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The great debate: more taxes vs. less spending


As Congress debates whether our massive budget deficits should be reined in by raising taxes or by cutting spending, it seems appropriate to republish the above chart. What it shows is that the top 10% of income earners paid 70% of all income taxes in 2008 (most recent data available). Moreover, it shows that the share of total taxes paid by the "rich" has increased substantially since the early 1980s, despite a huge reduction in the top marginal tax rate. If that is not a vindication of the Laffer Curve, I don't know what is. What the chart doesn't show is that the top 5% of income earners paid more in income tax than the other 95%, and roughly half of all workers pay no income tax. In short, the federal income tax burden is being shouldered by a small minority of taxpayers. This minority is now being subject to a "tyranny of the majority," in which the majority of those in Congress are trying to decide whether the minority of workers should effectively pay all the bills for everyone. In that context it's gratifying to note that according to a CNN poll, "two-thirds of voters favor the idea of tying a raise in the debt ceiling to spending caps and a balanced budget amendment." Congress may be out of touch with the people on this one.


As Milton Friedman taught us, the burden of government is not measured by taxes, but by spending. Whether a deficit is financed by raising taxes or by borrowing more, in the end, resources are taken from the private sector and spent by the public sector. That transfer imposes a burden on the economy since the public sector almost always spends money less efficiently than the private sector. So not only is the debate about who should pay for the huge increase in spending over the past several years, but also whether government spending should continue at such high levels. 


UPDATE: For the sake of perspective, I am republishing the following charts which show the different ways in which the federal government taxes and spends (currently at an annual rate of almost $3.6 trillion) our money:




PIIGS update: Greece to get a voluntary debt restructuring



The top chart shows the history of 2-yr sovereign yields for the PIIGS countries, while the bottom chart shows the rate on 5-yr Greek Credit Default Swaps. The deal being finalized in Europe that combines more aid to Greece with the "voluntary" participation of private bondholders in a debt exchange (aka restructuring) has had a significant impact on these sensitive indicators of default risk. It's not that a Greek default now has become less likely, it's that the magnitude of the default will be much less than the market feared. And that, in turn, has reduced the likelihood of a sovereign debt default contagion. It's interesting that the ISDA (the International Swaps & Derivatives Association that determines whether a "credit event" has occurred that would in turn trigger the payment of by those who have sold CDS) has indicated that a voluntary restructuring would not necessarily qualify as a credit event.


As this chart of 2-yr swap spreads shows, the degree of systemic risk in Europe hasn't changed much despite the restructuring deal. It's uncomfortably high, but not seriously so. Some banks could be in trouble, but swap spreads of just under 70 bps don't point to an untenable or out-of-control financial meltdown. In short, Europe is dealing with the PIIGS problem in a variety of ways and is likely to survive largely intact. Conceivably, this could all turn out to be a nonevent.

John Taylor nails it

Don't miss John Taylor's article in today's WSJ: "The End of the Growth Consensus." I think he summarizes quite nicely the reasons for why the economy is mired in a slow-growth recovery. It has nothing to do with partisan politics, and everything to do with policies that just don't make sense. Here's an excerpt, but please read the whole thing and pass it along:

In my view, the best way to understand the problems confronting the American economy is to go back to the basic principles upon which the country was founded—economic freedom and political freedom. With lessons learned from the century's tougher decades, including the Great Depression of the '30s and the Great Inflation of the '70s, America entered a period of unprecedented economic stability and growth in the '80s and '90s.

