Can Trump Boost Middle-Class Incomes?

December 2, 2016

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The state of the economy loomed large in the minds of voters as they went to the polls. According to CNN exit polling, 62% of the voters characterized the economy as “not good” or “poor,” and a majority of those who felt that way voted for Donald Trump. The 27% of voters who said they were worse off than four years ago voted for him by a 77% to 19% margin.

Although the economy has been growing steadily since the financial crisis of 2007-08, the rate of growth has been fairly slow, and the income gains from that growth have gone mostly to the very wealthy.

What does President-Elect Trump propose to do for the middle class? He would give them a modest tax cut, create good jobs by spending on infrastructure and negotiating more favorable trade deals, and stimulate the economy to increase the rate of economic growth. (I won’t discuss new trade deals here, since they are such an unknown at this time, and they require the cooperation of our trading partners.)

Taxes and spending

As I described in more detail in an earlier post, Trump would like to reduce personal income taxes and corporate taxes, as well as completely eliminate estate taxes. The income tax cut would provide a small benefit for the middle class. For example, a married couple with a $50,000 taxable income would have their taxes reduced from $6,572 to $6,000.

This might not be a free lunch, however. Like Ronald Reagan and George W. Bush before him, Trump would like to cut taxes and increase military spending at the same time. If past experience is any guide, that would increase the deficit and make it hard to fund any job-creating domestic initiatives. If Congressional Republicans run true to form, they will rush to cut taxes and then clamor for spending cuts to avoid raising the debt ceiling. Trump’s fiscal problem is likely to be especially acute, since he wants infrastructure spending as well as military spending increases. He also wants particularly drastic tax cuts, including complete elimination of estate taxes (a huge financial windfall for his own family and those of his billionaire friends) and a reduction in corporate rates from 35% to 15%.

Trump’s nominee for Treasury Secretary, former Goldman Sachs executive and hedge fund manager Steven Mnuchin, has created some uncertainty about tax cuts for the wealthy. He has said, “Any reductions we have in upper-income taxes will be offset by less deductions so that there will be no absolute tax cut for the upper class.” That would be good news for the rest of us, since it would make the tax cuts fairer and also preserve revenue that could be better spent on job creation. However, Mnuchin’s promise goes against strong Republican inclinations, as well as being in opposition to the plan previously announced by Trump himself. According to the New York Times:

In that plan, middle-class families would see a 0.8 percent increase in their after-tax income, according to an analysis by the Tax Foundation, while the top 1 percent of taxpayers would see a 10.2 to 16 percent gain. Another group, the Tax Policy Center, calculated middle-class families would get a 1.8 percent boost in after-tax income, while the top 0.1 percent of earners would see a 14 percent gain and a tax cut worth an average of $1.1 million.

I will be surprised of Congress can agree on enough changes in tax deductions to offset the large reductions in tax rates that Trump has proposed for the wealthy.

Economic growth

Ever since the Reagan Revolution, “supply-side” economists have dreamed of cutting tax rates without actually reducing government revenues, so as not to increase the federal deficit. In theory, that could be accomplished if tax cuts stimulated economic growth and increased the income base from which taxes are collected. In practice, Republican tax cuts since Reagan have not paid for themselves, and the annual deficit has risen under Republican administrations while falling under Democratic administrations. (The total national debt, however, has risen under both parties’ administrations, since only rarely has the government run a surplus. Bill Clinton did toward the end of his presidency, but then George W. Bush used the surplus as an excuse for another round of tax cuts and deficits.)

Since middle-class tax rates are already fairly low, the middle-class tax cut is probably too small to produce much stimulus. Those who believe in top-down economic growth are pinning their hopes more on the corporate tax cut. That could translate into widespread income gains, but only if corporations actually invest the money in expansions of output (as opposed to just distributing it in dividends to mostly wealthy shareholders or buying up existing assets), and spend a lot of it on labor, not just on labor-saving machinery.

