Current situation and Romney's economic plan

New Greg Mankiw's article in New York Times. Don't disregard it as merely "conservative thinking" - the first half of the article is an overview of the current economic situation which is unbiased and enlightening.

In the second part of the article Mankiw does express his view on the economic recovery: he opposes the "traditional fiscal stimulus", and instead argues for 1) lower taxation of income from corporate capital; 2) more pro-business policies, such as passing the free trade agreement with South Korea and reigning in the National Labor Relations Board, i.e. reducing unions's interference with businesses.

One may recognize the points of the economic plan recently unveiled by Mitt Romney - and indeed, Mankiw is apparently advising Romney's campaign on the economic matters.  

Taxes on the "rich": Common sense versus Economic analysis

Below are some additional thoughts regarding the ongoing debate on whether the "rich" should pay higher taxes in order to provide for the well-being of the "poor". I previously touched on the subject here.

(I put "rich" and "poor" in the quotation marks, since in the modern developed countries most of those who qualify for tax purposes as rich/poor are really the members of the middle class.)  

The common sense point of view is based on the concept of "social justice" - some people are more fortunate and should share with those who happened to be less lucky. This point can be perhaps made stronger by noting that the "rich" and their furtunes benefit from the protection of the state that they live in and therefore the state may demand from them to contribute a higher share.

Of course, the opposite argument can be made, based on the concept of "individual freedom": very often  wealth is a result of hard work put into earning and maintaining this wealth, so why should anyone share the results of his/her hard labor with others?

Of course, both of these points are philosophical and can hardly be convincing for the opponents of either. In addition, the debate nowadays is really not about whether the "rich" should help the "poor", but to which extent they should help: the tax-based government assistance ranges rom providing food and shelter to those who are truly poor to funding university scholarships and house-mortgages, which are really the benefits enjoyed by the middle class (although someone truly poor may call them "luxuries")

There are however some economic arguments which make clear that the "tax the rich" debate is not merely a matter of moral attitudes (as could be concluded from the political debates, where each side often blames the opponents for denying "social justice" or "personal freedom" .)

Here are two points to consider:

1. Tax incidence Who pays the tax? Most of the modern "rich" are owners of businesses who benefit from using other people's labor and selling the produce of their enterprize. The businesses minimize the reduction of their profits due to taxation by raising the prices, and lowering the wages or reducing the number of their employees. Thus, a part of the tax levied on the "rich" really falls on consumers and workers. How big is that part is apparently still debated by the economists. Yet, one should be aware that the "tax on rich" may really be more of a burden the "poor"

2. Laffer curve Raising the tax rates does not necessarily increase he revenue that the government receives from the taxes. This is exemplified by so-called "Laffer curve", which is based on a very simple logical argument:

Laffer curve

"The curve is constructed by thought experiment. First, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist at least one rate in between where tax revenue would be a maximum." [Emphasis mine]

If the tax rates are on the downward slope of the curve, then the way to increase the tax revenue is by reducing the rates rather than by increasing them! This observation led to what has become known as the "supply side economics", which was the basis for the tax policies of Ronald Reagan. The policies did not succeed, since every group of the society responds to tax insensitives differently: as the result of the Reagan's policies the revenues did not increase, but decreased. With the government spending on the same level as before this lead to the growing national deficite. 

Yet, Laffer curve may work, if the lower tax rates are applied to certain groups of society that respond to tax insensitives, and such a group of the society turns out to be... the "rich". Here is what Greg Mankiw's economics textbook says on the subject:

"Yet Laffer’s argument is not completely without merit. Although an overall cut in tax rates normally reduces revenue, some taxpayers at some times may be on the wrong side of the Laffer curve. In the 1980s, tax revenue collected from the richest Americans, who face the highest tax rates, did rise when their taxes were cut. The idea that cutting taxes can raise revenue may be correct if applied to those taxpayers facing the highest tax rates. In addition, Laffer’s argument may be more plausible when applied to other countries, where tax rates are much higher than in the United States. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more tax revenue if it had lowered its tax rates." [Emphasis mine]

Thus, astonishingly, the tax cuts aimed specifically at the "rich" may raise tax revenue to the greater benefit of the "poor"!

In conclusion, I would like to reiterate my main point: the question of whether the rich should pay higher taxes is more than a philosophical discussion of "social justice" versus "individual freedom". Deeper economic arguments can be made to support the point of view that lower taxes on the wealthier members of the society can be beneficial to the poorer ones. In fact, we have to separate the question into two: i) whether the "rich" should be responsible for the well-being of the "poor", and, ii) if "yes", whether the greater benefit to the "rich" (i.e. lower tax rates on high-income earners) and the greater benefit to the poor (more government services due to the higher tax revenue) are mutually exclusive.

