The dictionary defines a recession as "An extended decline in general business activity, typically two consecutive quarters of falling real gross national product." It defines a depression as "a period during which business, employment, and stock-market values decline severely or remain at a very low level of activity." Ronald Reagan said a recession is when your neighbor loses his job, and a depression is when you lose your job. Michael Sall defines a recession as the down trajectory of the business cycle, and a depression as a recession combined with government help.
We are in never never land. What are they doing? We learned from the depression that government intervention, raising taxes, make work programs (aka economic stimulus) and protectionism only make the economy worse, and a recession much worse. Yet that is exactly what we are doing today.
In the early 1950s the US State Department decided to send our excess food supply to African as a gesture of American largess. We sent vast quantities of food that we were buying from farmers and warehousing in order to keep domestic prices higher (or seen another way, in order to get the farm state votes). It cost us nothing to give it away, and in theory the Africans would be helped..Sure..right..African farmers couldn't compete with free food, prices there declined, and many gave up and moved to the cities. Whatever farm system they had completely broke down. Only a fraction of the domestic crops were grown, and famines ensued. Our "largess" destroyed their imperfect, but viable farming system.
How does this relate to the cause of our current economic crisis? Fannie Mae and Freddie Mac were created to make home ownership more broad based in America...certainly a laudable goal. But like every political attempt (aka folly) to do business in a rational way, it led to the current bank failures and breakdown of our financial system.
Here at home the creation of Freddie and Fannie (F&F) carried an implied credit guarantee by the US government. The government would make good on any money F&F borrowed. That meant F&F could borrow more cheaply than their competition, and as a result the competition all but stopped making loans. Competitors decided instead to originate loans, earning fees for doing so, and then sold them to F&F. The originators had no concern if the loans were paid, only that they could be sold off. Does that sound dangerous to you?
Later congress mandated that credit be eased (Community Reinvestment Act), and the mortgages were placed at an even faster pace, often to unworthy borrowers. The CRA mandated that F&F loan to sub prime (aka unqualified) borrowers. It also said that banks not doing business in poor neighborhoods and making these loans would not get federal approvals needed if they wanted to merge or buy another bank. Still, the originators were making money, Fannie and Freddie were complying with the law, the system was causing home prices to rise, and so long as that happened everything seemed fine.
The Wall Street Journal, the New York Times and many others warned that this was a dangerous game and could result in a catastrophe. The Republican congress tried to reign in F&F but capitulated to the Democrats when they were painted as having contempt for the poor. So, for several years all seemed well in in this fantasy land where money descends on people with just the passage of laws dictating it.
One might ask where F&F were getting the money to lend. They borrowed it. But who you ask, would lend to someone taking such imprudent risks. Everyone did, and the reason was that the US government was guaranteeing repayment. F&F couldn't have gotten into nearly the mess they did if they had to go out and borrow the money on their own credit. Not a fraction of the losses could have occurred.
But the plot thickens. The investment banks and others saw what was going on and wanted to expand the party. Voila! The use of credit insurance for mortgage backed securities was expanded. The players would accumulate a large number of mortgages, say $200,000,000 worth, and sell bonds backed by the entire pool of mortgages. The bonds were broken into small dollar increments, and could now could be bought and sold in the after market. In order to entice bond buyers, insurance was purchased (supposedly guaranteeing repayment of the bonds) which was underwritten by several large AAA companies. This way the bonds were able to get a AAA rating themselves, paying lower interest, and creating larger profits for those bundling the mortgages.
The bonds became an attractive place for life and other insurance companies to park money they needed to hold for their reserves. The problems here were first, the originator could care less if the loan was repaid so long as he was able to sell it off in these packages, and thus gave far less scrutiny to the loan than he would if it were his money, and secondly, the underwriter (mortgage insurance provider) wrote more policies than he could ever hope to pay if the system broke down.