What the country needs is a virtuous cycle of higher productivity and higher wages. Higher productivity justifies wage increases, and higher wages create the consumer demand that justifies investment in the expansion of supply. What is missing from the Trump economic policy, and from Republican policy in general, is much support for higher wages. That would mean federal support for workers in their efforts to bargain for a fairer share of the income gains the economy is capable of generating. For a man who presents himself as a friend of the working class, Trump has remarkably little to say on this subject. In a way, he is the personification of trickle-down economics, the billionaire who just asks people to trust rich folks like him to create wealth for the masses.

We get occasional hints that President-Elect Trump might depart from the standard Republican playbook of tax cuts for the wealthy and spending cuts for everyone else. His interest in infrastructure spending and his Treasury secretary’s support for concentrating tax cuts on the middle class are hopeful signs. But overall, I remain skeptical that much that is good for working families will survive Trump’s embrace of Wall Street and the Republican establishment.


Clinton and Trump on Fiscal Policy (part 2)

August 17, 2016

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The last post discussed differences between the candidates in their approach to taxing and spending. Both have ambitious spending plans, but Hillary Clinton proposes to raise the revenue to finance hers by increasing taxes on the wealthy. Donald Trump proposes to increase spending and cut taxes at the same time, with the largest reductions for the wealthy.

Estate taxes

The candidates also sharply disagree over estate taxes. As a result of previous tax cuts, estate taxes only apply to individual estates valued at over $5.45 million, or $10.9 million for married couples. Only one estate out of every 500, or 0.2% of estates, are large enough to have to pay any estate taxes at all.

Amounts that exceed these thresholds are taxed at 40%. However,the wealthy are also able to use various legal devices to limit the size of their taxable estates, so that most pay less than half of that.

Consistent with her aim to get the rich to pay “their fair share,” Clinton proposes to raise the estate tax rate to 45% and to apply the tax to more estates. The new, lower thresholds would be $3.5 million for individuals and $7 million for couples.

Trump would abolish the estate tax altogether, creating another big tax break that would benefit only the richest 1/5 of the 1%. For those as rich as himself (or at least, as he claims to be), the tax savings could run into the billions.  Personally, I think that any candidate who claims to care about struggling working families could find a better use for that tax revenue.

I will cheerfully state my own bias here. I think that taxes on large estates are a good idea in a democracy. They help equalize opportunity, rather than letting the children of the rich be born with a gilt-edge guarantee of future prosperity. They also help avoid the formation of  hereditary aristocracies or plutocracies, which tilt power toward the wealthy and away from average citizens. How strange that an alleged populist cannot appreciate that!

Business taxes

In the area of corporate taxes, the Clinton plan is again more moderate than the Trump plan. She proposes some small changes to the tax code in order to discourage businesses from moving abroad. For example, she would crack down on “tax inversions,” where companies avoid US taxes by merging with a foreign company and moving their corporate headquarters to that country.

Donald Trump would reduce the incentive of companies to leave the United States by lowering the corporate tax rate, which at 35% is one of the highest in the world. Many corporations take advantage of the many deductions and loopholes in our tax code, some pretty reasonable and others pretty tricky. In general, Trump proposes to do what many tax critics recommend, lower the rate but close many of the loopholes.

However, the Trump plan is radical in some respects. He proposes a new corporate rate of 15%, which is below even the House Republican recommendation of 20%. He would also apply that rate to all sorts of businesses, including partnerships, limited liability companies and sole proprietorships. As it stands now, those entities “pass through” income to individuals, who pay taxes on it at “ordinary income” rates as high as 39.6% (or 33% after Trump’s other cuts). According to the Center on Budget and Policy Priorities, two-thirds of this pass-through income goes to the top 1% of taxpayers, who are obviously in the top bracket. Taxing those entities at only 15% would be another windfall for the wealthy.

In addition, it would create a new tax loophole for wealthy individuals. Many highly paid employees could lower their taxes to 15% simply by reclassifying themselves as independent contractors and selling their services to their former employers.

