THE BEAR'S
LAIR Time
for root canal therapy By
Martin Hutchinson
As discussed in the past
two weeks, the next four years are likely to be
unpleasant. There are already several crises
heading towards us, and in the fiscal, monetary,
regulatory and general economic areas the Barack
Obama administration's policy is likely to be
counterproductive.
In these circumstances,
there is only one sound course of action for the
Republican congressional majority: they must
abandon all their natural politicians' preference
for avoiding short-term pain and adopt a
root-canal approach, welcoming short-term economic
pain for the sake of preserving the US economy
intact for better times ahead.
For the
past four years, Obama's trillion-dollar deficits
and Federal Reserve chairman Ben Bernanke's
negative real interest rates
have reinforced each
other. The deficits have removed capital from the
US economy, as banks and international investors
pile into Treasury bonds, starving small business
of financing.
Bernanke's policies have not
only made it easier for the US Treasury to finance
its trillion-dollar deficits, by buying much of
the long-term paper issued, but have also
suppressed saving in the domestic economy. To
balance the minimal domestic saving and massive
government borrowing, the corporate sector has run
a surplus while the United States as a whole has
run a gigantic balance of payments deficit.
Should these short-term-oriented policies
continue until January 2017, it's possible the
initial effect on the US people as a whole will be
limited, provided inflation remains within bounds
(by no means a certainty). Ultra-low interest
rates will push consumers into further spending,
which will be financed by a massive expansion of
credit card and second mortgage borrowing, as in
2002-06. Until credit lines start to be called in,
consumers will happily outspend their incomes.
My money would be on one or more gigantic
recessions during that period, combined with a
substantial decline in real median incomes (but
not necessarily in real median spending). However,
from Obama's viewpoint, anxious to maximize the
government's takeover of the economy and not
terribly concerned with the economy's future after
January 2017, this might well be a relatively
attractive outcome.
For the long-term
future of the US economy, it would be devastating.
The Federal debt would by 2017 exceed US$20
trillion, substantially increasing the debt-to-GDP
(gross domestic product) ratio (if inflation
pushes up GDP, it will also push up interest rates
and the deficit). Meanwhile consumers would also
be more heavily in debt than ever before.
The Fed's balance sheet would be a
substantial percentage of GDP, while foreign
holdings of US Treasuries would be gigantic and
highly unstable. The denouement would probably be
a devastating recession, with or without
hyperinflation, accompanied by government default,
a banking collapse and a catastrophic decline in
US living standards. The president, Republican or
Democrat, entering office in 2017 would be faced
with quite a legacy.
It has always been
clear that short-term-oriented policies would
eventually cause long-term economic destruction,
and that destruction would be increased
exponentially by allowing those short-term
policies to continue for another four years. For
the sake of our long-term future and that of our
children, Obama and Bernanke must be prevented
from condemning America to this fate. Following
his election victory, the short-term is Obama's,
and he is welcome to it, but the long-term belongs
to the American people, and the devastating duo
must be prevented from destroying it.
Fortunately, with Republican control of
the House of Representatives, there is the means
to limit damage, because the House more or less
controls spending. By following long-term-oriented
policies, the House Republican majority can force
the Obama administration to live within its means
and limit the destruction.
"Root canal
economics" was the insult thrown by the
supply-siders of the Reagan administration against
their budget-balancing predecessors, accused of
being "tax collectors for the welfare state".
Today, an economic root canal will be educational,
informing voters of the foolish choices they have
made, and will prevent economic toothlessness in
the future.
The first essential is for the
Republicans to embrace the "fiscal cliff",
preferably while making some modest show of being
forced into it by their political opponents. If
nothing is done and the fiscal cliff is allowed to
come into operation, taxes will rise on both the
wealthy and middle class, while automatic
sequesters are made in both defense and
non-defense budgets.
By this means, on
Congressional Budget Office figures, the Federal
deficit will fall to $641 billion in 2013 and $213
billion in 2015, while the total 2013-2022 deficit
will be reduced to $2.3 trillion from $10.0
trillion. In other words, 77% of the next 10
years' deficit problem will be solved, though work
will still need to be done on the growth of social
security, Medicare and Medicaid entitlements.
Whereas the "compromise" favored by Obama
would raise taxes only on the wealthy, the full
fiscal cliff program will raise taxes on
everybody, even the "47%" who currently don't pay
income taxes but would find themselves
unexpectedly doing so as tax allowances were
slashed.
