Epic fail

The so-called “supercommittee” of six Democrats and six Republicans, charged last summer with drafting a deal for $1.2 trillion in spending cuts over ten years, failed to do so by today’s deadline. The so-called teeth in last summer’s agreement to form a supercommittee was that Congress would either accept their proposal or submit to $1.2 trillion in automatic, across-the-board spending cuts. Is this good news, bad news, or irrelevant?

Good, says Paul Krugman. To be precise, he said that last week. His reasoning was that cutting spending is counterproductive in a time of economic depression, as it will just exacerbate the depression, so it’s best that they didn’t make a deal to cut spending. Today, he’s a bit more nuanced, noting a Bloomberg.com story about how the supercommittee’s failure is rattling markets but highlighting this aspect of the story (Krugman’s words):

‘. . . what it actually says is that market players fear that the absence of a debt deal means no stimulus. So the actual fear is not that spending won’t be cut enough, it is that it will be cut too much — which actually makes sense, and is consistent with the action in stock and bond markets.

‘But how many readers will get that? The way it’s presented reinforces the false notion that the deficit is the problem.’

Bad, says Kevin Drum. At least if you’re someone like Kevin Drum, Paul Krugman, or me, who thinks it’s foolish to cut social spending in a depression and really isn’t all that keen on slashing the social safety net in general. Unlike Krugman, Drum thinks many if not most of the automatic spending cuts will go into effect. The deal is only good if you’re a Republican who lives to cut social programs. In other words, the Democrats got rolled again, just as in the bogus “debt ceiling authorization” debate. Drum:

‘In any case, this should basically be viewed as a total victory for Republicans. Any alternative plan would have included some tax increases, so failure to come up with an alternative means that we get a big deficit reduction that’s 100% spending cuts, just like they wanted. And the 50-50 split between domestic and defense cuts was always sort of a joke. Republicans never had any intention of allowing the Pentagon’s half of the cuts to materialize, and the domestic spending half of the cuts was about as big as they wanted them to be. Big talk aside, they know bigger cuts would run the risk of seriously pissing off voters.

‘So Republicans got domestic spending cuts that were about as big as they really wanted. They know they’ll never have to implement most of the defense cuts. And there are no tax increases.’

Irrelevant, say the bond markets. The demand for ten-year U.S. Treasury bonds was actually up slightly today, whereas really bad news about the long-term U.S. fiscal position should send demand down and interest rates up. Either the market regards $1.2 trillion over 10 years as no big deal (and it is rather small compared with a national debt of $14 trillion), or they were expecting the supercommittee to fail all along. Or both.

U.S. 10-year 1.959% -0.051

Taxes — not lonely enough at the top?

Bruce Bartlett offers a fine economic history lesson on the U.S. top marginal tax rate. Most people know that the top rate has changed quite a bit over time. (For those keeping score: 91% from WW2 to the early 1960s; 70% till the early 1980s; 50% for most of the Reagan administration; 28% in the late 1980s; raised to 31%, then 36%, then 39.6% in the early 1990s; lowered to 35% in 2001). Bartlett compares the top tax rate with the economic growth rates during those intervals and finds basically no correlation. That, too, is not really news (and a more careful study would take other factors into account).

What is striking, however, is how the threshold level of income for the top rate has changed over time. The original income tax, at the height of the Progressive Era during the Wilson administration, set the threshold at $500,000, which is not only higher than today’s $374,000 but was in 1913. The price level has increased more than 20 times since then; adjusting for inflation, the 1913 top tax rate kicked in at $11 million.

The famous tax cuts engineered by Harding-Coolidge-Hoover Treasury Secretary Andrew Mellon in the 1920s lowered that threshold considerably (to $100,000, or $1.2 million in today’s dollars) but in real terms left it still well above today’s. Pres. Franklin Roosevelt raised both the top tax rate and the threshold to sky-high levels (79%, and a threshold that would be $80 million in today’s dollars and may have only affected one person; some called it “the Rockefeller tax”).  The threshold fell to $200,000 (equivalent to about $3 million today) during WW2 and basically stayed there till the early 1980s. The “Reagan tax cuts” of 1981 lowered the threshold to $85,600 (not quite $200,000 today). The Tax Reform Act of 1986, which Reagan signed, flattened the tax system further, with a top rate of 28% that kicked in at just $30,000 (about $50,000 today). The “Clinton tax increase” raised the threshold from $86,000 to $250,000, and inflation adjustments have raised it to $374,000 today.

