Friedman on Greed

Thanks, dad, for this link. I am having a bit of a libertarian weekend this weekend, mainly as a result of two factors. First, I finished a book called Random Family, by Adrian Nicole LeBlanc, who spent 11 years living in the Bronx with an extended family of the urban poor. These are the people who actually need government’s help — WIC, welfare, etc. — and I was reminded of the importance of personal responsibility (and birth control). Second, I had lunch with a friend who’s wife is applying for reisdency, and was reminded of the medieval, stratified, and secretive match system, which was originated and promulgated by the American Medical Association as a way of keeping doctors’ salaries high. I remember first reading about the AMA in Friedman’s Capitalism and Freedom. See a more recent take on the AMA here:

http://www.reason.com/news/printer/135682.html

The MBA Oath

OK, yeah, it’s kind of ridiculous that we even have to say some of this stuff out loud (“I will act with utmost integrity and pursue my work in an ethical manner”). But  a bunch of Harvard MBA’s are supporting ethical business practices by signing an MBA oath to, basically, be good people. I support the effort wholeheartedly.

The oath can be found here, and it’s full of stuff that you have to nod your head to. It is sad that the distorted incentives that have led to the financial crisis have prompted us to need this oath — one would hope that most people would agree and live by the principles that these students espouse. But, in an era where it is easy to play the blame game and to pass the buck to future generations, the government, or shareholders, I applaud managers supporting an ethic of individual responsibility and sustainable profitability.

I guess the journey of 1,000 miles starts with just one step…..

Wanted: A Voice for Free Markets

The Wall Street Journal editorial page highlights an issue that I have been brooding on for awhile: the fact that in the current economic and political debate, we are really missing the voice of Milton Friedman, and more broadly, pragmatic defenders of free markets. Stephen Moore puts it perfectly when he says:

With each passing week that the assault against global capitalism continues in Washington, I become more nostalgic for one missing voice: Milton Friedman’s. No one could slice and dice the sophistry of government market interventions better than Milton, who died at the age of 94 in 2006. Imagine what the great economist would have to say about the U.S. Treasury owning and operating several car brands or managing the health-care industry. “Why not?” I can almost hear him ask cheerfully. “After all, they’ve done such a wonderful job delivering the mail.”

The number of voices calling Milton Friedman “wrong” or “misguided” or at the veryleast “reaching the end of his usefulness” has increased dramatically overthe past six months. Noami Klein’s Shock Doctrine is but Exhibit A.Sadly, she bears many similarities o the crazy homeless woman who berates me every day as I pass her en route to the subway. Further exhibits are a bit disheartening — witness this recent article from Brad DeLong arguing that Friedman’s principles are essentially right, but that they may have outlived their usefulness. This is a great read — DeLong is an excellent economist with a clear agenda. He is well-reasoned and logical But his conclusions are a bit scary:

DeLong’s summary of Friedman’s perspective:

Friedman adhered throughout his life to five basic principles:

1. Strongly anti-inflationary monetary policy.

2. A government that understood that it was the people’s agent and not a dispenser of favors and benefits.

3. A government that kept its nose out of people’s economic business.

4. A government that kept its nose out of people’s private lives.

5. An enthusiastic and optimistic belief in what free discussion and political democracy could do to convince peoples to adopt principles (1) through (4).

He goes on to argue, essentially, that (1) conservative governments have failed against many of these benchmarks and (2) that, regardless of Friedman’s principles, one must admit that the market economy does not produce outcomes which are the most “just” or “fair.” With respect to (1), of course he is right — no government has ever lived up to Friedman’s principles. When I own my own private island, I will run it entirely accordingly to principles of free markets, and it will be easy, because there will just be one family in residence. As soon as you add more than one family, it becaomes hard to run a government exactly to Friedman’s principles. ultimately, it is a matter of degree: Who is closerto Friedman’s principles? Conservatives (Reagan, Thatcher) or liberals (Carter, Blair)?

With respect to (2), I feel DeLong is on truly dangerous ground. He argues (emphasis added):

[T]he distribution of economic welfare produced by the market economy does not fit anyone’s conception of the just or the best. Rightly or wrongly, we have more confidence in the correctness and appropriateness of political decisions made by democratically-elected representatives than of decisions implicitly made as the unanticipated consequences of market processes. We also believe that government should play a powerful role in managing the market to avoid large depressions, redistributing income to produce higher social welfare, and preventing pointless industrial structuring produced by the fads and fashions that sweep the minds of financiers.

