In his press conference yesterday, the President’s opening statement covered Iran, climate change, and health care.  Here he is on climate change:

This energy bill will create a set of incentives that will spur the development of new sources of energy, including wind, solar, and geothermal power. It will also spur new energy savings, like efficient windows and other materials that reduce heating costs in the winter and cooling costs in the summer.

These incentives will finally make clean energy the profitable kind of energy. And that will lead to the development of new technologies that lead to new industries that could create millions of new jobs in America — jobs that can’t be shipped overseas.

He is still not referring to it as a “climate change bill,” nor does he ever say “cap-and-trade.”  He refers once to “the carbon pollution that threatens our planet,” but continues to rhetorically frame this cap-and-trade legislation as a clean energy technology bill.  He has been doing this consistently since his first press conference, and it reaffirms for me that his political and communications advisors think that addressing climate change is less popular than promoting clean energy technology.

Also, his last sentence is misleading.  Raising the price of energy would lower U.S. GDP.  We would produce less carbon and would have lower incomes.  While the President did not say that this bill would help the economy by creating a net increase in jobs, he creates that impression by saying “that lead to new industries that could create millions of new jobs in America.”  It is misleading to suggest that cap-and-trade legislation, such as that being considered this week by the House of Representatives, will not harm the economy.  You can argue that the environmental benefits are worth the economic cost, but not that this will increase U.S. economic growth.

I don’t understand why he thinks that jobs that could be created in clean energy technologies would necessarily be created in America, or why they could not be shipped overseas.  I can see why the windmill maintenance guy and the solar cell installation firm would have to be based in America (like the classic economics course example of not being able to outsource haircuts).  But solar cells and windmill parts, as well as batteries, new building materials, and nuclear power plant components can all be designed, developed, and manufactured anywhere in the world.  The U.S. clearly has an R&D head start on the rest of the world, but I don’t see why the President thinks these jobs “can’t” be shipped overseas.

This Presidential statement is a rhetorical flourish, but I’d be interested to see CEA Chair Dr. Christina Romer try to defend it in front of an audience of her academic colleagues.  I think it’s indefensible:

The nation that leads in the creation of a clean energy economy will be the nation that leads the 21st century’s global economy.

This statement is true but incomplete:

At a time of great fiscal challenges, this legislation is paid for by the polluters who currently emit the dangerous carbon emissions that contaminate the water we drink and pollute the air that we breathe.

Thanks to a grad school professor, I have forever imprinted the question-and-answered, “Who pays taxes?  PEOPLE pay taxes.”  The President is correct that the costs of a cap-and-trade system would be directly imposed on those who produce power and fuel from carbon-based energy sources.  But power companies, like all firms, are aggregations of economic interests.  They would pass these costs through to their owners, employees, and customers.  So one could even more accurately say that “This legislation is paid for by anyone who uses electricity from a coal-fired or nautral gas-fired power plant, who drives, or who buys anything that has power or fuel as an input.  It is also paid for by the hard-working employees of those companies, and by those who own stock in those companies.”

Finally, I wish he would mention nuclear power when he talks about new sources of low-carbon energy.  Not doing so suggests a political calculation, because nuclear power is the one non-carbon power source that many on the far left oppose.

(photo credit: whitehouse.gov)

The President’s press conference: climate change

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Parsing the President: no “climate change”?
2. The New York Times (implicitly) calls for no climate change law
3. What did President Bush announce today on climate change?

Everyone wants to know when the U.S. economy will start growing.  I will focus on a related question:  when will the stimulus law begin to have a significant positive effect on U.S. economic growth?  And could it have come sooner if the Administration had done something different?

I believe the Administration made an enormous mistake in its legislative implementation of the stimulus.  As a result, the boost to GDP will come six to nine months later than it needed to (maybe more).  Given the President’s desire to do a large fiscal stimulus, and given his policy preferences, he could have had a different bill that would have been producing significant GDP growth beginning now, rather than in the middle of next year.  That’s a huge mistake with real consequences for the U.S. and global economies.

To illustrate this point, let me classify four types of fiscal stimulus:

1. a permanent tax cut;
2. a temporary tax cut;
3. one-time checks to people independent of their tax liabilities; and
4. increased government spending through federal and state bureaucracies:  infrastructure, energy spending, etc.

There is of course a fifth option:  no fiscal stimulus law.

If you’re going to do a fiscal stimulus (big if), the best kind is a permanent tax cut.  It is effective, efficient, and fast:

• effective – People spend a large proportion of a permanent tax cut.  This is derived from Milton Friedman’s “permanent income hypothesis.”
• efficient – People spend their own money on themselves, so they waste very little of it, and they spend it on things that matter to them.  Again, see Milton Friedman.
• fast – Checks are delivered quickly, and people spend most of their own money soon after they get the check.

This was part of the short-term logic behind the 2003 tax cut, which we designed to foster both short-term and long-term economic growth.  I also have a strong general policy preference for lower taxes rather than more government spending, but that’s a separable question from how it works as short-term stimulus.

In 2008 we knew we could not get a Democratic Congress to enact a permanent tax cut.  Q:  Do you then go for a temporary tax cut, or do nothing?  The President thought the risks of an economic slowdown in 2008 were significant enough that it made sense to pursue a (second best) temporary tax cut with the Congress.

Like the 2003 law, the 2008 law got the bulk of its short-term GDP boost by advancing tax refunds from the year to come, and delivering them as checks from the IRS to taxpayers.  As in 2003, the checks were delivered to taxpayers in the summer (mid-June to early-August), and consumers immediately started spending a portion of their rebates.

Because the 2008 law was a temporary tax cut, taxpayers spent a smaller proportion of it than anyone would have liked.  While designing the law, we assumed about 1/3 would be spent, and much of that fairly quickly.  The rest would be saved, which is also good but doesn’t help short-term GDP growth.  Economists agree that GDP in Q3 and Q4 of 2008 was higher than it otherwise would have been because of the 2008 stimulus law.  It was efficient, fast, yet only partially effective, with a smaller GDP boost than we would have liked:

• efficient – People were again spending their own money on themselves.  You get very little waste, and people know what they want and need.
• fast – Checks were delivered quickly, and much of the spending that did occur happened in Q3, with some in Q4, and with very little left by Q1 of 2009.
• only partially effective – Because it was a temporary tax cut, people saved a lot of their checks, as we expected.  Still we got a GDP bump in Q3 and Q4, and in retrospect we certainly needed it.

The 2008 law was mostly (2) from my list above – a temporary tax cut.  Some of the money went to (3), checks to people who didn’t pay income taxes.  This was necessary to reach a compromise with a Democratic Congressional leadership that placed a high priority on the distributional effects of the law.  Speaker Pelosi insisted that poor people who owed no income taxes still get “rebate” checks, and that high-income taxpayers get nothing.  So the 2008 stimulus law was mostly (2) with a little bit of (3).

Now fast forward to January of 2009, when President Obama proposed an enormous fiscal stimulus.  The President’s mistake was in largely deferring to Congress on the composition of the stimulus bill. Rather than allowing Congress to pump hundreds of billions of dollars through slow-spending and inefficient bureaucracies, the President should have insisted that Congress instead send all the funds directly to the American people and let them spend it quickly and efficiently.  Given his policy preferences, he could have directed a large share of those funds to poor people who don’t pay income taxes.  He could have again mislabeled these payments as “tax cuts,” or just correctly labeled them as one-time entitlement payments.  I would not have liked that policy, but it would have generated a faster macroeconomic boost than what he allowed Congress to do instead.

Let’s compare the two scenarios.  The enacted 2009 stimulus is:

• effective (eventually) – Most of the spending through government bureaucracies will (eventually) increase GDP.  Some of the funds transferred to State governments will be used to offset State spending or tax cuts that otherwise would have occurred, so there’s a loss.  But clearly the proportion of the $787 B that will eventually increase GDP will be high, and much higher than if all the funds were given to individuals and families.
• inefficient – It will be inefficient in two senses.  The spending represents the policy preferences of legislators (and all their ugly legislative deals and compromises), rather than the choices of hundreds of millions of Americans who presumably know better how they would like money spent on them.  The spending will also be wasteful, and we are starting to see signs of this in the press.
• s-l-o-o-o-w – CBO says that $25 B of spending had gone into the economy by May 22nd.  That’s less than 4% of the total budgetary impact of that bill.  Other news reports suggest that about $40 B is in the economy if you include the revenue side.  Remember that almost all of the 2008 stimulus was in private hands by August 1.  We will get very little GDP boost from fiscal stimulus in Q3 of 2009, and not much in Q4 either.  The stimulus will begin to ramp up in Q1 of next year, and be in full swing by Q2 and Q3 of 2010.

