My Law of Unintended Consequences

There is a provision buried deep within the tax bill now being negotiated in Congress that I will bet you have never heard mentioned. I have never seen it discussed on TV, and I watch a lot of news programs plus all three CSPAN channels. But in fact it is the most consequential item of all. It disrupts transactions that currently grease the skids of finance and it amounts to about $2.2T per day. Yes, that is a T for trillions and it occurs every single day! If that doesn’t impress you then you are really jaded.

The issue is repurchase (repo) agreements that provide a short-term funding market for banks and investment companies world-wide. Legislators had no intention of disrupting this, of course. What they were targeting is the way multinationals shift profits to offshore entities to exploit their lower tax rates. However, these repos also flow across borders and the bill would make them unprofitable by imposing a punitive tax on them.

No one knows what the consequences of this will be because it wasn’t discussed or modeled by anyone. Of course the banks are now aggressively lobbying to get this provision killed or modified, and quite possibly they will succeed. I certainly hope so.

But that is a bit beside my point. Our tax system has spread its tentacles into every area of the economy and even to other countries. Any attempt to meddle with it in a significant way will inevitably cause unintended consequences. Some may be good. Some may not. This repo issue is a prime example of My Law of Unintended Consequences, which states that any large-scale change in our economy will inevitably result in some effects that were neither desired nor proposed.

Consider, for example, the proposal to drop the tax deduction for home mortgages. Currently, when buyers purchase a home, part of their affordability calculation is this tax deduction. Remove it and some home purchases become unaffordable, with consequences to the buyers, sellers, and finance companies. But that isn’t the major problem. The real impact is that removing this deduction instantly reduces mortgaged home values throughout the nation by an amount proportional to the amortized deduction over time. This is a massive loss of wealth by the largely middle-class home owners, and it certainly exacerbates wealth inequality.

That was an obvious example and, as it turns out, legislators are currently considering these consequences. But there are more such unintended consequences. What are they, you ask? I haven’t the slightest idea, and neither does anyone else. That’s the whole point, and if that doesn’t scare you, it should.

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Entitlement Reform

Republicans rant endlessly about so-called “entitlement programs” as though they are evil theft from the treasury, while Democrats rise up in anger bearing torches and cudgels whenever the slightest economies are suggested for them. Well, that’s an exaggeration of course, but it does capture the essence of the sorry situation we are in. I believe both are sadly wrong and, if given their way, both will do irreparable damage to our economy. On this topic, as others, we need to be sensible, compassionate and frugal, and we need to listen carefully to those with whom we disagree. When did this ever describe the swamp dwellers in Washington?

That is just one-man’s opinion. Take it for what you will. But the point of this blog post is to relate a piece of oft-forgotten history involving what we now call entitlements. It is relevant to our times because it provides an important message for a possible way out of this mess.

Do you know what the greatest single reduction of entitlements in our history was, and who did it? The answer to the second part of this question surely should be a surprise. It is Franklin Delano Roosevelt, who is the originating force behind many of today’s social welfare programs. In 1932, he had campaigned on the promise to bring federal finances into better order at a time when they were in total disarray and many despaired for the nation’s future. At that time, veterans’ benefits took up fully 25% of the federal budget! A grateful nation had bestowed far more than they could afford on returning soldiers of WWI and even earlier on those from the Spanish-American War.

Almost immediately after taking office on March 4, 1933, FDR submitted a proposal that would slash the federal budget. It would eliminate several government agencies, reduce the pay of civilian and military federal workers and, most significantly, slash veterans’ benefits by 50%. The Congress acted swiftly, even in the face of stiff opposition, and passed this virtually intact as the Economy Act of March 20, 1933. In the event, the impact of this bill was not as great as had been hoped. The effect on the deficit was minimal, perhaps due to other influences and general inertia in the economy. And some of the veterans’ benefits were later restored by two Supreme Court decisions.

But that is beside the point, which is that entitlement reform is possible but, in my opinion, only if Democrats do it. But when was the last time you heard any Democratic leader propose entitlement reform as a party platform plank? They always proclaim that they are open to reasonable changes, but they do so with obvious reluctance and never on their own accord. Hence their response to any Republican plan is fear and loathing, together with loud complaints about doom for all but the fat cats.

Still, I remain an optimist. Some day a Democratic leader will arise with the good sense and guts to do what is necessary. It has happened before. I just hope it is soon enough.

Crazy Talk on Capital Hill

One of the major disputes about the Republican tax plan is whether middle class and lower strata will all get tax cuts, as promised by Trump, Ryan and McConnell. There are two aspects of this argument that are essentially crazy talk.

