24 Sep 2010 The Way Back

Once again a headline issue with both near and long-term impact on this country’s economic future was decided by the majority party, completely on political terms; this time it was for personal survival. Going back a few months it was in the name of economic survival. The extravagant American Recovery and Reinvestment Act of 2009 was supposed to save the day. Some derided the $787 billion bill as “Speaker Pelosi’s Payoffs and Pork Bill.” In fact it provided limited if any stimulus impact. And the crowning accomplishment of the majority party: The Affordable Healthcare for America Act. This massive sea-change of American culture and economy was literally rammed down the throats not only of the minority party in Congress, but the American people.

Yesterday’s tabling of the tax-cut issue by Senate Democrats until after the election cannot be couched in any other terms but political retreat. Nor can the importance of extending the tax cuts be minimized. The tax cuts enacted in 2001 and 2003 lowered rates on wages and investments for all Americans and are scheduled to expire December 31^st. A Goldman Sachs research note released Sept. 22^nd said that even a temporary failure by Congress to extend the cuts may erase US economic growth in the first half of next year. That is a gamble our political leaders chose to take.

Whether one blames George Bush for taking the country to the right or Barrack Obama for taking it in unprecedented fashion to the left, or the lousy economy, or all of the above; America is in political upheaval. The third party – the Tea Party has become a home for those fed up with Big Washington. Their growth is coming at the expense of Democrats and Republicans alike.

But our problems are deeper and considerably more dangerous than today’s political morass. In an opinion piece appearing earlier this month in the Wall Street Journal, economic heavyweights George P. Shultz, Michael J. Boskin, John F. Cogan, Allan Meltzer, and John B. Taylor co-authored a piece that laid out the Principles of Economic Revival. They claim “our prosperity has faded because policies have moved away from those that have proven to work.”

Our economic crisis and anemic recovery are largely the result of “economic policies that have deviated from proven fact-based principles. … The most fundamental starting point is that people respond to incentives and disincentives. Tax rates are a great example because the data are so clear and the results so powerful. A wealth of evidence shows that high tax rates reduce work effort, retard investment and lower productivity growth. Raise taxes, and living standards stagnate.”

They quote Nobel Prize-winning economist Edward Prescott who analyzed international labor market data and showed that changes in tax rates on labor effect changes in employment and hours worked. “From the 1970s to the 1990s, the effective tax rate on work increased by an average of 28% in Germany, France and Italy. Over that same period, work hours fell by an average of 22% in those three countries. When higher taxes reduce the reward for work, you get less of it.”

The writers are critical of many of the measures taken by both the administration and by the Federal Reserve. “The history of recent economic policy is one of massive deviations from these basic tenets. The result has been a crippling recession and now a weak, nearly nonexistent recovery. The deviations began with policies—like the Federal Reserve holding interest rates too low for too long—that fueled the unsustainable housing boom. Federal housing policies allowed down payments on home loans as low as zero. Banks were encouraged to make risky loans, and securitization separated lenders from their loans. Neither borrower nor lender had sufficient skin in the game. Lax enforcement of existing regulations allowed both investment and commercial banks to circumvent long-established banking rules to take on far too much leverage. Regulators, not regulations, failed.

They observe that “long-lasting economic policies based on a long-term strategy work; temporary policies don’t. The difference between the effect of permanent tax rate cuts and one-time temporary tax rebates is also well-documented. The former creates a sustainable increase in economic output, the latter at best only a transitory blip. Temporary policies create uncertainty that dampen economic output as market participants, unsure about whether and how policies might change, delay their decisions.”

“As the chart to the right shows, in all of U.S. history, there has been only one period of sustained decline in federal spending relative to GDP. From 1983 to 2001, federal spending relative to GDP declined by five percentage points. Two factors dominated this remarkable period. First was strong economic growth. Second was modest spending restraint—on domestic spending in the 1980s and on defense in the 1990s.”

The following excerpt is the complete unedited list of the authors’ recommendations.

“• First, take tax increases off the table. Higher tax rates are destructive to growth and would ratify the recent spending excesses. Our complex tax code is badly in need of overhaul to make America more competitive. For example, the U.S. corporate tax is one of the highest in the world. That’s why many tax reform proposals integrate personal and corporate income taxes with fewer special tax breaks and lower tax rates.

