NDN Blog

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.

The Real Crisis Here Isn’t Over the Budget or the Debt Limit

The United States, everyone seems to agree, faces an economic crisis, though its character depends on who raises the alarm.  Most economists are mainly worried about financial turmoil and a deep slump if the U.S. government defaults on its sovereign obligations.   Traditional conservatives fret about the prospects for future business investment and growth if Washington doesn’t cut deeply into its long-term deficits.   And progressives are stewing about rising unemployment and falling incomes if the drive to slash the federal budget succeeds.   The truth is, while all of these concerns are justified, the real crisis today isn’t really about the economy.  It’s about our capacity to govern ourselves – and this crisis of governance has more serious implications than any of the economic scenarios now haunting the experts and politicians.

The proof lies in the fact that everyone involved in the process knows full well how to resolve our current economic challenges.  We can avoid the turmoil that would follow a U.S. sovereign debt default by doing what Congress has done countless times before, raising the legal debt limit.  We can avoid stunting business investment and growth by adopting some version of the plans put forth by at least three bipartisan groups in just the last twelve months.  The Simpson Bowles Commission, the Rivlin-Domenici Task Force and, the new favorite, the  Gang of Six in the Senate have all laid out the basic outlines for reforming entitlements and defense spending and raising additional revenues.  And if the press accounts are correct, President Obama and House Speaker Boehner briefly agreed a few weeks ago on a blueprint with the same basic outline.   Even progressive concerns can be addressed by phasing in such a plan slowly, starting a year or two down the road. 

Everybody knows what they have to do and how to do it.  The crisis, then, comes entirely from their unwillingness or real incapacity to do what has to be done.   And since most politicians understand their own self-interest, we have to assume that their incapacity reflects popular sentiment in some way.

It all goes back to the way Washington responded to the financial and economic turmoil of 2008-2009.   Two presidents and two Congresses spent $1 trillion of taxpayers’ money to stabilize the financial system.  Yet, somehow, they neglected to require that the rescued institutions use any of the funds to help the rest of the country, for example by jumpstarting business lending or staunching the waves of home foreclosures.  They didn’t even apply any of those conditions to companies such as AIG, Citigroup, Fannie Mae and Freddie Mac, which the government owned outright or held a controlling interest after the bailouts.  Then, the Federal Reserve compounded this negligence by providing additional trillions of dollars in virtually cost-free funds to every large financial institution, again with no requirements that any of that largesse go to help support American businesses or homeowners.  The result is a corrosive popular cynicism that renders the normal responses to the debt limit and budgetary problems as somehow deeply suspect.

As much as anyone, the President had a profound interest in these steps working out better than they did.  One only has to recall the confident assertions of the White House that 2010 would see a “recovery summer” to know that that the President’s advisors truly believed that the flood of bailouts, stimulus, and free money for the banks would be enough to reignite business activity and stabilize housing prices.  This misplaced confidence is also the only reasonable explanation for the decision to turn the page on economic policy by turning to health care reform. 

Like all good leaders, the President came to recognize and learn from his mistakes.  So he cleaned out most of his original economic team and called for new public investments to invigorate the economy.  By then, however, the political damage was done.  Millions of voters turned to a new group of Tea Party radicals so caught up in their own cynicism about government that their agenda became its dismantling.  And with many of those radicals winning office by first defeating traditional conservatives like Utah’s Bob Bennett for GOP nominations, it put a quickening fear of involuntary retirement in the hearts of many GOP leaders.

The current crisis of governance comes from these radicals’ decision to begin their dismantling by refusing to approve any increase in the legal debt limit.  Some say so directly; others couch it in a catalogue of extravagant demands to slash spending and raise no new revenues.  So far, at least, the radicals’ intransigence has precluded the kind of compromise that the President and traditional conservatives seem prepared to carry out.

That leaves the resolution of this crisis largely with the Republican leadership.  Can John Boehner, facing an underground challenge from the radical Eric Cantor, and Mitch McConnell, facing a similar threat from Jim DeMint, face down their Tea Party members and cut the deal with the President?   And can the President give them some cover by mobilizing public support for such a compromise from the majority of Americans who remain cynical about government, even as they want to preserve most of it? 

If they fail, we may all face an economic deterioration that will only further magnify the public’s cynicism.  And, who knows?  We could also see new forms of radicalism emerge across the political spectrum which would make governing the world’s most powerful and important nation even more difficult.