First, Republicans are now saying that all cohorts of taxpayers will be ahead of the game, in other words those in each income group. That isn’t quite the same as saying all taxpayers, but why quibble when we hear politicians speak? By some scoring methods that seems to be true, although the division of spoils has a decidedly Republican slant. Democrats respond, “But I have a cousin in Albuquerque who will lose out because of the loss of some deductions, so you lied!” Of course, Republicans made a tactical error in the blanket assertion in the first place, so they are stuck with what was always unachievable.

The lesson is never to say all or everyone about any proposal whatsoever. There will always be exceptions. Still common sense says that, if this scoring is correct, their basic idea seems to be true and all that Democrats can do is to stick to their guns about exceptions. Thus, a crazy claim is now being met by an equally crazy response.

The second aspect of this argument is truly nuts. The Joint Committee on Taxation, which is doing the scoring, has just come out with a revised result based on the Senate plan that will thrill Democrats. It shows that every single income cohort below $75K would have net higher taxes in a few years time. The kicker is that the real reason for this is that repeal of the ACA mandate means that these people won’t get its associated tax subsidies. Obviously, that leaves them with a higher tax bill. Of course that also means that they won’t be paying exorbitant costs for health care policies they neither want nor need. Logically, that factor should have been included in the JCT scoring, since the tax bill itself is only part of the economic outcome. The real issue is net change in income after taxes. Recalculation using this factor changes the scoring back to positive for all income cohorts. Don’t expect this nuance to come through in the heat of this debate, however.

If the preceding paragraph puzzles you, consider the following analogy. Suppose you go into an auto dealership looking to buy an all-electric car. One factor you consider is that your state will give you a substantial tax credit to encourage switching from gas guzzlers. But after examining the available cars you decide they aren’t for you. As you walk out the door, the salesman calls out, “Sir, you are making a big mistake! By leaving you are substantially increasing your taxes!” That is factually true, but nevertheless it is crazy talk.

An Economic Mystery

Something has been going on for years in the economic realm that is unexpected and unexplained. It is really important and no one – and I mean absolutely no one – has a clue why it is happening. This mystery is a surprisingly subdued consumer price inflation. It is a world-wide phenomenon, except of course in countries like Venezuela that have sadly mismanaged their economies. One sometimes reads purported explanations by economists but they always fail one crucial test. What they predict will happen next never does, and indeed often the exact opposite occurs.

Even now, when producer prices are generally rising and developing economies are prospering, this condition remains essentially unchanged. It is always about to change “tomorrow”, but tomorrow comes and either nothing changes or the gap becomes even more pronounced. Take the euro zone for example. In May, the year-over-year producer prices rose 4.3%. But simultaneously in May the year-over-year consumer prices actually dropped from the April level of 1.9% to 1.4%.

The Fed is perplexed. The financial community is unable to predict future conditions so it is constantly having to defer long-term commitments. The bond market is becoming schizophrenic.

No one like inflation. It can ravage assets. But when inflation appears to have miraculously disconnected from the supply/demand cycle, all the classic economic rules of thumb go overboard. This leads to the worst possible condition: uncertainty.

Personally, I think that some as-yet undiscovered factor or confluence of factors is acting like a dam, holding back the normal flow of economic consequences. This will eventually burst and we will get a sudden spike in inflation just as we did in the 70s. Whatever is the case, this situation is clearly unstable.

Is 3% GDP growth feasible?

One aspect of Trump’s economic plan has evoked doubt and consternation. The plan depends upon achieving 3% annual GDP growth by 2021 in order to offset its cost. Most academics believe that this simply can’t happen. But here’s a relevant statistic. In the 70 years since the end of WWII, average GDP growth rate was about 2.9%. So why the skepticism?

The argument given, mostly by progressive economists, is twofold. First,  population growth was a major factor in the historical GDP trend, but this growth is now slowing significantly. And second, there are new impediments to growth resulting from government policy over the last few decades.

My thoughts are as follows. The population growth slowdown may be offset by gains from automation, robotics and AI. As I have argued before, we simply don’t need “busy hands” as much anymore, and this trend is increasing rapidly. Since I wrote, quite unexpectedly, there have even been inroads in some labor-intensive segments of the industrial farming economy. Even picking delicate fruit evidently can be effectively automated. Of course, whether this technological impact will be sufficient by 2021 is unclear, but no one can say it is impossible.

Secondly, the structural impediments in our economy are a self-imposed constraint. We could release some of them, and in fact that is a major part of the Trump agenda. These include undoing many regulations on business activity, freeing resource exploitation from some environmental protections, removing some constraints on the flow of capital, and so on. However, this entails significant risk because these impediments have benefits through engendering a safer and more stable economy. So it isn’t clear to me that this is a sensible course of action. Nevertheless, I am not so sure that following this path couldn’t restore the historical growth that built us into the dominant world power after WWII.

