Avoiding a New American Recession

Martin Feldstein

30 November 2012


CAMBRIDGEThe United States may be headed for a recession in 2013. Even if the country avoids going over the “fiscal cliff,” a poorly designed political compromise that cuts the deficit too quickly could push an already weak economy into recession. But a gradual phase-in of an overall cap on tax deductions and exclusions (so-called tax expenditures), combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that America needs without risking a new recession.

The US economy has been limping along with a growth rate of less than 2% during the past year, with similarly dim prospects in 2013, even without the shock of the fiscal cliff. That is much too weak a pace of expansion to tolerate the fiscal cliff’s increase in tax rates and spending cuts, which would reduce demand by a total of $600 billion – about 4% of GDPnext year, and by larger sums in subsequent years.

President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2% of earners, who now pay more than 45% of total federal personal-income taxes. His budget would also increase taxes on corporations, and would end the current payroll-taxholiday,” imposing an additional 2% tax on all wage earners.

Together, these changes could lower total demand by nearly 2% of GDP. And the higher marginal tax rates would reduce incentives to work and to invest, further impeding economic activity. All of that could be fateful for an economy that is still struggling to sustain a growth rate of less than 2%.

The Congressional Budget Office and the Federal Reserve predict that going over the fiscal cliff would cause a recession in 2013, with Fed Chairman Ben Bernanke recently saying that the Fed would be unable to offset the adverse effect on the economy. He could have said the same thing about the fiscal drag that would be created by Obama’s budget proposal.

Although Congressional Republicans rightly object to raising tax rates, they appear willing to raise revenue through tax reform if that is part of a deal that also includes reductions in the long-run cost of the major entitlement programs, Medicare and Social Security. Although some Republicans would like to see revenue increased only by stimulating faster economic growth, that cannot be achieved without the reductions in marginal tax rates and improvements in corporate taxation that the Democrats are unlikely to accept.

Raising revenue through tax reform will have to mean reducing the special deductions and exclusions that now lower tax receipts.
The potential recession risk of a budget deal can be avoided by phasing in the base-broadening that is used to raise revenue. A desirable way to broaden the tax base would be to put an overall cap on the amount of tax reduction that each taxpayer can achieve through deductions and exclusions.

Such an overall cap would allow each taxpayer to retain all of his existing deductions and exclusions but would limit the amount by which he could reduce his tax liability in this way. An overall cap would also cause many individuals who now itemize deductions to shift to the standard deductionimplying significant simplification in record-keeping and thus an improvement in incentives.

A cap on the tax reductions derived from tax expenditures that is equal to 2% of each individual’s adjusted gross income would raise more than $200 billion in 2013 if applied to all of the current deductions and to the exclusions for municipal-bond interest and employer-paid health insurance. Even if the full deduction for charitable gifts is preserved and only high-value health insurance is regarded as a tax expenditure, the extra revenue in 2013 would be about $150 billion. Over a decade, that implies nearly $2 trillion in additional revenue without any increase in tax rates from today’s levels.

Extra revenue of $150 billion in 2013 would be 1% of GDP, and could be too much for the economy to swallow, particularly if combined with reductions in government spending and a rise in the payroll tax. But the same basic framework could be used by starting with a higher cap and gradually reducing it over several years. A 5% cap on the tax-expenditure benefits would raise only $75 billion in 2013, about 0.5% of GDP; but the cap could be reduced from 5% to 2% over the next few years, raising substantially more revenue when the economy is stronger.

Slowing the growth of government spending for Medicare and Social Security is necessary to prevent a long-term explosion of the national debt or dramatic increases in personal tax rates. Those changes should also be phased in gradually to protect beneficiaries and avoid an economic downturn.

America’s national debt has more than doubled in the past five years, and is set to rise to more than 100% of GDP over the next decade unless changes in spending and taxes are implemented. A well-designed combination of caps to limit tax expenditures and a gradual slowing of growth in outlays for entitlement programs could reverse the rise in the debt and strengthen the US economy.
America’s current budget negotiations should focus on achieving a credible long-term decline in the national debt, while protecting economic expansion in the near term.
Martin Feldstein is Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982-1984, and is currently a member of the President's Council on Jobs and Competitiveness, as well as a member of the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the National Committee on United States-China Relations.

November 29, 2012, 6:34 p.m. ET
The Real Danger From the Fiscal Cliff
Taxing and borrowing from the private sector so the federal government can continue spending is no way to grow the economy.