I must admit not realizing this while it was happening, but the insurance purchases were a total waste of money. Individual pools of mortgages were not going to default. They were diverse enough that without a systemic breakdown, they would pay. If however there was a systemic breakdown, most of the pools would default, in which case the insurance companies didn't have nearly enough reserves to pay. Witness the bankruptcies of many of them and stock prices of the others.
The underwriters and buyers of these mortgage backed instruments looked only at the history of borrower repayment. Based on the worst of economic times in the past, excepting the depression, the insurance companies could cover any losses. The problem is that economic history is different every go round, and the past only shows a very small part of what might happen. In this case the cheap money from F&F (aka our government), produced higher and higher home prices, then the new instruments and credit insurance provided even more money, and once again home prices rose etc. and the bubble expanded.
But like any bubble or Ponzi scheme, at some point people begin to understand the system is walking on a tight rope with a hurricane kicking up and there is no net. People began to sell the bonds, and as the prices of the securities fell a bright light was shined on the problem. People there to fore unaware of the risk began to sell, and in this case the whole house of cards collapsed.
The exact reverse of what happened creating the crisis now occurred. Credit dried up, so even quality borrowers couldn't borrow. That drove home prices down. Declining prices cause defaults. Why pay a mortgage of $300,000 on a house worth $250,000? It is cheaper to walk away. Foreclosures occurred with the weak borrowers as well, and each house the banks foreclosed on and put on the market made every other house worth a little less, and as the avalanche of declining prices picked up speed, the would be buyers stepped aside and decided to wait and find how low prices would go. So here we are and no one knows where the bottom is. What I have described doesn't even take into account the effect these declines have on every other business. That's for another day.
The business cycle often carries things to excess and destroys wealth in the process. Business can be corrupt, and sometimes downright stupid or blind. That is the nature of capitalism. People take chances and sometimes things work out well and sometimes not. But left to it's own devices, the business cycle will take two steps forward and one step back. No one denies that these steps back are painful, but left alone business recovers in short order. Government involvement however (other than it's proper role as a referee and enforcer), either initiates problems or exacerbates them.
The first myth the government spread was that "predatory lenders" caused the problem. Sure..I con you into taking a loan you can't repay, and I make a profit..umm..sounds like a perpetual motion machine to me. The new myth that the government is promoting is that deregulation caused the problem. Regulation may have prevented a small part of the problem, but on balance the growth that regulation prevents from happening is far more costly than any accidents it prevents. The government should insure transparency, prevent theft, and enforce the law. It should not however, make what are basically business decisions.
For those of you who wonder why government is so bad at this, just ask yourself what ingredient is the most important in a financial success. How about desire..the desire to make money? In a capitalist system, one only makes money when he meets the public needs better and cheaper than anyone else. Is the government motivated by the same thing? Absolutely not. Politicians want to get reelected, and for them public perception is everything. If they can fool people into thinking they are helping, they get votes. The reality of what they are doing, or the damage, means nothing. Most politicians don't understand economics, and worse, don't care to. Their "expertise" is in getting votes. Certainly most people have lives far too busy to understand what supply side economics is, or most any other economic theory. So they are reduced to voting on sound bites and emotional appeal. And here we are.
Our current financial problems are primarily the result of government "help." The insanity I referred to in the first paragraph is that the government now plans to give more "help," to solve the problem created by the original "help" (for homeowners in forming F&F). It is as if a patient had an allergic reaction to a medication and the doctor decided that he would give him more of it to stop the reaction.
Tuesday, January 27, 2009
Wednesday, January 21, 2009
Tax Policy
It has been a while..but I am back. Read and learn. I'll be more attentive hereafter, or at least until I run out of wisdom to share.
The debate on taxes between liberals and conservatives is insane. Lowering taxes serves everyone's objectives. The government realizes more revenue, and individuals keep more of what they make. Lower taxes create more incentive for investors, thus more economic activity, and it keeps capital in private hands versus under inefficient government control. Consequently more wealth is generated. Why are we arguing?
