REVIEW & OUTLOOK
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August 22, 2012, 7:20 p.m. ET
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The Cliff the Keynesians Built
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Temporary tax cuts created the fiscal threat to growth.


  President Obama with Treasury Secretary Tim Geithner, left, NEC Director Larry Summers, right, and Budget Director Peter Orszag, far right
 
 

'A stimulus program should be timely, targeted and temporary."

—Lawrence Summers, January 29, 2008



Well, well. So the folks who have run U.S. economic policy since 2008 are alarmed about the peril of the 2013 "fiscal cliff." Too bad they didn't worry about that when they were creating the very ledge they now lament.




The latest warning comes from the Congressional Budget Office, which estimated in its mid-year budget outlook Wednesday that the economy will return to recession in 2013 if taxes rise and spending falls on schedule in January. "Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession," say the CBO sachems, "with real GDP declining by 0.5 percent" from this year's fourth quarter to the final quarter of next year and unemployment rising to about 9% from 8.3%.


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Yes, a year of falling output would "probably be considered" a recession, especially if you are one of the 9% jobless.


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One point to keep in mind is that CBO's economists are as true-blue Keynesians as exist on the planet. Like the Obama White House and Treasury, they believe in the "multiplier" that $1 of federal spending somehow creates $1.50 in greater GDP. Thus they plug large spending cuts into their economic models, and, presto, they find a recession.



One remarkable (and highly dubious) note in the CBO report is that the budget gnomes predict a big surge in tax revenues in 2013—to 18.4% from 15.7% of GDPdespite the recession they also predict. CBO simply doesn't think taxes matter much to taxpayer behavior, so it applies the higher rates to its current predictions of income and pretends revenues will roll in like the tides. But this will be a fantasy if enough Americans find ways to hide their income or work less, or if they simply earn that much less thanks to the recession.


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The larger policy point is that this is the fiscal cliff the Keynesians built. The 2008 quote above from Larry Summers, the Harvard economist who later became President Obama's chief economic adviser, sums up the mindset that has dominated policy for most of the last decade and especially since 2008.



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Rather than provide predictable, consistent policy for the long term, the Summers-Obama-Geithner-Krugman theory goes that government should jolt the economy with spending and tax cuts that are targeted and temporary. The jolt will drive the economy out of recession, rapid growth will resume, and the wizards of Harvard Yard can then tell us the precise moment when the stimulus can be withdrawn and taxes should rise again.



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Or, if the jolt doesn't work, then order up another jolt, which makes the tax cliff even steeper.



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The last decade has provided as clear a market test of this proposition as one can get. First, the Bush Administration had to accept a temporary window for its 2001 and 2003 tax cuts to pass the Senate's crazy budget rules. Its tax rebate of 2001 was such an economic bust that without the more ambitious and better designed 2003 tax cut Mr. Bush might not have been re-elected. But even the 2003 cut had to be temporary to pass Congress.


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Then came the Summers-George Bush-Nancy Pelosi $168 billion tax rebate and spending stimulus of February 2008. That goosed GDP for a quarter as temporary consumer and government spending showed up in the national accounts, but growth quickly sputtered even before the autumn 2008 financial panic.

 
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Then came the $830 billion stimulus of February 2009, followed by other "targeted and temporary" measures like cash for clunkers and the first-time homebuyer's tax credit. GDP rose modestly as the economy recovered, albeit at a historically slow pace considering the depth of the recession. The rate of growth has since sputtered in each of the last three years.


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That didn't stop Mr. Obama, who tried still another temporary tax fix after Republicans captured Congress in 2010. He agreed to extend the Bush tax rates for another two years, but only in return for an additional temporary payroll tax cut for one year. When that didn't spur faster growth in 2011, the President demanded and won another one-year payroll-tax extension for 2012. First half GDP growth this year fell again to 1.7%.


