CBO and the fiscal cliff

The CBO has released a report warning that a new recession could follow the  "fiscal cliff"

Background: Here's the CBO report and a Washington Post story  A few snippets from the CBO:

What Policy Changes Are Scheduled to Take Effect in January 2013?...

• A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. ...["Bush tax cuts expire"]
• Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.
• Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.
• Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire.

What Is the Budget and Economic Outlook for 2013?

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:

• The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.
• Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013...

And from the Post:

The nation would be plunged into a significant recession during the first half of next year if Congress fails to avert nearly $500 billion in tax hikes and spending cuts set to hit in January, congressional budget analysts said Wednesday.

The agency foresees a stronger contraction of 2.9 percent in gross domestic product, "similar in magnitude to the recession of the early 1990s." [I couldn't find thi].

“The magnitude of the slowdown we’re discussing next year is significant,” CBO director Douglas Elmendorf said at a morning briefing. He noted that going over the cliff could cost the nation about 2 million jobs.

Elmendorf said the shock of the cliff would be felt for years to come, with the unemployment rate stuck above 8 percent through 2014. And the effects are likely to be felt well before the fiscal cliff hits, according to the budget outlook released Wednesday, as “businesses’ and consumers’ concern about the scheduled fiscal tightening will lead them to spend more cautiously than they otherwise would have” during the remainder of 2012.

What do I make of this? I think the fiscal cliff is a big problem -- but that the CBO's analysis is way off.

The CBO’s projections are deeply and explicitly Keyneisan, relying on “multipliers.” If the government borrows a billion dollars and blows it on some useless porkbarrel project, the CBO will project that this raises GDP  to the tune of one and a half billion dollars. In analyzing the “fiscal cliff,” reducing such projects is bad for the economy.  That’s the key source of their estimate that the fiscal cliff leads to recession. If you, like me, think that the government spending less money on useless projects (say, ethanol subsidies) has a positive effect on output, or that taking less money from A and giving it to B has little effect, then you will not be so worried.

It used to be that the first thing you had to understand to call yourself an "economist" is that prices and taxes are first and foremost about incentives, and only secondarily about income transfers. That is especially true when thinking about national output, growth, etc. Income transfers matter a lot to people, but the overall economy really doesn't care who has the wealth. It cares about incentives.

A really good example: What will the effect on output and employment be of ending 99 weeks of unemploment insurance? That's part of the fiscal cliff, and the CBO's analysis (see above) says that reducing unemployment insurance will lower GDP. Really? A standard economic analysis comes to exactly the opposite conclusion. Generous unemployment and disability means that some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move.  So long as you stay unemployed, you get a check from the government. Subsidizing anything produces more of it. So, a standard analysis says that cutting back unemployment insurance lowers unemployment, and raises output and this part of the fiscal cliff analysis should go the other way.

Before you go all nuts on how heartless I am, keep the question in mind. I didn't say what's good or bad, I said what raises or lowers GDP and unemployment. The standard analysis of unemployment insurance says, yes, it raises unemployment and lowers GDP, but it provides important insurance for the truly needy and unfortunate. It's something we do out of compassion even though it hurts us.

But the CBO didn't score national welfare, or a compassion index. They scored GDP and unemployment, and their model comes to the opposite conclusion, subsidizing unemployment causes more GDP and less unemployment. As well as being compassionate. How do we have our cake and eat it too? Well, that's the magic of Keynesian economics, on which I will not digress here.  

So, in my view, most of the analysis is simply wrong. 

That doesn't mean I think the fiscal cliff is has no effect.

As a "standard" economist, I look first and foremost at incentives. Raising marginal tax rates lowers incentives to work, save, invest, start businesses.  That's not good. So I agree that the tax part of the fiscal cliff will drag down the economy. But not because it reduces Keynesian stimulus, but because it worsens incentives.

The bigger problem with the fiscal cliff is the utter chaos of it all. What serious country decides its tax laws year by year, in one big chaotic crisis during the first few weeks of the year? Will estate taxes be 55% or 0% next year? Who knows?

Moreover, this last-minute crisis atmosphere is ripe for salting the tax code with little goodies which nobody will notice until it's too late. It's a fiesta for lobbyists, tax lawyers and crony-capitalists of all stripes.

This is not how any serious country operates, let alone the supposed leader of the free world. And annual tax chaos is certainly not good for GDP.

What will the effects of the fiscal cliff be? I can't tell.  The incentive and expectations effects that I think matter aren't in any of the Washington models.