The choice

In her tax and spend proposals, Hillary Clinton comes off as the fiscal moderate but social progressive, wanting to finance her new spending plans with modest tax increases on the wealthy. Her tax plan is expected to bring in $1.1 trillion in additional revenue over ten years. Donald Trump comes off as the fiscal risk-taker and plutocrat, willing to increase the deficit in order to give out more tax breaks, primarily for the wealthy. His original plan would have reduced revenue by as much as $9.5 trillion over ten years, although he would hope to offset that by stimulating a higher rate of economic growth. (That’s what tax cutters always hope for but rarely achieve.) The current plan discussed here is just beginning to be analyzed, but I would be surprised if the cost in revenue would come out less than four or five trillion.

As I have said before, the Republican Party has the perennial problem of how to win electoral majorities while pursuing an economic agenda whose top priority is tax relief for rich people. The solution is often some form of cultural conservatism with broad appeal, such as Christian conservatism. Declining enthusiasm for the Religious Right has created an opportunity for a more troubling form of conservatism, more nativist and nationalist, to arise. In Donald Trump we have an odd marriage of nationalist populism and anti-tax plutocracy, the first appealing more to the less educated, and the second more to the rich. But not enough of the educated middle class are buying into this mix to make it the new ideological foundation for the party. Meanwhile, the Democrats are gradually becoming more progressive again, and they should be a formidable political force. For one thing, they are winning the battle for the hearts and minds of the younger generation, at least in this election.


Clinton and Trump on Fiscal Policy

August 16, 2016

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I am hoping that some potential voters are still interested in hearing about policy differences between the presidential candidates. As the election campaign stands now, it seems to be mostly a debate over the candidates’ character. Does Donald Trump have the right temperament to be president? Is Hillary Clinton trustworthy? Their actual policy proposals are often overshadowed by the latest mini-scandal, what Trump said about so-and-so, or what was found in an email on Clinton’s server. I watched the CBS evening news the day that Clinton presented her economic plan, and they made no mention of it. They did, of course, do a story on Trump’s description of the President as the “founder of ISIS,” which he later said he meant sarcastically, sort of.

Meanwhile, the country faces a number of difficult policy decisions, which will remain important regardless of who wins, but on which the candidates have taken very different positions.  Decisions about fiscal policy–how to tax, how to spend–are among the most important. They affect what the federal government is able to do, and what impact it has on the economy.

Spending

Both candidates promise to accomplish things that require new spending, although they often describe their goals without trying to put a price tag on them. One goal they have tried to price out is repairing and improving the nation’s infrastructure. Hillary Clinton has proposed to spend $275 billion over five years, and Donald Trump has promised to out-build her (that’s what he’s good at) with his own $500 billion plan.

Each candidate has other initiatives that will also need funding. Clinton wants to increase federal aid to education so that students from families with incomes below $85,000 can attend state colleges tuition free. (That threshold would rise to $125,000 over the next four years.) Trump wants to put more money into strengthening the military.

The candidates differ dramatically on how they would pay for their new spending. Clinton is the more fiscally conservative here, proposing to pay for new spending with higher taxes targeted specifically at the wealthy. Trump, on the other hand, wants to cut taxes, so at least in the short run the government would face a double whammy of more spending but less revenue. (He hopes that the government would recover at least some of that revenue when his tax cut stimulates the economy; more on that later.) Trump proposes to offset some spending with reductions in “waste, fraud and corruption,” a familiar goal to be sure, but I couldn’t find any proposals for specific budget cuts on his website. He has also said that he is willing to run a larger deficit and take on more debt. He has boasted about his ability to manage debt, but we know from his business history that his methods include declaring bankruptcy and repaying debt at less than full value. At one point Trump even suggested that the United States could also shortchange its bondholders, something that the country has never done. (That could very well end up costing the country more, since it would shatter confidence in our bonds and force the Treasury to pay higher interest rates.)

