NDN Blog

Is This the Final Countdown to a Global Financial Calamity?

Ground zero of the European sovereign crisis has moved from Greece to Italy, and that’s very bad news for Europe, the United States, and most everywhere else. For a year, Angela Merkel and Nicholas Sarkozy have looked for some way to both prevent Greece from defaulting outright and reassure bond investors that Italy’s sovereign debt will remain sound. This week, the price that Italy pays to borrow money soared as global investors determined that holding Italian bonds is increasingly risky. The salacious Silvio Berlusconi is on his way out, but that won’t change the market’s judgment that Merkel and Sarkozy’s stratagems have failed. Europe now faces a real and present danger that major banks across Germany and France, along with Italy and Greece, could fail soon. Such a meltdown would take down the American expansion with it.

It’s still premature for a post mortem. But for the past year, domestic European politics, not international finance, has squeezed the acceptable options to solve the Eurozone’s metastasizing sovereign debt problems. Merkel and Sarkozy have long known that their countrymen and women would pick up pitchforks if their governments moved to bail out big banks a second time. If that wasn’t enough to inspire street demonstrations, the contemplated bailout this time would go to stabilize financial conditions in other countries. So Merkel and Sarkozy came up with a plan that appeared to spare French and German taxpayers. Unfortunately, it also couldn’t pass a laugh test by worldwide investors:  The plan has Eurozone financial stabilization board raising $1 trillion from those investors to back up Italy’s debt, with a pledge that Eurozone governments would guarantee the first 20 percent of any losses. Think about it: Italy, Greece, Ireland, and Portugal , all hanging by a thread or worse, would help the rest of the Eurozone cover the initial losses from bonds used to bail out Italy, Greece, Ireland and Portugal — and if things go south, probably Spain as well.

The $1 trillion commitment kept a meltdown at bay for a few days, much as the Bush Treasury’s commitment to spend $700 billion to bail out Wall Street staved off a market collapse after Lehman failed. The original Paulson plan also didn’t pass the laugh test, but no one doubted that the U.S. Government could raise the $700 billion. This time, the Eurozone’s $1 trillion commitment has bought them at most a few weeks of breathing space, as investors wait for Merkel and Sarkozy to come up with a real plan to raise it. But those investors already are eyeing the exits. Interbank lending to Europe’s biggest institutions dried up this week, just as it did here in the days before Lehman sank. And interest rates on Italian bonds are now so high that, according to the industry’s financial models, Rome will be unable to service its debt much longer.

All of this means that neither global investors nor European taxpayers are prepared to bail out the Eurozone. Even at this very late date, however, there are ways out of this mess:  Under the least bad of the options left, the European Central Bank (ECB) would become the Eurozone’s bond buyer of last resort.  The ECB could pay for them by printing enough Euros, for starters, to stabilize Italian bond markets. It wouldn’t be pretty. The Euro would weaken. European interest rates might edge up as Europe slowed. And the ECB would have to come up with another credible plan to withdraw the excess Euros once the crisis passed. But the alternative is much worse.

In a period of worst case scenarios, here’s what could well happen later this month. Start with the fact that Italy alone has $2 trillion in outstanding government debt. Most of those bonds are held by Italian, French and German banks, including the biggest banks in the world. Anything approaching an Italian default would wipe out the capital of those banks, leaving them insolvent; and most of the Eurozone economies would grind to a halt.

It gets worse, because a financial meltdown centered on sovereign debt is much more dangerous than one triggered by mortgage-backed securities. In effect, a sovereign debt crisis strips sovereigns of their ability to act to contain the crisis. With Italy and Greece in default, for example, who will believe those governments as they move to head off general bank runs by, say, guaranteeing money market balances as the United States did successfully in the days after Lehman?  And if the biggest banks in France and Germany go down, Sarkozy and Merkel wouldn’t have the credibility to do much about it either.

The bad news doesn’t end with Europe. Our own big financial institutions, along with those in Britain and Japan, have thousands of deals going that involve the major banks in Germany, France and Italy. Overnight, all of those deals become suspect, which could spread financial panic beyond the Eurozone. And remember the credit default swaps that destroyed AIG?  No one knows precisely how many of those “guarantees” are out today against Italian government bonds and the commercial paper of French, German and Italian banks. The fact that no one knows could be a big problem in itself, since that, too, could breed a broader financial panic. In any case, there’s little doubt that those credit default swaps involve, at a minimum, hundreds of billions of dollars, Euros and pounds. That would leave American, European and Japanese financial institutions on the hook for those losses. And if they can’t make good on them, they could go down as well. Their only hope would be another bailout — if Congress could approve one before the Tea Party and Occupy Wall Street folks pick up their pitchforks.

All this is not yet inevitable. But much of it might well unfold, and probably in a matter of weeks, unless the Eurozone’s leaders face the grim music and finally find their way to a real program to head it off.

The Economic Appeal of the Occupy Wall Street Movement to Middle-Class Americans

Seemingly out of nowhere, economic inequality is no longer the political issue that dares not speak its name. Since the days of Ronald Reagan, politicians who talk about reducing disparities in incomes or wealth have been promptly charged with “class warfare.” The stunning success of the Occupy Wall Street movement in attracting adherents and sympathizers could change that, at least for the current political season. What lies behind the movement’s surprising middle-class appeal, however, isn’t high unemployment or slow economic growth. The real reason is that the 2008 meltdown and its economic aftermath have cut the wealth of millions of average Americans by up to half — and Washington has been unwilling to do anything about it.