Moving from "scoring the law" to "forecast," we also have to think if the cuts will actually happen.  The CBO also has to make forecasts based on Congress’ promises. But do you really believe congress’ promises? Not even the CBO does, really, which is why they make “alternative” forecasts.
Congress hasn't passed a budget in years. Will the supposedly mandatory cuts really happen? Congress can spend money on anything it wants to. It's not like someone will sue them for violating the sequester, any more than someone can sue them for blatantly violating the budget act.

A great example is the  "reductions in Medicare’s payment rates for physicians’ services" mentioned in the CBO report. I presume their model scores this as having a reduced stimulus effect since doctors will buy fewer BMWs.  I doubt its actual effect of doctors simply refusing to work are in the CBO model.

But in any case, it won't happen. Congress promises every year that next year it will cut health costs by simply paying doctors less. They then change their minds at the last minute, because, duh, doctors won’t work without getting paid. It seems a sure bet to me that will happen again, with "emergency" reauthorization. Ditto for important priorities like farm subsidies, the export import bank, ethanol subsidies, electric car subsidies and so on. 

So, my guesstimate of the fiscal cliff? Mild drag on GDP from chaos and higher marginal tax rates. Very little effect on spending, which will be restored in a sequence of last minute bills. Therefore, very little reduction in deficit. Continuation of our slide into low-growth sclerosis.
 
Update: As a commenter noticed, I'm being too kind. Jacking the estate tax back to 55% alone should be a great stimulus measure to get old folks to spend money on round the world cruises, private jets and tax lawyers.

I was working on this some more and ran in to the CBO's supporting documentation here  of which tax provisions are going to expire. To the CBO each of these is a little foregone Keynesian stimulus. To me the list is reminder A of what an obscenity our tax code has become. Yes, let's drop them all, yesterday!

 

Cellulosic Biofuel Credit,Credit for Past Minimum Tax Liability,Depreciation of Certain Ethanol Plant Property,Election to Accelerate AMT and R&E Credits in Lieu of Electricity Production Credit for Wind Facilities, Exclusion of Mortgage Debt Forgiveness ,Indian Coal Production Credit,Partial Expensing of Investment Property,Recently Discharged Veterans Eligible for WOTC,Section 179 Expensing, Andean Trade Preference Initiative,Generalized System of Preferences,Deduction for Energy-Efficient Commercial Buildings,Depreciation Classification for Certain Race Horses,Determination of Low-Income Housing Credit Rate,Energy Credit for Nonwind Facilities,Electricity Production Credit for Nonwind Facilities,Partial Expensing of Certain Refinery Property,Liquefied Hydrogen Fuel Incentives,Credit for Motor Vehicles with Fuel Cell,Hydrogen Refueling Property,African Growth and Opportunity Act,Noncommercial Aviation Fuel Rates for Certain Aircraft,AGI Floor for Individuals 65 or Older Remains at 7.5 Percent,Credit for Business Solar Energy Property,Credit for Residential Energy-Efficient Property,Earned Import Allowance Program for Dominican Republic,Haitian Value-Added Rule for Apparel,Increase Excise Tax on Coal,Caribbean Basin Trade Partnership Act,Haiti Trade Preferences,Fuel Surtax on Certain Aircraft,Transfer of Excess Assets in Defined-Benefit Plans..............

Should the Fed risk inflation to spur growth?

The New York Times asked me and two others this question for its "Room for Debate" blog. My answer follows. Not news for readers of this blog, but maybe a fun concise summary

Should the Fed risk inflation to spur growth? The Fed is already trying as hard as it can to spur growth, and to create some inflation. The Fed has created about two trillion dollars of money, set interest rates to zero, and promised to keep them there for years. It has bought hundreds of billions of long-term government bonds and mortgages in order to drive those rates down to levels not seen in a half a century.


The fact is, the Fed is basically powerless to create more inflation right now -- or to do anything about growth. Interest rates can't go below zero, and buying one kind of bond while selling another has minuscule effects. Which is just as well. While preventing deflation in the recession was vital -- and the Fed did it -- the idea that a deliberate inflation is the key out of our policy-induced doldrums makes no sense.

 Tight monetary policy is not the source of our problems. Monetary policy is loose by any measure. Anti-growth policies are our problem. Our economy is being stifled by over-regulation, chaotic taxes and policy uncertainty. You make money now by lobbying regulators for special treatment, not by starting companies. We fix that with growth-oriented policies that remove the source of the problem.