Had the President instead insisted that a $787 B stimulus go directly into people’s hands, where “people” includes those who pay income taxes and those who don’t, we would now be seeing a stimulus that would be:

• partially effective but still quite large – Because it would be a temporary change in people’s incomes, only a fraction of the $787 B would be spent.  But even 1/4 or 1/3 of $787 B is still a lot of money to dump out the door.  The relative ineffectiveness of a temporary income change would be offset by the enormous amount of cash flowing.
• efficient – People would be spending money on themselves.  Some of them would be spending other people’s money on themselves, but at least they would be spending on their own needs, rather than on multi-year water projects in the districts of powerful Members of Congress.  You would have much less waste.
• fast – The GDP boost would be concentrated in Q3 and Q4 of 2009, tapering off heavily in Q1 of 2010.

Why did the President not do this?  Discussions with the Congress began in January before he took office, and he faced a strong Speaker who took control and gave a huge chuck of funding to House Appropriations Chairman Obey (D-WI).  I can think of three plausible explanations:

1. The President and his team did not realize the analytical point that infrastructure spending has too slow of a GDP effect.
2. They were disorganized.
3. They did not want a confrontation with their new Congressional allies in their first few days.

I think the Administration now recognizes this problem.  Last month when they released a CEA paper “Estimates of Job Creation from the American Recovery and Reinvestment Act of 2009,” the paper danced around the timing of job growth and government outlays in 2009 and 2010.  Tips for reporters:  (1) ask the Administration to give you OMB estimates of quarterly cash flows for the stimulus law, and (2) ask them to give you the quarterly GDP and job growth estimates behind this CEA paper.  I know the first one exists, and I’d bet heavily the second does as well.

Fortunately, CBO Director Doug Elmendorf just gave a presentation titled “Implementation Lags of Fiscal Policy” to the IMF’s conference on fiscal policy.  All of the following data are from his presentation.

The final 2009 stimulus law broke down like this:

The problem is that only 11% of the first line (discretionary spending) will be spent by October 1 of this year.  In contrast, 31-32% of the entitlement and tax cuts lines will be out the door by that time.  (I have questions about the speed of the entitlement part.  The bulk of that is Medicaid spending, and it’s not clear to me that a Federal payment to a State means the cash is immediately flowing into the private economy.)

If we extend our window to October 1, 2010, then less than half the discretionary spending will be out the door, while almost 3/4 of the entitlement spending and all of the tax cuts will be out the door and affecting the economy.  The largest part of the stimulus law is therefore also the slowest spending part.  This is fine if you’re trying to increase GDP growth over the next 2-4 years.  If you’re going for short-term GDP growth, it makes no sense.

Director Elmendorf drills down further into discretionary spending and shows that defense spending happens quickly, highways and water extremely slowly:

• If you allocate $1 to defense spending, 65 cents has been spent within one year.
• If you allocate $1 to highway spending, 27 cents has been spent within one year.
• If you allocate $1 to water projects, only 4 cents has been spent within one year.

In fact, the infrastructure spending in the stimulus law will peak in fiscal year 2011, which goes from October 1, 2010 to September 30, 2011.  That’s too late from a macro perspective.

The Director further points out that the 2009 stimulus law created many new programs.  This slows spend-out, as it takes time to create and ramp up the new programs.

The Administration has made much of working with federal and state bureaucracies to find “shovel-ready” projects to accelerate infrastructure spending.  All of my conversations with budget analysts suggest this claim is tremendously overblown, and Director Elmendorf asks, “Is this practical on a large scale?”

The 2009 stimulus law will increase U.S. economic growth.  But the actuals are matching the budget analysts’ projections for the speed at which that effect will occur.

I would not have liked a stimulus law that would have given cash to people who didn’t pay income taxes.  But from a macroeconomic perspective, we need the faster economic growth now.  Had the President and his team insisted on giving money to people (taxpayers or not) rather than to bureaucracies, we would be seeing a huge growth spurt in Q3 and Q4 of this year.

It is sad that instead we have to wait until the middle of next year because the White House deferred to Congressional desires to spend on infrastructure.  This strategic mistake was avoidable, and the recovery will be delayed because of it.

Will the stimulus come too late?

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. A bipartisan economic booster shot
2. A “second stimulus”?
3. Stimulus 2008: a need for speed

1. Auto loans: a deadline looms
2. Auto loans: options for the President
3. Auto loans: the Bush approach
4. Auto loans: Chrysler gets an ultimatum, GM gets a do-over
5. Auto loans: the press forgot to ask about the cost to the taxpayer
6. Should taxpayers subsidize Chrysler retiree pensions or health care?
7. The Chrysler bankruptcy sale
8. Mixed results on the Chrysler announcement

This morning I posted some basic facts on the General Motors announcement.  Now it’s time for some analysis.  Like my post Understanding the President’s CAFE announcement, this is a monster post.  I hope you find it valuable despite its length.

I want to try to tease apart the various questions that get conflated in the public forum.  My primary goal is to give you a structure for thinking about the issue.  My secondary goal is to persuade you to agree with my views on each question.  I will be satisfied if you give me credit for achieving only the primary goal.

Here is how I tease apart the questions:

1. What are the arguments for further government intervention?
2. Given these arguments, should the U.S. government intervene further by putting more taxpayer funding at risk to prevent GM from liquidating?
3. Is the pre-packaged bankruptcy likely to succeed?
4. Is it fair?
5. Did the government structure the taxpayer financing correctly?
6. Will the Administration run GM?

Let’s take them one-by-one.

1.  What are the arguments for further government intervention?

Today the President explained why he chose to put another $30.1 B of taxpayer funds at risk to prevent GM from liquidating now.  Speaking about his decision on March 30th, he said today:

But I also recognized the importance of a viable auto industry to the well-being of families and communities across our industrial Midwest and across the United States.  In the midst of a deep recession and financial crisis, the collapse of these companies would have been devastating for countless Americans, and done enormous damage to our economy — beyond the auto industry.  It was also clear that if GM and Chrysler remade and retooled themselves for the 21st century, it would be good for American workers, good for American manufacturing, and good for America’s economy.

This is more expansive than what President Bush argued last December:

In the midst of a financial crisis and a recession, allowing the U.S. auto industry to collapse is not a responsible course of action. The question is how we can best give it a chance to succeed. Some argue the wisest path is to allow the auto companies to reorganize through Chapter 11 provisions of our bankruptcy laws — and provide federal loans to keep them operating while they try to restructure under the supervision of a bankruptcy court. But given the current state of the auto industry and the economy, Chapter 11 is unlikely to work for American automakers at this time.

The distinction is important.  President Bush’s arguments were time-dependent: (a) we should try to prevent our weak economy from taking another big hit right now, and (b) let’s buy GM and Chrysler time to get ready to restructure.  He also argued (c) that it was unfair to dump a liquidating auto industry on his successor (even if his successor might do something different than he would).  It was a “too big to fail now” argument.

Today President Obama made it clear that he made the decision to commit additional funds, if his conditions were met, at the end of March.  He then added new reasons to those expressed by President Bush:  that America needs “a viable auto industry,” and that it would be good for America if GM and Chrysler survived.  While he emphasizes what he would not do, “I refused to let these companies become permanent wards of the state,” President Obama defines a national interest in having auto manufacturers headquartered in the U.S.  He reinforced that with his closing line, which was surreal:

And when that happens, we can truly say that what is good for General Motors and all who work there is good for the United States of America.

This is a big expansion of the justification for government intervention in the market.  Ford is not failing, and Chrysler is emerging from bankruptcy.  President Obama is arguing that American taxpayers need to fund the survival of a third (the biggest) U.S.-based auto manufacturer, because it is important “to the well-being of families and communities across our industrial Midwest and across the United States” and because “it would be good for American workers, good for American manufacturing, and good for America’s economy.”  This argument could be extended to almost any large U.S. firm, at almost any time.

My view:  I am extremely uncomfortable with the President’s expanded argument for further government intervention.  Had the President instead argued, “The economy is beginning to recover, and we cannot jeopardize that with another major shock,” I would have been less uncomfortable with today’s commitment of additional taxpayer funds.

2.  Given these arguments, should the U.S. government intervene further by putting more taxpayer funding at risk to prevent GM from liquidating?

The public debate has evolved in the past two months.  Earlier this year the question posed was, “Should the Administration bail out GM?”  The basic options were “yes,” “no,” and “only if they enter bankruptcy, and if they do they should try to pre-package it.”  The President chose the last of these options.  The President decided to put $30.1 B of additional taxpayer funding at risk to help prevent GM from liquidating in the near future, and to help them through a restructuring process.

