November 11, 2012 4:39 pm

Obama has four years to fix the economy

The US election was fought on first principles: should government be strengthened or dismantled? The answer was resounding. The public wants better government, not less government.

Much of the economic debate in the US has been over short-term stimulus but the election turned on long-term structural issues. Barack Obama solidly carried much of the Midwest because he championed an industrial policy for the automobile and allied industries. What saved the Midwest was not a temporary stimulus but a skilful rescue package, complete with government financing and public investment in research and development directed at next-generation electric vehicles.

Though climate change was the issue, neither candidate wanted to mention it played the leading role in the final act, in the form of Hurricane Sandy. Not only was the east coast reminded of the furies of a rising ocean level; it was reminded again of the need for collective action to anticipate, ameliorate, and respond to emergencies.

The problem for Mr Obama in the second term is that he does not yet have an economic strategy commensurate with his vision of a proactive government. Low tax revenues continue to leave the US vulnerable. The US government collected only 32 per cent of gross domestic product in revenues last year, compared with 38 per cent in Canada, 45 per cent in Germany and 49 per cent in Sweden.

The latter countries can overcome budget deficits, poverty and outdated infrastructure. The US cannot. It will need a tax ratio like Canada’s by later this decade to get the job done.

Yet revenues are not enough. The entire Keynesian apparatus that dominates Democratic party circles is also outdated and outmoded. It is a cyclical theory trying to fit a secular (that is, long-term) structural challenge. The US needs massive overhauls of its key economic sectors, almost all of which have public and private sector components that are deeply intertwined. Aggregate demand management cannot fix excessive healthcare and college costs, broken infrastructure, or an economy based on fossil fuel that needs to be decarbonised.

The modern president must therefore not be the overseer of aggregate demand but the conductor of deep-seated structural changes. He should be the convener of governors, mayors, university presidents, CEOs, healthcare providers and scientists to clear the obstacles from investment programmes in energy, education, infrastructure, health and skills.

Mr Obama’s legacy should be to foster the overhaul of the US economy. The IT revolution can and should lead to low-cost online universities, radically lower healthcare costs, smart grids, smart cities and smart low-carbon energy systems. The government can lead the way, for example, using the federally supported land-grant universities to lower the costs of higher education through IT-enabled delivery. It can truly leave no child behind – as President George W. Bush’s education reform promised not through a naive test regime, but through upgraded pre-school programmes for poor kids, IT-enabled schools, e-tutoring, and countless other innovations already taking hold around the world but strangely lagging behind in the US.

Who will pay and who will back this new dispensation? It is easier than it looks. Wipe out the tax havens by charging a minimum 20 per cent corporate tax rate on all companies whether they book their profits in the Cayman Islands or not. Cap deductions for high-income taxpayers. Impose a modest wealth tax on the mega-rich. And tax carbon emissions and financial transactions. These measures are tough politics but good economics, and they are good revenue raisers. And they would fund a true reform agenda.

As for the governing coalition, the president need not put the fate of his reforms in the hands of Congressional holdouts and K-Street lobbyists. The business is with the people, and notably with the mayors and governors around the country. They want answers to storm surges, flooding, traffic jams, overpriced education and healthcare, and so on. They need electricity every day. This means four years of problem-solving out in the country. Yes, I’m sorry to say it, but the campaign has just begun. Yet this one is for America’s future, not for an elective office.

The writer is director of the Earth Institute at Columbia University and author of ‘The Price of Civilization’

Copyright The Financial Times Limited 2012.

The Fiscal Cliff is a Mole Hill Compared to This

November 11, 2012

By Shah Gilani,
Capital Wave Strategist

Everyone is afraid of falling off the "fiscal cliff." But there's another dangerous countdown clock about hit to zero.

And no one is talking about it, even though it will spell even more financial problems for us all.
At midnight on December 31, 2012, the Transaction Account Guarantee (TAG) program will expire.

The TAG program was initiated at the height of the
credit crisis when depositors were fleeing banks for fear they would go under.
To quell what was turning into a run on banks, the FDIC upped regular deposit insurance from $100,000 to $250,000 and under the TAG banner initiated unlimited insurance for all non-interest bearing transaction accounts.

