Deficit Politics

Ryan Avent wonders why the deficit has become such a big deal suddenly. Maybe it's because the bond market is panicking? Nope. The bond market is quite calm at the moment. Then maybe it's because the public is panicking? Apparently not, according to survey data anyway:

It actually looks as though the public doesn't care about the deficit either, at least relative to the state of the general economy. So why is the deficit such a big issue right now, at least in Washington?

The short answer is that President Obama has given the press a nice news peg in the form of the impending release of a report from his deficit reduction commission. Another question, then, is why the president felt the need to appoint a deficit reduction commission. And the answer there is some combination of "the deficit actually needs to be addressed" and "the president felt there was a political weakness that needed defending". Why the president felt a weakness on deficits is another, mysterious issue.

I don't think this is quite right. Leaving aside whether it was a good or bad idea, the deficit commission was a response to deficit hysteria, not the cause of it. And I don't think it was all that mysterious, either: it was basically a response to an excellent political game played by Republicans. Think about it: if you're opposed not just to a single initiative from the opposing party, but to every initiative from the opposing party, what's a handy umbrella for expressing that uniform opposition? Answer: deficit panic. After all, just about everything Democrats propose can be spun as a deficit buster. And it's pretty easy to to gin up the Republican base with talk of eventual doomsday and devalued currency. The deficit is just a perfect issue for Republicans and they did a great job of getting the maximum mileage out of it.

So you have to give Republicans an attaboy for playing the game well. The question is why Team Obama felt like they had to respond. And here I suspect Ryan is basically right. Obama probably really does believe the long-term deficit needs to be addressed, and he's pretty famous for listening to his inner technocrat even if it annoys his base and makes for poor politics. And he probably really did believe that the existence of the commission would take some of the air out of the Republican attack. This is more mysterious, since there was never any chance of that happening. There's no way that a nonbinding commission was ever going to have the slightest effect on what Republicans knew was a very effective line of attack against Democrats.

But it's too late now. As Ryan says, it all might have made some sense if Obama could have spun "medium-term deficit reduction as a means to create the fiscal room for more stimulus." But he never even tried to do that, and the moment when he could have pulled it off is long gone. Too bad. It would have been good politics and good policy.

Good Economic News of the Week

Since I posted a big ol' stew of bad economic news last night, it's only fair to perk up the start of your week with some good economic news:

U.S. retail sales surged in October, rising above expectations on robust car sales and solid spending for a broad array of merchandise going into the holiday shopping season.

Separately, inventories at U.S. businesses in September rose above expectations, a sign of confidence among companies in the economic recovery as the holiday shopping season grew nearer. Retail sales rose 1.2% last month....The increase was the biggest since March and the fourth in a row. September sales rose 0.7%, revised up from a previously estimated 0.6% increase.

I don't know if this is sustainable or not. Without a big drop in unemployment and steady wage gains, I doubt it, since consumers are still deleveraging and look to be doing so for a while now. Still, it's good to see. I guess all that regulatory uncertainty isn't holding back businesses after all.

"Outspoken and Unified"

According to a report in the Wall Street Journal, criticism of the Fed over its bank bailouts had largely died down earlier this year. Then they announced their quantitative easing program. Still, things remained relatively quiet:

But last week, potential GOP presidential candidate Sarah Palin delivered a stinging speech on the move and then, in a Facebook post, criticized Mr. Obama for defending the Fed.

Last Tuesday evening, about 20 economists and others met over sea bass at the University of Pennsylvania Club in Manhattan and hashed out a broad strategy. [Paul] Ryan, who has gained notice for a plan to balance the federal budget through deep spending cuts, joined the group as they discussed ways to encourage the GOP's new House majority to unite behind what they describe as a "sound money policy."

"We talked about the importance of the right being outspoken and unified on this," said a participant. Mr. Ryan couldn't be reached Sunday.

Over the weekend, organizers began discussions with possible GOP presidential candidates, including former Massachusetts Gov. Mitt Romney and former House Speaker Newt Gingrich. On Tuesday, Mr. Boskin and another signer, Paul Singer, head of hedge fund Elliott Management, will brief GOP governors at a conference in San Diego.

So there you have it. Sarah Palin makes a speech about technical monetary policy and within a few days the entire Republican establishment is scurrying around to make sure that everyone has their monetary policy marching orders. Zhou Xiaochuan, Arkady Dvorkovich, and Wolfgang Schaeuble should be very pleased.

