Hopeful prediction on the fiscal cliff

Here's an optimistic prediction

1. Raise Income Tax rates on those making more than $250,000 in taxable income
2. Eliminate or reduce Payroll Tax Holiday
3. Reduce defense spending
4. Reduce discretionary domestic spending (these last two in equal parts)
5. Raise the debt ceiling
6. Eliminate or reduce extended unemployment benefits
7. Agree on a framework for broader, longer term fiscal remedies which would include
• reduction on tax "spending" (special deductions or loopholes),
• further reduction on defense spending
• Medicare and Medicaid program cuts

Points 1-6 would deal with the tactical issues related to the expiration of the Bush era tax cuts and automatic sequestering.

Point 7 would be some loose agreement in principle to deal with the longer term fiscal issue.

If this is accomplished the economy will continue to grow albeit slowly in 2013.  Contrary to Speaker Boehner's ideas raising taxes on the wealthy in order to do lower the debt and fund some critical spending will create jobs.

Gini coefficient

I just finished reading a special report in the Economist on the trajectory of wealth and income distribution on a global basis.  The data show that the US has become more and more unequal primarily at the top 1% and the top 0.01%.  The US social safety net ensures the poor haven't lost as much ground as the lower middle class.  Those folks without a good education are steadily losing ground.   The broad trends of globalization and automation are key drivers behind this trend.  I have discussed these here before.

In addition to those broad trends that impact all low skilled workers in the developed world, in the US we have two additional factors, one social factor and one government policy.   The social factor is that more and more working class children live in one parent households and with that comes a slew of educational and development disadvantages. The government policy issue is that the US spends much less on the poor  as a percentage of  GDP - especially in education - than most development nations.

One of the conclusions of the Economist is that as income and wealth inequalities become too extreme than the nation's overall growth and prosperity will suffer.  Ironically this essentially is in agreement with the socialist perspective.

So this all reinforces my thesis that the government policy that promotes even modest  wealth and income "redistribution" will be a  job creation policy.  

The Presidential election debates had little substance.  But it seems to me that Gov. Romney ran on  decreasing income tax rates across the board while Pres. Obama has now run two victorious national campaigns on the policy of increasing tax rates for those making more than $250,000 or more in taxable income.

Let's see if Pres. Obama holds firm.  I don't think it will make much difference but at least it would be a step in the right direction.

Income inequality and jobs

Once again it's been a few months since I last posted. As expected the macro-economic situation has changed very little in that time. At the outset of the financial crisis I predicted that the job recovery would be very slow and that an unemployment rate over 8% may last a decade.

Nothing has happened in the last four years to change my view on that. Yesterday we had the US jobs report for July. More jobs were added again but once again not enough. Unemployment went up a tick to 8.3%. Even if job growth rises to 250,000 jobs per month, the unemployment rate could still be 8% or more. There are plenty of sources that describe how the official unemployment rate is misleadingly low so I won't go into that here.

This post is about how income and wealth inequality eventually result in economic stagnation and unemployment. My primary source is The Great Financial Crisis: Causes and Consequences. Unlike many of the books written about the bubble and meltdown this book focused less on the proximate causes and much more on a long term view. 

Here's that view.

Over the long term capital (wealth) will become more and concentrated.  The growth of the middle class in the US after WWII and subsequently in the other industrialized nations was an aberration.  This historical anomaly lead to economic growth in all of these countries.  Starting around 1980 the situation began to revert to its historical norm - which is concentration of wealth which leads to stagnation.

The data is somewhat misleading because of the bubbles and one time conditions.  In the late 80's and early 90's there was a peace dividend as the cold was ended.  The dividend was physological as well as fiscal.  This was followed in the next 15 years by two bubbles in the US that temporarily produced unstainable GDP growth and unstainable employment levels. After the financial crisis and "recovery" we are back on our path to long term stagnation.

The reason that concentration of wealth and income leads to stagnation is straight-forward.  Wealthy individuals spend less of their income and save and invest more of it.  If there are no investment opportunities in industrial or commercial investments then capital flows to financial assets or even bubbles.  We know how that story ended last time.  Low and middle income workers on the other hand spend more of their income which leads to more economic activity and possibly more jobs.  Remember though that globalization and automation still play a drag on job formation.

The evidence that there is a surplus of capital is all around.  Investments in money market or savings accounts pay less interest than the currently modest inflation rate.  Capital in these asset classes are 100% guaranteed to lose purchasing power.  10 Year US Treasuries are yielding less than 1.5%.  Unless there is a deflationary cycle the massive investments in US Treasuries will also lose purchasing power over the life of the investment.

Why then has capital not flowed into commercial and industrial assets?  Businesses invest capital for only one reason - maintain or grow income.  Investments can do this in two ways, increase revenue or decrease costs.  In a slow growth and low inflationary cycle it is hard to increase revenue by simply raising prices. The other option is to sell more goods and services.  But once again we get back to low overall demand due to sluggish consumer spending.  The second investment opportunity is to lower costs.   These opportunities do not depend on demand; innovation, application of new technology, or simply moving production to lower labor costs are all effective ways to invest.  Unfortunately the cost-saving investments may lead to more unemployment not less.

