The 290k increase in jobs is great news for the WH and congressional Democrats. The rising unemployment rate, from 9.7% to 9.9%, is not. Yes, it reflect workers moving back into the workforce, but it is still a lousy headline number. So, too, the rise in the broad U-6 unemployment number to 17.1%. The good news also gets drowned out by the big drop in the stock market and trouble with EU sovereign debt. Even if Greece’s problems do not metastasize, they still provide unsettling headlines for U.S. voters. Like something is still not right in the world. Then, of course, you still have the moribund U.S. housing market and all that evaporated net wealth. Stronger growth may be enough to keep Republicans from capturing the House and Senate, but big gains nonetheless.
Politics and policy from inside Washington
The great Jed Graham over at Investor’s Business Daily writes an important piece on America’s debt problems. It is not a long-term or intermediate-term issue, it is a short-term issue:
In the wake of the financial crisis and recession, Moody’s Investors Service has brought new transparency to its sovereign ratings analysis — so much so that 2018 lights up as the year the U.S. could be in line for a downgrade if Congressional Budget Office projections hold.
The key data point in Moody’s view is the size of federal interest payments on the public debt as a percentage of tax revenue. For the U.S., debt service of 18%-20% of federal revenue is the outer limit of AAA-territory, Moody’s managing director Pierre Cailleteau confirmed in an e-mail.
Under the Obama budget, interest would top 18% of revenue in 2018 and 20% in 2020, CBO projects.
But under more adverse scenarios than the CBO considered, including higher interest rates, Moody’s projects that debt service could hit 22.4% of revenue by 2013.
That bankers disdain their new Washington overlords is no surprise. To many of them, Congress is plagued by “unnerving ignorance” and a refusal to admit its own role in the financial crisis. At least that is how a controversial JPMorgan report puts it. Impolitic perhaps, but not inaccurate.
It’s one thing to discuss such grumbles in the executive suite. It’s another to explicitly lay them out in a widely disseminated research report, accompanied by data and a full-color chart for emphasis — in the midst of the delicate financial reform debate in the U.S. Senate, to boot. But that’s what JPMorgan’s James Glassman did in a May 3 economic note.
In last week’s Senate committee interrogation of Goldman Sachs executives, senators displayed “confusion about our market economy,” according to Glassman, along with plenty of unearned self-righteousness. He snarkily noted that the economic implosion of rust-belt Michigan, home of Carl Levin, the committee chairman, had nothing to do with esoteric derivatives.
It’s not news that many senators appear to have only a tenuous grasp of the financial industry. But Glassman’s larger point is more relevant. It’s not just that Congress doesn’t understand what Goldman, as a market-maker, does — it’s also that elected officials may not recognize that the financial crisis was rooted in Washington as well as Wall Street.
A similar point is made in new study by Ross Levine of Brown University, “An Autopsy of the U.S. Financial System.” Bankers may have rushed to create fancy new securities, but it was legislators who enabled risky behavior by housing giants Fannie Mae and Freddie Mac — and failed to instill watchdogs like the Federal Reserve and the Securities and Exchange Commission with the backbone needed to rein in risky activities. In detail, Levine makes these points that illustrate the role of Congress:
1) Credit Ratings Agencies. While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities. … Rather the evidence is most consistent with the view that regulatory policies and Congressional laws protected and encouraged the behavior of NRSROs.
2) Credit Default Swaps. I am suggesting that the evolution of the CDS market, the fragility of the banks, and the Fed’s capital rules illustrate a key feature of the financial crisis that is frequently ignored. The problems with CDSs and bank capital were not a surprise in 2008; there was ample warning that things were going awry. Senior government policymakers created policies that encouraged excessive risk taking by bankers and adhered to those policies over many years even as they learned about the ramifications of their policies.
3) The SEC and Investment Banks. Consider three interrelated SEC decisions regarding the regulation of investment banks. First, the SEC in 2004 exempted the five largest investment banks from the net capital rule, which was a 1975 rule for computing minimum capital standards at broker- dealers. Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that induced the five investment banks to become “consolidated supervised entities” (CSEs): The SEC would oversee the entire financial firm. Specifically, the SEC now had responsibility for supervising the holding company, broker-dealer affiliates, and all other affiliates on a consolidated basis. Third, the SEC neutered its ability to conduct consolidated supervision of major investment banks. … The combination of these three policies contributed to the onset, magnitude, and breadth of the financial crisis. The SEC’s decisions created enormous latitude and incentives for investment banks to increase risk, and they did.