Financial Crisis Not Over Yet

This weekend served up a heaping helping of my entire personal stew of economic nightmares. So here it is, your global economic news for the weekend:

LA Times: Commodities tumble on fears that China will try to slow its economy. "The fast-running bull market in commodities hit a wall Friday as prices plunged on fears that China will try to slow its economy to tame inflation. Rumors of another Chinese interest-rate hike started a chain reaction of selling across financial markets worldwide...."

Financial Times: Concern grows as Dublin spurns help. "Irish officials insisted on Sunday that they did not need fiscal assistance from the European Union, even as pressure mounted on Dublin to accept aid and present plans to restructure its banking system....Behind the scenes, the ECB has put pressure on Dublin to take steps within days that would provide an urgently needed boost to confidence in Ireland’s public finances and struggling banking system."

Wall Street Journal: Credit Fears, QE2, Elections Prompt Muni Selloff. "Investors sold off long-term municipal bonds in the past week, sending a shiver through a normally stable market....In recent months, with reports of financial woes in Harrisburg, Pa., and of some municipal borrowers walking away from debts, some investors have begun to question whether government borrowers are as reliable as investors' presumed about repaying loans."

Financial Times: Nervousness as bonds braced for Greek tests. "Eurostat, the Commission’s audit unit, is set to revise upwards Greece’s 2009 budget deficit figure to about 15.3 per cent of gross domestic product from the current estimate of 13.6 per cent of GDP....This could spark a sell-off in the Greek and other peripheral bond markets as investors are increasingly nervous about the ability of the weaker eurozone economies to turn round their economies and restore growth.....David Owen, chief European financial economist at Jefferies, the investment bank, said: [] 'If investors start to sell bonds of Spain and Italy in the way they have been selling Greek, Irish and Portuguese bonds, then the crisis will take on a whole new dimension.'"

All of these are trouble spots for the world economy. Throw in Eastern Europe and hot money flows into developing countries and you've got an even half dozen shocks that could send us into another tailspin. Hopefully none of them will happen. But all it would take is for one or two of them to unfold badly. Keep your fingers crossed.

Fiscal Stimulus

Bruce Bartlett:

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.

I get this, of course. Still, it's kind of too bad Bruce didn't say it anyway. Sometimes I think that we reality-based folks cave in to reality a little too quickly. It may be true that we're not going to get more fiscal stimulus anytime soon, but if that option is being shut down by congressional know-nothings then at least it should be clear to everyone just how many people believe it's really our first best option and why we're not getting it. If the public thinks it's just Paul Krugman yelling about stimulus, that's one thing. If they know that it's actually a pretty mainstream position outside of the tea party right, that's quite another. And in the end, public opinion matters.

Taking the Lame Out of the Duck

Lisa Mascaro writes in the LA Times that Democrats are lowering their sights for the lame duck session:

Gone is any hint that Democrats will try to ram through the rest of the ambitious legislative goals President Obama outlined two years ago when he took office with a Democratic majority in both chambers. No one, for example, is talking about a controversial bill to reduce global warming pollution with a cap-and-trade system.

Still, Democrats are intent on closing out the 111th Congress with a few final strokes that could provide a fitting coda to what historians have called one of the most productive sessions in a generation. Despite electoral losses that handed control of the House to Republicans and diminished Democrats' majority in the Senate, Democratic leaders are pressing an agenda that would extend middle-class tax cuts, fund the government and perhaps repeal the ban on openly gay men and women serving in the military.

I never believed for a second that Democrats could pass cap-and-trade, immigration reform, or card check during the lame duck session. It was a fantasy. If they couldn't do it during the regular session, what made anyone think they could do it during a lame duck?

Frankly, if they can pass a tax plan and repeal DADT, I'd consider that a pretty productive lame duck session. I'd even propose a deal that a few moderate Republicans might be open to: extend all the Bush tax cuts for three years in return for passage of the funding bills, including DADT repeal. If Democrats managed to do that, and possibly get Senate approval of New START too, it would go a long way toward showing that they haven't been entirely cowed by their "shellacking."

Empowering Women

Dani Rodrik notes the surprising news that among the countries that have most improved their human development indicators since 1970, the stars are mostly Muslim countries, including several in North Africa:

What was their secret? Determined policies to expand educational opportunities and access to health along with a willingness to depart from the conventional wisdom of the day and experiment with their own remedies. Even though all three North African countries are Moslem, empowering of women seems to have played an important role as well:

There is now substantial evidence that the health and schooling of children can be raised by empowering women, and this is precisely what Tunisia did when it raised the minimum age for marriage, revoked the colonial ban on imports of contraceptives, instituted the first family planning programme in Africa, legalized abortion, made polygamy illegal, and gave women the right to divorce as well as the right to stand and vote for election.

