More on the Oinking Bailout Bill

More detail on all the lovely goodies larded in via Karim Bardeesy at The Big Money (both someone at TBM and reader Jennifer pointed out the piece). Note that this is a partial list:

DIVISION C-TAX EXTENDERS AND ALTERNATIVE MINIMUM TAX RELIEF

SEC. 308. INCREASE IN LIMIT ON COVER OVER OF RUM EXCISE TAX TO PUERTO RICO AND THE VIRGIN ISLANDS.

(a) IN GENERAL.-Paragraph (1) of section 7652(f) is amended by striking ‘‘January 1, 2008'' and inserting ‘‘January 1, 2010''.

(b) EFFECTIVE DATE.-The amendment made by this section shall apply to distilled spirits brought into the United States after December 31, 2007.

SEC. 309. EXTENSION OF ECONOMIC DEVELOPMENT CREDIT FOR AMERICAN SAMOA.

Subsection (d) of section 119 of division A of the Tax Relief and Health Care Act of 2006 is amended-

(1) by striking ‘‘first two taxable years'' and inserting ‘‘first 4 taxable years"

SEC. 317. SEVEN-YEAR COST RECOVERY PERIOD FOR MOTORSPORTS RACING TRACK FACILITY.

3 (a) IN GENERAL.-Subparagraph (D) of section 168(i)(15) (relating to termination) is amended by striking ‘‘December 31, 2007'' and inserting "December 31, 2009''.

SEC. 325. EXTENSION AND MODIFICATION OF DUTY SUSPENSION ON WOOL PRODUCTS; WOOL RESEARCH FUND; WOOL DUTY REFUNDS.

(a) EXTENSION OF TEMPORARY DUTY REDUCTIONS.-Each of the following headings of the Harmonized Tariff Schedule of the United States is amended by striking the date in the effective period column and inserting ‘‘12/31/2014'':

(1) Heading 9902.51.11 (relating to fabrics of worsted wool).

(2) Heading 9902.51.13 (relating to yarn of combed wool).

(3) Heading 9902.51.14 (relating to wool fiber, waste, garnetted stock, combed wool, or wool top).

(4) Heading 9902.51.15 (relating to fabrics of combed wool).

(5) Heading 9902.51.16 (relating to fabrics of combed wool).

SEC. 503. EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN.

‘(B) EXEMPTION FOR CERTAIN WOODEN ARROW SHAFTS.-Subparagraph (A) shall not apply to any shaft consisting of all natural wood with no laminations or artificial means of enhancing the spine of such shaft (whether sold separately or incorporated as part of a finished or unfinished product) of a type used in the manufacture of any arrow which after its assembly- ‘‘(i) measures 5⁄16 of an inch or less in diameter, and ‘‘(ii) is not suitable for use with a bow described in paragraph (1)(A).''.

New Bailout Proposal Costs Estimated at $500 Billion to $1 Trillion

Repeat after me: bye bye the US's AAA rating and the dollar. Although the Paulson's plan is only sketchy, on the surface, it is utterly ridiculous. The authorities propose to save the economy by buying mortgage paper at market prices.

Why do we need the government to create a massive and costly effort to buy paper at market prices? Institutions can sell paper at market prices now. This is clearly ether a massive game of smoke and mirrors (f we are lucky) or a plan to buy bad assets at above market prices but somehow pretend that they are indeed correct.

The latter takes us straight down the Japan path. The government is left holding lousy paper it will have to dispose of at a loss, the banking system gets subsidized not based on triage, on who might it make most sense to rescue, but who gets enough of the crappy assets sold at a high enough price. It's a terrible, inefficient way to recapitalize the banking system. Why should taxpayers underwrite banks without getting some upside and a measure of control?

And as we have said before, Japan had high enough savings that it could manage its crisis internally. We don't. Foreign central banks are already coming under pressure from domestic constituencies over their dollar holdings. It isn't at all clear that they will support these initiatives by buying even larger amounts of Treasuries.

Oh, PS, and who gets to decide if the mortgage prices are fair? Consultants hired by the Treasury. Given how costly and ineffective this Administration's outsourcing has been, I have little faith that this would be implemented well separate and apart from the confused (or more likely misrepresented) objectives.

And the prospect of turning on the spigot has others clamoring for bailouts. There are calls for underwater homeowners to get handouts too.

Pray that this measure does not pass, or better yet, call your Congressman and Senator and raise hell. The importance of these initiatives and the dollars attached says they should not be rushed through in a panic, particularly when the underlying premise is so dubious.

From the New York Times:

The Bush administration, moving to prevent an economic cataclysm, urged Congress on Friday to grant it far-reaching emergency powers to buy hundreds of billions of dollars in distressed mortgages despite many unknowns about how the plan would work.

Henry M. Paulson Jr., the Treasury secretary, made it clear that the upfront cost of the rescue proposal could easily be $500 billion, and outside experts predicted that it could reach $1 trillion.

The outlines of the plan, described in conference calls to lawmakers on Friday, include buying assets only from United States financial institutions — but not hedge funds — and hiring outside advisers who would work for the Treasury, rather than creating a separate agency. Democratic leaders immediately pledged to work closely with Mr. Paulson to pass a plan in the next week, but they also demanded that the measure include relief for deeply indebted homeowners, not just for banks and Wall Street firms.

However, it is not clear that Congress is going to roll over:

As of Friday evening, Mr. Paulson had yet to deliver a formal plan to Congress. House and Senate leaders pledged to work through the weekend, but they insisted that Mr. Paulson bring them a detailed plan rather than just an outline.

An even bigger obstacle was the goal of the plan. President Bush and Mr. Paulson made it clear that their primary, and perhaps only, goal was to stabilize the financial markets by removing hundreds of billions of dollars in “illiquid assets” from the balance sheets of banks and financial institutions....

But Democratic lawmakers insisted that any plan would also have to provide relief to millions of families that were poised to lose their homes to foreclosure.

The House Speaker, Nancy Pelosi of California, said she would insist that the plan “uphold key principles — insulating Main Street from Wall Street and keeping people in their homes by reducing mortgage foreclosures.”

The Wall Street Journal discussed the need to sort out pricing:

However, the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets. The Treasury department, which hasn't commented on specifics about the plan, is expected to propose issuing debt in $50 billion tranches to fund the purchases.

The SIV rescue plan, the MLEC, did not get off the ground because the objectives of the sellers of bad mortgage debt, did not want to show much in the way of losses, while investors in the Entity, as it was called by some, were only interested in bying fairly-valued assets.

