NDN Blog

Some Thoughts on the Fiscal Cliff

The fiscal cliff is more of a cascade – or a game of dominoes.  First, the President and congressional Republicans have to make a deal on the terms for renewing the Bush tax cuts.  That appears to very possible, since GOP leaders seem to have conceded that additional revenues are inevitable.  So, the most basic deal to be struck is how precisely to raise $800 over 10 years from higher-income households.  John Boehner can probably get his caucus to agree with those revenues, especially since the President has recently talked about raising twice that total, and so long as it does not involve a new, 39 percent tax rate.  The only way to raise $800 billion without hiking the top rate is to increase instead the tax rate on capital gains, dividends and interest.  So, look for a new, 25 percent tax rate on capital income for the top 2 percent – a change that will hit some 25,000 very wealthy households more than some three-to-four million well-paid professionals.

If the two sides can manage to compromise on  the initial high-end tax increase, they get to move on to the next stage:  Some broad understanding about how much can be cut from defense, other domestic programs, and entitlements over the next 10 years – and perhaps, how much additional revenues can be raised from business.  As Republicans will have to concede more substantively on the initial, high-end tax increases, the administration will have to concede more here, especially on entitlements and almost certainly on business tax increases too.  But, any broad agreement on principles should be enough to let them delay the automatic across-the-board cuts in defense and non-defense spending now scheduled for January 1.  

And, if they can manage to compromise on the broad terms of a big budget deal, they get to move to stage three -- actually negotiating what to cut and by how much.  As Republicans are effectively going to dictate the terms of the tax increases on higher-income people which they’ve been fighting – i.e., no new 39 percent rate – the Democrats will get to dictate the terms of the cuts in Medicare and Medicaid which they’ve been resisting.  In the end, all of the changes will probably add up to less than everyone talks about today – perhaps $3 trillion over 10 years rather than $4 trillion, including the $1 trillion in cuts agreed to in the last debt-ceiling fight as well as the initial, $800 billion in  new revenues.  But, it will be enough to get sufficient GOP support to raise the debt ceiling in April, and the economic expansion should be able to continue on its course.

NDN Memo: A Better Way to Avoid the Fiscal Cliff on Taxes

With the fiscal cliff now in sight, the nation’s pundits are breathing as heavily as they collectively can over the prospect of political warfare over the Bush tax cuts.  Yet, a compromise between President Obama and congressional Republicans over taxes for the top 2 percent is already clear.  We extend the Bush tax rates but also cap the value of tax preferences for those two-percenters – an idea borrowed from Mitt Romney – so they pay the same additional taxes they would have if the top rates had gone back to 36 percent and 39.6 percent.  The President meets his commitment to ensure that well-to-do Americans pay more taxes, and congressional Republicans get to boast that they held the top rates at 33 percent and 35 percent.  And if we do it right, it could also be the first real step in a generation to address growing income inequality. 

                Yes, the President has called on Congress to re-enact the Bush tax cuts without the rate cuts for the top 2 percent.  But he has also said, sensibly enough, that compromise will be required to move away from the fiscal cliff, so we can assume that that his current position is not final.  Similarly, House Speaker John Boehner has said no to new taxes, but yes to additional revenues.  This compromise builds on that foundation, extends Romney’s idea of capping deductions to cover all tax preferences, and uses the revenues to pay down the deficit rather than fund more cuts in tax rates. 

              For progressives, this approach could also be a lot fairer than simply raising tax rates, if Congress and the President will just allocate a proportionate share of the new taxes to America’s truly rich households, by capping the value of all tax preferences.  The key here is that the top income tax rate applies only to the labor income – wages and salaries – that doctors, lawyers, business people, and other well-paid professionals actually earn.  Those top rates do not touch the capital gains and dividends that comprise most of the incomes of really wealthy people.  In 2008, for example, nearly 75 percent of all capital gains and dividend income went to the top 1 percent – and 80 percent of that was reported by the richest one-tenth of one percent of Americans.   That’s how Mitt Romney could legally pay a lower tax rate on his $20 million annual income than an average teacher pays on her annual $50,000 salary.   Repeal the top Bush tax rates, and most of the income of the very rich will still be taxed at 15 percent. 

                Instead, let’s think about how a hybrid Obama-Romney tax reform might work.  Repealing the Bush cuts for the top rates would raise about $800 billion over 10 years or an average of $80 billion per-year.  (The interest savings would come to another $130 billion.)  Our hybrid reform would allocate those additional taxes across the top 2 percent, based on income.  For example, in 2008, everyone in America with taxable incomes of $200,000 or more reported a total of $2.06 trillion in taxable income.  Some 3,470,000 households with incomes of $200,000 to $500,000 accounted for 38.3 percent of that total.  So, they would have to come up with 38.3 percent of the additional $80 billion in annual taxes, or $30.64 billion per-year.  That would come to about $9,000 per household. 

