Greenspan’s Grenade/Gift

The recently published memoirs of former Federal Reserve chairman Alan Greenspan are getting a good deal of attention from the punditocracy. A review on Bloomberg.com calls it a "Democratic Gift, Republican Grenade", and quotes Republicans who claim to share Greenspan’s concerns about the GOP, and Democrats who are thrilled to receive such heavy duty ammunition heading into the 2008 campaign for the White House.

Alan Greenspan, a conservative central banker, has tossed a political grenade into the 2008 elections and it exploded right under his Republican Party. In his memoir, “The Age of Turbulence: Adventures in a New World,” the former Federal Reserve chairman skewered President George W. Bush and congressional Republicans for what he said was reckless spending and a politically driven economic agenda and said they deserved to lose control of Congress in 2006. By contrast, he praised former President Bill Clinton, a Democrat, and his economic record.

I won’t be offering a review here since I’ve yet to read it, but among all of the laudatory accolades, Robert Novak’s harsh criticisms stand out to us. Yes, Novak may come across as increasingly "cranky" in his old age, as derided by hacks on the left recently, but as conservative political journalists go, he seems forthright and independent enough to listen to. He has also taken on a thankless but important task, reminding us that Alan Greenspan, like other personality cult icons, is simply a human being like the rest of us. In a short review, he gets rather personal, offering anecdotes that call into question Greenspan’s candor and carefully crafted image of reluctant public servant, but he offers some substance too when he questions Greenspan’s views on taxes, growth, and budget deficits:

In "The Age of Turbulence," Greenspan buys into the discredited depiction of Ronald Reagan (who first named Greenspan to the Fed) as an amiable dunce and does not conceal contempt for both Bushes (each of whom nominated him). Even more surprising is his adoration of Clinton. While scathing in attacking increased spending by George W. Bush, he ignores massive non-defense spending hikes under Clinton and embraces the Democrat’s tax increase "as our best chance in 40 years to get stable long-term growth." Greenspan’s book ignores Reagan’s tax-cutting supply-side movement as if it never happened. Seeing no inherent benefits from a lower tax burden, he accepts the Democratic deficit-reduction formula that a dollar of higher taxes is equivalent to a dollar of reduced spending.

While Novak’s economic criticisms will be dismissed out of hand by most, given his relative lack of bona fides next to Greenspan’s PhD, it’s important to note that this passage captures aspects of  longstanding debates within the economics profession. And looking forward to 2008, if Democrats focus on balancing the federal budget through tax hikes, while rest of the world expands incentives to private production and the Fed keeps policy easy to support the domestic economy, then the stagflationary specter for the U.S. will loom that much larger.

Romney: Defining Moment re Iran

In a column on NRO today, Republican presidential candidate Mitt Romney outlines his foreign policy strategy regarding Iran. He has been the most hawkish on this issue of the major candidates in either party. His five pillar strategy is:

1. Diplomatic isolation
2. Economic sanctions
3. Cooperation of Arab states
4. Nuclear threats
5. Expansive engagement with the Muslim world

Compared to Giuliani and Thompson, Romney’s odds of nomination have been trending smoothly upwards since early 2006, according to contracts on the InTrade market, and we think he’s one of the best schooled candidates in real world economics. However, as of this morning, the 23% probability placed on his nomination trails Thompson’s 25% and Giuliani’s 34%. It will be interesting to see how much of an effect today’s column has on his chances, if any. Our take on his pillars follows.