Since ideas along those lines haven't worked, we are now having the taxpayer stand in place of private buyers. And I guarnatee if this program sees the light of day, it will not pay arm's length prices. There'd be no point in doing that. This is a complete charade. But Paulson cannot say that this amounts to a recapitalization of banks, done in a very inefficient fashion. It would be too controversial to admit that. But Congress may figure it out regardless.

The New York Times' Joe Nocera, in "A Hail Mary Pass, but No Receiver in the End Zone" takes a very dim view of recent Treasury moves, including the latest bailout plan. The whole piece is very much worth reading, Key bits:

So rather than help solve the crisis, the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence....

Will this latest round of proposals end the crisis? I know the stock market reacted joyously on Friday, but I’m not hopeful. One solution being promoted by the Securities and Exchange Commission — to make life more difficult for short sellers — is a shameful sideshow. A second solution, which Mr. Paulson announced Friday morning, requires money market funds to create an insurance pool to cover themselves against losses.

That may provide comfort to investors who equate money funds with savings accounts, but it is fraught with moral hazard.

And the third solution — the big megillah — is Mr. Paulson’s plan to create a new government mechanism to buy mortgage-backed securities from big banks and investment houses. Once they are off those companies’ books, life can return to normal — or so Mr. Paulson hopes.

He acknowledged that it would likely cost taxpayers “hundreds of billions of dollars.” I think it will cost more than $1 trillion.

Paulson Gives Fannie and Freddie a Tax Break Too

I bet every on-the-ropes corporate borrower would like to get the tax bennie that the Treasury extended to the GSEs today, namely, giving them what amounts to a private waiver for their net operating loss carryforwards.

As much as one can argue that the Frannie and Freddie salvage operation is a unique situation, the notion that the Treasury is changing well-established tax principles to favor the GSEs is disturbing. Mind you, this is also after the plan diluted rather than wiped out common stockholders, so if the GSEs recover, this move would benefit the old shareholders. What else are the powers that be doing that either hasn't come to light or won't make its way into the press?

From CFO.com:

Wouldn't it be nice if the Internal Revenue Service issued a new tax rule that applied just to your company to help it retain all the net-operating losses it could? In that way, the NOLs could be used over the next 20 years to offset income, and reduce the company's tax bill.

That's what Treasury Secretary Henry Paulson did for Fannie Mae and Freddie Mac on Monday, when he had the IRS issue Notice 2008-76, which essentially allows the two government-sponsored enterprises to retain all of their NOLs, despite a change of control of ownership, tax expert Robert Willens told CFO.com.

Under the tax code — specifically Section 382 — NOLs are severely limited when there is a change of control... The NOLs for Fannie and Freddie are substantial. Over the last four quarters, Fannie and Freddie recorded about $14 billion in aggregate losses.

In essence, Paulson changed tax law so that the two lenders aren't paying more in taxes to the government as a result of that same government becoming their controlling investor. When the government structured its bailout of the two mortgage lending giants, it seized control of Fannie and Freddie by buying up $1 billion worth of senior preferred stock in each GSE. The plan also stipulates that Fannie and Freddie will pay a 10 percent annual dividend on the preferred stock owned by the government; and no other dividend can be paid out without the permission of the Treasury Department.

If the Treasury Department were simply another company, such a takeover would constitute a change of control under the tax code. But the new ruling creates a big exception for the two mortgage lenders. And while the IRS ruling was issued without any basis in law, says Willens, the NOL provision of the bailout was done "very effectively." He explains that the new rule eliminates the "testing dates" that normally would have applied to Fannie and Freddie, or any other company, in the event of a takeover....

With Fannie and Freddie's market caps at all time lows, the government would have been able to claim only a fraction of the original NOLs, opines Willens. However, by eliminating the testing date, the IRS also eliminates the question of whether the bailout constituted a change-of-control under the tax law. "It becomes a moot point," says Willens...

"I am not saying that the IRS ruling is a good thing, or a bad thing, it is just unusual," asserts Willens. "Then again, this is a very unusual situation."

Alan Blinder: "Is History Siding With Obama’s Economic Plan?"

Princeton economics professor Alan Blinder's article in today's New York Times provides a useful summary of a new book by a Princeton colleague, Larry Bartels, which finds consistent differences in economic performance and income inequality trends between Democratic and Republican administrations.

From the New York Times:

Many Americans know that there are characteristic policy differences between the two parties. But few are aware of two important facts about the post-World War II era, both of which are brilliantly delineated in a new book, “Unequal Democracy,” by Larry M. Bartels, a professor of political science at Princeton...

I call the first fact the Great Partisan Growth Divide. Simply put, the United States economy has grown faster, on average, under Democratic presidents than under Republicans....

Data for the whole period from 1948 to 2007, during which Republicans occupied the White House for 34 years and Democrats for 26, show average annual growth of real gross national product of 1.64 percent per capita under Republican presidents versus 2.78 percent under Democrats.

That 1.14-point difference, if maintained for eight years, would yield 9.33 percent more income per person, which is a lot more than almost anyone can expect from a tax cut...

The second big historical fact, which might be called the Great Partisan Inequality Divide, is the focus of Professor Bartels’s work.

It is well known that income inequality in the United States has been on the rise for about 30 years now — an unsettling development that has finally touched the public consciousness. But Professor Bartels unearths a stunning statistical regularity: Over the entire 60-year period, income inequality trended substantially upward under Republican presidents but slightly downward under Democrats, thus accounting for the widening income gaps over all...

The Great Partisan Inequality Divide is not limited to the poor. To get a more granular look, Professor Bartels studied the postwar history of income gains at five different places in the income distribution.

The 20th percentile is the income level at which 20 percent of all families have less income and 80 percent have more. It is thus a plausible dividing line between the poor and the nonpoor. Similarly, the 40th percentile is the income level at which 40 percent of the families are poorer and 60 percent are richer....The 95th percentile is the best dividing line between the rich and the nonrich that the data permitted Professor Bartels to study. (That dividing line, by the way, is well below the $5 million threshold John McCain has jokingly used for defining the rich. It’s closer to $180,000.)

The accompanying table...tells a remarkably consistent story. It shows that when Democrats were in the White House, lower-income families experienced slightly faster income growth than higher-income families — which means that incomes were equalizing...

The table also shows that families at the 95th percentile fared almost as well under Republican presidents as under Democrats (1.90 percent growth per year, versus 2.12 percent), giving them little stake, economically, in election outcomes. But the stakes were enormous for the less well-to-do. Families at the 20th percentile fared much worse under Republicans than under Democrats (0.43 percent versus 2.64 percent). Eight years of growth at an annual rate of 0.43 percent increases a family’s income by just 3.5 percent, while eight years of growth at 2.64 percent raises it by 23.2 percent.