This comes up repeatedly. As near as I can tell, the single most important thing that developing countries can do to ensure themselves a brighter future is to educate and empower women. I'm not sure there's even a close second.

The Uncertainty Meme

Why does the economy continue to suck? The LA Times is hosting a symposium on the topic today, and USC business professor Ayse Imrohoroglu says the answer is uncertainty:

Businesses don't know what will happen to interest rates. They have trouble calculating what new workers will cost in light of potential new healthcare mandates and costs. They don't know what will happen to tax rates, which could rise dramatically. They are uncertain about increasing financial regulation and the possibility of a carbon tax. And as if that isn't enough, the soaring deficits and national debt raise very real questions about the federal government's long-term ability to meet its debt obligations.

OK, let's take these one by one:

  • Interest rates will remain very low for a very long time. The Fed has made this as clear as any central bank possibly could.
  • PPACA has no impact on small businesses and only a minuscule impact on large businesses. Medium-sized businesses face a modest penalty if their workers use federal subsidies to enroll in private insurance programs via the exchange. In other words, the overall financial impact on the business community is pretty modest. What's more, there's really not much uncertainty here. The broad impact of PPACA's rules is already clear, and they don't take effect until 2014 anyway. This is not having a significant impact on business investment decisions in 2010.
  • There's no excuse for Congress leaving tax policy up in the air for as long as it has. But even with that said, the Bush tax cuts affected personal tax rates, not business rates. And despite demagoguing to the contrary, even if the Bush tax cuts expire completely the effect on small businesses would be close to zero.
  • Financial reform was a fairly modest affair, and in any case its effect is almost entirely restricted to the financial sector. Its effect on the rest of the business community is slight.
  • There is no possibility in the near future of a carbon tax.
  • There is no question about the federal government's long-term ability to meet its debt obligations, and even if there were this would have very little effect on short-term investment decisions by American businesses.

The uncertainty meme is just mind boggling. Businesses always have a certain amount of regulatory uncertainty to deal with, and there's simply no evidence that this uncertainty is any greater now than it usually is. (It is, of course, entirely believable that business owners who spend too much time watching Fox or reading the Wall Street Journal editorial page might believe otherwise, but that's a whole different problem — and one that Imrohoroglu should spend his time debunking, not promoting.) The only significant real uncertainty that American businesses face right now is financial uncertainty: that is, whether there will be enough consumer demand next year to justify hiring more workers and buying more equipment today. PPACA and carbon taxes rank very far down the list.

UPDATE: Let me add something that I just mentioned in an email to a friend. The main sources of regulatory change during Obama's term so far have been PPACA and financial reform. During George Bush's first five years, he approved No Child Left Behind, the PATRIOT Act, McCain-Feingold, Sarbanes-Oxley, the Homeland Security reorganization, Medicare Part D, bankruptcy reform, and two big tax bills. He also tried and failed to pass major changes to Social Security. And all this was in addition to the usual background hum of agency regulatory hearings and rulemaking changes — including a heap of financial deregulation that eventually contributed to an epic banking meltdown.

And yet, no one complained about regulatory uncertainty back then. Why? Because the economy was growing. Businesses like some regulatory changes and dislike others, but it's mainly financial uncertainty that keeps them from hiring and investing.

The Great IOR Mystery

I'd like to second this comment from Matt Yglesias:

If the country’s political press could redirect 10 percent of the attention currently being paid to the House Democratic leadership race and the GOP pre-campaign for 2012 to one thing I would suggest the Federal Reserve’s interest on reserves program.

....In late 2008, the Fed for the first time ever said that if banks wanted to hold extra reserves they would get interest payments in exchange for doing so. Then they raised the interest rate. And then they raised it again. Via Scott Sumner, Louis Woodhill makes a very strong argument that this has been a massively underrated factor in producing the recession. The IOR payments led to a steep decline in the velocity of money, which in turn led to a collapse in Aggregate Demand.

Now, I think Woodhill's argument is overstated in two ways. First, the Fed didn't just raise the IOR rate and then raise it again. The IOR rate is based on the fed funds rate, and the Fed raised the IOR rate at the same time that it was reducing the fed funds rate, producing a sort of choppy up and down trajectory for a couple of months in 2008. Overall, though, between October and December of 2008 the nominal IOR rate dropped from 0.75% to 0.25%.

