U.S.: If You Can’t Beat ‘Em, Beat On ‘Em

An interesting and little noticed story carried by CFO.com claims:

The U.S. government has started to bring subsidy cases against imports coming out of China, "and Chinese subsidiaries of U.S. companies are being caught in that net," says Philippe Bruno, a partner with international law firm Greenberg Traurig.

This is classic beggar thy neighbor policy. If the returns on certain types of capital investment are higher in China than in the U.S. (manufacturing in this case), then the U.S. can do one of two things to better level the playing field. One option is to lower the tax burden on those same investments in the U.S., allowing factories and workers in each country to compete. The other option is to raise the tax burden associated with escaping a high U.S. tax burden, bringing the return on man ufacturing in China down to a level closer to the return currently available in the U.S. It should be very clear which strategy has the most positive economic effects overall. That clarity doesn’t seem to be getting in the way of U.S. trade policy and tariffs though.

url: http://www.cfo.com/article.cfm/10546476?f=alerts 

Economic Update: Housing, Claims, Mundell vs. McCulley

Economic data today seems to confirm the status quo, with datapoints on construction and permits showing continued pain in the housing sector, and initial weekly unemployment claims falling slightly on a seasonally adjusted basis. Claims are still not at levels that would indicate a high probability of recession.

We believe that claims could move either way in the coming year, depending heavily in part on what forms pending "fiscal stimuli" take. Ben Bernanke’s testimony to Congress this morning might give some clues. So far, the White House has staked out a rather timid position on taxes. One bright spot we’re keeping in mind is that the Republican minority was able to skillfully pass an AMT patch without any ‘paygo’ austerity measures or other hostage taking at the end of the last session.

In the meantime, we continue to scratch our heads at the chorus of claims and policy nostrums emanating from folks like Paul McCulley on CNBC this morning, namely:

• In the midst of a domestic credit/asset deflation, a single "timely, targeted, and temporary" tax cut, providing a lump sum of $250-750 to American families, will do anything positive for (a) the economy or (b) those who are truly in need of help. First, the economic impact is simply to bring a % of future consumption into the present, which is likely to have a net economic effect somewhere around zero, and which will have no impact whatsoever on our competitive position globally. And second, the only good way out of a credit and asset deflation is to rebuild personal balance sheets through the use of ongoing (and preferably higher) cash flows, something that only a healthy private sector can provide. Note that there are few federal policies that actually stimulate broader employment and higher levels of cash compensation than would otherwise exist. As just one example, there’s no way for employees to use their health coverage, no matter how wonderful, to pay down existing debt.
• McCulley also claimed that the Federal Reserve has no control over things like agricultural commodity inflation. Giving him the benefit of the doubt, he may have meant that under its mandate (which, as he described it, is to guard against downside risks to the domestic economy), the option of stemming commodity inflation is not a policy choice that’s on the table right now. But the Fed certainly can influence the general level of commodity prices, and rather easily. Paul Volcker sure did. That’s a horrendously painful process, and one that a Federal Reserve Board might have trouble surviving politically, but the reality is that Fed is able to push the future level of commodity prices in whichever direction it wishes, if it is so inclined. The only way to ameliorate the pain of disinflationary policy is to coordinate it with fiscal policy in the form of lower marginal–and, given the state of global tax competition today, lower effective–tax burdens on productive activity and investment, including labor.

When McCulley claims that the Fed has no choice but to ease, despite the potential for inflationary consequences, he is echoing the sentiments that surrounded monetary policy in the stagflationary 1970s. Then, the overriding economic concern was unemployment, and it was believed at the time that (a) monetary policy was the only lever suited to reducing it, and (b) taxes were the appropriate lever for managing inflation. That model was proven by real world experience (and perhaps confirmed by Robert Mundell’s Nobel Prize) to be backwards, wanting, and destructive, and it remains so today. But incredibly, the lessons of the 1970s appear to be lost on about 90% of financial market pundits.

A Katrina Tale That’s Stranger Than Fiction

Here’s one of those news bits you’d have a hard time making up, and it’s a nice distraction from the flurry of cross winds buffetting financial markets. Via Yahoo! and AP, we learn that a baby who was once a frozen embryo in New Orleans and rescued during the Katrina aftermath has celebrated his first birthday:

…Five [Markham] embryos, including Noah’s, were among about 1,400 which The Fertility Institute of New Orleans had stored at a hospital that flooded when Hurricane Katrina hit on Aug. 29, 2005.