So on the face of it, Clinton seems to be the fiscal conservative, and Trump the fiscal risk-taker, which makes some Republicans very nervous. However, his “borrow and spend” approach isn’t that much of a departure from what Republican administrations actually do, as opposed to what conservative orthodoxy says they should do. While Republicans sound like the ultimate deficit hawks when they are opposing Democratic spending plans, their record on reducing deficits and balancing the budget is actually very poor. Both Ronald Reagan and George W. Bush ran up large deficits by doing a lot of what Trump wants to do, increase military spending while cutting taxes.

Ever since the 1980s, Republicans have supported their tax proposals with an argument from “supply-side” economics. Tax cuts aimed at corporations and the wealthy provide more capital that businesses can use to expand, create jobs, and boost incomes. That in turn increases tax revenues, so the tax cuts don’t really increase government debt in the long run. Not very many economists subscribe to this view today, at least with regard to cuts in personal income taxes. We have had relatively low taxes on the wealthy for 35 years, and we have experienced sluggish growth and a soaring national debt. In contrast, during the great period of economic growth in the mid-twentieth century, tax rates were higher, but growth rates were also higher and deficits were smaller.

Personal income taxes

As I said, Hillary Clinton proposes to increase taxes on the wealthy. She would put a 4% tax surcharge on incomes over $5 million, in effect raising the top tax bracket rate from 39.6% to 43.6%. She would also like to make anyone with an income over $1 million pay at least 30%. Although millionaires are in the 39.6% bracket now with regard to “ordinary income,” they can pay as little as 20% on income from capital gains. That’s why Warren Buffet can point out that he pays taxes at a lower rate than his secretary. (He is supporting Clinton’s plan, by the way, even though it will raise his own taxes.) The proposal for a 30% minimum rate for millionaires was previously proposed by President Obama, and has come to be known as the “Buffet rule.”

Clinton is not proposing any major tax changes for the non-millionaire majority. Donald Trump, on the other hand, is proposing “lower taxes for everyone, making raising a family more affordable for working families.” His first proposal cut taxes so much that most analysts dismissed it as fiscally irresponsible. More recently, he has apparently adopted the plan put forth by House Republicans, at least with regard to tax rates. The details are not entirely clear because they are not yet available on the Trump website.

We do know that the Trump plan proposes to simplify the rate structure by replacing the current seven tax brackets with only three: 12%, 25% and 33%. To keep the presentation brief, I will focus on households headed by married couples filing joint returns, but the general conclusions would be true for single filers as well. Here is how the plans would affect households with various taxable incomes (after deductions and exemptions):

  • $25,000: Currently this household is in the 15% bracket, but their effective tax rate is only 11.3%, since the first $18,550 is taxed at only 10%. Their tax is now $2,822. After Trump’s simplification, all their income is taxed at 12%, so their tax rises slightly to $3,000.
  • $30,917: I’ve picked this odd number because it is the break-even point where Trump’s plan makes no difference. The household is currently in the 15% bracket, but their effective rate is 12% already, and it remains 12% in Trump’s plan. Their tax is $3,710 either way.
  • $50,000: This household is also in the 15% bracket under the current system, with an effective rate of 13.1% and a tax of $6,572. After Trump’s simplification, they are taxed entirely at 12%, for a tax of $6,000 and a savings of $572.
  • $100,000: This household is currently in the 25% bracket, but with an effective rate of 16.5%. Under Trump’s plan, they are still in the 25% bracket, but their effective rate drops to 15.2% because the first $75,300 of their income is taxed at his 12% rate. Their tax goes down from $16,542 to $15,211, a savings of $1,331.
  • $1 million: Currently they are in the top 39.6% bracket, with an effective rate of 34.2%. Trump’s top bracket is only 33%, so their effective rate comes down to 30.2%. Their taxes fall from $341,666 to $301,695, a savings of $39,970.

And so it goes. The greater the taxable income, the larger the tax reduction, not only in dollars but in rate. Like all Republican tax proposals, this one gives the greatest tax relief to the wealthy who pay the most taxes, with the aim of making the rate structure flatter and less progressive.

In addition, the Trump plan does not address the “Buffet rule,” and so it continues allowing millionaires to pay a lower rate if their income is primarily from capital gains.