Second, I have my doubts that this was responsible for the great collapse of 2008. Woodhill bases his argument on coincidental drops in stock market prices, but this is fairly weak tea. The stock market was both very volatile and generally falling during this entire period, and the drops following the IOR increases were made up pretty quickly. It's not impossible that the fluctuation in the IOR rate was driving some of the stock market changes, but the evidence is thin. [See update below.]

That said, however, the general argument here seems unassailable: regardless of whether bouncing IOR rates affected the stock market badly in 2008, the fact that the IOR rate today is greater than zero seems very, very strange. As Woodhill says:

The Fed knows that IOR is contractionary. Chairman Bernanke has testified that raising the IOR interest rate is one option for fighting inflation. Two Fed staff economists issued a report in July 2009 ("Why Are Banks Holding So Many Excess Reserves?") that describes how paying IOR at the Fed Funds target rate would stop the "money multiplier" process dead in its tracks.

....In the absence of IOR, there is an incentive for anyone who receives a dollar to immediately pass it on by doing another transaction. There is also an incentive for banks to lend out their excess reserves....The payment of IOR at an "above market" interest rate (which has been the case for the past two years) short-circuits the processes described above. IOR creates a "roach motel" for money — the dollars go in and they don't come out.

In other words, if the IOR rate is zero, banks might as well lend their money and hope to make a profit on it. It's better than nothing. Conversely, if they can earn a safe return on their reserves just by parking them at the Fed, that might seem like the better deal. And so credit tightens and businesses have a hard time getting loans.

Control over the IOR rate, which was given to the Fed in 2006, is an important monetary lever. So why would the Fed announce a quantitative easing program designed to stimulate a weak economy at the same time that it keeps the IOR level set at a mildly contractionary level? It doesn't make sense. Once the Fed has officially announced that it believes the economy is stuck ("Pace of recovery...continues to be slow...high unemployment, modest income growth, lower housing wealth, and tight credit....Employers remain reluctant to add to payrolls. Housing starts continue to be depressed"), why wouldn't it use the IOR lever in addition to the QE lever? Why have them pointing in opposite directions?

I suppose one reason this doesn't get very much attention is that there's nothing much to say about it. The Fed won't comment on it, members of Congress are mostly unaware it even exists, Glenn Beck hasn't devoted a show to it, and there's nothing to say in a news story other than "once again, the Fed has taken no action on the IOR rate." Your editor won't let you write that story very often.

Still, it's a pretty interesting question. Why is the IOR rate still stuck at 0.25% instead of zero? Is it because the Fed believes that lending is constrained by demand and the IOR rate isn't playing a role? Is it because they think providing a steady source of profit for the banking system is still Job 1? Is it because they consider IOR's effect on lending to be pretty trivial at 0.25% and not worth bothering with? Or what? It is indeed mysterious.

UPDATE: My intent in this post was to agree with Matt Yglesias's point about the IOR rate being too high without also implicitly buying into the Louis Woodhill argument that he links to. That's the only reason I spent any time on it at all. However, Niklas Blanchard thinks my skepticism was too mild:

IOR policy wasn’t the driver of the collapse in 2008, inadvertently tight monetary policy was. If you are hardcore about monetary disequilibrium, like I am, then that was the key to the entire recession (contra what was happening with financial intermediation). The IOR policy was just heaping gasoline on a fire, so to speak.

I mostly agree, and I should have been more pointed about this. The great collapse of 2008 was largely driven by economic fundamentals. Regulatory issues played a role in making the collapse worse than it had to be, but it would have happened regardless. Likewise, IOR fluctuations may have affected stock market prices in late 2008 — though even that's not indisputable — but the recession had been underway for nearly a year by that time, the financial system had come close to collapse a month earlier, and the IOR policy, at worst, might have made things slightly worse. The argument that it caused the collapse just doesn't hold water.

Baubles vs. Hard Truths

Derek Thompson is disappointed with liberal reaction to the deficit commission report. For example, liberals like me:

The third most frustrating criticism comes from folks like Kevin Drum, who claims that any effort to reduce the deficit that isn't 98% health care reform isn't serious. The fact is, there are no feasible ways to definitively curb health care inflation starting today (if Kevin has some in mind we need to hear them!). We can shoot a thousand arrows at the medical inflation monster — health care reform, to its great credit, does. We can nudge providers and customers away from pay-for-service, which rewards over-treatment. We can increase cost-sharing to help patients react to prices, increase transparency and quality through exchanges, and so on. But these are efforts, not answers. If we waited for the messianic Answer to health care inflation, we might never act on the budget. I can't imagine that's what Kevin would prefer. Instead, we should make the changes we can make today, slowly.

