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Monday, July 19, 2004

Battle Tax Cuts - Challenger - Opening Arguments

Unsustainable Path

These long-run budget projections show clearly that the budget is on an unsustainable path, although the rise in the deficit unfolds gradually. As the babyboomers reach retirement age in large numbers, the deficit is projected to rise steadily as a share of GDP. Under most scenarios, well before the end of the projection period for this chapter rising deficits would drive debt to levels several times the size of GDP.


Office of Management and Budget, Analytical PerspectivesFebruary 2004

I would love to talk about George Bush's tax cuts, but the reality is that for all practical purposes, there haven't been any. A tax cut is a reduction in planned government revenue coupled with either reducing the size of a surplus, or by reductions in planned spending. This is the essence of the Pay as you go or PAYGO system. But the two major tax bills Economic Growth and Tax Relief Reconciliation Act" of 2001 and the Jobs & Growth Tax Relief Reconciliation Act of 2003 do not have any spending reductions, and there was only a very small surplus to distribute. In otherwords, the tax bills offered revenue reductions, but not true tax cuts.

What we are really talking about then is whether it is good economic policy to have a large shot of investment demand stimulus, and a large program of borrowing money at the Federal level. What we are really faced with is whether reducing federal revenues alone will produce a better economic performance than some other economic policy.

That federal revenues as a share of GDP have been slashed is something everyone agrees on, the numbers are very clear on this. What is also clear is that the budget deficit, as a percentage of GDP is back to early 1990's levels, to the point where even Greenspan is warning on the dangers of deficits.

That the bill is demand side was stated by Bush himself:


"The principle of the bill is pretty simple," Bush told reporters as he took a victory lap around Capitol Hill Thursday morning. "We believe the more money people have in their pockets, the more likely it will be that somebody can find a job in America."


Tax policy, no matter how it is phrased, is always about the demand side. More money = more demand. It's crude Keynsianism by Bush's own admission. That means that the design of the tax bills should be visible by who the money was given to and for what purposes. To make it to the supply side, the tax bills needed to address deficiencies in the economy.

Which means that if you loved Ronald Reagan, you should hate George W Bush. Let me explain, Bush has broken the series of compromises in the economy that Reagan helped engineer.

Back in the 1970's we had consumer inflation. The problem? We had reached the limits of Consumer Keynesianism. Whenever money was pushed into the consumer economy, energy prices, specifically oil, went up. There was inflation endemic in the economic system. There were two parts to this. One is that interest rates were too low, and therefore it was too easy for people to borrow their way around problems. Carter realized this, too late to save himself, and appointed Paul Volker, and inflation hawk, to run the Fed. Volker raised interest rates and cut down on liquidity, and began squeezing prices down.

But there was a second part, and this is where Ronald Reagan came in. After a 12 year long bear market, no one wanted to invest in stocks. Stocks are where capital comes from, and so the other part of the equation was to increase investment demand. Reagan was far from as radical as people thought at the time. The major change was to move from pushing consumer demand up, to pushing investment demand up. Up until then, the theory was that consumer demand would produce supply: lower the risks of spending, and give people money, and someone will produce things for them to spend it on. After the oil shocks it was realized that the limit to consumer growth wasn't full employment, it was full energy usage. More consumer demand produced more dollars chasing the same number of barrels of oil.

Reagan shifted to investment demand, but not investment supply. Investment demand is money, investment supply comes from the new businesses that come into being that return enough to pay for the cost of money. Real supply side means addressing business formation. In the 1970's we learned that there was a limit to consumer demand: namely the point where energy demand rises. The Reagan solution was to push up investment demand, and hope that demand would create its own supply in investment.

Most people will talk about deficits at this point, and Republicans are forced to talk about how "deficits don't matter". This is nonsense, of course it matters if government is borrowing more money and crowding out private investment. However, a deficit is as much a symptom as a cause. Just as hiring numbers, or lack there of, are a symptom, and not a cause. There will be plenty of time in rebuttals to go over hiring data, and how the Executive has been consistently wrong on the number of jobs that will be created, and on deficits, and how the budget predictions show deficits as far as the eye can see, even assuming that the entire tax program is allowed to sunset in 2010. But the real case is the root cause, the fundamental numbers to keep ones attention focused on.

The strategy of Reaganomics was to pressure oil prices down by keeping a lid on wages, and by pumping money into investment. However, if investment demand ran ahead of investment supply, the result was a flat stock market – as we saw in the wake of the crash of 1987, which meandered slowly upward until in the early 1990's the deficits were being pared down, and the internet provided a whole new kind of investment supply.

The real fundamental of the economy is simpler: there are very few goods that the US must import, chief among these is energy, either directly, or indirectly in the form of goods that we import that cost energy to make. In order to grow we have to either sell investments overseas, or we have to sell goods abroad, or we have to find a way to make more GDP with the same amount of energy. The real supply side then, is either making new investment supply that others want to buy, or by creating investment supply that will make new goods to sell, or by creating investment supply that will reduce the energy cost of GDP. Bush's tax policy, isn't doing any of these for us.