The Trump plan is marketed as “lower taxes for everyone, making raising a family more affordable for working families.” But the family with a $50,000 taxable income saves $572, while the family with the million-dollar income saves $39,970. Why should the government give up badly needed tax revenue to help families that are already doing fine?

A word of caution: a complete analysis of a tax plan would have to consider more than just the tax brackets and rates. For example, the House Republican plan (and maybe the Trump plan?) also proposes to increase the standard deduction from $12,600 to $24,000, while eliminating the personal exemption. Some households, especially those without children, would see their taxable income fall. Others, especially families with two or more children, could lose more from the loss of exemptions than they gain from the increased standard deduction. I don’t think that changes my basic conclusion, but it is not simple. The candidates need to post their plans with as much specificity as possible, so that outside experts can evaluate them.

One suspects that the real objectives of the Republican plan are probably something else besides providing tax relief to the working class. Many Republicans sincerely believe that more tax cuts for the wealthy will promote economic growth, although doing that from the top down is a dubious proposition. Democrats are more likely to believe that government spending on useful job-creating projects is a more direct path to growth. The difference is even starker, since some Republicans have advocated tax cuts specifically to deprive the federal government of revenue in order to keep government small and weak, “small enough to drown in a bathtub,” as anti-tax crusader Grover Norquist has put it. As far as I know, Donald Trump has not made that argument. He really can’t, since he is promoting increases in both military and domestic spending. But it may be an objective of House Republicans, who could be very influential in a Trump administration. They do want to reduce domestic spending, although they have to be careful about how they present that to the public. Better to speak of “entitlement reform” than “cutting social security benefits”; better to speak of “reducing dependency on government” than “taking away food stamps from hungry children.” Surveys have found that Americans like the idea of limited government in the abstract, but rarely rally around when specific programs are on the cutting board.

A presidential campaign should be an opportunity to have an honest, fact-based debate over fiscal policy, among other things. Right now, that’s just not the kind of thing that get’s voters’ attention.

In the next post, I’ll discuss differences between the candidates on estate taxes and corporate taxes.

Continued


The Shifts and the Shocks (part 3)

December 19, 2014

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The last part of Martin Wolf’s book deals with solutions to financial instability and the sluggish economic recovery. This is the hardest part to summarize, since Wolf discusses a great many ideas, organizes them rather loosely, provides little in the way of prioritization, and conveys little confidence that some of the more promising ideas will actually be adopted. In keeping with Wolf’s interest in underlying macroeconomic causes of financial crisis, I will highlight the solutions that would address those causes.

To review some of the main themes, Wolf describes a global economy in the aftermath of a great credit boom and bust. Underlying the financial crisis was a global savings glut that was really an excess of saving over investment. When an economy generates more income than is spent on current consumption, the surplus should sustain economic activity through investment in future production and consumption. Also, some people’s savings can go to finance other people’s consumption, as long as the loans are sound and the debtors can repay them out of future earnings. But in the global economy prior to the crisis, not enough of the world’s savings was used for either sound investment or sound consumer borrowing, and too much was used to finance high-risk consumer loans and asset bubbles, especially in housing.

The world became more divided into creditors and debtors: creditor and debtor countries (such as Germany in relation to peripheral Europe and China in relation to the US), creditor and debtor economic classes (increasingly unequal households, especially in the US), and creditor and debtor economic sectors (the corporate sector with surplus income and the government and household sectors running deficits). When the credit boom got too far out of hand, some debtors defaulted, some creditors stopped lending, and the system crashed.

The challenge for the future is then to tighten financial rules to discourage credit excesses, but also to reform the system to make better use of economic resources. It isn’t enough just to stop creditors from making risky loans and force debtors to pay down debt. If something else isn’t done to put excess savings to good use–in either investment or consumption–austerity will only weaken economic demand, increase surplus savings and produce long-term economic stagnation. That is what Wolf fears:

Far more likely [than adequate reform] is an enduring slump in high-income countries, at least relative to pre-crisis expectations. That would impose huge costs – of investments unmade, of businesses not started, of skills atrophied and of hopes destroyed. Should that fate be avoided, another temporary credit-driven boom might emerge, followed by another and still bigger crash.