As it happens, many people earning between $200,000 and $500,000 would still end up ahead, because they would retain an average of $12,000 in tax savings from the extension of the Bush rate cuts on income below $200,000.  Now, consider what would happen to the very rich.  Those reporting incomes of $10 million or more accounted for 16.9 percent of that $2.06 trillion in taxable income, or $339 billion.  So, in fairness, they should bear 16.9 percent of the $80 billion annual tax bill or about $13.5 billion per-year.   The 13,401 households responsible for that $339 billion in reported income would face additional taxes averaging about $1 million each.

The alternative – leave the big tax preferences for the wealthy untouched and just roll back the top two Bush rate cuts on labor income – would unfairly shift most of the burden to some 3 million or so affluent professionals.   The irony is that according to the supply-side catechism, that would lead them to work less, depriving the economy of some of their valuable labor.  Economists are still divided over whether those effects would be significant or modest.  What is less controversial is that changes in capital gains taxes have little effect on how much people save and invest.  That’s why Ronald Reagan was willing to tax capital gains (and dividends) at the same rate as wages and salaries.  This new alternative, inspired by Mitt Romney himself, would leave unchanged the low marginal rates on capital gains and dividends, but limit the value of the benefits wealthy people can claim from those low rates.  In the bargain, the President and Congress could cut $1 trillion from our deficits over the next ten years and make the first real progress in a generation towards containing today’s record-high income inequality. 

What Actually Happened to the Earnings of Working Americans, and What the Next President Can Do About It

The disappointment and anger many Americans feel about their economic lot has held center stage in this year’s elections.  Mitt Romney, of course, blames President Obama.  New Census Bureau data, however, tell a different story.  The economic problems facing working Americans did not begin with the current slow recovery or even with the financial crisis of 2008-2009 and the subsequent deep recession.  A new report issued last week by NDN tracks the earnings of working Americans of various ages, year by year, as they have grown older.  It shows that average working people racked up steadily-rising wages and salaries through the economic expansions of the Carter, Reagan and Clinton presidencies.  I also found that this progress stopped abruptly in the expansion of 2002-2007, when people’s wages and salaries stagnated through five years of strong productivity gains and reasonable growth.  

This new analysis recasts the significance of our current slow recovery.  As many economists have pointed out, slow recoveries are the norm when an economy suffers a serious financial crisis, whether it was the United States and Europe in the 1930s, Latin America in the 1980s, or Japan in the 1990s.  In fact, the Obama program stopped a dangerous spiral towards a second Great Depression and restored modest job gains that have far outpaced the job growth following the 2001 recession.  The economy now seems poised for stronger growth over the next four years.  The outstanding question is whether the programs offered by the President or Mr. Romney can address the forces that halted earnings progress in the 2002-2007 expansion.  The evidence suggests that Obama’s program comes much closer to that mark than Romney’s proposals. 

To answer that question, we first need an accurate picture of how Americans have really fared economically over the last two generations.  To capture people’s actual economic experience over that period, I tracked the median wage and salary earnings of various age cohorts as they aged over the last 45 years.  We followed the earnings path of working Americans age 25 in 1975 until they reached 55 in 2005, those age 25 in 1985 until they reached age 50 in 2010, and those age 25 in 1995 until they reached age 40 in 2010.  A clear pattern emerged.  The earnings of working people grew by 2.8 percent a year as they aged through the Carter expansion of 1976-1979, followed by gains of 3.2 percent per year through the Reagan expansion of 1982-1989, and then another 3.8 percent per year in the Clinton expansion of 1992-2000.   Then came the expansion of 2002-2007, which produced annual wage and salary gains ranging from 1.7 percent for those in their 20s and early 30s, to negative 1.5 percent for those in their late 40s and early 50s.  Across all age cohorts, people’s earnings progress averaged 0.5 percent per year through the Bush expansion, nearly 85 percent less than the average wage and salary gains achieved during the three previous expansions.

These findings transcend partisanship.  The policies of the Carter, Reagan and Clinton administrations all enabled average working Americans to achieve healthy wage and salary gains as they aged.  To begin, this suggests that changes in people’s marginal tax rates – down under Reagan and up under Clinton -- do not materially affect whether their wages and salaries increase as they age.  In addition, of course, earnings progress virtually stopped in the last decade, despite the Bush tax cuts.  Therefore, there is no historical evidence that the centerpiece of the Romney program, a 20 percent across-the-board cut in marginal income tax rates, will make any difference for people’s wages and salaries.