The Real Dangers from the New Austerity

To an economist, the current crusade by congressional Republicans to slash spending during a slow expansion seems to be about half ideology — the crude Tea Party view that most of what government does is corrupt or wasteful — and about half simple partisanship. But it’s hard to ignore the fact that so many governments have been gripped by a similar devotion to austerity; and this week, the Bank of International Settlements came on board as well. This is not the first time that this particular, political conventional wisdom has become dangerous economic nonsense. Austerity was the state-of-the-art view in the early 1930s of central bankers, Treasury officials, presidents and prime ministers — and, yes, most economists. So, the United States and most of Europe applied it, and turned a stock market collapse and nasty recession into a banking crisis, trade war and, finally, a great global depression.

This time, the call for economically destructive budget-cutting in this country has come largely from Republican politicians, although they’ve managed to bully many of their centrist Democratic colleagues to join. Still, the Federal Reserve, the IMF, the World Bank and, this time, virtually all economists are trying to hold the line for economic sanity; and Martin Wolf of the Financial Times, perhaps the leading economic commentator in the English-speaking world, wrote this past week that the new austerity “risks a disaster.” Yet, if the know-nothings have their way with our economic policy, as they did 80 years ago, the ultimate winner could well be China.

These stakes are so high that it’s worthwhile to walk through the actual economics in play here. The basic issue here is not whether both the public and private sectors, here and in most other advanced economies, have too much debt for our own good. They do. As for the private sector debt, yes, most Americans used their credit cards too freely for a decade. But the main reason for the high levels of personal debt, especially relative to people’s assets, is the housing meltdown: It destroyed much of the equity American held in their homes — the main asset for most families here — while leaving their mortgage debts largely untouched. And American households have responded sensibly: Personal saving is way up — which is why consumer spending is weak and, in turn, the expansion has been disappointing.

The only way to strengthen personal spending when most people are busy rebuilding their savings is to give them more money to spend. In principle, the additional money could come from higher wages, which recent productivity gains would support. In practice, with unemployment stuck at high levels, businesses feel little pressure to raise wages. In addition to raising wages, business has another way to inject demand into the economy: Invest at high levels. If they did that, the companies that produce equipment and other business assets would have to hire more workers, and when those workers got paid, consumer spending would increase. But most companies can’t justify investing more when most consumers are still on the sidelines, rebuilding their savings.

Just like American consumers, American businesses are saving more too: In the face of strong profits — much of them earned abroad, in stronger economies — they’ve increased their “retained earnings.” With everybody in the private economy holding back, the United States has slipped into what the Jerome Levy Forecasting Center calls a “contained depression,” when everybody but the government tries to strengthen their balance sheets at the same time.

Given that, what happens if the government decides to join everybody else and save more as well, by eliminating its own structural deficit at once? The austerity hawks promise it would restore “business confidence” and so drive an economic rebound. Only in their dreams would fiscal tightening in the face of weak consumer demand move businesses to unleash an investment boom — and most business people aren’t dreamers. In the real world, sharp government cutbacks shrink GDP and corporate profits, reinforcing the determination of consumers and businesses to save more.

To his credit, the President has tried to resist the new austerity. He argued for expanding public investments, and (alas) nobody listened. Now he’s trying to offer the Republicans a little stimulus in ways that under more normal conditions they couldn’t refuse — a temporary cut in both the employer and employee sides of the payroll tax. That would give consumers a little more money to spend, and it would give businesses a supply-side tax cut to hire more workers. The President even offers to assuage the jealous gods of budget restraint by offsetting the revenues with cuts in tax subsidies for unpopular industries. Yet, GOP leaders keep on saying no. That’s hard to reconcile with claims that the GOP’s current positions on the deficit and taxes represent a sincere economic perspective. And that only leaves partisanship to explain their insistence on austerity in the face of basic economics.

There is one other big difference between today and the 1930s: While the United States and Europe struggle today as they did 80 years ago, this time globalization has enabled the two-fifths of the world made up of emerging economies to enjoy something close to boom times. Introduce government austerity on top of a “contained depression” in the advanced economies, and the prices of western stocks and other assets will tumble. That’s the moment when the sovereign wealth funds, fledgling multinationals and recently-minted billionaires from China and other large developing countries will inject a bundle of new demand into our economy: They’ll start buying up our companies and other assets at fire-sale prices. The end game of the current fling with know-nothing austerity economics, then, is that our strongest and most ambitious rivals will walk away with a big slice of our future prosperity.