Wolf argues that the long-term costs of failing to sustain high economic output are greater than the costs of wars, and also greater than the costs of inflation (relevant because fighting inflation has often been such a high priority of economic theorists and policymakers).

Banking reform

Throughout his discussion of solutions, Wolf is willing to entertain more radical reforms than have been adopted so far, although he acknowledges the difficulties of implementing them. For example, he would like to make fundamental changes in the way bankers do business:

So the business model of contemporary banking is this: employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; invest in high-risk assets; promise a high return on equity, unadjusted for risk; link bonuses to the achievement of this return target in the short term; ensure that as little as possible of those rewards are clawed back in the event of catastrophe; and become rich. This is a wonderful business model for bankers….For everybody else, it was a disaster.

The solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.

Before the crisis, the median ratio of debt to equity in UK banks was 50:1. That meant that a mere 2% drop in the value of the typical band’s assets would make it insolvent. Wolf would like to see a maximum ratio of 10:1.

Wolf also devotes considerable space to a discussion of the even more radical “Chicago Plan,” which would eliminate the role of bank lending in the creation of money and dramatically increase the government’s control over the money supply. But he acknowledges that this would be too disruptive, and that more moderate reforms should be tried first.

Macroeconomic reforms

The deeper problem is how to stimulate demand and put savings to constructive use, so that excessive credit is not needed to maintain economic activity.

Wolf deplores the almost exclusive reliance on monetary policy (low interest rates and bond purchases by central banks) to bring about economic recovery. At least in the short run, increases in government spending would have accomplished more in a shorter time. “The decision to withdraw fiscal support for the recovery, taken at the G – 20 Summit of June 2010, delivered a longer and deeper slump than necessary….It has also meant relying on a more uncertain tool – that of unconventional monetary policy – and abandoning a less uncertain one – that of fiscal policy.” The notion that government borrowing and spending interferes with private investing lives on, although it made more sense when capital was scarce and expensive than it does now, when capital is abundant and cheap.

In the longer run, total economic demand must be increased by reducing the excess savings of creditors and increasing the income of debtors. High-saving, high-export countries like China and Germany need to stimulate domestic demand by allowing their workers to consume more, while debtor countries need to stimulate foreign demand by becoming more globally competitive and earning more income abroad. Corporations should be discouraged from accumulating excess savings, but encouraged by changes in corporate governance and taxation to distribute profits not needed for investment. Government should have the tax revenue it needs to create needed social goods. Low-income households should get a larger share of income through higher wages or progressive taxation, so they can maintain consumption without relying so heavily on debt.

Saving the Eurozone

Wolf minces no words in his discussion of the European Monetary Union; he regards it as a “bad marriage,” since it created a unified currency without first creating a unified state. “Proponents thought that creating a currency union would bring the peoples of the Eurozone closer together. Crises divided them into contemptuous creditors and resentful debtors instead. This has been a march of folly.”

As I discussed in the first post, the common currency made it easier for strong economies to export and weaker ones to borrow. But when the credit bubble burst, there was no central state to help repair the damage. Wolf notes that in the United States, some states are economically weaker than others, but their citizens participate in a federal safety net and their bank deposits are federally insured. The European Central Bank was very slow to intervene to maintain liquidity in the countries hardest hit by the financial crisis. Wolf maintains that since “the creditor countries bear a full share of the responsibility for the mess, they should expect to bear a full share in its resolution as well,” by refinancing some debt with lower interest rates and longer terms. Wolf also wants to see a strengthening of the central bank, with stronger powers to regulate banks and issue eurobonds “for which the Eurozone states are jointly and severally liable.”