The benefits and costs are similar to what I described in late March.  Here’s the updated version:

Benefits

• If the firm survives the bankruptcy process intact, it has a higher probability of being viable in the long run (than in a restructuring outside of bankruptcy).
• If the firm survives restructuring, the taxpayer has a higher probability of being repaid.
• Old equity holders faced the full costs of the firm’s failure (by being wiped out).  No additional moral hazard is created.

Costs

• There are still significant risks to GM’s survival:
  • Will GM and the Administration defeat the objecting unsecured creditors in court?  (however unfair that might be)
  • Will the bankruptcy process conclude quickly (within 90 days)?
  • Will GM continue to lose market share?  Can GM make cars and trucks that people want to buy?
  • Will the new fuel economy and emissions rules restrict GM’s ability to make attractive vehicles?
• This is a big new cash outlay from the taxpayer.  This costs the taxpayer, and further constrains available TARP funds.

The President made clear his answer to this question on March 30th.  At that time he laid out the conditions under which he would provide additional funding, and those conditions were met.  No one should be surprised that he is now putting more taxpayer funding at risk.  I am surprised that they only need $30 B.

My view:  We crossed this bridge back in late March.  It is not a new decision today to put more taxpayer funding at risk.  I don’t like it, but I am at least glad that some incentives have been restored:  the firm has to go through a bankruptcy process, shareholders are wiped out, and management was fired.  I remember arguments from last fall and earlier this year that GM should get more taxpayer dollars outside of a bankruptcy process.  That would have been far worse, and today’s actions mitigate some moral hazard.

Given the relative strength of the U.S. economy now compared to last December, I would have preferred an outcome of a pre-packaged bankruptcy + private DIP financing, and not exposing taxpayers to any additional risk.  If GM is really as viable as GM and the President claim it now is, then they should have no problem convincing capital markets to provide them with short-term financing.  (Judge Richard Posner argues this.)  I will guess that this was not actually a viable option, because the pre-packaging could only come together with the direct involvement of the government.  I think the real options would have been expose taxpayers to $30B more risk, or allow GM to liquidate.  I would go with the latter:  if GM can’t find private financing, they’re on their own.  I assume this means they would liquidate.  This would have been harsh and painful for those affected.  I believe the consequences of further intervention now are worse for a larger number of people in the long run.

3.  Is the pre-packaged bankruptcy likely to succeed?

There are two components to this question:

• Is the bankruptcy process likely to be quick and successful?
• Will the resulting company succeed without additional taxpayer aid?

I do not feel well-qualified to comment on the first question.  The talking heads all repeat that “GM’s bankruptcy is more complicated than Chrysler’s,” with little detail about why.  I would point out that the Administration is one for one in this process.  Their use of this part of the bankruptcy code (section 363), and the process where the old GM sells the good stuff to a new GM, and then the remaining parts are liquidated, appears to have worked for Chrysler.  From my perspective, the burden of proof now shifts to those who argue this bankruptcy will take more than 90 days.  I didn’t like it because of the precedent it set, but I wouldn’t bet against the Administration succeeding again.

Other than the “good for GM is good for America” quote, the biggest surprise in the President’s remarks was how heavily he was betting that a restructured GM will succeed.  He could easily have taken the posture, “GM has made some hard decisions, and they have a tough road ahead if they want to survive and succeed.”  Instead, he attached his own credibility to GM’s future success and said:

So I’m confident that the steps I’m announcing today will mark the end of an old GM, and the beginning of a new GM; a new GM that can produce the high-quality, safe, and fuel-efficient cars of tomorrow; that can lead America towards an energy independent future; and that is once more a symbol of America’s success.

Even with a cleaned up balance sheet and more taxpayer funding, it is by no means certain that GM will survive for the long run.  If GM fails in the next few years, the taxpayers will have lost an additional $30.1 B that the President committed today.  In addition, the above quote will come back to haunt the President.  I understand wanting to set a positive and optimistic tone.  I am confused why he did so at such great political risk to himself.

I found it useful to return to my first post on the autos and review what this new pre-packaged bankruptcy + DIP financing does to the wide range of challenges faced by GM:

Revenues

• The economic slowdown means fewer vehicles are being purchased from all auto manufacturers, foreign and domestic.
• Even apart from the economic slowdown, U.S. auto manufacturers have been losing market share over time.
• This is in part because they made a bet on light trucks versus smaller cars.  This product mix doesn’t work when gas prices are high.  Think of the proliferation of SUV’s in the past 10 years.  (Note that this was in part the fault of U.S. government policies.  SUV’s are technically light trucks, and so they qualify for lower fuel economy requirements.)

Costs & productivity

• The Detroit 3’s ongoing labor costs are higher than those of foreign-based firms.  This is still true when you compare an American worker in a GM plant in Michigan, for instance, with an American worker in a Nissan plant in Mississippi.
• Productivity is lower in U.S. plants of U.S. firms than it is in U.S. plants of foreign-based firms.  Some of this is because of the UAW contract that mandates certain inefficiencies.  Some of it is poor management.
• The Detroit 3 have huge dealer networks that are costly to the manufacturers.  These dealer franchises are often protected by state laws that make it hard for the manufacturers to make these networks smaller and more efficient.
• Auto manufacturers face a burdensome and unpredictable legislative and regulatory environment.

Balance sheets

• The Detroit 3 have enormous legacy costs from their retirees.  Past UAW contracts provided generous benefits that continue to burden these firms.  This drains profits (when they earn them) away from productivity-enhancing investments.

So can GM survive, and for how long?  Can they profit and flourish, as the President suggests they will?

• The Administration and GM argue that a restructured GM can break even in a national market of only 10m vehicles sold in America each year.  (We’re now around 9.5m/year.  “Normal” is around 16m/year.)  If accurate, this is astonishing.  This would appear to address all three of the bullets under revenues.  Addressed?  I’m skeptical.  I need to review the assumptions in GM’s new plan, especially about market share.
• I have seen no evidence that GM and UAW have reduced significantly GM’s ongoing labor costs to be competitive with the transplants.  Maybe I have missed it.  Unaddressed.
• Productivity is still lower in U.S. plants of U.S. firms that it is in U.S. plants of foreign-based firms.  As a result of high compensation costs per worker and low productivity, it appears that labor cost per vehicle produced will still be uncompetitive with the transplants.  Unaddressed.
• GM’s dealer network is being dramatically reduced.  Addressed.
• The CAFE and emissions requirements are even more burdensome than predicted, but now have at least some degree of stability, given the national standards.  On net, worse than before.
• The balance sheets will be relieved of enormous debt and legacy health and pension obligations.  Addressed.

My view:  I need to look more at what GM is assuming for market share.  The removal of the legacy obligations, combined with a big chunk of taxpayer change, will buy then many months of survival.

The Administration is stressing the balance sheet improvements, and they deserve credit for that.  Conservative critics focus on the additional burdens of the fuel economy and emissions rules, and they’re right, too.

I would focus even more on the questions asked by several commenters: “Will people want to buy GM cars and trucks?”  Additionally, can GM make a profit with still high labor costs, still low productivity, still burdensome work rules, and still slow product development cycles?

I want to GM to survive and be profitable in the long run.  Their chances are now drastically improved, assuming they survive bankruptcy.  But I don’t know if that’s an improvement from a 1% chance to a 20% chance, or from a 1% chance to an 80% chance.  A lot more needs to change beyond just cleaning up the balance sheet, and many of those needed changes are deep-seated in the culture, structures, and processes of America’s third-largest company.

4.  Is the pre-packaged bankruptcy fair?

Absolutely not.  But I want to be precise in my criticism.

The easiest thing to do in Washington is to criticize the negotiator.  “I could have gotten a better deal,” we say.  I should begin my expressing my sympathy and offering my congratulations to Steven Rattner and the Obama team for closing what was undoubtedly a complex and difficult set of negotiations.  I’m sure this one was not easy, and theirs was a thankless task.

At the same time, I share the concerns of many that the deal was not even-handed, and that the precedent will damage future business lending.  I have grave concerns about how far they were willing to stretch bankruptcy processes and the traditional capital structure to get a deal.

First I need to correct the Administration, as well as some bad reporting today by the Washington Post.  In last night’s background briefing for the press, an unnamed Senior Administration Official claimed (emphasis added):

Secondly, as you know, the UAW has reached a new agreement with GM and that agreement has been ratified that involves significant concessions by the UAW — concessions that are in virtually every respect more aggressive than what the previous administration demanded in its loan agreement.

