The Economy

Monetary & Fiscal Policy. Why the Tug-of-war?

This is an ideal time to look at Friday's GDP data and ask the question "what role does the government have in affecting this data?" GDP is big. It is THE measure of the size of the economy. The analysis is that part of the government is trying to expand the economy and part is trying to contract the economy. Moreover whenever there is such a tug of war one of those parties is destined to always win.

The United State government gets involved in the economy in three manners: regulatory, monetary and fiscal. Regulatory has to do with such as minimum wage, working conditions, FDA, OSHA etc. While these regulations are all of import they have little to do with the cycles which we are so fond of discussing.

Back up a Minute Here

There is some common perception that somehow the Federal Government runs the economy and creates jobs and yada, yada, yada. This is simply not true. Politicians make this an issue. They make high profile speeches during campaigns stating that they have created jobs or the other guy has not. The fact is that this is total hogwash. These speeches serve two purposes: 1) they confuse people about what politicians are responsible for and 2) they confuse people about how the economy functions.

The economy consists of a coming together of business (capital and management) with workers and customers. Business is the crux of the economy. This is not to say that business is the economy; it it the crossroads of economic activity. Domestic business has changed a great deal in the past few decades. Ours is no longer a goods producing economy where the jobs are at factories but rather a service producing economy where the jobs are in offices. The "machines" are computers, faxes and copiers. The jobs which are created are created by business not by government. Jobs growth requires investment from business and training and education from workers. Lamenting the loss of jobs to businesses in other countries is a futile activity. We live in a "smaller world" where low cost communications and transportation and the efficiency of retail chains such as Wal-Mart have altered things. The benefit is low prices. But, as the Home Depot slogan says, "Low prices are just the beginning." The downside is the loss of domestic manufacturing jobs.

To a very large extent, changes in the structure of the economy are the result of technological forces and worldwide macroeconomic forces such as globalization.

How the Government Is Involved

Significant government involvement in the economic process involves monetary and fiscal policy. Monetary policy is the business of the Federal Reserve. The Fed controls interest rates and the money supply. It controls short term rates essentially by caveat. It does not really get involved in the short term market but, in effect, tells everyone else what the yield on the 1 year Treasury should be and what prime should be.

The Fed maintains its control of the money supply by buying or selling Treasuries. When it sells Treasuries it takes money out of supply. When it buys Treasuries it increases money supply. Money supply needs to change in response to 1) seasonal variations in spending (the money supply needs to be larger during the Christmas shopping season and 2) expanding GDP. Money supply should move in step with GDP. Increase in GDP necessitate increases in the money supply. It might be easier to see that money supply needs to be tied to Retail Sales and that Retail Sales must have strong correlation to money supply.

Money supply goes hand in hand with rates. Note that at present the Fed has been increasing short term rates. This has the effect of slowing the rate of growth of the economy. The Fed is not doing this for any sinister purpose. It is doing this to abate inflation. The healthy economic growth we have had for the past 3+ years has the lingering possibility of creating unwanted inflation and higher rates should slow the rate of growth and help to contain inflation.

Fiscal Policy

Fiscal policy is not under the control of the Federal Reserve. It is instigated by the President and Congress with its policies regarding taxes and spending. At present with one party in control of the White House and Congress fiscal policy is largely in the hands of the White House. They lowered taxes which had the effect of expanding the economy in the short term (more money in the hands of consumers) and increased spending which is also expansionary. It is to this extent that the government does have any effect on creating jobs. The increase in expenses was largely in reaction to 9/11 and the contemporary mini-recession.

Making no judgment of the worth of these activities per se it is important to keep one's opinions untangled from ones perception of the effect that this has on the economy. That spending is expansionary. It increases GDP. This is not to say that increased spending and lower tax rates are, in the long, a good idea. That is a more complicated topic. The point is that they are expansionary in the short term. We might find that, in the long run, we regret the price of the deficits which this policy has created.

My own view about fiscal policy is spelled out here. Essentially it says: let Congress and the administration do the spending part of fiscal policy but let decisions about tax rates and deficits up to a third party similar in constitution to the Federal Reserve. It would be wonderful if our elected officials were in total control of fiscal policy but it is my opinion that this system simply does not induce healthy fiscal decisions. It appears that the motivation to adopt responsible fiscal policy takes a back seat to political concerns. If we are going to allow revenue to fall below expenses for the purpose of economic expansion that I would prefer than an entity with the long-term vision and one which does not have to answer to the electorate determine that policy.