There is little controversy among economists that the fabled U.S. land of opportunity has become one of the world’s most unequal societies. Using the standard measure (the “Gini Coefficient”), America now ranks 93rd in the world in terms of economic equality. That puts us behind places like Iran, Russia and China. The poverty in those places is much worse, but the concentration of wealth is much greater here. According to the Federal Reserve, the top 1 percent of us in 2007 owned nearly 35 percent of everything of value, net of debt — that includes savings, stocks and bonds, real estate, art, furniture, clothing, on and on. Perhaps more important, the top 20 percent of Americans owned 85 percent of the country’s net wealth.

Yet, such striking inequality still cannot explain the appeal of Occupy Wall Streeters — I’ll call it the OWS movement — because comparable disparities of wealth have been around for a generation. Go back to 1983, and the top 1 percent of Americans owned 34 percent of the country, and the top 20 percent claimed 82 percent.

The answer here lies in the particular way that the financial and housing meltdown has affected middle-class families. Consider the following: While the bottom 80 percent held only 15 percent of the nation’s wealth in 2007, most of it was tied up in the value of their homes. We know that, because when we break down that 15 percent figure, we find that the bottom 80 percent held just 7 percent of all financial assets in 2007 but 40 percent of all residential real estate assets. And the housing boom topped out in 2007.

The reason the OWS movement resonates so broadly today lies in the subsequent loss of so much housing wealth.  The 2008 meltdown and its aftermath have driven down the value of residential real estate by about 35 percent. And that 35 percent included most or all of the equity that millions of middle class families had in their homes in 2007.  America already was a place where 80 percent of the people held only 15 percent of the country’s wealth. Now, do the math. About half of that wealth was in financial assets like savings and pensions (the Fed’s 7 percent figure), and the rest was in home equity. So, since 2007, the bottom 80 percent of Americans have lost up to half of their net wealth.

Those losses also aren’t distributed evenly:  Households in their 30’s and 40’s, for example, usually have almost everything they own tied up in their home equity, and which typically adds up to less than one-third of their homes’ value.  They’ve been wiped out, wealth-wise.  Older households, on average, have larger home equity, so they still have some modest increment of wealth. But if they’re approaching retirement or already retired, there’s also little they can ever do to make up their losses.

When middle-class Americans turn to Washington, they see the resounding success of the government’s efforts to stabilize the financial markets – where the top 1 percent derive most of their wealth. The rich are back to becoming even richer. That’s the way America has operated for at least the last generation. What grates on middle-class Americans this time is that they’ve been getting poorer. And Washington has done little to stabilize the market from which they derive most of their wealth, which is housing.

To be fair, President Obama can claim a little credit here, since he has proposed a series of initiatives to support housing, mainly by giving banks incentives to refinance more mortgages at favorable terms.  But the largest force driving down housing prices and wiping out middle-class home equity is sky-high home foreclosure rates.  The President hasn’t yet taken on those foreclosures, but he still has time to champion a new initiative.  For instance, he could call for temporary loans for families whose mortgages are in trouble, financed through lending by the Federal Home Loan Banks.

Mitt Romney, Obama’s most likely challenger, can’t call for anything.  Last week, Romney went to the state with the highest foreclosure rate in the country, Nevada, and made what may turn out to be a very costly mistake.  Embracing GOP dogma that “the right course is to let markets work,” he declared that Washington should let the foreclosure process “run its course and hit the bottom.”

Yet, this is the very process now hollowing out a good-sized slice of the American middle class.  Given Romney’s position, the issue provides a new opportunity for the Obama campaign.  Much more important, however, the problem itself presents a critical challenge for economic policy makers. If they and the next President ignore it, inequality in America almost certainly will enter a very nasty, new phase.

Can Europe Save Itself - and Avoid Pulling Down the U.S. Recovery?

At last weekend’s IMF / World Bank annual meetings in Washington, the question on everyone’s minds was, what’s happened to Europe’s instinct for economic survival?  While our Congress squabbles over bookkeeping for disaster assistance, the talk in the corridors of the IMF was that Europe is two to three weeks away from financial meltdown.  It would start in the sinking market for Greek government debt, followed by turmoil in much-bigger markets for the public debt of Italy and Spain, as well as Portugal and Ireland.   And if Europe’s leaders can’t head that off, it will likely take down most of Europe’s large banks.  Angela Merkel, Nicholas Sarkozy and their counterparts across Europe get this.  What they don’t want to face is that the only solutions ultimately lead to a radical rewriting of postwar social contracts across the Eurozone.  

The financial carnage wouldn’t stop at the continent’s shores.   British banks have large holdings of Spanish, Italian and Irish government bonds, so they would be very vulnerable.   Our own banks sold most of their portfolios of European government bonds over the last year.  But U.S. officials worry privately that U.S. banks are holding unknown billions of dollars of credit-default swaps against both those bonds and the European banks that hold them.  That puts them in a position that recalls AIG in late August 2008, as insurance providers for a catastrophe that now lies somewhere between the possible and the likely.  Finally, a meltdown of European finance would mean horrendous recessions across Europe and an end to our own recovery.

The sober minded men and women at the IMF aren’t given to nightmare scenarios.  They believe in data, and it’s the analysis of those data that now points to impending crisis.   Over the last six months, for example, the shares of the largest banks of Greece, Italy, Spain and France have sunk 30 percent to 50 percent.  Even scarier, the costs to insure against the failure of those banks reached the same levels last week as they did here for Lehman Brothers a few weeks before its collapse.  And the costs to insure against the complete default of Greek, Italian and Spanish government debt – financial Armageddon -- have risen 60 percent to 80 percent.

