Monday, October 27, 2008

Political Diary: Examining the Fundamentals  

I and a number of my friends have been arguing about Obama and McCain's financial packages ... one of them even asked, "So, which of these guys is going to win the war on pandering?"

  • http://www.cnn.com/2008/POLITICS/10/13/campaign.wrap/index.html
  • http://www.politico.com/news/stories/1008/14406.html
I'm not going to dig into their proposals. Instead, I have spent some time digging into economics in response to the crisis and at my 50,000 foot level I've come across the following approximations about how the economy works as a whole, which lead me to question my knee-jerk idea of "pay the debt down now!" We've been discussing these ideas in emails, and I'm going to attempt to summarize some of what I'm thinking about, and some of their responses, here.

In sum, looking at the economy as a whole:

  • Spending equals income. The nation's net income - the GDP - sets the limit on the nation's net spending. The GDP is made up out of what consumers buy, governments spend, investors invest, plus our net exports (that last bit is a current net negative). This has a few corolloraries:
    • If government spending goes down, the GDP goes down, and hence, so does the aggregate income of the nation. Put another way, if you lay off a cop, he buys less donuts.
    • If government taxes go down, the GDP goes up, and hence, so does the aggregate income of the nation. Put another way, if you cut the cop's taxes by 10%, he buys more donuts.
  • We consume less than we earn. If wages double, spending doesn't double - it goes up somewhat less. This doesn't hold for transient events like stimulus checks, which people tend to "discount" as a one time event, but it does hold for "permanent" tax cuts, which people tend to factor in to their long-term plans. If you measure this factor over the long term, it's roughly sixty percent or so, depending on how you measure it. Take that as an approximation.
  • Spending changes have a multiplier effect. If the government cuts spending or raises taxes, there's a disproportionate effect that ripples through the economy. When you cut the cop's pay by 10%, he buys 6% less donuts (and other stuff), which leads the donut shop cutting its employees' hours 6%, which leads to 3.6% less other expenditures ... in total, that 10% becomes roughly a 25% hit on the economy. A tax cut of the same magnitude has a positive effect, also about 2.5x its initial value. This is also an approximation.
  • Lack of liquidity increases the multiplier. If your income goes up 10%, but all of your money is tied up in long-term CDs, you can't buy that new house. If mortgages are not available, you can't buy that new house. If you don't have a credit card, you have to wait until after Christmas to buy gifts, even if your Christmas bonus is a sure thing.

The actual economic picture is MUCH more complicated than this Keynesian ideal (for example, net exports have an opposite effect, and this does not factor in investor confidence, etc), but at the 50,000 foot view, it seems like a few corolloraries in this crisis might be:

  • Government services should be maintained. If the government does a radical belt-tightening or even a spending freeze relative to its current growth, there will be money in the government coffers that does not go out to the economy - and all those defense contractors, cops, social workers, civil engineers and so on that are out of work are not going to have money to spend or save, having a further impact on the economy.
  • Taxes should be cut. If the government raises taxes, even for the "good" reason of being fiscally responsibile, individuals will have less money to spend or save, having a further impact on the economy.

So, shockingly, the two candidate's plans to cut taxes are not as horrible as I thought they were. I'm not completely sure about the above logic, as the economy is very complicated, but while I'm speculating I'm going to go further on a limb and try a few more ideas:

  • If (if!) taxes are to be raised, perhaps they should be raised on the high end of the consumption curve. I'm not certain, but I strongly suspect that the consumption curve above is nonlinear - that the higher end of the curve flattens out, as Bill Gates and Warren Buffet do not have a million homes each. Since most of the money is on the high income end of the curve anyway, this is where you will have to raise taxes. It will hurt - don't kid yourself that it won't hurt - but it will have less impact than if you tried to get the same money out of the bottom end of the curve. (For example, at the bottom end of the curve people will go into debt rather than starve).
  • A tax on consumption would directly impact the consumption curve, and should be avoided. Taxing consumption is like putting a brake on the relationship between national income and national spending - it will decrease the marginal rate of consumption (the 0.6 above) and raise the Keynesian multiplier (the 2.5 above) putting the brakes on the economy. This seems to indicate that sales taxes are a bad idea, and perhaps is bad news for the FairTax idea - the FairTax may be designed to make the system more fair, but it applies taxation to a place in the economy that will interfere with the growth of GDP. I haven't dug into the FairTax in detail, so they may have an answer which will ease my fears on this issue.

I'm not arguing here based on whether I think government should be big or small, or whether I want higher or lower taxes. I want lower taxes so I can buy more books, pay off my house more quickly, or get a new hybrid electric car; but more importantly, I want lower taxes because I think it will get the economy moving, as I've stated above. Speaking frankly, I have no desire to soak the rich: the rich pay most of our taxes (no, really) and do most of our investment upon which many of us rely for their jobs. So I don't want to make their lives harder; however, the rich have a greater ability to pay and still be able to invest and consume so if (if!) we were to raise taxes they should go up on the higher end. So based on these ideas ...