From a macroeconomic perspective, the Eurozone will suffer from weak demand if Germany continues to rely for its prosperity on its high level of exports while weaker economies import less in order to pay down debt. If all of Europe is trying to consume less than it produces, that will in turn aggravate the problem of weak demand in the global economy. Austerity may work for some countries, but it cannot work for all.

The implications of the attempt to force the Eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the Eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, probable….Not least, the shift of the Eurozone into surplus is a contractionary shock for the world economy.

Wolf thinks that the chances are good that many European countries will suffer from economic stagnation for a long time, putting an economic drag on the entire European and global economies.

Secular stagnation?

Clearly Wolf regards many of our economic problems as secular (long-term) rather than just cyclical (tied to phases of expansion and contraction). He believes that developed countries with aging populations can expect to experience slower economic growth from now on. “Not only will the labour force shrink absolutely in many countries, as the population falls, but the proportion of it that is young, flexible and innovative will decline further.”

I’m not entirely convinced of that, especially the part about innovation. Age may be related to innovation, but so are education and occupation; consider Richard Florida’s The Rise of the Creative Class. Slower population growth does reduce one obvious reason for new investment–the need to expand the quantity of existing goods and services–but there can still be innovations in type and quality. And even if businesses do find it harder to come up with things to invest in–which I gather is Wolf’s point–a thriving economy remains possible as long as enough income finds its way into the hands of those who will use it for something useful. These could be working families trying to raise children, or governments trying to fund improvements in infrastructure or education. They certainly don’t have to be wealthy financiers squandering the world’s income on risky loans.

Neither economic evil–stagnation on the one hand or credit binge on the other–is inevitable. Wolf helps us understand how we might avoid them, if we have the wisdom and the will. However, the author himself is not sure that we do.


The Shifts and the Shocks

December 15, 2014

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Martin Wolf. The Shifts and the Shocks: What we’ve learned–and have still to learn–from the financial crisis. London: Penguin, 2014.

British economic journalist Martin Wolf provides a comprehensive account of the global financial crisis and its aftermath. The story unfolds slowly and covers a lot of ground, so the reader needs to read the entire book carefully to get the full picture.

Wolf’s own policy perspective is fairly moderate. He supported much of the economic liberalization and limitation of state power under Margaret Thatcher and Ronald Reagan, but he now believes that liberalization got out of hand and became a major cause of the financial crisis. “The financial driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis.” He also faults naïve economists for exaggerating the efficiency of free markets and overlooking the signs of increasing instability, thus condoning the risky behaviors that led up to the financial meltdown.

The title of the book refers to Wolf’s distinction between the underlying shifts in the global economy that made financial markets less stable, and the actual financial shocks that caused a sharp contraction of economic activity and created a need for government intervention. In organizing the book, Wolf chose to cover the shocks in Part I and the shifts in Part II. I thought that made the book’s argument harder to follow, reversing the chronological order of events and putting the financial cart before the economic horse that was pulling it. Wolf describes the financial crisis in Chapter 1, but doesn’t discuss the reasons for financial instability until Chapter 4. He only sets the scene briefly by describing four features of an ultimately unsustainable global situation: “huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain.”

When investors lost confidence in the value of the loans they had made and the assets they had helped inflate, major investment banks failed and credit dried up. That forced governments to intervene, very likely bringing to an end the era of financial liberalization. The US government took over the biggest mortgage lenders, injected capital into failing businesses, lent money to banks at zero or near-zero interest rates, and held down longer-term rates by purchasing private bonds.

Post-crisis recovery and its limitations

Judging from the size of the banks that failed, the financial crisis was even worse than the crash of 1929, but the rapid policy response kept the economic situation from becoming as bad as the Great Depression. Nevertheless, the success of the recovery has been limited by the failure of government to be even more aggressive. Wolf’s verdict is that it rescued the world economy “fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned.”

The post-crisis recovery has been weak for many reasons: Borrowers reduced borrowing and spending and turned to paying down debt. Investors also pulled back as a reaction against previous overinvestment, especially in housing that buyers couldn’t really afford. Financial institutions became more reluctant to lend, and borrowers could no longer count on inflation to increase the price of their assets while reducing the real value of their debts. The result was a general state of economic “malaise” in which low consumer demand and low investment reinforced each other.