For months, financial analysts and global investors have tracked the perfect storm now taking shape across the Eurozone.  But unlike the weather, European leaders know how to head off much of it and to contain most of the rest.  Yet, like Henry Paulson’s Treasury throughout much of 2008, Germany’s Merkel and France’s Sarkozy have spent the six months trying to ignore the undeniable.  The bottom line this time: Monetary unions across states or countries, like the Eurozone, work only when the full faith and credit of the whole stands behind the full faith and credit of each part.  

The classic example of a successful monetary union was the United States in the late 1700’s.  Under the Articles of Confederation, the southern states paid off their revolutionary debts, and their credit was sound – think of them as Germany, the Netherlands, and Northern Europe today.  But profligate Massachusetts, Connecticut and most of the rest of the north let their debts, both old and new, just pile up – they were the Greece, Italy, Spain, Ireland and Portugal of their day.  Resolving these debts hung up approval of the new U.S. Constitution, so the framers created a Bank of the United States which assumed the debts of the northern states.  In return, by the way, the credit-worthy southern states got to take the national capital away from New York and relocate it in a swampy track on the border of Virginia.  

A similar task now faces Merkel, Sarkozy and the Dutch and Finnish members of the Eurozone –- in effect, pledge their own good credit to guarantee the same for the Eurozone’s profligate southern countries.   So far, they’ve thrown a lot of money at Greece, hoping it would satisfy global investors.  We now know that hasn’t worked, and that much harder adjustments lay ahead. 

In fact, Europe’s crisis is even more serious than our own in 2008.  To begin, Europe’s banks hold the failing sovereign debts of the southern Eurozone countries as well as toxic assets left over from 2008.  Moreover, no one doubted the U.S. Government’s capacity to step in and bail out our banks and provide massive stimulus for an economy spiraling downward.  This time, it’s sovereign debt itself that’s under attack, so that option isn’t available for Greece, Spain, Italy, Portugal, or even France.   Washington also could head off bank runs when Lehman, AIG and Merrill Lynch collapsed, by guaranteeing everyone’s money market balances.  None of the Eurozone countries in such deep trouble today would have the credibility to take such a step.  So, if everything begins to unravel, there’s very little they can do to save their banking systems.  And such a banking crisis will hit Germany as well, since its private banks also hold many tens of billions of Euros in Greek, Spanish and Italian debt.  

There are still a few precious weeks left to head off this Euro-catastrophe.  The Eurozone’s rescue fund so far has focused on delaying Greece’s default.  In the next two weeks, it will have to, at once, inject capital into unknown numbers of large banks and buy massive amounts of Greek, Spanish, Italian and Portuguese debt on the open market.  The politics of pulling that off are daunting, because it will require the unanimous support of 17 Eurozone governments.  So far, only six have agreed, and they’re mainly the ones that would be rescued.  Of the others, Finland, for one, has put up impossible demands that will have to be dialed back.  And while Merkel now says she’s prepared to do what she said a month ago she’d never do, it’s unclear if her own party will go along in a vote scheduled for later this week.  

One reason for their opposition is that most of the bill will fall to Germany and the five other Eurozone countries that still have sound credit.  There are ways to stretch the bail-out capital, however.  The European Central Bank could underwrite it – it still says no to that -- or the rescue mechanism could guarantee losses of up to 20 percent on sovereign bonds.  But such moves are immensely complicated matters to work out in just a few weeks, especially when everything requires the unanimous consent of the Eurozone governments.  When Henry Paulson had to come up with a bailout plan quickly as Wall Street melted down, he managed to pull together three pages of general principles saying the Treasury could whatever it wanted.  That won’t wash this time.  

The second reason will be even harder to handle.  If the Eurozone can find its way to guaranteeing the sovereign debts of all of its members, their future debts will have to be centrally and uniformly constrained.  In short, the solution to the crisis could spell the end of each government’s autonomous right to conduct its own spending and tax policies, since that’s what generates sovereign debt.   That would require fundamental revisions of the long-time social contracts these governments have with their peoples, including provision for the world’s most extensive public pensions and health care coverage.   That’s the real reason Merkel, Sarkozy and the rest have spent so long denying the emerging crisis.  The next two to three weeks will tell whether they have the courage and vision to finally address it. 

Why The President’s New Economic Plan Is A Good One

I released the following statement today on the President's new economic plan:

"The President has offered a plan suited to both the short-term challenges arising from our current economic conditions and the long-term challenges coming from rising global competition.    

He begins in the right place, with a package of policies seen by most economists as particularly well-suited to jumpstart job creation and support stronger growth.   He also has presented a fiscal plan to help sustain that strong growth, by reigning in long-term deficits while enhancing strategic investments.  The administration’s long-term deficit plan would further trim domestic spending, including defense, wind down our wartime spending in Iraq and Afghanistan, raise additional revenue from high-income Americans, and reduce the unnecessary and least necessary areas of spending for Medicare and Medicaid.  In this way, the administration relies on all of the same sources for deficit savings as the Simpson-Bowles Commission, the Senate “Gang of Six,” and the deficit-reduction programs carried out under both Bill Clinton and Ronald Reagan.  