A serious program to restore earnings progress has to begin by identifying what has changed in the economic landscape, so national policy can respond effectively to an economic environment that stalls that progress.  One factor almost surely involves the budget deficit.  When deficits ballooned in the 1980s, President Reagan and Congress stabilized them, largely by ending his defense buildup and raising taxes on businesses (1982), payrolls (1983), and energy use (1984).  When deficits ballooned again in the 1990s, President Clinton and Congress moved the budget to surpluses largely through defense cuts, Medicare changes and tax increases on higher-income households.  Strong gains in wages and salaries in both decades also were crucial to curbing those deficits, by expanding the revenue base for income and payroll taxes.  By contrast, when the deficit ballooned in 2001 and 2002, and earnings stagnated, the Bush administration enacted another tax cut in 2003, increased entitlement spending for the new, unfunded prescription drug benefit, and expanded Pentagon spending for the wars in Iraq and Afghanistan.

Obama’s program seems much more likely to address this factor than Romney’s plan.  The President’s deficit proposals mirror those of Reagan and Clinton, covering defense cuts, additional revenues, and spending restraints in Medicare and discretionary programs.  By contrast, the Romney program begins with large increases in defense spending and big, new tax cuts.  In recent weeks, to be sure, he suggested that he would pare back his tax cuts to ensure “revenue neutrality.”  But he remains unalterably opposed to the revenues increases that all of his predecessors except George W. Bush used to help control deficits.  That leaves his pledge to control deficits entirely dependent on the Ryan budget.  He will have to persuade Congress and the public to accept a Medicare program reorganized around vouchers, state-run Medicaid systems with one-third fewer resources, and the deepest cuts ever seen in federal support for education, natural resources, law enforcement, export promotion and everything else.  Once again, there is no historical evidence that Mr. Romney’s approach will bring deficits under control.

Another force shaping the new economic landscape is globalization.  China’s total imports and exports, for example, jumped from $200 billion in 1994 to $500 billion in 2000 and an astounding $2.4 trillion in 2008.   Over the same years, American businesses and workers also have had to face new competition from businesses in many other countries, including India, Korea, Brazil, Mexico, and much of Eastern Europe.  This new level of competition has affected the wages and salaries of Americans, because it has made it much harder for American businesses to pass along their cost increases in higher prices.  The result is that those companies have cut other costs, starting with the wages and salaries they pay.

Globalization is not going away.  So, the only course available to ease this new pressure on the earnings of Americans is to help businesses address some of costs which rose rapidly in the 2002-2007 expansion – namely, health care and energy.  Once again, Obama’s program seems more promising than Romney’s plan.  For example, Obamacare includes numerous provisions which may help slow fast-rising medical and insurance costs.  They range from new prevention programs and active promotion of cost-effective best practices, to mandatory coverage for healthy young people.  But Romney is committed to repealing all of these reforms and would depend instead on the current patchwork of private competition which has proved unable to make a dent in these costs. 

On the energy front, both candidates pledge to expand our supplies of fossil fuels, which in recent years actually have increased substantially on their own.  However, Obama also would continue to actively promote alternative forms of energy.  Romney wants to end those efforts.  In addition, Obama says he will to continue to use new federal laws and regulations to increase energy conservation and efficiency.  For example, he raised fuel mileage standards for new automobiles, which effectively reduce unit energy costs.  Romney has suggested he would end these conservation efforts and roll back many existing regulations, undoing some of this progress in containing future energy costs.

The central economic challenge facing the next president is to restore healthy wage and salary gains for average Americans.  This challenge will not be met by cutting taxes and rolling back government.  Rather, it will take a sustained effort to address the forces which, following 25 years of steady gains, have stalled further earnings progress for the last decade.  On this basis, the President’s program offers much more promise than Mr. Romney’s agenda.



The Good News In Last Week's Jobs Report is Better Than You Realize

This morning’s employment report makes the President’s case that the economy is not only strengthening, but has been for some months now.  The unemployment rate fell to 7.8 percent; and this time, it was not because more people dropped out of the labor force.  The number of discouraged workers or people “marginally attached” to the labor force actually declined.  Rather, the bullish numbers come not only from creating 114,000 net new jobs in September, but from stronger job creation in July and August than originally reported.  Job creation was revised upward from 141,000 to 181,000 for July and up from 96,000 to 142,000 for August.  In addition, the average hours worked was up, and so was average hourly pay.

The Labor Department actually collects the jobs data in two ways.  The Census Bureau surveys business establishments, which produces the numbers above.  It also surveys households, and the household survey is usually more bullish than the establishment survey.  This month was no exception.  It found that the number of unemployed fell by 456,000 in September and total employment rose by 873,000.  Now, some 600,000 of those newly employed people found only part-time work, so the increase in those employed full-time last month was about 270,000 according to the household survey.    When the establishment and household surveys diverge this much, it usually means that a revision is coming down the line, just as we saw this month for July and August.  It is a good bet that in early December, we will learn that under the establishment data, employment last month rose not by 114,000, but by closer to 140,000 to 160,000. 