It's the second part that's important because that's the piece that will soon come to an end.

When the unlimited insurance expires, corporations, businesses and depositors -- whose soon- to- be- uninsured deposits, which total some $1.4 trillion, are likely to flee smaller banks -- will rush into money market funds and seek the safety of short-term U.S. Treasuries.
This will create serious negative repercussions affecting our economic future.

The Unseen Perils at the Bottom of This Cliff

Here's how each of those actions will affect the economy and you personally.
First, the too-big-to-fail (TBTF) banks that created the credit crisis and spawned the Great Recession are much bigger now than they were in 2008, and are about to get even bigger.

Because the failure of any one of America's big five banks would implode the global financial system, they will never be allowed to fail. That makes them a fortress for depositors, regardless of expiring guarantees.


The same isn't true for the smaller banks that will start disappearing.

U.S. corporations are sitting on at least $1.75 trillion in cash. Most of those funds are being held in checking and transaction accounts.

When the unlimited insurance on their deposits expires they will move some of their money elsewhere. But, on account of large payroll and other transaction account services corporations are reliant upon, a lot of that cash will still be parked at the biggest banks.

Cash on deposit at other institutions, greater than what will be insured, which is $250,000 since that higher insurance guarantee was made permanent, will gravitate to the big banks because of their fortress status.

But, it's not just big corporations that will park their money at big banks. Most other businesses that have transaction accounts with balances above the covered $250,000 limit will start moving their accounts to the TBTF banks for the exact same reason.

The problem for the economy is that TBTF banks are going to have to make bigger and bigger loans and orchestrate far-reaching lending schemes that encompass wide swaths of the population (as they did with mortgages) to accommodate the greater economies of scale their huge size demands. That's going to lead to massive concentrations of risk, which the TBTF banks have proven has been, and will be, their downfall.

Personally, for you and me as small consumers of banking services, there will be less competition, and borrowing and transaction costs will rise.

Community banks will start disappearing. Access to credit at the local level will be replaced by impersonal lending factories, which as a result of their economies of scale will not likely be willing to bear the one-off risks of financing small business start-ups and small business' credit needs, at least not without charging significant "risk premiums."

Second, in the

Federal Reserve no-interest rate environment, depositors were more comfortable leaving their money in insured accounts than chasing tiny yields on the short-term instruments available to them. With the expiration of unlimited guarantees many corporations and businesses will start looking for some yield on their idle cash.

The reason they will start reaching for yield is that companies, whose treasury managers are counted on to shepherd cash balances, will want to add income to their huge cash hoards and can no longer justify parking cash just to be safe.

Money market funds will be the preferred parking place for a lot of that cash. Even though money market funds don't pay much, they allow quick withdrawals and are considered a good substitute for non-interest bearing checking accounts at banks.

But, there's a problem with money market funds. They aren't guaranteed.


They were back when the Federal government was guarantying all financial parking lots at the time of the crisis, but no more. The Securities and Exchange Commission has been trying to get money market funds to set aside capital reserves, like banks have to do, but to no avail.
What's potentially problematic is that if billions of dollars of cash goes seeking some yield in money market funds, fund managers are going to have to put those new monies to work.
And where do a lot of money market funds go to buy short-term interest bearing instruments so they can offer the best yields to potential billion- dollar customers?
Too often they turn to European banks issuing short-term paper, unfortunately.
If money market funds see huge inflows as a result of cash coming out of uninsured checking accounts, they will start reaching for yield themselves. And we know where that can lead the economy.
Personally, for the rest of us starving for yield, some of those money market funds may start looking more enticing. But, they aren't insured and you may be heading into a trap.

Even More Unintended Consequences

Lastly, and this is as convoluted and complicated as it gets, a lot of the cash coming out of bank checking accounts is going to go into short-term Treasury bills and notes.
The unintended consequences of that happening are going to spread through the capital markets and end up causing economic problems on top of the ones we already have.