Finally, the President preserves those public investments which undergird strong growth and U.S. competitiveness, especially in basic research and development, education and training for American workers, and basic infrastructure that all businesses and workers depend on.  This package deserves the support of the country and the Congress. "

Protectionism Remains a Danger to Economic Recovery

Tough times almost always raise the pressure for trade protection, and the current global economic troubles are no exception.  President Obama has generally resisted this impulse, asking Congress to approve new free-trade agreements with Colombia, Panama, and South Korea.  Still, Congress has yet to act. And here and around the world, new duties or other restrictions have been applied on a range of imports. More broadly, protectionist demands from India, Brazil and other large developing nations have stalled the completion of the Doha multilateral trade round.   Even so, a renewed commitment by Congress and the Administration to expand trade may be the best way currently available to help support a faltering U.S. recovery. 

Such a push will have to confront the strong temptation in times like these to turn to measures which would reduce trade, most notably anti-dumping and countervailing duties against imports from developing countries.  The futility of this approach has been demonstrated time after time, perhaps most recently in the decision by the International Trade Commission (ITC) to slap anti-dumping and anti-subsidy duties on imports of coated paper products from China and Indonesia.  I won’t argue about whether or not that decision was consistent with U.S. law.  My focus is entirely on whether or not it will help or harm American consumers, paper companies and their employees.  So I conducted a case study to find out:  The conclusion is, those duties harm American consumers without providing any assistance to American paper companies and their workers.

This issue is especially timely since September 21 of this year is the one-year anniversary of the Department of Commerce decision to impose the new antidumping and countervailing duties on coated paper imports from China and Indonesia.  The ITC reaffirmed the duties last October with the final vote in November 2010.

The case began in September 2009, when three large U.S. paper companies and the United Steel Workers, which represents 6,000 of their employees, filed for relief from the ITC under the anti-dumping and countervailing duty laws.  They won their case: The ITC imposed duties of between about 8 percent and 135 percent on coated-paper imports from China and duties of 18 percent to 20 percent on imports of those products from Indonesia.  These duties, of course, raise the prices for those imports here, wiping out most or all of the difference between the prices that Americans businesses and consumers paid for those imports and the prices they paid for coated-paper products made here.  And without that price competition, the result is higher prices not only for the imports, but also for U.S. and European paper products.  

This makes no economic sense:  At a time when overall demand by American consumers and businesses is flagging, forcing them to pay more for these products only leaves less for them to spend on everything else.  

Nor are there benefits for our own paper producers and workers to offset these higher costs.  The reason lies in the fact that our producers compete with Indonesian and Chinese paper makers not only here, but around the world.  So, as the new duties contract their share of the U.S. market, the Indonesian and Chinese paper producers have more product to sell in third-country markets.  We found that this increase in the available supply of these products will drive down the prices of Chinese and Indonesian coated paper in those countries between 7 percent and nearly 19 percent.  The predictable effect is that their market share in those countries will increase at the expense of American producers.   That’s how global markets work.  

In addition, our new duties may trigger retaliation by China and Indonesia, targeting U.S. exports of the same products to their own markets.  That’s precisely what happened in other cases of U.S. antidumping and anti-subsidy duties.  Since China is the third largest market for U.S. coated paper products, such retaliation could further harm our own producers.

The irony is that coated paper is an example of an unusually well-functioning market.  From 2007 to 2009, when this particular case was filed, coated-paper imports to the United States had actually contracted by more than 30 percent.  Imports from China and Indonesia had increased, but imports from European countries had declined even more, so the domestic market share of American producers had increased from 61 percent to 66 percent.  In addition, the prices paid for these products by American consumers and businesses had fallen by between 2 percent and 6 percent.   This was not a market than needed to be “fixed” by new duties.

Further, the U.S. market for these products was segmented quite efficiently.  An ITC survey had found that business customers for these products judged American, Chinese and Indonesian products comparable in terms of quality, product consistency, packaging, discounts, and credit terms.  Business customers also found Chinese and Indonesian products superior for their lower prices. The survey also reported that American customers preferred the American-made products for the range and availability of product, reliability of supply, delivery terms and delivery time, and technical support.   Various advantages and disadvantages, then, produced a market in which buyers choose based on what is most important to them.  

The emergence of China and Indonesia as major paper producers also has followed a very powerful and natural dynamic in the global paper industry; namely, that paper production follows paper consumption.  In nearly all cases, a country’s capacity to produce paper products has expanded or contracted with its share of worldwide consumption of the products.  For example, as the U.S. share of worldwide consumption of paper products fell from 41 percent in 1970 to 19.4 percent in 2009, our share of worldwide production of the same products fell from 40 percent to 20.5 percent.   Similarly, China and Indonesia’s combined share of worldwide consumption of paper products went from just over 2 percent in 1970 to 25.3 percent in 2009.  Over the same years, their combined share of worldwide production of those products rose from just under 2 percent to 25.6 percent.

It is also only natural that companies like to see their competitors hobbled.  Laws and regulations in the United States, as in most other countries, still contain hundreds of instances in which a special burden is imposed on certain companies or a special benefit is conferred on other companies, all to the detriment of their rivals.  Consumers almost never win from such special grants.  And as this case study shows, when the special burdens involve protectionism targeted to an industry’s foreign rivals, the American firms and workers that called for the protection also lose in the end.

A New Report on Contribution of ICT To Economic Growth

I am excited to be releasing a new report today on the role and impact of information and communications technologies (“ICT”) in the American economy, and evaluates the likely effects of several current policy proposals and choices that involve ICT. This study includes both the reviews of the existing literature in this area as well as new analysis of the economic impact of ICT. Our critical findings include the following:

• In 2009, ICT firms contributed about $1 trillion to U.S. GDP, or 7.1 percent of GDP. This total includes nearly $600 billion in direct contributions from their own operations and more than $400 billion in indirect contributions through the benefits other sectors derived from the use of ICT.