1. On diplomatic isolation, Romney writes, "Rather than invite its leaders to address world forums, they should be treated like a pariah. Indicting Ahmandinejad under the Genocide Convention should be a first step…" This is a mistake in our opinion, and one need only to have watched any of the interviews given by Ahmandinejad yesterday. If a political rival wants to shoot themselves in the foot, or in both feet, why stop them? Going further, why not encourage it, and aim to have as many spectators as possible? We glean some lessons from history that can be applied to this pillar: public humiliation, especially of the self-imposed sort, is a potent and cost effective way to separate a leader from popular support, while heavier handed tactics like extralegal indictments or military attacks tend to have an opposite effect.
2. We have two caveats regarding economic sanctions. First, while they can be effective, history shows that they are also extremely blunt and tend to have their most horrific impact on those with the least political capital–this can have the perverse effect of enriching and entrenching those in power, especially in less open economies. Second, in an increasingly global economy, direct control of economic activity by the U.S. in any given region is most likely shrinking. We agree that actions should be taken to prevent financial assets from being used to support violence against the U.S. whenever possible. However, winning economic disengagement from non-U.S. parties will take more than cajoling–it will also take bribes and other concessions to have any chance of being effective.
3. On this pillar Romney writes, "Arab states must join this effort to address the Iranian threat. These states can help by supporting Iraq’s democratically-elected government, turning down the temperature of the Arab-Israeli conflict, stopping the financial and weapons flows to Hamas and Hezbollah, thawing relations with Israel, and telling the Palestinians they must drop terror and recognize Israel’s right to exist." Nothing new there. We wish him luck.
4. On this pillar: "Iranians must understand that if any of the nuclear material their nation develops falls into the hands of terrorists and is used, the response from the world would be directed not only at the terrorists, but also at the nation that supplied the fissile material. And the response would be devastating." Bluster and threats can certainly be effective in politics. And if nuclear terrorism were to occur, "devastating" options deserve consideration. But this position is somewhat troubling, because it doesn’t comport well with the idea that Iran is a tyrannical state where the people do not have sufficient control over their government. ‘Desert glass’ resonates with a minority of the U.S. electorate, but Romney will need to tread carefully and thoughtfully on this one. 
5. Finally, he writes that "…our allies and friends must support progressive Muslim communities and leaders battling radical jihadists…I have called for the creation of a Partnership for Prosperity and Progress…We must also strengthen public diplomacy through both government and independent foundations…Only Muslims will be able to permanently defeat the radical jihadist threat. We should help them any way we can." First, we’d counsel patience. Winning hearts and minds over to a competing cultural worldview is messy stuff that may take generations to unfold. And second, in communities towards which these efforts are directed, it might smack of paternalism or misguided samaritanism, and deluded expectations. For example, have we ever said "Only Ulster Protestants /  Irish Catholics / renegade Mormons / anti-abortionists / displaced Baathists / alienated youth / racial separatists or supremacists / disenchanted landowners / radical Old World immigrants / etc [history is replete with possibilities] can permanently subdue the terrorist elements in their midst"? Of course not. So why do we find it so easy to say about Muslims? Yes, subcultures matter, but in the end, this is carrot and stick stuff, i.e., it’s about the political, economic, and social incentives that lead individual choices to reach a tipping point that steers a society towards a greater or lesser incidence of terrorism. As for any permanent eradication, as we say in Philly, fuggedaboutit. Political conflict is inevitable, and will at times sometimes lead to violence. It’s also well documented that, although its incidence varies widely across time and societies, terrorism is a persistent feature of diverse and open societies; it is still preferable to the civil wars that are a hallmark of closed political systems. Terrorism can be managed by effective civilian vigilance, law enforcement, and keeping real or perceived alienation from the political process to a minimum. Eradication strikes us as a utopian ideal, and utopian ideals pose their own unique dangers to a political system.

In a global world, managing real or perceived political alienation is a far more challenging objective–if the programs outlined in Romney’s fifth pillar can impact the Muslim world on that count, so much the better. But in our view, an Aikido-like approach to diplomacy will be more effective than a full frontal assault. At the margin, providing someone like Ahmedinejad with public forums as happened yesterday can have potentially beneficial effects. First, if might dampen the political alienation felt by some in the Middle East and the Muslim world, and second, it simultaneously exposes his domestic and international political capital to some serious credibility testing.

Holtz-Eakin: U.S. Tax Code a “Basic Impediment”

The House Ways and Means Committee, chaired by Rep. Charles Rangel of NY, held hearings over the past several days on the fairness of the U.S. tax code. We share the concern that the legislation to come out of these hearings will be focused solely on a redistribution of the tax burden in the name of fairness, to the exclusion of making our tax code more efficient and our economy more competitive. If so, this will place yet another straw on the camel’s back of domestic output, a reality that is critically linked to the current state of financial markets, signs of domestic sluggishness, and pressure on the Federal Reserve Open Market Committee (FOMC) to cut interest rates.

As we continue to point out, the U.S. dollar is still the world’s primary reserve currency, meaning that it can be used to finance economic activity in most of the world. In order to stabilize the value of the USD, the FOMC has to influence interest rates towards a level that approximates the expected return on marginal investment–not just investment opportunities in the U.S., but anywhere that dollars (and eurodollars, to be technically correct) can be used to finance investment.

In other words, the effectiveness of U.S. monetary policy is dictated by global economic realities, a fact that most policymakers, especially the current Congress, as well as many market pundits and participants, seem oblivious to. And as long as the marginal cost of a dollar falls below the marginal return on expected investment in the global dollar economy, persistent inflation will result. That means that the value of the USD steadily declines in real terms, i.e., in purchasing power. Congress and markets must realize that the FOMC cannot do anything about the relative quality of investment opportunities versus the rest of the world. As such, a cheaper dollar in the current global environment will mean a return of stagflation as we experienced in the 1970s–probably not to the same extent, but demoralizing nonetheless.