The sources of such large differences make for a slightly complicated story. In the early part of the period — say, the pre-Reagan years — the Great Partisan Growth Divide accounted for most of the Great Partisan Inequality divide, because the poor do relatively better in a high-growth economy.

Beginning with the Reagan presidency, however, growth differences are smaller and tax and transfer policies have played a larger role. We know, for example, that Republicans have typically favored large tax cuts for upper-income groups while Democrats have opposed them. In addition, Democrats have been more willing to raise the minimum wage, and Republicans have been more hostile toward unions.

The two Great Partisan Divides combine to suggest that, if history is a guide, an Obama victory in November would lead to faster economic growth with less inequality, while a McCain victory would lead to slower economic growth with more inequality. Which part of the Obama menu don’t you like?

Wall Street Losses a Disaster for New York City Finances

One of the shifts in leading edge conventional wisdom is the "cities are cool" sentiment. It's a lagging indicator, so lagging as to set for a near-term reversal.

Mind you, I like cities and particularly like not owning a car, which limits me to particularly densely populated and/or enlightened metropolises. The logic of the new-found enthusiasm for city living among the chattering classes was in part a recognition that high cost energy makes suburban living much more expensive (it's not just the driving but also the expense of heating an isolated home versus even a similar-sized space ensconced in a larger apartment building). The other factor os quality of life, which until recently, was perceived to be better in the 'burbs. But now that kids no longer amuse themselves in the neighborhood but instead have activities and play dates, and cities offer convenience, street life, and closer proximity play dates, suddenly urban living looks child-friendly.

But the charm of cities depends on adequate municipal budgets. It wasn't until the Giuliani era that the number of parents deciding to remain in the City grew sharply, and with good reason. Even in the fat years of the 1980s, Manhattan wasn't entirely safe. I was lucky. I merely had my wallet stolen more times than I can remember,

Perhaps a better indicator: during the later 1980s, I lived in a townhouse on a very nice block (69th between Park and Madison). The building had an outer door that was unlocked and a keyed inner door. I was the first person out of the building in the morning and inevitably had to step over a homeless person sleeping between the two doors. I would walk down Madison and there would be at least one homeless person on each side of the street sleeping in the doorways of the fancy boutiques.

All cities will be hit by declining tax revenues, but New York will fare worse due to its dependence on financial services. Despite the view that foreign buyers will keep the real estate market from declining too far, a return to 1980s conditions may dampen their enthusiasm.

From Bloomberg:

Wall Street's mortgage losses have grown so large that some firms may pay little or no taxes for years, widening New York City and state deficits and challenging their ability to provide services, Mayor Michael Bloomberg said.

Some companies are seeking refunds from the city on taxes they prepaid, saying losses have cut their tax liability to zero. The banks pay tax on 110 percent of earnings in advance as a ``safe harbor,'' protecting against penalties for underpayment.

``I think it will be a number of years before Wall Street starts paying taxes again,'' the mayor said at a press conference yesterday in Manhattan. ``They will carry forward all of those losses.''...

New York Governor David Paterson called the Legislature back to work next week in an emergency session to address widening deficits as revenue, including tax receipts from Wall Street, declines. Sixteen of the state's largest banks sent taxes totaling $5 million to the state treasury in the most recent reporting period, a 97 percent decrease from a year earlier, when they accounted for $173 million in revenue, Paterson said.

The state faces a $26 billion deficit over the next three years and a $630 million shortfall in the current year that began April 1, Paterson has said. The governor yesterday outlined $630 million in administrative spending cuts he intends to apply this year, and he called upon the Legislature to cut at least $600 million more later in August.

``A lot of what we're facing now are the diminished revenues from Wall Street...,'' Paterson, a Democrat who took over as governor in March following Eliot Spitzer's resignation, said yesterday.

In the city, where Wall Street provides about 5 percent of jobs and more than 20 percent of total personal income, deficits are projected to widen to $2.3 billion in fiscal 2010 beginning next July, growing to $5.96 billion and $5.4 billion in 2011 and 2012, city Comptroller William Thompson has said.

``I think we still haven't come to grips with how deep will be the impact on New York City's and the state's economy and budget resulting from this credit crisis,'' said Kathryn Wylde, president of the Partnership for New York City, a civic group of corporate chief executives organized to promote commerce....

``I am worried about the state's bond rating, and it will start to fall if the governor doesn't do something about his budget problems now,'' Bloomberg said. ``The rating agencies are cognizant of what's happening to our economy.''

And You Thought You Could Quit Worrying About Fannie and Freddie For Now

It would be nice if Fannie and Freddie would have the good taste to stay out of the spotlight, particularly since bad news is a sign of higher odds that Things Are Not Going Well, Especially for Bagholders Taxpayers.

However, it looks like we may not be so lucky. Bloomberg's Jonathan Weil did some digging into the GSE's reports, and they are even less pretty than we thought. Remember Poole's remark that Freddie is "technically insolvent'? That view is based on a reading of the GSE's "fair value" report (the comparable figure for Fannie as of March 31 is a not very encouraging $12.2 billion). The GSEs of course maintain that these reports are irrelevant and misleading, yet that methodology is more comparable to the published financials of banks and investment banks than the presentation more commonly used.

Weil tells us even those reports are overly rosy. From Bloomberg:

Forget everything you've read about how woefully undercapitalized Fannie Mae and Freddie Mac are. The situation is much worse....

Deferred-tax assets consist of tax-deductible losses and expenses carried forward from prior periods, which companies can use to offset future tax bills. Under generally accepted accounting principles, they are valuable only to companies that are profitable and paying income taxes. To the extent a company doesn't expect to have enough profits to use them, it's supposed to record a valuation allowance on its GAAP balance sheet.

Fannie and Freddie so far have recorded no such allowances

As noted above, Fannie's fair value, which is tantamount to its mark-to-market net worth, is a mere $12.2 billion, and as former Fed president William Poole and others have discussed, Freddie's is negative. Weil tells readers that the deferred taxes are one of the reasons the GSEs, which are not subject to SEC requirements, can report higher equity levels in their public financial statements:

....core capital includes deferred-tax assets. Commercial banks, by comparison, normally don't get to count these in their capital, because they can't be sold by themselves and, thus, can't be used as a cushion against losses....

But even the fair value balance sheets contain this adjustment:

Without that $14.3 billion of tax adjustments, the fair value of Fannie's net assets would have been negative $2.1 billion, by my math. Exclude deferred-tax assets entirely, and it would have been negative $19.9 billion as of March 31....take out the tax write-up, and Freddie's net assets had a fair value of negative $15.3 billion. Exclude deferred-tax assets entirely, and that falls to negative $31.9 billion....

And removing these adjustments means both GSEs have negative net worth.

