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     Nov 21, 2012

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.)





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