I flatly disagree with the bolded statement. In fact, if I were to summarize, I would make the exactly opposite statement:

“I have more confidence in  correctness and appropriateness the deceisions implicitly made by market processes than I do in the political decisions made by democratically-elected representatives. “

There, that sounds better.

If given 100 decisions to make, I believe appropriately designed markets would make a better decision than politicans probably 75+ times out of 100. Nothing is perfect.

Which brings me back to my main point — where is the reasoned voice supporting free markets, let alone Milton Friedman? Who can make the case for free trade, free labor markets, innovation-friendly property rights, and deep capital markets, all of which have advanced the human casuse so greatly over the past 500 years?

Mankiw vs. The Austrians on Interest Rates

An amusing retort by Robert Murphy, at the Mises Institute, arguing against Mankiw’s proposal favoring negative interest rates.

First, Mankiw’s proposal:

Let’s start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

Assumption #1 that will anger Austrians everywhere — lower interest rates encourage consumption and borrowing, which is good for the economy.

How to do it though?

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent

Ridiculous, you say?

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

This is all straight from Mankiw. Now, there is one majorly faulty assumption with this argument, as noted above. Mankiw is referring to the interest rate as a tool to regulate spending, as Murphy notes, but he fails to mention it’s role in regulating saving.

Perhaps the single biggest mistake in Mankiw’s worldview is his treatment of the interest rate as merely a brake or governor on “spending.” In this standard yet woefully simplistic approach, “the” interest rate serves to either stimulate or suppress how much money people spend today. So if businesses are laying people off, why, the answer is obvious: cut the interest rate to induce more spending, so businesses hire those workers back.

But in reality, interest rates coordinate production and consumption decisions over time. They do a lot more than simply regulate how much people spend in the present. In particular, certain sectors are much more sensitive to interest rates than others. For example, if interest rates fall, it’s not merely that consumers and businesses spend more, but that they spend more on particular items such as houses, cars, and factories. When interest rates fall, the share price of General Motors might rise, but not General Mills, because breakfast cereal is not a durable good (at least not in my household).

The key question which Mankiw and Murphy disagree on is this: is it better to postpone the pain associated with paying off your debts, deflating them over time with a weakened currency, or is it better to swallow the bitter pill today, in one massive, painful deflationary swallow? Get personal savings rates back to 10%, let the savers among us who have capital to lend charge egregious interest rates on this capital because there is simply none available.

Mankiw assumes (without telling the reader) that encouraging spending and smoothing consumption is a good thing, well worth the (quite hefty) costs. Murphy focuses on the costs, of which are there are many. For example, what would an extended bout of inflation do the dollar’s status as an international reserve currency? What might that cost us in terms of cost of future borrowing? Just one example.

I don’t know which is correct. But it’s always good to question assumptions.

The most important debate of the next 2-3 years is the future of the global currency system

Ken Rogoff, an amazing prognosticator thus far and an economist with a great overview of the history of financial crises, highlights the key debate about the future of the global currency system. Basically, the options come down to the following:

(1) A more conservative revision of today’s system.

Above all, regulators would force financiers to hold more cash on hand to cover their own bets, and not rely so much on taxpayers as a backstop. Geithner also aims to make financial deals simpler and easier to evaluate, so that boards, regulators, and investors can better assess the risks they face

The US proposals…. would make universal banking far harder, in part because they aim to ring-fence depository institutions that pose a “systemic risk” to the financial system. Such changes put pressure on universal banks to abandon riskier investment-bank activities in order to operate more freely.

(2) Everything else.

It is #2 that is scary, as Rogoff highlights, because no one has really come up with a better alternative. People like China’s system, but forget that it requires a massive number of people to oversave because the state’s social support structures (retirement, health care, education) are inadequate. Rogoff runs through the other options as follows:

China’s approach represents a huge disguised tax on savers, who are paid only a pittance in interest on their deposits. This allows state-controlled banks to lend at subsidized interest rates to favored firms and sectors.