In the term sheet for the December loan we (the Bush Administration) made to General Motors, we set out “targets,” which we took directly from the Corker amendment offered the week prior on the Senate floor:

1. Reduce outstanding unsecured debt by not less than 2/3 through conversion into equity or other debt;
2. “Reduce the total amount of compensation, including wages and benefits, paid to their U.S. employees so that, by no later than December 31, 2009, the average of such total amount, per hour and per person, is an amount that is competitive with the average total amount of such compensation, as certified by the Secretary of Labor, paid per hour and per person to employees of Nissan Motor Company, Toyota Motor Corporation, or American Honda Motor Company whose site of employment is in the United States.”
3. Eliminate the jobs bank.
4. Apply work rules no later than 12/31/09 “in a manner that is competitive with Nissan … Toyota or Honda in the U.S.”
5. Not less than half of their VEBA payment should be in the form of stock.

As best I can tell:

• They more than accomplished target #1.
• They did little to nothing on #2.  I have seen no evidence that compensation of current workers has been changed.  UAW Chief Ron Gettelfinger claimed in a message to his members, “For our active members these tentative changes mean no loss in your base hourly pay, no reduction in your health care, and no reduction in pensions.”  Maybe there’s a distinction between this statement and “total compensation.”  If so, it would be great if someone could help me understand this.  But it appears GM and UAW did nothing to address target #2.
• UAW agreed to #3 in late March.
• They made no apparent progress on target #4.  I have neither seen nor heard evidence that the work rules have been relaxed.  I am happy to be corrected.
• They accomplished #5.

It was incorrect for the Senior Administration Official to call these “demands” of the Bush Administration.  They were targets, not hard conditions.  It is an overstatement to say that they “are in virtually every respect more aggressive than what the previous Administration demanded,” unless “virtually every respect” means “except for compensation and work rules.”  (I am happy to be corrected if I have just missed the changes.)

The Washington Post then further flubbed it by writing:

Critics say it is unfair that the restructuring plan gives the union health trust a larger share of the new GM than the bondholders. But administration officials defend the plan, offering several justifications.

First, they note that the terms of the proposed GM restructuring echo the terms laid out by the Bush administration in December, when it extended $13.4 billion in loans to GM.

The Bush administration’s loan agreement required a 50 percent reduction or “haircut” for the union trust, but a 66 percent cut for the bondholders. The Obama deal requires larger cuts for both sides, though more for the bondholders.

The agreement does more than meet three of the five targets laid out by the Administration.  It appears to make no progress on the other two targets.  Thus the terms do not “echo the terms laid out by the Bush administration in December.”

More importantly, the targets we (Bush team) laid out said nothing about the distribution of equity shares.  The criticism is not that the deal doesn’t cut the VEBA enough, or reduce unsecured debt enough.  The criticism is that someone lower in the capital structure (UAW’s VEBA) got a much greater equity share than someone higher in the structure (unsecured creditors).  It is disingenuous to point to the targets in the Bush Administration’s December loans to justify this inequity.

The deal is unfair to unsecured creditors, because they get a worse deal than someone standing behind them in line (the UAW’s VEBA).  It has nothing to do with who those parties are (labor vs. creditors).  It is about the importance of maintaining a stable and predictable set of rules to govern the capital structure of a firm, and the value that stability creates for firms’ ability to raise capital.  All these arguments boil down to the cardinal rule of waiting in line for the kindergarten bus:  it’s not fair to cut in line.  If that rule is broken too often, chaos ensues.

The Administration could be arguing, “Sure it’s unfair, but UAW had more leverage on us than the creditors, so we struck the best deal that we could.  We needed UAW to sign onto the deal, while we thought we could roll the creditors in court.”  This would better justify the disproportionate equity shares than claiming, “This is a fair deal.”

The objecting creditors will now defend their rights in court.  If the Chrysler precedent is an example, you should bet against them.  It is interesting that the President did not attack them as “speculators” this time, so at least the rhetorical leverage against them is weakened.

My view:  I am more concerned with the signals this unfair treatment sends to future investors. I worry that the President’s actions create political risk and will permanently raise the cost of capital for certain firms.  I wish I knew whether a different prepackaging was possible, one which would have maintained the precedence of the capital structure and did not stretch the bankruptcy process again.  Unfortunately, it is impossible to know.

5.  Did the government structure the taxpayer financing correctly?

Judge Richard Posner argues the government should have provided a loan rather than taken an equity stake in GM.  The President suggested one reason why they preferred an equity stake:  a loan would further burden GM with a stream of near-term interest payments to the government.

I think Judge Posner strikes a nerve with his suggestion.  It seems that much of the public discomfort comes from the government now being the owner of GM.  It’s the 60% number that made me gasp.  It highlights a tradeoff between two goals on which conservatives focus:  value for the taxpayer, and avoiding government interference and control.  There is a tradeoff between the two.

I believe the U.S. government could auction its equity shares late this year and divest itself completely from General Motors.  This would solve the government ownership problem.  In doing so, I presume that taxpayers would recoup far less than the $30 B of cash provided.

Question for conservatives:  How much of a loss are you willing to take on the $30 B to get the U.S. government out of GM quickly?

My view:  I assume there is a non-trivial chance that GM may still fail in the next several years.  I like the President’s and his team’s strong language today that this $30 B is the last taxpayer aid, but I would like to reinforce that by ending the government’s ongoing involvement in GM as quickly as possible.  I am willing to sacrifice a significant portion of the $30 B to achieve that goal.  I therefore recommend that, if GM emerges from bankruptcy, the Administration then establish a much more rapid timetable for selling its equity stake, even if that means the taxpayer loses much of the $30 B.  Get us out of GM before the end of 2010.  This will strengthen the bulwark against providing additional taxpayer funds if GM fails again.

Note:

• Under current law, the authority to provide any firm with additional TARP funding expires December 31, 2009. Correction:  Secretary Geithner can, after notifying Congress, extend the TARP authorities to October 3, 2010.
• The “set a timeline” argument has direct parallels to a certain national security debate…

6.  Will the Administration run GM?

Here I give the Administration credit for good intent and good initial execution.  I take at face value the President’s statement that he does not want to run or control GM, and I give him points for saying so explicitly.  I am sure there are others, including some in his Administration and some on Capitol Hill, that would love to run GM as Government Motors.  I will trust the President when he says he is not one of those people.

I further give the Administration credit for the “Principles for Managing Ownership Stake” they released in today’s fact sheet.  While they are being released in the specific context of the U.S. government’s new equity stake in GM, the White House writes more generally “(T)he Obama Administration has established four core principles that will guide the government’s management of ownership interests in private firms.”

• The government has no desire to own equity stakes in companies any longer than necessary, and will seek to dispose of its ownership interests as soon as practicable. Our goal is to promote strong and viable companies that can quickly be profitable and contribute to economic growth and jobs without government involvement.
• In exceptional cases where the U.S. government feels it is necessary to respond to a company’s request for substantial assistance, the government will reserve the right to set upfront conditions to protect taxpayers, promote financial stability and encourage growth. When necessary, these conditions may include restructurings similar to that now underway at GM as well as changes to ensure a strong board of directors that selects management with a sound long-term vision to restore their companies to profitability and to end the need for government support as quickly as is practically feasible.
• After any up-front conditions are in place, the government will protect the taxpayers’ investment by managing its ownership stake in a hands-off, commercial manner. The government will not interfere with or exert control over day-to-day company operations. No government employees will serve on the boards or be employed by these companies.
• As a common shareholder, the government will only vote on core governance issues, including the selection of a company’s board of directors and major corporate events or transactions. While protecting taxpayer resources, the government intends to be extremely disciplined as to how it intends to use even these limited rights.

Given that I trust the President’s statements on this point, the risks here are unintended consequences, from within his own Administration and from the Congress.  They are big risks, and these are dangerous waters.  I hope the Administration treads carefully.

My view:  Given the undesirable situation of government equity stakes in, and even controlling ownership of, firms like GM and AIG, as well as potentially Citigroup and other banks, these are good principles. They are also easy to monitor.  It is interesting and good that the White House fact sheet says, “The [UAW’s] VEBA will have the right to select one independent director and will have no right to vote its shares or other governance rights.” (emphasis added)

I urge the President to:

• Enshrine the principles from today’s fact sheet in the term sheets for the taxpayer investments in GM (and other firms). We did this last December in the GM and Chrysler term sheets. Tie yourself to the mast. This will give you an easy excuse later when someone pressures you to vote those shares in a way that conflicts with the taxpayer’s interest.
• Set clear rules for Administration contacts with GM – it’s probably best to funnel all contacts through specific Treasury or NEC officials on the autos task force.  No freelancing phone calls to the Administration-appointed directors or “informal chats” with them from White House staff, or from DOT, EPA, USTR, DOE, even State.  Put a firewall around interactions with GM.
• Come out hard and quickly against the first proposal from a Member of Congress to leverage the ownership stake for a non-taxpayer goal.  Nip it in the bud, especially if the idea comes from a friend.