Over the last 50 years the jury (history) watched and heard both sides of the tax debate. They returned a unanimous verdict. Cuts help everyone. John Kennedy, Ronald Reagan and George W Bush lowered taxes and the economy skyrocketed every time. Herbert Hoover and FDR raised taxes and we had a depression. People say Bill Clinton raised taxes and the economy was great. That's true. But the marginal rate increases were modest, whereas his capital gains tax cut was substantial. Also the tech boom and his passage of NAFTA helped a lot.
There is a concern on the left that tax reduction dis-proportionately helps the wealthy, and it does. We can all agree that wealth creation in a capitalist system is top heavy. But capitalism still creates the greatest amount of wealth in every individual quintile of the income scale. If you are in the bottom 20% of earners, would you rather your income stagnate but remain proportional to someone in the top quintile, or would you rather earn more yourself and have the top earners gain disproportionally? I would care less about what was happening at the top so long as I was moving forward.
20 years ago Ireland's economy was one of the worst in Europe. They passed a law allowing artists to settle there and pay no taxes. Needless to say many people extended the meaning of artist (isn't a plumber creative?), and all of a sudden immigrants were coming from throughout Europe. The Parliament noticed that the economy was growing in a way they had never seen before, so they passed a general tax cut. Voila! There was more economic activity, more jobs, more net personal income, and more tax revenue. Since then they cut taxes 13 times. 13 times the economy grew, and 13 times the government realized more tax revenue. Ireland has gone from one of the worst economies in the EU to the second best, behind Luxembourg. Before the reductions they had 50,000 people a year leaving the country looking for work. Today they have 200,000 coming into the country looking for work.
Over the last 50 years Hong Kong has been the fastest growing of all western economies. They also have the lowest tax rate. In fact it even "favors the rich," in that it is a 16 percent flat tax. Still, the lowest rate among western economies not only produces the highest growth rate among them, but also produces the highest tax revenue per capita.
In about 1970 Communists won elections in Chile and nationalized industries and of course raised taxes. Needless to say the economy ground to a halt, there was high inflation, and despair ruled the country. Colonel Augusto Pinochet (head of the army) took control of the government, and his advisers (a group of free market economists from University of Chicago known as The Chicago Boys) had him privatize industry and lower taxes and regulations. There were huge job losses and more economic contraction at first, but within a couple of years the economy began to grow, and like Ireland, Chile became the economic miracle of their continent.
In 1945 Argentina had a standard of living higher than France. In the succeeding years the communists/ socialists took over, raised taxed and did all the things socialists do (including severely curbing personal freedoms). As a result the country went from vibrant growth to a stagnant second rate economy. Even France, with all its oppressive taxes, has grown faster and larger than Argentina.
The Heritage Foundation (a conservative think tank) and the Wall Street Journal compile statistics annually called the Economic Freedom Index. They quantify with a point value each area they think is important to the growth of an economy. The total point score gives an overall rating to each country gauging their economic freedom and growth potential. Taxes are the most important, but things like regulation, the judicial system, respect for private property, infrastructure etc are included. If you graph the ratings of each country, and placed it next to a graph of each countries economic growth, or per capita income, or living standard, or government revenue, or most anything we hope to get from our economy, you will see a mirror image. The higher the rating in the Economic Freedom Index, the higher the economic growth rate and overall prosperity.
Government is the problem, not the solution. Obviously we need government. We need a protector and an enforcer (police and armed forces). We also need a referee (settle disputes, insure transparency etc.). But mostly we need government to stay out of the way. Ironically, one might think lower taxes would starve the beast (government), but counter intuitively, lowering taxes actually produces more money. Eventually we will reach a point where the rate goes so low that revenue does begin to decline. Then we can argue. But please, not now..
