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* The Wall Street Journal

* OPINION
* MAY 31, 2006

Mr. Paulson’s Challenge

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By N. GREGORY MANKIW

When Hank Paulson replaces John Snow as Treasury secretary, he will be taking stewardship of an economy that is enjoying low unemployment and brisk growth. But while Mr. Snow helped steer the economy through a recessionary storm, he leaves for Mr. Paulson a more daunting task — getting the long-term fiscal numbers to add up.

To understand the challenge that Mr. Paulson faces, let’s start with a fact about which every serious policy analyst agrees: The government budget is on an unsustainable path. Americans are living longer and having fewer children. Together with advances in medical technology that are driving up health-care costs, this demographic shift means that a budget crunch is coming when the baby-boom generation retires. The promises made to my generation for Social Security, Medicare and Medicaid are just not affordable, given the projected path of tax revenue.

Policy analysts diverge, however, on what to do about it. Those on the political left want to raise taxes to fund all those promises. Some want to go even further by expanding entitlements, such as providing taxpayer-financed national health insurance for all Americans. That is a feasible choice, as many European nations demonstrate, but it is not advisable. As we economics professors never tire of explaining, market economies allocate resources efficiently (with a few exceptions, which I will return to in a moment). Taxes distort incentives and debase market outcomes. In technical terms, they cause “deadweight losses.” In less formal terms, taxes shrink the size of the economic pie, leaving most people with a smaller serving of prosperity.

Some supply-siders like to claim that the distortionary effect of taxes is so large that increasing tax rates reduces tax revenue. Like most economists, I don’t find that conclusion credible for most tax hikes, and I doubt Mr. Paulson does either. Yet the supply-siders are right about one thing: Because higher tax rates reduce the size of the tax base, raising taxes generates less revenue that the “static” revenue estimates assumed in Washington would suggest.

One of Mr. Paulson’s first briefings from the Treasury staff should be about what high taxes have done to the economies of Europe. According to research by Nobel laureate Edward Prescott and by economists Steven Davis and Magnus Henrekson, the high tax rates in Europe have reduced work effort and distorted the industrial mix. The Davis-Henrekson study reports that a tax increase of 12.8 percentage points (a change of one standard deviation) reduces work for an average adult by 122 hours per year. It also reduces the employment-population ratio by 4.9 percentage points and increases underground economy by 3.8% of GDP. As Mr. Paulson works to resolve the fiscal imbalance, he should keep the European experience firmly in mind.

President Bush confirmed his commitment to low taxes when he announced Mr. Paulson’s nomination: “One of Hank’s most important responsibilities,” he said, “will be to build on this success by working with Congress to maintain a pro-growth, low-tax environment.” Avoiding tax hikes, however, does not mean avoiding hard choices. The only alternative to large tax hikes is large spending cuts. Politically, this option may be even harder, but it should be the focus of public debate and Mr. Paulson’s attention.

Many economists, including myself, would recommend that the nation consider a gradual but substantial increase in the age at which people become eligible for taxpayer-financed benefits for the elderly, including both Social Security and Medicare. We face three options: raising taxes on those who are still working; reducing benefits for the very old; or reducing benefits for the relatively young old. I would rule out the first option on grounds of economic efficiency, the second on the grounds of social compassion, leaving the third as the best of a bad lot. If we raise the age of eligibility for retirement benefits, people could still retire early, but they would do so on their own nickel, rather than the taxpayer’s.

The fiscal problem we now face arises largely because the age of eligibility bears little relation to demographic reality. When Franklin Roosevelt established Social Security, he set a fixed age of retirement; when Lyndon Johnson established Medicare, he followed suit. Imagine if, instead, Roosevelt and Johnson had set up an entitlement system in which the youngest 90% of the population agreed to support the oldest 10% — and those percentages were fixed over time. Such a system would have been better able to withstand the changes in demography that have occurred over time.

There is still time to correct their mistake, taking an approach adopted in a small way in Ronald Reagan’s 1983 Social Security reform. Congress could pass a law increasing the age of eligibility by, say, two months every year. That increase would continue until the Trustees for Social Security and Medicare (a group that includes the Treasury secretary) declared the programs in long-term fiscal balance. Those already retired or near retirement would not be affected, but those of us now middle-aged would have to work longer or save to finance our own early retirement. The beneficiaries of such a reform would be our children, who would not have to inherit European-style tax rates.