It’s easy to criticize a huge decision like the one made by the President today.  I strongly disagree with where we are headed, and I am concerned with the precedent that this deal sets for capital investment in American firms.  The alternative, however, is that you have to be willing to allow GM to fail.  I would be willing to do so, and it is therefore easy for me to express my views.  In summary, they are:

1. I am extremely uncomfortable with the President’s expanded argument for today’s government intervention. 
   
2. My first choice would have been to push GM to get private DIP financing.  Assuming that was infeasible, I would have recommended denying GM the DIP financing, even if that meant they would liquidate.  The economy is sufficiently healthier now than it was last December that I would be willing to risk the additional shock.  But I agree the President crossed this bridge at the end of March.
   
3. I would bet in favor of GM emerging from bankruptcy, and against them surviving as an intact firm for 5 years without additional taxpayer funding.
   
4. The pre-packaging deal was unfair to unsecured creditors, to the benefit of UAW retirees.  The Administration loses credibility with me by trying to argue this was a fair deal.  They would have been more credible if they had argued it was the only deal they could get.  I worry that the President’s actions create political risk and will permanently raise the cost of capital for certain U.S. firms.
   
5. If a loan rather than an equity purchase had been possible, I would have preferred that – I find Judge Posner’s arguments persuasive.  Given the equity investment, I urge the Administration to divest as quickly as possible, even if it means a loss to the taxpayer.
   
6. Given the undesirable situation of the U.S. government owning GM and other large firms, the Administration’s new “Principles for Managing Ownership Stake” are solid.  They need to lock them in, and corral or beat back all those people who work in the Executive Branch and Congress who have other goals in mind for GM and will be tempted to exert some leverage.

I thank you for making it through this extremely long post, and again want to thank all of the fantastic commenters.  If you dislike the President’s announcement, I urge you to consider this question:  Suppose the deal announced today were the only possible pre-packaged bankruptcy, and your choice was to take it or allow GM to liquidate now.  What would you do?

Understanding the GM bankruptcy

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Auto loans: a deadline looms
2. Dr. Goolsbee gets it wrong on the auto loans
3. Basic facts on the General Motors bankruptcy

America appears to lack a high-probability strategy for how to get China, India, and Russia to agree to self-impose a significant positive carbon price.

The Administration and its Congressional allies are trying to impose a significant carbon price in the U.S. through something like the Waxman-Markey bill, while entering an international negotiation process in which as much as 60% of global carbon emissions could face little to no carbon price.  The likely outcome would dramatically tilt the global economic playing field, harming U.S. workers and firms relative to their counterparts in China and India.  At the same time, it would make little progress toward addressing the risk of severe global climate change, as a large portion of global carbon emissions would remain effectively uncapped.

In that post I identified two questions that American policymakers need to answer to fill that hole.  The first of those was:

What tools should we use to try to convince the government of China to impose a positive carbon price as part of a global effort?  (choose one or more)

1. Leadership:  U.S. goes first and self-imposes a price.  Then we use diplomacy to try to convince the Chinese to do the same.
2. Carrots:  The U.S. pays the Chinese to reduce their emissions.
3. Sticks:  The U.S. imposes import tariffs on Chinese goods as long as the government China does not impose a carbon price.

I now see that I was eight days behind Dr. Paul Krugman in identifying this challenge.  On May 14th, he wrote in his New York Times column “Empire of Carbon”:

(T)he people I talk to are increasingly optimistic that Congress will soon establish a cap-and-trade system that limits emissions of greenhouse gases, with the limits growing steadily tighter over time. And once America acts, we can expect much of the world to follow our lead.

… But that still leaves the problem of China, where I have been for most of the last week. … But China cannot continue along its current path because the planet can’t handle the strain. … And the growth of emissions from China — already the world’s largest producer of carbon dioxide — is one main reason for this new pessimism.

I’d like to compare where I think Dr. Krugman stands on various elements of the strategic question I posed, and compare them with my own views.  We differ in our concern about the risks and costs of severe climate change, and that difference leads us to radically different policy recommendations.

I should state at the outset my views on the science and risk of climate change.  There is a significant amount of evidence that there is a long-term risk of severe climate change.  But there is little discussion about the numbers:  How big of a risk?  How much warmer?  How quickly?  How certain are we?  And the numbers matter a lot.  If we knew with certainty that Earth would warm 10 degrees over the next 20-30 years, I would be screaming for an immediate big carbon tax.  If instead we think Earth is likely to warm one degree over the next century or two, then climate change is a trivial concern and we needn’t worry about it.  The problem is that nobody knows where we are between these two extremes.  This uncertainty matters a lot, and it makes the problem hard.

Given this uncertainty, I believe there is a small but non-trivial risk that there will be severe climate change over the next century or two.  And so I am willing to consider significant and effective policy actions to slow the growth of greenhouse gas emissions to reduce that risk.  I do not, however, believe that risk is so great or so certain that we must immediately commit to drastic changes in our economy, or that we must ignore the costs of those policy actions.  I treat this like any other policy question:  Given tremendous quantitative uncertainty, what are the marginal costs and benefits of our current emissions path, compared with various recommended policy options?  I will quantify my thinking on these questions in a separate post.  I am willing to consider policies to set a domestic carbon price, if I can be convinced that they’re worth it and will work.  So far I have not seen any carbon pricing proposal that I think (a) would have benefits that exceed the costs, and (b) is feasible in the real world of nation-states with differing national interests.  But I’m open to suggestions.

For now, let’s focus on two different answers to the China/India question in the American climate strategy.

• Dr. Krugman appears to believe that, if China does not slow its global greenhouse emissions growth, actions by the rest of the world will be insufficient to significantly slow global emissions.  Krugman:  “In January, China announced that it plans to continue its reliance on coal as its main energy source and that to feed its economic growth it will increase coal production 30 percent by 2015.  That’s a decision that, all by itself, will swamp any emissions reductions elsewhere.”  I agree with him on this point.
  
• I agree with Dr. Krugman’s read of the official Chinese position:  “So what is to be done about the China problem?  Nothing, say the Chinese.  Each time I raised the issue during my visit, I was met with outraged declarations that it was unfair to expect China to limit its use of fossil fuels.”  This is consistent with what I know about the Chinese position from our Administration negotiators in 2007 and 2008 , and with what the Financial Times reported last Friday:  “Beijing reiterated its belief that developing countries, including China, should curb emissions on a voluntary basis, and only if the cuts ‘accord with their national situations and sustainable development strategies.’”  Translation:  We’re not setting a domestic carbon price.  The Chinese are proposing that the U.S. and other rich nations choose answer (B) Carrots from my menu above:  rich countries pay China to reduce their emissions.
• It appears that Dr. Krugman believes Chinese leaders will not be swayed by option (A) Leadership:  “And once America acts, we can expect much of the world to follow our lead.  But that still leaves the problem of China …”  I largely agree with him on this point.
• Dr. Krugman appears to presume that we must slow the growth of global greenhouse gas emissions starting now. I disagree with Dr. Krugman on this point, and am more persuaded by Dr. Bjorn Lomborg.  The state of technology is such that economic costs of near-term emissions reductions are high, and the long-term climate benefits are small.  As an example, Dr. Lomborg estimates that $1 expended through the Kyoto agreement would produce the equivalent of about 30 cents of long-term climate benefits.  To the extent you believe long-term climate change must be addressed, we are better off devoting resources to technology pushes that try to reduce the cost of carbon-r

  educing technologies.  The less expensive these technologies, the easier it is for everyone to make significant emissions reductions, and the easier it would be to get a global emissions reduction agreement that includes China and India (presuming you think such an agreement is necessary).

• Since Dr. Krugman believes that we must persuade the Chinese to change their growth path “because the planet can’t handle the strain,” he appears to conclude that we should threaten a carbon import tariff.  His phrasing is quite careful, but he is clearly floating the idea:

As the United States and other advanced countries finally move to confront climate change, they will also be morally empowered to confront those nations that refuse to act. Sooner than most people think, countries that refuse to limit their greenhouse gas emissions will face sanctions, probably in the form of taxes on their exports. They will complain bitterly that this is protectionism, but so what? Globalization doesn’t do much good if the globe itself becomes unlivable.