The debate on taxes between liberals and conservatives is insane. Lowering taxes serves everyone's objectives. The government realizes more revenue, and individuals keep more of what they make. Lower taxes create more incentive for investors, thus more economic activity, and it keeps capital in private hands versus under inefficient government control. Consequently more wealth is generated. Why are we arguing?
Over the last 50 years the jury (history) watched and heard both sides of the tax debate. They returned a unanimous verdict. Cuts help everyone. John Kennedy, Ronald Reagan and George W Bush lowered taxes and the economy skyrocketed every time. Herbert Hoover and FDR raised taxes and we had a depression. People say Bill Clinton raised taxes and the economy was great. That's true. But the marginal rate increases were modest, whereas his capital gains tax cut was substantial. Also the tech boom and his passage of NAFTA helped a lot.
There is a concern on the left that tax reduction dis-proportionately helps the wealthy, and it does. We can all agree that wealth creation in a capitalist system is top heavy. But capitalism still creates the greatest amount of wealth in every individual quintile of the income scale. If you are in the bottom 20% of earners, would you rather your income stagnate but remain proportional to someone in the top quintile, or would you rather earn more yourself and have the top earners gain disproportionally? I would care less about what was happening at the top so long as I was moving forward.
20 years ago Ireland's economy was one of the worst in Europe. They passed a law allowing artists to settle there and pay no taxes. Needless to say many people extended the meaning of artist (isn't a plumber creative?), and all of a sudden immigrants were coming from throughout Europe. The Parliament noticed that the economy was growing in a way they had never seen before, so they passed a general tax cut. Voila! There was more economic activity, more jobs, more net personal income, and more tax revenue. Since then they cut taxes 13 times. 13 times the economy grew, and 13 times the government realized more tax revenue. Ireland has gone from one of the worst economies in the EU to the second best, behind Luxembourg. Before the reductions they had 50,000 people a year leaving the country looking for work. Today they have 200,000 coming into the country looking for work.
Over the last 50 years Hong Kong has been the fastest growing of all western economies. They also have the lowest tax rate. In fact it even "favors the rich," in that it is a 16 percent flat tax. Still, the lowest rate among western economies not only produces the highest growth rate among them, but also produces the highest tax revenue per capita.
In about 1970 Communists won elections in Chile and nationalized industries and of course raised taxes. Needless to say the economy ground to a halt, there was high inflation, and despair ruled the country. Colonel Augusto Pinochet (head of the army) took control of the government, and his advisers (a group of free market economists from University of Chicago known as The Chicago Boys) had him privatize industry and lower taxes and regulations. There were huge job losses and more economic contraction at first, but within a couple of years the economy began to grow, and like Ireland, Chile became the economic miracle of their continent.
In 1945 Argentina had a standard of living higher than France. In the succeeding years the communists/ socialists took over, raised taxed and did all the things socialists do (including severely curbing personal freedoms). As a result the country went from vibrant growth to a stagnant second rate economy. Even France, with all its oppressive taxes, has grown faster and larger than Argentina.
The Heritage Foundation (a conservative think tank) and the Wall Street Journal compile statistics annually called the Economic Freedom Index. They quantify with a point value each area they think is important to the growth of an economy. The total point score gives an overall rating to each country gauging their economic freedom and growth potential. Taxes are the most important, but things like regulation, the judicial system, respect for private property, infrastructure etc are included. If you graph the ratings of each country, and placed it next to a graph of each countries economic growth, or per capita income, or living standard, or government revenue, or most anything we hope to get from our economy, you will see a mirror image. The higher the rating in the Economic Freedom Index, the higher the economic growth rate and overall prosperity.
Government is the problem, not the solution. Obviously we need government. We need a protector and an enforcer (police and armed forces). We also need a referee (settle disputes, insure transparency etc.). But mostly we need government to stay out of the way. Ironically, one might think lower taxes would starve the beast (government), but counter intuitively, lowering taxes actually produces more money. Eventually we will reach a point where the rate goes so low that revenue does begin to decline. Then we can argue. But please, not now..
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