In India, financial repression is used as a means to marshal captive savings to help finance massive government debts at far lower interest rates than would prevail in a liberalized market.

A big part of Russia’s current problems stems from its ill-functioning banking system. Many borrowers, unable to get funding on reasonable terms domestically, were forced to take hard-currency loans from abroad, creating disastrous burdens when the ruble collapsed.

Europe wants to preserve its universal banking model, with banks that serve a broad range of functions, ranging from taking deposits to making small commercial loans to high-level investment-banking activities.

No easy answers. Sadly, concerns over sovereignty will derail a lot of the discussions about international financial regulators and/or reserve currencies.  But let’s not forget the stakes fr the U.S.

The stakes in the debate over international financial reform are huge. The dollar’s role at the center of the global financial system gives the US the ability to raise vast sums of capital without unduly perturbing its economy. Indeed, former US President George W. Bush cut taxes at the same time that he invaded Iraq. However dubious Bush’s actions may have been on both counts, interest rates on US public debt actually fell.

More fundamentally, the US role at the center of the global financial system gives tremendous power to US courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the US financial system has helped to fuel such a deep global recession.

Economics does not equal personal finance

Leave it to California to suggest that personal finance replace economics in high school economics courses. This is scary. Don’t get me wrong — personal finance is important, and the fact that so many Americans don’t understand what an APR is or why the interest payments on their homes are going up soe dramatically is saddening. But the study of economics is a paradigm, a mental model of how the world works. It is not learning how to balance your checkbook.

The John Galt Grassroots Campaign

Who can resist this tasty opportunity? How many of our 100 senators and what, 435 (?) congressmen have actually read Atlas Shrugged.

http://www.go-galt.org/

Props for the referral from RealClearMarkets in this fun article.

The Right Perspective on AIG

I couldn’t agree more with Michael Lewis’ thoughts on AIG bonuses. It’s a quick read, but he makes these key points:

Apart from Andrew Ross Sorkin at the New York Times, it occurs to no one to say that a) the vast majority of the employees at AIG had as little as you or I to do with its quasi- criminal risk taking and catastrophic losses; b) that the most- valuable of those employees can easily find work at AIG’s competitors; and c) that if the government insists on punishing those valuable employees they will understandably leave, and leave behind a company even less viable than it is, and less likely to give the taxpayer back his money.

And also — oh, yes — that if the government can arbitrarily break contracts made by firms in which it has taken a stake no one in his right mind will ever again make a contract with one of those firms. And so all of the banks in which the government has investment will be damaged.

He draws, I think, fairly rational conclusions:

From this episode we can observe several general truths about the financial crisis, and the attempt to end it:

1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. (The trillions we owe foreigners, for example.)

2) As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy.

But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.

3) The complexity of the issues at the heart of the crisis paralyzes the political processes’ ability to deal with them intelligently. I have no doubt that, by the time this saga ends, we will all know what happened to every penny of that $165 million in bonuses and each have our opinion of the morality of it.

For those wanting a slightly different perspective, I recommend this recent resignation letter from an AIG executive vice president. I found it poignant and personal. It reminds us that this credit crisis is impacting all of us, even those we villify and accuse of incompetence.

 

 

 

Barro: 20% of depression

Many thanks to Robert Barro in a recent WSJ article for doing two things.

First, definiing a “depression.”

Could we even experience a depression (defined as a decline in per-person GDP or consumption by 10% or more)?

Second, I particularly enjoyed Robert Barro’s use of data to inform the unending debate about whether this is a “depression” or just a severe “recession.”

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a “minor depression” (macroeconomic decline of 10% or more) will occur when there is a stock-market crash. There is a 9% chance that a “major depression” (a fall of 25% or more) will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes (our data show the probability is 92%).

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today’s prospects by consulting the history of nonwar events — for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes — 69% for minor depressions and 83% for major ones.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

Ok dok — thanks for bringing facts to the debate. I find this quite useful. I also like comparing today’s price action to former bear markets — there is a nice chart making the rounds that looks something like this.

History of Bear Markets

Peter Bernstein on Stocks for the Long Run

Fantastic op-ed in the Financial Times by one of my favorites, Peter Bernstein. He argues that “Stocks for the Long Run” is a misnomer, because the Long Run depends heavily on where you start.