Inflation remains a danger, but not so much because of what the Fed is doing. U.S. debt is skyrocketing, with no visible plan to pay it back. For the moment, foreigners are still buying prodigious amounts of that debt. But they are mostly buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the US will pay back its debts. If their fear passes, or they decide some other haven is safer, watch out. The inflation some are hoping for will then come with a vengeance. It's not happening yet: Interest rates are low now. But so were mortgage-backed security rates and Greek government debt rates just a few years ago. And inflation need not happen, if we put our fiscal house in order first. But if it happens, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity.

Followup thought (more on the last paragraph):

Yes, interest rates are low, and there is little sign of inflation. I hate to use the word "bubble," but US government debt strikes me as a "bubble," meaning "whatever it is you thought was going on with houses, mortgage backed securities and Greek government debt in 2006, or internet stocks in 1998,  and used the word "bubble" to describe, is going on with US government debt now."

More precisely, an asset can have a high value (government bond prices are high, interest rates are low) because people think its "fundamental" cashflows are high, or because people are willing to hold the asset for a year or two, and they think they can get out and sell it before its value falls.

It's hard to make a story that US long term debt has a high price (low interest rate) because investors are really impressed with the huge budget surpluses in a credible long-term US fiscal commitment. (!) If you don't buy that story, then the admittedly huge demand for US debt is must be a short-term demand, a low required return, a "flight to quality" that can easily evaporate. It can also easily increase for a few years before it evaporates. Europe does seem to be going down the tubes.

It has to be one or the other though. People (you know who) who say "interest rates are low, inflation is low, the government can borrow huge amounts and blow it on preparations for an alien invasion, don't worry, it's not a bubble, it can't burst" have to assume that markets really trust the government to pay back those debts.

Need Leave Of Absence.

Hello Friends,
For some time now, I have been unable to devote time to this blog. For that matter, I am unable to devote time to the market as well. The reason being I am in the middle of the career switch and possible relocation. I tried to do a post on the week-end but could not do anything worthwhile.
I have gained so many friends over the years and I feel bad letting down everyone. But I am helpless for now and I do not think I will be able to do justice to the blog till September 15th, 2012.
Therefore, I request leave of absence till mid-Sept.
I hope you will understand and allow me to take the time off from here to set things in order.
It is time to say " au revoir" at least for now.

GM and Fannie & Freddie and Spain

The taxpayer stepped up to the plate in the fall of 2008 to underwrite General Motors and FNMA and FMAC requiring a commitment of $ 250 billion plus.  We are now approaching round two.  Government Motors, as most people now call GM, is rapidly on a glide path to another bankruptcy, which will cost taxpayers approximately $ 50 billion and require, at a minimum, another $ 25 billion to protect the unions' juicy benefits.  Fannie Mae and Freddie Mac have an unlimited lifeline and their losses, now over $ 200 billion, are essentially unlimited.  But both GM and FNMA and FMAC have created many more millionaires as government-appointed bureaucrats, lawyers and accountants feast at the taxpayer's expense.  This is what happens when the government gets involved.

Europe has its own version of this.  Propping up banks in Spain, France and Germany has simply made matters worse in the Eurozone and has weakened, not strengthened, the banks.

GM and Fannie and Freddie and the European banks should have been permitted to fail.  By now, a new automobile company financed and organized by the private sector would have emerged and would be competing globally in a way that GM will never be able to.  Propping up Fannie and Freddie has prevented a housing recovery and cost the taxpayers hundreds of billions of dollars.  Had there been no bailout (and no Dodd-Frank), housing would now be in its second year of a strong recovery.  Pretending that Spain's banks are saveable has cost the Spanish government and European taxpayers several hundred billion euro -- so far.  Meanwhile unemployment in Spain surges past 25 percent.

Simply letting companies fail when they make bad decisions or when they are the victim of bad luck is the proper response.  Getting government into the act has never worked and it never will.  It only makes matters worse.

Apologies For My Absence

I am really sorry for not being able to update regularly and in time. Even now I am working but I do keep a check on the pulse of the market.
I think we have an exhaustion bar today and 30 Year is now going to turn.
So lets wait and see. This being an OpEx week, I am not going to attach much importance to whatsoever happening.
In the mean time, be safe out there.
Once again, sorry, and I hope to be there on weekend with you guys.

Inevitable slow recoveries?

The economy is stuck in slow growth, not the fast growth we should see after a steep recession. (See previous post here, as well as John Taylor on the subject)

But we've heard the defense over and over again: "recoveries are always slower after financial crises."  Most recently (this is what set me off today) in the Washington Times,

Many economists say the agonizing recovery from the Great Recession...is the predictable consequence of a housing market collapse and a grave financial crisis. ... any recovery was destined to be a slog.