The jobs picture is improving, because the elements of a stronger expansion finally are coming together.  Household debt has largely returned to normal levels and housing prices have stabilized, and both are bolstering consumer demand.  Next, we should see business investment strengthen in response to the stronger consumer demand.  In fact, conditions would be even better, but for the rest of the world.  For the first time in years, the biggest drag on the American economy is coming not from the after-shocks of the 2008-2007 financial meltdown, but from a new recession in much of Europe and economic weakening in China. 

After The Debate, Romney No Longer Has a Tax Plan

The press may not yet realize it, but last night’s debate actually made a little news:  Mitt Romney no longer has a tax plan.  For more than a year, he has promised to cut all tax rates by 20 percent.  When the President noted that the non-partisan Tax Policy Center has calculated that such rate cuts would cost $4.9 trillion over 10 years, Romney responded with a new promise to not let his tax plan increase the deficit.  That means the $4.9 trillion will have to come from closing or reducing deductions, such as mortgage interest and state and local taxes.  The Tax Policy Center study assumed the same, and then calculated that there isn’t enough money in deductions for high-income people to fund their 20 percent rate cut.   That is why the Center concluded that Romney’s plan would result in net tax increases for the middle class. 

To counter those facts, Romney last night said that he wouldn’t reduce the overall income taxes paid by the wealthy.  Since their deductions can’t pay for their rate cuts, that means that their 20 percent rate cut won’t happen either.  Similarly, funding a 20 percent rate cut for middle-class households would require terminating all of their deductions, from home mortgages and child care to college tuition and charitable contributions.  Since Romney would never support ending those deductions for middle-class households -- and even if he did, it would never happen – it means that their 20 percent rate cut also can’t happen.   As the President confronted Romney with basic arithmetic, the basic elements of the Romney tax program unraveled, one by one.

For more see this recent essay by Rob, "Mitt Romney Is Just Not Ready To Be President."

Mitt Romney is Just Not Ready to be President

For a candidate running for president on promises to reform taxes and entitlements, Mitt Romney provided evidence this week that he understands little about either taxes or federal transfer programs. Here is what he said: 47 percent of Americans are “dependent” on government transfers. They are the same 47 percent of Americans who pay no income taxes. And nothing he might do or say in his campaign will convince that 47 percent of the country to “take personal responsibility and care for their lives.”

To begin, those who do not pay federal income taxes — 46 percent last year, but in normal economic times, about 40 percent of the country — are not the same people who receive transfer payments. Generally speaking, about one-third of Americans who pay no income tax do not receive any transfer benefits. They are too young to collect Social Security or Medicare, and they are not poor enough to collect Medicaid or welfare. Then there is the flip side: About 40 percent of those who receive transfer payments also pay income taxes. Americans who collect Social Security and Medicare, the vast bulk of federal transfer payments, are distributed across the income distribution. In fact, the average household in the top 1 percent collected $9,000 in those transfer payments in 2009. And incidentally, that $9,000 was only a little less than the average transfer payment collected by those households smack in the middle of the income distribution.

Mr. Romney says these are people who won’t take personal responsibility for their own lives. Among those who receive transfer payments, 70 percent of their payments come from Social Security and Medicare. Those benefits, of course, are available only to working people who paid into the systems from the (via their ?) paychecks. Much of the rest goes to veterans and to students receiving federal loans and grants, also people hardly unwilling to “take personal responsibility and care for their lives.”

If we consider Mr. Romney’s view of personal responsibility from the other direction – those who pay no income taxes – we find that 61 percent of them work for a living, since they pay payroll taxes.  In fact, the payroll tax rate they pay, 15.3 percent, is higher than the 13.6 percent income tax rate that Mr. Romney paid last year on his $21 million income.  Another 22 percent of those who pay no income taxes are elderly people collecting Social Security and Medicare, again after working for it their whole lives.  The remaining 15 percent – equal to 7 percent of the country, not 47 percent — pay neither income nor payroll taxes, because they’re either disabled or desperately poor.

This juxtaposition of payroll and income taxes should alert Mr. Romney that looking at only one form of tax will tell you little about who and how we pay for government. In fact, everyone is a taxpayer when you consider all forms of tax — federal taxes on personal income, corporate income, estate and excise taxes, as well as state and local income, sales, property and excise taxes. Looking at all taxes, the top 1 percent pay out about 29 percent of their total income. That is only a little more than Americans in the very middle of the income distribution, who pay 25 percent of their total incomes in federal, state and local taxes. Even the poorest 20 percent of households pay about 17 percent of their meager incomes in all federal, state and local taxes. These tax burdens hardly describe the free-ride that Mr. Romney attributes to nearly half of Americans.