• Technically, Dr. Krugman does not say (1) the U.S. (2) should propose (3) a carbon import tariff.  He instead predicts that “sanctions, probably in the form of taxes on their exports” will be imposed by unnamed countries “sooner than most people think.”  By itself, this is only a prediction,  But in the following two bolded sentences, he endorses such “sanctions, probably in the form of taxes on [Chinese] exports” by unnamed countries.  With this clever phrasing, Dr. Krugman has floated an aggressive but ultimately deniable policy proposal:  a carbon import tariff.
• I believe there are cures that are worse than the disease.  An import tariff would be protectionist (Dr. Krugman concedes this point).  In the context of a global climate change negotiation in which different countries are establishing different domestic carbon prices, and in which two of the world’s largest economies (China and India) refuse to do the same, it is easy to see how a carbon import tariff by the U.S. could set off a global trade war, with potentially devastating effects on the world economy.  It appears that Dr. Krugman is willing to bear the increased risk of a global trade war for the benefit of an increased probability that China (and India?) will slow their greenhouse gas emissions.  I am not.

For completeness, my answer to my own strategic question is “(D) None of the above.”

• Even if the U.S. establishes a domestic carbon price through a cap-and-trade or carbon tax, diplomacy alone will be unable to convince the Chinese and Indian leaders to do the same in their countries.   Option (A) Diplomacy won’t work by itself.
• Without reductions in Chinese and Indian emissions, I expect that the total climate benefits of the likely global reductions in future emissions growth would not be worth the economic costs to the U.S. of a domestic carbon price (in the near term).
• I oppose the U.S. paying large developing countries like China and India to reduce their emissions.  I am confident the U.S. Congress would agree with this view.  Option (B) will not happen in the U.S., nor should it.
• Because I think the risks of significant damage from severe climate change are small, and the costs of near-term emissions reductions using current technology are high, and because I am deeply concerned that a carbon import tariff might provoke a global trade war, I strongly oppose option (C) Sticks, including any form of carbon import tariff.  Free trade, including with China, is more important to me than the possibility of creating leverage on Chinese leaders to try to change their energy development path.
• We are not talking about small numbers here.  China thinks developed countries should contribute 1/2 – 1 percent of GDP to help poorer countries cut their emissions, and the economic effects of domestic carbon prices are measured in the same orders of magnitude.  When you’re measuring things in percent of GDP, you’re shooting with real bullets.  I oppose imposing such a tariff, threatening one, or even floating the idea as Dr. Krugman has done.
• Therefore, I conclude the best policy is for the U.S. not to impose a domestic carbon price in the near future.  To the extent policymakers believe severe climate change is a risk that should be addressed, I instead recommend they focus on pushing carbon-reducing technology R&D, and reducing tariffs and other trade barriers to the exchange of such technologies, as Dan Price has recommended.
• I would be comfortable with the U.S. contributing taxpayer funds to a joint international R&D effort, if it were an alternative to a domestic carbon price, and as long as U.S. firms maintained their property rights to such research.

I have tremendous respect for Dr. Krugman’s past work as an international economist.  I am surprised that he is willing to risk a global trade war, and that he would apparently fire the first shot when the global economy is so weak.

The Smoot-Krugman carbon import tariff

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. The wrong way to address climate change
2. The G-8 agreement (especially on climate change)
3. What did President Bush announce today on climate change?

Suppose I take my three-year old car to Jiffy Lube for an oil change.

Jiffy Lube has all the latest information technology, as well as good data on both manufacturers’ recommendations and best practices.

After entering my license plate into their database and checking my odometer, the technician says, “Mr. Hennessey, it’s been only 3,000 miles since your last oil change.  Your manufacturer recommends an oil change once every 12,000 miles.  We have even better data based on comparing wear and tear on vehicles from all over the country, and we recommend once every 10,000 miles.  Still, you have at least 7,000 miles to go before you need to change your oil.”

I argue, “But I thought you were supposed to change your oil every 3,000 miles?”

He replies, “Those were the old practices.  We have better diagnostic technologies, better engines, and better oil.  It’s now every 10,000 – 12,000 miles.”

I respond, “Thanks.  How much does an oil change cost?”

Imagine if the technician were to say, “$50, but your insurance covers it.  You only have to pay a $5 deductible.”

What would you do?

The President is absolutely right when he says, “We can’t allow the costs of health care to continue strangling our economy.”

The President’s budget director, Peter Orszag, is the lead Administration advocate for this policy.  Director Orszag is right when he writes on his blog,

Now, many of you have heard me go on about how important it is to reform health care in order to bend the curve on long-term costs and get our nation on firmer fiscal footing – and this data shows how critical that effort is. When we say that health care is consuming too much of our GDP, we are not just citing an abstract statistic. These costs have real implications in sectors across our economy, limit our economic growth, reduce opportunities, and harden inequalities.

He then, however, argues,

This is why the Administration is making historic investments through the Recovery Act in efforts that will be crucial in bending the curve on the growth of health care costs while improving the health outcomes we can expect from our medical system. We are investing over $19 billion in health information technology to help computerize Americans’ health records, which will reduce medical errors and enhance the array of data that physicians and researchers have at their disposal. We are investing $1.1 billion in comparative effectiveness research, which will yield better understandings of which medical treatments work and which do not.

Additional information is good, but the example above shows why information by itself will not significantly slow the growth of medical care spending.  Information must be combined with the incentive to purchase high-value medical care – a decision that involves both the medical benefit of the treatment and the financial cost.  The government could use this information to reduce costs in health programs that it runs, like Medicare and Medicaid (I am certainly not endorsing that).  But those of us with private health insurance are largely protected from the costs of the medical care we use because of the general prevalence of low deductibles and copayments.  Even if we have better information, we may not care if the benefit of a particular medical treatment is small, as long as it seems really inexpensive.  The Administration’s proposals on health information technology, electronic medical records, and medical outcomes research may improve health, but they will have little effect on slowing the growth of health care spending for those with low-deductible, low-copayment private health insurance.

I favor helping individuals get information so they can decide what is high-value for them.  I imagine that those who favor a single-payor system would say those tradeoffs should be made for everyone by the government.

The Administration is giving an incomplete answer.  They need to explain not just how much they will spend on health information technology, electronic medical records, and medical outcomes research, but how that information will be used to reduce cost growth, and by whom.

To be able to credibly claim that they will slow the growth of health spending, the Administration needs to answer the following questions:

• Who will be empowered to make decisions based on this improved information?
• Upon what basis will that decision-maker compare the costs and benefits of a particular medical treatment, good, or service?
• How will you change policy to create incentives for that decision-maker to choose high value medical care?

Until they provide answers, they cannot legitimately claim to be slowing the growth of health spending in the private sector.  They are just increasing government spending on technology.

Jim Capretta has discussed this in greater detail on his excellent blog, Diagnosis.

Slowing health cost growth requires information AND incentives

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. CBO: Health IT and preventive care won’t save a lot of money
2. Third party payment in health care (part 3): Technology drives cost growth
3. How to measure health care cost control

Suppose I argue that I will save $2000 this week, because I intend to refraining from buying an additional iPhone today, nor will I buy one this Wednesday, Thursday, or Friday.

Suppose I plan to buy a new flat screen TV tomorrow for $1500.

Can I claim I that have paid for my TV by cutting other spending, and that in addition I will be saving $500 this week?

This is what the Administration has done with war costs in their budget.

There is no debate about how much I will spend this week:  $500 for the iPhone, plus $1500 for the TV, equals $2000 of total spending.

The question is instead whether I have increased or decreased my spending compared to what it otherwise would have been.

In this example, I argued that I will cut my total projected spending by $500, and I am also paying for the TV by cutting spending.

You argue that it is absurd to assume that I would buy an iPhone each day this week.  The right baseline, you argue, is to treat the iPhone purchase as a one-time expenditure, and tp use a spending baseline of zero for the remainder of this week.  Thus the $1500 TV purchase is a spending increase, not a spending cut.

The argument about whether the President’s budget increases or cuts the deficit is therefore a debate about the baseline – what would happen otherwise?

Rep. Paul Ryan (R-WI) did a good analysis of the war spending assumption in the President’s budget.  He and his staff conclude that the President’s budget includes $1.5 trillion of phony savings (over 10 years) by inflating the war spending baseline the way I did with my mythical cancelled iPhone purchases.  The President’s budget makes a similar $330 B assumption for Medicare payments to doctors.

Even more intriguing, the President’s budget (table S-5 in this document) argues that the $9 trillion of incremental baseline debt they argue they “inherited” should include $835 B of additional debt resulting from two laws President Obama signed:  the stimulus law, and the omnibus appropriations law.  Clearly that $835 B of additional debt was not inherited, and should be netted out against their claimed future deficit reduction.

Here is the math behind the Administration’s claim of fiscal responsibility, and CBO’s countervailing analysis.  All figures are for the next ten years (2010-2019):

Let us walk through this step by step.