Notice a partisan pattern here? It’s no secret that Republicans think the rich are overtaxed and Democrats think the rich are undertaxed, but the discussion almost always focuses on the top tax rate. What’s often missing is just where the definition of “rich” begins. In the historical record, Democrats (Wilson, Franklin Roosevelt, Clinton) have tended to set the top tax threshold high, whereas Republicans (Harding, Reagan) have tended to lower it. Much of this comes down to different notions of fairness: Democrats tend to favor a progressive income tax in which richer people pay a larger share of their income and poor people pay little or none; Republicans tend to favor a flat income tax (or no income tax), in which everyone pays the same marginal rate. Having the top rate kick in at very high levels of income tends to go hand in hand with a multiplicity of different tax rates and a highly progressive tax structure, whereas having it kick in at low levels of income means a much flatter tax.

Ever since the “Bush tax cuts” of 2001 were passed, many Democrats have talked about raising the top tax from 35% back to 39.6%, but until recently I’d  heard surprisingly little talk about raising the threshold.This was surprising to me, because, as Bartlett points out, many people do not regard $250,000 or even $374,000 as particularly rich — at least not if, say, you live in New York City and have a family of four. It’s rather unclever politics to talk about raising the top rate without reassuring upper-middle class people that you’re not going to raise their taxes too. Republicans, with clever simplicity, typically truncate “tax increase on the wealthy” to “tax increase,” implying that it’s a tax increase on everybody. Lately Pres. Obama has called for raising the threshold to $1 million, so that people making $374,000-$999,999 would still pay 35 cents on their last dollar of income but people would pay 39.6 cents on every dollar of income above $1 million.

It is still debatable whether raising anyone’s taxes in a depression is ever a good idea, but ideally whatever major long-term deficit reduction plan Congress passes will go into effect only when recovery is well underway and unemployment is down to, say, 7% or less. When that happens, I agree with Bartlett that raising revenues efficiently and equitably will entail raising taxes on the top brackets (either through raising rates or, better yet, closing loopholes) and raising the top tax threshold.

Self-inflicted wounds: Nov. 23 edition

Another Kabuki dance has commenced in Washington, now that Congressional leaders of both parties have made their selections for the Gang of Twelve charged with crafting $1.5 trillion in savings in 2013-2022. They have until Nov. 23 to agree on a package of savings. If Congress can’t pass that package, then $1.2 billion of automatic, across-the-board spending cuts (no tax increases) would kick in.

I’d place my bets on none of those things happening. Here’s what I foresee:

1. Negotiations among the twelve constantly are on the verge of breaking down along party lines, especially on the issue of tax increases. Possibly they are unable to reach a compromise at all. Even if they do, few of them will throw much weight behind it.

2. If a budget plan emerges, getting majority support in the House and 60 votes (or 51 votes, if nobody filibusters it) in the Senate will prove impossible. The partisan acrimony will look like open warfare.

3. With the specter of $1.2 trillion in across-the-board cuts, including maybe $500 billion in Pentagon cuts, the Secretaries of Defense, Homeland Security, and other agencies, joined by citizens and interest groups all over the nation, will howl that these cuts would devastate our country. Congress’s approval rating will plummet even further, to about the same level as the Taliban’s.

4. Congress will pass a new bill that says, um, nevermind about all those spending cuts. (This is an inherent problem in trying to tell future Congresses what to do, or even telling oneself what to do a little ways down the road.) Republicans will continue to pummel Obama and the Democrats for overspending, but neither side will be able to push a new deficit-reduction plan through both houses of Congress.

Now, what about the reaction of the markets to all this? I think that most of the market already expects something like this and has basically priced it in. It’s decades-old news that Congress has no stomach for long-term deficit reduction, and obvious by now that the partisan split in this Congress is among the worst ever. If the above predictions come to pass, then the markets and economy will get worse, as this failure becomes definite. As I’ve written before, I think the market is reacting less to the U.S. debt burden than to continued evidence that U.S. politicians are simply not doing their job when it comes to dealing with the Little Depression. I think they’re appalled that Congress and the White House are wasting so much time on this doomed debt deal and have basically painted themselves into a corner with this Nov. 23 deadline and automatic-spending-cuts mechanism. They see the writing on the wall; either Obama, Boehner, Reid, et al. don’t or each side is cynically thinking that they can spin this fiasco-in-waiting to their advantage. Either way, they’re not doing their job. They’ve set themselves up to fall, each side hoping that the other falls further.