“A housing collapse is very different from a stock market bubble and crash,” said Nobel Prize-winning economist Peter Diamond of the Massachusetts Institute of Technology. “It affects so many people. It only corrects very slowly.”

This argument has been batted back and forth, but a new angle occurred to me: If it was so obvious that this recovery would be slow, then the Administration's forecasts should have reflected it.  Were they saying at the time, "normally, the economy bounces back quickly after deep recessions, but it's destined to be slow this time, because recoveries from housing "bubbles" and financial crises are always slow?"

No, as it turns out. I went back to the historical Administration Budget proposals and found the "Economic Assumptions" in each year's "Analytical Perspectives." This gives the Administration's forecast at the time.

Here is actual real GDP (black line) together with the Administration's forceasts (blue lines). The red line is the current blue chip consensus (also as reported in the budget), which I'll get to in a minute.

As you can see, there is nothing like an inevitable, forecastable, natural, slow recovery from a financial crisis or "housing bubble" in the administration's forecasts.

Their forecasts at the time look just like my quick bounce-back-to-the trend line that you see in my previous posts, and John Taylor's, and lots of others'. And they are surprised each year that the fast recovery doesn't happen.



Here is the same information in growth rates:

Here you see that each year the Administration was forecasting  that within a year the economy would experience a sustained period of strong, 4% or more, "catchup growth" until it gets back to trend.  And each year they have been disappointed.

So, if a slow recovery is the inevitable result of a financial crisis, why was the Administration forecasting the "normal" fast recovery all along?

The natural conclusion is that the administration thought, as I thought, that the economy should have grown quickly, as it typically has in the past. The "slow growth after financial crises" isn't a fact in the first place. And to the extent that it is a fact (it's a "fact" over a sample of countries not very representative of the US now), slow growth is not the inevitable result of a financial crisis itself, but a result of the mismanaged policy that typically follows a financial crisis, such as bailouts, close-the-barn-door-after-the-horse leaves banking regulation, trampling of property rights that scare creditors away, high taxes and so forth. After all, there isn't any economic theory of this "natural" slowness.

Browsing around the budgets, I found they had made the case even more convincingly than I have. Here are two graphs from the 2010 budget (p. 176, p. 181)

The Administration expected strong growth, financial crisis or no financial crisis. In fact they're a bit defensive that they expect stronger growth than the blue chips.

And the 2012 budget contains this beauty

Along with a lovely explanation

Some international economic organizations have argued that a financial recession permanently scars an economy, and this view is also shared by some American forecasters. On that view, there is no reason to expect a full recovery to the previous trend of real GDP. The statistical evidence for permanent scarring comes mostly from the experiences of developing countries and its relevance to the current situation in the United States is debatable. Historically, economic growth in the United States economy has shown considerable stability over time as displayed in Chart 2-7. Since the late 19th century, following every recession, the economy has returned to the long-term trend in per capita real GDP. This was true even following the only previous recession in which the United States experienced a disastrous financial crisis – 1929-1933 – although the recovery from the Great Depression was not complete until World War II restored demand. The U.S. economy has enormous room for growth, although there are factors that could continue to limit that growth in the years ahead.

Ok, except for that silly bit about how great WWII was, (almost echoing Paul Krugman's idea that the key to prosperity is for the government to fake an alien invasion) we seem agreed.

So, the natural conclusion is, what are these "factors" that "continue to limit growth?" If the patient should naturally recover quickly on his own, as every time in the past, perhaps, just perhaps, too much doctoring is to blame?

Now, the red line, the blue chip consensus forecast. The administration's forecast is quite a bit above the blue chips. As it was throughout. A natural interpretation is that this is the usual "rosy scenario" used to make budgets look better. Possible, but I prefer the interpretation that these are honest forecasts, reflecting the natural and correct idea that the economy should spring back quickly from deep recessions, no matter whether associated with more or less financial turmoil.  Really, it make no sense that they knew they were in for 3 years of horrible growth and joblessnes, but just kept putting out ridiculously optimistic forecasts, which they knew would be wrong.

The blue chips could simply be reflecting a more cynical (or in my view, realistic) effect of how bad the Administration's policies would be for growth and recovery. They are supposed to be forecasts of how the economy will behave given policy, not it's "natural tendencies."

Bloomberg TV Interview

An interview on the Tom Keene's show this morning on Bloomberg TV


I always feel bad after these things, that I could have answered much better or clearer. Or found a better tie. Well, we do what we can. A direct link