Instead, energy inflation has been reignited, the stock market in global terms is flat, and there is a lack of quality investment supply presently in the US. The first is easy enough to show, the "refiner acquisition cost of oil", a good rule of thumb measurement for the cost of energy, the numbers show how starting in 1998 the cost began marching back up. The "bubble" in stocks was not creating economic improvement. But what is symptomatic of bad policy after this is that the recession of 2001 barely put a dent in the march upward in price. Prices of gasoline, electricity and other forms of energy, of course, mirror this same graph. So the energy supply side has not been helped, on the contrary it has gotten worse.

Some people will point to the rising stock market as proof that there has been real recovery in supply side - but that's not growth, that is devaluation. Measured in world buying power, gold, oil or the Euro the stock market has been essentially flat after the relief rally from Iraq. This means that the US is not producing more investment that people want, but instead investment is being propped up by tax cuts and borrowing.

Finally there is exporting, and here too, we have a singularly deficient policy. Instead of making goods that no one else can, and selling them at a premium, the current policy has been to allow devaluation, and the reduced selling price in other currencies that come with it. This hasn't worked, because, as pointed out above, all it does is increase the price of the commodities we have to have, namely energy, which soaks up any advantage that we gain from a cheaper dollar. The trade deficit has widened to record levels.

In otherwords, in all three of the supply side areas, the current tax policy creates demand, but does not encourage the formation of new investment supply, If you want to know who is killing supply-side economics, look no further than the White House.

This means that the fundamentals of the American economy are very simple: consumer supply can only grow, sustainably, at the rate of energy supply. This is what Paul Volker and Alan Greenspan understood: as long as wages grew less than productivity, and energy prices fell, the interest rates could be lowered, if not, they had to be raised to choke off consumer inflation. But what is the limit to investment demand? At what point is it merely touching off inflation? The answer is also simple: capital improves the efficiency of the use of resources. As long as capital is finding a way to get more real GDP out of the same amount of basic materials, then it is working. That's Greenspan's "virtuous cycle": more investment demand, leads to more investment supply, which means that the same amount of input labor and material can go farther, which means more to split between wages and dividends.

This means that the usual numbers thrown around, GDP, job creation, inflation and so on, are symptoms, and not causes. And the kind of touting of mediocre performance that Bush's apologists have been doing is next to useless. Creating 1.5 million jobs in 6 months is a pathetic performance for an economy in economic rebound. March 1946 saw 944,000 jobs created - and September 1983 saw 1.1 million jobs created. Those are both in a single month totals. The best single month of job creation under Bush, as a percentage of total payrolls ranks at 132 of months since records were kept. The US economy has often created more than 2 million jobs in six months - and in the Reagan Rebound from the 1981-1982 recession and the Truman Rebound from the 1949 recession, the American economy added more than three million jobs, in much smaller economies. In the Clinton rebound in 1994, 2.136 million jobs were added in 6 months. That's as good as the best month Bush has had laid end to end for 6 months.

For there to be real progress then, the government has to address the real problems of supply. To do this means that the first step is to stop spinning our fiscal wheels on investment demand solutions that are not getting any traction, because there aren't enough investment opportunities.

It also means addressing the failure of Iraq head on. Iraq, in economic terms, was meant to do two things. One was to reduce geo-political risk of terrorism, and the other was to put a large supply of cheap oil on line, and under US control The failure to find WMD in Iraq, at the same time that North Korea, Pakistan and now Iran are reaching for full fledged atomic deterents, is a failure to reduce that risk, and as with Carter's failure to deal with Iran, a sign that Bush does not have the judgment to be President. But as bad as going to Iraq and no getting WMD, is going to Iraq, and not finding cheap oil.

The result is that the investment demand side continues to pressure upwards the price of oil – now over 40 dollars a barrel on the spot market, without a supply shock. It also means that until the equities market reignites, there is the danger we will have the repeat of the late 1970's, when speculative money poured into commodities. Based on a purely demand model for oil, I calculate that crude should be at 33.00 a barrel. This is slightly on the high side of consensus estimates, but not by much. The other 7 to 10 dollars a barrel of cost comes from "risk premium". Which is investor speak for speculative money looking to make a killing. While solving Iraq will reduce this premium, reducing the amount of excess demand in the investment sector will be required.

In short, we need to go back to a government which prevents risks, rather than takes them, and which focuses on finding ways of overcoming long term bottlenecks in the economy, so that the free market can exploit opportunities without friction. The current revenue reduction program coupled with massive borrowing does neither of these two fundamental goals of government, and, therefore, should be abandoned at the first possible opportunity.

Congress sees deficits as far as the eye can see, while revenues as a percentage of GDP are predicted to shoot up from 15.8% to 20%. That's what the friends of this economic package are predicting: that current spending plans are going to be in deficit forever, even assuming that the entire series of revenue reductions passed by Bush and his Congress are rolled back.

However, if, as planned, the current tax packages are maintained and the very popular changes to the Alternative Minimum Tax are made – to fix this generation's version of "bracket creep", where people of relatively middle class incomes lose their deductions - then the projected deficit, according to Concord Coalition Budget Projections balloons from 1.7 Trillion dollars of accumulated deficit to over 5 trillion. This is on top of the 7.2 trillion that has already been accumulated. This cannot go on, because, as the CBO itself admits, the budget is "unsustainable".

And that which can't go on, won't.
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