The beatings will continue until morale improves

The stock markets are looking pretty Keynesian today. A 512-point (4.3%) drop in the Dow Jones average today, and drops of 4.8% and 5.1% in the S&P 500 and Nasdsaq; overall a drop of more than 10% (a.k.a. a “market correction”) in the past 10 days. Might it have something to do with the fact that Washington is obsessed with deficit-cutting while the rest of the world is obsessed with jobs and economic growth, or the lack thereof?

Jeff Macke of Yahoo! Finance’s Breakout blog puts it this way:

‘There’s a growing realization among even the most optimistic investors that the United States is entering a new recession — a dreaded “double-dip.” Adding to the pain is the sense that the government and Federal Reserve are out of both ideas and ways to stimulate the economy. Corporate America is sitting on record amounts of cash but is refusing to make new investments with so little end demand for its products. Consumers and corporations are hoarding cash, and the economy appears to be seizing. The debt ceiling debate was a fiasco, snuffing any remaining confidence traders had for help from Washington, D.C.’

Yes, Mr. President (and happy birthday, by the way), the time-suck that was the debt-ceiling negotiations was a “self-inflicted wound,” as you said last night. Now why couldn’t you have said the same about the debt ceiling itself? Worldwide investor confidence could not possibly have been inspired by this fight over a redundant institution that no other democratic country (besides Denmark) has and which serves no purpose besides political grandstanding. You may have looked like the only grownup in the room during that whole travesty, but I think the world would like to see a grownup with a clue. You’re talking about focusing on jobs now, but how on earth are you going to do that having just committed yourself to cutting government spending? If you were a Republican, the (specious) answer would be deregulate the hell out of everything, but traditionally Democrats have looked to fiscal stimuli, be they spending programs (Roosevelt), tax cuts (Kennedy-Johnson), or both (you in 2009). It looks to me like you’ve let the Republicans box you into a corner, and you’ve boxed yourself in even further by parroting their rhetoric about the primacy of deficit reduction and how government, like a family, has to spend less in hard times.

The Budget Control Act of 2011 took another hit today when Defense Secretary Leon Panetta said that the Pentagon could not absorb any more cuts beyond the $350 billion over 10 years in the first round of cuts. The second round calls for across-the-board cuts of $1.5 trillion, including $600 billion from the defense budget, if Congress can’t agree on specific cuts. Panetta said that would “do real damage to our security, our troops and their families, and our ability to protect the nation.” I’ll pass on whether or not he’s right, but I’m pretty sure his objection and the military-industrial complex will carry the day. Which makes it more likely that (a) the budget ax falls even harder on ordinary families who would spend the money they’d receive from the government, or (b) the spending cuts just don’t happen, which is better for the economy but bad for the government’s credibility. The battle over that second round of cuts looks to be nasty, brutish, and horrifying.

Not shaken, not stirred

So far, the Treasury bond market seems remarkably unconcerned about Washington politicians’ abject failure to reach an agreement on raising the debt ceiling. As of 3:20 pm Monday, after a weekend of dashed hopes for a bipartisan agreement for deficit reduction, the interest rate on 10-year T-bonds was 3.00%, up just 4 basis points from Friday’s close of 2.96%. I admit, I woke up expecting more of a negative reaction from the bond market. What gives?

From what I’ve read, there seem to be two factors at work here, of which the bond market is well aware:

(1) The debt ceiling drama has happened before, and those in the bond market expect Congress to raise the ceiling in time, just as they always have before (with the exception of 1979*). In all, Congress has raised the debt ceiling 74 times since 1962, including an average of once a year since 2001. Barry Ritholtz provides an excellent compendium of newsbites about past debt ceiling votes.

(2) Washington tends to go down to the wire on these deals, and this year “the wire” is Aug. 2, i.e., eight days away. Again, history suggests they’ll get a deal done this time, too.

* The 1979 episode has oddly disappeared down the memory hole, despite two months of hostage-taking over the current debt ceiling and despite the fact that the temporary default of 1979 — it lasted two weeks and was caused by a combination of Capitol Hill shenanigans and computer problems at the Treasury — caused Treasury interest rates to be an estimated 50 basis points higher for years, costing taxpayers billions in increased interest payments on the debt and slowing the economy. (Hat tips: Andrew Sullivan, Bruce Bartlett. The 50-basis-points estimate is from finance professors Terry Zivney & Dick Marcus.)