The cold statistics have hardly been encouraging for the traditional view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts.

These data are not to be taken lightly.

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent  a year.

He goes on to make the point that stock market returns are not independent observations from a trending data series. In fact, they depend heavily on policy decisions, regulatory framework, and a whole host of other variables that determine returns.

There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.

This, of course, leads to some scary logic. Given where we are today, how do we think about the long run return from stocks? Massive fiscal deficits, burgeoning entitlements, questions about the very core of capitalism (credit, private property, etc.) all mean that we are currently, in the first quarter of 2009, presented with a new and dangerous set of initial conditions.

Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.

For what it’s worth, the father of Stocks for the Long Run, Jeremy Siegel, recently published an op-ed in the Wall Street Journal arguing that from a long-term perspective, stocks are exceptionally cheap. Basically, he argues that earnings from Citi, BofA, and other failing banks are weighing down the S&P core earnings, making earnings look artificially low and therefore, P/E multiples artificially high.

I tend to agree with John Mauldin, who argues that this line of logic is a bit off-the-mark. At the end of the day, these earnings matter, and though figuring out how to weight them is hard, you still need to give them some weight in the S&P index earnings.

Paradox of Thrift

From Mankiw’s recent blog

Indeed

I couldn’t agree more — I am angry!

Robert Samuelson hits the nail on the friggin head. Seriously folks — let’s stop talking about redistributing wealth and start talking about generating wealth. How do we grow the pie?

You’re being played for chumps. Barack Obama and John McCain want your votes, but they’re ignoring your interests. You face a heavily mortgaged future. You’ll pay Social Security and Medicare for aging baby boomers. The needed federal tax increase might total 50 percent over the next 25 years. Pension and health costs for state and local workers have doubtlessly been underestimated. There’s the expense of decaying infrastructure — roads, bridges, water pipes. All this will squeeze other crucial government services: education, defense, police.

Couldn’t agree more. What should we do? Here’s what Samuelson proposes. Again, I couldn’t agree more.

What should you — the young — do? First, get angry — at the media and think tanks for discussing this problem in misleading euphemisms (for instance, the problem is not an “entitlements crisis”; it’s excessive benefits for the old); at the candidates for exploiting your innocence; and at yourself for your gullibility.

Next, start picketing AARP. It’s the citadel of seniors’ political power and the country’s most powerful “special interest.” It wields a virtual veto over roughly two-fifths of the federal budget. Your activist groups ought to be there every day with placards reading “Give Us Generational Justice” or “Get Off Our Backs.” Ask direct questions of federal candidates about what benefits they’d cut, which they’d keep and why.

You need to appeal to the shame and guilt of older Americans by reminding them that their present self-absorption is not a victimless exercise. Only if older Americans act on their rhetorical pledges of worrying about their children will the political climate change. If you — the young — don’t stand up for yourselves, believe me, your elders and your politicians won’t.

Anyone want to grab a sign and head down to AARP headquarters?

Mankiw Uses Game Theory to Support Obama’s Tax Policy

Mankiw with an insightful piece in today’s NYT. He begins by arguing eloquently for lower taxes on corporate dividends. I couldn’t agree more.

But the interesting bit is that essentially, Mankiw thinks that McCain’s tax plan will never be implemented, so it’s not a real plan. Therefore, electing McCain will ensure that the Bush tax cuts expire in 2010 and we go back to the pre-2000 tax regime. Obama’s plan, on the other hand, dials back some, but not all, of the Bush tax cuts. Therefore, his presidency actually stands a higher likelihood of lower taxes than McCain’s.

I like the logic.

Key excerpts below:

Four years later, however, Senator Obama enters the picture with, apparently, a different point of view. He has not been coy about wanting to use the tax code to redistribute income more aggressively. He has proposed modest tax cuts (about $1,000) for numerous middle-class Americans, cuts to be financed by much higher taxes on the richest few percent of the population. When all of Senator Obama’s proposed tax increases on the rich are added up, the top marginal rate on wage income would be nearly 50 percent.

