over gaps with additional short-term debt that they think they can roll over forever. They just keep trying to hit the “defer” button, avoiding any significant reforms, in an effort to preserve the “status quo.”

Woj’s Thoughts - After reviewing the results of my 2012 predictions, I mentioned:

My main takeaway is that politicians are far more determined to maintain the status quo than I had expected. The underlying economic (and social) problems have once again been kicked down the road for future governments to handle.

Although David’s policy recommendations are becoming increasingly pervasive, they unfortunately remain nowhere near the level necessary for governments to test uncharted waters. 

2) Can Germans become Greeks? by Dirk @ econoblog101

The ECB as well as other policy makers and politicians do not understand economics. They think that a simple recipe like “decrease government spending, export more” is enough to solve the euro zone crisis. The increase in government debt is a symptom of the crisis, not a cause. The cause of rising government debt was negative economic growth and bank bail-outs. These are the two problems which must be tackled. They are intertwined, so solutions should address both. Households cannot pay their mortgages in Spain and Ireland at the existing unemployment levels, and that is due to a lack of demand as households consume less and save more. This downward spiral must be stopped and turned around, since at negative growth rates even a government debt of €1 is too high.

It seems that instead of Greeks becoming Germans now the German are becoming Greeks. That means that without government spending Germany will not have positive growth rates. While this will come as a surprise to many, it shouldn’t be.

Woj’s Thoughts - Germany managed to run a slight fiscal surplus during 2012 that ultimately came at the expense of growth. In the fourth quarter, German GDP shrank by 0.5 percent. Meanwhile, attempts at structural reform (i.e. fiscal consolidation) in the European periphery appear to be speeding up the rise in unemployment and decline in growth. This dynamic is neither economically or socially sustainable, therefore the governments and ECB must either substantially change the current course or wait for countries to eventually exit the Eurozone.

3) Did We Have a Crisis Because Deficits Were Too Small? by JW Mason @ The Slack Wire

The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield -- i.e. maximum price -- of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It's very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.

Woj’s Thoughts - The scenario laid out by JW sounds equally plausible and compelling to me. Changes in tax policies during the 1980’s and 1990’s set the stage for massive increases in real estate loans and the corresponding housing price boom. Then the unmet demand for safe-liquid assets prompted both the rise of shadow banking and the dispersion of U.S. housing assets to the rest of the world. So as the last sentence attempts to make clear, the “crash would have been much milder” but a similar crisis would likely have occurred.

Tax Policies Created a Real Estate Monetary Standard

Michael Sankowski, at Monetary Realism, asks us to consider the possibility that we are on a Real Estate Monetary Standard:

I’ve been thinking a lot about this over last few weeks when I have the chance to think. It seems like we are on a real estate monetary standard. Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.

Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

If we did operate under a real estate standard, we would expect to see the larger economic business cycle greatly impacted by the real estate cycle, far more than the declines in real estate activity would predict.

The impetus for this discussion is a recent paper by Ed Leamer, “Housing is the Business Cycle,” that confirms Mike’s prediction. The following graph shows real estate loans at all commercial banks as a percentage of total loans and leases:Notice that the percentage held relatively steady around 25 percent for nearly 40 years following the end of WWII. Then, in the mid-1980’s, the percentage surged higher. This massive change may have been a consequence of the Tax Reform Act of 1986 that included “ increasing the Home Mortgage Interest Deduction,” a “Low-Income Housing Tax Credit,” and changes to “ the treatment of imputed rent, local property taxes, and mortgage interest payments to favor homeownership.” After leveling off in the mid-1990’s, the percentage of real estate loans once again spiked higher beginning in late 1998. Once again, changes in tax policy may have played a substantial role. The Taxpayer Relief Act of 1997 substantially lowered the capital gains rate and “exempted from taxation the profits on the sale of a personal residence of up to $500,000 for married couples filing jointly and $250,000 for singles.”

The shifting of bank lending from primarily commercial to real estate loans has clearly been accompanied by shifts in policy to vastly reduce taxes accompanying rents, interest and capital gains. These changes, as well as other public policy initiatives, have helped significantly increase the value of homes that could be borrowed against. As Michael Hudson argues in The Bubble and Beyond, the overall effect has been to transfer former tax payments to private financial institutions, ultimately increasing wealth inequality and making the economy (and government) more beholden to the banks.

Although total real estate loans have actually fallen during the past few years, they still account for nearly 50 percent of total loans. This real estate monetary standard is certainly not restricted to the U.S. and actually appears to be prominent in Europe, as well as several other developed nations. To the degree that bank lending affects aggregate demand, real estate will clearly continue to have an outsized effect on the global business cycle.


