As a follow up to our post on the financial industry yesterday, Advisor Perspectives has offered a couple of interesting pieces on the state of the industry.
One is from former IMF economist Simon Johnson, who argues that the political power of large banks will tend to work against potential solutions to the financial crisis:
Overall…I think the administration has done a much better job than the last one in putting together a package that has a chance of turning things around.
But there could be an Achilles heel, and it’s likely to be the banking system. That’s where many distressed economies often get into trouble. We’ve seen even when a lot of good policies were in place that if you’re not fixing the banking system up front–that is to say, if you don’t recapitalize it sufficiently, and you don’t replace the people who got you into trouble in the first place–then those deficiencies could work against everything else you’re doing.
The reason the government gives is that it’s concerned stricter demands would further damage the banking system, which will cause additional problems for the economy. Behind that kind of logic is the belief that big finance is important and good for the economy, and you need to support financial intermediation with whatever means you have during a crisis like this. But if a troubled third-world nation was making this kind of argument, we would regard it as a mistake, and I think it is a mistake here too.
The other is from PIMCO’s Bill Gross, who foresees a “new normal” of high public debt and low economic growth in the U.S. Interestingly, he attributes much of the prosperity of the past four decades to abandonment of the gold standard in 1971-73, which made money more plentiful and thus accelerated financial innovation. This led to rising leverage and consumption that eventually reached unsustainable levels.
Gross offers a warning to investors, policymakers, and taxpayers…
To zero in on the U.S. of A., its annual deficit of nearly $1.5 trillion is 10% of GDP alone, a number never approached since the 1930s Depression. While policymakers, including the President and Treasury Secretary Geithner, assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery’s corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington’s hat. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those “sixteen tons” in Tennessee Ernie Ford’s famous song of a West Virginia coal miner. “You load sixteen tons and whattaya get? Another day older and deeper in debt.”
…and to the investment profession (including investors and regulators – see the last sentence):
I remember as a child my parents telling me, perhaps resentfully, that only a doctor, airline pilot, or a car dealer could afford to join a country club. My how things have changed. Now, as I write this overlooking the 16th hole on the Vintage Club near Palm Springs, the only golfers who shank seven irons into the lake are real estate developers, investment bankers, or heads of investment management companies. The rich are different, not only in the manner intoned by F. Scott Fitzgerald, but also in who they are and what they do for a living…over the next several decades, the ability to make a fortune by using other people’s money will be a lot harder. Deleveraging, reregulation, increased taxation, and compensation limits will allow only the most skillful – or the shadiest – into the…Forbes 400.
Intuitively, it makes sense that the same industries represented at the modern country club would wield asymmetrical power over government policies, as Simon Johnson argues. But Gross’ personal and literary reflections imply that other industries are going to displace financial services at the country club buffet and government luaus. Thus, while Johnson’s concern might be very relevant in a contemporary sense, it’s likely to fade over time, as other industries come to wield more power over public policy.
Although this post is getting a bit long on the verbage, Gross offers some policy views that are worth discussing. First, he throws a jab at supply side wingnuts (although he does pull it slightly):
The fact is that supply-side economics was a partial con job from the get-go. Granted, from the 80% marginal tax rate that existed in the U.S. and the U.K. into the late 60s and 70s, lower taxes do incentivize productive investment and entrepreneurial risk-taking. But below 40% or so, it just pads the pockets of the rich and destabilizes the country’s financial balance sheet.
That sounds like an awfully speculative assertion (and a veiled aspersion towards the Wall Street Journal’s editorial board perhaps). He might be on to something, but he doesn’t substantiate it. In similar fashion, he demolishes a favorite claim of many Democrats:
Bill Clinton’s magical surpluses were really due to ephemeral taxes on leverage-based capital gains that in turn were due to the secular decline of inflation and interest rates that at some point had to bottom.
That’s true to some extent, although to be fair, the Clinton administration and a Republican congress did some important leg work on outlays.
Regarding tax policy, Gross concludes:
We are reaping the consequences of that long period of overconsumption and undersavings encouraged by the belief that lower and lower taxes would cure all.
This leaves us scratching our heads a bit, as it obscures what Gross believes the underlying cause to be. Was it the shift in central bank operations in the early 1970s as he initially asserted, or falling tax rates? The best we can come up with is that Gross is conflating two arguments: (1) end of gold standard led to financial innovation, leverage, undersaving, overconsumption, to be followed by high public debt and slow growth; and (2) higher and steeper tax rates are going to be necessary in the future (a logical argument for a large bond shop to make under current circumstances). Perhaps he’s doing so in an attempt to defuse the resistance that the second argument is bound to arouse. We’ll try to do a bit of defusing ourselves.
As we pointed out in our Wingnuts piece, the argument that lower taxes can cure every economic ill is indeed tired and a bit threadbare (and arguments about taxation are largely debates over competing personal and social values). But that does not mean that a better designed tax system would have no impact on productivity, output, and public indebtedness, especially when considered in the context of an open and competitive global economy, as opposed to the system of closed national and regional economies that prevailed at the time Keynes developed his General Theory. As we wrote in 2007:
In a relative sense the U.S. tax system is probably more optimal than most, but that competitive edge is eroding at the margin, a fact that is critical to our future well-being. While other nations are creating increasingly friendly (and thus competitive) environments for capital, the U.S. is largely treading water (even taking it on, perhaps).
And in 2008 (emphasis added):
…our tax code interacts with inflation in a way that creates strong disincentives to saving, and encourages debt financed consumption.
…increasingly complex and heavy handed regulation, a rising tax burden, and restrictive trade policies are the last thing that a slowing or contracting economy needs.
Today, we can substitute China, India, Brazil, emerging Europe, and many other parts of the world for Germany, Japan, and the rest [in the 1960s and 70s]. And the current dynamic is similar to that earlier one: a combination of bad tax, trade, and regulatory policies are driving down the expected rate of return in the U.S. economy, and the Federal Reserve has reacted by lowering its interest rate target; but the Fed’s actions can do little more than fuel eurodollar or petrodollar financed growth and inflation in faster growing countries, which eventually contributes to stagflation at home. In other words, by trying to induce growth in the U.S. economy, the Fed unintentionally engages in inflationary finance outside our borders. The only way around this is to improve the competitiveness of the real economy through better tax, trade, and regulatory policies. Admittedly, these have improved since the 1970s, but what matters most is not the absolute level of taxes, tariffs, and regulations, but rather their relative level and direction compared to the rest of the world.
This topic brings a lot of threads together, but the bottom line, in our view, is that continuing to tax productive activity – via corporate and personal income taxes, at increasingly uncompetitive levels – will only increase the likelihood that the U.S. end up like Japan – older, slower, and deeper in debt (though according to GapMinder, it’s still not a bad place to live).