• ICT companies accounted for 3,535,000 jobs in 2009. While total ICT employment declined since 2000, average compensation has risen sharply. In 2009, the compensation of full-time ICT employees averaged $107,229, 80.6 percent higher than the average for all full-time workers. From 1991 to 2009, average compensation in the ICT industry increased 162 percent, the fastest income gains of any U.S. industry.

• From 1991 to the present, ICT firms have contributed directly an average of $577 billion per-year in value-added to America’s GDP. These direct contributions were equivalent to nearly one-third of the value-added provided by all manufacturing.

• According to an analysis by Federal Reserve economists, the use of ICT accounted for 28 percent of all U.S. productivity gains from 1995 to 2001, capital investments in those technologies explain another 34 percent of those gains, and changes in the organization of firms and worker training in response to ICT innovations accounted for another 10 percent of productivity gains.

• From 1991 to 2009, full-time ICT workers experienced larger wage and compensation gains than workers in any other sector, and the average compensation of ICT workers in 2009 was more than 80 percent higher than the average for all other private-sector workers.

• ICT’s direct contributions to GDP have increased nearly 25 percent since the 1990s, growing from 3.4 percent of GDP per-year in 1991-1993 to an average of 4.2 percent per-year over the years 2005-2009 – gains unmatched by any other industry.

And of course there is much more.  To see the whole study go to http://www.sonecon.com/docs/studies/Report_on_ICT_and_Innovation-Shapiro-Mathur-September8-2011-1.pdf.  And feel free to let us know what you think. 

Grading Obama and the GOP Hopefuls on their Plans for Jobs and the Economy

Last week’s GOP debate at the Reagan Library, followed the next night by the President’s address to Congress, throw into stark relief the strengths and weaknesses of each side’s understanding of job creation and the economy. The Republican hopefuls get a gentleman’s C on the impact of regulation on economic activity. But their approaches to the overall economy and job creation ranged from silly to dangerous, and earn them all F’s. The President has to produce results, and his ideas aren’t constrained by primary challengers. This may help explain why his approaches are broader and more thoughtful, earning him a solid B on the overall economy and an A-minus on job creation.

All of the Republican hopefuls — the two leaders Rick Perry and Mitt Romney, the so-serious minded Jon Huntsman and Ron Paul, and the media-infatuated Michelle Bachmann and the rest — agree on one economic prescription: Apply deep and immediate budget cuts to an economy generating little growth and no jobs. This common position not only defies the basic dynamics of supply and demand in a slow economy. It also rejects the policies of the last five GOP presidents. After all, it was true-blue conservatives Ronald Reagan and George W. Bush who justified big spending increases for defense and big tax cuts to boost the flagging economies of their own times.   

Nor are the Republican wanna-be’s chastened by the current examples of Germany, France and Britain, which all embarked on austerity programs this year while the European Central Bank (ECB) raised EU interest rates. The results have been even more anemic growth than our own. In fact, the two GOP frontrunners along with the inimitable Mr. Paul not only demanded deep spending cuts, but also sided with the ECB by denouncing Fed chairman Ben Bernanke as an inflationist. The markets they all claim to worship don’t see it that way, since our long-term interest rates remain near record lows. For their determined contempt of elementary macroeconomics, all of the GOP putative presidents flunk.

The current President at least appreciates that this economy needs a boost, not more headwinds. His package adds $450 billion over 12 months, in theory adding new demand equal to 3 percentage points of GDP.  In practice, it would work out to be less than that, since people will save some of the money they gain from lower payroll taxes, and some of the tax cuts for businesses won’t be taken up.  The administration also gets credit for recognizing that the sick housing market is a critical piece of the puzzle behind the slow economy. Their answer, however, missed a basic point: Mr. Obama called for expediting Fannie Mae refinancings to put more money in the pockets of some homeowners. That’s all for the good, but it won’t affect the more economically consequential, high foreclosure rates that have been pushing down housing values, and so dampening people’s willingness to spend.  On balance, give the President’s economic team a solid B on the overall economy.

Both sides also call for tax cuts to spur job creation. All of the GOP candidates, however, focus on cutting corporate taxes. Now, most economists agree that the corporate tax cries out for reforms, especially a lower marginal rate tied to ending distorting tax breaks for favored industries.  But no reputable economist who doesn’t aspire to a top position in the next GOP administration has found that those reforms would have noticeable effects on jobs in any short or medium-term. And with large U.S. businesses already holding some $1 trillion in banked profits, by what other economic logic would additional tax cuts move them to create jobs?

The only route from this GOP position to new jobs depends on lower corporate taxes translating into higher dividends, mainly for the very affluent, which they would then spend and so boost demand. Even so, much of those additional dividends probably would be saved, which wouldn’t create any jobs under today’s conditions. Moreover, the GOP hopefuls also insist on spending cuts to offset lower corporate tax revenues — and that would mean job losses. For their resolute ignorance of labor economics and public finance, these hopefuls score another F.

President Obama’s tax plan is both more detailed and better targeted to creating jobs. First, he would reduce the cost to businesses of creating new jobs and maintaining their current workers. To do this, he would temporarily suspend the employer side of the payroll tax for new hires by firms with about 1,000 employees or less, and temporarily cut by half all employer-side payroll taxes for firms with about 100 workers or less. This strategy is eminently sensible — and downright brilliant compared to the broad corporate tax cut championed by the Republican hopefuls. Full disclosure: I’ve urged the administration to propose cutting the employer side of the payroll tax for new hires since October 2009, including a dozen times in these blog essays.