• Second, balance the federal budget by reducing spending. The publicly held debt must be brought down to the pre-crisis safety zone. To do this, the excessive spending of recent years must be removed before it becomes a permanent budget fixture. The government should begin by rescinding unspent “stimulus” and TARP funds, ratcheting down domestic appropriations to their pre-binge levels, and repealing entitlement expansions, most notably the subsidies in the health-care bill.

The next step is restructuring public activities between federal and state governments. The federal government has taken on more responsibilities than it can properly manage and efficiently finance. The 1996 welfare reform, which transferred authority and financing for welfare from the federal to the state level, should serve as the model. This reform reduced welfare dependency and lowered costs, benefiting taxpayers and welfare recipients.

• Third, modify Social Security and health-care entitlements to reduce their explosive future growth. Social Security now promises much higher benefits to future retirees than to today’s retirees. The typical 30-year-old today is scheduled to get an inflation-adjusted retirement benefit that is 50% higher than the benefit for a typical current retiree.

Benefits paid to future retirees should remain at the same level, in terms of purchasing power, that today’s retirees receive. A combination of indexing initial benefits to prices rather than to wages and increasing the program’s retirement age would achieve this goal. They should be phased-in gradually so that current retirees and those nearing retirement are not affected.

Health care is far too important to the American economy to be left in its current state. In markets other than health care, the legendary American shopper, armed with money and information, has kept quality high and costs low. In health care, service providers, unaided by consumers with sufficient skin in the game, make the purchasing decisions. Third-party payers—employers, governments and insurance companies—have resorted to regulatory schemes and price controls to stem the resulting cost growth.

The key to making Medicare affordable while maintaining the quality of health care is more patient involvement, more choices among Medicare health plans, and more competition. Co-payments should be raised to make patients and their physicians more cost-conscious. Monthly premiums should be lowered to provide seniors with more disposable income to make these choices. A menu of additional Medicare plans, some with lower premiums, higher co-payments and improved catastrophic coverage, should be added to the current one-size-fits-all program to encourage competition.

Similarly for Medicaid, modest co-payments should be introduced except for preventive services. The program should be turned over entirely to the states with federal financing supplied by a “no strings attached” block grant. States should then allow Medicaid recipients to purchase a health plan of their choosing with a risk-adjusted Medicaid grant that phases out as income rises.

The 2010 health-care law undermined positive reforms underway since the late 1990s, including higher co-payments and health savings accounts. The law should be repealed before its regulations and price controls further damage availability and quality of care. It should be replaced with policies that target specific health market concerns: quality, affordability and access. Making out-of-pocket expenditures and individual purchases of health insurance tax deductible, enhancing health savings accounts, and improving access to medical information are keys to more consumer involvement. Allowing consumers to buy insurance across state lines will lower the cost of insurance.

• Fourth, enact a moratorium on all new regulations for the next three years, with an exception for national security and public safety. Going forward, regulations should be transparent and simple, pass rigorous cost-benefit tests, and rely to a maximum extent on market-based incentives instead of command and control. Direct and indirect cost estimates of regulations and subsidies should be published before new regulations are put into law.

Off-budget financing should end by closing Fannie Mae and Freddie Mac. The Bureau of Consumer Finance Protection and all other government agencies should be on the budget that Congress annually approves. An enhanced bankruptcy process for failing financial firms should be enacted in order to end the need for bailouts. Higher bank capital requirements that rise with the size of the bank should be phased in.

• Fifth, monetary policy should be less discretionary and more rule-like. The Federal Reserve should announce and follow a monetary policy rule, such as the Taylor rule, in which the short-term interest rate is determined by the supply and demand for money and is adjusted through changes in the money supply when inflation rises above or falls below the target, or when the economy goes into a recession. When monetary policy decisions follow such a rule, economic stability and growth increase.

In order to reduce the size of the Fed’s bloated balance sheet without causing more market disruption, the Fed should announce and follow a clear and predictable exit rule, which describes a contingency path for bringing bank reserves back to normal levels. It should also announce and follow a lender-of-last-resort rule designed to protect the payment system and the economy—not failing banks. Such a rule would end the erratic bailout policy that leads to crises.

The United States should, along with other countries, agree to a target for inflation in order to increase expected price stability and exchange rate stability. A new accord between the Federal Reserve and Treasury should re-establish the Fed’s independence and accountability so that it is not called on to monetize the debt or engage in credit allocation. A monetary rule is a requisite for restoring the Fed’s independence.

These pro-growth policies provide the surest path back to prosperity.”