Run-up for the Cuban missile crisis

Contrary to the impression that one may receive from the popular historical accounts, the Cuban missile crisis did not come out of nowhere, but had been preceeded by extensive nuclear preparations. It is hardly conceivable that during the previous year either Kennedy or Khrushchev had any doubts that they were gearing up for the total war:

"What followed was a veritable nuclear-testing frenzy. More than 250 tests were conducted in the 16 months following the aborted attempt to put the nuclear genie back in its bottle – more explosions than in the 16 preceding years. One test explosion set the infamous record for the largest-ever manmade explosion: the Soviet Tsar bomb, detonated on October 30, 1961, was the equivalent of 4,000 Hiroshima bombs. It is no coincidence that a year later, in October 1962, the world found itself on the brink of nuclear war during the Cuban missile crisis." [Emphasis mine]

Welfare state or Angli-Saxon model? - Both are broken!

Here is the statement, obviously intending to put to rest the continuing dispute about the advantages of a welfare state versus Anglo-Saxon style capitalism:

"To enable market-oriented economies to operate as they should and can, we need to return to the right balance between markets and provision of public goods. That means moving away from both the Anglo-Saxon model of laissez-faire and voodoo economics and the continental European model of deficit-driven welfare states. Both are broken." [Emphasis mine]

However, I find the author's arguments  in support of this point (or the lack of thereof) unconvincing.

The article also contains a useful list of the existing economic tools for fighting recessions/depressions:
"Until last year, policymakers could always produce a new rabbit from their hat to reflate asset prices and trigger economic recovery. Fiscal stimulus, near-zero interest rates, two rounds of “quantitative easing,” ring-fencing of bad debt, and trillions of dollars in bailouts and liquidity provision for banks and financial institutions: officials tried them all. Now they have run out of rabbits."

More on stimulus vs. austerity discussion

The Economist is currently hosting a debate about the nature of the current economic situation in the US and the possible ways to improve it.

The pro-stimulus advocate describes the nature of the current recession as follows:
"... a rare type of recession that happens only after the bursting of a nationwide asset-price bubble financed with debt. In this type of recession, now called balance-sheet recession, the private sector is actually minimising debt instead of maximising profits because the liabilities it incurred during the bubble days are still on the books while the assets it purchased with borrowed funds have collapsed in value, leaving its balance sheets seriously underwater and in need of repair." [Emphasis mine]
(This was a subject of one of my earlier posts.)

The stimulus-based solution to the problem is then formulated as:
"Since the government cannot tell the private sector not to repair its balance sheets, the only way for the government to keep the economy from collapsing is to borrow and spend the unborrowed savings in the private sector and put them back into the economy's income stream. And this stimulus must be maintained until the private sector has regained enough financial health to borrow money again."

On the opposing sides, the doubts regarding the value of the stimulus and temporary tax cuts are summarized as follows (see my other recent post regarding the tax cuts):
"A main implication of their work is that permanent tax cuts have a lasting effect, but temporary tax cuts do little or nothing. Recipients of a temporary windfall reduce debt or save. The same is true of a one-time increase in spending. The teachers and firemen who kept their jobs for a year because states received large transfers from the federal stimulus in 2009 did not run off to buy a car or furniture. Most of them knew that temporary assistance comes to an end quickly, as it did. Many of their jobs ended. By saving instead of spending, they prepared for an uncertain future." [Emphasis mine]



Hence, the proposed austerity measures are:
"Here are some useful first steps. Reduce uncertainty about future tax rates by adopting a long-term plan to reduce entitlement spending. Declare a five-year moratorium on new regulation, except for national security. Adopt an inflation target with enforcement to make sure that high inflation will not return. Pass the trade agreements. And pay for reduced corporate tax rates by closing loopholes."

Middle-Eastern logical twists

In view of the recent violence in Israel and Gaza, there are some who perceive as strange the fact that Israel retaliated against the Popular Resistance Committee (PRC) in Gaza, despite the latter's denial of any complicity in the Eilat attacks.

While there may be no proof (in the open media) of the PRC responsibility for the attack, it seems that even the critics of the retaliation against PRC are so deeply absorbed by the situation that they take for granted many things that must seem awkward to an objective observer.