The administration’s decision to limit these new tax incentives to small and medium-size companies is less than ideal, since big businesses employ nearly half of all U.S. workers. On the other hand, big businesses are sitting on hundreds of billions of dollars in banked profits, so they clearly have the means to hire more workers. On balance, these proposals deserve an A-minus.

The same score goes to the President’s call for more job-related, direct federal spending. This includes new funds for the states to prevent more layoffs of teachers, police and firefighters; new support for school construction; and additional investments in infrastructure (through a National Infrastructure Bank).  The jobs benefits from other parts of the plan may be more problematic, including the President’s otherwise sensible support for expanded access to high-speed wireless and public-private partnerships to rehab homes and businesses. There’s also little direct jobs benefit in the administration’s laudable plans to reform the unemployment insurance system and bar employers from discriminating in hiring against long-term jobless people. All told, another A-minus.

The Republican hopefuls still have time to develop better strategies for growth and jobs, especially compared to their current dismal positions. They’ll have to play catch-up, however, because President Obama has proposed a sound new jobs agenda. And if congressional Republicans refuse to work with him on it, the President can ensure that the public will know whom to blame.

For a Strong Economy, Keep Europe Afloat and Keep Americans in Their Homes

The persistent sluggishness of the recovery here in the United States and in most of the world’s advanced economies should underscore a stark lesson from economic history: Systemic financial crises are the products of deep economic problems, and they can’t be solved by simply treating the after-effects of slow growth. It’s long overdue that the United States and Europe directly address the deep market distortions that brought about the crisis of 2008 and 2009.

So far, all we’ve done is substitute large doses of fiscal and monetary stimulus for the hard work.  That pulled us back from the brink of a Depression. We also shouldn’t have been surprised that once the stimulus played out, the same distortions reasserted themselves. We may technically be experiencing a recovery. But unless we’re more forthright in our interventions into both the housing and financial markets — on both the international and domestic stage — we’ll remain exposed to the possibility of a renewed crisis, one even more severe than the one that began three years ago.

These considerations don’t drive policy, in part because so many economists still see the crisis as an anomaly, one that will be followed in due course by markets reasserting their natural optimality. This view, of course, ignores or slights the overwhelming evidence of how inefficiently and “sub-optimally” the financial and housing markets have performed for years. U.S. and European financial markets have systematically failed to reasonably price the risks of trillions of dollars of derivative securities; housing markets here and across much of Europe have sustained a classic speculative bubble and equally classic crash. 

Our current predicament has as much to do with our own lame responses to the consequent crisis, as it does with the original crisis itself. Washington provided bailouts and virtually-free credit for financial institutions without applying requirements as to how that new-found money ought to be used. There also were new housing initiatives, but based on a fanciful view that a little federal money would be enough to convince bankers to extend new credit to people already on the brink of default. Finally, there was a substantial fiscal stimulus — a good and necessary move — but one cobbled together from the wish lists of hundreds of members of Congress.

The results are now clear in the data. Financial institutions amassed trillions of dollars without expanding business lending, mainly because the financial-market distortions that brought on the crisis are still with us. These institutions are still holding trillions of dollars in wobbly asset-based securities, whose risks even now they cannot reasonably price. So they sit on most of their new capital (after paying out their bonuses), in hopes of avoiding another bout of bankruptcy from those assets, should another crisis erupt. Yet, the prospect of new legislation to sustainably resolve those weak assets by pulling them off the books — as Sweden did in its early-1990s banking crisis, and we did in the S&L crisis of 1989-1990 — is nonexistent.

The prospect of another imminent crisis on the horizon ought to put the necessary policies into relief. One initiative that cannot wait: President Obama should call an emergency G-8 meeting to help head off a new financial meltdown in Europe. The sobering fact is that many of Europe’s largest banks are nearly insolvent. It’s a legacy from not only the 2008 – 2009 meltdown, but also the EU’s decision in 2007 to reduce bank capital requirements under the level set by the “Basel 2” accords. Americans benefited from the fact that our own banking regulators dawdled in making similar changes desired by the Bush administration, by which time even the Bush Treasury had doubts about cutting capital requirements. The result today is that the German and French banking systems in particular are in much worse shape than Wall Street.

Now these weak banks face additional, large-scale losses from the falling values of Italian and Spanish government bonds, a contagion from the now-anticipated defaults of Greek and Portuguese public sovereign debt.  If this turmoil intensifies, it will probably pull down some of Europe’s largest banks. And if institutions such as BNP Paribas and Deutsche Bank (the world’s two largest banks) fail, the U.S. and global economies would probably follow. Moreover, this time, the consequences would be even more dire than in 2008 – 2009, since governments have already exhausted their fiscal and monetary policy options.

We can still head off a 1931 scenario if Germany and France will accept the inevitable and obvious: A common Euro currency requires that every member pledge its full faith and credit for Eurobonds to support the full faith and credit of everybody else. Otherwise, the failure of a small member (today, Greece and/or Portugal) can destroy confidence in the economic sustainability of much larger members (Italy and Spain). And then, everybody’s goose is cooked.

The political catch is that the solution puts French and German taxpayers on the hook to bail out fiscally-inept Greece and Portugal. Chancellor Merkel and President Sarkozy have tried to avoid the political blowback from introducing Eurobonds by trotting out smaller options. It is a decision that hearkens to the Bush administration’s misguided attempts to avoid bailing out Lehman Brothers. Investors aren’t buying it. So if Greece goes down now, Sarkozy and Merkel will be forced to rescue Italy and Spain — and perhaps France itself — at incalculably greater cost to everyone.