Additionally the large US corporations have generated so much cash that many do not need outside capital for their investments.  Instead they are contributors to the excess capital conditions we have today.  They form part of the Giant Pool of Money and contribute to the concentration of capital into fewer hands.

So here we are and here we will stay.

As long as politicians, pundits and policy makers insist that higher taxes on high income individuals will cost jobs here we will stay.  As long as politicians, pundits and policy makers propose government austerity here we will stay.

I am not sure there is a solution.  The best try would be to significantly increase taxes on high income individuals, increase taxes on the upper middle class, eliminate tax loopholes, allow corporations to treat dividends as a business expense and at the some time tax personal interest and dividend as wages - including the payroll taxes of Social Security and Medicare.  The government then has to use that additional revenue to actually create jobs by the most direct and cost-effective means - hire people.

Right now we need more public sector jobs - teachers, fireman, librarians, construction and maintenance workers, and yes - regulators.

Greece: How to leave the Euro

The giant credit bubble spilled over to Greece with the help of Goldman Sachs and a whole host of commercial banks in Europe. Greece was able to borrow way more than they will be able to repay. The private lenders have taken a hair cut already which is fair since they made the bad lending decisions. However the austerity program forced on Greece by the IMF and the EEU has, of course, led to a recession. The drastic cuts in government spending caused the recession as predicted by Keynesian economics.

So Greece will still be unable to pay down its existing debt or to borrow more money.

The typical long term solution is to devalue the currency. Imports become more expensive. Consumers suffer an immediate hit on their standard of living. Usually you would expect a steep decline in the units of imported goods especially any discretionary consumer goods. On the other hand exports become cheaper. For Greece, olive oil, wine, cheese become cheaper in the world markets which can increase demand and help grow all export industries. Tourism is an a sense a service industry export and for Greece a significant one. Presumably services purchased as part of the tourism industtry - hotels, restaurants, events, guides, transportation become cheaper for the foreigner visitor. After devaluation Greece could become a very, very popular destination.

The problemis of course that Greece does not have its own currency.

So how does it get there.

All bank deposits need to be converted from Euros to drachmas. All goods and services are prices in drachmas. Day One - it is a one-to-one conversion. After one month - Euro currency is no longer accepted. After a few months the drachma is devalued so that one drachma equals 0.7 Euros. All bank deposits and all Drachma in currency now have lost 25% of their purchasing power. The Greek government is now able to issue new bonds in Drachma and have the central bank buy them - essentially printing money. Inflation would probably be in double digits but now the economy is growing again. Through economic growth, slow reduction in government spending and inflation Greece will be able to balance its budget and pay down its debt.

Greece will simply default on their existing Euro bonds.

This is the scenario worked out over time by many other countries. The savers and investors take a big hit. The bond holders take a hit. Consumers take a hit. Private borrowers may get a break.

The unique challenges for Greece is that bank deposits can be moved to other countries. Why would anyone leave their Euro deposits in a Greek bank and subject themselves to this devaluation. No one will. That's why when this is done it has to be done "overnight" even if "ovrrnight" means a one week bank holiday to allow the banks to fix their bank deposit accouting and payment systems.

The run on Greek banks has already started. With the massive withdrawals already undeway most Greek banks are insolvent. The government will likely need to nationalize the banks for some time.

Bubble and Meltdown - Jobs again

I haven't added to this thread in awhile but nothing much has changed so I can pick up where I left off. We are back in an election cycle so the conversation about policy is pretty much over. For the next 11 months the conversation will be about politics and personality not policy.

Much of the political discourse on jobs and the economy is not focused on what is actually happening.

1) US jobs are being lost due to automation and globalization. Nothing can stop this trend.
2) The largest percentage of US GDP is consumer spending. It is about 70% and it is growing very, very slowly.
3) Businesses do not need tax breaks to create jobs they need demand for their products and services.
4) The biggest uncertainty that businesses faces is not tax policy or the health care insurance reform. The biggest uncertainty is whether there will be demand for their products and services. On the global basis the biggest threat to demand is the Euro crisis. European governments are adopting "fiscal reforms" and "austerity budgets" that will likely result in a recession in Europe in 2012.
5) US consumer spending can only increase on a sustainable basis when personal income increases. The credit bubble allowed consumer spending to increase but spending more than you earn is not sustainable.
6) Accumulation of wealth and income in the US hampers job growth.
7) The conversation about the POTUS "managing the economy" or "creating jobs" is surrealistic. The federal government is powerless to do either one.

So what it the way forward?

A slow recovery. Eventually consumer spending will increase as people who work continue to first pay down their debt and then slowly increase spending. I expect unemployment to be over 8% for years and years.

The US fiscal problem will eventually be sorted out by:
- increasing taxes especially on the affluent
- inflation
- massive cuts on defense spending
- reducing health care costs by expanding on the health care reforms already passed
- economic growth

This will all take time.