Americans are told that they face a "fiscal cliff" if automatic federal spending cuts and tax increases occur at the end of the year. I'm not in favor of jumping off a cliff, but the logic of the supposed threat needs to be questioned.

The fiscal-cliff narrative assumes that spending cuts are bad for the economy. It follows, then, that more spending (and therefore more government debt) are good for the economy.

Didn't we try that with President Obama's trillion-dollar deficit-spending spree? You remember the stimulus—the one that created or "saved" American jobs at a cost of $400,000 per job. The one that left the unemployment rate over 8% for 43 consecutive months, the longest span since the Great Depression.

So is it good for the federal government to borrow more and spend more, or is it good for the economy to spend less and borrow less? These questions might need to be addressed before we wring our hands in despair at the possible fiscal cliff.

Now let's consider the assumption that raising taxes could lead to "taxmaggedon." The implication here is that raising taxesthat is, extracting and confiscating more income from workers and businesses—is harmful to the economy. I am easily persuaded of this truism. As Milton Friedman said, nobody spends someone else's money as frugally or as wisely as they spend their own.

But if raising taxes would lead us toward trouble, why would raising taxes only on some people ("the rich") not have some of the same harmful effect? Since the top 1% of income-earners pay about 40% of the income tax, raising taxes only on the 1% still significantly increases the tax burden on the private sector.

Any notion that it matters whom you tax is simply a parlor game played by the class-warfare crowd. There are only two repositories of money—the private sector (which efficiently distributes goods) and the public sector (which doesn't distribute anything well). No central planner possesses the omniscience to assign fairness.

The only guide to fairness of distribution that I can imagine is the minute-by-minute vote of the most exacting and direct democracy ever known: the marketplace.

None of this is to say that we don't need government or that government doesn't strive to do good things. It is to say that government doesn't do anything very well, and that government should be limitedconfined to those duties that absolutely can't or won't be done by the private sector.

When evaluating any government expenditure, legislators should be forced to acknowledge the "Bridge to Nowhere," the roughly 10,000 FEMA trailers bought but never delivered to Katrina victims, and the thousands of pounds of ice that never made it to New Orleans and required a new contract to have someone come melt it and dispose of it.

Apologists for big government say that we must raise taxes, that there simply isn't enough spending to cut. Maybe these legislators ought to look at the $100,000 that the State Department spent this year to send comedians to spread American culture in India (part of a $600 million program). Or the $2.6 million spent by the National Institutes of Health to teach Chinese prostitutes to drink responsibly. Or the $947,000 spent by NASA studying what type of food we should serve on Mars. Or the $100 billion ($115 billion last year) that is improperly spent across the federal government each year, according to the White House Office of Federal Financial Management.

Many Republicans are beginning to cave on the tax front. Some say to hell with the Taxpayer Protection Pledge they made to voters (drafted by Americans for Tax Reform) not to raise taxes. Some say they'll eliminate some undeserved loopholes. But the truth remains: If taking more money from the private sector is harmful, it doesn't matter whom you tax or what form the revenue increase takes. Taking more money out of the private sector is injurious to economic growth.

Where are the Republican calls for reducing revenue to government? Where are the calls for lowering taxes? If you want to stimulate the economy, leave more money in the economy. When Republicans give in on this argument, we doom not only the economy but our party as well.

Some Republicans are saying that if the tax rates expire, taxes will go up $2 trillion, so any increase in revenue less than $2 trillion is really a tax cut. I don't think that fuzzy Washington math will mollify the conservative grass roots.

Even for believers in wealth redistribution and big government, the facts militate against higher tax rates. As Stephen Moore recently pointed out on this page, in the 1920s, 1960s and again in the 1980s, lower tax rates increased the percentage of taxes paid by the wealthy. And the economy grew.

Any legislator considering capitulating on the Taxpayer Protection Pledge should remember that revenue is down now because of the recession and slow economic growth, not because of the lower tax rates that have been in place for almost a decade. Raising revenue by increasing rates or ending deductions won't spur the economy. It may even depress the meager economic growth we have and raise less tax revenue.

While there is no bigger believer than I am in a balanced-budget amendment, I don't want to balance a $5 trillion budget (which the Congressional Budget Office estimates we will have by 2020). I want to balance a budget that is limited in scope by the Constitution and limited in scope by the understanding that the private sector is more efficient than the public sector.