President Obama should not delay to call for a G8 meeting: Europe needs to hear that the United States considers its current course unacceptable, and that Washington would be ready to help fund IMF support for a broader solution that can head off another full-blown crisis.

If we intervene to put Europe back on course and avoid a replay of 1931, we still will be facing the prospect of a persistently slow economy. Preventing that kind of long-term stagnation would require that we finally address the distortions in the housing market by stabilizing housing prices. Policymakers’ most promising avenue to that end would be to focus on bringing down foreclosure rates and keeping American families in their homes.

There is no doubt that housing prices are central to our current growth dilemma. People spend freely when their incomes are rising or their wealth is increasing. During the last expansion and leading up to the current crisis, the incomes of most Americans stagnated. Instead, growth and business investment were driven mainly by the “wealth effect” created by fast-rising housing values. Now, the economy is caught in the flip-side, as four years of sliding housing prices drive a powerful negative wealth effect that continues to hold down consumption.

The broad reach of these effects reflects how wealth is now distributed in the United States: According to Fed data for 2007, the bottom 80 percent of American households held 40 percent of the value of all real estate assets, compared to a miserable seven percent of the total value of all financial assets (and yes, that includes pensions). Home equity, in short, is very nearly the only real asset for more than half of all Americans. The decision to allow housing values to fall for four straight years—in contrast to the equity and bonds of large financial institutions—leaves the majority of American consumers growing poorer month after month. Just as people who grow richer spend more, people who find themselves poorer spend less. So, consumer demand and with it business investment will not recover until housing values stabilize.

To help make that happen, policymakers could establish a temporary loan program for homeowners whose mortgages are in trouble, to help bring down foreclosure rates and so begin to stabilize housing prices and stem the negative wealth effect. The program should not be a giveaway; if it were, it would create enormous moral hazard and enrage everyone who works hard to keep up their own mortgages. So, the loans would carry an interest rate above current 30-year mortgage rates, and those who take advantage of them would have to turn back to taxpayers a share of any capital gains earned later from selling their homes.

It’s very important that we get this right. Unfortunately, the signs from Washington right now aren’t promising. The Obama administration reportedly is considering a program to promote large-scale mortgage refinancings at the current, low fixed rates. If it worked, lower mortgage payments could free up an estimated $85 billion for consumers. But since those whose mortgages are in trouble probably wouldn’t qualify, the refinancing program would inject a little stimulus without affecting housing values. That means it would leave intact the current, negative wealth effect.

We don’t have time to wait for the markets to begin operating rationally again. The economy will only right itself when housing values stabilize and distortions in Wall Street’s and Europe’s financial systems have been addressed. We will need to intervene on both domestic and international fronts, to restore consumer demand and business investment — and with them, President Obama’s prospects for reelection.

The Best Advice for the President: Think Big and Move On

In good times, a President without clear economic policies may not suffer for it.   But in shaky and uncertain times like today, failing to advance a coherent strategy to ease people’s genuine economic troubles can be fatal politically, for a president or his opponent.  Yet, it happens with some regularity, often because the candidate simply prefers to talk about foreign policy or other things.  Consider the first George Bush in 1992, dismissing people’s economic worries to return again and again to his Gulf War success.  Think of John McCain in 2008, with no plan to stem the financial meltdown but eager to talk about his opponent’s character failings.  And reaching further back, there was George McGovern decrying the Viet Nam War, but with little to say about the inflation and slow growth.  

Both parties will certainly have economic programs for 2012.  Yet, both parties are in danger of passing lightly over the core issues of jobs, housing values, and incomes.  The problem for the Republican nominee is the Tea Party, which may well force him or her to embrace its’ radical bromides.  That assumes, of course, that the GOP doesn’t nominate Rick Perry or Michelle Bachman, who won’t need to be convinced.   Whoever the nominee is, he or she will have to stand for abolishing the minimum wage.  On the budget, the nominee will have to support moving Medicare towards vouchers with spending caps that don’t take account of health care costs, and a balanced budget amendment that won’t take account of recessions.  The nominee also will have to stand for the repeal of Wall Street regulation and more tax cuts to frost the cake of the rich.  

This prospect presents President Obama with two choices.  He can run against the Tea Party platform and insist that a minimalist approach is preferable to the other side’s eccentric agenda.  One catch is that the GOP nominee almost certainly will have a “Sister Souljah” moment when he ostentatiously distances himself from some loony piece of the Tea Party platform.  (My personal favorite is the call to abolish our “fiat” currency and revive the long, well-buried gold standard.)  And if the GOP nominee can weave a story about how a balanced budget and less government will help create jobs and restore housing values, and repeat that story often enough, it could be sufficient to trump Democratic minimalism. 

But the President has another choice.  He can offer up a new program of “Big Ideas” that directly takes on jobs, stagnating incomes, housing values, and the nation’s debt.  The conventional wisdom is that this is too risky, because it would tacitly acknowledge that his first-term program didn’t deliver the prosperity his economic team promised.  But since everyone in the country is already aware that it didn’t deliver as promised, acknowledging it would be a small concession.  

To be sure, the Tea Party-dominated House probably wouldn’t pass anything that Obama proposes before the election.  The economy will get a little more support from the Fed, but essentially will be on its own.  Nevertheless, the President can lay a foundation for stronger job and income gains in a second term – if he’s reelected – by campaigning for a new economic program.