Wolf, Becker, and Posner on Oil (With a Shocker From Posner)

There are some interesting cross currents in the day's offerings on oil.

What a difference a year makes. Not so long ago, the peak oil crowd was seen in much the same light as the discredited Club of Rome: worrywarts about a bad future that would probably take a long time to arrive. Now everyone is on the resource scarcity bandwagon.

Martin Wolf offers a workmanlike treatment of the "this time it's real" thesis; what is intriguing are some divergent observations from Gary Becker and in particular Richard Posner (hat tip reader Steve), who advocates aggressive taxing of energy. Mirable dictu, I never would have expected that from his end of the political spectrum (although Posner isn't as easily pigeonholed as some other thinkers). I hope his stature encourages others to warm up to the idea.

First from Wolf in the Financial Times:

Here are three facts about oil: it is a finite resource; it drives the global transport system; and if emerging economies consumed oil as Europeans do, world consumption would jump by 150 per cent. What is happening today is an early warning of this stark reality. It is tempting to blame the prices on speculators and big bad oil companies. The reality is different....

It looks increasingly hard to expand supply by the annual amount of about 1.4m barrels a day needed to meet demand. This means an extra Saudi Arabia every seven years. According to the International Energy Agency, almost two-thirds of additional capacity needed over the next eight years is required to replace declining output from existing fields. This makes the task even harder than it seems. As the latest World Economic Outlook from the International Monetary Fund adds, the fact that peak production is reached sooner, because of today’s efficient technologies, also means that subsequent declines are steeper.

This is not to argue that speculation has played no role in recent rises in prices. But it is hard to believe it has been a really big one.... As I have argued before, if speculation were raising prices above the warranted level, one would expect to see inventories piling up rapidly, as supply exceeds the rate at which oil is burned.

Note that Wolf's views on oil are in part based on the assumption of continued strong growth ex the US. This is contradicted by IMF forecasts that anticipate global growth of 3.7% (that may sound like a good number for the US, but is considered sluggish for the world as a whole). Over the last two quarters, the IMF has slashed its forecasts from 4.9% and sounded this cautionary note in its end of April release:

Citing the unfolding financial market turmoil as the biggest downside risk to the global economy, the April 2008 report said the IMF expects world growth to slow to 3.7 percent in 2008—0.5 percentage point lower than what was forecast in the January 2008 World Economic Outlook Update.

Further, world growth would achieve little pickup in 2009, and there is a 25 percent chance that the global economy will record 3 percent or less growth in 2008 and 2009, equivalent to a global recession.

Contrast this with Wolf:

The price spikes of the 1970s were followed by big absolute falls in demand and output (see chart). This was partly because of the recessions and partly because of rising efficiency. Both forces should work again this time, but to a much smaller extent. The slowdown in the US economy is indeed likely to be significant. Slowdowns will also occur in western Europe and Japan and even in the emerging world. But the latter will still grow rapidly. Overall, the world economy – and so world oil demand – is likely to continue to grow reasonably briskly. Similarly, the improved efficiency of use of petroleum, as people switch to more efficient vehicles, notably in north America (where the room for doing so is so large), will be offset by the rising tide of demand for motorised transport in the world’s fast-growing emerging countries.

This is admittedly a difference of degree rather than kind. His evidence:


The areas of difference with the Becker/Posner tag team are instructive. First from Becker, who claims that conservation and new technology will tame oil price hikes:

The run-up in the world price of oil during the past several years, and especially the rapid climb during the last few weeks to over $120 per barrel, has fueled predictions that the price will reach $200 a barrel in the rather near future. Such predictions are not based on much analysis, and mainly just extrapolate this sharp upward trend in oil prices into the future. The price of oil in "real" terms (i.e., relative to general prices) will not reach $200 in this time frame without either terrorist or other attacks that destroy major oil-producing facilities, or huge taxes on oil consumption....

The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations....To be sure, supply problems.... have contributed...

[A]ny rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible...For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small....

However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.

Clearly, given high enough oil prices, many ways are available to increase the supply of petroleum....Rising prices of oil and other energy inputs will eventually be controlled by new technologies that greatly economize on the use of these inputs. Increased supplies of oil and other energy sources that become profitable to exploit only with prolonged high prices will also push these prices back.

Now from Posner, who argues that high taxes on oil, or preferably CO2 emissions, will produce a benefits on a variety of fronts (including reducing wealth transfer to the Middle East):

I would like to see the price of oil rise to $200, despite the worldwide recession that would probably result, provided that it rises as a result of heavy taxes on oil or (better) carbon emissions. The taxes would jump start the development of clean fuels, and the financial impact on consumers could be buffered by returning a portion of the tax revenues in the form of income tax credits. That would not reduce the effect of the taxes on the demand for oil or the incentives to develop alternative fuels, because the marginal cost (the production and distribution cost plus the tax) of oil to consumers would not be affected. Higher oil prices are necessary to check global warming, reduce traffic congestion, and reduce dependence on foreign oil, so much of which is produced by countries that are either unstable or hostile to the United States. Heavy taxes on oil would reduce not only the amount of oil we import but also the revenue per barrel of the oil exporting nations, so there would be a double negative effect on those countries' oil revenues: they would sell less oil and earn less per unit sold. The reason for the latter effect is the upward-sloping supply curve for oil. Suppose the first million barrels of oil can be produced at a cost of $1 per barrel and the second million at $2 per barrel. If total demand is one million barrels, the suppliers break even: they have revenues of $1 million and costs of $1 million. If total demand is two million barrels, the suppliers have revenues of $4 million (because the price of all barrels is determined by the price that the marginal purchaser is willing to pay) but costs of only $3 million ($1 million for the first million barrels, $2 million of the second). The lower the price of oil received by the oil producers (that is, the price net of tax), the lower their net income.

Unfortunately I cannot see a confluence of political forces that would make heavy taxes on oil feasible. We seem to be experiencing a democratic failure, in which long-term problems simply cannot be addressed.

Thomas Palley Questions Housing Subsidies

An odd set of voices is beginning to question the wisdom of America's extraordinarily generous subsidies to homeowners. Paul Krugman once remarked that American like to consume houses, while the French prefer to consume vacations, but we shouldn't overlook the role of incentives in those choices.

At the Milken Institute Global Conference, a true disciple of Milton Friedman. Gary Becker (University of Chicago), was the only one to argue that the considerable benefits lavished on homeowners didn't make for great policy. But for Becker, that is part of a general libertarian, anti-interventionist stance.

