StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between

How to Fix the Economy: Short-Term Version and Long-Term Version

14 Nov 2010
Posted by Bruce Bartlett

Just by coincidence, I have articles in both the New York Times and Los Angeles Times today dealing with different aspects of our economic problem. The LA Times asked me and a bunch of people far more distinguished than myself what could be done to stimulate growth in 300 words. Although I think there is a case for further fiscal stimulus, I didn't see any point in saying so since the political chances of that were zero even before Republicans won control of the House. So I suggested some ideas for the Federal Reserve, because it is really the only game in town.

The New York Times also had a symposium with me and some others far more knowledgeable than me. But our assignment was what to do about the long-term debt problem in 250 words. I reiterated my belief that significantly higher revenues will be necessary to a permanent solution and that a value-added tax would be the best way to raise those revenues.

All of the contributions to these symposiums are worth reading. I reprint mine below as a convenience to CG&G readers.

Los Angeles Times

November 14, 2010

Don't subsidize reserves; tax them 

It's unfortunately the case that sometimes you get only one bite at the apple. That's what happened to the Obama administration and fiscal stimulus. It had just one chance to enact a meaningful program, and unfortunately it didn't do enough.

While there is a strong case for additional fiscal action to stimulate growth and lower unemployment, realistically that was not in the cards even before Republicans gained control of the House of Representatives.

That leaves only the Federal Reserve with the freedom of action to stimulate the economy via monetary policy. Just recently, it announced a plan to buy $600 billion more Treasury securities in order to goose the economy. But there is already more than $1 trillion in excess bank reserves available for lending that banks are just sitting on. Many economists believe that the Fed's latest round of quantitative easing will simply add to that total without providing any additional stimulus.

What is desperately needed from the Fed is some action that will force the banks to lend and get the money that is sitting idle into the economy where it will finance consumption and investment. One idea would be to emulate Sweden and tax excess reserves rather than subsidizing them as the Fed now does by paying banks 0.25% per year on money that is not lent. Another would be for it to intentionally raise inflationary expectations because people tend to spend today when they think prices will be higher tomorrow.

The Fed has shown an admirable ability throughout the crisis to act in unprecedented ways. Its actions prevented a second Great Depression, but they have been insufficient to restore sustainable growth. Now that the Fed is the only game in town, however, it may be necessary for it to go beyond its comfort zone. The alternative could be a decade or more of stagnation of the sort we have seen in Japan.

New York Times

November 14, 2010


Tax Consumption, Not Savings
We have a growing debt problem that is too large to stabilize just with spending cuts. Therefore, tax increases will have to be part of the solution. The magnitude of the necessary tax increase, however, is so large that it would cripple the economy if achieved through higher income tax rates.
A value-added tax can raise revenues by taxing consumption while minimizing damage to growth.
The Congressional Budget Office estimates the long-term revenue trend to be 19 percent of gross domestic product once the recession is well past. It also projects spending will rise to 35 percent of G.D.P. by 2035 absent legislation to slash Social Security, Medicare and Medicaid. Completely abolishing every other program, including national defense, will not be enough to prevent a substantial spending increase.
It’s unrealistic to think that spending is going to be cut by 16 percent of G.D.P., which would be necessary to balance the budget without a tax increase. But financing just a third of the deficit reduction on the tax side will require net new revenue of more than 5 percent of G.D.P. Such a large tax increase must be achieved in a way that minimizes damage to incentives and growth. A value-added tax can do that by taxing only consumption and exempting saving.
But a VAT needs two to three years to implement. If enacted now, it could provide the revenue for reforming the tax code, permanently fixing the alternative minimum tax, and possibly abolishing the corporate income tax. When Congress is ready to adopt serious deficit reduction, a VAT will then be available to raise additional revenue without raising income tax rates.



Bruce, your recommendation

Bruce, your recommendation would increase the value of the dollar, and hurt the ability of the US economy to grow by shrinking the trade deficit. Bernanke's goal appears to be to have mild inflation in the US, and high inflation in PRC and other countries with currencies pegged in nominal terms to the USD. If Bernanke succeeds in doing that, the real value of the USD drops compared to the real value of the RMB and other pegged currencies, and helps shrink the trade deficit.

Having Congress push through austerity measures in the US, while Bernanke prints money would also help Bernanke's goal.

The money Bernanke prints is flowing to the developing world, and causing inflation there. He is growing a US version of the Japanese householders that ZIRP policy drove to invest in countries with higher interest rates, which depressed the Yen.


Re: The Fed - 30 day T-Bills are currently yielding 0.14%. If you lower the interest rate on reserves much below that (or eliminate them or tax them, which is just a negative interest rate), then banks just shift their excess reserves into T-bills. The net effect on the economy will be minuscule. Banks are not going to start making loans to consumers and businesses just because you eliminate interest on reserves, they'll just look for a substitute with similar attributes (short term, liquid, risk-free).

Re: A VAT tax - I'm not opposed to the idea, but politically, it's unlikely to happen. You'd also need to couple it with some sort of rebate/prebate at the individual level to prevent it from massively increasing the tax burden on the poor and lower middle classes.

Over-Investment and Under-Consumption

The reason that short-term interest rates are zero is that we have insufficient consumption and too much investment. A consumption tax is exactly the wrong policy. The Japanese imposed a consumption tax to address the deficit and the result was a stalled economy and a much larger debt than when they started.

We must break the cycle of believing that more investment will lead to more jobs. When we have so much excess capacity, we have to embrace consumption, not punish it. Once demand rises enough to pull interest rate above the zero bound, that is the time to address the deficit and consider a consumption tax.

future deficits

IANAE (I trust this is decipherable) -- But.