The Taxpayer Protection Pledge simply codifies what is incontrovertibly true. The economy and all individuals in it thrive when we are allowed to keep more of what we earn. If Republicans give up on that principle, we may as well disband the party.

Mr. Paul is a Republican senator from Kentucky.

On Wall Street

November 30, 2012 1:50 pm
It’s 2007 again, thanks to the US Fed

Financial conditions are as loose today as they were in 2007, Ben Bernanke noted in a speech he gave in New York on November 20. The Federal Reserve chairman had good reason for that observation.

High-yield bond and loan market issuance year to date in both the US and Europe stands at about $570bn on a par with the peak five years ago. Almost 30 per cent of all junk bonds have few terms, a new high, according to data from JPMorgan, while debt issuance for the purpose of paying the owners dividends is also above 2007 levels. Issuance of collateralised loan obligations this year will come in at about $45bn, more than the past four years combined.

Most shadow banks and credit hedge funds have never had it so good. So far, this year, distressed debt is among the best-performing hedge fund strategies. “You should be thankful for the Federal Reserve if you are an investor in credit markets,” notes Michael Cembalest, chief investment officer of the private bank at JPMorgan. “The rising tide in credit has lifted all boats.” Today, the debt of fewer and fewer companies trades significantly below 100 cents on the dollar, Mr Cembalest adds.

Also this past week, Equity Residential, the apartment landlord controlled by Sam Zell, partnered with AvalonBay to buy property company Archstone Enterprise, paying $6.5bn for 60 per cent and 40 per cent respectively. Archstone was formerly in the hands of Lehman Brothers. The bank’s original top-of-the-market purchase of Archstone was typical of the frenzied activity in evidence in 2007, as well as one of the main contributing factors to Lehman’s downfall.

Thanks to the Fed, there are so many ways in which it seems it is 2007 once again. But to what extent is that a good thing?

Mr Bernanke’s speech was hardly upbeat; it was all about the necessity for Washington to come to grips with issues surrounding the fiscal cliff, the package of tax increases and spending cuts due to take effect from January unless a deal is reached. But neither in the speech nor in the questioning after (led by his former colleague at Princeton University, Alan Blinder) was there much discussion about the downside of the current Fed policy.

There are several downsides, quite apart from the fact that the Fed’s policies cannot continue indefinitely and their efficacy diminishes with each round of easing. That is one reason why Jeff Aronson, co-founder of Centerbridge Partners, returned money to investors recently. At this point, after so much credit spread tightening, there is far more potential downside than upside. Other drawbacks, of course, are that households cannot earn anything on their savings, pension funds are badly underfunded and insurers cannot generate enough investment income. The real beneficiaries of easy money are speculators.

Meanwhile, from a narrow financial markets point of view, yet another downside is the fact that market prices have lost any real meaning. Prices suggest that the world is a safer place but is it really?

Probably not. The world is much more frightening today than it was in 2008. Growth in most parts of the world is far slower, while Europe looks to be in recession.

Joblessness is a challenge in many parts of the globe. The geopolitical situation is far less stable. Governments are cash strapped and have far less room to support either their economies or their banks.

Yet prices don’t reflect risk at all. Should Philippine government debt really be yielding 3.6 per cent? In 2008, it cost 800 basis points to buy protection against a Philippine default. In June, the price was 220bp. It is now a mere 100bp. Hedge funds nervous about the state of the world and seeking to buy protection in the credit default swap market have had a disastrous time as the credit markets keep tightening.

In 2007, senior staff at the New York Fed compiled a list of all the indicators, suggesting the prices of many financial assets were no longer rational, and presented that list to their colleagues in Washington. Among the indicators they cited was a Middle Eastern telecoms group whose initial public offer was close to 700 times oversubscribed. Their concerns were dismissed.
This time, Mr Bernanke’s Fed is even more complicit.

Copyright The Financial Times Limited 2012.

Greek deal frays as IMF threatens walk-out on debt buy-back impasse

The eurozone's debt relief plan for Greece has hit serious trouble within days as banks and pension funds balk at fresh losses, raising fears that the package could unravel before a deadline in mid-December.