Thomas Palley, who comes from the opposite end of the political spectrum, is also opposed to housing incentives. He believes that they fed the housing bubble and are regressive, since taxpayers in higher income brackets get proportionally greater subsidies than the less well off (although in high income tax states, the AMT undercuts the writeoffs). He minces no words, describing a "cult of homeownership" and pointing out an unpleasant fact: tax breaks make housing more costly, so the subsidy, now that it is in place, is eroded by higher prices. To put it even more bluntly, the main beneficiaries are those who profit from higher priced housing units, namely, builders and brokers. But no one wants to see the sacred mortgage tax deduction as ineffective (in terms of its intended beneficiaries) and a hugely inefficient, expensive benefit to a small sector of the economy (the housing sector is 5% of GDP).

But Palley goes even further than that, claiming that the allure of homeownership leads to more dual income families which produces broader social costs. That claim isn't inconceivable; I know couples where one partner would be working less were it not for the home payments. But Palley's assertion begs for empirical support. Interest expenses have long been tax deductible; it was only in the 1980s that individual filers lost the ability to deduct interest on loans unrelated to housing. Similarly, mortgage interest was deductible in the 1950s, the Ozzie and Harriet age of stay-at-home moms. Other factors have contributed to two earner households, such as a long generation shift in attitudes toward debt and more attractive opportunities for women to work.

To Palley's credit, he provides a short list of reforms which would not be too painful to implement (but finding the political will to touch this third rail issue is a completely different matter). Note he does not discuss phasing out Fannie and Freddie, but that would seem to be part and parcel of this sort of program.

My view (and I suspect that of at least some readers) lies in the middle. Housing subsidies in America are sacrosanct. It would be easier to cut Social Security than housing benefits (not that I favor cutting Social Security; the entitlements problem is not as intractable as critics suggest). Yet from an efficiency standpoint, it's nuts to encourage so much investment in a sector that does nothing for our national competitiveness. With energy costs rising, the McMansions of the recent boom, the product of big tax deductions, are going to start looking like white elephants. Given our low savings rate and burgeoning federal deficits, we are going to have to make some tough fiscal choices. Housing is a logical, if controversial, place to cut.

From Palley:

The bursting of the recent house price bubble has focused attention on the failures of monetary and regulatory policy. However, tax policy also likely played a role by providing tax subsidies that contribute to a cult of home ownership. This policy is flawed. However, it is politically difficult to change because households see the benefits of tax subsidies and higher house prices but do not recognize the accompanying costs. By showing the downside of high prices, the housing bust provides an opportunity to escape this political trap.

Current tax law exempts capital gains on private homes up to $500,000 and treats mortgage interest as a deduction. Both measures are intended to help middle-class families, yet the reality is they distort the economy, are costly, and likely do little to make working families better off. That speaks for changing housing’s tax treatment.

The mortgage interest deduction is extremely expensive, costing the Treasury approximately eighty billion dollars in 2007. Moreover, it is highly regressive because high-income taxpayers get to deduct their interest payments at top marginal tax rates, whereas others deduct at lower tax rates. That means high-income taxpayers get a higher subsidy rate, and their subsidy is further increased because they also tend to have larger mortgages. Meanwhile, many poor workers get no housing assistance because they rent and rental expenses are non-deductible.

Both the mortgage interest deduction and housing capital gains exemption encourage home ownership. Mortgage interest deductibility encourages switching from renting to owning, while the capital gains exemption encourages owning housing instead of other forms of wealth.

This tax treatment has increased demand for houses, raising prices. However, higher house prices entail larger mortgages so that households end up with larger gross interest payments that offset much of the interest deduction. Additionally, larger mortgages make households more vulnerable to losses if they have to sell under unfavorable conditions – as is now happening.

Since most households lack capital, higher house prices also make it difficult to come up with down-payments. That has encouraged risky non-traditional mortgages such as zero-down products, and these products are a significant factor in the current housing crisis. Furthermore, these mortgages carry higher interest rates that further offset the benefit of mortgage interest deductibility.

At the social level, higher house prices mean both spouses have to work, which undermines family structure. It also puts downward pressure on wages by increasing labor supply. However, the system gives every family an incentive to buy a house to lock-in ownership, even though the system may make them collectively worse off.

Higher home prices are also very unfair from an inter-generational standpoint. Increasingly, younger workers cannot afford houses, and that promises to undermine the market with those buying last losing most.

Finally, excessive home ownership may increase unemployment. This is because workers become tied down to their homes by attached financial obligations, reducing responsiveness to changing job market conditions.

The tax system has helped create a cult of home ownership, and that cult appears to have been an ingredient in the recent house price bubble. Rather than creating wealth, the tax treatment of housing redistributes wealth inter-generationally and makes households financially vulnerable. That means tax policy should change. Here are some suggestions.

First, the capital gains exemption should be abolished for all new home purchases. Instead, the base cost of houses should be indexed to inflation so that homeowners are not taxed on inflation gains. Existing homeowners should be grand-fathered under current law to discourage selling to protect unrealized gains, which would destabilize the housing market.

Second, the ceiling (currently $500,000 per taxpayer) on mortgages qualifying for interest deductibility should be gradually lowered to zero over a ten-year period. Such a gradual phase-out can actually help existing middle-class homeowners because it will make top-end homes relatively less affordable compared to mid-market homes that retain the tax subsidy. That will shift demand toward the mid-market segment, helping maintain mid-market prices and thereby mitigating the housing slump.

Third, since everyone needs housing, the Federal government should phase in a refundable housing cost tax credit available to all, regardless of whether they own or rent. That credit can be financed with revenues generated by phasing out the mortgage interest deduction. During the transition every taxpayer should have the choice between taking either the available mortgage interest deduction or receiving the housing tax credit.

Current tax treatment of housing is intended to benefit working families, but it actually creates bad outcomes. The reality is current tax law distorts the economy, promotes house price speculation, renders households over-indebted and financially vulnerable, and undermines wages and family structure. There is a better way to help working families afford decent housing, and now is a good time for policy to transition in that direction.

Quelle Surprise! Tax Rebates Looking Increasingly Ineffective

The rebate checks haven't yet arrived, and they are already being deemed likely to have little impact on the economy.

That isn't surprising. What is perplexing it that they were successfully portrayed for a short while as likely to do anything other than increase the Federal deficit.

Readers may recall at the time the idea of fiscal stimulus was first mentioned, quite a few economists were not impressed with the rebate plan, arguing instead for programs that would put more cash in the hands of those with a high propensity to consume (read the low income), such as an increase in food stamps and extending unemployment benefits.

And the boost now looks to be lower than even the pessimists thought. Only 30% of the consumers surveyed by the University of Michigan intend to spend their check. The majority plans to save it ''as a safeguard against worsening future conditions.''

A Bloomberg story argues that the boost provided by those who do the American thing and hit the malls will be largely offset by fuel and food inflation:

Since President George W. Bush signed the stimulus package in February to much fanfare, the price of a gallon of gasoline has risen 64 cents,...