Although the fiscal gap could be completely closed with reduced spending, a realistic political compromise will likely include higher revenues as well. Even here, however, rather than consider a reversal of the Bush tax cuts, the new Treasury secretary should look for more efficient revenue sources.

Economists have long noted that while most taxes distort incentives and shrink the size of the economic pie, others improve incentives and enlarge it. A higher tax on gasoline, for example, is better than CAFE standards as a policy to improve the fuel efficiency of the American car fleet. It would also encourage people to drive less by, for instance, living closer to where they work. A tax on carbon is the best way to deal with global warming. These are called Pigovian taxes, after the British economist Arthur Pigou, an early advocate of using taxes to correct market imperfections.

Similarly, economists have increasingly viewed “sin taxes” as a good way to raise revenue. While Pigovian taxes aim to protect innocent bystanders from the actions of others, sin taxes aim to protect people from themselves. To the extent that people have problems with self-control, sin taxes can be welfare-enhancing. Economists Jonathan Gruber and Sendhil Mullainathan report evidence that smokers are happier when cigarette taxes are higher. Of course, non-smokers won’t object to shifting the tax burden to others. Maybe we should consider higher taxes on smoking, drinking, gambling and other activities about which people lack self-control.

Finally, even if the income tax is to be used to increase revenue, we should broaden the base rather than raise rates. Last November, the President’s Advisory Panel on Federal Tax Reform offered several good suggestions when it handed its report to John Snow. Mr. Paulson should continue talking about tax reform and insist that these ideas get more attention from Congress than they have gotten so far. For example, the panel proposed eliminating the deductibility of state and local taxes. This makes sense. Under current law, if one town enacts high local taxes to finance a municipal pool while a neighboring town does not, the first town gets a federal subsidy at the expense of the second. That outcome is neither efficient nor equitable.

The President’s Advisory Panel also proposed scaling back the mortgage-interest deduction. The federal tax system now tilts the playing field toward residential capital at the expense of corporate capital, which in turn reduces productivity and real wages. Even if one believes that policy should promote homeownership over renting (a debatable claim), there is no reason to encourage people to buy ever larger homes. Let’s lower the cap on subsidized mortgages well below its present $1 million level.

There are many options for dealing with the long-term fiscal imbalance while keeping tax rates low. The main reason the problem is not yet resolved is that the American people have not put enough pressure on their elected representatives to take the issue seriously. The sooner they do, the better. If Hank Paulson wants to leave the nation’s finances in better shape than he found them, his main job will be to focus attention on the problem.

Mr. Mankiw, a professor at Harvard, is a former chairman of President Bush’s Council of Economic Advisers.
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Time to tackle the real evil: too much debt

By Nassim Nicholas Taleb and Mark Spitznagel

Published: July 13 2009 19:11 | Last updated: July 13 2009 19:11

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

Our ability to forecast suffers due to this complexity and the occurrence of the occasional extreme event, or “black swan”. Such degradation in predictability should have made companies more conservative in their capital structure, not more aggressive – yet private equity, homeowners and others have been recklessly amassing debt. Such non-linearity makes the mathematics used by economists rather useless. Our research shows that economic papers that rely on mathematics are not scientifically valid. Not only do they underestimate the possibility of “black swans” but they are unaware that we do not have any ability to deal with the mathematics of extreme events. The same flaw found in risk models that helped cause the financial meltdown is present in economic models invoked by “experts”. Anyone relying on these models for conclusions is deluded.

Third, debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. Then there are products such as complex derivatives, which in the name of “modern finance” make the system even more fragile.

Against this background, we have two options. The first is to deflate debt, the other is to inflate assets (or counter their deflation with a collection of stimulus packages.)

We believe that stimulus packages, in all their forms, make the same mistakes that got us here. They will lead to extreme overshooting or extreme undershooting. They lead to more borrowing, by socialising private debt. But running a government deficit is dangerous, as it is vulnerable to errors in projections of economic growth. These errors will be larger in the future, so central bank money creation will lead not to inflation but to hyper-inflation, as the system is set for bigger deviations than ever before.