With persistent, high unemployment, he needs to show that he knows how to reduce the costs for businesses to create new jobs and preserve old ones.  One direct way to do that would be to cut the employer side of the payroll tax by half, and then he could propose to pay for it through tax reforms that include a carbon-based tax to help address climate change.  He also can show that he knows how to help create new, small businesses which, in turn, will create new jobs.  Since our major financial institutions have largely stopped providing credit to small entrepreneurs, he could propose a new government-sponsored enterprise that could float bonds for community banks to finance those business loans. 

The biggest obstacle to a stronger recovery remains the sick housing market.  Nearly two-thirds of American households, in effect, grow poorer every month as the values of their homes decline and, with it, any equity they built up.   And people who feel they’re becoming poorer don’t spend, which in turn keeps this recovery anemic.  The best leverage we have to stop the decline in housing prices is to bring down home foreclosure rates.  The President can show he knows how to do that too, by proposing a new temporary loan program for homeowners with mortgages in trouble.  To be sure, this is treacherous territory, politically and economically, since it could enrage homeowners who don’t qualify and induce moral hazard for those who do.  But the President can address both problems with some tough love.  Homeowners who receive the loans would be on the hook not only to pay them back.  On top of that, 10 percent of any capital gains from an eventual home sale could go back to the taxpayers. 

Finally, the President can show that he knows how to help Americans prepare for the new jobs that the rest of his program would help create.  Nearly half of all working people age 35 and over today still have only the most rudimentary computer skills, leaving them unprepared to perform well in most 21st century jobs.  The President could propose a new grant program for community colleges that will keep their computer labs open and staffed in the evenings and on weekends: Any adult would be able to walk in and receive IT training at no personal cost.  

This program won’t assuage the Tea Party’s followers – in fact, it will likely incense them.  Let’s hope so.  The President should welcome a debate – okay, a pitched battle -- over a genuine and understandable strategy to improve the lives of Americans.  Even if unemployment is still well over 8 percent, a serious plan to bring it down should trump the grab bag of far-right nostrums that passes for policy in the Tea Party. 

This Week's Debt Deal Is George W. Bush's Revenge – But It Won't Last

There is plenty of blame to go around for the recent debt and deficit shenanigans, but who should get the credit? I nominate George W. Bush.  Not only did his administration’s negligence secure the foundations for the financial upheavals which ultimately created much of the short-term deficit.  The role of his tax cuts in driving much of the medium term deficits is also certainly well-known.  But the last month’s budget warfare also highlights the significance of his distinctive innovation in fiscal policy:  Unlike FDR and LBJ, W established a major new entitlement – Medicare Part D prescription drug benefits for seniors – without a revenue stream to pay for it.  This unhappy innovation also helped shape the austerity plan the President signed this week.

Consider the following.  The only certain budget cuts in the deal are $915 billion in discretionary program reductions over ten years.  In fact, those cuts very nearly match the $815 billion in unfunded costs for Medicare Part D over the same period.  And Bush’s dogged resistance to paying for those benefits has now revealed the priorities of those in both parties who think we do have to pay for them.  Since those priorities dictate no new revenues for Republicans and no cuts in Part D benefits for Democrats, that leaves only the large-scale cuts in discretionary programs in this week’s deal.

But this also creates a quandary that is certain to become very prominent, very soon.   The plan says clearly that avoiding entitlements and taxes trumps everything else in the budget.  Yet, the arithmetic, both budgetary and political, says that Congress and the President cannot deal with the long-term deficits and debt without venturing deeply into both areas. So far, the Tea Party’s acolytes in both houses have vetoed any new revenues, which in turn has locked in the progressives’ veto on entitlement changes.  Yet, this week’s deal also sets up a choice down the road that will very likely isolate the Tea Party’s denizens in Congress.

The President and Harry Reid in the Senate have already vowed that unless revenues are part of the next, $1.5 trillion tranche of fiscal changes, they’re prepared to let across-the-board cuts go forward – and blame the other side.   And when that tranche of deficit reductions comes due, the Tea Party won’t have the leverage of an expiring debt limit.  Instead, progressives will have more leverage, because the across-the-board cuts would slice through the fat at the Pentagon and well into the muscle.  If history is any guide, conservative Republicans hate deep cuts in defense spending even more than they abhor tax increases.

George W. Bush never had to choose between defense and taxes, because Bill Clinton left a big budget surplus to spend.   When it ran out, W. opted for his legacy of large, structural deficits.  Ronald Reagan started out the same way, but the deep recession of 1981-1982 brought on his big deficits quickly.  And when that happened, Reagan opted repeatedly for new revenues to protect his defense spending.   Today’s Tea Party Republicans are no Reaganites:  As John Boehner discovered when he tried to cut a deal with Barack Obama that included higher revenues and limited defense cuts, Tea Party House members have been determined to avoid new revenues even if it means much less for defense.

Limited defense cuts – $350 billon over ten years – are already part of the initial round of cutbacks.  When the additional $1.5 trillion comes due, defense’s share of across-the-board cuts will draw dire predictions and protests – all with the administration’s tactical blessing.  When that happens, what can conservatives like John Boehner and Mitch McConnell do but follow Ronald Reagan’s example.  So, whatever the rightwing flank of the GOP says today, next time out Republicans will be forced to accept revenue increases.  And since Medicare is on the line with defense, Democrats will also be forced to accept some changes in entitlements.  The combination will leave the Tea Party with no choice but to howl and take their case into the 2012 elections.

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