Food prices, too, have climbed at an annual rate of 5.1 percent since the start of the year, meaning another possible $5 billion or so bite out of consumers' buying potential.

The increases will eat into the $25 billion to $50 billion economists expect the rebates to add to spending in the coming months. Personal consumption accounts for more than two-thirds of the U.S. economy.

``A lot of that stimulus money is going to go to filling the gasoline tank and the refrigerator,'' says Mark Zandi of Moody's Economy.com in West Chester, Pennsylvania. ``It's not going to be quite the boost that most of us were hoping for when it was put together a few months ago.''

The Internal Revenue Service plans to send out about $50 billion in rebates by the end of May. That's more than many economists anticipated and has caused some of them to raise their forecasts for second-quarter gross domestic product....

The stimulus package gives as much as $600 to individuals who earn $75,000 or less a year. Married couples with household incomes as high as $150,000 will receive as much as $1,200. Families will get an additional $300 for each child.

Retailers, eager to get their hands on the money, are offering consumers incentives to spend....Americans may not take the bait. Consumer confidence fell in April to the lowest level in a quarter century, according to the Reuters/University of Michigan monthly survey. Plans to purchase furniture, appliances and home electronics declined to the lowest level since the 1980s.

Consumers are being hit by a triple whammy: rising prices, increasing unemployment and shrinking wealth. Companies have cut payrolls for five straight months, by a total of 326,000 workers.

House prices in 20 metropolitan areas fell 12.7 percent in February from a year earlier, the biggest drop since S&P/Case- Shiller began tracking the data seven years ago.

``We've had a very significant deterioration in the financial position of households in the past year,'' Sinai says. ``Consumers can't tap their housing equity any more.''

Household debt has risen more than 85 percent since the middle of 2001 -- the last time the government handed out tax rebates in a bid to spur the economy. That has prompted some on Wall Street, including David Rosenberg, Merrill Lynch's North American economist in New York, to conclude that consumers will spend less this time, paying down debt instead.

``You have a much more stressed-out consumer today than you had in 2001,'' he says...

Clarence Wright, an event planner who lives in Dale City, Virginia, is among those hunkering down, rebate check or no. ``Gas prices are definitely cutting into my budget,'' says Wright, 40, who fills the tank of his Nissan Altima twice a week. ``We all had a good time in recent years, but it's going to take several years before we get back to times like that.''

Mirable Dictu! A Good Column by Ben Stein!

I nearly fell off my chair.

Ben Stein's column this week, "What McCain Could Do About Taxes," is sensible and vastly more tightly written and argued than his previous work. No free association or gratuitous name-dropping, no leaps of logic, no wishful thinking.

More shocking, not only does he take issue with the Republican party line, he comes out on the same page as Dean Baker.

I wondered if he had gotten a ghost writer.

He tells McCain to forget about tax cuts, they burden future generations and leave us indebted to foreigners, and that tax increases need to target the rich.

Reasoning like that shouldn't be cause for celebration, save that the Republicans have become hooked on faith-based economics. While one robin does not make a spring, Stein's piece may be a hopeful sign that reality is finally starting to sink in among GOP loyalists.

I found nothing objectionable on a first pass, which (given my critical eye) is a noteworthy accomplishment.

This is the guts of his article:

Let’s start with the obvious. Almost everyone dislikes taxes. No sane person enjoys writing out a big check to Uncle Sam when he could spend that money or bank it for retirement. By the same token, almost everyone likes the phrase “tax cuts” for the same reason.

The problem, and it’s a killer, is that over the years we have obligated ourselves as a nation to spend truly staggering sums. These sums are growing rapidly. They consist mostly of entitlements, like Social Security and Medicare; fixed obligations like interest on the national debt, pensions for federal and military employees and various subsidies that have already been enacted; and morally mandatory expenses like those for national security.

All politicians campaign on the promise to cut federal spending by identifying hitherto unfound waste, fraud and corruption. None of them ever do so in a meaningful way. Total federal spending has not once fallen noticeably since 1954, no matter the party or the promises of the incoming chief executive,

That is the first thing you need to know. The next thing is that the Republican Party (my party and yours) has for the last 30 years or so been operating under a demonstrably false and misleading premise: that tax cuts pay for themselves by generating so much economic growth that they replace the sums lost by tax cutting.

This would be a lovely thing if true, and the best of all ideas, the “something for nothing” idea. In fact, tax cuts lower federal revenue and generate federal deficits. It is also true that they do stimulate the economy and after a long period of years, federal tax receipts go back to where they were before the tax cuts.

For example, when President Bush enacted his tax cuts in the early 2000s, income tax receipts fell dramatically. It took almost six years for them to reach the level they had been in the last year of the Clinton administration, while G.D.P. in that period rose by roughly 30 percent. In the eight years Ronald Reagan was president (and I love and worship him), tax receipts did not fall anywhere near as much, but they rose more slowly, on a percentage basis, than they did in any other comparable eight-year period after World War II.

In other words, tax cuts do not pay for themselves, at least not on any basis I can see. Certainly, they are not worthless. They make taxpayers feel good and they generate growth. But basically, they shift the tax burden from us to our progeny and add immense amounts of interest expense to the federal budget. At this point, taxpayers shell out about $1 billion a day just for that item.

Moreover, immense federal deficits in modern life are financed largely by foreign buyers of our debt. This means that the American taxpayer must work a good chunk of the year to send money to China, Japan, the petro-states and other buyers of United States debt. In effect, we become their peons.

By flooding the world with debt, we in effect beg foreigners to take our dollars, and this leads to a lower value of the dollar and a higher cost of imports, including oil. If you feel pain filling up the tank, you can partly thank those tax cuts. If you feel the sting of inflation, you can partly thank the supply siders. Deficits matter....

You can propose still more tax cuts, create still more deficits and add to the debt, and say to yourself, like Louis XV, “Après moi, le déluge.”

Or, you can raise taxes. But whom to tax? The poor are, well, poor. The middle class is struggling to pay for its middle-class life. That leaves the rich. It would be lovely if we did not have to tax them. Many have worked hard for their money. Many have created useful businesses. Many of them are fine people.

But as Willie Sutton said when asked why he robbed banks, “Because that’s where the money is.” By definition, the truly rich have a lot more money than they need. If they don’t, then they are not rich by my standards. The first step toward putting our house in order, once we are past the seemingly looming recession, is much higher taxes on the truly rich and serious enforcement to prevent offshore tax evasion.

To put it even more starkly, the government — which is us — needs the money to keep old people alive, to pay for their dialysis, to build fighter jets and to pay our troops and pay interest on the debt. We can get it by indenturing our children, selling ourselves into peonage to foreigners, making ourselves a colony again, generating inflation — or we can have some integrity and levy taxes equal to what we spend.