4) Fannie and Freddie. Deterioration in the financial condition of the GSEs was not a surprise. … But, Congress did not respond and allowed increasingly fragile GSEs to endanger the entire financial system. It is difficult to discern why. Some did not want to jeopardize the increased provision of affordable housing. Many received generous financial support from the GSEs in return for their protection. For the purposes of this paper, the critical issue is that policymakers did not respond as the GSEs became systemically fragile. Again, I am not arguing that the timing, extent, and full nature of the housing bubble were perfectly known. I am arguing that policymakers created incentives for massive risk-taking by the GSEs and then did not respond to information that this risk-taking threatened the financial system.
Of course, even senators who do understand finance may choose to indulge in ignorant-seeming grandstanding for political and electoral reasons. JPMorgan, in turn, has distanced itself from Glassman’s views, presumably to smooth any ruffled political feathers. Even if the bank’s management secretly agrees with its economist, it’s about as likely to say so as members of Congress are to admit their enormous shortcomings.
Some illumination on Greece. First, The Great One, Larry Kudlow:
Merkel and other European leaders would like the IMF to be the fiscal-discipline policeman for Greece and the rest of southern Europe. But as Nobelist Robert Mundell has argued, while the unified and fixed exchange rate of the euro currency system, along with liberalized trade, has been good for economic growth, things have broken down with the failure of the so-called fiscal-stability pact that was never enforced.
With tens of thousands of Greek government union workers marching in the streets of Athens calling for more general strikes in protest of IMF austerity measures to cut back on bloated pensions, voters in Germany and perhaps other EU countries do not believe the bailout conditionality will ever work. Voters see solvent nations being saddled with more debt that the European Central Bank may well monetize into higher inflation.
Indeed, the debt follies of Europe and the bankruptcy of the European entitlement state should be a lesson for Obama’s Washington, where overspending and borrowing have reached absurdly grand heights. As a share of GDP, U.S. debt is projected to move toward 100 percent in the wake of the new Obamacare entitlements. That’s near the 125 percent debt ratio of Greece.
Now Ed Yardeni:
The risks of a sovereign debt contagion clearly increased over the past 48 hours on mounting evidence that the bailout of Greece has been botched. The response of the EU wasn’t swift enough, and Greek workers are staging strikes protesting austerity measures including a second set of wage cuts for public workers, a three-year freeze on pensions, and a second increase this year in sales taxes and the price of fuel, alcohol, and tobacco. … Governments around the world are rapidly becoming the problem rather than the solution. In addition to all the anxiety about a sovereign debt contagion triggered by the mess in Greece, there is mounting evidence that governments are making it more expensive to do business, especially for oil companies, mining companies, and banks:
(1) BP’s liability for the massive Gulf of Mexico oil spill on April 20 is capped by law at $75mn. But Senator Robert Menendez (D-NJ) is co-sponsoring a measure that would raise the liability limit to $10bn–retroactively, so it can apply to the April 20 spill. The measure reportedly has the Obama administration’s support.
(2) The left-center Australian government on Monday slapped a 40% tax on mining company profits to fund increases in worker wages and pensions during this election year. The new tax would raise about A$12bn (US$11bn) and force the companies to reconsider whether to continue their huge investment programs. Shares of Rio Tinto and BHP Billiton fell sharply on the news.
(3) Treasury Secretary Timothy Geithner told the Senate Finance Committee on Tuesday that financial regulatory legislation should include a tax on large financial firms to help recoup financial crisis bailout funds.
The good folks at the Heritage Foundation alert me to a House bill proposed by Republicans Jim Jordan and Jason Chaffetz: Here is what H.R. 5209 would do: 1) Eliminate the tax on capital gains; 2) Reduce corporate income tax to 12.5 percent; 3) Kill the death tax; 4) Immediate expensing of business expenses; 5) Reduce payroll tax by half for 2010.
Me: The payroll tax cut would be a huge revenue loser, as would the death tax. But the rest seem smartly targeted for economic growth. Given the budget deficit, tax-cutters need to be really smart and pick reductions that optimize economic growth.