So at present we have fiscal policy which is expansionary and monetary policy which is contractionary. Looking at the data today it becomes more apparent that fiscal policy as created by this administration was expansionary but that the effective lifetime of that expansion is short. Tax decreases translate into something like one to one increases in GDP. They boost GDP by a certain amount but that boost is not exponential. On the other had the Federal Reserve is in this for the long haul and it is their tight monetary policy which is quite deliberately slowing GDP growth.

The issue as to whether lower taxes and deficits contribute enough to the economy to make them wise should be left to someone other than politicians. One note at the end here. I am not stating that having one part of the government try to expand the economy while another is trying to contract it is utter foolery. While it would certainly not be my way of running things I grant that perhaps this is a form of "checks and balances." I am saying that, on the surface, it seems to be less than ideal. It would make more sense to me if monetary and fiscal policy were not engaged in a tug of war. My thesis here is implied in the last paragraph. The Fed will always win these tugs-of-war. I emphasize here that these are my opinions on what is indeed a complex topic.  

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Dick Lepre

We Need a Fiscal Authority to Complement the Fed

Two current events earlier this year highlight the poor state of fiscal policy in the U.S. The President proposed a budget and the effect was similar to the dropping of the puck at the start of a hockey game. Is this really the way to conduct fiscal policy in a manner conducive to the health of the U.S. economy? Why do we have so much trouble with fiscal policy and so little trouble with monetary policy?

With Ben Bernanke having taken over the post of Fed Chairman, attention is directed to asking, "Can he do the job?" That is a fair-enough question but in light of the Fed's generally superb monetary policy performance over the last twenty years it misses the real source of current macroeconomic problems in the U.S.: the federal government's not-so-stellar fiscal policy performance. By contrast, the effectiveness of the Fed in monetary policy is barely a question.

Monetary policy involves the tweaking of interest rates to achieve macroeconomic objectives. The Fed does this with near complete independence from the rest of government. Monetary policy - here and abroad - has been well-served by keeping politicians out of the loop. In contrast, fiscal policy is an intensely political process, involving federal taxing and spending, incessant haggling between the Administration and Congress, and the now fairly distant possibility of an occasional electoral correction.

The present fiscal policy process does not serve the public well. Used as a tool for short-run macroeconomic management, fiscal policy has become a plaything of politicians to curry favor with special interest groups. Poor fiscal policy has been offset only by the ability of the monetary authority - the Federal Reserve - to adeptly conjure monetary policy solutions to fiscal policy mistakes. It is time to give the monetary authority a fiscal authority counterpart. The current Council of Economic Advisers, an advisory body for the President, should be disbanded and a new entity - the Council of Fiscal Authority (CFA) - should be constituted.

As is the case for the Fed now, CFA governors would be appointed to nonrenewable 14-year terms, report twice a year to Congress on the state of the economy, and possess certain decision-making powers with real bite. In particular, the CFA would have the authority to influence fiscal policy by specifying economy-wide average personal and corporate tax rates. The CFA would not specify marginal rates, would not dole out tax exemptions, and would not speak to tax reform, would not - in a word - be caught up in administrative and tax-burden distribution issues that are properly the domain of elected representatives. Congress would still need to fulfill its constitutional duty to "lay and collect" taxes, only that the average rate would be set by a disinterested outside party, the CFA. Congress must spell out in the enabling legislation that it is granting this agency the right and power to set only average tax rates commensurate with Congressional spending and the interests of the nation's economy. Just as IRS collects the taxes with agency from Congress the CFA will "lay taxes" by setting the rates with the agency granted to it by Congress. Congress shall not forego its ability to take back that right at some time in the future. The CFA would have no right to create new taxes only the right and power to set the rates on income taxes created by Congress. The rates would be set in accordance with the spending dictated by Congress.