Although Mr. Romney seems unaware of it, the payroll tax has become the signature tax of American government. Last year, Americans paid about $300 billion more in payroll taxes ($1.4 trillion) than they did in income taxes ($1.1 trillion). In fact, the federal income tax today claims just 11 percent of all personal income. Moreover, among all Americans who work, 86 percent pay more in payroll taxes than in federal income tax. Even among the top 20 percent of households, 54 percent pay more payroll tax than income tax. In fact, 2.3 percent of people in the top 1 percent pay more in payroll taxes than income taxes. That means, of course, that those who pay little or no income tax include some of the country’s wealthiest people.

Most of this week’s commentary on Mr. Romney’s views of taxes, transfer payments and personal responsibility has focused on his political insensitivity. But his views reveal something much more important. He clearly has devoted considerable time and effort to understand how to minimize his own taxes. Yet, through his many years of preparing to run for president, he never bothered to understand the fundamental shape and distribution of American taxes and entitlements, and how they affect everyone’s lives. In a moment of candor that recalls, of all people, Sarah Palin, Mr. Romney has demonstrated he is not yet equipped or ready to be president.

GOP Revisionism: Rewriting Economic History Against Obama

As Published in the Washington Post on August 17, 2012:

Two respected economic advisers to the Romney campaign launched a new line of criticism of President Obama’s economic stewardship on this page this week [“Obama’s faulty math; his economic arguments contradict themselves,” op-ed, Aug. 16]. The case offered by Kevin Hassett of the American Enterprise Institute and Glenn Hubbard of Columbia Business School contained three bold claims.

Two of the three are demonstrably wrong as matters of economics, and the other is off-point.

First, Hassett and Hubbard say that the president has misled the country in claiming that economies that suffer financial crises typically recover only very slowly. Second, they insist that Obama himself didn’t expect a slow recovery, judging by his administration’s initial forecast. And they say that if Obama did expect a slow recovery, he should have known that Keynesian stimulus wouldn’t work under that circumstance.

If this brief were true, it could suggest that the president was befuddled in his early months in office, then lied to promote his stimulus package and now is lying again. But this brief is simply wrong, and as good economists, they should know it.

To refute Obama’s claim about the slow recovery — as well as a recent, landmark study documenting hundreds of disappointing recoveries following financial crises around the world — Hassett and Hubbard cite a less well-known study from the Cleveland Federal Reserve Bank. That study, by Michael Bordo and Joseph Haubrich, found that financial crises in the United States often have been followed by strong recoveries. But the main evidence comes from the long series of financial busts from 1880 to the 1920s. In fact, Bordo and Haubrich note that the three major U.S. financial crises since the 1920s — 1932-33, 1990-91 and 2007-08 — were all followed by notably slow recoveries. Moreover, as Ezra Klein reported in The Post this month, Bordo believes that the slow pace of the current recovery reflects not the president’s policies but the fact that it follows a meltdown in both finance and housing.

The Romney campaign’s notion that the 2007-08 financial crisis should have been followed by a rapid, strong recovery — and, by implication, would have been but for Obama’s policies — ignores other well-known economic evidence. The data show, for example, that the current recovery is comparable to the one that followed the 2001 recession, when Hubbard chaired George W. Bush’s Council of Economic Advisers. In the three years following the end of the 2001 recession, which did not involve a financial crisis, real gross domestic product grew only modestly faster than it did in the past three years. Moreover, in the 37 months since the end of the 2007-09 recession, U.S. businesses created nearly 3.9 million new jobs. Recall that fewer than 1.1 million were created in the first 37 months after the 2001 downturn.

The Romney advisers then criticized the Obama administration for its first economic forecast. Yes, the administration initially predicted a stronger recovery than has occurred. In part that was because administration officials, along with everyone else, underestimated the depths of the precipice the economy had fallen into. The Bush administration made much the same mistake, with much more dire consequences. The Bush team ignored all signs of an impending meltdown and then stood by as Lehman Brothers collapsed, taking AIG, Merrill Lynch and others down as well.

Finally, the Romney advisers claim that if Obama had expected a slow recovery, he should have known that stimulus would produce only a temporary lift, to be followed by a comparable decline. There is an economic theory called “rational expectations”; it holds that stimulus never works. Almost all economists dismiss it because the overwhelming consensus is that stimulus often does work. In any case, there is no theory or evidence to support the peculiar claim that the expectation of a slow recovery will disarm Keynesian stimulus. In fact, within two months of Congress passing Obama’s stimulus, our sickening slide toward a depression halted, and growth and job creation resumed — albeit at the moderate pace characteristic of recoveries following a financial and broader economic crisis.

Yes, growth has slowed periodically since then, but not to anything like the degree the Romney advisers claim. According to their notion, we should be in a deep recession today. In any case, the president asked repeatedly for additional measures to bolster the recovery, which Republicans in the House of Representatives have repeatedly rejected.