(Note: For those interested, Leamer actually discussed this paper during an episode of EconTalk with Russ Roberts back in May 2009.)  

Tax Law Made Financialization Happen

After the 1982 recession, a straight-line increase of financial assets up to 50% of total corporate assets. As much as half the assets are financial assets.

Half the assets of non-financial corporations are now financial assets.

Tax law made that happen. I'm sure of it.

Read it at The New Arthurian Economics
FRED at Random: #3AO
By The Arthurian

From the comments:
The Arthurian said...

The implication, of course, is that tax law can make it NOT happen, too. Tax law can reduce this imbalance, and change things back to the way they were.

Of course, we must first be aware of the imbalance and see it as a problem.

Woj said...

I completely agree with this view. Unfortunately the struggle making the public concerned with these tax distortions. So much of discussion today is focused on monetary or fiscal policy, but not the enormous number of imbalances created through tax expenditures or other tax laws (which don't show up as spending or even directly count against the budget deficit). This will be an uphill battle but it's definitely worth it.

Related posts:
Facebook's $500 Million Tax Refund and The BIG Political Lie
Bruce Bartlett's Pessimistic View on Tax Reform
Foreign Income Rising

Bruce Bartlett's Pessimistic View on Tax Reform

Last Wednesday night, Bruce Bartlett spoke to George Washington University students about his new book, The Benefit and The Burden: Tax Reform-Why We Need It and What It Will Take, and experience on capitol hill. The guest lecture was for a class on Public Budget and Tax Policy taught by two highly esteemed economists, Marvin Phaup and Diane Lim Rogers. I took the course last year and absolutely recommend it for any GW students interested in the topic.

Bartlett’s path to capitol hill and into the world of budget and tax policy is a fascinating tale. After dropping out of grad school, he went to work for a Texas congressman that had just won a special election (Ron Paul). When Paul lost the next election, Bartlett decided to apply for a position on capitol hill researching budget and tax policy for Congressman Jack Kemp. Despite having no formal economics training, Bartlett got the job and has spent the rest of career working and writing on these topics.

Moving to the present, Bartlett discussed his ultimate transformation from Republican to Independent after Medicare Part D was passed without any intent of recouping a penny of the massive long-term expenses. A separate part of this change was recognizing that ‘supply-side’ economics may have worked for a time but was not applicable in the current situation. Bartlett argues that the current troubles are largely due to insufficient demand and therefore requires further stimulus now, with plans to tackle structural issues later on.

As the lecture moved to the current potential for tax reform, the outlook (from my perspective) became very pessimistic. Bartlett noted that despite acknowledging failed tactics, such as trying to “starve the beast”, many dogmas remain embedded in our system simply because of the political advantage provided. Another example of this was recalled from an old article by Jude Wanniski: Taxes and a Two-Santa Theory. The basic theory was that Democrats were the party of government spending, which everyone enjoyed, therefore the Republicans should become the party of tax cuts to improve their popularity. While this proposition has been very successful politically over the past 35 years, the budgetary effects have been quite the opposite. Both parties are now so intent on maintaining their roles that tax reform is increasingly unlikely.

A specific topic of interest, stemming from Dr. Phaup and Dr. Rogers, is potential reform of federal tax expenditures. These tax cuts, effectively spending programs, account for approximately $1 trillion per year. Bartlett recognized that this was a serious issue for tax reform, but suggested that voter support for the largest programs is too high to expect any changes in the near future. I find it surprising that support is so high, given how regressive many of the programs are, and wish Bartlett had been pushed to offer his thoughts on altering support.

On the whole I thought Bartlett painted a good picture of many necessary reforms to our current budget and tax policy. Given his experience on the hill, I think he could have provided greater insight on potential ways to change public perception in this arena. My main takeaway was that, unfortunately, progress is unlikely as long as politicians election or re-election chances are improved by holding to falsified dogmas and supposedly offering a ‘free lunch’.

(Note: I have not yet read Bartlett’s book, but here are a couple reviews from other bloggers I follow:  My Review of Bruce Bartlett, Bruce’s New Book)

Liberals Demonstrate Conservative Bias for Manufacturing

Last Friday, over at TripleCrisis, Jeff Madrick posted 10 Questions for Economists Who Oppose Manufacturing Subsidies. Conversations regarding this topic have been persistent for much of President Obama’s term in office and are unlikely to dwindle heading towards the election. Although the questions are posed towards mainstream economists, of which I am not, here are some succinct, sensible, non-mainstream responses in opposition to to manufacturing subsidies.  