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So here we are now facing the expiration of all of these temporary measures at the same time. And that's not all. You have to add the higher tax rates that Mr. Obama has proposed in his budget, such as the 30% "Buffett rule" tax rate on capital gains. And don't forget the new 3.8% surcharge on investment income that is part of ObamaCare and also starts in January.



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The nearby table compares current tax rates with those that arrive next year with the tax cliff, as well as Mr. Obama's budget proposals and Mitt Romney's tax reform plans. Mr. Romney is proposing an across-the-board rate cut, while Mr. Obama would keep rates the same only for those earning less than $250,000. Everyone else would see a huge tax increase, one of the largest in history.



Republicans are pointing to the CBO report as proof of Mr. Obama's policy failure, and it is. But rather than gawking at the potential for another recession, they ought to explain the folly of "temporary, targeted" tax and spending stimulus. The fleeting tax elixir does little to change incentives to work or invest because everyone knows its impact is temporary. It also creates tremendous uncertainty as expiration nears, which can also harm incentives and growth.



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The problem is political, but more important it is intellectual. The Keynesians and their allies who have dominated tax policy for most of the last decade (the 2003 bill excepted) need to be exiled back to Harvard, Princeton and Wall Street. And the Romney-Ryan Republicans need to understand and not repeat the Bush mistakes of 2001 and 2008.


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Instead of "timely, targeted and temporary," tax policy should include lower rates (and fewer loopholes) that are applied as broadly as possible and are permanent. These were the principles that guided the Reagan policy of the 1980s, and they need to be revived.



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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved



Safeguarding Asia’s Growth

Jong-Wha Lee

21 August 2012
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SEOULEmerging Asian countries should be proud of their economic resilience. Despite a global economy plagued by weak growth, persistently high unemployment, and heavy debt loads, the region’s emerging and developing economies grew at an average annual rate of 6.8% from 2000-2010, propping up global output and buttressing recovery efforts.
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The region’s success has been underpinned by dynamic growth in China and India, which account for almost 60% of the continent’s total GDP in purchasing power parity terms. Furthermore, economic-policy changes and structural reforms that were enacted in the wake of the 1997-1998 Asian financial crisis significantly reduced the region’s vulnerability to financial shocks over the past decade.
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But Asia cannot be complacent: financial systems remain fragile; economies are burdened with high fiscal and current-account deficits; and Asia remains too heavily dependent on North American and European export markets, increasing its vulnerability to external shocks. Moreover, if conditions in the eurozone continue to deteriorate, Asia could be more severely affected. Already, spillover effects from trade and financial transmission channels are beginning to take their toll: China’s GDP growth rate in the second quarter of 2012 averaged 7.6%, reflecting a significant slowdown, and India’s growth rate is expected to decline to roughly 6% this year.
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China’s potentially strong domestic-demand base and ample room for policy maneuvers can help it to avoid a hard landing. It has already aggressively loosened monetary policy, and it can employ further fiscal stimulus. But policy mismanagement and structural weaknesses in the financial sector and local governments could undermine efforts to safeguard growth.
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Meanwhile, India, constrained by a high fiscal deficit and persistent inflationary pressure, has less scope for expansionary policies and faces significant challenges in pursuing credible structural reform.
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This has serious implications for the rest of Asia. Over the last three decades, increased economic and trade integration has bolstered the region’s growth. For example, segmented production for global supply chains has stimulated trade in intermediate goods and promoted foreign direct investment. Now, however, closer economic integration means that sluggish growth in China and India will reduce job opportunities and slow the rate of poverty reduction throughout the region.
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Faced with weak demand in advanced countries, Asian economies are working to rebalance their sources of growth by shifting toward domestic and regional markets. As a result, growth in intra-regional trade has outpaced overall trade growth, with intra-Asian trade now accounting for more than half of the continent’s total trade turnover.
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But China’s established role as the assembly hub for the region’s production-sharing networks means that it is becoming a source of autonomous shocks – with a large and persistent impact on business-cycle fluctuations.
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So, what policies must emerging Asian economies pursue to reduce their vulnerability to regional and global volatility?
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The most immediate challenge is to safeguard the financial system’s stability against external shocks. Policy reform should aim to promote market transparency, improve risk management, and strengthen effective supervision and regulations.
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Second, emerging countries must develop more effective macroeconomic frameworks, including better macro-prudential regulation and a broader monetary-policy framework that takes into account asset prices and financial-market stability. A wide range of official measures could be employed to support domestic demand while protecting medium-term fiscal sustainability. And, to address volatile capital flows, countries should increase exchange-rate flexibility, maintain adequate international reserves, and implement carefully designed capital controls.
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Third, emerging economies must further rebalance their sources of growth. Reducing dependence on external demand – for example, by promoting private-sector investment and encouraging household expenditure – is crucial. Supply-side policies that promote small and medium-size enterprises and service industries accommodating domestic demand are also critical to ensuring more inclusive and sustainable growth.
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Finally, enhanced regional and global financial cooperation – including closer policy coordination at the G-20 and International Monetary Fund – would help countries to respond more effectively to shocks and crises. A key regional initiative is the $240 billion multilateral reserve pool of the ASEAN+3 (the Association of Southeast Asian Nations plus China, Japan, and South Korea), which can provide short-term liquidity to members when needed. Institutional arrangements in regional liquidity provision and economic surveillance must be enhanced.
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Asians need not be pessimistic; the perfect storm of a hard landing in China, a double-dip recession in the United States, and a collapse of the eurozone is unlikely. But they cannot rule out the downside risk of a synchronized global downturn. Only with preemptive policies designed to manage risk better can emerging Asian countries protect economic growth from the threat of current and future crises.
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Lee Jong-Wha, a senior adviser to the president of South Korea and Professor of Economics at Korea University, was Chief Economist and Head of the Office of Regional Economic Integration at the Asia Development Bank. His most recent book, edited with Robert Barro, is Costs and Benefits of Economic Integration in Asia.