With power out and the city sweltering in the days after the storm, authorities used flatboats for a water rescue of the canisters holding the embryos.

The one that became Noah was defrosted and implanted into his mother’s womb in May 2006. He was among eight babies delivered from 59 frozen embryos implanted that year at the same clinic. Of the clinic’s 1,750 frozen embryos, all but 350 were at the hospital that flooded…

You might have caught the significance of the name Noah. For readers who like to "oooh" and "awwww" at baby pictures, you’ll probably want to check his out. He’s a cutie, but we like the story for its broad themes, such as cultural-biological-technological change and adaptation, and for its description of actions that confirm there’s still a high value placed on bringing new lives into the world.

Taxes: Three T’s, or Long Term Investment?

Some of the ideas coming out of Washington about what will make effective "fiscal stimulus" has us scratching out heads, particularly the Lawrence Summers’ trilogy of ‘targeted, timely, and temporary’ tax cuts. The conservative Heritage Foundation has published a piece, "Tax Rebates Will Not Stimulate The Economy" (http://www.heritage.org/Press/Commentary/ed011008c.cfm) that captures  the fundamental problems with these kinds of proposals:

…Lower corporate and investment taxes encourage the savings and investment vital to producing more plants and equipment, as well as better technology.

By contrast, tax rebates fail because they don’t encourage productivity or wealth creation. No one has to work, save, invest or create any new wealth to receive a rebate…

Simply put, low tax rates encourage new wealth creation. Tax rebates merely redistribute existing wealth.

Take the 2001 tax rebates. Washington borrowed billions from the capital markets, and then mailed it to families in the form of $600 checks. Predictably, consumer spending temporarily rose, and capital/investment spending temporarily fell by a corresponding amount. This simple transfer of existing wealth did not encourage productive behavior. The economy remained stagnant through 2001 and much of 2002.

It was not until the 2003 tax cuts — which instead cut tax rates for workers and investors — that the economy finally and immediately recovered. In the previous 18 months, businesses investment had plummeted, the stock market had dropped 18 percent, and the economy had lost 616,000 jobs. In the 18 months following the 2003 tax rate reductions, business investment surged, the stock market leaped 32 percent, and the economy created 5.3 million new jobs. Overall economic growth doubled.

Bingo. Targeted, timely, and temporary "tax cuts" as proposed by Summers et al will do nothing to combat the whiffs of stagflation currently swirling around the U.S. economy. And as Fed chief Ben Bernanke has finally stated publicly, monetary policy is incapable of doing the job alone. The U.S. is in need of good tax policy, something that we’ve recently begun to lag behind in. Just look at our neighbors to the north for starters.

BLS: Ugly CPI, Real Earnings Slowing?

BLS released CPI and Real Earnings announcements today, and the data aren’t pretty. The one year change in headline CPI was 4.1%, higher than any other calendar reading since 2000. The core rate (ex-food and energy) came in at 2.4%. That’s down from 2.6% in 2006, but above the seven year average of 2.2%, and still outside inflation targeter’s official comfort zone of 2%. And three month annualized rates are printing very high, indicating that additional inflation pressures might be in the pipeline.

 

However, when measured in constant 1982 dollars, real wages have turned increasingly negative since October:

Barron’s: Rountable 2008

We highly recommend the latest copy of Barron’s, which contains their annual ‘Roundtable’ of market gurus for 2008. Bill Gross of PIMCO was among the invited luminaries, and although he’s a died in the wool Keynesian with whom we don’t often agree, he offered some of the more interesting observations. We even agree with him on some points, despite coming to them from different theoretical and conceptual backgrounds.

His assertion that the current economic malaise has a unique character, thanks to extreme leverage employed by the financial system: 

…the most affected economies are the finance-based economies — the ones that depended upon financial engineering. The U.S. is the prime culprit, and the U.K. is close in terms of its problems. These economies are paying the price as the so-called shadow banking system contracts. A normal bank reserves 15% against deposits. The shadow banking system of SIVs [structured investment vehicles] and financial conduits has no reserves. Financial engineering has run amok. This isn’t going to be a normal cyclical downturn in which inventories are addressed, paving the way for the economy to be rebuilt. The contraction in the shadow banking system will probably be with us for a number of years. It is a unique situation the world hasn’t faced in modern times.