So is this summer’s repugnant, reckless, Republican posturing over this issue all that different from past obstruction by Democrats and Republicans over the necessary and obvious business of raising the debt limit so that the government can honor its commitments to creditors, employees, contractors, retirees, etc.? I haven’t seen anything this extreme since I started following politics, but then again that’s only been 30 years, and this time-wasting exercise that is the debt-ceiling vote has been around since 1917. (It probably served a purpose back then, as we were entering a world war.) If this time is different, the difference may be the simple fact that a great many Republicans (not just Michele Bachmann and the Tea Partiers but 53% of all Republicans, according to a Pew Research Center poll) think it will be no big deal if the debt limit is not raised by Aug. 2, or perhaps if it is not raised at all. Since President Obama clearly does and is unwilling to press for a clean vote to raise the debt limit with no strings attached, they’ve got him over a table.

Yes, kick the can down the road

I don’t say this often, but Eric Cantor is half right. The Republican House Majority Leader’s mantra in the current debate over a long-term budget fix has been “You don’t raise taxes in a recession.” That is good policy advice, and any Keynesian economist would tell you the same. Tax increases lower GDP, indirectly, by lowering people’s disposable income — if they have less money, most people will spend less money, so consumption drops. But any Keynesian economist would also tell you, “Don’t cut spending in a recession.” Cuts in government spending directly lower GDP and indirectly lower it by lowering the consumption of laid-off government workers and government contractors. So neither tax increases nor spending cuts are a good idea in this time of 9.2% unemployment.

(It’s a pity that Cantor doesn’t understand the second part, or pretends not to. But not a surprise. Misrepresenting Keynes is a cottage industry among Republican politicians and pundits. Ezra Klein notes that Cantor wrote in his campaign manifesto of last year that Keynesianism is the theory that “government can be counted on to spend more wisely than the people.” But I digress . . .)

Right now, we’re told August 2 is the deadline for an agreement by Congress to raise the national debt ceiling or face a partial government shutdown in which some Treasury bondholders, government employers, government contractors and/or other government creditors won’t get paid. I’ve written again and again that the whole concept of a debt ceiling is self-destructive and a waste of time — and, as usual, The Onion says it better than I ever could — but the “grand bargain” that the president seeks could easily be self-destructive as well. Both Democrats and Republicans say they want to pass a long-term deficit reduction plan that reduces the national debt by several trillion dollars over the next decade. That’s fine in a broad sense, as health care costs continue to jump by leaps and bounds, two wars continue to drain our resources, and federal taxes as a share of GDP are at their lowest level in a half-century. But if the tax increases and spending cuts kick in while the economy is still in this Little Depression, with unemployment well above its normal range of 5-7%, then the grand bargain becomes a starvation diet.

If we could just fine all politicians and pundits a dollar each time they say “we can’t afford to kick the can down the road any more,” we could pay off the national debt. Barring that, we can at least question that bit of conventional wisdom, telling them, no, it’s not a good idea to raise taxes or cut spending while the economy is still in the tank, and any plan to do either or both that kicks in while unemployment is still above 7% is a bad one. Worse than defaulting on the government’s obligations? Probably not. But a lot worse than doing nothing on both fronts.

The Other 2%

One of the big issues before Congress right now is whether and how to extend the Bush tax cuts, enacted in 2001 and scheduled to expire at the end of this year.  Congressional Republicans want to make them permanent.  President Obama and many Democrats want to extend the Bush tax cuts for everyone except the very wealthy, i.e., those in the top tax bracket (which would go from 35% back to 39.6%, where it was in 2001).

Throughout this debate I had agreed with the Democratic position, for reasons of both equity and economics.  Over the past thirty years, incomes and wealth in this country have become much more skewed in favor of the rich, so as long as we have a progressive tax system why not use it to push back against that trend?  (I’m not saying let’s equalize incomes, just that trying to check the increase in inequality is a reasonable thing to do.) Only about 2-3% of households — those earning over $373,651 —  are in the top tax bracket, and even then their first $373,651 of income would be taxed at the same rate as before, so the pain associated with raising the top tax rate seems small.  On the economic side, cutting taxes for the wealthy provides a smaller boost to consumer spending than just about any other tax cut or benefit increase you can think of.  See, for example, the “stimulus bang for the buck” table on page 5 of this testimony by Mark Zandi, Chief Economist of Moody’s Analytics back in April.  In the case of making the Bush tax cuts permanent, a dollar of tax cuts would raise GDP by 32 cents, compared with, say $1.41 from an increase in aid to state and local governments or $1.61 for an extension of unemployment benefits.  (The logic is that wealthy taxpayers save much of their income, so small differences in their after-tax income won’t affect their spending much, at least not compared with other taxpayers.  And increases in government spending increase GDP directly and can, if the government starts jobs programs, employ people directly.) And then there are the tax revenues to consider — those top 2-3% of taxpayers have a huge amount of taxable income, so a 4.6% difference in that top tax rate makes a big difference in the government’s deficit and debt.