• The Administration has a radically different starting point than CBO.  The President’s budget starts by assuming that $9.0 trillion of debt will be accumulated over the next ten years if the President’s budget is not enacted.  The Congressional Budget Office assumes that $4.5 trillion of debt will be accumulated over the next ten years in the same scenario.
• The Administration assumes that its policies will result in $7 trillion of additional debt added over the next decade.  That is $2.3 trillion less than CBO assumes.  We saw why yesterday – the President’s budget assumes that the economy will grow faster than CBO assumes.  This faster economic growth assumption would result in faster revenue growth for the government, and therefore smaller (but still huge) budget deficits.
• These two differences in assumptions result in two completely different views of the President’s budget.  The President and his advisors argue they are being responsible by reducing the deficit by $2 trillion over the next decade, while someone relying on CBO’s numbers would say the President’s budget is horribly irresponsible and that it increases the debt by $4.8 trillion more than it would otherwise be.

This debate about whether the sign is a + or a – is politically significant.  The -$2 trillion figure is the cornerstone of the Administration’s claim to fiscal responsibility.  It allows them to justify big spending increases like the $600+ B new health entitlement.

At the same time, we should not let this important debate obscure that, even using the Administration’s more optimistic numbers, the President’s budget would mean that debt held by the public will increase by $7 trillion over the next decade, to a share of the economy not seen since the end of World War II.

Even if you believe the Administration’s deficit reduction claim (I do not), it is nowhere nearly enough deficit reduction.  We need either to dramatically slow spending growth, or raise taxes, or some combination of the two.  I support doing it all on the spending side while keeping taxes from increasing.  Your view may differ.  But we cannot accumulate $7 to $9.3 trillion more debt over the next decade and claim that we are being fiscally responsible.

Baseline games

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Deficits & debt under the President’s budget
2. Debt and the real threat
3. America’s long run fiscal problem is spending growth, not taxes

What would federal deficits and debt held by the public be if the President’s budget were to become law exactly as proposed?

We will look at it both from the Administration’s point of view, and from that of the Congressional Budget Office, which serves as the referee for Congressional legislation.  While the two differ in some respects, the fundamental conclusions are the same.

We will begin with spending.  You can see from this graph that CBO and OMB agree precisely on how much the President’s budget would spend over the next ten years.

Now we turn to revenues. The President’s budget assumes faster economic growth than does the CBO.   A bigger economy leads to more revenues for government, so OMB assumes more revenues from the same set of policies as CBO.

Don’t be fooled by the scale of the graph.  That’s a $500 billion difference in 2019.

It is this difference in revenue assumptions that leads OMB to have a more optimistic deficit forecast for the President’s budget than CBO.  I am going to put the proposed deficits in historic perspective, and switch to % of GDP so we have a fair comparison over a long timeframe.

The light green line shows historic deficits (above the line).  The light blue line shows the post-World War II average deficit of 1.7% of GDP.  Red is the CBO’s estimate of deficits under the President’s budget, and yellow is the Administration’s estimate.  The gap between the two is because of different assumptions about GDP growth leading to different estimates of future federal revenues.

I find it more interesting and worrisome that both estimates show annual budget deficits for the next decade that far exceed historic averages.  The Administration’s estimate hovers around 3.0% of GDP, while CBO’s estimate climbs steadily to 5.7% of GDP by the end of the decade.  Neither is anything to brag about.

Now let us look at the effects of the President’s budget on debt held by the public.

Again, red is CBO, and yellow is OMB.  Orange is Budget Director Peter Orszag’s new net worth measure of debt held by the public, minus the value of financial assets.  While interesting, we should not ignore the yellow and red lines.  If you borrow money to buy stock, you still are in debt.

No matter which estimate you choose, the conclusion is inescapable:  under the President’s budget, debt held by the public will climb to a level not seen since the aftermath of World War II.  And in the early 1950’s we were paying down debt.  Now we will be increasing our indebtedness, just as the federal government begins to expend massive amounts to pay Social Security, Medicare, and Medicaid benefits for the Baby Boomers.

In case you’re interested, the last year of this graph is 2019.  In that year:

• OMB’s estimate of debt net of financial assets is 60.5% of GDP.
• OMB’s estimate of debt held by the public is 67.2% of GDP.
• CBO’s estimate of debt held by the public is 82.4% of GDP.

Here are my conclusions:

1. CBO and OMB differ on their economic assumptions.
2. CBO and OMB differ on how they define the baseline (not covered in detail here).  This affects the rhetorical debate about whether the President’s budget makes deficits bigger or smaller.
3. CBO and OMB basically agree on the qualitative picture of the results of the President’s budget on future deficits and debt.  They disagree more about the point of comparison than they do about the result.
4. No matter whose economics or baseline you use, the result is terrible for federal deficits and debt over the next ten years, both of which are way above historic averages and not showing any positive trends.

Thanks to Steve McMillin for his help with this post.

Deficits & debt under the President’s budget

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Debt and the real threat
2. Does the President’s budget cut the deficit in half?
3. America’s long run fiscal problem is spending growth, not taxes

I am a low-tax guy.  I have worked on tax issues for 12 of my 15 years in Washington, helping elected officials lower taxes and prevent tax increases.  You can see a list of the taxes President Bush cut here.  I would like to cut taxes far below where they are today, and I will continue to make the case that America is better off with a bigger private sector and a smaller government.  America’s long run fiscal debate, however, is instead principally about whether we will allow future spending increases to force taxes to increase dramatically above where they are today.

I believe that America’s greatest economic policy challenge is the projected long run growth of spending on three programs: Social Security, Medicare, and Medicaid.

I would like to show you why I believe this, and how it relates to taxes.

Let’s begin by looking at federal taxes over time, as we did yesterday.  You can see that they bounce around quite a bit.  Some of that is from changes to tax law by Congress, and some because total revenues track economic growth fairly closely.  What is remarkable about this graph is that the Federal government’s take from the U.S. economy has remained basically flat since the end of World War II.

(Technical note:  If you click on a graph you will see a bigger version.)

All that fluctuation is distracting.  I will remove it and leave just three trend lines for reference.  By doing so I remove much noise and lose little information.

The blue and green dotted lines below represent averages for different periods:  the green line is the 50-year average, at 18.1% of GDP.  The blue line is the average of the last 30-years, at 18.4% of GDP.  The post-WWII average is below the blue dotted line, at 17.9%.

The red dotted line is a trend line.  It shows a 5-year moving average of the graph above.  There is a very gradual upwards slope, growing about 0.025 percentage points per year (that’s two and one-half hundredths of a percent).  Since the end of World War II, total federal taxes have therefore increased at a rate of about 1 percentage point of GDP every 40 years.

Now I will make a judgment call.  I argue that the remarkable flatness of these lines is the result of a broad-based policy consensus, or at least a long-term balancing point of political forces, of how much in total taxes we as a nation are comfortable taking from those who earn it and giving to the federal government.  Since World War II, between 17 cents and 19.1 cents of each dollar earned have gone to the federal government.  The average is between 18.1¢ and 18.4¢, depending on what time frame you choose.  The number has been creeping up, by about one penny per dollar each 40 years.  The highest that trend (the 5-year moving average) has ever been is just under 19.1¢ per dollar.  My personal preference would be well below any of these numbers.

I will now take those trends and extend them for another 70+ years, to 2080.  I am letting the red line grow at its historic long run trend of +1 percentage point every 40 years.  I hate that trend.

What is nice about this graph is that we can zoom out from discussions of specific tax policies, and instead just focus on the total level of taxation.  When current law has allowed taxes to creep up above the low 18’s, the political pendulum swings and Congress “cuts” taxes.  In aggregate terms, they are not really cutting taxes, they are instead preventing taxes from increasing as a share of GDP (which we learned yesterday is still an increase in real dollars taken by the government).  Since the end of World War II, our political system has dynamically adjusted to change current law as needed to keep taxes in the low 18’s as a percent of GDP.  Unfortunately, the same appears to be highly unlikely for future spending.

Let us turn to historic total federal spending, again with a 5-year moving average trend line.

I am going to take the spending trend line and superimpose it on our earlier long-run tax graph.  Yellow is spending, and all other colors are taxes:

You can see that we usually run budget deficits, since the yellow spending line is generally above the red tax line.  If spending is greater than taxes, then the government is running a deficit and has to issue Treasury bonds to borrow funds from the private sector.  The bigger the gap between the yellow spending line and the other tax lines, the bigger the budget deficit.  Bigger deficits are bad for the economy.  So are higher taxes.

Now all we need to do is add projected spending under current law for the long run.  I will draw it in white.

Whoa!  Hold on.  What happened?  The scale of the vertical axis changed, and that white long-run spending line is ridiculous.  Surely that can’t be correct?

It is correct.  If I could have you remember only one thing about economic policy, it would be this graph.  You can see that the current law spending trend is clearly unsustainable in the long run.  Under current law, total federal spending will grow steadily, reaching 40% of GDP by 2080.