That's as it should be. Voters
should not be led to believe they can vote for
endless expansion of wasteful government programs
without having to pay for them. The nation has
been on an immense credit card binge since 2008;
it is now time for it to live within its means, so
that the full cost of spendthrift government is
made apparent even to the Obama-voting classes.
The fiscal cliff, if fully implemented,
has a few hiccups, but they can be tweaked later.
The estate tax limit falls all the way to $1
million while the rate rises to 55% - both far too
restrictive; there's a good case for doing away
with the estate tax altogether. Tax on capital
gains rises only to a tolerable 20%, but dividends
once again become fully taxable, raising their
overall tax rate, including corporate, federal and
state individual taxes, to around 70% in high-tax
states.
The solution to this is not to
make dividends tax-favored at the individual level
but to make them tax-deductible at the corporate
level, thus eliminating the use of many corporate
tax loopholes, since passing money onto
shareholders will be tax-free for the corporation.
(It will also eliminate share repurchases, blights
on modern corporate finance that represent an
unearned bonus from individual shareholders to
management). Finally, the Alternative Minimum Tax
(AMT) will revert to its full rigor, not as
damaging as it appears given the higher tax rates.
The solution to these problems is to carry
out a modest negotiation in 2013, trading off
dividend taxes, estate taxes and AMT reform in
return for eliminating or capping the wasteful
deductions in the individual tax code, which also
primarily benefit high incomes (as well as one or
two egregious loopholes like the "carried interest
deduction" for private equity).
Mitt
Romney's proposal makes sense here, for an overall
limit on deductions, which can be used for
charitable deductions, state income tax
deductions, medical insurance tax deductions or
home mortgage interest deductions as wished. This
will ensure that the necessary tweaks to the code,
combined with the reduction in deductions, simply
represent a rearrangement of income among the
rich, which should thus be able to pass congress
without attracting a presidential veto.
Going over the fiscal cliff will probably
cause a recession in 2013. If only spending cuts
were involved, the result might well be neutral or
even stimulative, since the cuts would simply
direct resources from wasteful to efficient uses.
However, given the fiscal cliff's emphasis on tax
increases, which suck resources away from optimal
uses towards the government, it's likely a mild
recession would occur, as it did in 2011-12 in
Britain, which increased taxes but did not cut
spending significantly.
That's not a real
problem. The US is almost bound to enter a
recession before 2017 and even the Obama
administration and the Democrats in congress
benefit by getting that recession over with. From
the point of view of the economy's long-term
health, an early recession that cuts the deficit
is entirely beneficial.
It then remains to
apply the "root canal" principle to monetary
policy. If Bernanke continues to print money at
the current rate and to keep interest rates near
zero, the US economy will still be de-capitalized
by 2017, as savings rates will remain far below
the level needed to maintain the US capital base.
What's more, even if Bernanke can be harassed into
retirement in January 2014, Obama will appoint his
successor, whose confirmation is controlled only
by the Democrat senate.
Nevertheless, once
the deficit has been brought down, it's likely
that any modest signs of inflation, combined with
ultra-low yields in the Treasury bond market, can
be used to convince any Bernanke successor who
wants to be confirmed that sounder monetary policy
is a worthwhile price to pay for their
confirmation. Of course, if inflation takes
off, congress will be in an excellent position to
demand an immediate reversal of policy. This would
not require a Republican Fed chairman; Roger
Ferguson, Fed vice chairman in 1999-06, is an
African-American Democrat, originally appointed by
president Bill Clinton, whose monetary policy
views are about as sound as it's possible to get
in a naughty world.
Root canal policies
will not bring rapid economic growth - for one
thing Obama's addiction to regulation and his
immense army of dull-eyed fanatics in the
regulatory agencies will ensure that signs of
economic growth are stamped on wherever they
appear.
The long-term fall in productivity
growth to 1.8% per annum in 1973-2011 from 2.8%
per annum in 1947-73 indicates the long-term
effect regulators can have, and Obama's
regulators, in office for four years and full of
ideas, will no doubt depress productivity growth
still further. Nevertheless, even if by 2016
living standards have declined sharply, any
spending excesses will have more or less been paid
for, US savings will have been less depleted, and
the economy will be ready to grow again and
provide wealth to the American people once
restrictions have been removed and taxes and
spending lowered.
Of course, if the
American people elect another economically
counterproductive administration in 2016, all bets
are off. Even root canals have their limits.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