Thus, dismissing Trump’s plan in this way is a mistake. It is quite possible that we could achieve this ambitious goal if we are willing to accept concomitant risks. What the skeptics really mean is that it can’t be achieved safely. That isn’t the same thing as feasibility, and not speaking clearly on this topic is a serious rhetorical mistake. The real question is not whether 3% GDP growth is feasible but rather whether it is desirable, given what we must do to achieve it.

Our Economy in Perspective

One of my favorite bloggers is Mark J. Perry of AEI and the University of Michigan. Check out his economics blog Carpe Diem yourself and see if you agree. His June 6 post included this map that presents world GDP data in a unique and more relatable fashion.

StateGDP

He has two major point to make. First, this provides a clever visualization for how our gigantic GDP totally dwarfs most of the rest of the world, by labeling each state with the country having approximately the same GDP in 2015. The GDP matches are not perfect of course, but they are usually well within 10%. The second point, not directly shown, is that invariably our states achieve their results with many, many fewer workers. The U.S. economic engine is receiving mostly bad reviews in our current political season. However, while it is far from perfect, I think few residents of these states would prefer the quality of life in their world counterparts.

I am reproducing the map here because I wanted to relate a few of my reactions, which range from surprise to amusement to outright astonishment. Some items jump out. Texans are justly proud of their state, perhaps a bit too much for the rest of us, but to rank equal to Canada is amazing. Maybe the chatter about breaking off and resuming independence isn’t so crazy after all! Even proud New Yorkers might be surprised to find that their GDP slightly outranks South Korea, with its plethora of technology companies whose products we see everywhere in our homes and on our streets. As to my home state, California, its massive GDP is really no surprise. Still, to rank slightly higher that the EU powerhouse, France, is a bit eyeopening.

Our rust belt states are seen as faint images of their past glory, mostly characterized by economic decline, population loss, and urban decay. Yet Ohio’s GDP still is similar to Switzerland’s, Illinois outranks The Netherlands, and Pennsylvania’s GDP is only slightly less than the growing and vibrant Turkey. This perspective makes these states seem more economically sound, doesn’t it? And New Jersey almost equaling the petroleum giant, Saudi Arabia, is astounding, although the recent decline in oil prices no doubt played a role.

Old line Massachusetts has few resources other than its well-educated people and many of its manufacturing jobs have migrated overseas. Nevertheless it ranks with Nigeria, known as “the Giant of Africa” due to its enormous population and an economy that now ranks first on the continent.

Further down the economic ladder, other comparisons probably say as much about the ancient countries of the world as it does about the economies of our states. Colorado and Egypt make an odd pair, as does Missouri and Denmark, Iowa and Greece, and the District of Columbia and Hungary. On the other hand it seems quite appropriate that Minnesota is paired with Norway. Do you think their Scandinavian roots may have contributed to comparable economies? Similarly, the island economies of Hawaii and Sri Lanka seem natural partners.

A few pairings are just amusing. Surely Kentuckians might have expected to outrank their partner, Bangladesh. And enormous but sparsely populated Montana is performing similarly to the world’s gambling mecca, the tiny enclave of Macau. While The Oriental Republic of Uruguay and Sarah Palin’s Alaska strike me as the comedy duo of this report.

I am sure that other pairings will strike your interest and amusement. Enjoy!

The Little Engine That Couldn’t

yellen-and-rate-hike-cartoon

The Federal Reserve once again did a head fake. Interest rates will remain at historic lows for yet another cycle. You can hear echoes of the children’s fairy tale from our little economic engine, “I think I can. I think I can. Hmm…maybe not this time.” This is getting old and the markets are coming to realize this. Keep this up and no one will listen to the Fed, even though it is speaking publicly at historic volumes.

Fed Chair Janet Yellen says that they really, really want to normalize rates, and the economic indicators support this if they ignore short-term effects as they should. But they always find some monster on the horizon that deters them. So far anyway, these monsters never bite, although statistically we know that one eventually will. The latest is Brexit plus a disappointing jobs report. Will there ever be a clear field ahead? Probably not. The nature of our world economic system is that threats are endemic. Sooner or later, the Fed must accept the risk and move firmly forward on rates, but if they wait until the coast is entirely clear, timidly dithering on the edge, disaster is likely.

Consider this. Remaining in an unsustainably low-interest environment removes the main lever that the Fed has to respond to a real problem when it inevitably strikes. Of course they can always print money, but that is a fool’s errand.