This is fair up to a point. But only up to a point. Here's the problem: most plans to reduce the long-term deficit consist of three things: shiny baubles, smoke and mirrors, and actual deficit reduction measures. You want to minimize the former and emphasize the latter, and on that score I don't think Simpson-Bowles does very well.

Their discretionary cuts are a combination of baubles and smoke and mirrors. The baubles are the trivia, like cutting printing costs and eliminating earmarks. The smoke and mirrors comes from vague non-choices like cutting the federal workforce 10% or pretending that a spending cap will actually accomplish anything. Discretionary spending isn't really a long-term problem in the first place, but if you're going to address it anyway, then address it by proposing actual program cuts. You think manned space exploration is a boondoggle and you want to cut NASA's budget in half? Fine. You think ethanol subsidies are outrageous and you want to eliminate them? Great. You think our nation would be safe with nine supercarrier groups instead of a dozen? Preach it. But that's what it takes to cut the discretionary budget: cuts to real programs, not handwaving about caps and generic rollbacks.

Next up are their tax reform proposals, which are almost entirely smoke and mirrors. You can make any deficit reduction plan easier by proposing a tax system that (you claim) will boost growth rates by 1% per year. Run that out over 50 years and economic growth will take care of half your problem. Hooray! But the evidence that this will actually happen is close to zero. Our current tax system just isn't that inefficient. Pretending that a better tax regime will supercharge economic growth isn't as bad as relying on the infamous troika of waste, fraud, and abuse, but it's close.

Their Social Security proposal is.....actually not bad. With one change I could probably accept it as is.1 Still, even though I favor taking action on Social Security now, this is basically a bauble. It's reponsible for only a small part of the long-term deficit, and it's not something that rises forever. It's a one-time increase associated with the retirement of the baby boomer generation.

And then you get to healthcare. This is the big one. This is 90% of our long-term deficit problem. I don't have any real problem with tackling inefficient discretionary programs or sprucing up the tax code or fixing Social Security. But burbling on at length about this stuff mainly serves to allow us to avoid talking about our real problem. Because, as Derek says, it's too hard. But that's like an alcoholic nattering on about putting a taxi service on speed dial or remembering to take his vitamins every day. Those are great ideas, but they're basically distractions that prevent you from facing up to the fact that you need to stop getting hammered every night.

The whole point of a deficit reduction commission is that they can address the hard truths that a bunch of politicians can't. If Simpson-Bowles were really dedicated to hard truths, their report would have said two things in no uncertain terms. First, we're not going to waste too much time on discretionary spending or Social Security. They're shiny baubles that distract us. So here are links to half a dozen good plans for reining in both of them. Go ahead and read them at your leisure.

Second, healthcare costs are going up. We're getting older, medical technology is advancing, and the spending curve on healthcare heads to infinity if we don't do something about it. So we've decided that essentially our entire report is going to be about healthcare because we want to rub your faces in the fact that you have to deal with it whether you like it or not. This means, at a minimum, two things: (1) distilling the best ideas around for reining in rising healthcare costs, and (2) acknowledging that costs are going to go up anyway and we're going to have to raise taxes to deal with it.

But as hard truths go, I guess that's a little too hard. Tax increases! Paying doctors less! Telling the American public that they can't have every procedure they want just because they want it! Besides, we just spent over a year passing healthcare reform, and we're all exhausted. PPACA made only modest progress on cost controls, and that was hard enough. Better to just do some handwaving about a cap on growth rates and call it a day.

I get it. No one wants to dive back into that briar patch right now. But that's too bad. So go ahead: take a whack at reducing discretionary spending by 2% if it makes you feel virtuous. Go ahead and reform the tax code. It needs it. And sure, fix Social Security just as a warmup to prove that you can hit AA pitching before you move on to the show.

But don't pretend that you've really done much of anything about the long-term deficit. For that, we're going to need a whole bunch of straight talk about tax hikes nobody likes and cost controls that everybody hates. But isn't straight talk like that exactly what Simpson and Bowles were supposed to give us?

1I would ditch the increase to the retirement age and pay for it by gradually increasing payroll tax contributions from 12.4% to 13%. The rest of their proposal strikes me as fairly reasonable.