Beyond the partisan cherry-picking of economic evidence, the question remains: Could Obama have done anything else to drive a more robust recovery? The history of economic meltdowns suggests that a strong recovery is possible only if you directly address the underlying causes of the crisis. In our case, that meant not only stabilizing the financial markets, which we did, but also taking decisive steps to stabilize housing prices by reducing home foreclosures.

Now, imagine the political firestorm if the president had tried to force banks to refinance the mortgages of homeowners in danger of losing their houses or offered short-term loans to help them meet their mortgage payments until the economy recovered. The president’s opponents can hardly blame him now for not taking steps that they would have blocked in any case.

The Eurozone Crisis is Back, and All of Us Are in its Crosshairs

Once again, the Eurozone debt crisis threatens to suck the oxygen out of the global economy.  Two years of austerity across most of Europe continues to produce the predicted effects:  We learned this week that Europe’s private sector keeps on contracting.  Moreover, global investors began to bail again on Spain, driving interest rates on 10-year Spanish government bonds to an unsustainable 7.6 percent.  Greek, Portuguese and Irish public finance faced comparable rates, so they have to rely on bailouts.  Yet, there isn’t nearly enough money in those bailout facilities to rescue Spain, too.  That’s why this week, Moody’s downgraded its outlook for the region’s strongest economies, Germany and the Netherlands.   If anything, that move was cautious.  If Spain spirals into default, it would likely trigger a continent-wide banking crisis, followed in all likelihood by a real Depression.  It also could upend our own economy on the eve of the election.  

It’s a crisis with lots of nubs.  For one, Spain is in the middle of the world’s sharpest housing contraction and a recession currently forecast to last into 2014.  That what happens when austerity dramatically slows public spending while the nation’s private banks are writing down tens of billions of Euros in mortgage loans gone south.  The result is that government revenues have been falling faster than government spending, piling up more debt – and now several of the country’s provincial governments say they also cannot keep on going without major support from Madrid. 

That is why foreign investors see a growing risk that, sometime soon, Spain’s government won’t have the money to service its fast-rising debts.  The 7.6 percent interest rate on new Spanish debt is the market’s current demand to offset that risk.  But unless Brussels and Berlin step in with new, credible assurances for those holding Spanish bonds, the interest rate will keep on rising until everyone begins to dump the bonds.  Madrid would have to try to borrow even more money, and if it cannot, a sovereign debt default would quickly follow.

Eurozone leaders have tried to head off all of this, but only through a series of indirect and inadequate measures.  The immediate threat from a major sovereign debt default is the collapse of dozens of large banks with large holdings of those sovereign bonds.  German and French banks, for example, hold $600 billion in Spanish bonds.  The Eurozone could have followed the basic rule of monetary unions, and used the European Central Bank (ECB) to guarantee those bonds in some way.  That’s what the Federal Reserve has done for a century here (and the Treasury did it for 50 years before the Fed was created).  Yes, it would be harder for the Eurozone to pull that off, since it has no single national government.   But it does have a single central bank. 

Yet, Angela Merkel has consistently vetoed that course, preferring instead to build a new political and economic environment that could head off future defaults.  So, while Greece and Spain slowly sink, with Italy not far behind, Merkel pursues continent-wide banking regulation to discourage future bank runs from one Euro country to another.  She also is pushing for continent-wide fiscal arrangements to head off the large deficit spending down the road that can cripple an unproductive economy when bad times strike.  For the current crisis, she has agreed to spend €100 billion from the Eurozone to pay the bills of Greece’s government this year.  She also has allocated another €100 billion to bail out the balance sheets of Spanish banks.  And she has allowed banks in Germany, France, Italy and elsewhere to use their Spanish and Italian bonds as collateral from hundreds of billions of Euros in low-cost loans from the ECB.  

This week, the markets rendered their latest judgment on those steps.  The sky-high interest rates now in Greece, Spain, and looming in Italy tell us that all of Mrs. Merkel’s handiwork will not be enough to head off a sovereign debt default.  The results could be disastrous for many major European banks and the Eurozone economies.  How bad could it be?  Even before facing final default, Greece has seen its GDP shrink by 25 percent, its average wage fall by nearly 20 percent, unemployment rise past 20 percent, and government pensions cut back 30 percent.

One final word.  On this side of the Atlantic, the political season has made every development fodder for campaign attacks.  So, we can count on the President’s opponents charging that America under his leadership is following the path of Spain and Greece.  That is nonsense.  The Eurozone faces a crisis of confidence about the capacity of its less productive economies, burdened by deep recessions and large debt overhangs, to honor their future debts.  The irreducible proof is the rising risk premium on new Greek, Spanish and Italian bonds.  There is not the slightest hint of such doubts about the United States.  The interest rate on 10-year U.S. Treasury bonds is 1.75 percent, less than one-fourth Spain’s level, and actual yields are even lower.  And while Europe is deep into a double-dip recession with fast-rising unemployment, we have had more than three years of slow but steady growth and job creation.  