1. Doesn’t America already have an anti-manufacturing strategy? It has enthusiastically supported a high value for the dollar since the 1990s. The high dollar raises export prices but, as noted, very much helps Wall Street attract capital flows and lend at low rates. Shouldn’t we get the value of the dollar down?

Answer - Lowering the value of the dollar will make exports cheaper, but it will likewise make imports more expensive. Many Americans, not on Wall Street, will therefore be able to purchase less goods with the same income. Reducing the dollar value is also an imprecise mechanism that could very well drive up food and energy prices well in excess of any benefits to manufactures.

2. Don’t Germany, China, and many other countries subsidize their own manufacturing industries? Do you really think the World Trade Organization works all these out? If they do subsidize, isn’t it only fair to place manufacturing on a level playing field and subsidize our own?

Answer - While Germany, China and many other countries do subsidize their own manufacturing industries, America currently does as well. A cursory glance at the tax statements of GE, GM, Ford and a host of other manufacturers will display a multitude of tax breaks/loopholes specifically to support American manufacturing. A better questions is whether or not American taxpayer dollars are best used supporting/bailing out manufacturing companies so that foreign consumers can buy goods at cheaper prices.

3. Doesn’t manufacturing having a multiplier effect? Some say we can never boost the share of manufacturing adequately. So what if we create even as much as another 2 or 3 million manufacturing jobs. (The president is settling for a couple of hundred thousand.) But wouldn’t manufacturing’s multiplier effect stimulate the rise of other manufacturing and service industries and the creation of other jobs?

Answer - Despite receiving massive subsidies over the past decade(s), the companies mentioned in question 2 have been shedding American workers. Efforts to stimulate manufacturing jobs are more likely to redirect funds from other sectors, resulting in American job losses outside of manufacturing. Accounting for the potential production of those 2 or 3 million outside of manufacturing, any multiplier effect is not necessarily positive. A cardinal rule of economics is there is no free lunch, hence creating manufacturing jobs will not be free.

4. How can we get our trade deficit down if we don’t sell more manufactures? They account for about seven-eighths of our exports. I know the answer some of you will give: savings. But do you really think raising our savings rate will reduce capital inflows adequately to lower the dollar in order to promote more exports?

Answer - This question assumes that reducing the trade deficit is definitively positive and that a lower dollar is needed to promote exports, both of which are not true. Until this past year, Japan ran persistent trade surpluses notwithstanding an almost perpetually rising Yen. Regardless, a different answer than the one expected: services. As noted above, manufactures are not the only form of exports (or imports). During the past century, US exports shifted dramatically from agriculture to manufactures. Over the next century is may shift again towards services.

5. Without manufacturing, what will we export? Isn’t there a point at which we lose too many industries and labor skills to make a comeback? Given the symbiotic nature of business clusters and supply chains, aren’t we rapidly losing the subsidiary companies that make manufacturing and exports possible?

Answer - As mentioned above, similar arguments were made when manufacturing began encroaching on agriculture’s territory. Looking back, few people probably wish that agriculture had been protected so that many of us would still be working on farms today. Google makes enormous profits across the globe even though it manufactures almost nothing. What’s wrong with most Americans eventually working in offices rather than factories?

6. Weren’t persistent trade imbalances a major cause of the 2007-2008 financial crisis as debt levels soared? Don’t you worry that the export-led models of China, Germany, and Japan are unsustainable? On a worldwide basis, they are really debt-led growth models. How do we get balance without promoting our exports?

Answer - Trade imbalances and debt levels are separate, relatively uncorrelated factors, of which the latter was more likely a major cause of the financial crisis. Total debt levels soared in the US and many European countries with import-led models as well. If debt levels are a major problem, which I believe is true, than one option to achieve balance would be reducing subsidies to acquiring debt, such as the mortgage interest deduction.

7. Isn’t manufacturing a source of innovation in and of itself? Isn’t that where the scientists and engineers are? Don’t we learn and innovate by doing? One commentator recently said that those innovations are exploited by others, so it doesn’t matter. Really? Then maybe we should stop promoting R&D altogether.

Answer - Manufacturing is one source of innovation, but what about companies like Amazon, Netflix, Apple and Facebook. Is buying goods online today not cheaper and quicker? Is watching movies and listening to music not more accessible for less cost? Can we not interact with people all over the world far quicker and more easily? These companies and others are constantly innovating and improving our lives, undeterred by a lack of manufacturing or scientists..

8. Where will the good jobs come from? You always say high technology. But America now imports more high-technology products than it exports, especially to China. Even Germany has a high-technology deficit with China. I ask again, where will the jobs come from as technology gets more complex? Do you think more education is really an adequate answer, the only answer?

