November 15, 2010

How Obama can outflank GOP on 250+ tax cuts:
The payroll exemption

If President Obama actually had a pair, this is what he would do:

Propose trading the additional tax cuts for those making over $250k/year with extending the personal exemption to payroll taxes. Frame it as the top-two-percent-of-millionaires tax traded for the everyone-trying-to-keep-food-on-the-table-in-tough-times tax.

Unlike federal income tax that allows for a $5700 personal exemption, a W-2 wage earner currently pays payroll taxes starting with his very first dollar, with no exemptions or deductions allowed towards the tax. This is how a tax with a published rate of 7.65% brings in about as much revenue as a tax with a top published rate of 35%. It is also how 4 out of 5 taxpayers pay more in payroll tax than in federal income tax.

The hit to revenue would be approximately equal. Extending the Bush tax cuts for those making over $250k/year would reduce federal tax revenue by approximately $70 billion/year. Exempting the first $5700 of wages from the payroll tax would result in a loss of only $54 billion/year in revenue.

Put Republicans on the defensive. Make them explain how it is better to take food off the table of those struggling to get by so that those making over a quarter-of-a-million can have an additional tax cut that no one else has. Remind Americans of just how marginal taxation works and how even those making over $250k/year will still be getting a tax cut on every dollar earned below $250k, just not additional tax relief on earnings above that figure. Put on your professorial hat and explain how the backward bending supply curve of labor suggests that such tax policy might even get more output from this group of people. Explain to us the Ramsey growth model, the fact that growth results from savings, regardless of who is doing the saving. President Obama is great at explaining complex things such as financial derivatives and capital leverage ratios in plain speak. He can explain how a tax cut for someone else may be better than no tax cut at all but certainly isn't better than a tax cut for yourself, and it is that very bit of illogic that Republicans are trying to sell.

President Obama should use this as the opportunity to return to his class-warfare-stoking populist roots. The alternative is continued class dominance corporatism.

-- Also at my Seeking Alpha blog --

November 12, 2010

QE2 inflation worst case scenario

The absolute worst case inflation scenario of continued quantitative easing (QE) would involve the entire world losing confidence in the dollar, simultaneously dumping US currency and US Treasury securities, the lender of last resort becoming the lender of only resort, and monetizing the entire deficit. Given a set of known figures, this translates into an initial inflation shock of roughly 52%, followed by an annual inflation rate of 13-15%. Painful? Yes. Government toppling as many fear mongers have suggested? No.

It is commonly accepted monetary theory that only the M2 broad money supply relative to the amount of stuff to buy with it affects inflation. M2 is currently $8.65 trillion. [Note: Definitions for M1 and M2 are at that link.] Foreign holdings of US Treasury securities total $4.21 trillion. University of Wisconsin economist Edgar Feige estimated in 2009 that 30% of the $965 billion of US currency in circulation is held abroad for an estimated total of $298 billion. Finally, the CBO estimates the 2010 federal deficit to be $1.3 trillion. With this set of givens as our inputs, calculating the effect on M2 and thus the inflation rate under a total crisis-of-confidence scenario is relatively easy. If currency held abroad is sent home to circulate domestically, that will increase the price of domestic consumption. If foreign holders of US Treasury securities sell their IOUs, someone will have to buy them to keep the price from plummeting and the yields from skyrocketing. That someone is the Fed.

First, M2 would quickly grow from $8.65T to $13.16T, an increase of 52%. This likely would happen faster than the real supply of goods could increase by any appreciable amount; thus, virtually the entire growth in M2 would translate into inflation. After the initial shock, with confidence lost and no traditional lenders to borrow from, the entire federal deficit would have to be plugged through debt monetization. Given that entitlements, most government pay, and the deficit are pegged to inflation, the deficit would stay in proportion to the new M2 supply and the new nominal gross domestic product (GDP), roughly 15%. Given 2% growth in the amount of real stuff to buy, that would translate to roughly 13% inflation, or 15% under total real stagnation.