Let us try to evaluate the situation objectively:
A group of armed men from country A entered country B, murdered several people, and escaped back to A. Elsewhere this would be considered and act of war, and B would demand an investigation and compensation from A, threatening a just retaliation. A resolution by the UN Security Council would follow as well.

In practice:  
A (Egypt) demands an investigation from B (Israel), while B carries out strikes against C (Gaza). And even those who oppose strikes by B against C, agree that A has nothing to do with this, and don't mind A to mediate between B and C.

There is an underlying assumption here that the terrorists certainly were not Egyptians, but Palestinians. And curiously this is accepted without questioning even by those claiming that the strikes against PRC were unjustified.

Even those who agree with this, however, should not forget about the responsibility that still lies with Egypt: It is Egypt's obligation as a state to fight the crime in its territory, whether it threatens Egyptians or the citizens of other countries. And it is Egypt who has to prove that the terrorists were not Egyptians and that Egypt did not have hostile intentions towards Israel. And even then Egypt still would have the responsibility towards the families of the victims.

All this does not happen, and the Israeli defense minister, Ehud Barak, has correctly hinted that Egypt is a failed state (just by definition of a state failing to exercise such state functions as fighting crime and protecting its borders.) Yet, in an awkward twist, it is Israel that has apologize for stating this fact. And it is Israel that has to carry out an investigation into the deaths of several Egyptian soldiers, who were caught in gunfire when the Israeli border guards chased the terrorists.

Let us note that the lack of the Egyptian complicity in the terrorist attack is far from obvious: some commentators claim that, in order to remain unnoticed by the Israeli guards, the terrorists infiltrated into Israel in front of an Egyptian outpost, with likely knowledge of the Egyptian army. The fact that the infiltrators were retreating towards a group of the Egyptian soldiers, which resulted in several Egyptians killed, raises questions regarding the Egyptian army possibly covering the terrorists's retreat.


However, the worst thing that has been made obvious by these events is the Israel's fear to alienate Egypt, which prevents Israel from demanding from Egypt the actions that are required by the international law (i.e. the investigation and the compensations to the victims.)
I don't blame the government for this - it just shows how bad the geopolitical situation is for Israel.
 

Keynes vs. Hayek debate is still alive

Here is an enlightening article about the two theoretical approaches to the economic crises, pioneered by John Maynard Keynes and Friedrich von Hayek. The author claims that the Hayek's approach has been discredited, and that the Keynesian stimulus is the only salvation to the World economy. (In case you have no time to read the whole article, I provide a few relevant quotes below.)

It is worth however noting that the Keynes vs not-Keynes division among the American economists passes precisely along the Republican-Democrat divide. This seems consistent, since the Democrats support more socialist society with a greater role of the government in regulating markets. But in Europe, which is essentially the Democratic ideal of the welfare state, the view seems to be just the opposite - the European Union response to the escalating debt crisis consists of imposing more and more austerity measures in Greece, Spain, Ireland, Italy etc.

This is probably the result of the different economic backgrounds, resulting in the drift of the two continents towards the middle ground, which humorously could be described as the difference between "Continental" and "English-speaking" approach.

The quotes: according to Hayek "the “crisis” results from over-investment relative to the supply of savings, made possible by excessive credit expansion. Banks lend at lower interest rates than genuine savers would have demanded, making all kinds of investment projects temporarily profitable.

But, because these investments do not reflect the real preferences of agents for future over current consumption, the savings necessary to complete them are not available. They can be kept going for a time by monetary injections from the central bank. But market participants eventually realize that there are not enough savings to complete all the investment projects. At that point, boom turns to bust."

The Keynes's position is just the opposite: "under-investment relative to the supply of saving – that is, too little consumption or aggregate demand to maintain a full-employment level of investment – which is bound to lead to a collapse of profit expectations."

Consequently the two economists offered different recipes for dealing with economic crises: "Whereas for Hayek recovery requires the liquidation of excessive investments and an increase in consumer saving, for Keynes it consists in reducing the propensity to save and increasing consumption in order to sustain companies’ profit expectations. Hayek demands more austerity, Keynes more spending."

The last recession is commonly blamed on the sub-prime mortgage crisis: the sharp drop in the price of real estate assets made these assents cheaper than the amount of money previously borrowed to purchase them. This explanations seems to be taken directly from the Hayek's book. Ironically, the stimulus approaches (i.e. more spending) adopted by both George W. Bush and Barack Obama, are the prescriptions taken from Keynes.