Globalization 2.0 and the Rise of the Rest

International economic conferences like the one I attended in Rio a few weeks ago can be a little tedious, when experts debate their latest econometric models.   Yet, I sat up and listened intently when an IMF official remarked, almost as an aside, that the world’s emerging economies would account for 48 percent of global GDP this year.   That means that by 2013 or so, developing countries will produce a majority of the world’s output.   Since the 1980s, globalization has proceeded largely along the lines of American capitalism.   These developments herald the beginning of Globalization 2.0, which will present entirely new challenges to the American economy. 

Experts will quibble over the numbers.  The IMF used “purchasing power parity (PPP)” to produce its numbers, adjusting each country’s official GDP data for its relative cost of living before converting it into US dollars.   However, the same pattern holds if we measure each country’s GDP simply in U.S. dollars at current exchange rates.  By that measure, the share of global output coming from the advanced economies – that’s us, plus Western and Northern Europe, Canada, Japan and Australia -- has fallen from more than three-quarters a decade ago to somewhere between 60 and 65 percent today.   Most of that decline has come out of the economic hide of Europe and Japan.  Still, our ability to shape globalization in our own economic image -- from opening up everyone else’s borders to U.S. investors and strictly protecting intellectual property rights, to the dollar’s role as the world’s reserve currency – grows weaker, year by year.

The evidence is all around us.  China and India scuttled the Doha multilateral trade round, an outcome unimaginable a decade ago when they and most developing nations were much more willing to accept our judgments about the global economy.   From Latin America to Africa and parts of Asia, the recent efforts of the international “Financial Action Task Force” to crack down on money laundering and terrorist financing have been openly flouted.   And the international financial system’s rules for dealing with sovereign debt defaults, which for decades ensured generally fair compensation for foreign lenders to developing nations, have been openly mocked and discarded by such countries as Argentina and Ecuador.  If those nations’ approach were to spread in Europe’s festering sovereign debt crisis – still a remote prospect -- it would destabilize German and French banks with awful consequences for the United States, and dampen future foreign funding for poorer developing nations.  

No country can roll back this kind of global economic development.  Experts expect China and India alone to account for 40 percent of worldwide growth over the next several years – that used to be our role – with other emerging economies accounting for another 30 percent.   Chinese, Indian and Brazilian multinationals will contest with our own for global market shares, and use their home field advantages to good effect – for them.  And on the model of the purchase of IBM’s PC division by the Chinese firm Lenovo, emerging market multinationals will begin to claim a real share of our own domestic markets by buying up our companies.   

We have our own advantages, especially in developing and applying new technologies, materials and production processes; adopting new ways of financing, marketing and distributing goods and services; and coming up with new ways to manage the workplace and organize a business.  But the rise of the developing world will inescapably intensify the dark side of Globalization 1.0, especially pressures on job creation and wages.  U.S. job losses from direct off-shoring could become less of a problem, since the new prosperity and rapid modernization of developing economies drive up their wages and other costs.   But the squeeze on job creation and wages that we’ve seen for the past decade, as intense global competition collides with fast-rising health care and other costs for U.S. employers, almost certainly will become more fierce.   

The policy imperative here is to reduce the cost of creating new jobs.  We can start right now by cutting the employer’s side of the payroll tax.  And so long as the economy remains weak, we shouldn’t try to replace those revenues.  As we recover, we can replace the foregone revenues from lower payroll taxes through a new, carbon-based energy fee, a tax shift with the extra benefits of driving greater energy efficiency and addressing climate change.  A second step we can take to address the impact of Globalization 2.0 on American jobs would involve expanding and strengthening the cost-saving provisions of the President’s health care reforms.  Under the new model of globalization as under the old one, the inescapable fact is that we  simply cannot restore strong job creation until we slow the rate of increase in medical insurance costs for both businesses and the rest of us.  