Now some will protest that when we are entering a recession is not exactly a propitious time to raise taxes. Fair enough. But the general drift of Stein's argument is a badly needed counterbalance to those who think the US can run up a tab to be paid by overseas is a game we can keep up forever.

Our foreign debt suppliers are already starting to wise up. They used to be content to buy Treasuries, which is the least costly way for us to compensate them. Put on your business hat: any startup prefers to fund itself with debt, preferably cheap debt, like friends and family. But more costly debt is preferable to giving up equity.

But now foreign governments, with massive foreign exchange reserves, are looking to invest overseas and are moving out of debt into equity related investments. That has the effect of increasing our cost of funding.

So even if we as a nation aren't able to discipline ourselves, our friendly money sources will.

BofA to Get Big Tax Bennies on Countrywide Purchase (and Critiques of the Deal)

The Fortune article by Allan Sloan, "BofA's awesome Countrywide tax break' was more blunt, pointing out that we taxpayers are helping subsidize Bank of America's purchase and Mozilo's payout.

The tax savings are reported to be worth a half a billion over the first five years after the deal close, due to Bank of America using Countrywide losses to reduces its own tax liabilty, and there may be additional saving year six. The article states that the strategy is so arcane as to defy easy summary.

Even with the reduction in the effective cost of buying Countrywide, Bank of America will come to regret this deal. Countrywide is an organization that has made an art form of just barely staying on the right side of the law, and even then screws up. There is certain to be more dirt, and therefore legal liabilty, that hasn't yet risen to the surface. Furthermore, it is well nigh impossible to impose procedures and standards on rogue cultures. Look what happened to Bank of America when it purchased US Trust, a company that had a great franchise but one in which the account managers had more autonomy (and incurred more customer-related expenses) than Bank of America's officers did. BofA succeeded in driving away the many of the best account officers, who took customers with them.

Now the cultural challenges of integrating a Countrywide are very different than dealing with a US Trust, but consider: US Trust was a highly valuable franchise in an area the North Carolina bank said was a priority, and they screwed it up just about every way they could. And US Trust was a much smaller organization too, so the acquisition should have been easier to manage.

Thus, Bank of America has shown itself to be an inept acquirer, at least of businesses with different cultures and business requirements. And this deal comes at a time when management is facing tough conditions is its core businesses, and senior management will find it hard to give the Countrywide makeover the attention it demands.

Housing maven Robert Shiller criticized the Countrywide acquisition for more straightforward reasons: the price is too rich. From Bloomberg:

Robert Shiller, Yale professor of economics and co-creator of the S&P/Case-Shiller Home Price indexes, said the falling U.S. housing market may cut the value of Countrywide Financial Corp., the mortgage lender being acquired by Bank of America Corp.

``There's a tendency for people to underappreciate the risk of the housing market,'' Shiller said. ``I might have a lower valuation of Countrywide than Bank of America does.''....

A record number of foreclosures has contributed to home price declines that leave many borrowers owing more on their mortgages than their homes are worth. Shiller compared the housing slump to a ``tidal force.''

``Maybe Countrywide and Bank of America are going to have some problems going forward,'' he said. ``When people see that their houses are worth a lot less than their mortgage balance, they have an incentive to default. The troubled mortgages that Countrywide already has will be followed by even more troubled ones.''

Similarly, Housing Wire reports that top-level Countrywide talent has started to depart. Its chief information officer, Richard Jones, is going to Fiserv.

Now the irony is that Jones, and likely many of his direct reports, would get canned after the transition period. There is inevitably redundancy in administrative and operational groups, and almost without exception, the acquirer's team is kept on. But in an area like IT, you want the incumbents around through the integration, and perhaps a bit longer, since no system is every extensively documented (short-sighted managements won't pay the additional costs, and the geeks don't fight too hard, since it makes it more difficult to be rid of them).

Now Jones leaving is probably not much of a loss. In the great majority of cases, the CIO is not involved enough in the nitty-gritty of the systems to be invaluable. But he is likely to take the best of the next level with him, and that could be highly detrimental to the integration process.

From Fortune:

Guess who's helping Bank of America pay for its $4.1 billion purchase of Countrywide Financial? Answer: The taxpayers of the United States.

That's because Bank of America, which is solidly profitable, will be able to use some of Countrywide's losses to offset its own taxable income. The tax break could total about half a billion dollars over the first five years, according to an estimate by tax guru Robert Willens, who left Lehman Brothers Friday after a 20-year run and will be in business as Robert Willens LLC starting next week. The losses could be worth considerably more to Bank of America starting in the sixth year, depending on how big Countrywide's losses are when Bank of America formally acquires it.

At this point, of course, no one knows how much in losses Countrywide has run up since the junk mortgage market began souring and defaults accelerated. Countrywide itself probably doesn't know. But it seems almost certain to ultimately be in the billions..... Willens estimates that Bank of America will be able to deduct $270 million of Countrywide's losses annually for the first five years it owns the firm.

That's based on a $6 billion purchase price - $4 billion to Countrywide's common stockholders, plus the $2 billion of preferred stock that Countrywide sold to Bank of America in August. Willens says that you multiply that $6 billion by 4.49 percent - the so-called "long-term tax-exempt rate" - to calculate how much of Countrywide's losses Bank of America can deduct annually for five years after the purchase.

A $270 million annual deduction would save Bank of America something more than $100 million a year in federal and state income taxes. The long-term tax-exempt rate, which is based on Treasury rates and other things so complicated that they make my teeth hurt. The rate changes each year, Willens says, but not by much. When I asked how it's calculated, Willens, a master of tax arcana, threw up his hands. (Metaphorically, of course.) "It's like the formula for Coca-Cola," he said, "no one outside the circle knows it" and it's so complicated that, "no one else wants to find out."

So over the first five years, Bank of America can use a total of $1.35 billion of Countrywide's losses to shelter its income. (That's five years of $270 million annual losses.) If Countrywide's embedded losses when Bank of America buys it exceed $1.35 billion, Willens says, the bank will be able to deduct the rest of the losses, without limit, starting in the sixth year.

Isn't life fun?

Larry Summers' "Why America Must Have a Fiscal Stimulus"

In the Financial Times, former Treasury Secretary Larry Summers calls for the implementation of a fiscal stimulus package in the US in the first half of 2008. He argues that the question is not whether to prop up the economy, but how, that is, whether via monetary or budgetary actions. His view is that a "diversified" approach is better than relying on monetary policy alone, since government spending or tax relief programs can give aid to families that are hurt by a slowdown, while monetary policy's direct impact is on financial institutions. Summers also believes that government measures can shore up faltering consumer demand.