Economic policy in the '80s and '90s was decidedly noninterventionist, especially in comparison with the damaging wage and price controls of the '70s. Attention was paid to the principles of economic and political liberty: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform led to lower marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. And with strong economic growth and spending restraint, the federal budget moved into balance. 
As the 21st century began, many hoped that applying these same limited-government and market-based policy principles to Social Security, education and health care would create greater opportunities and better lives for all Americans. 
But policy veered in a different direction. Public officials from both parties apparently found the limited government approach to be a disadvantage, some simply because they wanted to do more—whether to tame the business cycle, increase homeownership, or provide the elderly with better drug coverage. 
And so policy swung back in a more interventionist direction, with the federal government assuming greater powers. The result was not the intended improvement, but rather an epidemic of unintended consequences—a financial crisis, a great recession, ballooning debt and today's nonexistent recovery. 
The change in policy direction did not occur overnight. We saw increased federal intervention in the housing market beginning in the late 1990s. We saw the removal of Federal Reserve reporting and accountability requirements for money growth from the Federal Reserve Act in 2000. We saw the return of discretionary countercyclical fiscal policy in the form of tax rebate checks in 2001. We saw monetary policy moving in a more activist direction with extraordinarily low interest rates for the economic conditions in 2003-05. And, of course, interventionism reached a new peak with the massive government bailouts of Detroit and Wall Street in 2008. 
Since 2009, Washington has doubled down on its interventionist policy. The Fed has engaged in a super-loose monetary policy—including two rounds of quantitative easing, QE1 in 2009 and QE2 in 2010-11. These large-scale purchases of mortgages and Treasury debt did not bring recovery but instead created uncertainty about their impact on inflation, the dollar and the economy. On the fiscal side, we've also seen extraordinary interventions—from the large poorly-designed 2009 stimulus package to a slew of targeted programs including "cash for clunkers" and tax credits for first-time home buyers. Again, these interventions did not lead to recovery but instead created uncertainty about the impact of high deficits and an exploding national debt. 
Unfortunately, as the recent debate over the debt limit indicates, narrow political partisanship can get in the way of a solution. The historical evidence on what works and what doesn't is not partisan. The harmful interventionist policies of the 1970s were supported by Democrats and Republicans alike. So were the less interventionist polices in the 1980s and '90s. So was the recent interventionist revival, and so can be the restoration of less interventionist policy going forward.

A deficit reduction bill should push interest rates higher

Markets got excited yesterday at the prospect that Congress may be closing in on a bipartisan deficit reduction bill. 30-yr Treasury yields fell 12 bps, as investors reasoned that a reduction in federal debt issuance would lead to higher prices for Treasury debt. (Much of that drop in yields has been reversed so far today.)

I think this is one of those times when the bond market's initial reaction to some new and important development is wrong, or at least not well thought out.

To understand why, it is important to realize that yields on Treasury notes and bonds are fundamentally determined by inflation and inflation expectations. Inflation expectations, in turn, can be impacted by the market's perception of the economy's strength, because the market, and the Fed, believe that strong growth can add to inflation pressures, while weak growth creates deflationary pressures.

It's also important to understand that every bond issued in dollars is priced relative to Treasuries of a comparable maturity. Since Treasuries are the risk-free bedrock of the dollar-based bond market, non-Treasury securities have to pay a higher yield, or spread. That spread can change, of course, but if Treasury yields rise significantly, then it's a safe bet that the yields on all bonds will rise significantly.

The larger point here is that a change in the yield on Treasuries affects the yields on all bonds. Treasuries do not exist in isolation.

Our current $1.3 trillion federal deficit is a fairly large percentage of the $9.7 trillion of Treasury debt held by the public (about 13.5%), but the marginal borrower (in this case the U.S. government) does not set the price of the outstanding stock of U.S. debt, which is more than $30 trillion. Even very large $2 trillion deficits would have little impact on the level of bond yields, because the new supply of bonds would still be only a small fraction (6-7%) of all the investment-grade and high-yield bonds outstanding in the U.S. market. And I'm not even considering the more than $30 trillion in liquid, non-U.S. bonds outstanding in the world. Let me hasten to add that new Treasury issuance need not have any direct impact on inflation fundamentals, unless the Fed takes action to expand the money supply by more than the world desires.

Whether the federal government borrows $2 trillion or $1 trillion in the next year is not going to have much of an impact on the level of interest rates, taken in isolation, because the outstanding stock of bonds is orders of magnitude bigger. What could have a meaningful impact on interest rates, however, is how meaningful the package of spending cuts turns out to be. Many worry that a big cut in spending would weaken the economy, and that in turn would lead to lower inflation and lower interest rates.

But I think that a big cut in future spending would have a positive impact on the economy, since it would free up resources that can be better utilized by the private sector, and, by reducing future deficits, it would greatly increase the expected after-tax returns to investment. Combined, this could prove to be a powerful stimulus to growth. And so I think that upon reflection, a serious debt reduction package would eventually be perceived by the market to be good for the economy and therefore "bad" for the bond market, and that would mean higher, not lower yields.