The exact slope of that white spending line depends on a lot of assumptions, and there are esoteric debates about those assumptions.  Some analysts would have it reach about 36% by 2080, and others in the mid 40’s.  Those are huge differences, but everyone’s line ends up looking similar, and the basic conclusion remains unchanged – the long-term spending line slopes up dramatically.  The tax lines remain basically flat, as they have since the end of World War II.  The difference between these slopes creates an unsustainable borrowing trend that, if left unchecked, would eventually cause the U.S. economy to collapse.

The white spending line I show here was done for me by OMB staff in 2007.  Since then some spending assumptions have changed a bit, and we also have a new President.  The dip you see in the early years of the white line will be shallower than you see here, because near-term spending will be higher than we assumed in 2007.  Neither of these changes modify the basic conclusion.

For now, I will ask you to trust me that the increase in the white spending line is driven by the growth of three entitlement spending programs:  Social Security, Medicare and Medicaid.  I will show this later.

I posted yesterday about the battle on total taxation.  The two ends of that debate, House Republicans and House Democrats, are separated by 1.4% of GDP on how much federal taxes they would collect.  The House Republican plan would collect just under 18% of GDP in taxes.  The President’s budget would collect just under 19%, and the budget passed through the House by Democrats would collect just over 19%.  In each case, however, that is just setting the level of the flat flat line.  Nobody is talking about a permanent upward change in the slope of tax lines, so you’re arguing about whether you should be a smidge below that flat blue line, or up to 0.8 percentage points above the flat green line.  Either way, they are all flat tax lines.

Even the long-term red tax trend line, which slopes slightly upward and which I hate, hits 19.4% in 2080.  That is higher than taxes have ever been for a sustained period of time, and it is less than half of projected spending in that year.

Even the highest level of taxes imagined in the current short term debate does no good in addressing this long-term fiscal problem, because the current law spending line will just keep growing above that, forever.  At some point you have to bring the spending and tax lines together, or at least to be roughly as close as they have been in recent history.  While undesirable, we can sustain deficits in the 2-ish% of GDP range indefinitely without the economy collapsing.  We cannot sustain deficits that grow and keep growing as a share of the economy.

To close that gap, we have to reduce the slope of the spending line.  Raising taxes as a share of the economy is an upward shift in the flat tax lines.  This can delay the day of reckoning, but it cannot solve the problem.  And raising taxes causes economic damage of its own.

America’s long run fiscal problem is the projected future growth of spending under current law.  If we do not prevent that white line from growing as you see above, our economy will eventually implode, no matter what we do with taxes.

America’s long run fiscal problem is spending growth, not taxes

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Are taxes too low?
2. A short history of higher taxes
3. USA Today op-ed: Keep taxes low

Let’s start by looking at just the total amount of taxes collected by the Federal government over time, adjusting for inflation.

You can see taxes growing fairly steadily over time.  The various bumps are a combination of changes in law and economic cycles.  Still, even given those factors, the total amount of inflation-adjusted dollars going to the federal government has clearly climbed over time.  In real terms, government’s take has gotten bigger.

Some argue that we should instead measure total federal taxes as a share of the economy.  This presumes that as the economy gets bigger, government “should” get bigger proportionately.  I disagree with that view.  Some things that government does clearly are related to the size of our population, or are related to other measures of society’s income or wealth.  I do not buy that principle as a general matter.  Still, let’s look at that perspective.

You can see that the federal government’s take from the economy has remained roughly constant since the end of World War II.  The flat line is at 18.1%, and shows that, on average over the past 50 years, Uncle Sam takes about 18.1¢ out of every dollar earned in America.  This graph makes the policy changes and economic fluctuations easier to see.  For instance, you can see the effects of the 1993 reconciliation bill (which raised taxes), plus the economic growth of the 90’s, ending in the stock market “bubble” (I use that term loosely) in 1999 and 2000 with phenomenally high capital gains revenues, followed by the stock market decline and recession in 2001 and 2002, combined with the effects of the 2001 tax cuts.

There’s actually a slight upward trend to this line.  If you look at share of GDP since the end of World War II, the average is 17.9%.  If you look over the past 50 years, it’s the 18.1% I have displayed on the graph.  Over the past 40 years, it’s 18.3%, and over the past 30 years it’s 18.4%.  So there is a creeping upward (measured as a share of the economy), but it’s pretty slow:  one or two tenths of a percent of GDP over time.  Remember that a flat line on this graph would still represent more real dollars each year going to the federal government.

Still, the overwhelming impression this graph should give you is that of a basic constancy since World War II.

Now let’s add State & local taxes to this graph.

You can see that while Federal taxes have remained roughly constant (with fluctuations), State & local taxes have grown fairly steadily over time, measured as a share of GDP.

Now let’s add the two lines together to see government’s total take from taxpayers.  Check out the orange line up top.

It’s a little hard to see the long-term trends on the orange and red lines, but the greatest graphing program ever, Swiff Chart, allows me to add trend lines that make it easier to see.

From this graph, you can see our conclusions:

1. Federal taxes have remained roughly constant as a share of the economy since the end of World War II, at just over 18% of GDP (I use 18.1%, others use 18.3%).
2. Even if federal taxes remain constant as a share of GDP, total taxes collected by the federal government are going up in real terms.
3. In contrast to federal taxes, State and local taxes have grown fairly steadily since 1950.
4. So the trend line of government’s take of the U.S. economy is steadily upward since the end of World War II, from around 21% of GDP in 1950 to about 28% now.  Seven cents more of each dollar earned are going to government now than in 1950.

Please remember that just-over-18 percent of GDP number from #1.  You’re going to need it later.

A short history of higher taxes

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. Are taxes too low?
2. America’s long run fiscal problem is spending growth, not taxes
3. Debt and the real threat

Keith Hennessey, a former top economic adviser to President George W. Bush, saw this one coming. He rightly predicted that the Group of 20 would drop a key word from its communique at the conclusion of the London Summit: Free.

Here is my original post from Wednesday:  A quick guide to the G-20 summit.

Unfortunately the problem is even bigger than just dropping the word “free” before “markets.”  Let’s compare the text of the November G-20 leaders’ declaration and the April G-20 leaders’ declaration.

Here is the key paragraph from the November summit, hosted in Washington by President Bush.  Thanks to President Bush’s negotiators, led by his “Sherpa,” Dan Price, and Treasury Under Secretary for International Affairs Dave McCormick, the following text is incredible.  Last November, I wrote about this paragraph:  “Let’s look at some important wins in the actual text of the declaration.  Formerly Communist China and Russia (along with all the other participating nations) agreed to the following text.”

12. We recognize that these reforms will only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively regulated financial systems. These principles are essential to economic growth and prosperity and have lifted millions out of poverty, and have significantly raised the global standard of living. Recognizing the necessity to improve financial sector regulation, we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows, including to developing countries.

Let’s parse it a bit:

1. “… a commitment to free market principles …”
2. “… rule of law …”
3. “… respect for private property …”
4. “… open trade and investment …”
5. “… competitive markets …”
6. “… and efficient, effectively regulated financial systems.”
7. “… we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows …”

Now let’s examine yesterday’s text:

3.  We start from the belief that prosperity is indivisible; that growth, to be sustained, has to be shared; and that our global plan for recovery must have at its heart the needs and jobs of hard-working families, not just in developed countries but in emerging markets and the poorest countries of the world too; and must reflect the interests, not just of today’s population, but of future generations too. We believe that the only sure foundation for sustainable globalisation and rising prosperity for all is an open world economy based on market principles, effective regulation, and strong global institutions.

Parsing this new language:

1. “… a commitment to free market principles …” has been replaced by “… based on market principles …”.  Note that the word “free” is nowhere in the document.
2. “… rule of law …” is nowhere in the document
3. “… private property …” is nowhere in the document
4. “… open trade and investment …” has been replaced by “… open world economy …”  (This one is fine, I think.)
5. “… competitive markets …” and the word “competitive” are nowhere in the document
6. “… efficient, effectively regulated financial systems” has been replaced by “effective regulation, and strong global institutions.”
7. The over-regulation caution is gone.

What makes this so disappointing is that all G-20 nations agreed to the November text.  It should have been an extremely easy lift for negotiators from capitalist countries to insist that this leaders’ declaration merely repeat what the leaders agreed to last November.

Wednesday I wrote, “In the short run, it is easy to see how a negotiator might give this up for a more concrete immediate objective.  In the long run, few things are as important.”

What happened to FREE markets in London?

© 2010 Keith Hennessey - Your guide to American economic policy

Related posts:

1. What was accomplished at the G-20 Summit?
2. President Bush’s speech on financial markets and the world economy
3. A quick guide to the G-20 summit