But for dividend income, Senator Obama has proposed only a modest increase in the top tax rate, to 20 percent from 15 percent. That is, the personal income tax would continue to tax dividends at a far lower rate than ordinary income. This decision must surprise many of his Congressional supporters. But it should be making President Bush smile.

In light of Senator Obama’s stand, the politics of dividend taxation may take some surprising twists. Senator John McCain wants to maintain the current tax rate of 15 percent on dividends (while cutting the corporate tax), but it is a good bet that if Senator McCain is elected president, while Congress remains Democratic, Congress won’t give the Republican president what he wants. They would instead let the Bush tax cuts expire, returning the dividend tax for high-income taxpayers to about 40 percent.

By contrast, if Mr. Obama is elected, Congressional Democrats will be less likely to balk at his proposed 20 percent dividend tax rate and thus embarrass the new president from their own party.

Credit is Overdue for Subprime Mortgage Lending

A blast from the past from the Dallas Fed. This 1998 article from the Dallas Fed is full of fun little tidbits. But it’s a useful piece of history, as we think about the right way to regulate lending practices going forward.

In case you ever feel stupid for missing the massive crisis presented by subprime lending and the disconnect between risk and return that enabled it to flourish, just take a quick read through the Dallas Fed’s conclusion in 1998:

The use of modern marketing tools and celebrity spokespeople has contributed to increasing consumer awareness of subrpime mortgage lenders and their products. Subprime customers are neither limited to a single lender nor compelled to settle for the first lender that will provide credit. Increased visibility and competition have given the subprime borrower the option of shopping for a lower rate and receiving a higher level of customer service. These changes have allowed many subprime mortgage borrowers the opportunity to gain credit that might not have been available before the recent expansion of the subprime market, obtain a more competitive interest rate and improve their credit history by successfully meeting the terms of the loan.

In addition, technological advances have begun to provide lenders with automated underwriting and scoring tools that, although new to the subprime sector, may help in pricing loans and predicting defaults. These advances, combined with reactions to changes in economic conditions, may represent the beginning of a financial revolution that will create a much broader and more unified mortgage lending industry. In this respect, the subprime market provides another example of our free enterprise system’s “democracy of consumption”  with respect to financial services as well as physical goods.

Marty comes out in favor of McCain’s tax plan

The tax debate continues. Not a lot of new information from this recent OpEd from the WSJ, but I like Marty’s perspective (I have soft spot for my former Ec10 teacher). His basic argument is as follows:

John McCain’s tax policies are designed to create jobs, increase wages and allow all Americans — especially those in the hard-pressed middle class — to keep more of what they earn. His plan achieves these goals in three important ways.

First, he proposes a package of tax incentives that will create jobs and raise earnings by inducing firms to invest more in the U.S. Second, he is strongly committed to blocking any increase in tax rates while doubling the personal exemptions for families with children, which will reduce the tax burden on working Americans. Third, he proposes a new, refundable tax credit that will increase health-care coverage, reduce the cost of health care, and provide more funds for families and individuals to purchase health care.

None of this is really new, although a bit uneven for a guy who admits that Social Security is broken and generally has good deficit fighting credentials. However, I found particularly interesting the argument in favor of McCain’s healthcare tax rebate. I LOVE the idea that we might be able to separate our employement from our healthcare insurance — I believe this is one of the largest structural problems in America’s labor markets and provides a significant smokescreen behind which healthcare costs increase astronomically each year, unbeknownst to their consumers or their providers. See Marty’s analysis below:

Mr. McCain’s overall tax policy will also expand health-insurance coverage, and make health care more efficient. Most taxpayers will also pay less in tax. Here’s how it will work. His plan includes a refundable tax credit of $2,500 for single individuals and $5,000 for couples, if they receive a qualifying health-care policy from an employer (one that includes adequate coverage against large medical bills), or buy a qualifying policy on their own. The credit will replace the current tax rule, which excludes employer payments for health insurance from employees’ taxable incomes.

This tax credit will be available to everyone, including the self-employed and the employees of businesses that do not provide health insurance. Thus it will lead to a major expansion of health-insurance coverage. The tax credit will of course be available to people who are between jobs, or have retired before they’re eligible for Medicare.

Since any part of the credit not used to pay for insurance could be invested in a health savings account, individuals will have an incentive to choose less costly health-insurance policies. This will improve the efficiency of health care, to everyone’s benefit.