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Is Germany Entering a Recession?
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By Charles Gave
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Aug 22, 2012






The western world's post-2007 economic horror show has already been lumped into the simplified moniker "Great Recession". In fact, the last five years have seen a series of distinct economic cycles that started with the precipitous global contraction induced by Lehman Brothers' failure.



Subsequently, a series of "second wave" recessions have hit Europe; these contractions started at the periphery with Greece and Ireland, moved to Portugal, Italy and Spain, touched France and are now heading for the core of industrial Europemighty Germany. Such an outcome would kill any hopes of Europe's biggest economy dragging the rest to safety. So the central question for every Europe-focused investor is: will Germany also enter a recession? And if the answer is yes, what will be the broader impact on the region's incredibly fragile economies?



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Let's start with a simplified definition of a recession which we identify as a period when both industrial production (smoothed) and GDP experience annualized declines.



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Since 1993, Germany has experienced four such recessions and in each case the IFO Business Expectations Index fell by six points or more in the prior 12 months. The lead time before a recession started has been about six months. Consequently, we can draw two clear conclusions:




1. A recession may have started already in Germany, since industrial production has registered a YoY decline, while, at the last reading, annualized GDP growth was hovering at about 1%.




2. The recession could be pronounced since the momentum of the IFO index seems to be deteriorating, falling again below -5. Put simply, the fact that the improvement of spring 2012 has fizzled suggests that economic activity in Germany will probably be lower six months hence. And this could result in GDP readings going negative by 4Q2012. Ergo, Germany would be in recession.
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Moreover, three of our preferred leading indicators (German IFO Business Expectations Index, OECD leading indicator for Germany and the Gavekal indicator of economically sensitive prices) are all turning down. The advantage of the GaveKal measure is that it leads the other two by about two months, although corroboration is needed, as it produces more false signals. Hence, in this paper we will stick with the IFO as it is widely available and does not come out of our own bratwurst factory.
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Having established that Germany's economy is in slow-down mode, the next point to test is which sectors will bear the brunt of the adjustment.
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Capital spending