(a) Suppose we increase federal tax rates by one percentage point, for all income types. People with jobs making 10,000 per year would be expect to pay 100 dollars more than they do now; people earning a hunded million from investments and bonuses would pay an extra one million, etc. We might also raise business taxes one percent. We might begin an effort to reduce the size and complexity of the current tax code.

(b) We could postpone the age for receiving full social security benefits from 67 years to 67 years and six months for people born after 1970.

(c) We could make a fifty billion dollar cut in the military budget. Whether this is for ongoing operations or future procurement is immaterial.

(d) We should monitor the operation of the incoming health insurance regime, looking for places to tinker usefully with regulations.

(e) We might impose a tax on large financial transactions. Something like 1/4 of one percent seems not unreasonable.

(f) We might begin an effort to reduce the size and complexity of the current tax code. There ought to be explicit, visible, possibly loud and ill-mannered debate about provisions which are obsolete or too obviously giveaways. There should be some raucous horse-trading, all aimed at spreading the taxation base, simplifying administration, and maybe even reducing corruption.

(g) There might be a low-level carbon tax, explicity described as a revenue enhancing measure.

These are minor tweaks of the existing system, it strikes me. None of these proposals looks too horrible for consideration by either liberals or conservatives. None is even very new. What's different is that these proposals, even if all enacted, would NOT stop the federal deficit. On the other hand, they would reduce the deficit growth, and after a few years we might choose to ratchet taxes upward again, and again until we have tended to the deficit. And when we have reached that point, we will be in much better shape for prescribing and giving tax cuts.

Why not tax...

Why not tax high frequency trading? Gotta be some do-re-mi there, right? How much? And who would notice? Yacht brokers and Art auction houses? Gulfstream? Would probably decrease the volatility of the stock market, increase small investor confidence.
Why not raise the 15% tax rate on dividends to something closer to ordinary income? You guys can tell ME what that's worth, I'll bet. US Corporations have close to $2 trillion in cash that they can't put to work because demand is inadequate to justify new investment and capacity utilization rates are at close to historic lows? So the argument that dividend tax rates need to be low to foster investment and growth is completely full of mullarkey.

Excess Reserves, Once Again


As Andrew once observed, you have put me in the position of arguing for a more conservative solution than the one you advocate. This is interesting, though mostly unfamiliar, territory.

Those who argue that there is inflation "directly on the horizon" (and tacitly assume that said inflation is a bad thing) tend to complain that someone will enact precisely your LAT argument--charge interest on (effectively, tax) excess reserves and leave the banks with no choice but to put All That Money into Circulation.

The rest of us realise that "excess reserves" is just a lie told by TBTF banks whose capital markings are--let's be nice--rather optimistic. And that paying interest on those "excesses" is just a backdoor method of getting the banking system marginally closer to solvency. (That this is being done on the backs of smaller, more solvent banks and unemployed and underemployed consumers seems to be fine with the Fed; see Mr. Lacker's recent speech.)

The optimistic result of "taxing" excess reserves was presented by RuetheDay above: moving that money into T-Bills, which at least has the virtue of steepening the yield curve, and still pretending to be solvent.

The realist perspective--that those reserves are excess in part because of accounting lies (the "balance sheet recession" remains recessed because the balance sheets are, as noted above, not telling the real story) and partially because businesses are stockpiling cash themselves; that is, that I is reduced s.t. S>I--would acknowledge that the 0.25% being paid is distortionary, but might conclude (as Andy Harless did) that it's a minor distortion, even in (or so long as we are in) a liquidity trap that shows no signs of ending. It's a transfer payment of about $2.5 billion p.a., which is relatively small and will have a marginal positive effect on the private sector and a net zero effect on the U.S. fiscal picture.

The pessimistic version is that the banks will loan that money, expecting that their return will be greater than the interest charge from the Fed. This has the virtue of assuming that there is a backlog of demand for monies loaned for projects with an expected real return (r) between -0.03 and 0.0025, which somewhat requires higher inflation rates (pi) to produce an i that makes any sense at all. So the money will be circulated, and therefore wasted, and create nothing other than inflation. (Whether the pessimists realize the current solvency/"balance sheet" aspect of the banks is left as an exercise.)

In none of the scenarios except the pessimistic one does charging interest on excess reserves result in anything that cannot be done by QE II. And the implications of that scenario on the health of the financial intermediaries seems somewhat prohibitive.

Not paying interest on excess reserves might be a perfectly reasonable policy: it would reflect the economic reality that there is no useful purpose to which those excesses can be put by the government on an overnight basis, and therefore acknowledge that rewarding banks for not lending is at best a transfer payment of no net economic effect and at worst an inhibition to returning the economy to its natural level of activity.

But charging interest on "excess" reserves ignores the underlying reasons for which those reserves are being held--the lack of private-sector demand from businesses and the lack of true accounting from financial intermediaries. Sadly, your idea, goes a step too far, and in so doing fails to address either underlying issue.

Let's perform a test.

Drop interest on reserves by 10 basis points and see what the market reaction is. 

Switch 100% to a carbon tax

And watch the investments fly, particularly since, according to McKinsey, about half the US emissions can be eliminated at a net cost savings. Watch the CO2 avoidance schemes proliferate. Watch every business with a cash stockpile spend it to make their products more efficient. Changing to a carbon task would pull forward half or more of the monthly energy expenditures over the next 20 years to be spent on capital equipment in the next 5.

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