But equity and economics are unlikely to carry the day in Washington, D.C.  Today’s New York Times has a remarkable op-ed by the same Mark Zandi, titled “A Tax Cut We Can Afford,” in which he argues for extending the Bush tax cuts, sort of.  He says they should be extended for the wealthy, too. His reasoning is political:  Yes, it would be ideal to let the top rate go back to 39.6% and use the new revenue to pay for jobs programs or bigger jobs tax credits, but that option is not on the table.  Republicans and conservative Democrats would undoubtedly block it.  Another truly sizable spending stimulus is not on the table either.  What is feasible, besides minor measures like the jobs bill passed this month, is . . . extending the Bush tax cuts.

Although extending tax cuts on those making $374,000+ a year is not a great option, Zandi says, raising their taxes and (with effective stimuli off the table) doing nothing with it is a worse option.  Most of U.S. GDP is people’s consumption, and even though the rich consume less of their income than other people do, they still consume a lot, so much that their consumption may determine the fate of GDP over the next few years.  The Times recently reported that rich Americans have cut back on their spending.  The article quotes Zandi yet again: “One of the reasons that the recovery has lost momentum is that high-end consumers have become more jittery and more cautious.”  The top 5% of Americans account for one-third of consumer expenditures, according to the piece.

Generally speaking, you don’t raise taxes in a recession.  That’s one of the endlessly repeated lessons of the Great Depression (Hoover and Congress raised taxes in 1932, Roosevelt and Congress did so in 1936), and it still applies.  Again, if you could raise upper-income taxes and use them to pay for well-targeted stimulus programs, that would be fine, but to quote Zandi again, “it is asking too much of our political system now to get it just right. I’m skeptical that a politicized Congress would be able to pull it off, and failure to do so would leave us next year with higher taxes and a hobbled recovery.”

Zandi says the tax-cut extension for wealthy households should be temporary, to be removed when “the economy is off and running,” with the increase phased in perhaps over a three-year period.

I am pretty well convinced.  I’ve been arguing in this space that the severe slump we’re in makes this a terrible time for drastic spending cuts.  By the same token, this is not a good time to raise taxes on anyone.

Selective-attention deficit disorder

debt/gdp ratio

So who’s the party of fiscal responsibility again?  That mantle seems to be claimed by whichever party does not occupy the White House.  In the late 1970s, Ronald Reagan and other Republicans charged that Jimmy Carter’s deficits (although puny in retrospect) were inflationary and needed to be stopped.  As president in the 1980s, Reagan presided over the largest deficits ever (in absolute terms) and the first-ever major peacetime increase of the national debt-to-GDP ratio in history.   Leading Democrats pounded him for the deficits, and Reagan swatted them away as “born-again budget balancers.”  Dick Cheney said later (quoted in one of the Bush 43 administration tell-all books), “Reagan proved that deficits don’t matter.”  Economists by and large weren’t buying it, but aside from relatively high real interest rates and relatively low levels of business investment, the economy was prospering as it hadn’t in two decades, and Democratic attacks on Republican deficits found little traction.  Just ask Walter Mondale.

As we can see from the red line in the diagram, courtesy of my former professor Willem Buiter, the debt/GDP ratio (our best measure of the overall burden of federal deficits and debt):

• mostly fell during the 1970s, as appears to be the norm for the economy in peacetime (at least in non-recession years);
• more than doubled during the 1980s and all through Bush 41’s presidency, from about 24% to 54%, likely due to tax cuts, the Reagan military buildup, and the growth of health care costs and entitlements spending;
• fell sharply during the Clinton years to about 34% in 2000, likely due mostly to the booming economy and the post-USSR “peace dividend”;
• rose sharply in the Bush 43 presidency, likely due initially to the 2001 recession, tax cuts, and Medicare prescription drug expansion, then to the Iraq and Afghan wars, rising health care and entitlement costs, the aging of the population (including early baby boomer retirements), and of course the 2008 recession and bank bailouts.

So what? you ask . . .