Now I hate to sound like an economic Luddite, but I question this preoccupation with avoiding a recession. It appears to be based on wishful thinking that has been around since the 1960s, that the economy can be tuned so finely as to make slowdowns a thing of the past.

Yes, recessions result in job losses, which tend to hit lower income workers worse (although, ironically, this time around, workforce cuts are likely to be greatest in financial services, which pays above average wages), so it would be preferable to avoid them. But are we kidding ourselves as to the cost/benefit tradeoff?

Consider this selection from a recent post on the Fed's Jackson Hole conference:

James Hamilton (enough of a Serious Economist to get to present a paper as Jackson Hole) comments approvingly on an observation by UCLA's Ed Leamer (note he was lukewarm about other aspects of Leamer's presentation):

I found another of Leamer's main themes to be an intriguing suggestion. He claims we should think of monetary policy as doing very little about the long-run growth rate (which he thinks will be within 3% of a 3% annual growth line regardless of policy), and that stimulating the housing market therefore just changes the timing. Specifically, Leamer believes we bought ourselves a boom in 2004-2006 at the expense of a recession in 2007-2008.

That view suggests that monetary stimulus is no free lunch.

Now what if Leamer is right, that cheap credit pushed the US above trend-line growth and a period of below-average growth is inevitable? That means that the best stimulus measures can do is reduce the severity of the slowdown but at the cost of increasing its length. At worst, if they succeed in pushing growth to or above trend line, they will make the inevitable contraction worse.

So the real problem may be that we want to have our cake and eat it too. There is some evidence that a service based economy will show lower productivity gains than a manufacturing-driven economy (remember, economic growth is due to population gains and productivity improvements). But high growth periods help assure re-election, among other things. So the public at large approves of the good times they enjoy in unsustainable high growth periods, and then wants to avoid the inevitable consequences of a retrenchment.

And if you subscribe to the Schumpeterian line of though, recessions are a useful, "creative destruction" phase. They set the foundation for future growth, thining the herd and punishing excesses. And we've seen plenty of excesses recently.

Summers also argues that use of fiscal rather than monetary measures will reduce pressure on the dollar, since rates will not be cut as far. Short-term, yes, but remember, the weakness of the dollar is ultimately due to our negative domestic savings. And Summers tells us that one reason to implement a stimulus package is to keep aggregate demand up. Presumably, consumers will go from near zero savings to a modest level of savings, but that will be matched (or even more than offset, given job losses) by an increase in the government deficit. Our negative savings will increase, which will lead to an increase in our current account deficit, which will depress the dollar. Again, no free lunch.

In fairness to Summers, things may get so bad that some sort of stimulus package becomes necessary. And it is generally believed that stimulus is more effective when applied early rather than late. So if the US is going to go down the path of increasing the deficit in an effort to salvage the economy, better to do it sooner rather than later.

From the Financial Times:

The odds of a 2008 US recession have surely increased after a very poor employment report, growing evidence of weak holiday spending, further increases in oil prices, more dismal housing data and further writedowns in the financial sector. Six weeks ago my judgment in this newspaper that recession was likely seemed extreme; it is now conventional opinion and many fear that there will be a serious recession. Markets now predict the Federal Reserve will provide further stimulus to the economy by cutting rates by an additional 125 basis points on top of the 100 basis points they have already been cut so that rates fall to the 3 per cent range.

Given the market’s prediction of Fed policy actions, the debate now is not about whether or not to provide macro economic stimulus. That question appears to be settled. The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

Beyond policy mix considerations there is the desirability of maintaining stable demand by insuring against excessive declines in consumer spending that lead to reduced employment and further declines in incomes and spending. The economy has been more stable in recent years than historically – one reason is that consumer credit markets have allowed households that suffered income declines as the economy turned down to maintain spending by borrowing on credit cards or home equity. These mechanisms, like monetary policy, are less reliable with burdened borrowers and troubled financial institutions. Japan’s experience in the early 1990s – when it failed to act decisively to respond to a downturn associated with collapsing financial bubbles and then experienced a disastrous vicious cycle of economic downturns and credit problems – should be highly cautionary regarding the importance of supporting consumption in the wake of financial problems.

Fiscal stimulus is appropriate as insurance because it is the fastest and most reliable way of encouraging short run economic growth at a time when a serious recession downturn would pressure American families, exacerbate financial strains, raise protectionist pressures and hurt the global economy.

Poorly provided fiscal stimulus can have worse side effects than the disease that is to be cured. This suggests close attention to three issues:

First, to be effective, fiscal stimulus must be timely. To be worth undertaking, it must be legislated by the middle of the year and be based on changes in taxes and benefits that can be implemented almost immediately.

Second, fiscal stimulus only works if it is spent so it must be targeted . Targeting should favour those with low incomes and those whose incomes have recently fallen for whom spending is most urgent.

Third, fiscal stimulus, to be maximally effective, must be clearly and credibly temporary – with no significant adverse impact on the deficit for more than a year or so after implementation. Otherwise it risks being counterproductive by raising the spectre of enlarged future deficits pushing up longer-term interest rates and undermining confidence and longer-term growth prospects.

Taken together these criteria suggest the desirability of a programme of equal payments to all those paying either income or payroll taxes combined with increases in unemployment insurance benefits for the long-term unemployed and food stamp benefits. Such a programme could be implemented quickly and would largely benefit those most likely to be cut off from credit markets and with the most urgent need to spend. It could easily be made temporary. Ideally, further stimulus would be provided by measures to reduce future deficits and increase long-run confidence.

How large should a programme of fiscal stimulus be? It depends on what else is done to help the economy – a subject to which I will return soon. But a $50bn-$75bn package implemented over two to three quarters would provide about 1 per cent of gross domestic product in stimulus over the period of its implementation. With some multiplier effects the total impact would be in the range of 1 per cent of GDP over a year. This seems large enough to take some burden off monetary policy and yet unlikely, if properly implemented, to risk substantial damage given flexible monetary policy if the economy proves stronger than expected. After many months of behind-the-curve policy, moving to implement such measures seems more prudent than waiting till the necessity of even greater ones has been unambiguously established by further pain.

The Not-So-Good Federal Budget Outlook

Menzie Chin at Ecnobrowser supplied this chart from the Congressional Budget Office November Budget Review:



The red line is receipts, and if you are an optimistic sort, you might persuade yourself that the gap has gotten smaller and therefore will continue to shrink.

The fly in the ointment, however, is obvious. Receipts are a function of tax rates and incomes. The economy has been at full employment, albeit with stagnant wages. This is as good as it gets, and it isn't good enough to close the deficit.