In this context, the U.S. tax code is defective in two important ways–neither of which were given much attention by Congressman Rangel’s committee. First, it is rendering our economy less competitive globally than it would otherwise be. And second, because it is not indexed for inflation, greater "fairness" in the form of steeper progressivity will impose ever larger penalties on people in terms of real wealth. For these reasons, we think that the testimony of Douglas Holtz-Eakin is worth a read, as it illuminates some of the important flaws in the federal tax code. While distribution of the tax burden is an important issue, the flaws pointed out in Holtz-Eakin’s testimony are far more important to our future economic performance:

The tax code is a basic impediment to the United States’ ability to grow robustly and compete in global markets…At present, the federal tax system is roughly achieving its goal of providing financing for federal spending.  However, there is little else to defend in the current tax code.  It is overly complex and burdensome, interferes too much with commerce and economic competitiveness, and is riddled with uneven treatment.  Far-reaching reforms are merited; more modest efforts will not succeed in raising federal revenues in a pro-growth and fair fashion.

ETUC: Flat Tax an Affront to “European Social Model”

Joining other ‘European tigers’ like Ireland and many ex-Communist bloc countries, Bulgaria has announced plans to lower personal income taxes to a flat 10%, in line with its current corporate tax code. However, this plan has attracted unfavorable attention from two Bulgarian labor confederations and the European Trade Union Confederation (ETUC):

Just a few months after Bulgaria joined the European Union, the Government of Prime Minister Sergey Dmitrievich Stanishev has agreed a tax reform introducing a flat tax rate of 10%…At a joint press conference yesterday (2/9/07) in Sofia, ETUC Deputy General Secretary Reiner Hoffmann stressed that flat taxes are in clear contradiction to the principles of the European Social Model. “…Only countries with decent and graduated tax systems, like those in Scandinavia for example, will meet the Lisbon targets of economic competitiveness, social cohesion and environmental sustainability.”

We prefer a more sober assessment of flat tax systems as articulated by William Gale of The Brookings Institution:

In principle, replacing the income tax with a…tax, such as the flat tax, offers the possibility of improving the efficiency, equity, and simplicity of the tax system. But these gains are uncertain and depend critically on the details of  the reform.

EIU: World Economy Headed for the Rocks?

Economist magazine’s ‘Economic Intelligence Unit’ has published its current take on global financial market turmoil. The full report in pdf is available here, and a brief web summary here.

The tremors in financial markets have gone far beyond their beginnings in the US subprime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets, and the repercussions on the global economy, remains unclear, but we can sketch out three broad scenarios:

• Scenario 1. The Economist Intelligence Unit.s central forecast, to which we attach a probability of 60%, sees the impact being contained by timely monetary policy action, with only a modest effect on the global economy.

• Scenario 2. Our main risk scenario, with a 30% probability, envisages the US falling into recession, with substantial fallout in the rest of the world.

• Scenario 3. Should the US enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the US into the world economy with devastating effect. We attach only a 10% probability to this outcome, but the potential impact is so severe that it warrants careful consideration.

We have some quibbles with the analysis, but it’s an informative one nonetheless, with plenty of good data points. However, regarding EIU’s primary concern that "the main risk to the world economy is a deflationary spiral in asset prices", we would simply point out that it’s important to distinguish between a credit crisis and a monetary one. Both cause market volatility. But a credit crisis is a normal feature of the business cycle, and provides an important signal that profitable opportunities in a particular area have been exhausted for the time being (a compounding factor this time around is financial innovation, which is causing a great deal of uncertainty; but the tradeoff was greater availability of credit during the boom and, assuming business practives and accounting standards can adapt in short order, this benefit should continue). Only a broad monetary crisis can cause a significant contraction in overall economic activity and anything resembling economist Irving Fisher’s general ‘debt deflation’. And the indicators we rely upon for assessing the state of monetary policy are still rather tame at the moment. The Bernanke Fed’s use of the discount window implies that they see this as a credit crunch, and it marks an encouraging change from the operating tendencies of his predecessor (that the ECB stood pat today may signal that major central banks are largely in agreement with this view).

Based on the foregoing assessment and our model of how the world economy works, we disagree with the EIU conclusion that timely monetary policy is the best answer to the current crisis, and instead would reiterate that the most beneficial measures that could be taken in this country are non-monetary in nature, and would aim at raising long term expected rates of return in the U.S. That requires lower taxes and more efficient regulation overall, i.e., lowering the cost and thus raising the return of doing business. Utterances from Congress about bringing fairness into the U.S. tax code are fine and good, but will only help the economy if they lower the effective burden on productive activity, and improve our competitive standing in the world.