Answer - Why are manufacturing jobs so ‘good’? Does this imply that all non-manufacturing (or high-tech) jobs are ‘bad’? What about teachers or doctors? The future offers a potentially massive increase in service jobs with new markets that have not yet been conceived. Education within schools may not be adequate and is certainly not the only answer, however education through increasing work apprenticeships may be a good place to start.

9. Why did the job market do so poorly throughout the 2000s? If you say we can’t know where jobs will come from, that the market will decide, then why aren’t you worried about the job market’s poor performance over the last decade, with huge losses in manufacturing jobs? Again, you say, inadequate education. Yetaccording to CEPR’s John Schmitt, we have not produced more good jobs as GDP grew — good jobs measured by wages and benefits provided. Is there hard evidence we don’t have the labor to fill the high-technology jobs — and if we did, are there enough jobs going unfilled to make a difference?

Answer - According to CEPR’s Dean Baker, in The End of Loser Liberalism: Making Markets Progressive, supposedly “free-trade” agreements have exposed many lower wage (manufacturing) jobs to foreign competition while erecting barriers against trade in higher wage areas such as health care and law. At the same time, patent laws and tax codes have been continually adjusted to protect large corporations and enforce monopolies. The economy is also structured to encourage home buying/building, which for some time vastly expanded construction jobs beyond a sustainable amount. Even with all of these poor choices, about 92% of Americans desiring work are employed today. Americans have the knowledge and expertise to reach full-employment, but policies that raise the cost of hiring workers and discourage small business creation are not helping.

10. Will the jobs come from services? The rapid growth of finance has fouled up the numbers. Finance services did provide high-paying jobs, but we now know many of these were phantoms. And the salad days may be over. The other big area of productivity growth in services was retail. We all know what kinds of jobs Wal-Mart provided.

Answer - Yes, services will provide one source of new jobs but hopefully finance will not be a significant contributor. It remains unclear why manufacturing jobs are necessarily better than retail or other service jobs. Either way, the beauty of capitalism is that the future is unknown but there has been no better economic system in history for supporting growth. Jobs will return, but manufacturing subsidies are not the best approach and may well cause more job losses than they create.

Quote of the Week

...is from p.162-163 of Hyman Minsky’s superb book, John Maynard Keynes:

“The economy is now a controlled rather than a laissez-faire economy; however, the thrust of the controls is not in the direction envisaged by Keynes. Investment has not been socialized. Instead, measures designed to induce private investment, quite independently of the social utility of investment, have permeated the tax and subsidy system.”

“The success of a high-private-investment strategy depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital—i.e., rentier and entrepreneurial income. But such high and increasing quasi-rents are particularly conducive to speculation, especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions. A high-investment, high-profit strategy for full employment—even with the underpinning of an active fiscal policy and an aware Federal Reserve System—leads to an increasingly unstable financial system, and an increasingly unstable economic performance.”

Minsky has been on my mind frequently over the past few months as much of today’s economic work in Post-Keynesianism and Modern Monetary Theory stem from his unique insights about instability in a capitalist society. In Facebook's $500 Million Tax Refund and The BIG Political Lie, I was trying to shed light on the manner by which politicians control the tax system to redistribute income upwards. Minsky brilliantly expands on this concept above, noting how policy that guarantees profits (quasi-rents) from speculation leads to instability. The rise in non-traditional mortgages, extremely low levels of down payments and government support in the recent housing crisis represents a prime example of the consequences highlighted above. As long as policy continues in this manner, economic performance is likely to be volatile and current income inequality will persist or expand even further.

Facebook's $500 Million Tax Refund and The BIG Political Lie

Over the next nine months, leading up to the Presidential election, conversations about optimal tax rates are certain to play a major role. Much of the recent media focus has already addressed the low effective tax rates paid by both Warren Buffett and Mitt Romney (although the light in which the two are held is a world apart). Current debate generally regards the low level of taxes paid by both men as being “unfair,” leading to calls for higher income tax rates on the wealthy. Although this proposed solution seems obvious, the reality is that neither Buffett or Romney will end up paying significantly more even if income tax rates return to the levels during the Clinton era.