On the need for prompt fiscal stimulus:

…the possibility of a fiscal package is small. Monetary policy has borne the brunt of the rescue effort, and it is relatively ineffective in this type of market. Both parties are fixated on "pay-as-you-go." That orthodoxy has to be given up. Both Republicans and Democrats have to sense that fiscal deficits must expand by 2%, 3% and perhaps 4%…

Here’s his analysis of past financial market and economic performance, and pessimistic outlook:

For years the economy’s growth has been predicated on asset inflation — stocks in the 1990s, then housing. There are no large, classic asset categories left to inflate, and as some assets deflate — namely housing — credit contracts. Economic growth will be below zero or mildly above it for a long time, and nothing like what we’ve grown used to in the past 10 to 15 years. Get used to anemic growth or a mild recession in terms of the economy, job creation and wealth creation. It’s not a favorable forecast.

On that last count, we disagree strongly. Over 25 years, financial markets should be reasonably efficient, which means that his "asset inflation" is a misnomer. Asset appreciation is more appropriate. And to the extent that improving economic policies worldwide improved growth expectations, that appreciation was entirely reasonable. Furthermore, there are many, many assets remaining in the world that still have room to appreciate. Not only foreign emerging economies, real estate, etc, but also 4.5 billion or so human beings. By making the proper investments in people, and keeping taxes and other burdens on their output low, the so-called "asset inflation" of the past 25 years can carry on for quite some time. Finally, we would point out that many assets in the U.S., such as certain types of factories and certain groups of laborers, have "deflated" in the past 25 years, as capital investment has gone overseas in response to high U.S. tax rates on corporate and personal income and capital gains. Simply improving the U.S. tax code would also support asset values, and "reflate" some long depressed ones.

WSJ: China, Capital, Root Canals

A few pieces of interest in today’s WSJ:

Firs, a story that the Chinese government may be opposed to a possible investment by China Development Bank in struggling Citigroup ("China’s Givernment Could Hamper Citigroup’s Plans to Raise Capital", 01/14/2008, subscription required). So much for the ‘global savings glut’.

Next up is an op-ed by Bear Stearns’ supply side economist David Malpass, "Markets and The Dollar", in which he opines:

As a next step in addressing financial-market turbulence, the Fed and the administration should say they want the dollar to strengthen in order to attract capital, spur U.S. growth and slow the inflation rate. There’s still time. Jobless claims are not yet at recession levels, stock prices are high, and exports are booming. The weak dollar doesn’t seem to be at a tipping point — it’s more of a constant drag on the economy, like…the anti-growth tax code.

This is the first time we’ve seen a respected supply side economist offer what, in our view, is essentially a monetary version of ‘root canal’ economics. Historically, root canal economics has been used by supply siders to deride fiscal policy measures that put the cart before the horse by placing a higher priority on balanced budgets than on economic growth. In his op-ed, Malpass places monetary strength above true growth incentives, such as lower taxes. Here’s our case against his proposal, briefly:

Real evidence of a U.S. slowdown and possible recession continues to mount. This clearly reflects the overinvestment that occurred in the housing sector. Beyond that, it might reflect nothing more than a mid-cycle slowdown, as some have argued. However, we think that there’s an elephant in the room that is much larger than U.S. dollar weakness, which is that (1) tax rates on capital and investment are set to rise in the near future (2) important corporate tax incentives from 2003 have expired in recent years and (3) there is some political momentum behind higher marginal tax rates on income and capital, at a time when leading indicators of inflation are intensifying.

These trends echo the stagflationary 1970s, and the echo will get louder to the extent that (1) Bernanke’s Fed becomes increasingly dovish (2) domestic policies become increasingly anti-growth and (3) foreign policies become increasingly growth-friendly. Assuming current tax trends continue, the U.S. is guaranteed to become a less competitive destination for investment capital. And in a worst case scenario, this trend would become a secular one (which seems possible under certain political outcomes in 2008), similar to England’s experience in the 20th century, and to Japan’s since 1989 (Malpass remarked on Japan in his op-ed, so it puzzles us that he could miss the connection between taxes and money as badly as he did). We do take some comfort in Reuven Brenner’s observation the the U.S. political system is far more responsive and dynamic than most, but we would prefer to see the economic policy debate set on better footing now rather than later (the prevailing uncertainty around policy choices also echoes the 1970s).