Right now the Treasury issues about $30 billion of one-month T-Bills every week.

If the majority of the $1.4 trillion sitting in banks in soon to be uninsured accounts heads into these most liquid instruments it would take a year of issuance to satisfy that demand.

. .
Now, don't forget, the Federal Reserve is buying some $45 billion a month of Treasuries and agency paper. And, what about money market funds? If they get flooded with cash, they too will be buying the short- term issues spit out by the Treasury.

Not to complicate things, but what happens if there is actually some deal on the fiscal cliff that results in smaller deficits? Oh, the Treasury wouldn't have to issue as much new debt as it does now.

The demand for short-term Treasuries could very conceivably turn their yields negative.

What happens then? As if corporations, pension funds, and people aren't yield starved enough. Will the further implosion of yields and the continuing destruction of fixed income cause everyone to reach further and further out on the risk curve?

It's already happening. Junk bond funds are seeing record inflows as investors are clamoring for yield.


And just like what's going to happen with money market funds, issuers of junk are rushing to soak up the cash being waved at them by the funds trying to place their customers' new money.

Personally, are you going to get caught up in that rat race and end up in another trap?

There's no question that the fiscal cliff is on everyone's mind and certainly front and center in the financial news and press.


But, if we don't look hard and fast at what could happen, and probably will happen when TAG becomes just another legacy of the credit crisis, we may miss the naked truth that the flames of the next great financial conflagration are being fanned starting January 1, 2013.

November 11, 2012 8:19 pm

Competitiveness will not save the euro

After Germany’s 2002 elections, its government embarked on a series of economic reforms, mostly to the labour and welfare sectors. The German economy continued to stagnate until about 2005 but experienced a solid recovery, interrupted by the 2009 recession.

These are the facts. But the story told across Europe is that the reforms have caused a new German economic miracle.

The argument is a logical fallacy of the post hoc ergo propter hoc variety: after this, therefore because of this. First the reforms, then growth, hence causality, hence universal applicability. Every European official seems to have bought into this chain of argument. And they are now applying their flawed logic to France.

Last week a report by Louis Gallois, former chairman of EADS, suggested measures to render France more competitive. The report and the debate that came with it reflect a wider intellectual muddle about the nature of reforms. I detect a triple misdiagnosis – about the effects of reforms in Germany; about the kind of reforms that are now needed in France, and in Italy and Spain; and about the focus on competitiveness.

The first of the three fallacies concerns Germany. Throughout the postwar period, Germany’s economy performed strongly in fixed exchange rate mechanisms. Its first economic miracle occurred during the Bretton-Woods era of the 1950s and 1960s, as it managed to devalue its real exchange rate against other members of the system. It should come as no surprise that Germany prospers in the eurozone doing exactly the same thing. The recovery that followed the financial crunch in the early part of the last decade was caused by a long period of wage moderation.

So is there a link between reforms and wage moderation? If that were so, one could establish causality between the reforms 10 years ago and the subsequent increase in economic performance. To answer this question, one needs to look at the nature at the trade-off between wage policies and unemployment, and at other factors that were present. While German unions accepted lower wages to prevent job losses, the nature of the trade-off between inflation and unemployment – the so-called Phillips curve – has proved stable over time. German unions and employers moved along the curve to a position where wages were lower and employment higher, but the reforms did not change the nature of the trade-off itself. So could reforms then at least have contributed to that movement along the curve – by making unions accept such a trade-off in the first place? That question is harder to answer but my intuitive explanation is that the process of outsourcing to central Europe, an external shock, was the main reason trade unions acted as they did. In a country with low regional labour mobility, the closure of a factory would otherwise produce persistent unemployment.

Second, to fix the economic problems of France, one should apply a clear-headed and targeted approach. France and Spain suffer from high youth unemployment. The problem is well understood.

It is caused by a fragmented labour market, which protects workers with a permanent labour contract but discriminates against outsiders and the young. With youth unemployment at 52 per cent in Spain, this should be the priority for economic reform. We should therefore distinguish between reforms that serve a specific and well-defined purposesuch as the introduction of a single labour contract, or a pension reform – from reforms with unproved effects. We should also separate specific reforms from those that stem from pure rightwing ideology.