Relying on standard models to build policies makes us all fragile and overconfident. Asking the economics establishment for guidance (particularly after its failure to see the risk in the economy) is akin to asking to be led by the blind – instead we need to rebuild the world to make it resistant to the economist’s mystifications.

Invoking the pre-internet Great Depression as guidance for current events is irresponsible: errors in fiscal policy will be magnified by this kind of thinking. Monetary policy has always been dangerous. Alan Greenspan, former Federal Reserve chairman, tried playing with the business cycle to iron out bubbles, but it eventually got completely out of control. Bubbles and fads are part of cultural life. We need to do the opposite to what Mr Greenspan did: make the economy’s structure more robust to bubbles.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.

It is sad to see that those who failed to spot the problem (or helped to cause it) are now in charge of the remedy. Just as the impending crisis was obvious to those of us who specialise in complexity and extreme deviations, the solution is plain to see. We need an aggressive, systematic debt-for-equity conversion. We cannot afford to wait a day.

The writers are with Universa Investments; Prof Taleb is author of ‘The Black Swan: The Impact of the Highly Improbable’

Copyright The Financial Times Limited 2009

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Op-Ed Columnist
The Stimulus Trap

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By PAUL KRUGMAN
Published: July 9, 2009

As soon as the Obama administration-in-waiting announced its stimulus plan — this was before Inauguration Day — some of us worried that the plan would prove inadequate. And we also worried that it might be hard, as a political matter, to come back for another round.
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Unfortunately, those worries have proved justified. The bad employment report for June made it clear that the stimulus was, indeed, too small. But it also damaged the credibility of the administration’s economic stewardship. There’s now a real risk that President Obama will find himself caught in a political-economic trap.

I’ll talk about that trap, and how he can escape it, in a moment. First, however, let me step back and ask how concerned citizens should be reacting to the disappointing economic news. Should we be patient and give the Obama plan time to work? Should we call for bigger, bolder actions? Or should we declare the plan a failure and demand that the administration call the whole thing off?

Before you answer, consider what happens in normal times.

When there’s an ordinary, garden-variety recession, the job of fighting that recession is assigned to the Federal Reserve. The Fed responds by cutting interest rates in an incremental fashion. Reducing rates a bit at a time, it keeps cutting until the economy turns around. At times it pauses to assess the effects of its work; if the economy is still weak, the cutting resumes.

During the last recession, the Fed repeatedly cut rates as the slump deepened — 11 times over the course of 2001. Then, amid early signs of recovery, it paused, giving the rate cuts time to work. When it became clear that the economy still wasn’t growing fast enough to create jobs, more rate cuts followed.

Normally, then, we expect policy makers to respond to bad job numbers with a combination of patience and resolve. They should give existing policies time to work, but they should also consider making those policies stronger.

And that’s what the Obama administration should be doing right now with its fiscal stimulus. (It’s important to remember that the stimulus was necessary because the Fed, having cut rates all the way to zero, has run out of ammunition to fight this slump.) That is, policy makers should stay calm in the face of disappointing early results, recognizing that the plan will take time to deliver its full benefit. But they should also be prepared to add to the stimulus now that it’s clear that the first round wasn’t big enough.

Unfortunately, the politics of fiscal policy are very different from the politics of monetary policy. For the past 30 years, we’ve been told that government spending is bad, and conservative opposition to fiscal stimulus (which might make people think better of government) has been bitter and unrelenting even in the face of the worst slump since the Great Depression. Predictably, then, Republicans — and some Democrats — have treated any bad news as evidence of failure, rather than as a reason to make the policy stronger.

Hence the danger that the Obama administration will find itself caught in a political-economic trap, in which the very weakness of the economy undermines the administration’s ability to respond effectively.

As I said, I was afraid this would happen. But that’s water under the bridge. The question is what the president and his economic team should do now.

It’s perfectly O.K. for the administration to defend what it’s done so far. It’s fine to have Vice President Joseph Biden touring the country, highlighting the many good things the stimulus money is doing.

It’s also reasonable for administration economists to call for patience, and point out, correctly, that the stimulus was never expected to have its full impact this summer, or even this year.

But there’s a difference between defending what you’ve done so far and being defensive. It was disturbing when President Obama walked back Mr. Biden’s admission that the administration “misread” the economy, declaring that “there’s nothing we would have done differently.” There was a whiff of the Bush infallibility complex in that remark, a hint that the current administration might share some of its predecessor’s inability to admit mistakes. And that’s an attitude neither Mr. Obama nor the country can afford.