As we have argued repeatedly on this site, as long as the U.S. dollar remains a global reserve currency that can be used to finance investment at home and abroad, whenever the U.S. imposes a heavier tax burden on productive activity relative to the rest of the world, any attempts to improve the U.S. economy through monetary stimulus are likely to increase inflation at home and further undermine the dollar. Malpass’ prescription might lessen inflation, but it would probably come at the cost of marginally lower real output and employment.

It’s well past time for Wall Street and policymakers to stop harping on the Fed about this, and put the focus where it belongs–the U.S. tax code.  

Club for Growth Coming Around to Huckabee?

The Club for Growth has been in a political spat with Mike Huckabee for the better part of 2007. They’ve lambasted his record as governor of Arkansas, while he’s dubbed them the Club for Greed. This has surprised given that Huckabee’s endorsement of the Fair Tax is about as pro-growth as you can get. Well, we finally found someone among the CFG leadership who agrees with us. The following is by Louis R. Woodhill, a member of the Leadership Council of the Club for Growth:

Mike Huckabee’s dramatic rise in the polls has focused attention on the FairTax, for which, among presidential candidates, Huckabee is the leading advocate. The FairTax would replace personal income taxes, payroll taxes, capital gains taxes, corporate income taxes, and the death tax with a national retail sales tax…

The FairTax would provide a tremendous boost to economic growth. That is because it would reduce taxes on saving and investment to zero…If Americans did no more than reinvest the taxes that they no longer had to pay on savings and investment and the associated compliance costs, this would be sufficient to raise our real growth rate by 1.4 percentage points.

NYT: Let Them Buy Cake

We’ll file this op-ed from the NY Times in the category of ‘missing the point entirely’:

…lawmakers must come up with a stimulus package that addresses the country’s clear and present threat of recession. To be effective, stimulus must be targeted at low- and middle-income Americans. As a group, they will spend most, if not all, the assistance they receive, giving the economy an immediate lift.

Point #1 — Yes, the present sluggishness in the U.S. economy is due in part to retrenching U.S. consumers. This is not surprising given the incredible level of consumption, much of it financed with debt, since the early part of this decade. Normally, when a horse is exhausted, the best course if to give it nourishment and rest. Likewise, U.S. consumers need time to retrench and repair household balance sheets.

Point #2 — Unless the federal government runs a greater deficit at the same time (which flies in the face of the New York Times’ professed love of balanced budgets), this is nothing more than a shell game. The same dollars are spent, whether by consumers or the federal government. Furthermore, economies and markets are driven by expectations, ie, they are forward looking. If everyone knows a tax rebate is a one time thing, then what possible difference can it make to long term economic growth? Other measures, like extension of unemployment benefits and direct aid to states might make sense. But this particular recommendation is tired, worn, and wanting.

Point #3 — The ‘classism’ of this policy recommendation, which has been repeated every time recession is feared, has always struck me as more than a bit insulting to "low- and middle- income Americans," among whose numbers I am counted in most years. It’s as if they’re saying, "Let them buy cake…"

Point #4 — Growth, rising incomes, wealth creation, and improved standards of living come about through investment and productivity–not consumption. This op-ed captures a prevailing error among today’s political left, which is to ignore the realities of the global competition for capital. A higher capital to labor ratio will improve the lot of most "low- and middle- income Americans." The quickest and least painful way to increase that ratio is to stop taxing capital investment and other productive activities at levels that are becoming increasingly less competitive; in other words, cut taxes, don’t raise them, and if possible, remove taxes on productive activity (including incomes) altogether. Ah, but that could mean marginally lower consumption…heaven forbid…

CFO: Carbon Trading = Hot Air?