This average rate would be set so as to compel Congress to attend to its spending habit with more care than it has in recent years. If Congress "overspends," driving federal budget deficits and national debt beyond economically acceptable limits, the CFA could raise the average tax rate, obliging Congress to accept the consequences of its profligacy. Politicians fond of pork would be encouraging taxation, sure to result in considerable political discomfort. The ideal is that the existence of the CFA would induce fiscal responsibility in those who are elected.

Our scheme is not a one-way street. If the CFA felt that the average tax rate were too high or that the economy would do better in the long-run with a year or two of deficits then it could dictate a lower average tax rate. The key is to take an important portion of fiscal policy management out of the hands of politicians. For example, for fiscal year 2004, federal government receipts were 16.03 percent of GDP, whereas federal outlays amounted to 19.54 percent of GDP. Under our scheme, the CFA could mandate Congress to raise the average tax rate to result in tax collections equal to 17, 19, 20, or an even higher percentage of GDP. Presumably, Congress would rather cut spending than to be compelled to "lay and collect" more taxes. In turn, boundaries should be set to prevent the CFA from setting an average tax rate that deviates by more than, say, two percentage points from spending levels. The only exception to the CFA's tax-regulation powers would be a declaration of war by Congress when dealing with an emergency involving a foreign power. (The CFA would also have the authority to forbid Congress to impose unfunded mandates on state or local governments or to impose taxes under any euphemistic name such as "user fees.")

Our proposal will strike some readers as fancy. Why would Congress give up certain fiscal powers? One answer is that Congress already has delegated numerous important powers - including monetary policy - to certain federal agencies, jobs they are better suited to take on. Thus, Congress created the ICC, FCC, FDA and, regarding its constitutional charter to "lay and collect" taxes, created the IRS to collect the taxes. Creating an agency to set the tax rates is no more an abrogation of its authority and responsibility than is the existence of the IRS.

In creating a CFA, we need to mirror what works with the Fed: real power, terms spanning several administrations, and a "non-dismissal of governors" rule. In time, the CFA might be given other useful powers such as setting budgeting and accounting rules for the federal government that mirror more stringent private-industry practice, especially those that track obligations coming due in future. But the foremost need today is simply to get fiscal policy out of politicians' hands back into the realm of macroeconomic policymaking proper. The CFA would help do that. In short: let politicians do the spending but let another entity provide fiscal "checks and balances" by having final authority over taxation.

Also make a visit to Jurgen's site

-- Dick Lepre & Jurgen Brauer

The Twin Deficits

Often, for whatever reason or reasons, two things get coupled together in what seems like little more than an effort to obfuscate clarity. The present topic of interest is the so-called "twin deficits". The twin deficits are the Federal budget deficit and the balance of trade deficit.

We seek here to answer the following questions:
- why does each of these deficits exist?
- what can be done about the budget deficit?
- what can be done about the trade deficit?
- are the two causally connected?
- what are the implications of the fact that the
two are so large at the same time?
- is inflation an inevitable consequence of these?

The Federal Budget Deficit

I think that an underlying truth is that the Federal government has been enamored for quite a while with spending more money than it takes in. It's a bad habit like smoking. People who smoke know that there are consequences. The consequences are, generally, deferred in time. The pleasure - or whatever the high is that come from nicotine - is now.

The current state of the budget deficit is the result of at least 3 things that have happened recently.

- the dot-com/telecom booms created a lot of jobs, a lot of wealth, a lot of capital gains and, consequently, a lot of income for the Federal (and state and local governments). When the dot-com and telecom bubbles busted tax receipts fell. The economy has recovered but the latent effects of counting on that surplus are still being felt. For several years it was state budgets which were hardest hit. Unlike the Feds they do not have the ability to create money or approve a $750 billing deficit cap hike.

- 9/11, Afghanistan and Iraq happened and the Federal government spent a heck of a lot of money on things having to do with homeland security and the military

- Bush decided that a way to cure the mild recession was a tax cut

The Federal budget deficit exists largely by our choosing and partly as a result of unsound fiscal policy. I do not think that it is not possible for the administration and Congress to balance the Federal budget with sound fiscal policy. I wrote about this in the piece which suggest a new agency to manage fiscal policy - mainly taxes. That piece was coauthored by Jurgen Brauer and may be viewed here Rate Watch #499.

There are only three paths through which the budget deficit can be addressed:

1) higher tax rates

2) substantial economic growth leading to higher revenues at the present tax rates or

3) less spending.