The US has lived through double digit inflation before. 1974 saw 10-12% inflation, and 1979-1981 saw 10-14% inflation. Continued quantitative easing is a painful scenario, but it's a far cry from Weimar or Zimbabwe. Gold would soar. Any industry dependent on the discretionary spending of the middle class would get crushed as consumers cut back on nicities to afford necessities. Inferior goods industries such as Walmart, Dollar Tree, and McDonalds would do well.

Additional inflationary factors that would mostly distort relative prices in addition to general prices:

• US currency and securities dumping could lead to specific foreign currency appreciation (depending on what the dollar denominated reserves are replaced with) and therefore an increase to US import costs beyond the inflation of M2 expansion. However, total imports are only 17% of GDP.
• Petrodollars would cease to exist, and the price of oil for Americans would increase beyond the inflation of M2 expansion and likely beyond even the increase in the relative price level of total imports. Oil imports are 2% of GDP.

To address a working assumption that some may have picked up on by now: The Fed will continue to incentivize banks to sit on their excess reserves by paying them not to lend. The entire point of QE is to maintain and to preserve the system, not to bring it down. The most surefire way to bring the system down would be to allow the broad money supply to increase by a factor of 10 or more. This is about keeping banks solvent and about keeping rates low. Bernanke is more likely to allow deflation than he is to allow a 10-fold or more increase in the broad money supply and the 1000%+ inflation that would accompany it. Given the mission at hand, given the players involved, and given reality as it currently stands, this is the worst possible case scenario.

-- Also at my Seeking Alpha blog --

November 3, 2010

QE2 Throws Out Keynesian Playbook

The Fed is now firmly in make-it-up-as-you-go-along territory. As controversial as Keynesian economics is, this latest round of quantitative easing (QE) is decidedly un-Keynesian. It violates or ignores the heart of Keynesian economics -- the IS/LM model. Additional points to consider:

1. We lasted only 7 months between end of QE1 and start of QE2.
2. At $75 billion per month, we are monetizing virtually all of the "new" deficit.

Keynesian economics states that an increase in the REAL money supply will lead to an increase in aggregate demand and national income. That's just a roundabout way of saying we can buy more stuff with a stronger dollar. However, the Fed can only increase the NOMINAL supply of money. According to Keynesian economics (and according to common sense), this means that the increase in the money supply will be counteracted by the fact that each dollar is worth less. The net outcome will be ZERO effect on aggregate demand (AD) or real gross domestic product (GDP).

Keynesian economics also points out an effect called the "interest rate sensitivity of demand." That's a fancy way of saying that when rates are really low (think at or near zero), there will be very little effect on the demand to borrow. This is where the term "pushing on a string" comes from. Recently, only 4% of small business owners cited lack of credit as their top concern. As of November 3, 2010, all Treasury yields for terms less than 5 years are all under 0.5%. Yields for everything under 10 years are under 1%. The 10-year yield is in the low 2's, and even the 30-year is at 4.0. Where exactly are rates supposed to go, and how much additional demand can you expect even if you pound the entire yield curve flat to zero?

The 2011 Federal Deficit is projected to be 1.267 trillion dollars. QE2 will fill most of it where foreign lending has decided to cutoff our national Visa card. More importantly, it will fill virtually all of our "new" deficit. That is, the deficit that exceeds the average for the decade leading up to the Great Recession. From 1998 to 2008, federal deficits average 2.3% of GDP. With US GDP at 14.8 trillion, the "normal" deficit (based on the decade average of 2.3%) should be about $340 billion. 1267 actual minus 340 normal equals 927 billion dollars. We are within a rounding error of the $900 billion pledged.

This is not about "growing the economy." This is about saving the banking system from the collapse that unsustainable prices relative to income is calling for. With the Tuesday's election results, there will be no serious spending cuts and no serious tax increases. The result: deficits and QE to fill them as far as the eye can see. Even in the mid-1300s, gold is still a good buy.

-- Also at my Seeking Alpha blog --