domingo, noviembre 11, 2012


Barron's Cover
Shock Treatment

The so-called fiscal cliff has all to do with tax increases and almost nothing to do with spending cuts. Can the economy survive?

                                          Scott Pollack for Barron's
    When Ben Bernanke gets concerned, the rest of us should start worrying. "If the fiscal cliff isn't addressed," warned the Federal Reserve chairman in a Sept. 13 appearance before the Senate Finance Committee, "I don't think our tools are strong enough to offset the effects." After thus disavowing central-bank responsibility if the U.S. economy falls of the fiscal cliff, Bernanke plaintively added, "So I think it's really important for the fiscal policy makers to, you know, work together and find a solution."

    Nearly two months later -- and just days after the presidential election -- policy makers have yet to find a solution, mainly for lack of trying. On Friday, Republican House Speaker John Boehner and newly re-elected President Barack Obama declared their intention to try to work together to avert the fiscal cliff. If they fail, the Congressional Budget Office has warned of a "contraction in output in the first half of 2013 [that] would probably be judged to be a recession." From real growth in gross domestic product in the second half of this year that is likely running at an annual rate of 2%, the CBO projects a contraction in the first half at an annual rate of 1%.

    More optimistically, Barron's puts the odds of an outright contraction at even money, a risk no responsible policy maker should want to take. More likely than recession would be a return of that ugly economist's neologism, a "growth recession," in which economic growth continues, but at such a subdued pace that the unemployment rate rises. That's because the nation's jobs growth wouldn't be enough to offset the growth in the labor force.

    The fiscal cliff is far less about spending cuts than it is about tax increases. As commonly defined, the fiscal cliff refers to an unusual combination of federal tax hikes coinciding with reductions in federal spending, all of them coming on Jan. 1, 2013. Indeed, a Wall Street Journal front-page story last week spoke, for example, of "deep, automatic federal-spending cuts and tax increases."

    Wrong. While the tax increases will certainly be steep, the "deep" spending cuts are much shallower. More important, the spending cuts will be more than offset by inexorable increases in the cost of entitlement programs.

    The net result will be no reduction in federal spending. The cuts popularly cited mainly consist of automatic reductions under the 2011 Budget Control Act that require equal dollar cuts in defense and nondefense programs starting in fiscal 2013, through an action known as sequestration.

    Painful as those cuts may be, however, they are not enough to cause the government's overall spending to decline. Projections by the nonpartisan Congressional Budget Office and the White House's Office of Management and Budget both show that overall dollar spending won't decrease in calendar year 2013. What all the projections do show is a much slower rate of increase.

    That's partly because the huge influx of aging baby boomers will be laying just claim to their Social Security benefits right on schedule. So we are again dealing with the budgetary newspeak of decreases in spending that are really just a reduction in the increase.

    Even that smaller-than-usual increase might be somewhat understated. Both CBO and OMB might have erred on the side of optimism about one wild card in federal spending, the cost of servicing the burgeoning federal debt. Since the federal budget will still be running a deficit, the outstanding debt will grow.

    But OMB and CBO both project only a modest increase in servicing cost based on the assumption that interest costs will stay at their historical lows. If not, total federal spending will increase by even more.

    Those sensitive to the nuances of fiscal policy might still argue that even a slowdown in the rate of increase in spending still has dampening effects on the economy. But that sin of omission should still have much less of an impact than the far larger sin of commission on the tax side.

    The CBO projects nearly a half-trillion-dollar jump in tax revenue in calendar 2013 that has no offsets. According to CBO estimates, that will mean a 2.7% increase in tax as a share of GDP. To put that figure in perspective, there has not been a single year since 1970 when an increase in federal tax revenue ran even as high as 1%, with just three years of +0.9%. The last year comparable to this was one was 1969, when the rise in tax revenue as a share of nominal GDP ran 2.1%. By fourth quarter 1969, the economy had slipped into recession.

    FOR STARTERS, IT'S CLEAR THAT, if spending and investing power proportionate to 2.7% of GDP is drained from consumers and business over the course of a year through higher taxes, there is likely to be a slowdown in economic activity. Whether the result will be outright recession depends on something more difficult to gauge -- the extent to which the tax hikes really do shock, taking consumers and business by surprise. When consumers and business are relatively unprepared, the slowdown in economic activity is likely to be greater.

    As for any shock and surprise on the spending side, half the spending cuts mandated by the 2011 Budget Control Act will fall on defense, and were probably anticipated. It's unclear how much shock will be caused by the tax increases.