The solution may be a combination of these elements.

If the government is going to spend more than it is taking in there are only two possibilities for making up the difference:

1) it can create more money or

2) it can borrow the money. It has been doing a lot of both of these over the past couple of years. M2 is $6,370.8 billion dollars as of 11/15/2004. It was $5,284.6 the day before 9/11/2001.

The general policy of the Fed has been to increase money supply (M2) at a rate approximating GDP growth. For the vast part the deficit is made up by increased borrowing. Like a big cash-out mortgage on the old USA.

The Treasury Department can also sell securities (notes, bills and bonds) on the open market and, in essence, borrow money to pay its present
spending habit and pay it back with interest. And this is where things get interesting.

The pain of borrowing money and paying it back later should be measure by the difference between the interest rate and the rate of inflation. Interest rates on Treasuries with maturities less that 3 years were all in 2004 less than 3%. CPI is less that 3% so that, in terms of real dollars, carrying that debt
was costing us nothing. Pay it now or pay it later it is the same bill.

One problem that the U.S has is the low savings rate. Since we save so little, most of the borrowing that the Treasury Department does comes from abroad.

It must be noted that, in recent years, the Fed had decided to issue less long-term debt and more short term debt. Only recently has the Fed started issuing 30-year binds again.

Some make the case that there is a nexus between the Federal budget deficit and the trade deficit. I think that the answer is that theoretically there should be but
there, in fact, is not.

The fact that the money supply has been increased so aggressively in the past three years could have led to inflation. This is the concept that "too many dollars chasing the same amount of goods" causes the prices of those goods to rise.

That did not happen. Inflation has been tame. Instead, two other things happened: 1) the dollar dropped in value 2) the "global economy" has been actualized. The fact that so many goods are available (mainly from China) means that this larger number of dollars is chasing a supply of goods which, for all practical purposes, can expand to provide whatever is demanded. The traditional rules about supply and demand are not operational when a nation with a population of over 1 billion and an ever-mounting amount of hard currency achieved from exports becomes a player.

The Trade Deficit

The Trade Deficit is, from my perspective, like the weather - there is little that can be done about it. The simple fact is that since the cost of labor is so small in
China, India, Mexico and Central America vast quantities of "stuff" will be made there because

1) the consumer seeks low prices

2) gigantic retailers have cut the supply chain to a very small size

3) transportation costs are so low. Containerized shipping, inexpensive international telecommunication, commercial air travel, the Internet and computer software managing the mating of supply and demand have served to make the world a very small place.

In fact, if anyone is threatened by the ability of the Chinese to provide a myriad of consumer goods it may be the EU that should be more concerned than the U.S. If the Chinese can manufacture a car that is perceived to be more like a BMW or Honda than a Hyundai there are going to be some auto plant closings in the EU
and Japan. China has the example of Hyundai to learn from. This car was perceived to be a low quality joke here in the U.S. and despite the vast improvement in quality is still not respected here.

The trade deficit is an inevitable effect of the disparity in labor costs. It is not going away any time soon but what are the consequences? In the long term the answer is not evident. In the short term what happens is that the Chinese wind up holding U.S Treasury debt. The Chinese are helping, in no small way, to finance the undertakings of the United States government. What would Chairman Mao think if someone told him that the Chinese are enabling the U.S. to simultaneously
lower taxes here and fight a preemptive war in Iraq? Strange times.

The Chinese are becoming our de facto economic ally. Their interests and ours are becoming coincident. They provide stuff. We consume in and send them debt - a promise to pay back that money in the future. Unless I am missing a big piece of the puzzle, that encourages peaceful coexistence.

The consequence is that manufacturing jobs are lost here. There is little that can be done to stem this. We need to make sure that a greater portion of our population
is trained for the service-sector jobs that now make up 80% of the economy.

One important point is that the Chinese currency is pegged to the dollar so the effect of a declining dollar has had no impact on the price of Chinese goods.
It is interesting to note what can happen when the dollars that wind up abroad are "repatriated". If you are a foreign company with a ton of dollars you have
an initial choice to make: do you go to your Central bank and exchange them for your local currency or do you purchase U.S. Treasuries on the open market?
If the dollars are exchanged for local currency the decision now is passed to that central bank. They can either create more of their own currency to provide
for the demand of the dollar-exchangers or they can go to the Foreign Exchange market and trade the dollars for their currency. Theoretically, the creation
of local currencies to exchange for dollars can create inflation in those countries if trade barriers exist and that large supply of Chinese goods is not allowed in.

