(snip)"This week, the theme in various publications was the lack of available credit for small businesses, with plenty of anecdotal evidence. This goes along with the surveys by the National Federation of Independent Businesses, which continue to show a difficult credit market.
Businesses are being forced to scramble for needed investments, generally having to make do with cash flow and working out of profits. This is an interesting quandary for government policy makers, as 75% of the "rich" that will see the Bush tax cuts go away are small businesses.
There was a great graphic (that I now cannot find) showing that all net new jobs of the past two decades have come from small businesses and start-ups. And yet as of now, when structural employment is over 10% (if you count those who were considered to be in the work force just a few months ago), we want to reduce the availability of revenues to the very people we want to be hiring new workers, and who are cash-starved as it is.
It is not just that taxes will go from 35% to just under 40%. It is the increase in Medicare taxes coming down the pike, too. We are taking money from private hands, where it has the potential to increase productivity, and putting it into government hands, where it will do nothing for growth of the economy. There is no multiplier for government spending. And tax increases reduce potential GDP by a multiplier of at least 1 and maybe 3, depending on which study you want to cite.
I understand that taxes have to go up. I get it. But we would be better off having a discussion of where we want to tax dollars to come from before we risk hurting an economy that will barely be growing at 2% in the 4th quarter, and may be well below that. It is the increase in taxes that has me concerned about a double-dip recession.
That being said, the announcement by several prominent Democratic senators that they think we should extend the Bush tax cuts is significant. As I said a few weeks ago, we should not experience a double-dip recession absent policy mistakes. A slow-growth world, yes. But an actual double dip is rare.
If Congress were to extend the Bush tax cuts for at least a year, until the presidential commission on taxes is done with its work and THEN have the debate, it would make me far more optimistic. And it would be quite bullish for stocks, I think. Businesses would know how to plan, at least, for a year, and the economy would be given more time to actually recover. I am not ready to channel my inner Larry Kudlow, but from what we see this summer it would make me more optimistic and reduce the chances of a double-dip recession significantly."(snip)
(snip)"Falling home prices and a weak housing market are one more element of deflation. This is happening not just in the US, but also much of Europe is suffering a real estate crisis. Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.
In the short run, reducing government spending (in the US at local, state, and federal levels) is deflationary in the short run. Martin Wolfe, in the Financial Times, wrote the following last week (arguing that that the move to "fiscal austerity" is ill-advised):
"We can see two huge threats in front of us. The first is the failure to recognize the strength of the deflationary pressures ... The danger that premature fiscal and monetary tightening will end up tipping the world economy back into recession is not small, even if the largest emerging countries should be well able to protect themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in management of the financial sector and in export-dependency, that are needed if a sustained and healthy global recovery is to occur."
Finally, high and chronic unemployment is deflationary. It reduces final demand as people simply don't have the money to buy things.
Deflation that comes from increased productivity is desirable. In the late 1800's the US went through an almost 30-year period of deflation that saw massive improvements in agriculture (the McCormick reaper, etc.) and the ability of producers to get their products to markets through railroads. In fact, too many railroads were built and a number of the companies that built them collapsed. Just as we experienced with the fiber-optic cable build-out, there was soon too much railroad capacity, and freight prices fell. That was bad for the shareholders but good for consumers. It was a time of great economic growth.
But deflation that comes from a lack of pricing power and lower final demand is not good. It hurts the incomes of both employer and employee, and discourages entrepreneurs from increasing their production capacity, and thus employment.
That is why it will be important to watch the CPI numbers even more closely in the coming months. The trend, as noted above, is for lower inflation. If that continues, the Fed will act. I did a summary of Bernanke's 2002 speech on deflation a few weeks ago. For those who didn't read it, here is the link.
If the US gets into outright deflation, I expect the Fed to react by increasing their assets and by outright monetization, buying treasuries from insurance and other companies, as putting more money into banks when they are not lending does not seem to be helpful as far as deflation is concerned. More mortgages? Corporate debt? Moving out the yield curve? All are options the Fed will consider. We need to be paying attention.
One final thought before I hit the send button. Recessions are by definition deflationary. One of the things we learned from This Time is Different by Rogoff and Reinhart is that economies are more fragile and volatile and that recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.
I think we can take it as a given that there is another recession in front of the US. That is the natural order of things. But it would be better to have that inevitable recession as far into the future as possible, and preferably with a little inflationary cushion and some room for active policy responses. A recession next year would be problematic, if not catastrophic. Rates are as low as they can go. Higher deficits are not in the cards. Yet unemployment would shoot up and tax collections go down at all levels of government.
That is why I worry so much about taking the Bush tax cuts away when the economy is weak. Now, maybe those who argue that tax increases don't matter are right. They have their academic studies. But the preponderance of work suggests their studies are flawed and at worst are guilty of data mining (looking for data that supports your already-developed conclusions.)
Professor Michael Boskin wrote today in the Wall Street Journal:
"The president does not say that economists agree that the high future taxes to finance the stimulus will hurt the economy. (The University of Chicago's Harald Uhlig estimates $3.40 of lost output for every dollar of government spending.) Either the president is not being told of serious alternative viewpoints, or serious viewpoints are defined as only those that support his position. In either case, he is being ill-served by his staff."
As noted at the beginning of this letter, I find it very encouraging that there is a movement among Democrats to think about at least postponing the demise of the Bush tax cuts until the economy is in better shape. Those who advocate letting them lapse are in effect operating on our economic body without benefit of anesthesia. If they are wrong, the consequences will be most severe."(snip)
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