Thursday, January 31, 2008

Stimulating the Economy or the Voting Booth? Raining Dollars on America

Some time in February, Congress will have passed and the President will have signed an economic stimulus package, a bill ostensibly intended to jump start a weakening U.S. economy. Many economists, including me, thought that the economic malaise of the 1970s had laid to rest U.S. adherence to Keynesian economics with its fundamental reliance on government spending as a tool to boost a lethargic economy. Even if such spending were effective, by the time Congress slices, dices, and delays any bill, the negatives will outweigh the positives.

First, it is a dubious proposition that a mere $150 billion, approximately one percent of the nation’s yearly output, dumped into the hands of low to middle income taxpayers will have the intended impact. Nobel laureate Milton Friedman advanced and empirically validated the idea that consumers spend based on permanent income, not transitory income flowing from any financial windfall, including government largesse. Accordingly, with credit card debt growing by more than seven percent over the past year, it is likely that a high proportion of the rebates will be used to pay down these balances rather than spent on goods and services.

Second, inflationary pressures in the U.S. economy for 2007 grew to their highest levels since 1990. To the degree that the stimulus package does have an impact on consumer spending, it will tend to advance inflationary pressures. Thus, the Federal Reserve rate setting board will be less aggressive in cutting interest rates to pump up the economy since such a reduction would fuel even higher inflation. That is, the benefits of the stimulus package, in the unlikely event that it does expand spending, will be offset by higher interest rates from the Federal Reserve.
Third, the federal budget deficit for the latest fiscal year will approach $200 billion. Increasing the size of this deficit with a stimulus package will add to the nation’s debt just at the time when austerity is demanded. In 2008, the oldest of the nation’s “baby boomers” will qualify for social security retirement benefits. Over the course of the next 18 years, the number of retirees receiving social security benefits will expand at rates not seen since the program was launched by President Roosevelt in the middle of the Great Depression. A questionable stimulus program will only exacerbate this problem.

Fourth, the stimulus package will further shift the burden of funding federal spending to higher income individuals, diminishing their willingness to engage in productive work behavior. As the package currently stands, families making more than $175,000 yearly will not receive “rebate” checks from the federal bureaucracy. In 1981, the first year of the Reagan Presidency, the top 1.0 percent of income earners paid 17.6 percent of federal taxes. In 2005 after the often labeled “unfair” Reagan and Bush tax cuts, the top one percent of wage earners paid 39.4 percent of all federal taxes. Unfortunately for tax collections, the top earners, as compared to low income recipients, also possess greater ability to cut back on their work effort. For example, physicians can, in many cases, increase their leisure by reducing the hours that they work per week. Thus, increasing the relative tax burden for high income workers inflicts a dual economic hurdle of reducing federal tax collections at the same time that it undermines higher income individuals’ support for a system that places them in the tax bulls-eye. Of course there is the political benefit for Congress of shifting the burden of funding the federal government from the 99 percent of citizens who are taxed at relatively low rates to the one percent who are taxed at high rates.

So what should Congress and the President do to provide a bounce to a waning U.S. economy? They should extend the Bush tax cuts of 2001 and 2003. Rather than a short-term band-aid, this will serve as a needed long-term positive structural change. It is certainly plausible that the current downward spiral in the stock market has been the result of investors expecting a win by either Clinton or Obama in the November Presidential elections. Each has either signaled or explicitly stated his or her intent to raise tax rates on dividends and capital gains when the Bush tax cuts expire in 2010. Such a large tax increase on the horizon has been a factor pushing stocks lower over the past several months. That is, rational investors are looking ahead to soaring taxes on stock gains from tax-and-spend political leaders. As I have stated in an earlier essay, such policies make good politics but lousy economics.

Ernie Goss


Shawn said...

Hi Dr. Goss,

If the consumers spend the $150 million on credit cards then doesn't that at least at minimum help prevent the adverse events happening in the mortgage industry spill into the credit card industry, which is likely at any rate?

I don't think it was the $150 million, which was unforeseen until late, which caused the inflation spike written in the blog post. The Federal Reserve has continued to be aggressive in reducing the interest rate and reduce the amount banks are required to hold as reserves which has caused inflation.

The deficit could be eliminated by removing Bush's tax cuts or increasing taxes on high income earners. That derivative trader who made $1 billion in wages is a good starting point for this tax.

Physicians reduce their work week because they can, not necessarily because the tax rate goes up. This seems to be due more to problems within the health care system in terms of bargaining power rather than tax incentives.

I disagree with the premise that the market is pricing a Democratic President. Why would any company and/or investors timely reduce the value of stock because of a Democrat? Those same stocks alluded to in the blog incurred higher stock prices under the Clinton administration. Even if they were pricing a Democratic President, this would mean the stock prices were simply inflated at that time.

Anonymous said...

I agree and disagree with the first comment leaver. The 150 billion will not be priced into inflation until Aug/Sept as CPI is retroactive. However, the notion that spending the checks on credit cards is absurd. 50% of these people are going to blow this money before they even get the check, 40% will save it or payoff debt and the other 10% will use it to invest or buy assets. The impact of reducing our personal debt will be minimal.

Further, raising taxes on the rich is the exact opposite of what we need to do, we need to eliminate personal taxes and reduce corporate taxes by 50%. The US has the 2nd highest cost of capital in the world, meaning it is the most restrictive or another way to put it is, our corporations pay too much in taxes to be competitive with the ROW.

Where I thought Dr. Goss' blog left room for what should be done is to reduce Corporate Taxes by 50% across the board and simplify much of the corporate tax code.
Second, and almost the most important thing, is that gold and silver need to trade as currencies in the US. Not backing each paper dollar with gold, like the original gold standard, but merely not charging taxes and fees on the purchase of gold and silver coins and bullion. Think going to Wells Fargo and trading in a 500$ bill for some gold coins, much like you would change a $500 bill for 5 $100 bills without taxes or fees.

Next, the government has to spend less money. We need to pull our military back and spend that money domestically and reduce our need for oil. Pulling back our military would strengthen American families would reduce the Department of Defenses oil guzzling habits and return those military wages to the United States.

Hillary and Obama are communists, not sure why we call them democrats. Hillary said she would imprison people that don't buy universal health care that can afford it, that is communism. Our country cannot afford universal health care let alone social security, why do you think the Gov't has tinkered with the CPI calculation for the last 30 years?

Because the largest expense to the Federal Government is about to be social security which is pegged to the CPI index, seems a lot cheaper to alter the CPI calc and keep it around 2-3% then tell the truth and increase social security payments year over year 8-10% the actual cost of inflation right now.

The Federal Reserve, Wall St and our Government are all in bed together as we walk down the road of fascism and socialism as they perpetuate fear in every aspect of our life. They have made the basic same mistakes the societies governed by rich and selfish governments have made for 5,000 years, they debased our currency, take our rights away, expanded to far militarily across the globe and turned us from a creditor nation to a debtor nation, and now we are about to pay for it.

Vote Ron Paul and we may have a chance.


These are some darn interesting comments. I am quite interested to see you angle on the President's new "vision" of the FED's role in economics. Would these be a case of the fox watching the hen house?

Please stop by and visit my bolg when you get a
We have many similar sentiments about the markets.

bookanalyzer said...

...and people invest on oil!