CFO.com has an interesting article on the current state of ‘carbon cap and trade’ schemes. It sounds like game theory in action:

…The uncertainty surrounding carbon credits has not deterred many U.S. businesses from jumping into the offset game…Nike has not only purchased offsets, it has produced them. The apparel maker generated the credits through an agreement signed in 2001 with the World Wildlife Fund’s Climate Savers…All in, Nike reduced its greenhouse gases by 18 percent from 1998, far exceeding its agreement with Climate Savers. And in the process, Nike has amassed a registered balance of nearly 8 million metric tons of emission reductions. Other companies, including Whirlpool and DuPont, are also sitting on sizable caches of credits.

…demand in cross-border CO₂ projects has led to problems. Stories have already appeared in The Financial Times and elsewhere about manufacturers in India purposely building factories with excessive greenhouse-gas emissions so they can sell the reduction credits. In addition, several reports have documented cases in which sellers of credits have miscalculated carbon baselines, thus bumping up CO₂ reductions. "You’ve got guys saying, ‘Hey, we’ll get you an offset if you give us some money,’" says Clean Air Watch’s O’Donnell. "It’s like the Wild West."

… Given so much uncertainty regarding how carbon markets currently operate and how legislation will ultimately unfold, there is a very real risk that companies will find themselves holding a commodity that’s worth substantially less than what it cost.

That’s especially true if congressional legislation exclude a specific offsets from being used in a national carbon-trading scheme. But that possibility has not stopped U.S. businesses from investing in more-controversial offset programs. In September, Dell Computer launched a plan called Plant a Forest for Me. ABN AMRO, AMD, Ask.com, Salesforce.com, Staples, Targus, and WellPoint partnered on the project. "We see reforestation as a legitimate solution that addresses overall climate impact," says Mark Newton, environmental policy manager at Dell. "But there is some uncertainty about how to manage it adequately."

…Green Mountain Coffee Roasters used to purchase forestation-based credits but has since backed off. "Trees are unpredictable," says Comey. "Will they be there in 20 years? Do you go to Lloyd’s of London to insure the credits from 50 acres of trees?"

…many businesses are already preparing for coming federal limits on carbon emissions. For most companies, the first step in the process involves performing a greenhouse-gas inventory. This is no small task. To begin with, businesses must choose how to conduct the carbon accounting. There’s no shortage of advice on that score. The list of CO₂ reporting protocols includes ISO 14064, the Voluntary Carbon Standard, and the GHG Protocol Corporate Accounting and Reporting Standard. Outside of the ISO checklist, none of the protocols appears to be nearly as rigorous as GAAP. The GHG Protocol, devised by a coalition of businesses, government agencies, and pro-green groups, seems to be as much guidance as standard.

…Assessing the carbon emitted outside a company’s factory walls poses a number of challenges. Little information is available from the many links in a company’s supply chain, and assigning responsibility for emissions can prove tricky…Don’t expect precise numbers, either. Nancy Hirshberg, vice president of natural resources at yogurt specialist Stonyfield Farm, notes that some of the numbers are hardly rock solid. "Carbon footprinting isn’t that advanced," she says. "You have to estimate a fair amount. It’s not worth taking extra time and money to try and get actuals."

Carbon regulation is going to be costly, and it will be messy. As a comparison, consider the example of Prohibition in the U.S. This was a national program that affected only a narrow scope of human activity. And yet it generated all kinds of shenanigans, criminal and otherwise, directed untold resources away from other better uses, and created new wealth for those who had the brains, the gall, and the survival skills to game the system it created. Carbon regulations on the other hand will be global in scope, and will affect nearly all human activities. One will not have to engage in criminal activity to amass wealth by exploiting whatever regulations are eventually implemented–knowledge, creativity, connections, foresight, and political capital and savvy are all you need. But it’s critically important to understand two things: first, this will cause a massive, global diversion of resources away from other social problems that appear to present better risk-reward tradeoffs, such as disease, nutrition, water management, and trade (as per Bjorn Lomborg’s work in this area); and second, because this is unfolding in a global political context, it may be more difficult to reverse serious errors (as Reuven Brenner has argued, the strength of the U.S. political system is that it enables policy errors to be corrected relatively quickly); and errors will be especially difficult to reverse if they have enriched certain people by creating asset values that would otherwise not exist . As difficult as carbon accounting is, adding up the unseen costs of carbon regulation is even harder; and perhaps more important, too.