Importantly, the tax credit will be a clear gain for most employees. Consider a married taxpayer whose employer now pays $10,000 for a health-insurance policy. Ending the exclusion will raise that individual’s taxable income by $10,000 — but the $5,000 tax credit will exceed the extra tax liability whether the marginal tax rate that individual pays is 10% or 35% or anywhere in between. Indeed, the lower the taxpayer’s income, the more of the credit that will be available to pay for health care that’s not reimbursed by insurance.

The devil is, of course, in implementation, and this tax policy has a chance of being a serious bear. But if we could implement it smoothly…. wow, that would be awesome. Imagine if you actually cared what your health insurance cost. Or your eye exams.

Dueling Visions — Comparing Obama’s and McCain’s tax plans

Great piece in Barron’s last week comparing the tax plans of McCain and Obama. I’ve blogged about this before, but it’s interesting to watch the debate unfold.

The piece is not even-handed — after all, you can’t expect Barron’s to support a Democratic candidate — but they do raise some good points about the Obama plan. It seems that there is real debate about what the right tax policy is for the economy today (i.e., in the midst of a downturn in the business cycle). Barron’s comparison looks something like this:

Key differences are the fact that Obama increases the progressivity of the tax code — i.e., the differential in tax rates between high earners and low earners. McCain basically preserves the Bush system and goes one step further, reducing the corporate tax rate from 35% to 25% (a move that I love, in the long-term).

A second crucial difference is the revene generating impact from the different plans.

Obama’s tax plan, at least in the original version, would generate $131 billion a year in new revenue for the government, according to the Tax Policy Center, a joint operation of the Brookings Institution and the Urban Institute in Washington. His proposal to make the wealthiest taxpayers pay higher Social Security taxes than everyone else could net Uncle Sam another $40 billion a year. He’s recently had second thoughts about this proposal and said that he might delay its implementation to 2018, way beyond his term.

Over all, he would raise $800 billion more over 10 years than the government would if the Bush tax cuts were made permanent, according to the Tax Policy Center. McCain’s plan, which keeps all the Bush cuts and trims corporate taxes to 25% from 35%, would cut revenue by $600 billion.

IN short, there is something to recommend in both plans. McCain’s has more of what I feel is the long-term approach to balancing growth and a fair tax code — maintaining low taxes on capital gains and dividends and increasing America’s corporate competitiveness through a lower corporate tax code (as an international investor, I can assure you this is a bigger problem than people admit). However, his plan gets nowhere close to balancing the budget, and he would need a massive machete to cut enough spending to get us back into fiscal balance.

Obama’s plan is not as dramatically bad as conservative bastions such as the WSJ and Barron’s decry. However, his plan to increase capital gains tax and in particular, expand Social Security taxes, seem particularly off the mark to me. Moreover, I question whether a Democratic president with one of the largest Democratic majorities in Congress in recent history can be trusted to use his new tax revenues wisely — i.e., to pay down the deficit and invest in national infrastructure and other public goods — rather than squander these new revenues on the types of projects that seem to occupy same-party Presidents and Congresses — i.e., grand social engineering experiments, bridges to next-to-nowhere, and an expansion of government’s involvement in private citizen’s lives.

Since I think Obama is going to win, my hope is that his intellectual curiosity and flat-out reasonableness will trump this dynamic. One can only wait and see…..

Obama’s Tax Policy — The Debate Begins

Barack has given us some color on his planned tax policy. Advisors Austin Goolsbee and Jason Furman published a detailed and well-reasoned OpEd in the WSJ last week. Despite my preference for smaller government, as far as tax increases go, this one isn’t that bad. Here’s a quick summary from the horse’s mouth.

Sen. Obama believes that responsible candidates must put forward specific ideas of how they would pay for their proposals. That is why he would repeal a portion of the tax cuts passed in the last eight years for families making over $250,000. But to be clear: He would leave their tax rates at or below where they were in the 1990s.

- The top two income-tax brackets would return to their 1990s levels of 36% and 39.6% (including the exemption and deduction phase-outs). All other brackets would remain as they are today.

