The Bear's Lair: Digging the hole deeper

Oct. 15, 2001 at 7:00 PM
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WASHINGTON, Oct. 15 (UPI) -- Governments in the United States, Britain and Japan moved quickly following the Sept. 11 attacks to combat the recession that all three governments now recognize. Unfortunately, when faced with an economic hole in the form of a recession, they appear to be digging deeper.

In the United States, Congress began by giving a $15 billion bailout to the airline industry. This prevented the necessary shakeout in an industry that during the late 1990's expanded too far and allowed service -- and doubtless safety standards --to slip. More important, it raised the perceived return for lobbying Congress, thus diverting even more streams of resources into this utterly economically unproductive activity.

According to the Cato Institute, corporate welfare increased from $65 billion in fiscal year (ends Sept. 30) 1997 to $87 billion in FY 2001. The airline bailout no doubt is just the first in an explosively growing total of corporate welfare for fiscal year 2002.

As well as the airline bailout, the Bush administration and Congress are working on a $60 billion economic stimulus package on top of the $40 billion package already passed for disaster recovery and military renewal. Items in the package that might boost economic growth, such as a reduction in the capital gains tax rate, a reduction in corporate tax rates and an acceleration in the individual income tax rate reductions in the spring Bush tax plan, were quickly taken off the table.

Instead, the $60 billion is likely to consist mostly of extra federal spending, with tax reductions confined to additional depreciation allowances (grossly partial in their application, and subject to widespread abuse, as was demonstrated in 1981-82) and possibly some kind of tax relief for those that don't pay taxes -- de facto, additional social spending.

If it passes in this form, the stimulus package will represent the most primitive kind of Keynesian demand management. Public spending stimulates the economy short-term because it withdraws resources (either through taxes or through borrowing) from the private sector, which saves part of its inflows, and spends 100 percent of the resources so withdrawn. Of course, in the United States, with its savings rate of either 1 percent or negative, depending on how you calculate it, this effect is minor to infinitesimal --- presumably if the savings rate is negative, then extra public spending actually deflates the economy rather than inflating it!

But in the long term the damage done to the fiscal balance of the economy by a big spending boost is much more important than the short-term Keynesian kicker. I wrote three months ago that the deficit for fiscal 2002 might total as much as $200 billion. With the additional $100 billion of "stimulus" programs already announced, this figure is likely to be raised to the $250-300 billion range. This deficit will not of course appear in the early budget numbers discussed by Congress, it will merely become apparent in the final outcome, which will not be known until October of next year. By then it will be too late.

The U.S. budget once more will be clearly in substantial and prolonged deficit, and long-term real interest rates will inevitably increase.

While Larry Kudlow, in National Review Online, recently propounded the extraordinary theory that an increase in long-term rates, being associated with an economic recovery, would be a good thing, the balance of economic opinion, probably since the days of Thomas Mun and the physiocrats, is on the other side of that argument. A recovering economy increases the demand for funds and thus increases real interest rates, Larry, NOT the other way around! Clearly a rise in long-term real interest rates at a time of economic recession simply prolongs and deepens the recession -- as was amply proved in 1931-32.

This column a few weeks ago studied the effect of public spending on economic growth, using OECD statistics from 30 countries over the 40 year period 1960-2000 (thus dampening out the effects of the business cycle), and discovered that fully half the variation in economic growth, over time and between countries, was explained by two factors: the level of public spending expressed as a percentage of GDP, and its rate of increase on the same basis. High public spending, or rapidly increasing public spending, severely depress economic growth --- the effect of rapidly increasing public spending is a likely explanation both of Japan's problems in the 1990's and the U.S. problems in the 1930's. Public spending tends to increase as a percentage of GDP in a recession anyhow, so deliberately increasing public spending going into a recession, as the administration and Congress are proposing, is likely to be particularly destructive of U.S. economic health.

In Britain, the costs of the Afghanistan operation and an economic stimulus package have simply been added to a budget balance that was already out of kilter. Chancellor of the Exchequer Gordon Brown pledged at the Labor Party Conference Oct. 3 that if because of recession or unexpected spending demands there was a conflict between maintaining current levels of taxes and trimming back on Labor's already announced spending plans for the life of this parliament (2001-05), then taxes would just have to go up.

This is traditional Labor policy, which the Blair government was supposed to have abandoned in favor of fiscal moderation (though in practice there were a number of "stealth" tax increases in the government's early years.) Most likely tax increase: the earnings limit on National Insurance contributions will be abolished, meaning an extra 9 percent tax on all earned income (and presumably, by additional legislation investment income) above the current 29,000 pounds, making the top effective marginal rate of tax 49 percent.

This has the additional advantage to the government that being an "insurance" contribution, it can be left out of many tax calculations and comparisons. Since the higher income taxpayer will get absolutely no benefit from the increased contribution, however, it will have exactly the same effect as an increase in income tax.

In any case, Labor's plans for a steady increase in public spending and an anti-supply-side increase in tax to pay for it will push Britain firmly up the league of sclerotic high-tax EU countries and further depress the economy.