By Ambrose Evans-Pritchard

6:14PM GMT 29 Nov 2012

Protesters clash with riot police officers during a 24-hour nationwide general strike on October 18, 2012 in Athens, Greece

It is far from clear whether Greek society will accept yet more cuts as the economy contracts a further 4.5pc next year Photo: Getty Images

If the IMF withdraws, Finland and Holland will also pull out of the programme. "This has become a really big problem," said Raoul Ruparel from Open Europe.

The dispute comes as Moody’s said the EU-IMF deal to unlock €44bn in bail-out payments to Athens merely papers over cracks and does little to alleviate Greece’s "extreme economic and social fragility".
"We believe that the country’s debt burden remains unsustainable," it said. Moody’s warned that there can be so lasting solution until EU states and official creditors agree to write down their holdings, now the lion’s share.

Private investors are furious at demands that they take a second "haircut" of 70pc on residual holdings, after already taking a 53.5pc loss earlier this year, while official creditors still refuse all loses.
Greek banks told finance minister Yannis Stournaras on Thursday that they cannot take part in the "buy-back" plan unless the Troika-imposed terms of Greece’s bank recapitalisation scheme are relaxed. They still hold €22bn of Greek bonds, mostly used as collateral for raising money under the European Central Bank’s emergency liquidity assistance (ELAs).

"It is our patriotic duty to make the scheme succeed. It must succeed," said Mr Stournaras, although he also alluded vaguely to a "Plan B".

Mr Ruparel said the burden will have to fall on foreign pension funds, insurers and banks with some €30bn of bonds, but it is unclear how they can be made to comply. The scheme is supposed to be voluntary. "Most want to hold the debt to maturity and have no interest in crystalising losses," he said.

Under the buy-back plan, investors sell their bonds back to Greece at a 70pc discount - last week’s market price. Greece in turn borrows the money from the eurozone bail-out funds.

The Institute of International Finance (IIF) said it would be an outraged if its members are forced to take further losses.

"Debt restructuring was clearly explained to investors as a one-off, as unique, not to be repeated. If they do restructure again, their own credibility is at risk," said the IIF's Hung Tran.

In theory, the plan could cut Greece’s €301bn debt by €20bn, but the IMF has been sceptical from the start. Without it, Greece cannot come close to meeting the agreed debt target of 124pc of GDP by 2020.

Leaked documents have already cast serious doubts on that target, much to the irritation of the IMF, which fears that its own credibility is being damaged by the continued fudge over figures that appear to be extracted out of thin air and have repeatedly proved wide of the mark over the past two years.

There is mounting irritation among the Asian and Latin American members of the IMF Board - as well as the US - at the failure of the Europeans to deploy their full wealth to clean up an internal EMU problem.

Gary Jenkins from Swordfish said there is a risk that the deal will "fall apart" over coming months. "It is a long way away from the permanent fix that the IMF had been insisting upon. It is just one more big kick of the can down the road.

Dario Perkins from Lombard Street Research said the convoluted deal aims to veil the fact - until after Germany’s elections next year - that German taxpayers are facing real losses for the first time since the crisis began. "In the meantime, Greece’s Greater Depression will just get greater," he said.

Mr Perkins said the package inflicts serious humiliations on Greece. The Troika will confiscate all privatisation revenues and the primary surplus at source for debt payments, yet offers no real change in strategy. "The plan to ‘save’ Greece shares the same fatal flaw as all the others.

Rather than recognize that its policy prescriptions are fundamentally wrong - that austerity is no solution to a depression and Greek debt must eventually be written down completely - the Troika has stuck to its view that lack of success reflects poor Greek effort."

It is far from clear whether Greek society will accept yet more cuts as the economy contracts a further 4.5pc next year. Youth unemployment is already 58pc. The anti-Memorandum Syriza movement is running at 32pc in the polls.

While there is no doubt that the German Bundestag will back the deal for Greece in a vote on Friday, it is becoming hard for Chancellor Angela Merkel to disguise the mounting cost.

FT Deutschland said the process had become a charade. "Almost everybody knows Greece will need debt restructuring in the long run. It will remain cut off from capital markets and dependent on the international community for aid, and European citizens should be made aware of this. Political integrity from the eurozone-IMF talks are long overdue. Instead they are maintaining the illusion - especially in Germany - that the whole thing won’t cost taxpayers much."

Die Welt said the Chancellor’s office is still trying to "play down" the awful truth that the eurozone is turning into a "transfer union". The newspaper said it will soon be clear to everyone that the ultimate red line has been breached.