- The top capital-gains rate for families making more than $250,000 would return to 20% — the lowest rate that existed in the 1990s and the rate President Bush proposed in his 2001 tax cut. A 20% rate is almost a third lower than the rate President Reagan set in 1986.

- The tax rate on dividends would also be 20% for families making more than $250,000, rather than returning to the ordinary income rate. This rate would be 39% lower than the rate President Bush proposed in his 2001 tax cut and would be lower than all but five of the last 92 years we have been taxing dividends.

- The estate tax would be effectively repealed for 99.7% of estates, and retained at a 45% rate for estates valued at over $7 million per couple. This would cut the number of estates covered by the tax by 84% relative to 2000.

Overall, in an Obama administration, the top 1% of households — people with an average income of $1.6 million per year — would see their average federal income and payroll tax rate increase from 21% today to 24%, less than the 25% these households would have paid under the tax laws of the late 1990s.

Sen. Obama believes that one of the principal problems facing the economy today is the lack of discretionary income for middle-class wage earners. That’s why his plan would not raise any taxes on couples making less than $250,000 a year, nor on any single person with income under $200,000 — not income taxes, capital gains taxes, dividend or payroll taxes.

Overall, I came away thinking this isn’t that bad. I tend to agree that going back to Clinton level of income taxes will not be that deleterious to economic growth, especially if the surplus is used to balance the federal budget (which it won’t be, but that is a topic for another session). However, the one thing that made me dreadfully uncomfortable is the following:

[Sen. Obama] also believes it is critical to work with members of Congress from both parties to strengthen Social Security while protecting middle-class families from tax increases or benefit cuts. He has done what few presidential candidates have been willing to do by making a politically risky proposal to strengthen solvency by asking those making over $250,000 to contribute a bit more to Social Security to keep it sound.

Sen. Obama does not support uncapping the full payroll tax of 12.4% rate. Instead, he is considering plans that would ask those making over $250,000 to pay in the range of 2% to 4% more in total (combined employer and employee). This change to Social Security would start a decade or more from now and is similar to the rate increases floated by Sen. McCain’s close adviser Lindsey Graham, and that Sen. McCain has previously said he “could” support.

I don’t care when it starts, this idea is awful. The answer to restoring the solvency of Social Security does NOT lie in uncapping the payroll tax and putting more money into the system. It lies in restoring the system to a state of structural solvency. This, in turn, requires acknowledging that the worker to retiree ratio is on a fundamental path of decline, which means that the returns to workers paying in today is declining and almost definitely negative. While I applaud Obama for even mentioning Social Security in his campaign (most presidential candidates avoid this infamous third rail), his proposal merely serves to delay the inevitable and lock-in a system that fails to serve the needs of any major constituency, but hides the degree to which this system continues to decay.

Anyway, after this article was published (and again, kudos to the Obama team for publishing in the WSJ rather than the NY Times, the usual home for liberal policy statements), Obama was typically skewered for admitting he would raise taxes and decreasing the marginal incentive to work (i.e., when we pay a higher tax rate, we keep fewer pennies out of every dollar we earn, and therefore, we have less of an incentive to work). Interestingly, the attacks seem to agree with my take — his plan isn’t that bad, with the exception of the Social Security tax increase.

See, for example, this retort from Michael Boskin, also in the WSJ. His intro deserves quoting for sheer shock value, and gets on thinking:

What if I told you that a prominent global political figure in recent months has proposed: abrogating key features of his government’s contracts with energy companies; unilaterally renegotiating his country’s international economic treaties; dramatically raising marginal tax rates on the “rich” to levels not seen in his country in three decades (which would make them among the highest in the world); and changing his country’s social insurance system into explicit welfare by severing the link between taxes and benefits.

The first name that came to mind would probably not be Barack Obama, possibly our nation’s next president. Yet despite his obvious general intelligence, and uplifting and motivational eloquence, Sen. Obama reveals this startling economic illiteracy in his policy proposals and economic pronouncements. From the property rights and rule of (contract) law foundations of a successful market economy to the specifics of tax, spending, energy, regulatory and trade policy, if the proposals espoused by candidate Obama ever became law, the American economy would suffer a serious setback.

I don’t entirely agree with his polemic, but this chart is eye-popping.