To be sure, a European banking crisis triggered by a sovereign debt default, one which spread from Spain to Italy and then across the continent, would almost certainly end our own expansion.  American exports to Europe – our largest foreign market -- would fall sharply.  American banks would be hit by losses on thousands of investments and other deals that involve European banks which such a crisis will take down.  So, in the end, our presidential election could turn on events entirely beyond the influence or control of either President Obama or former Governor Romney.  Not even their legions of consultants and operatives, and the stream of billionaires funding the campaign’s television wars, will be able to override the economic consequences here at home of either a full-blown Eurozone meltdown or, for that matter, the successful resolution of the crisis.

The LIBOR Mess Could Be the Biggest Financial Fraud in History

If our financial policies were based on recent experience, the debate over government regulation versus self-regulation by Wall Street would be settled.  Yet, the refrain that “the big banks know best” remains the default position of most American conservatives and many policymakers.   This childlike faith will be tested by the new scandal swirling around some of the most basic interest rates in the global economy, the LIBOR or “London Inter Bank Offered Rates.”  This past week, Barclays Bank admitted that it secretly manipulated LIBOR rates for years, all to pad its own bottom line.  And Barclays is not some lone, bad apple.  Investigators here and in London, Brussels and Tokyo are hard at work looking into reports of similar manipulation by other big players, including Citigroup, Deutsche Bank and J.P. Morgan Chase.  This could turn into the largest consumer fraud ever seen.

It will take months for the general public to catch on to what this latest scandal is about.  It starts with one basic fact: LIBOR interest rates are not set by the supply and demand for credit, like many other rates.  Instead, every morning, representatives of the 18 largest Western banks report on what they would be willing to pay to borrow funds from each other (“Inter Bank”) in the future.  Under LIBOR rules, the four highest and four lowest estimates are eliminated, and the average of the rest becomes the official rate.  For example, in 2007, the LIBOR rate to borrow three months in the future, in dollars, averaged 5 to 5.5 percent.  

LIBOR rates are a very big deal, because they are benchmarks for countless other interest rates.   The majority of adjustable rate mortgages, for example, are set at a LIBOR rate plus 2 or 3 percentage points.  So are millions of student loans, auto loans, and credit card finance charges.   LIBOR rates also are used to set or reset small business loans, futures contracts, and interest rate swaps.  All told, an astonishing $360 trillion in loans around the world are indexed to LIBOR.   That is more than five times the value of the world’s entire GDP this year. 

One reason that LIBOR has such a far reach is that there are numerous LIBOR rates for different purposes.  Each rate has a time frame – rates for loans one day from now; one month, three months and six months out; one year, five years and ten years from now, and so on.  There are 15 such time frames, all told.  In addition, separate LIBOR rates also are provided for dollars, Euros, yen, and seven other currencies.  The integrity of these LIBOR rates, however, depends entirely on the honesty of banks reporting the rates they actually would be willing to pay.  Inevitably, we got what we should have expected. 

So, when Barclays (and almost certainly others as well) had investments that paid off, or simply paid off more, when interest rates rose, it simply reported a higher figure to LIBOR in order to nudge up the average.  And that usually led to higher interest rates for millions of other businesses and people with loans indexed to the LIBOR.  Sometimes, it worked the other way.  In late 2008, Barclays (and probably others) low-balled the rates they reported for LIBOR averaging.  The purpose was to make themselves look more sound than they actually were, since they would be willing to borrow only at low rates.  They presumably figured that might reassure their shareholders and perhaps even dampen public demands for tighter regulation.  

For several years, academics and a number of market followers warned that something funny was going on with LIBOR.   The evidence was not hard to find   For example, the “spread” or difference between U.S. Treasury rates and LIBOR rates for loans of the same time frame began to widen.  From 2000 to 2006, LIBOR rates averaged one-quarter of one percentage point above Treasury rates, and the two rates moved up and down together in lock step.  In 2007, however, that spread more than doubled to nearly two-thirds of a percentage point, and their movements up and down did not track each other so closely.  By 2008, the difference in the rates was five times what it was in 2000-2006, averaging 1.3 percentage points, and the up-and-down movements of the two rates no longer tracked each other.

All of the obvious parties that might have done something about it – the Fed and the SEC, for example, or the Financial Services Authority in Britain – apparently looked the other way.  This tolerance for sub rosa interest rate manipulation has cost millions of ordinary Americans and Europeans a great deal of money.  Early analysis suggests that for several years, the LIBOR was off by an average of 30 to 40 basis points.  (100 basis points equal one percentage point in an interest rate.)  That is enough, for example, to add $300 to $400 to the annual cost of a $100,000 loan.  