    The looming fiscal cliff has gotten so much play in the media that it already has probably placed a damper on economic activity. And to the degree that it has, one saving grace is that consumers and business will be better prepared for the cliff's effects.

    As Stanford University economist John Taylor recently pointed out on his blog, "The fiscal cliff was not created by aliens from outer space. It is another poor government policy created in Washington." When we look on the tax side (see above), we see an odd assortment of inadvertent reversals of tax cuts all converging at the same time.

    In his address Friday, President Obama made it clear that he wants to retain the tax cuts on the first $200,000 of taxable income for individuals and $250,000 for couples. It turns out that most of the pending increases in terms of sheer dollars will fall on these "non-rich." So the president should have a natural desire to strike a deal.

    The largest impact ($161 billion) consists of the still-pending rollback of the tax cuts passed under former President George W. Bush. According to Obama's own Office of Management and Budget, nearly 60%, or $95 billion, of what would be raised by rolling back the tax cuts would come from taxpayers who fall below the income thresholds of $250,000 for couples and $200,000 for single people. Both sides of the aisle will probably favor postponement for this group, especially because $95 billion will do a lot to blunt the tax shock.

    The president made it clear Friday that he plans to restore these taxes on the richest 2%, which will raise the remaining $66 billion. A substantial portion of that ($28 billion) is expected to fall on their dividends and capital gains. Boehner, however, made it equally clear that he's against "raising taxes on the wealthiest Americans."

    Regarding the $66 billion that OMB estimates could be realized though higher taxes on the top 2%, the estimated $28 billion from dividends and capital gains could be too high. Steeper tax rates can alter behavior, especially investment behavior. The full realization of that $28 billion depends on the size of the dividends received and capital gains realized.

    Investors now face a neutral trade-off between dividends and long-term capital gains, since both are taxed at 15%. With the rollback of the tax cuts, the level playing field will be tilted once again, with capital gains taxed at 20% and dividends taxed as ordinary income, with rates as high as 39.6%. That sort of differential will mean a return of the perverse desire by investors to have companies reinvest earnings rather than distribute them as dividends, in the hope that the reinvested earnings will turn into more lightly taxed capital gains. The result will be what economists have referred to as a "lock-in" effect, with harm to economic efficiency.

    Another tax that falls mainly on the non-rich is the alternative minimum tax ($114 billion). Each year, a taxpayer is supposed to pay the AMT or a regular tax, whichever is greater. But since the AMT was hurting middle-income taxpayers, an exemption roughly indexed to inflation, called a "patch," has been protecting them against its effects. The last exemption expired in December 2011, however, which means income earned in 2012 could feel the influence of the AMT. Since the bad news will be learned by taxpayers when they file their returns, the CBO projects that the huge sums will be paid almost entirely in 2013.

    It seems likely, however, that the patch on the AMT will have a good chance of getting extended. Less likely -- so far, at least -- will be the continuance of the cut in the payroll tax on employees by two percentage points (worth $120 billion), instituted in January 2011. That payroll-tax holiday, which is technically hurting the solvency of Social Security, doesn't seem popular with the White House.

    BUT IF POLICY MAKERS do take Fed Chairman Bernanke's warning seriously, everything should be on the table. That would mean rescinding many of the tax hikes, while less happily reversing the spending cuts, thus allowing federal spending to increase faster than planned. No matter which way it gets done, the result would be a widening of the fiscal deficit.

    That might set off alarms. For those deficit hawks concerned about red ink virtually without end, why not sit back and celebrate the fiscal contraction otherwise known as the fiscal cliff?

    The standard drug-addict analogy helps answer that question. Much as we might have opposed shooting up the economic patient with such huge doses of fiscal-deficit heroin to begin with -- much as we might welcome the ultimate return to balanced-budget sobriety -- we might still fear the consequences of withdrawal if the dose gets cut so drastically in so short a time.

    The economy's deficit habit must be abandoned, or the build-up in debt will cause a major crash. But the fiscal cliff, or tax shock, poses a great risk to economic growth in 2013. Our leaders must therefore kick the deficit-reduction can down the road yet one more time. We might take comfort in knowing that they have a talent for that sort of activity.

    Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

    Underinvesting in Resilience

    Michael Spence

    08 November 2012


    NEW YORKThe hurricane on America’s eastern seaboard last week (which I experienced in lower Manhattan) adds to a growing collection of extreme weather events from which lessons should be drawn. Climate experts have long argued that the frequency and magnitude of such events are increasing, and evidence of this should certainly influence precautionary steps – and cause us to review such measures regularly.
    There are two distinct and crucial components of disaster preparedness. The one that understandably gets the most attention is the capacity to mount a rapid and effective response.