In Japan, Prime Minister Junichiro Koizumi was elected in April on a platform of determined economic reform to right the Japanese economy, and has so far done very little to justify voters' confidence in him. On bank restructuring, he has proposed that bad bank loans be bought out by the state at a price far in excess of their economic value, thus continuing the hidden subsidies that riddle the Japanese economy. On postal bank privatization, supposedly his No. 1 issue, a report is supposed to appear at the end of this year, but it is expected to recommend only turning the postal system into three public corporations, with actual privatization being pushed into the indefinite future.

Most damagingly, on public spending, Koizumi appears to be weakening on his commitment to cap public borrowing at 30 trillion yen ($250 billion) for the fiscal year to March 31, 2002. With Japan's recession deeper than was expected, and additional costs being incurred for anti-terrorist operations, talk of a "fiscal stimulus" package is reaching a crescendo, and it is more than likely that the rural barons of Koizumi's LDP will succeed in forcing Japan's fiscal position still further into the red.

At which point, however much Koizumi's "position may have strengthened" as the Economist claims, he will de facto become just another faceless bureaucrat Japanese prime minister, distinguishable from the rest only by his hairstyle. The Japanese recession meanwhile, will stagger on into its 12th year, with the Great Depression's all-time record (September 1929-December 1941) only months away.

All three governments, therefore, are making their country's recession possibly deeper and certainly longer. In the case of the United States and Britain, it can be argued that policymakers are still working on the premise that this recession can be avoided or may be very short and mild. In Japan's case, after 11 years, there can be no such self-delusion. Instead it is becoming increasingly clear that the Japanese political system may have become so resistant to change that nothing can be done. In that case, Japan's position as the world's second largest economy, and as a beacon to Asian people everywhere of what can be achieved with a few decades of hard work and good policy, may ultimately be in danger.

Yet the asset overvaluation in the United States and Britain, that is causing this recession to be so much longer and worse than had been expected, still continues. Indeed, in Britain, it is still getting worse. The London stock market never became as overvalued as New York, but the London housing market, instead, has reached levels wholly beyond comprehension and is now priced like the dot-coms. Thus there is similarly a downward revaluation, with corresponding negative wealth effect, yet to come.

In Japan, the change in Koizumi's policies may miss the escape from another decade of recession, although it is hard to believe that such a diligent, productive people won't find a way out somehow. In Britain, if the Blair government pushes up taxes and depresses the economy, the electorate will have a clear choice in 2005-6, in Ian Duncan Smith's Conservatives.

In the United States, the political cycle may work against rather than for economic recovery, as continued gloom may produce a big-spending leftist administration and Congress.

Yet even in the U.S., there is a policy alternative. The U.S. corporate tax system is anomalous, in that it taxes dividends twice, once at the corporate and once at the individual level, producing true marginal tax rates of up to 60.8 percent (35 percent corporate, compounded with 39.6 percent individual) even before state and local taxes are considered. This could easily be reversed, in the context of a stimulus package, by making dividends tax-deductible at the corporate level, thus taxing them only at the recipient level. With corporate dividends totaling $160 billion per annum, the cost of this reform would be at most $56 billion per annum.

While corporate dividends could be expected to increase following such a change, there would be no further income loss from substitution, since dividends would still be taxable for the recipient. On the other hand, there would be a further revenue gain from winding up leasing and other tax-avoidance deals, and from domesticating much foreign income of U.S. companies -- shareholders would not be impressed by a management which entered into complex leasing transactions or sheltered income in a tax haven, when it could achieve an equal corporate tax benefit by paying it to them in dividends.

The real benefit of such a tax change, however, would be in the value of U.S. stocks, which in theory would be increased by 54 percent (35/65.) In practice, the increase would be less than this, since many companies already pay tax at far less than the statutory rate and would not be able to take full advantage of dividends' tax deductibility. Still, the equilibrium value of the Dow might rise from 5,000 to say 6,500, thus greatly reducing the further market fall to be expected, and the wrenching negative wealth effect thereof.

There would be other benefits. Dividends would increase so investor returns would come more from higher dividends and less from capital gains. Company management would no longer have a tax excuse not to pay dividends, so their stock options would be valuable only if the company succeeded, and not through sheer reinvestment of other stockholders' earnings. Both these changes would stabilize the U.S. stock market, a greatly needed change.

It is surely obvious by now that the excessive rise in stock prices in 1995-2000, and still more the excessive rise in tech stocks quoted on NASDAQ, has been highly destabilizing to the economy. The less resemblance between the New York Stock Exchange and a second-class Las Vegas casino, the better.

This is a tax change, of about the same size as is being considered, that would truly stimulate the economy, in both the short and long term. It is of course most unlikely to be enacted. That's politics.

(The Bear's Lair is a weekly column which is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the last 10 years, the proportion of "sell" recommendations put out by Wall Street houses has declined from 9 percent of all research reports to 1 percent. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

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