In 2007 and 2008, Americans held $11.1 trillion in outstanding residential mortgage debt.  At the time, between 30 percent and 40 percent of that debt carried adjustable rates.  If the bankers’ manipulations of the LIBOR was responsible for raising LIBOR rates by just 20 basis points in that period, their shenanigans added between $6.6 billion and $8.9 billion to the yearly interest paid by American homeowners.  And those mortgages account for less than one percent of all of the financial assets and instruments affected by manipulated LIBOR rates.  

LIBOR hearkens back to a time when finance operated like a gentlemen’s club, and its leading members behaved honestly.  That is a universe away from the current Wall Street culture and behavior.  They take out bets and pay themselves fortunes for doing so, even when they cannot make good on those bets without taxpayer bailouts. They create securities they know are likely to fail, on behalf of clients prepared to bet against those instruments – and then pawn off the same securities on other clients as safe investments.  And now, we also know that when they bet on interest rates rising or falling, they stacked the LIBOR deck to nudge rates in the direction that made them money.  And they left everybody else with the bill.    

So long as big finance will do almost anything to goose its own profits and bonuses, “self-regulation” is a dangerous myth.  It should give way to sound law enforcement, which in economic terms means more government regulation. 

A New Economic Challenge Facing Europe – and the United States

I spent much of last week in Geneva, Switzerland.  Even in that city of global institutions, in the European country most untouched by the continent’s sovereign debt crisis, most conversations found their way to hand-wringing over Europe’s economic decline.  As the Eurozone governments struggle to save their common currency, it is increasingly clear that the misguided austerity policies of many European governments have exacted large tolls on employment and growth.  Moreover, Europe’s economic problems will last much longer than the current debt crisis, even if it ends better than anyone now imagines.  One reason is that capital investment, the foundation of future growth, has been depressed since the crisis of 2008-2009. 

With capital investment persistently slow across most of Europe, political and economic leaders need to ask themselves, where would additional investment produce the greatest benefits?  One part of the answer is the same for Europe as it is here, in the United States.  Perhaps the single most important area of investment today lies in the telecommunication infrastructure, networks and devices on which business and social activity increasingly rely.  Earlier this year, NDN issued a new study I wrote with Kevin Hassett of the American Enterprise Institute on one aspect of this development.  We investigated the impact on job creation in the United States associated with the transition from 2G to 3G infrastructure and devices.  We found that this shift created almost 1.6 million jobs from April 2007 to July 2011, even as overall U.S. employment fell by nearly 5.3 million jobs over the same years.   

The current transition to 4G networks and devices should produce a similar economic bounce, so long as the necessary policies and capital investments are there to help drive it.  For example, since 4G involves more intensive data streams, the transition requires additional spectrum.  It will take strong White House leadership to ensure that the private investment needed to build out more spectrum and related, next generation IP broadband infrastructure are available to support 4G services.  In the process, these advances will promote the President’s larger goals of a strong recovery, job creation and universal broadband.  

Like the economy they enable, these technologies are inherently global.  So, the same dynamics apply to Europe, even in its current straits.  Throughout much of the 1990s, Europe had a real edge over the United States in advanced telecommunications, especially in the mobile or wireless space.  That is no longer the case.  Europe’s transition to 4G, for example, has been much more rocky than ours.  In its latest Digital Agenda report, the European Commission noted that while people and businesses in Europe “are generating enough digital demand to put Europe into sustainable economic growth,” this potential is undermined by a “failure to supply enough fast internet, online content, research and relevant skills.” 

Two years ago, the European Union set a goal of doubling its public investments in advanced telecommunications facilities and skills by 2020, which assumed annual growth in these areas of about six percent.  So far, the actual growth has averaged just two percent.  Moreover, private capital spending on 4G infrastructure across Europe also has lagged the United States.  In 2011 and 2012, American telecom companies invested more than $25 billion per-year in wireless facilities alone.  Yet, since 2007, comparable investments across the European Union, with a GDP slightly larger than ours, have been 15 percent to 40 percent less than in the United States. In response, European Digital Affairs Commissioner Neelie Kroes, warned recently, “Europeans are hungry for digital technologies and more digital choices, but governments and industry are not keeping up with them.  We are shooting ourselves in the foot by under-investing.”

The substantial effects on employment which we documented from the transition from 2G to 3G, and now from 3G to 4G, are signs of larger dynamics at work.  Across professions, industries and nations, Internet technologies have become integral parts of most economic activities and operations.  Moreover, with the advent and dispersion of 4G technologies, wireless Internet has begun to assume a pivotal role in these operations and activities.  National policy and business strategies ignore these developments only at great cost.  

To be sure, both Europe and the United States face special and more immediate challenges today, which neither has yet mastered successfully.  But the task of promoting investment in 4G infrastructure and networks is well within the capacity and understanding of all modern governments and businesses, and should be a national priority.  Fifteen years ago, in the transition to 2G, the United States followed Europe’s example, to America’s benefit.  Today, it is Europe’s turn to follow our spectrum policies and investment strategies. 


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