Conclusions

The twin deficits are not related. The budget deficit can and should be fixed. Either tax increases are in order or Congress and the administration need to get the Federal Reserve more involved in fiscal policy.

The trade deficit is an effect of America's wealth and the low price of labor elsewhere. The hope should be that we are helping economies all over the world to advance
from poverty.

Should we worry about the twin deficits? We should be concerned about them. We should encourage fiscal policy to reduce the budget deficit. The trade deficit will be a problem if it causes continued erosion of the dollar or a demand for higher Treasury yields.

The fall of the dollar has been deliberate and orderly. If the dollar continues its fall and interest rates rise considerably there is some concern that the housing market
could be hurt. Higher rates would translate into fewer sales and defaults. This might result from people who had adjustable rate loans and did not strategize for a high
rate scenario. Serious levels of defaults could threaten the banking system. This is not likely to happen but being concerned about things not likely to happen sometimes
keeps them from happening.

The dollar is still the most respected currency in the world and may be seen as a bargain at present Forex prices.

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Dick Lepre

Income Taxes. Who Pays What?

A few weeks ago I made the suggestion that Fiscal policy needed to be changed to allow the Federal Reserve a say. The intentions were to enable the Fed to control the deficits and in a manner which it saw most beneficial to the economy. See RateWatch #479 A Major Change to Fiscal Policy

I was thinking of expanding the discussion about fiscal policy and started to look into income taxes. I wanted to understand who paid how much income tax. Understand, I am only talking about Federal Income Tax. In 2003 (the last year the IRS has data available for public viewing) the top 1% of all income earners paid 34.27% of all the income tax (they had 16.77% of all income). The next 9% (the 2%-10% of income earners) paid 32.96% of all income tax. The top 10% of income earners paid 64.84% of the total collected for income tax. They had 42.36% of the income. The top 25% of income earners earned 64.86% and paid 83.88% of the income tax. The top 50% of all income earners paid 96.54% of all Federal income tax. They had 86.01% of the income.

Federal Income Tax Paid by Percentile 2003 ("AGI"= Adjusted Gross Income)

	Number of Returns	AGI ($ millions)	Income Taxes Paid ($ millions)	Group's Share of Total AGI	Group's Share of Income Taxes	Average Tax Rate
All Taxpayers	128,609,786	$6,287,586	$747,939	100.00%	100.00%	11.90%
Top 1%	1,286,098	$1,054,567	$256,340	16.77%	34.27%	24.31%
Top 2-5%	5,144,391	$906,109	$150,257	14.41%	20.09%	16.58%
Top 5%	6,430,489	$1,960,676	$406,597	31.18%	54.36%	20.74%
Top 6-10%	6,430,490	$702,794	$85,855	11.18%	11.48%	12.22%
Top 10%	12,860,979	$2,663,470	$492,452	42.36%	65.84%	18.49%
Top 11-25%	19,291,468	$1,414,757	$134,928	22.50%	18.04%	9.54%
Top 25%	32,152,447	$4,078,227	$627,380	64.86%	83.88%	15.38%
Top 26-50%	32,152,446	$1,329,624	$94,647	21.15%	12.66%	7.12%
Top 50%	64,304,893	$5,407,851	$722,027	86.01%	96.54%	13.35%
Bottom 50%	64,304,893	$879,735	$25,912	13.99%	3.46%	2.95%

Some notes: 2003 was the year in which all of the tax cuts proposed by the present administration kicked-in.

AGI = Adjusted Gross Income

Source: Internal Revenue Service See Table 5 on that page for 2003

If you have trouble with that link, it is: http://www.irs.gov/taxstats/indtaxstats/article/0,,id=129270,00.html

The original table on the IRS site presents as an Excel spreadsheet and is somewhat well-hidden. Look in the last row (2003)of each part of table 5 to find the data in the above table. I started with the IRS data and found that is was presented in this much more clear table at Tax Foundation

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