The 2 1/2 year bottom in housing starts


Housing starts have been incredibly weak for the past 2 1/2 years, much weaker than at any time since records were first kept beginning back in 1959. As a result, residential construction has fallen to a record-low 2% of GDP, after averaging around 5% since WWII. During this extended and bitterly painful construction collapse, the economy has recovered from a severe recession, personal income has grown 8%, retail sales are up 15%, after-tax corporate profits have surged 38%, Apple stock has more than tripled, households' net worth has risen by over $8 trillion, and the U.S. population has increased by about 6 million, among a host of other notable milestones. Housing starts are almost certainly well below the rate of new household formations, so every month that starts remain at currently depressed levels puts us one month closer to an inevitable boom in new home construction, since the excess inventory of homes is shrinking daily. The outlook for housing is thus likely to be stable at the least, and eventually extremely positive.

Bond market sees very weak growth & higher inflation


The yield on 2-yr Treasuries is once again at rock-bottom levels (0.36%). This yield is a window to the market's expectations for Fed policy, since it can be equated to the expected average Fed funds rate over the next two years. With Fed funds currently at a mere 0.1%, the market obviously doesn't expect much in the way of Fed tightening over the next two years. Those expectations, in turn, flow directly from the market's collective belief that the economy is going to be dreadfully weak for a long time, thus forcing the Fed to remain ultra-accommodative. Weak growth and low yields, in other words, go hand in hand; as the above chart illustrates.



Many observers argue that the extremely low level of short-term Treasury yields is also a sign that the market expects very low inflation or deflation, but the chart below shows that in fact just the opposite is true. The bond market's inflation expectations have been on the rise, as reflected in a steeper slope between 10- and 30-yr Treasuries, and a rise in the 5-yr, 5-yr forward expected inflation rate that is embedded in Treasury and TIPS prices.


The message of the bond market also illustrates the policy conundrum that confronts the Fed: despite the most accommodative monetary policy ever, the economy is refusing to respond. The knee-jerk reaction of bureaucrats and politicians is to apply yet more stimulus when stimulus fails to work, but we've now had several years of super-accommodative monetary policy and massive fiscal spending stimulus, to no apparent effect. All we have to show for this exercise in public sector hubris is rising inflation expectations and moribund growth expectations. Which is not surprising to me, since as a supply-sider I have always thought that growth can only come from hard work, investment, and entrepreneurial risk-taking. The proper role of government is not to direct the economy's efforts, but to provide for essential services, uphold the rule of law, protect private property, and protect the purchasing power of the currency, among other (limited) things.

So the right thing to do is not to do more of the same, but to reverse course. Tighter monetary policy would reduce inflation expectations, strengthen the dollar, punish the gold and commodity speculators, and restore investors' confidence. Reduced government spending would free up resources for the private sector to exploit and increase investment, since it would automatically reduce future expected tax burdens—and increase the expected after-tax return to risk-taking. 

The bond market is trying hard to send its message to Washington. Is anyone listening?

Carmageddon, free markets, and the PIIGS crisis

Residents of the Los Angeles metropolitan area have known for almost two months that this weekend would be our worst traffic nightmare: the two-day closing of a key stretch of the 405 freeway. Signs have been posted everywhere with the warning, even as far away as San Diego. And what happened? Absolutely nothing. In fact, traffic hasn't been so good for as long as I can remember. Why? Because almost everyone stayed home to avoid the traffic.

If you want a good example of how powerful free markets can be, this is it.

If you want a reason to not worry about the looming PIIGS sovereign debt crisis, this is it.

When people have access to information and an incentive to act on it, they will.

The world has known since April of last year that the governments of Portugal, Ireland, Italy, Greece, and Spain were in a bind and might not be able to meet their outsized debt obligations. For many months markets have been bombarded with the news that if one of the PIIGS defaults, it could trigger a default contagion that could bring down other PIIGS and perhaps the entire European banking system. Only those who have been in a coma could not know by now that this has the potential to be Debt Armageddon.

How many people are likely to be blindsided by a Greek default? Not many, I think, because the price of Greek debt already reflects something like a 40% default "haircut." How seriously could European banks be affected by a default? It would be painful, but it's quite likely to be far less than a catastrophe, as suggested by 2-yr Euro swap spreads of 70 bps. Would a PIIGS default present a serious problem for the U.S. economy? Not likely at all, as suggested by 2-yr U.S. swap spreads of 30 bps.

The reality of a PIIGS default is likely to be much less than the world fears, because the world has had a long time to prepare for it and most of the ill effects have already been priced in by the market.