How could this be? Behind this confusion lies innumerable intricacies within the US tax code, where rates differ for varying types of income and the laws are littered with various deductions, credits and provisions. Facebook’s upcoming IPO displays a perfect example of the unintended consequences of US tax laws. In Options and Taxes: Is a "Facebook" tax next?, Aswath Damodoran (NYU finance professor) comments that:

“Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him.”*

On the surface, this seems reasonable since Zuckerberg will be paying nearly 40 percent between federal and state income taxes. The criticism stems from the corporate tax deductions that Facebook is permitted based on the exercise of employee stock options, including Zuckerberg’s. As WithumSmith + Brown states in Tax Aspects of the Facebook IPO (Alternate Title: Mark Zuckerberg Could Buy Most of Europe With His 2012 Tax Bill):

“Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL [net operating loss] that will be carried back to generate $500 million in tax refunds.”

From a distinctly corporate perspective, Facebook, which may earn upwards of $2 billion in pre-tax income this year, will not only owe nothing in taxes but may actually receive a $500 million refund. How is it that an extremely profitable company ends up with a sizable tax refund? Why has GE and numerous other companies not paid taxes during the past decade despite earning substantial profits (G.E.’s Strategies Let It Avoid Taxes Altogether)? Why does Warren Buffett pay a smaller effective tax rate than his secretary?

When these questions are posed, a typical response suggests these outcomes represent the natural workings of a free-market system. Sadly this could not be farther from the truth. As Mish Shedlock points out in Is Romney to Blame for Paying Low Taxes or is 72,536 Pages of Tax Code to Blame? What's the Real Solution? Thanks to AMT, Man Pays 102% Tax Rate, “from 1984 until now, 46,236 pages of tax code have been added.” (shown below) Anyone would be hard pressed to find an economist who believes this level of complexity is either efficient or representative of a free-market economy. 

click on chart for sharper images
Image from Tax Law Pile Up

The reality is that consistent increases and alterations of US tax code, over the years, is primarily intended to benefit a special group or class. A rational choice perspective of public policy and administration implies that much, if not most, of this tinkering is done at the behest of groups with the largest political sway (funding capacity and desire).

Improving the tax system is possible both from the perspective of reducing government intervention and increasing progressiveness. Unfortunately the right (conservatives) has been persuasive in convincing individuals across the political spectrum that a complex tax code is part of a free-market system. In The End of Loser Liberalism: Making Markets Progressive, Dean Baker expresses his feelings on this subject noting:

“the vast majority of the right does not give a damn about free markets; it just wants to redistribute income upward.”

It’s important to note that the left (liberals) has also been complicit in this false perception, frequently adjusting the tax code in regressive ways to garner political funding and support.

Heading towards the election, both political parties will try to represent the current US tax system as “unfair” in an effort to push new laws that will “right” the system. Adding more layers of complexity, however, is unlikely to make the outcomes either more efficient or progressive. Overcoming the current trend requires exposing the truth that our current tax codes do not represent a free market. Hopefully both sides of the political spectrum can join together in encouraging politicians to create a far simpler, progressive tax system.

*Zuckerberg plans to exercise options for 120 million shares with an exercise price of $0.06. The nearly $5 billion profit assumes a per share value of approximately $40.

Points of Public Interest

1. Why Limiting Itemized Deductions (Still) Makes Sense - My former professor, Diane Lim Rogers, offers her support for a proposal to limit itemized deductions to a 15 percent rate. This policy will simultaneously increase the progressive nature of income taxes, substantially reduce total tax expenditures and raise revenue.
2. The Fed Is Misleading Congress About Europe - Warren Mosler, a founding member of Modern Monetary Theory, argues that the Fed’s dollar swap lines are unsecured lending and should therefore be the responsibility of Congress.
3. Philip Pilkington: Is QE/ZIRP Killing Demand? - Pilkington describes the counterproductive efforts of Fed policy. Milton Friedman also believed ZIRP (zero interest rate policy) would restrict demand as I outlined in Deflationary Monetary Policy.
4. The Liberalism of Classical Liberalism - Peter Boettke tries to correct some typical misrepresentations of classical liberalism with a good dose of historical background.
5. Show Me the Daylight 'twixt Sanction and Tariff - Samuel Wilson considers recent trade sanctions against Iran and China, and why the two are viewed in different lights by Americans.
6. The Future of Economics - Steve Keen, a leading post-Keynesian, makes a case for incorporating disequilibrium, dynamic modeling and emergent properties into the core of future economics.
7. The European Crisis Deepen - Peter Boone and Simon Johnson, former IMF Chief, explain why current optimism is likely unwarranted and how the realistic end may include a break-up of the Eurozone.

Regressive Tendencies

“The tax code, government’s favorite instrument for distributing wealth to favored factions, has been tweaked about 4,500 times in 10 years. Generally, the beneficiaries of these changes are interests sufficiently strong and sophisticated to practice rent-seeking.”

Read it at WashingtonPost.com
Government: The redistributionist behemoth
by George Will