I will say this: As much as I press WH officials to take a victory lap on the economy, they want no part of that — especially not with unemployment at these high levels and the evolving EU debt crisis. David Rosenberg of Gluskin Sheff gives some more reasons for caution:
1. Markets were unimpressed with the size of the just-announced $145 billion rescue package or the ability of Greece to meet the terms. A bailout of all Club Med countries would, according to estimates I’ve seen, approach $800 billion. This is bigger than LEH.
2. China raised reserve ratio requirements 50bps for the third time this year (to 17%). A decisive slowing in China and the U.S.A. is a crimp in the near-term commodity price outlook.
3. Australia just unveiled a massive new mining tax. This is weighing on material stocks overnight.
4. Possible criminal probe on Goldman weighing massively on the stock price; financials being re-rated by rising spectre of financial re-regulation. Shades of Sarbanes-Oxley. There has never been a financial crisis that was not met afterwards with regulatory reform — it’s how the SEC was created in the first place.
5. ECRI leading economic index just slipped to a 38-week low. With the restocking phase complete and fiscal stimulus waning, prospects of a second half slowdown loom large. Buy the recovery story when ISM is at 30 and policy stimulus in full swing (13 months ago); fade it when ISM approaches 60 and stimulus subsides. Market Vane sentiment is pushing towards 60% too — yikes! Too much priced in. As for the macro scene, the U.S. economy is barely growing at all, net of all the federal stimulus (+0.7% SAAR in Q1). And net of housing impacts, neither is Canada … should set us up for a fascinating second-half.
6. Attempted terrorist attack in Times Square a reminder that geopolitical risks have not gone away.
7. Treasury yields have collapsed nearly 35bps from the nearby highs and are not consistent with the recent move by equities to price in peak earnings in 2011. Junk bonds trading back to par for the first time in three years.
8. The U.S. implicit GDP price deflator receded to its slowest rate in 60 years in Q1 (+0.4% from +2% a year ago) in a sign that this profits recovery is still being underpinned by cost cuts, tax relief and accounting shifts than by anything exciting on the pricing front.
9. The latest Case-Shiller house price index confirmed that we are into a renewed leg down in home prices. Financials, retailers and homebuilders are not priced for this outcome.
10. Initial jobless claims, around 450k, are not consistent with sustained employment growth, notwithstanding what nonfarm payrolls tell us this Friday. A new peak in the unemployment rate and a new trough in home prices stand as the most pronounced downside surprises for the second half of the year
A nice primer on the issues surrounding a value-added tax from Greg Mankiw. This is the key part for me:
Moreover, a VAT is the twin of the flat tax that conservatives sometimes advocate. To see why, imagine that we started with a VAT. Then we add a wrinkle: We allow businesses to deduct wages, in addition to the cost of goods and services. We also require households to pay a tax on their wage income.
Other than shifting the responsibility for the tax on wages from the business to the household, it might seem that we haven’t done anything significant. Indeed, we haven’t. But the new tax system would no longer be a VAT. It would be the flat tax that Robert E. Hall and Alvin Rabushka first proposed back in 1981.
Me: Wouldn’t the D-R compromise here be a Hall-Rabushka VAT as a revenue-neutral replacement for the income tax? See how to what extent it works its pro-growth magic before boosting it. But those would need to significant given the disruption converting a brand-new tax system would cause. Just eliminating investment taxes is a quick and easy way to a consumption tax.
Some Democrats seem to have no problem raising the cost of capital. Dividend taxes rates are scheduled to triple, while capital gains rates will only increase by a mere 60 percent. But as a I poke around the liberal idea factories here in Washington, I am hearing more and more about wealth taxes on the wealthy, just like they have in Europe.
This goes far beyond estate and property taxes. In theory, even portfolios would be taxed on paper gains, from 1 percent to 3 percent. If applied to just the top 1 percent of taxpayers, such a tax could theoretically raise $300 billion in new revenue. Assuming, of course, all those rich folks didn’t hightail it to tax havens abroad. (Just ask Gov. Chris Christie of New Jersey about capital flight in the fact of high taxes.) No wonder so many nations want to crack down on these pockets of economic freedom.
I would dismiss the idea as nonsense if it were not for the fact that Democrats a) constantly complain about U.S. income inequality, b) seem so cavalier about cranking up taxes on wealthier Americans and c) think boosting taxes is the only way to deal with the budget deficit.