    Such a capacity will always be necessary, and few doubt its importance. When it is absent or deficient, the loss of life and livelihoods can be horrific – witness Hurricane Katrina, which ravaged Haiti and New Orleans in 2005.
    The second component comprises investments that minimize the expected damage to the economy. This aspect of preparedness typically receives far less attention.
    Indeed, in the United States, lessons from the Katrina experience appear to have strengthened response capacity, as shown by the rapid and effective intervention following Hurricane Sandy. But investments designed to control the extent of damage seem to be persistently neglected.
    Redressing this imbalance requires a focus on key infrastructure. Of course, one cannot at reasonable cost prevent all possible damage from calamities, which strike randomly and in locations that cannot always be predicted. But certain kinds of damage have large multiplier effects.
    This includes damage to critical systems like the electricity grid and the information, communication, and transport networks that constitute the platform on which modern economies run. Relatively modest investments in the resilience, redundancy, and integrity of these systems pay high dividends, albeit at random intervals. Redundancy is the key.
    The case of New York City is instructive. The southern part of Manhattan was without power for almost a full workweek, apparently because a major substation hub in the electrical grid, located beside the East River, was knocked out in a fiery display when Hurricane Sandy and a tidal surge caused it to flood. There was no pre-built workaround to deliver power by an alternate route.
    The cost of this power failure, though difficult to calculate, is surely huge. Unlike the economic boost that may occur from recovery spending to restore damaged physical assets, this is a deadweight loss. Local power outages may be unavoidable, but one can create grids that are less vulnerable – and less prone to bringing large parts of the economy to a halt – by building in redundancy.
    Similar lessons were learned with respect to global supply chains, following the earthquake and tsunami that hit northeast Japan in 2011. Global supply chains are now becoming more resilient, owing to the duplication of singular bottlenecks that can bring much larger systems down.
    Cyber security experts rightly worry about the possibility of bringing an entire economy to a halt by attacking and disabling the control systems in its electrical, communication, and transportation networks. Admittedly, the impact of natural disasters is less systemic; but if a calamity takes out key components of networks that lack redundancy and backup, the effects are similar. Even rapid response is more effective if key networks and systems – particularly the electricity grid – are resilient.
    Why do we tend to underinvest in the resilience of our economies’ key systems?
    One argument is that redundancy looks like waste in normal times, with cost-benefit calculations ruling out higher investment. That seems clearly wrong: Numerous expert estimates indicate that built-in redundancy pays off unless one assigns unrealistically low probabilities to disruptive events.
    That leads to a second and more plausible explanation, which is psychological and behavioral in character. We have a tendency to underestimate both the probabilities and consequences of what in the investment world are calledleft-tailed events.”
    Compounding this pattern are poor incentives. Principals, be they investors or voters, determine the incentives of agents, be they asset managers or elected officials and policymakers. If principals misunderstand systemic risk, their agents, even if they do understand it, may not be able to respond without losing support, whether in the form of votes or assets under management.
    Another line of reasoning is that businesses that depend heavily on continuity – for example, hospitals, outsourcing firms in India, and stock exchanges – will invest in their own backup systems. In fact, they do. But that ignores a host of issues concerning the mobility, safety, and housing of employees. A broad pattern of self-insurance caused by underinvestment in resilient infrastructure is an inefficient and distinctly inferior option.
    Underinvestment in infrastructure (including deferred maintenance) is widespread where the consequences are uncertain and/or not immediate. In reality, underinvestment and investment with debt financing are equivalent in one crucial respect: they both transfer costs to a future cohort. But even debt financing would be better than no investment at all, given the deadweight losses.
    Cities and countries that aspire to be hubs or critical components in national or global financial and economic systems need to be predictable, reliable, and resilient. That implies a transparent rule of law, and competent, conservative, and countercyclical macroeconomic management. But it also includes physical resilience and the ability to withstand shocks.
    Hubs that lack resilience create cascades of collateral damage when they fail. Over time, they will be bypassed and replaced by more resilient alternatives.
    Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, and Academic Board Chairman of the Fung Global Institute in Hong Kong. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth.

    Editorial Commentary


    The Enemy Within


    Don't blame aliens for the failures of the government to meet pressing problems.



    All the important things that were left to simmer until after the election are now back on the stove, on "high." The administration that did not want to take a chance on burning the rice before the election now has to cook a double batch in half the time. It will be harder than ever to serve a decent meal.

    Some issues are settled. Obamacare will shake up one-sixth of the economy, if the bureaucracy can make it work. The Dodd-Frank law will rule financial services, again if the bureaucracy can make it work.