Wolf also discusses “sectoral balances,” the balance of income and spending within the household, corporate, government and foreign sectors of economic activity. When US households and corporations reduced spending and started generating large surpluses, the economy required deficit spending by government to avoid protracted recession. This turned on its head the old idea that government spending crowds out private spending by borrowing money that could be put to better use by business. With the central bank lending money for practically nothing and corporations failing to invest much of it anyway, Wolf argues that “the private-sector cutbacks crowded in the fiscal deficit.” He believes that if the government had followed the advice of conservatives and slashed the deficit, that would have caused an economic depression.

Nevertheless, world economic leaders became so concerned about fiscal deficits that they pledged to cut them in half at the Toronto Summit of 2010. In the US, ideological opposition to government intervention remained strong, heightened by Republican opposition to the Obama presidency:

In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance.

The crisis in the Eurozone

While the United States was starting to recover from the financial crisis, “the epicenter of the crisis moved inside the Eurozone, where it subsequently remained.” The contraction of credit exposed weaknesses in European national economies that had been masked by the adoption of a common currency.

When each nation has its own currency, the strength of that currency can reflect the competitiveness of its economy. Weak demand for its products on world markets will usually weaken demand for its currency, and the low buying power of its currency should keep it from buying more than it produces and trades. Investors from stronger economies can lend to weaker ones, but usually at high interest rates to reward lenders for taking more risk. The common European currency papered over these national differences and encouraged an excessive flow of goods and credit from the stronger economies, especially Germany, to the weaker economies of Southern Europe, such as Spain. The fiction that every euro was worth the same made it too easy for the Spanish, Greeks, Italians and others to borrow from German banks and buy German goods. The various economies appeared to be thriving together, but only until the end of the credit boom brought the game to an end.

The credit crunch put the poorer countries in the position of either defaulting on their debts or adopting austerity measures that threw their economies into recession:

Given their difficulty in borrowing and their lack of access to central-bank financing, the crisis-hit countries could not offset these deep recessions, indeed true depressions, with fiscal or monetary stimulus, at least without external support. That was not to be forthcoming on any significant scale. This was partly because Germany, supported by other creditor countries and the European Commission, argued that necessary structural reforms would not occur without remorseless economic pressure and, for that reason, regarded greater external support as counter-productive.

Wolf criticizes Germany for refusing to accept any responsibility for the crisis:

Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis. As Bagehot indicates, excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip. A country that chooses to run current-account surpluses, indeed, one that has built its economy around generating improved competitiveness and increased external surpluses, has to finance the counterpart deficits and must, accordingly, bear responsibility for the wastage of funds.

Wolf thinks it is misleading to blame the European economic crisis on government deficits in particular. What the troubled economies had in common before the crisis were not government deficits but balance-of-trade deficits, which were a consequence of policies in both creditor and debtor countries. After the crisis, private spending declined, but government deficits increased due to falling tax revenues and counter-recessionary spending. Fiscal austerity alone, without any other economic reforms, is a recipe for continued recession.

Emerging economies

Emerging economies in Asia and Latin America generally grew at a faster rate both before and after the financial crisis. Most of them managed to avoid credit booms that would leave them as heavily indebted as the United States or Southern European countries. On the contrary, some of them, especially China, ran large surpluses by exporting more than they imported and investing heavily in other countries. Although this has been a successful growth strategy in the short run, Wolf questions its sustainability. Again, if countries like Germany and China run surpluses, others must run deficits; and if too many countries embrace austerity at the same time, global output must fall. Like Michael Pettis, Wolf thinks it is silly to treat austerity and lending as moral goods, while treating spending and borrowing as moral evils. At the macroeconomic level, the problem is finding a balance, for example by having creditor countries increase domestic demand and debtor countries increase their exports.

My next post will deal with the global economic shifts to which Wolf attributes the financial crisis in the first place.

Continued