What Mr. Obama needs to do is level with the American people. He needs to admit that he may not have done enough on the first try. He needs to remind the country that he’s trying to steer the country through a severe economic storm, and that some course adjustments — including, quite possibly, another round of stimulus — may be necessary.

What he needs, in short, is to do for economic policy what he’s already done for race relations and foreign policy — talk to Americans like adults.
Sign in to Recommend More Articles in Opinion » A version of this article appeared in print on July 10, 2009, on page A25 of the New York edition.

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Do We Need a Second Stimulus?
A more troubling question is why so little is being spent from the first.
* JULY 9, 2009

By EDWARD P. LAZEAR

In “Brewster’s Millions,” a comedy starring Richard Pryor, a man is told he can keep $300 million if he manages to spend $30 million in one month. The movie documents — with a great deal of humor — his difficulties getting the money spent. The Obama administration is currently facing a similar problem with its “stimulus” spending, only without the humor.

With the economy weak and the labor market continuing to decline, there is now talk of a second stimulus (which is actually the third, counting President Bush’s 2008 tax rebates). This would be a mistake. The truth is there hasn’t been any stimulus to speak of so far this year. Moreover, what’s being called stimulus is just a smoke screen for a permanent expansion of government. Let’s start with some facts.

By June 26, about $56 billion was spent on the stimulus from the American Recovery and Reinvestment Act of 2009, passed Feb. 17. A large proportion of that actually reflects mere transfers from the federal government to state governments, so the amount that has gotten into the economy is significantly lower.

But even if we call all of the $56 billion spending, it’s still not enough to make a meaningful impact. By this point of the year in 2008, the Bush administration’s tax-rebates got out about $80 billion. Most economists believe the rebates had a positive but hardly dramatic effect on the economy.

The Obama stimulus, being significantly smaller, cannot possibly be expected to turn the economy around. The economy will improve. But it will do so because the financial sector is recovering, largely due to the Fed policies to enhance liquidity and the success of the Bush administration’s Troubled Asset Relief Program, continued by the Obama team, in helping to recapitalize the banks.

Congress and the Obama administration have used the economic downturn as an excuse to expand the size of government. Calling it a stimulus, they have instead put in place a spending agenda that will unfold over the next two years. Although a little over one-third of the American Recovery and Reinvestment Act of 2009 goes to tax relief, the rest is in the form of spending programs that will be difficult to stop once they are up and running.

Only a small share of the spending will occur in 2009, even though Keynesians would argue that stimulus spending should be frontloaded to kick-start growth. The Congressional Budget Office estimates that the largest share of the spending will occur in 2010, with the amount in 2011 being slightly larger than in 2009. Again, the timing exacerbates the problem: It will be tough to cut back on spending written into budgets as far out as 2011.

Additional evidence that the Obama administration wants to expand government rather than stimulate the economy comes from the president’s own statements about deficit reduction. When the budget came out, he announced a goal of reducing the deficit to around 4% of GDP by 2013, at which point the administration believes the economy will be fully recovered. Yet to keep the ratio of public debt to GDP constant, the deficit must actually stay below about 2.7%.

For perspective, recall that the Bush deficit, which has been criticized for being too large, reached a peak of 3.6% of GDP in 2004. But it fell steadily to 1.2% of GDP by 2007 before rising again to about 3% after TARP.

Some argue that a tax cut is a weaker stimulus than direct government spending. This point is debated among economists. But it is clearly much easier for Treasury to write checks to the public than it is to get agencies to rev up spending programs and do so in a way that does not simply throw away money.

It’s a bit odd that the reaction by the Obama administration and some congressional leaders to a policy that has not worked is to consider putting a similar policy in place. One interpretation is that this is yet another opportunity to spend more on programs that Democrats have wanted for years.

It may be the case that the country wants more government, that Americans now believe the European model of big government is best. That is a decision that society must make. But it should do so with no illusions: The current stimulus and calls for a future one are primarily government growth policies, not strategies to shorten the current recession.

Mr. Lazear, chairman of the President’s Council of Economic Advisers from 2006-09, is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.