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Germany is a major player in the intensely competitive machine tools and capital equipment market. While competitive dynamics mean the industry is in a constant process of upgrading and modernization, it still conforms to a fairly predictable cyclical pattern tied to the IFO index (there are notable exceptions such as 1999). Consequently, we would expect that gross capital formation will shortly be subtracting from GDP growth (see chart).
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Impact on net exports



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Germany is an export power house in a euroland region which is tipping into recession. Experience shows that when this happens the effect on German exports (in constant prices) is to generate annualized declines (notable exceptions to this rule were 1993 and 2003). Current data shows a particularly tight relationship between German exports and the IFO index with the implication that exports will shortly start to experience annualized declines (see chart).
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But to get the full picture of foreign trade, imports must be factored into the equation. Germany, as we all know has a huge trade surplus and it is notable that imports and exports have been growing roughly at the same rate (see chart ). Hence, it could be assumed that an economic contraction would prompt a matching decline in imports, leaving net exports unchanged. The problem is that imports are coming off a lower base, so their reduction is unlikely to fully offset the export decline. The conclusion must be that foreign trade's contribution to GDP in the quarters to come will be negative.
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Consumption





Since German government spending is likely to stay flat at best, the last potential prop for the Teutonic economy is domestic consumption. Unfortunately the ever rational German consumer is not one for credit card binges when chill winds are blowing through the factory heartland.



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Indeed, German consumers tend to be deeply pro cyclical and usually hunker down during recessionary periods. Only when the economy is clearly back in recovery mode do they tend to start spending in earnest.
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In summary, Germany is likely to experience declines in capital spending and net exports, while government spending and private consumption should remain stable. Hence, the analysis points toward a mild German recession as the most likely outcome.





While Europe's biggest economy should be able to endure this loss of altitude, the reverberation across Europe will be significant. The absence of exchange rate volatility over the last 15 years has allowed economies such as Italy and France to escape depression-type conditions, which might otherwise have occurred given their economic underpinnings.




Now, however, there can be no escaping the fact that reduced German imports must cause a decline in French and Italian exports. This will likely be a shock for those who expect the German juggernaut to drag the southern economies back to growth. To put it bluntly, Germany will very shortly be subtracting from growth in the rest of Europe.



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And since the French and Italian economies are NOT competitive versus their German rival (see chart on next page), the concern is that a retrenching German consumer will have an especially big impact on these countries' exporters. It is always the least efficient, marginal producers that are first to lose market share.







In light of this analysis, we can envisage two likely scenarios





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1. Miraculously, some kind of solution is found for the euro, supply side measures are embraced by France, Spain and Italy, and Germany suffers a "small" recession. Under this scenario, the euroland markets are a buy, given they tend to be priced on the cheap side.




2. No miracles materialize and the debt trap already visible in Spain and Italy moves to France. Fairly shortly, all the southern economies enter a "secondary depression."




From such a situation there is a high probability of Germany entering a far more serious downturn. Under this scenario, the sequence of resulting events would likely cause the Eurozone to break apart.



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Given these uncertainties, it would be bold to buy massively into euroland. That said, attractive valuations mean that one should be ready to pounce as soon as the fundamentals start improving. In facing this decision tree the IFO index is a useful tool for estimating when to reenter the German stock market. A reasonably good rule of thumb is to buy the French or German stock market only if the IFO index is up over the previous three months (non shaded periods in the chart below).
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For the time being, the three month rate of change of the German IFO Index is still negative and so is our GaveKal growth indicator. Hence, on the basis that it is probably better to be safe than sorry, investors should, for now, resist the urge to buy back into euroland stock markets (select European export champions would remain an exception to this view).