Lastly, why do we always focus on competitiveness? Businesspeople talk endlessly about it but it is a less useful concept on a macroeconomic scale. It conflates two concepts: macroeconomic competitiveness, as expressed by the real exchange rate, and total factor productivity, or TFP, a proxy for a country’s technological dynamism. A cut in unit labour costs is only a gain if you achieve it but nobody else does. Once you advocate it as a policy for everyone in the eurozone, you end up in a zero-sum game. We cannot all devalue at the same time. If we are saying that the eurozone should reduce unit labour costs to the level of Germany, why do we think that Germany will not do the same?

So that leaves TFP. This would be fine, but then it would be better to focus on it specifically, rather than through the distraction of the nebulous concept of competitiveness. Furthermore, we may not know as much about TFP as we think.

Specific reforms can be useful, but nobody should fool themselves that structural reforms could solve what is ultimately a balance-of-payments crisis. You have to resolve this crisis first – rather than seek refuge in the age-old debate Europeans love to waste their time with: on institutional reforms and structural reforms. They are both not irrelevant, but they are irrelevant to the resolution of this crisis.

Copyright The Financial Times Limited 2012.


November 11, 2012, 6:16 p.m. ET

The Hard Fiscal Facts

Individual tax payments are up 26% in the last two years.


While the rest of America was holding an election last week, the gnomes at the Congressional Budget Office released the final budget totals for fiscal 2012. They're worth reporting because they illuminate the real fiscal choices that confront the country, as opposed to the posturing you'll be hearing over the next few weeks.

The nearby table lays out the ugly details. The feds rolled up another $1.1 trillion deficit for the year that ended September 30, which was the biggest deficit since World War II, except for each of the previous three years. President Obama can now proudly claim the four largest deficits in modern history. As a share of GDP, the deficit fell to 7% last year, which was still above any single year of the Reagan Presidency, or any other year since Truman worked in the Oval Office.

Tax revenue kept climbing, up 6.4% for the year overall, and at $2.45 trillion it is now close to the historic high it reached in fiscal 2007 before the recession hit. Mr. Obama won't want you to know this, but this revenue increase is occurring under the Bush tax rates that he so desperately wants to raise in the name of getting what he says is merely "a little more in taxes." Individual income tax payments are now up $233 billion over the last two years, or 26%.

This healthy revenue increase comes despite measly economic growth of between 1% and 2%. Imagine the gusher of revenue the feds could get if government got out of the way and let the economy grow faster.

Now let's look at outlays, which declined a bit in 2012. That small miracle was achieved thanks to a 4% fall in defense spending, a 24% fall in jobless benefits, and an 8.9% decline in Medicaid spending.

Note, however, that federal spending remains at a new plateau of about $3.54 trillion, or some $800 billion more than the last pre-recession year of 2007. One way to think about this is that most of the $830 billion stimulus of 2009 has now become part of the federal budget baseline. The "emergency" spending of the stimulus has now become permanent, as we predicted it would.

When Beltway politicians claim they want a "balanced" approach to reducing the deficit, what they really mean is raising taxes to finance this new higher spending level. And the still-higher level that is coming with ObamaCare.

The reality is that the fastest way to raise revenue is with faster economic growth. To the extent that raising tax rates will reduce the rate of growth, it will slow the flow of tax revenue and increase the deficit.

Even if Mr. Obama were to bludgeon Republicans into giving him all of the tax-rate increases he wants, the Joint Tax Committee estimates this would yield only $82 billion a year in extra revenue. But if growth is slower as a result of the higher tax rates, then the revenue will be lower too. So after Mr. Obama has humiliated House Republicans and punished the affluent for the sheer joy of it, he would still have a deficit of $1 trillion.

Most of our readers know all this, but we thought you'd like some new evidence to rebut the kids who voted for your taxes to go up when they return from college for Thanksgiving. Maybe they'll figure it out when they have a job, if they can find one.

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