The Cost of Playing Games with the Full Faith and Credit of the United States

I spent last week in Rio attending a meeting of the IMF’s advisory board for the Western Hemisphere — and returned this week to Washington for the latest round of threats and charges over raising the U.S. debt limit. The contrast was, at once, disturbing and farcical. At the IMF meeting, former finance ministers, prime ministers and other ex-economic policy officials tried to unravel the grim implications for all of us if (when) Greece, Portugal or, in the worst case, Spain is forced to default on their sovereign debts. Back in Washington, congressional Republicans laid out their terms for not driving the United States into a voluntary default on its sovereign debt. Perhaps holding onto a child-like faith that bad things don’t happen to the United States, under God, they spelled out terms which everyone knows will never be accepted by President Obama and a Democratic Senate. The irony is that the GOP gambit of holding out a potential debt default if they don’t get their way could, in itself, make long-term control over deficits much harder.

The reason lies in the powerful influence of worldwide investors on our interest rates. Thankfully, global capital markets still have confidence that our two political parties can settle this dispute on reasonable terms, and that in time the United States will regain control over its deficits and debt. We know that confidence is still there, because the interest rates and yields on U.S. Treasury bills, notes and bonds all remain near historic lows. If there were real doubts about our capacity to control long-term deficits, those interest rates would be rising as investors demanded higher returns to offset the risk that we’ll fail. This confidence makes sense, because we succeeded at the same task twice before, in the 1980s and again in the 1990s. It took several years of squabbling and compromise, but President Reagan and a Democratic House agreed to raise taxes, cut defense and reduce Medicare and Medicaid spending in the 1980s — and the same pattern played out again a decade later with President Clinton and, first, a Democratic House and then a GOP one. That combination of revenues, defense and health care was, and remains today, inevitable, since those are the only pieces of fiscal policy big enough for cuts and reforms that can make a significant difference for deficits.

But neither Reagan nor Clinton faced opponents prepared to hold the full faith and credit of the United States hostage to their own partisan approach to the deficit. To make this gambit appear respectable, House Majority Leader Cantor even claimed last week that major players on Wall Street had assured him that a U.S. default would be a matter of economic indifference. The only explanation is that Mr. Cantor, without realizing it, was talking to short-sellers getting ready to bet billions that U.S. stocks and bonds might crash — as they will if we actually do default.

Happily, worldwide investors are probably correct that the likelihood of a U.S. debt default is still very, very small. If it ever came close to that, the real players on Wall Street would face down the U.S. Congress. But cutting it close may turn out to be very expensive, too.

Let’s perform a small thought experiment. A Tea-Party infused GOP takes us to the edge of default and then pulls back. A really close call, however, would almost certainly make worldwide investors nervous. They would begin to question whether our politics truly are up to the task of dealing with our deficits, so they add a small risk premium to our interest rates. Let’s say — and this would be optimistic in this scenario — that short-term rates on Treasury bills go up one-half of a percentage-point; medium-term rates on Treasury notes rise three-quarters of a percentage-point, and long-term rates on U.S. bonds increase by 1.25 percentage-points.

Now, let’s be optimistic again and assume that Congress and the President eventually agree to cut the 2012 deficit by 10 percent — $108 billion off of the current projection of $1.081 trillion. That will leave a 2012 deficit of $973 billion to be financed. The small increases to interest rates would add about $7 billion just to the first-year interest costs of the 2012 deficit. And that’s just the beginning: All publicly-held Treasury bills also have to be refinanced in 2012 — nearly $2 trillion worth at last count. The tiny 0.50 percentage-point increase in those rates would add another $10 billion to next year’s interest costs. That comes to $17 billion in extra interest costs in just the first year, and just on publically-held debt. Those premiums would become embedded in those interest rates, adding much more to our interest costs, year after year, as additional deficits have to be financed and some $7 trillion in publicly-held Treasury notes and bonds come due for refinancing. A single refinancing of that current stock of publicly-held Treasury notes and bonds, with the new risk premiums, would add more than $50 billion, per-year, to interest costs. And the actual risk premiums demanded by global investors could be significantly higher than we assume here, and so that much more expensive.

These incremental increases in interest rates also wouldn’t be confined to U.S. Treasury rates; they would be transmitted immediately to other interest rates, from mortgages to credit cards. That means the expansion would further slow, American incomes and the government’s revenues would grow less, and, lo and behold, the deficits would be even bigger.

That’s the math. Even if congressional Republicans don’t mean it, the political games they’re playing today with a U.S. debt default, purportedly in the name of fiscal responsibility, could make U.S. deficits and debt even more unmanageable, and U.S. prosperity more problematic.

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