Now, what this says to me is that basically, this tax plan is fine, with the exception of the Social Security payroll tax. Without this, the marginal tax rate at the top income bracket would increase from 44% to 50% or so. Not bad, and entirely acceptable in my view (again, if used to close the budget deficit, rather than to shower new spending on the Department of Defense or new government programs).

Pundits should focus on this crucial issue — almost a sidebar according to Goolsbee and Furman. Without this, Obama’s plan is fine, a marginal change. With the increase in payroll tax, we’re talking about a serious decrease in the incentive to work — I may be spending more time blogging.

I should also add that this entire analysis puts aside the fact that no one is even thinking about talking about the real issue here — that we should be trying to move away from a tax on income towards a tax on consumption. Probably the wrong time to do it, considering we’re entering a consumer downturn, but in a world where we tax things that we want people to do less of (gasoline, cigarettes), do we really want to tax people for working?

Steady as she goes

Why does it so often fall on the Economist to remind us of what common sense tells us already? In this case, that development aid that is given STEADILY is more important than the QUANTUM of development aid given. And in fact, widely volatile development aid (for example, the massive swings in aid that can occur before and after a country arrives on the United Nations Security Council) can actually have a deleterious effect. How can we expect a country to plan for capital investment when they don’t know whether the next dime will materialize?

A new paper, by Oya Celasun of the IMF and Jan Walliser of the World Bank, suggests that failing to honour promises can in fact be more harmful than not offering any money in the first place. The authors examined yearly aid commitments, not long-term ones of the Make Poverty History variety. They show how unpredictable such aid flows are. The paper finds that the average absolute difference between aid promised and aid given was equal to 3.4% of each sub-Saharan African nation’s GDP between 1990 and 2005. That is far greater than in any other region of the world. In countries that had experienced war, the fluctuations were particularly marked, partly because of shrinking economies: in Sierra Leone the swings were equivalent to 9% of GDP. It is also a myth, the authors show, that donors always give less than they promise: they are both capriciously generous, as well as capriciously stingy. During the same period, rich countries exceeded their yearly aid commitments to sub-Saharan Africa by an average of 1% of each recipient country’s GDP.

“Don’t worry, we’ll get to it next year:”

But more often than not, unpredictability is not the recipient’s fault but the donor’s, because of either changing governments or reallocations of aid to causes that are more fashionable than poverty relief, such as climate change. Frequently aid gets lost in a jungle of red tape. A survey of aid donors cited in the study found that 29% of delayed or lost disbursements were because of administrative problems in the donor countries.

Instead of being critical, I will try to be solutions focused here. Why not a long-term commitment mechanism for international development aid, to ensure that countries could use said development aid in capital investments? OF course, this would need to be “pre-funded” — i.e., it would require a lump sum payment up-front to fund all future commitments. Why? Because politicians are terrible at maintaining the unfunded commitments made by their elected predecessors (unless you are talking about Social Security or Medicare).

Inflation

Who is so hardened of heart and so untouched by a feeling of humanity that he can be unaware, nay that he has not noticed, that in the sale of wares which are exchanged in the market, or dealt with in the daily business of the cities, an exorbitant tendency in prices has spread to such an extent that the unbridled desire of plundering is held in check neither by abundance nor by seasons of plenty….

Diocletius, 310 AD, as the Roman Empire crumbled around him.

Pick a Door

The New York Times revisits an absolutely classic problem — the Monty Hall Problem in a neat article about humans handle cognitive dissonance. I get this wrong nearly every time I try it, despite learning it in my statistics class and repeated the problem several times at different points in my life. I have excerpted the description of the problem entirely, but for the answer, you will need to refer to the original article.

Here’s how Monty’s deal works, in the math problem, anyway. (On the real show it was a bit messier.) He shows you three closed doors, with a car behind one and a goat behind each of the others. If you open the one with the car, you win it. You start by picking a door, but before it’s opened Monty will always open another door to reveal a goat. Then he’ll let you open either remaining door.

Suppose you start by picking Door 1, and Monty opens Door 3 to reveal a goat. Now what should you do? Stick with Door 1 or switch to Door 2?

….

Before you write, at least try a few rounds of the game, which you can do by playing an online version of the game.

I’ll leave it at that — this one should give you well enough fodder for dinner table conversation tonight.