  • Obama's tax cut idea is not horrible. It raises taxes on wealthy people, but overall it is a tax cut, and should stimulate the economy.
  • McCain's tax cut idea is better. It lowers taxes on more people, for a larger overall total, and should stimulate the economy more.
  • McCain's spending freeze is questionable. It's not a terrible idea, but it does suggest that we should focus on trying to grow the economy to the point it can pay for our services, rather than cut our services and thus stop pumping that money back into the economy.
  • Obama's idea to back up states the way we are banks is not a horrible one. The biggest problem is the moral hazard it creates ... obviously all 50 states cannot do this forever, or basically we're draining our income taxes into our state budges. But if we allow governments to stop providing services, it will hurt the economy.

A few notes on things not completely covered by this model:

  • McCain's mortgage plan is ... WTF? Seriously, as a friend put it recently, "if we're going to spend 700B we should think out of the box". The answer may or may not be McCain's plan, which is more complicated than my simple little model and my dime-store understanding of economics. It would save homeowners and reduce risk to lenders, which should help things ... but the moral hazard, and investment risk, worry me.
  • Paulson's plan to buy into banks is ... not so bad? The capital injection into the banks, because it comes with a 5% dividend, sounds like a good idea. If the government is buying things at a steal, this could help the taxpayers.

Unfortunately, I think we are in "uncharted waters", as both the Google CEO Eric Schmidt and Google gadlfy Mark Cuban. We have a crisis of investor confidence, which has led to a severe drop in the amount of investment recently. Some bold people with liquid cash, like Warren Buffet, may make money ... unless we are on the high side of a slide down to the market losing 90% of its value, as another friend pointed out happened in the Great Depression.
In this case, larger issues that the simple Keynesian model come into play:

  • Moral hazard. What kinds of behaviors do our policies enable? As one friend. has repeatedly reminded me, "if this goes on" we would keep bailing people out forever. The solution to that is to increase regulation on the bailed-out industries ... which will slow them down. So do you not bail them out ... in which case the lack of a bailout will cause a certain amount of pain. How much pain is too much pain? If we avoid bailouts and regulation, is that saying that we as a nation have to depend entirely on the market and sort of hope that maybe it will do the things we need to supply our nation with the things it needs to defend itself and maintain its global position (which in turn enables the functioning of our market)?
  • Investor confidence. As investor confidence drops, the amount of money invested in the economy drops ... causing multiplicative effects as we have seen above. In recent times these "factors" have become highly nonlinear and disruptive ... so we can't predict how much investment will happen from overall effects on the GDP. We have three big variables we as a nation can use to affect the economy: how much we tax, how much we spend, and how easy it is to lend money. The third factor has gone off the rails because of investor confidence ... it is looking like we have little control of this right now, though the TED spread is getting better. The tax and spend equation is also off the rails because of our huge debt, which means that some huge percent of our government income is not directly getting fed back into the economy in terms of goods and services, but instead is being paid off as debt, sometimes to people outside this country.

If we could wave a magic wand and fix things, we'd see a country with:

  • No debt, and thus not driving with the parking brake on.
  • If possible, less taxation overall, which would make it easier for people to spend/invest what they have.
  • If possible, less government spending in relation to GDP, which will increase the rate of growth of the economy and over time give us the revenues we need to do a wide variety of useful government programs.
  • Government spending close to government income, aaaaand...
  • A large cash reserve. This would be used to smooth over the rough times when we need to drop taxes or expend services to jumpstart the economy. It could also be used for bailouts or to smooth over state budgets ... money that was loaned out at strict rules and/or with high interest. Which makes you wonder ...
  • Is the idea of buying in to the banks a better one than we ever realized? Should the U.S. Government become a (safe, risk-averse) investor?

Right now I'm still researching, so these are more discussion points for ideas, not proposals at this point. But my big point here is I'm not talking ideology here. I'm not saying that big government is good or bad or saying that it would be wrong to redistribute wealth or wrong to encourage dependence on government. I'm saying, economically, some things will work and some things won't. Taxing the hell out of ourselves is going to slow the economy. Cutting government spending is going to slow the economy. Running with low taxes and high spending too long is going to raise debt and slow the overall growth rate of the economy, so when we get the economy running again we need to trim spending further to raise the investment rate - even if you want to ultimately provide more government services, you have to grow the economy first or you're trying to save the world with your hands tied.

If we want to have the resources available to us to do what we want - whether we want to buy guns or butter - we need to clean out the tank, release the parking brake, and drive the country's economy in the right direction.

-the Centaur



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