    But contentious issues will return in energy, immigration, housing, welfare, transportation, trade, and a slew of other topics. The next administration's challenges will look just like the last one's unfinished business.

    Leading a long list of deliberately delayed problems is the so-called fiscal cliff of tax increases and spending cuts. (See other coverage: "Shock Treatment" and "Obama and the Cliff.")

    In our $15 trillion economy, with its $3.8 trillion of federal spending, a "fiscal speed bump" would be more like it. It's not a serious reason for the panic that politicians intend to create.

    The policies dubbed the fiscal cliff would cut projected spending by about 1% of GDP in fiscal 2013 and raise expected revenues by less than 5% of GDP.

    Out of Proportion
    Nearly all economists and lobbyists and politicians in the Washington area claim those policy changes would hurt the economy more than borrowing another trillion dollars or so and spending it. The Congressional Budget Office, for example, has an economic model that says inflation-adjusted GDP would contract at an annual rate of 1.4% in the first half of next year.

    "Going over the fiscal cliff would mean allowing a massive and immediate cut to nearly every major government agency and activity, including those vital to our national security or economic growth," says Erskine Bowles, who led and lost the effort to construct a rational deficit-reduction plan in 2011.

    Assuming that there are agencies vital to national security (none are vital to economic growth), there are none that could not withstand having 10% of their spending put off a year. And the automatic cuts won't stop Congress from approving supplemental and emergency defense appropriations (like the ones that provided off-budget financing for the wars in Iraq and Afghanistan).

    As economist John Taylor reminds us, "The fiscal cliff was not created by aliens from outer space." Shortsighted solons created the fiscal cliff in 2011 to shock themselves into finding responsible alternatives later -- but "later" is now.

    Lawmakers may respond to the shock and the pressure from interest groups, but there's no sign of sanity yet, unless you count a few ambiguous comments from House Speaker John Boehner and President Obama.

    Americans can choose between the recession that looms if they go over the cliff, or the inflation that looms if they don't. Or they can have both at once, in a rerun of the 1970s.

    A recession is preferable by far. Even the CBO says that its projected contraction in the first half of 2013 would be followed by a rebound to a real annual growth rate of 2.3% in the second half.

    A Longer View

    Beyond the fiscal cliff, reality looms in ways that were rarely discussed in the campaign. Remember how the foreign-policy debate kept coming back to "jobs, jobs, jobs"? Now that President Obama has the job for another term, foreign policy will resume its position as the part of his job where he can act freely.

    With the exception of Ronald Reagan's second-term success on tax reform, most re-elected presidents since World War II (Eisenhower, Nixon, Reagan, Clinton, Bush II) have found their opportunities to make marks on history's tablet lay overseas.

    As Obama told Dmitry Medvedev, then the Russian president, last March, "After my election I have more flexibility." He was talking about limiting missile defense, but it applies to other subjects as well.

    A core principle of Democratic politics since Reagan's "Star Wars" project is that missile defense is a snare and a delusion. It will never work, they say, and if it does work it would destabilize relations with Russia. Obama's flexibility is likely to freeze missile defense; the issue of interest is what he will ask President Vladimir Putin to trade for killing it, if anything.

    A more immediate problem is Iran, its soon-to-be-realized nuclear weapons capability and the concomitant capability of Israel -- which already has nuclear weapons -- to make a long-range strike on deeply buried facilities. After four years of chill, Israel and its plans are far beyond Obama's influence, but he will have to deal with the consequences of an attack, if one comes.

    Europe may become the president's biggest problem, but he has even less control there. The hopeful muttering from European leaders about a euro that is indestructible will not help Obama cope with the repercussions when the euro is destroyed.

    In the latest developments, Greece held a vote on austerity inside the parliament building while public sector unions staged a two-day strike, joined by lawyers, engineers, hospital staff, power workers, telecommunications workers, dentists, bank personnel, teachers, dockworkers, air-traffic controllers, and radio technicians.

    "These are the very last painful measures," the prime minister promised, underscoring the ritual implausibility of the exercise. Greece needs more new money and it has to roll over some short-term debt in the next two weeks.

    Meanwhile, Spain and Italy are sinking into recession and France is digesting a new report calling for economic reforms to provide a "competitiveness shock" to the economy.

    But the French government wants to maintain the purchasing power of households and help industry cut labor costs and cut the budget deficit and cut payroll taxes and avoid increasing the value-added tax.

    Are the French getting to be more like Americans? The U.S. has very similar policy goals and very similar problems making ends meet.

    Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved