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Where's That Inflation?

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 17 Nov 2009 14:54:00 EST

From September 2008 to September 2009, the Federal Reserve pumped an unprecedented $2 trillion into the financial system by buying Treasury bonds and assets from banks. According to most mainstream economists, such action should create a general increase in prices.

Inflation is the result of more dollars chasing the same number of (or fewer) goods. As the Nobel laureate Milton Friedman put it, in one of his main contributions to “monetarist” economics, inflation is always and everywhere a monetary phenomenon—that is, it’s caused by an expansion in the supply of money or credit. So why haven’t we seen inflation in 2009? Are we looking in the wrong places, or is it time to update monetarist theory?

The monetary base, which consists of currency in circulation plus bank reserves on deposit with the Federal Reserve, has exploded, as Figure 1 shows. Figure 2, by contrast, shows inflation as gauged by the consumer price index (CPI)—the cost of goods purchased by the average U.S. household—and by a measure called the median CPI. Standard CPI is the traditional measure for inflation, but a few extreme outliers (such as the price of fuel) can throw off the average; thus the median is a more robust statistic to estimate the central tendency in the data.

So while the standard CPI shows deflation over the past year, that stems from a few anomalous sectors, such as energy, where prices have dipped significantly since 2008. The median CPI, on the other hand, shows an inflation rate that does not look very unusual.

The standard explanation for the lack of inflation is that banks are sitting on all that new cash. As soon as the economy shows signs of recovery, goes the theory, banks will make more loans, and the broader monetary aggregates will shoot up rapidly. But that expectation ignores an important factor: Beginning in October 2008, for the first time in history, the Federal Reserve started paying interest on reserves held by banks. So even when the economy starts heating up, banks will have an incentive to hold money rather than lend it.

What’s more, should inflation rear its head anytime soon, the Fed could suck the newly created money out of the banking system by selling assets, such as some of the higher-quality mortgage-backed securities it bought from banks at the depth of the financial crisis. That would decrease the amount of money in the system and choke back inflation.

On top of that, the Georgetown University economist Donald Marron has argued, if investors really thought we were on the verge of inflation, we would see the 10-year Treasury or 30-year mortgage rates go through the roof. But that hasn’t happened.

Marron’s view reflects what might be called the monetarist consensus. It is embraced by economists across the political spectrum, including Obama’s economic adviser Larry Summers and the current and former Fed chairmen. It is a position that relies on the wisdom of politically independent (and hopefully monetarist) central bankers to manage both the economy and the threat of inflation.

Besides placing undue faith in the Fed’s ability to time perfectly any necessary anti-inflationary measures, the consensus suggests that the nation’s central bank now has the heretofore undiscovered ability to increase the money supply without creating inflation. If true, this would be an important new development, since inflation has long been rightly vilified for destroying entrepreneurship and long-term economic growth. But if false, this conceit could prove dangerous indeed. And it’s probably false.

On his blog Free Advice in September, the Pacific Research Institute economist Robert Murphy argued that inflation is already here but economists are missing the signs. “From [December 2008] until August 2009, the unadjusted CPI level has increased 2.7%, which translates to an annualized increase of just over 4%,” Murphy wrote. He acknowledged that “ten-year yields [on Treasury bonds] are…low” but added that the price of gold has increased enormously. “Why do we assume that TIPS [Treasury Inflation-Protected Securities] traders are genius forecasters, but gold traders are morons?” he asked.

In an email message, Murphy adds: “I believe we are currently witnessing a bubble in Treasury debt. I consider the current yields on 10-year U.S. government bonds to be absurdly low, just like the price of housing was absurdly high in early 2006. After this bubble bursts, investors will slap themselves on the forehead and say, ‘What were we thinking? Why did we rush into Treasurys even as the government told us it was planning to double the federal debt burden in a decade?’ ”

The St. Lawrence University economist Steven Horwitz agrees both that inflation is already happening and that it is widely misunderstood. Monetarists, he says, were “too focused on aggregates like ‘the’ price level, which led economists to ignore the way inflation could distort individual prices at the microeconomic level, causing resource misallocation in the process.” Virtually all economists now agree, for example, that the Fed’s low interest rates inflated housing prices earlier in the decade. Yet as the prices of houses went up, few economists worried about inflation because the CPI looked relatively stable, due in part to a decrease in energy prices. When housing started to crash in 2007, many economists thought the Fed should inject still more funds into the system to stave off further declines. They failed to see that the Fed had distorted relative prices in the first place.

As the George Mason University economist Peter Boettke explains, “A problem with the current monetarists is that while they learned from Friedman the idea that we should fight inflation, in practice they learned from his writings on the Great Depression that central banks should fear deflation.” As a result, economists who are theoretically inflation-hating Friedmanites now want to meet every downturn by fighting deflation.

Because of this tendency, bursting government-created bubbles leads to the creation of new ones. The real lesson may be that inflation is not only a monetary phenomenon but also a political one. Which makes it that much more difficult to predict, much less control.

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

The Secret Message of Stimulus Spending

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 03 Nov 2009 12:42:00 EST

The idea behind the $787 billion stimulus bill is that government can create jobs by spending money. For now, let’s ignore fact, history, and economic theory and assume that government spending can actually create jobs.

In that case, we should expect the government to invest relatively more money in the states that have the highest unemployment rates and less money in the states with lower unemployment rates. So let’s check the data.

Using numbers from President Obama’s website Recovery.org and the Bureau of Labor Statistics, this chart plots the amount of stimulus funds spent per person in each state and the corresponding unemployment rate in that state. The solid blue line shows what the allocation of funds should look like if the administration was allocating relatively more money to the states with higher unemployment rates.

Yet, with a few exceptions, the data show that this is not the case. Many higher-unemployment states are getting far fewer stimulus dollars than lower-unemployment states.

Take Michigan, for instance. Michigan’s 15.2 percent unemployment rate is the highest in the country. So far, it has received $403 per person in stimulus funds. That’s above the average stimulus per person across all states ($326). However, it’s lower than the $409 per person that the state of Vermont, a state with relatively low unemployment (6.8 percent), has received so far. Michigan's per-person take is also much lower than the $707 per person the District of Columbia received. D.C.'s unemployment rate is 9.9 percent.

Now look at the state with the lowest unemployment rate in the country: North Dakota. It’s getting $253 per person with a 4.3 percent unemployment rate. Many other states are receiving roughly the same amount of stimulus funds per person despite much higher rates of unemployment.

Which suggests that stimulus funds are being allocated without thought to the level of unemployment within states. If government spending could in fact create jobs, then the problem of unemployment could be mitigated by distributing funds to states based on their relative unemployment levels.

But that's not being done at all. Instead, funds are being distributed randomly, as quickly as possible, among the states. That in turn suggests something else: Even the federal government doesn't believe the myth that government spending can actually create jobs.

Veronique de Rugy is an economist at The Mercatus Center at George Mason University and a columnist for Reason. This column first appeared at Reason.com.

The Myth of the Multiplier

vdereugy@gmu.edu (Veronique de Rugy) — Mon, 19 Oct 2009 12:19:00 EDT

Give us money, and we’ll give you jobs. That was the promise President Barack Obama made when he asked Congress for a $789 billion stimulus bill. The cash, he said, would create millions of jobs during the next two years. Without the stimulus, the administration warned in a January report by economic advisers Christina Romer and Jared Bernstein, unemployment by the end of 2010 would reach as high as 9 percent.

Well, Obama got his money. Since then, the economy has shed more than 2 million jobs and the unemployment rate has climbed to 9.4 percent. By May 2009, the Council of Economic Advisers (CEA) had changed its message. Now the stimulus would “save or create” 3.5 million jobs by the end of 2010.

Measuring total jobs “saved” by a piece of legislation is as difficult as measuring total crimes prevented by police patrols. That’s why no agency—not the Labor Department, not the Treasury, not the Bureau of Labor Statistics— actually calculates “jobs saved.” As the University of Chicago economist Steven J. Davis told the Associated Press, using saved jobs as a yardstick “was a clever political gimmick to make it even harder to determine whether this policy has any effect.”

A look at the CEA’s job creation model undercuts its promises even more. The model’s calculation of saved or created jobs is based on a macroeconomic estimate, not on actual data. According to the authors, the estimate rests on a “rough correspondence over history” that indicates a 1 percent increase in gross domestic product (GDP) represents an increase of 1 million jobs. They might as well have said the estimate was picked at random.

How did they come up with the 1 percent figure? Since government spending is increasing, and since such spending is a component of GDP, they assumed GDP would grow whether or not the spending produced real growth in the economy. This is akin to assuming I will have a baby in nine months whether or not I am pregnant.

The May report concedes that while the CEA will attempt to measure job creation through data collected from stimulus recipients, the results will contain errors and inconsistencies. “Because of these limitations,” it warns, “the reported jobs numbers will need to [be] used with caution and as part of a more complex estimation strategy.”

Since then, Romer has told CNBC she couldn’t say for sure how many jobs would be created, since we can’t know what would have happened without the stimulus. But didn’t her report pro-ject what would happen if the stimulus wasn’t passed? Wasn’t the 3.5 million number supposed to be the difference between employment with the stimulus and employment without it?

The confusion flows from the faulty theory underlying the stimulus bill. In Keynesian thought, a decline in demand causes a decline in spending; since one person’s spending is someone else’s income, a fall in demand makes a nation poorer. As a poorer nation cuts back on spending, it sets off another wave of declining income. So any big shock to consumer spending or business confidence can set off waves of job losses and layoffs, as fewer goods are demanded and more workers become useless.

Under this logic, one possible remedy is for public spending to take the place of private spending. As government increases its spending, the money creates new employment. That, in turn, spurs those new workers to consume more and prompts businesses to buy more machines and equipment to meet the government-induced demand. Economists call this increase in aggregate income the “multiplier” effect. One dollar of government spending, the theory goes, ends up creating more than a dollar of new income. It’s a rare free lunch.

As appealing as the Keynesian story sounds, many economists have long doubted it. In 1991, looking across 100 countries, Robert Barro of Harvard presented historical evidence that high government spending actually hurts economies in the long run by crowding out private spending and shifting resources to the uses preferred by politicians rather than consumers. For a dollar of government spending, we end up seeing less than a dollar of growth. Can long-term poison be short-term medicine?

Even in the short run, if there’s a big decline in the demand for workers, why should that alone cause mass unemployment? If all those workers really want to work, why won’t wages just fall until all the workers have jobs? That’s how markets end a glut, whether it’s a glut of employees or a glut of blue jeans: with lower prices. If recessions really are caused by a fall in demand (and nothing else), why don’t wages fall enough to keep people from losing their jobs?

It’s because wages are sticky, Keynesians argue. Wages and salaries don’t change on a daily basis the way stock prices and gas prices do, so if a company hits a sales slump, salespeople might earn fewer commissions, but the vast majority of workers don’t get a pay cut. There’s something about the market for workers that keeps businesses from cutting wages in a slump. As long as wages are sticky, in the wake of a nationwide collapse in sales, entrepreneurs will start firing people.

If a decline in demand means mass firing, a rise in demand can mean mass hiring. Even if government spending is inefficient, pork-laden, and financed by future tax increases, the theory goes, it can still create some real jobs, some real output, in both the public and private sectors.

So what do the data say? There aren’t many studies of the issue. But two stand out: Robert Barro’s work and research by Valerie Ramey, an economist at the University of California–San Diego, on how military spending influences GDP. Both studies found that government spending crowds out the private sector, at least a little. And both found multipliers close to one: Barro’s estimate is 0.8, while Ramey’s estimate is 1.2. This means that every dollar of government spending produces either less than a dollar of economic growth or just a little over a dollar. That’s quite different from the administration’s favored multiplier of four. What’s more, Ramey also found evidence that consumer and business spending actually decline after an increase in government purchases.

Why this crowding out of private spending? Government spending comes from three sources: debt, new money, or taxes. In other words, the government can’t inject money into the economy without first taking money out of the economy.

Take taxation: Taxes simply transfer resources from consumers to government, displacing private spending and investment. Families whose taxes have increased will have less money to spend on themselves. They are poorer and will consume less. They also save less money, which in turn reduces the resources available for lending.

In addition, higher taxation encourages people to change their behavior to avoid taxes. They might switch their efforts to nontaxed activities, such as household production, or to the untaxed underground economy. Economists call this a deadweight loss, because people give up the taxed activity or good they prefer.

There are high costs to the other options as well. If the government borrows money, that leaves less capital for the private sector to borrow for its own consumption. If the government prints new money, it will create inflation, which reduces the value of the money we own and decreases everyone’s purchasing power.

Overall, government spending doesn’t boost national income or standard of living. It merely redistributes it—minus the share it spends on the bureaucracy that collects and spends our tax dollars. The pie is sliced differently, but it’s not any bigger. In fact, it’s smaller.

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Corporate Tax Burden Is Already a Whopping 40 Percent

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 14 Jul 2009 15:22:00 EDT

Reason magazine

President Barack Obama is very insistent on the need to “save American jobs.” The spending and the Buy American provisions of his massive stimulus package, approved by Congress in February, were meant to “create or save” millions of U.S. jobs. “Saving jobs” was also the stated goal of his recent pledge to eliminate tax advantages for companies that do business overseas. But instead of saving American jobs, Obama’s new corporate tax is apt to worsen what is already the highest unemployment since 1983 and make America’s companies even less competitive in the global marketplace.

Last spring, partly in response to the anti-bailout tea parties that were sweeping through the country on and around the April 15 tax deadline, the president announced that he plans to simplify the tax code. That sounds like a worthwhile goal, but it turns out that forObama, simplification means taxing previously untaxed income.

For instance, the proposal targets what executives consider to be a lifesaving feature of an otherwise depressing corporate tax code: permission to indefinitely defer paying U.S. taxes on income earned overseas. According to the Obama administration, this practice keeps $700 billion or more of American corporate earnings in overseas accounts, beyond the taxman’s reach.

The president also wants to overhaul what he describes as a “much-abused” set of tax regulations known as the “check-the-box” rules. These regulations give companies some latitude in deciding where their subsidiaries will be taxed and make it easier for multinationals to transfer money between countries. The result, which Obama frowns upon, is that many companies have placed their offshore subsidiaries in low-tax countries.

While he’s at it, the president wants to restrict tax credits that the U.S. grants companies to offset taxes they pay to foreign governments.

Until now, Obama said when unveiling his plan in May, we’ve suffered under “a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York.” This notion is wrong in several ways.

It is a mistake to assume that U.S. domestic firms and U.S. multinationals are primary competitors, engaged in a zero-sum struggle. In fact, the true competitors of U.S-based firms with international operations are mainly foreign-based companies. And in that competition, the existing U.S. corporate tax code puts American firms at a clear disadvantage—one for which the alleged tax loopholes were intended to compensate.

The U.S. corporate tax rate is simply too high. When you add state corporate taxes to the 35 percent federal rate, you arrive at a whopping 40 percent average corporate tax burden, the second highest among the 30 countries in the Organization for Economic Cooperation and Development (OECD).

Economists are in broad agreement that cutting the corporate rate is a national priority. In a 2002 study, American Enterprise Institute economists Kevin Hassett and Eric Engen argued that the most efficient corporate tax rate is zero. The mobility of capital income means that even a small amount of tax introduces large distortions into an economy as capital flies away to a lower tax environment. More interesting, if counterintuitive, is the fact that because of capital mobility the people who stand to benefit most from a corporate tax cut are workers. In a 2006 study, the economist William C. Randolph of the Congressional Budget Office concluded that “domestic labor bears slightly more than 70 percent of the burden” imposed by corporate taxes.

Not only is the U.S. rate too high, but the U.S. government also taxes corporations on their worldwide income. That means profits made by an American-owned computer plant are subject to U.S. tax whether the plant is located in Texas or Ireland.

Most other major countries do not tax foreign business income as aggressively. In fact, about half of OECD nations have “territorial” systems that tax firms only on their domestic income.

The combination of high rates and a competitive global marketplace makes the U.S. corporate tax system extremely punishing. Imagine a French firm competing with a U.S. firm for business in Ireland. The Irish government taxes each subsidiary on its Irish income at the (low) national rate of 10 percent. Fair enough. But unlike the French competitor, the U.S. parent company must also register its Irish affiliate’s dividends back home as income, which is then taxed. If the company can meet certain requirements, it can receive a credit for taxes paid to the Irish treasury. But the firm would still have to pay American taxes at the American rate on the Irish income minus the tax credit. The result is double taxation, costly paperwork, and less competitiveness than the French.

These differences have important implications for American companies competing in foreign markets. Because of higher tax costs, U.S.-based firms are losing foreign market share, generating lower returns for American shareholders, and hiring fewer skilled workers back home in the United States. Under these conditions, it’s no surprise that American multinational companies that want to sell their goods abroad try to keep as much cash out of the U.S. as they legally can. It’s a matter of survival.

Other countries understand this. Several nations, most recently including Japan and Britain, are moving to a territorial system, taxing only corporate profits earned within their borders. By contrast, Obama is proposing to move in the opposite direction: He wants to make U.S. companies doing business abroad as miserable as U.S. companies doing business at home.

What will happen if the president succeeds? To stay competitive some American companies will change their structures to become foreignowned firms. This is called corporate inversion: A company switches to the flag of a lower-tax jurisdiction. Such transactions generally have little real effect on U.S. business operations. Firms still pay taxes on all U.S. income, but they no longer pays U.S. tax on foreign income. Companies that can’t afford the costs of inverting probably would have to reduce operations and/or fire workers.

Corporate inversions are just one of many ways in which a U.S. firm can end up being owned by a foreign parent company. A forward-looking American startup may decide to incorporate abroad to enjoy long-term tax savings. That means fewer new jobs in the United States. Foreign acquisitions of U.S. companies have soared from $91 billion in 1997 to $340 billion by 2007.

Is it the president’s goal to destroy jobs? Probably not. So instead of making the corporate tax system worse, why not reform it? Why not avoid old protectionist tricks such as Buy American provisions and instead let U.S. firms compete abroad without the chains of the U.S. tax code?

Veronique De Rugy (vdereugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University and contributing editor at Reason magazine, where this column first appeared.

Do the Economics of Piracy Demand the Privatization of the Sea?

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 16 Jun 2009 15:26:00 EDT

Reason magazine

At the beginning of April, after a vessel was captured off the Somali coast, the military liberated the crew by storming the boat and killing two of the pirates. While the crew was saved, the ship’s captain was killed in the attack, leaving behind a wife and a 3-year old son.

That’s not the story you heard? That’s because you’re not French. While the story of the Maersk Alabama and the Navy SEAL operation that freed its captain were gripping American attention, the French were focused on the drama unfolding upon the Tanit, a 40-foot sailboat on an around-the-world voyage. When it became clear that negotiations for the crew’s release had come to an impasse, French commandos moved in.

The French government had warned the skipper not to proceed into the Gulf of Aden, where piracy has increased dramatically during the last four years. But the captain chose to ignore the advice. He apparently was chasing a dream to drop out of commercial society and would not be dissuaded.

Most piracy, by contrast, stems from very material dreams, on the part of both the pirates and the plundered. All affected parties are looking to make a living and constantly calculating the most efficient means to do so.

While tourists occasionally have fallen victim to piracy, most hostages are crew members on commercial ships. This is no surprise. According to a 2008 RAND study, the main factor behind the re-emergence of old-style piracy has been a massive increase in commercial maritime traffic. Combined with the large number of ports around the world, this growth has provided pirates with a wide range of tempting, high-payoff targets. And as more seaborne commercial traffic passes through narrow and congested maritime chokepoints, the ships must reduce their speed to ensure safe passage, heightening their exposure to interception and attack.

No one has bested the 18th-century pirate Bartholomew Roberts’ pithy summation of why piracy exists: “In an honest Service, there is thin Commons, low Wages, and hard Labour; in this, Plenty and Satiety, Pleasure and Ease, Liberty and Power; and who would not balance Creditor on this Side, when all the Hazard that is run for it, at worst, is only a sower Look or two at choaking. No, a merry Life and a short one shall be my Motto.”

The time and place may have changed, but Roberts’ reasoning still holds true. Like Roberts in the 18th century, Somali pirates have little to lose in the 21st. Their country is wracked by chaos and poverty. It is also adjacent to one of the most heavily traveled shipping lanes in the world; 20,000 ships a year pass through the Gulf of Aden. Ransoms for crews can be as high as $3 million. The International Maritime Bureau counted 111 pirate attacks off Somalia in 2008, a threefold increase over the previous year.

For Somalia, piracy is an economic boon, benefiting both the pirates and the economies of the areas in which they live. Somali pirates made an estimated $30 million to $150 million in ransom in 2008 alone. Through purchases of homes, cars, clothes, food, and other amenities, this money ends up boosting the regional economy as well. Just as certain Caribbean ports of call catered to the needs of 17th- and 18th-century pirates, so do certain spots in Somalia cater to the needs of contemporary pirates. The port of Eyl, the Tortuga of Somalia, is booming. It’s even rumored to have restaurants dedicated to feeding hostages.

While it’s pretty clear why some Somalis would become pirates, it might not be as obvious why shipping companies respond the way they do to the pirate threat. Despite increased piracy, the shippers seem to carry on heedless of the danger and without exploring alternative possibilities.

For instance, commercial ships don’t have to go through the Gulf of Aden and around the Horn of Africa. They could avoid the area entirely by going round the Cape of Good Hope. But this route adds 20 days to the trip and brings on many new expenses, which are particularly problematic if competitors keep taking the old short cut.

Even in known pirate waters, commercial crews are rarely armed. Some say the reason is that the varying port laws make it difficult to carry weapons aboard ships. Others argue that pirates are more merciful to unarmed crews than they would be to those packing heat. There’s some truth to both arguments, but the chief rationale for remaining unarmed appears to be more economic than legal.

Overall, the International Maritime Bureau estimates the cost of piracy to the shipping industry to be anywhere from $1 billion to $16 billion per year. That is hardly prohibitive when measured against the annual value of maritime commerce, which in 2005 (the most recent year for which we have reliable figures) totaled $7.8 trillion.

Interestingly, as piracy has become more profitable in recent years, its overall lethality has dropped. That too makes economic sense. George Mason University economist Peter Leeson, author of The Invisible Hook: The Hidden Economics of Piracy, explains in an email: “Since wantonly brutalizing captives would have undermined their ability to make profits, 18th-century pirates typically refrained from doing so. Some crews went as far as to enshrine rules prohibiting prisoner mistreatment in their articles. The Somali pirates seem to have realized the benefits of such rules for their bottom line as well. At least one Somali pirate ‘code’ regulating the treatment of prisoners has been found, and several Somali pirates have claimed that it’s a universal rule among them not to harm innocent sailors they overtake.”

So while piracy may be on the rise, it still falls under the standard costs of doing business that have existed since man first started shipping goods by water. The world’s navies have effectively been tasked with protecting cargo and rescuing crew members.

But should the world’s navies be responsible for protecting shipping? It’s not clear they even can. As Michael Mullen, the chairman of the Joint Chiefs of Staff, told Good Morning America in April, “There are actually 16 nations who have naval vessels out there, and it is a tough area. It’s a tough problem. It’s a big area, over 1.1 million square miles, four times the size of the state of Texas. And it’s a going business for the pirates.”

There are deeper reasons why companies should secure their own ships. After all, their boats, their crews, and their profits are at stake.

In an ideal world, we would leave protection up to the owner of the water in question. But today no one really owns the waters where pirates operate. And if no one owns them, no one protects them. Usually governments exercise an implicit ownership of the waters off their coast, but the absence of credible government in Somalia bars that possibility. What’s more, today’s pirates also operate far from any coasts, in water that nobody claims.

If possible, it would be productive to find ways to privatize those pirate-infested seas. There are obvious difficulties, though not insurmountable ones, in the Somali case, where there’s no central government capable of conducting an auction. The alternative, a bottom-up homesteading approach, might end up granting the waters to the pirates themselves, but the best way to pacify the pirates may be to allow them formal ownership rights. In the long run, privately controlled waters would generate new solutions to the piracy problems. Former pirates, for example, could serve as escorts to commercial ships, not unlike the way retired hackers often emerge as computer security consultants.

No matter what solution emerges, shipping companies, not taxpayers, would bear the costs of their own protection. That in itself is enough reason to start thinking creatively about privatization.

Veronique De Rugy (vdereugy@gmu.edu) is a senior research fellow at the Mercatus Center atGeorge Mason University. This column first appeared in Reason magazine.

The Federal Deficit Grows and Grows

vdereugy@gmu.edu (Veronique de Rugy) — Mon, 01 Jun 2009 00:00:00 EDT

Reason magazine

Beware when politicians promise “fiscal responsibility.” It’s pretty much a guarantee that every word that follows the phrase will be a lie. President Barack Obama’s first budget, entitled An Era of New Responsibility: Renewing America's Promises, is no exception to this rule. Every page comes with a promise to end budget tricks and save money by reforming procurement and cutting various types of waste, but the actual plan boosts spending and deploys gimmicks galore. If this is a new era, it’s one made of debt.

Promise No. 1: “While we have inherited record budget deficits and needed to pass a massive recovery and reinvestment plan…we must begin the hard choices necessary to restore fiscal discipline, cut the deficit in half by the end of my first term in office, and put our nation on sound fiscal footing.”

In fiscal year (FY) 2009, the deficit is projected to be $1.75 trillion. This amount is equal to the entire budget of the United States in FY 2000. The deficit represents 12.3 percent of gross domestic product and results from the federal government spending $3.9 trillion—an increase of 32 percent over 2008—while collecting less than $2.2 trillion in revenue. Most tellingly, the public debt stands at 58.7 percent of GDP, compared to 40.8 percent in 2008.

It is true, as Obama says, that he inherited most of the FY 2009 deficit. It was George W. Bush, with the support of most Republicans in Congress, who engineered a series of expensive bailouts and the federal takeover of the mortgage companies Fannie Mae and Freddie Mac. But it didn’t take long for Obama to add his own billions (see table): $789 billion in “stimulus” (25 percent of which will be spent in 2009), a promise to spend at least another $250 billion to “rescue” more financial institutions, and so on.

To fulfill his promise of “fiscal discipline,” the president would have to shave billions off the federal budget. Yet there are no real program cuts in his budget. Instead the president proposes to dramatically boost health care spending and add many new subsidies for energy companies, students, broadband Internet service, highspeed rail, and low-income Americans.

The result is an expansion of the federal government that will persist long after the current spike of stimulus and bailout spending. Based on government data and Obama’s proposed outlays through 2019, Figure 1 shows the dramatic increase in nonmilitary spending as a percentage of gross domestic product between 1990 and 2019. In 2019 nonmilitary spending would reach 17 percent of GDP. That’s 30 percent higher than at the end of the Clinton years.

And this chart understates Obama’s vision. First, it includes only a down payment for his forthcoming health care plans. Second, it assumes that “temporary” stimulus spending actually will be phased out. Which is not happening. Take the Environmental Protection Agency: Do we really believe that after getting a 92 percent increase in the “stimulus” and a 33.9 percent increase in 2010, the agency will let its budget increase drop to 0.7 percent in 2011?

Promise No. 2: “This budget does begin the hard work of bringing new levels of honesty and fairness to our government. It looks at a full 10 years, making good faith estimates about what costs we would incur; and it accounts for items that under the old rules could have been left out, making it appear that we had billions more to spend than we really do.”

To the president’s credit, this budget does contain some positive changes along these lines. For instance, it includes a number of items that the previous administration did not include in the regular budget, such as the cost of the Iraq war.

But the document is not free of tricks. First, Obama told Congress his budget team has “already identified $2 trillion in savings” to help tame record budget deficits. About half of those “savings” come from proposed tax increases. And the administration lists as “savings” until 2019 the annual $170 billion cost for Iraq, totaling nearly $1.5 trillion. Yet even the Bush administration planned on getting out of Iraq by 2012. Cutting spending that was not going to occur isn’t saving; it’s dissembling.

The president’s budget also claims cuts in discretionary spending by merely shifting several programs from one category of spending to another. One example is Pell Grant funding ($116 billion over 10 years), which is converted from a discretionary program to an entitlement. A recent memo from the House Budget Committee explains that “if these accounting changes were not applied, and the spending continued in the discretionary portion of the President’s budget, non-defense discretionary spending would be…$18 billion higher in 2009 [than what the administration claims] and $24 billion higher in 2010, and would rise to $34 billion higher in 2019.”

Finally, the budget relies on utterly unrealistic economic projections. Obama projects that the economy will be growing by 3.4 percent next year and by 6.2 percent in 2012. Those figures are several percentage points higher than any other reputable forecast.

That's bad news, because even Obama’s doctored projections still show gigantic deficits in our future, dwarfing even the deficits of the Bush years (see Figure 2). While President Obama promises a new era of responsibility, what he’s delivering is a continuation of President Bush’s fiscal recklessness—this time on steroids. Unfortunately, we already know the consequences: slower growth, more unemployment, a lower standard of living, and higher levels of poverty.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University and contributing editor at Reason magazine, where this column first appeared.

Seeing is Believing

vdereugy@gmu.edu (Veronique de Rugy) info@reason.org (Eileen Norcross) — Tue, 12 May 2009 10:05:00 EDT

When President Barack Obama signed the $787 billion stimulus bill in February, he promised the American people transparency and efficient spending. Yet contrary to those promises, there was nothing in the bill to guarantee that the money wouldn't be wasted. In fact, even the president's promise to have a searchable online version of the spending bill has proven to be little more than talk. The result will be billions of dollars shoveled at beautification projects, museums, parks, and street lamps.

Consider the $80 billion of stimulus spending allocated to the states. We've all heard how the money will be spent for critical, urgent "ready-to-go" local projects in transit, infrastructure, housing, airports, and school modernization. Yet there is nothing in the bill explaining how that spending will take place or even what projects will be funded. The U.S. Conference of Mayors gave us a peek in December, and it wasn't pretty. The shovel-ready wish list from 779 cities topped out at $149.7 billion for 18,750 projects.

Based on that list, we can map a worst-case scenario of how cities might spend your money. For instance, the bill appropriates $1 billion for the Housing and Urban Development's Community Development Block Grant (CDBG). Based on the mayors' requests, that money might buy 23 restroom projects, 79 athletic fields, 77 sidewalks and street lighting projects, 3 dog parks, 14 animal shelters, 11 zoos, and 31 museums.

On top of that, $10 billion in public housing funds could be going to projects that have nothing do with shelter or improving public housing safety. The mayors requested millions of "housing" dollars for parking lots and landscaping projects, art centers, security cameras (some at museums), gazebos, domestic violence shelters, sidewalks, shoreline restorations, recreation centers, and playgrounds.

The Senate version of the stimulus bill had provisions designed to stop money from going to wasteful or low-priority uses such as casinos or other gambling establishments, aquariums, zoos, golf courses, swimming pools, stadiums, community parks, museums, theaters, art centers, and highway beautification projects. However, the conference committee abandoned that commitment to rooting out pork and waste. The final bill—now the law—allows money to flow to museums, stadiums, arts centers, theaters, parks, and highway beautification projects.

Here are a few of the ways the states might spend it: There are 20 planned beautification projects—including landscaping and tree planting—for a total of $68 million. Another $868 million is slated for streetscape work, such as edging and sidewalk renovations, 23 of which are in Miami/Dade, Florida alone. Mayors might spend $453 million on 19 entertainment venues, including a new $375 million performing arts center in Las Vegas, not to mention $145 million for 36 theater projects.

This worst-case scenario is not far-fetched. In many instances, the most ludicrous examples from the ready-to-go wish list—such as $2.1 million for a new state-of-the-art eco-conscious "green animal rescue foundation building" for the city of Superior, Wisconsin—aren't examples of fraud. They're run-of-the-mill federal spending. It's perfectly legal to use Public Housing Modernization dollars to buy doorbells and HVAC units. Whether it's a good idea or not is another matter.

Most importantly, the stimulus simply does not have any built-in mechanisms to safeguard taxpayers against wasteful spending. To be sure, the Obama Administration promised to let us track stimulus money through Recovery.gov, a website the administration set up to publish reports on stimulus spending. Supposedly, those who are interested will be able to see certain detailed reports. But there are several glaring problems.

First, the administration doesn't even believe that its plan will work. Earl Devaney, the chief auditor overseeing the stimulus spending, told a House Oversight and Government Reform Committee hearing several weeks ago that some fraud and waste is inevitable. In fact, according to Rep. Dan Burton (R-Ind.), the industry standard level of government fraud is 7 percent. That would mean $55 billion wasted.

As Devaney explained, "The problem will be aggravated by a lack of federal workers needed to oversee the spending. Federal agencies will have difficulty hiring enough skilled workers ‘to minimize the risks associated with moving this amount of money quickly.'" Let's get this straight: The federal government will have massive waste because it can't hire enough bureaucrats to watch what state and local governments are doing with taxpayers' money?

Second, the stimulus bill only requires states and cities to provide project-level receipts for the money they spend. In other words, the money disappears once it changes hands twice. The federal government will disclose how much money it gives to a particular state, and that state must then report back on how the money was first distributed. Beyond that, there's no requirement for disclosing where the money ends up.

None of this will give the American people a clear picture of their stimulus dollars at work. Besides, the devil is always in the details. The essential questions we need answered are as follows: Who got what? What did they buy? And how, if at all, did it help revive the economy?

For a preview of what we can expect from Recovery.gov, visit USASpending.gov, a site created to provide transparency in federal spending. There we can see that in fiscal year 2008, New York City received $656 million from the federal government (channeled through New York State). The city's Office of Community Planning and Development spent $148,500 of that money for the federal Special Neighborhood Initiative. How did the city spend the rest? That information is not online. To find out, you have to call city hall.

Finally, there won't be any real data on Recovery.gov until at least October or even sometime next year. Which means that accountability for a year's worth of stimulus spending is likely to be lost forever. This matters because Congress has already crippled the effort to control wasteful spending by removing a competitive bidding provision from the stimulus package.

Transparency is neither hard nor expensive. Nebraska recently created a budget website giving taxpayers an easy way to track where the state's money is going. After much howling about the expensiveness of the site, in the end it cost the state a mere $38,000. And when it comes to tracking stimulus spending, the private sector is doing it for free. Onvia, a company that matches contractors with government needs, has already launched Recovery.org, a free, searchable database of stimulus projects. (Go here for a Reason.tv video with Onvia's CEO.)

If President Obama means what he says about transparency, he will demand that governors, mayors, city executives, and grantees be required to account for every dime that comes into their hands. And he'll do so now, not in a year. Until American taxpayers are provided detailed information at every stage of the stimulus process, we can only assume the worst.

Veronique de Rugy and Eileen Norcross are economists at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

When Do Deficits Matter?

vdereugy@gmu.edu (Veronique de Rugy) — Mon, 20 Apr 2009 16:01:00 EDT

On January 5, The New York Times reported that “the incoming Democratic chairmen of the House and Senate Budget Committees today called upon the President to work with them on a deficit-reducing package that would include tax increases and spending cuts.” Concerned that deficit projections were unrealistic because they didn’t include military costs, Democrats urged the administration to increase taxes on the wealthiest Americans.

That was January 5, 1987. Ronald Reagan was president, and the deficit had reached almost 5.4 percent of gross domestic product (GDP). Now, three decades later, Democrats have changed their minds about the dangers of deficit spending. In February 2009, the nonpartisan Congressional Budget Office estimated that the deficit will reach $1.2 trillion this year—roughly 8.3 percent of GDP. That giant increase is attributable mainly to Washington’s September 2008 bank bailout and the federal takeover of mortgage lenders Fannie Mae and Freddie Mac.

And that figure assumes that the 2009 budget issued last year by the Bush administration will stay at its proposed level, which it surely won’t. The calculation does not include the cost of the Iraq and Afghanistan wars, and it doesn’t include the chunk of the new $787 billion stimulus bill that will be spent in 2009. Add all these numbers together, and the deficit swells to $2 trillion, or roughly 13.5 percent of GDP (see Figure 1).

This is by far the highest share of the economy that deficits have taken up since World War II. It is well over twice the record set by Ronald Reagan in the 1980s. Yet we don’t see Democrats denouncing the deficit explosion on the network news, like they did two decades ago.

The Democrats aren’t the only ones who have reversed their opinions about deficits. Republicans were relatively comfortable with Reagan’s unbalanced budgets. And when President George W. Bush turned a massive surplus into a series of giant deficits, few in the GOP objected. During the administration’s internal debates over proposed tax cuts in 2002, Vice President Dick Cheney reportedly told Treasury Secretary Paul O’Neill that “Reagan proved deficits don’t matter.”

In a 2007 interview with Fortune, Cheney refined his position, explaining that “you’ve got to evaluate them relative to other priorities. Another priority, for example, would be defending the nation in wartime.”

In other words, if the spending that creates deficits supports your party’s programs, fiscal irresponsibility doesn’t matter. Republicans don’t mind deficit spending if the trade-off is tax cuts and more money for the military. Democrats tolerate deficits when they buy goodies for union workers and allow other increases in domestic outlays.

But can you blame politicians for flipflopping on the issue? Economists—even free market ones—can’t agree on whether deficits matter either.

The main academic debate over deficit spending is whether it raises long-term interest rates and therefore reduces economic growth. Some economists believe that deficits financed by borrowing increase the demand for capital. This in turn increases the price of capital—i.e., interest rates. Higher interest rates then increase the cost of doing business, which slows down the economy.

Others disagree. In 1987, for instance, the Harvard economist Robert Barro wrote in his textbook Macroeconomics that “this belief does not have evidence to support it.” When deficits get bigger, he argued, individuals increase their savings to offset government spending.

Even without assuming Barro’s private savings offset, scholars haven’t been able to find a clear correlation between interest rates and deficit spending. In 1993, for instance, the North Carolina State University economist John Seater surveyed the academic studies on deficits and interest rates. After reviewing the literature, Seater concluded that the data “are inconsistent with the traditional view that government debt is positively related to interest rates.”

Figure 2 shows 30-year mortgage rates, inflation rates, and deficits as a percentage of GDP during the last three decades. Although the federal budget deficit both rose and fell during this period, the 30-year mortgage rate has trended consistently downward.

Still, most free market economists are more cautious about denying a correlation exists. Arnold Kling, an adjunct scholar with the Cato Institute who blogs at EconLog, argues that the reason we haven’t seen a correlation between budget deficits and interest rates so far is that foreign investment in American assets has increased over the years, dulling the impact of fiscal policy. The real question—and the real threat—is what will happen if that investment stops, or even if it merely slows down.

Moreover, deficits have reached a level that economists haven’t really studied before. Current circumstances remind Kling of “a guy jumping out of a building from the 10th floor, passing the third floor, and saying, ‘It’s all fine so far.’ ” Deficits do not matter up to a certain point. But at which level do we hit the ground with a splat? Ten percent of GDP? Twenty percent?

Economic debates aside, deficits certainly do matter if you care about shrinking the size of the state. Budget gaps are a kind of Ponzi scheme. Any year the federal government spends more money than it collects in tax revenue, we have a budget deficit. That means the citizens through their taxes authorize politicians to spend a certain amount yet the government spends more.

The plan is to pay this additional spending back with future taxes, just as Bernard Madoff figured he’d pay off early investors with dollars from pigeons he conned down the road. As with any Ponzi scheme, there will inevitably come a time when the con is exposed, along with all the participants’ losses.

John Maynard Keynes, the 20th century’s preeminent defender of deficit spending, famously quipped, “In the long run, we are all dead.” Keynes did not give much guidance, though, on how we would pay for the funeral.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

The End of Financial Privacy

vdereugy@gmu.edu (Veronique de Rugy) — Fri, 20 Mar 2009 16:04:00 EDT

Despite a long, storied history of protecting financial privacy, Switzerland, Luxembourg, and Austria recently announced that they will soften rules on banking secrecy to root out tax dodgers for foreign countries. Fearful that they might be missing a chance to collect more taxes, European bureaucrats have pressured the three countries to change their policies for years. After the Organization for Economic Cooperation and Development (OECD) threatened to put them on a blacklist of tax havens just before the start of April's Group of 20 (G-20) meetings, Switzerland, Luxembourg, and Austria have finally caved.

Bank secrecy laws have long been seen as an obstacle to tax enforcement. Supposedly by setting up "safe havens" for French euros, bank secrecy laws get in the way of the French government forcing its high income tax rates down its taxpayers' throats. The only way to fix this problem, the French argue, is for all nations to implement an automatic and unlimited exchange of information about nonresident investment. So-called tax havens, goes this line of thinking, should collect private financial data on foreigners and turn that information over to the appropriate governments.

Forcing relatively low-tax jurisdictions to serve as vassal tax collectors for European welfare states is a brilliant idea if one wants to preserve higher-tax policies and impose multiple layers of taxation on saved and invested income. It is a death blow to healthy tax competition, since it would permanently undermine the right of nations to determine how income earned inside their borders—such as interest paid to foreigners on the income they invest in another country—is taxed. Like other forms of economic competition, tax competition is good at generating new and innovative ways of doing business and creating value. But European politicians have always claimed that tax competition and the financial privacy that goes along with it simply abets tax evasion. The politicians want instead a policy of "tax harmonization," which they think would make countries less competitive and reduce capital flight from one place to another.

However, basic economic theory tells us that if a country wants to reduce tax avoidance and evasion, all it has to do is lower its own tax rates and simplify its tax code. These are far more effective tools for thwarting tax evasion and reducing capital flight than tax harmonization across a number of countries. European governments should give tax reform a try instead of trying to force other nations to adopt a single, uniform system.

But most of them won't, and as they keep losing capital to lower-tax nations, they will continue to try to undermine countries with strong privacy laws. Until now the European Union (E.U.) failed to force countries such as Switzerland and Luxembourg to give up their privacy laws, mainly because the United States refused to agree to participate in the shared information schemes pushed by the E.U. As one of the biggest recipients of foreign capital, the U.S. knew that it had much to lose.

So why would Switzerland, Austria, and Luxembourg cave now? The Paris-based OECD announced that it was preparing an updated list of uncooperative tax havens for presentation at the April 2 summit of the leaders of the G-20 countries. These meetings traditionally feature politicians from around the world jockeying to promote bad ideas. This one looks to be no exception, with members planning to discuss sanctions on banking centers that fail to provide legal assistance with international tax probes.

Switzerland, Austria, and Luxembourg were on the new OECD blacklist. After meeting together to discuss the matter, the countries decided to give up their years of resistance to avoid the financial consequences of being treated as rogue financial states. It didn't help that the U.S. and China—two countries who might have been on their side in the past—are going to the meeting with some bad ideas of their own, such as convincing unwilling Europeans to spend more money on stimulus-spending plans. In order to have a better shot at getting what they want regarding pump-priming, Switzerland, Austria, and Luxembourg seem more than ready to sacrifice previous stands on financial privacy. After all, neither the Obama administration nor China appears to value financial privacy much anyway.

While that sort of political compromise is understandable, it is sad news for those who do value financial privacy—or any other kind of privacy. Switzerland claims that it will share information only after a country issues a detailed request on an individual case. Don't count on it. German Finance Minister Peer Steinbrueck has told Der Spiegel that he wants countries like Switzerland to unveil the names of their account holders "even when there's no concrete suspicion of tax evasion." Like virginity, financial privacy is awfully difficult to regain once surrendered.

Veronique de Rugy is a Reason columnist (read her archive here) and an economist at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Stimulating Ourselves to Death

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 17 Mar 2009 15:40:00 EDT

Barack Obama says his “unprecedented” economic stimulus package will not merely be “a short-term program to boost employment.” No, it “will invest in our most important priorities like energy and education; health care; and a new infrastructure that are necessary to keep us strong and competitive in the 21st century.”

The massive cost of the stimulus doubled even before any legislation was written, much less approved. Originally tagged at $400 billion, the proposal quickly jumped to $825 billion, and latest estimates at press time have it costing north of $1 trillion (comprised of 60 percent spending and 40 percent tax cuts).

Given the size, will the stimulus work as advertised? Will the goods and services—be they concrete for new highway projects or groceries for hungry families—pump up flagging demand and boost stalled economic activity?

If so, it will be the first time in modern recorded history.

Take the New Deal. According to the economists Christina Romer—chair of Obama’s Council of Economic Advisers—and David Romer, New Deal spending did not pull the economy out of recession. In a 1992 Journal of Economic History paper, the Romers examined the role that aggregate demand stimulus played in ending the Great Depression. They concluded: “A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods.”

Even the massive spending during World War II, long touted as pulling America out of the Depression, didn’t necessarily help. In a 2006 paper for the National Bureau of Economic Research, the economists Joseph Cullen and Price V. Fisher asked whether the local economies that were the biggest beneficiaries of federal spending on military mobilization during World War II experienced more rapid growth in consumer economic activity than others. Their finding: Military spending had virtually no effect on consumption.

Another economist, Robert Higgs, offered an even more thoroughgoing critique in an excellent 1992 Journal of Economic History paper. After challenging the conventional portrayal of economic performance during the 1940s, Higgs concluded that “the war itself did not get the economy out of the Depression. The economy produced neither a ‘carnival of consumption’ nor an investment boom, however successfully it overwhelmed the nation’s enemies with bombs, shells, and bullets.” Breaking windows in France and Germany didn’t bring prosperity in America.

In his 2008 book Macroeconomics: A Modern Approach, Harvard economist Robert Barro shows that $1 of government spending in wartime produces less than $1 in GDP—80 cents, to be exact. Stanford economist Bob Hall and Sand Hill Econometrics chief Susan Woodward, neither particularly pro-market, argued recently that each dollar of government spending during World War II and the Korean War produced about $1 of GDP. In other words, the economy is not stimulated by war spending.

The example of 1990s Japan, with its collapsed housing and stock markets, is also relevant. Between 1992 and 1999, Japan passed eight stimulus packages totaling roughly $840 billion in today’s dollars. During that time, the debt-to-GDP ratio skyrocketed, the country was rocked by massive corruption scandals, and the economy never did recover. All Japan had to show for it was some public works projects and a mountain of debt.

Finally, the Bush administration passed the Tax Relief Act of 2001 and the Economic Stimulus Act of 2008, two similar packages with similar effects on the economy. Which is to say, not much. In 2008 the major component was sending $100 billion in cash to Americans so they would have more to spend and thus jumpstart the economy. It failed. People spent little if anything of the temporary rebate, and consumption did not recover.

The chart shows how personal disposable income jumped at the time of the rebate while personal consumption did not increase noticeably. Formal statistical work by Joel Slemrod, a professor of tax policy at the University of Michigan, has shown that rebates generally produce no statistically significant increase in consumption.

The theory of economic stimuli suffers from several serious problems. First, it assumes people are stupid. Tax rebates, for example, presume that if people get some money to increase their consumption, businesses will expand their production and hire more workers. Not true. Even if producers notice an upward blip in sales after the rebate checks go out, they will know it’s temporary. Companies won’t hire more employees or build new factories in response to a temporary increase in sales. Those who do will go out of business.

Second, the thinking behind stimulus legislation assumes that the government is better at spending $825 billion than the private sector. When Obama says, “We’ll invest in what works,” he means, “unlike you bozos.” The president’s faith in Washington is sweet, but politics rather than sound economics guide government spending. Politicians rely on lobbyists from unions, corporations, pressure groups, and state and local governments when they decide how to spend other people’s money. By contrast, entrepreneurs’ decisions to spend their own cash are guided by monetary profit and loss. That’s likely to work better and certain to produce more innovation.

The biggest problem is that the government can’t inject money into the economy without first taking money out of the economy. Where does the government get that money? It can a) borrow it or b) collect it from taxes. There is no aggregate increase in demand. Government borrowing and spending doesn’t boost national income or standard of living; it merely redistributes it. The pie is sliced differently, but it’s not any bigger.

In fact, the data suggest that stimuli often end up shrinking the pie. In a 2008 paper, budget analyst Brian Riedl of the conservative Heritage Foundation summarized several studies that found past increases in government spending reduced the economic growth rate by between 0.14 and 0.36 percentage point. This means that every dollar’s worth of production used to satisfy the government’s demand is offset by more than a dollar’s worth of production that is no longer available to consumers and businesses.

Present or future tax increases that fund government spending often end up burdening the economy. Such was the case in the 1930s, during World War II, and in 1990s Japan. Thankfully, the 2001 and 2008 tax rebates, while ineffective as stimuli, didn’t make things worse.

If politicians actually want to do something cost-effective to solve our economic woes, here’s some advice: Stay away from spending and tax rebates. Instead, focus on real incentives to work and invest, such as cutting marginal tax rates for everyone.

Contributing Editor Veronique de Rugy is an economist at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Here's What $800 Billion Buys Today

vdereugy@gmu.edu (Veronique de Rugy) — Fri, 13 Feb 2009 16:08:00 EST

The final version of the stimulus bill is ready to be voted on by the House and the Senate.

Here's the good news: The $246 million tax credit to Hollywood that made its way to the initial House bill and was removed in the Senate version didn't make it to the final bill.

That's pretty much it for the good news.

Total spending amounts to $792 billion, with $570 billion in direct spending and $212 billion in tax provisions. These numbers don't include the massive amount of interest that will accrue on the increased debt. If we include that, the total amount comes to $1.14 trillion.

Supporters of the package describe the legislation as transportation and infrastructure investment, the idea being to use new spending to put America back to work while at the same time fixing decrepit infrastructure. However, only 17 percent of the discretionary spending in this package is for infrastructure items. More worrisome still, the final version lacks any mechanism to ensure that spending will be targeted toward infrastructure projects with high economic returns.

The conference report dedicates 30 percent of all discretionary spending to 33 new programs totaling $95 billion and expands 73 programs which are normally part of the regular appropriations process by $92 billion.

In one interesting twist, the conference committee dropped many of the prohibitions included in the version passed by the Senate. These prohibitions were the result of an amendment sponsored by Sen. Tom Coburn (R-Okla.) last week. The Senate voted 73-24 to prohibit wasteful or low-priority spending items from the bill. The amendment read as follows:

None of the amounts appropriated or otherwise made available by this Act may be used for any casino or other gambling establishment, aquarium, zoo, golf course, swimming pool, stadium, community park, museum, theater, art center, and highway beautification project.

However, the conference version includes the following provision, which drops many of the prohibitions from that list.

SEC. 1604. none of the funds appropriated or otherwise made available in this Act may be used by any State or local government, or any private entity for any casino or other gambling establishment, aquarium, zoo, golf course, or swimming pool.

So now funds can go to museums, stadiums, arts centers, theaters, parks, or highway beautification projects. Most significantly, this reopens the door for many of the projects on the U.S. Conference of Mayors' wish list of "shovel ready" projects that includes many items that are nothing but waste and pork, such as doorbells, construction of dog parks, replacement of street lights, and money for a "mob museum."

To get a sense of what made it through the supposedly thorough "scrubbing" process, consider the following povisions:

$24 million for United States Department of Agriculture buildings and rent
$176 million for renovating Agricultural Research Service buildings
$290 million for flood prevention
$50 million for watershed rehabilitation
$1.4 billion for wastewater disposal programs
$295 million for administrative expenses associated with food stamp programs
$1 billion for the 2010 Census
$200 million for public computer centers at community colleges and libraries
$650 million for the digital TV converter box coupon program
$2 billion for Byrne Justice Assistance Grant program
$10 million to combat Mexican gunrunners
$125 million for rural communities to combat drug crimes
$1 billion for the Community Oriented Policing Services program
$1 billion for NASA
$300 million to purchase scientific instruments for colleges and museums
$400 million for equipment and facilities at the National Science Foundation
$3.7 billion to conduct "green" renovations on military bases
$375 million for Mississippi River projects
$10 million for urban canals
$5 billion for weatherizing buildings
$2 billion to develop advanced batteries for hybrid cars
$3.4 billion for fossil energy research
$5.1 billion for environmental cleanup around military bases
$5.5 billion for "green" federal buildings
$300 million for "green" cars for federal employees
$20 million for IT upgrades at the Small Business Administration
$200 million to design and furnish Department of Homeland Security headquarters
$98 million earmarked for a polar icebreaker
$210 million for State and local fire stations
$125 million to restore trails and abandoned mines
$146 million for trail maintenance at National Park Service sites
$140 million for volcano monitoring systems
$600 million for the Environmental Protection Agency Superfund environmental cleanup program
$200 million to clean up leaking underground storage tanks
$500 million for forest health and wildfire prevention
$25 million for the Smithsonian Institution
$50 million for the National Endowment for the Arts
$1.2 billion for "youth activities" (for "youth" up to 24 years old)
$500 million earmarked for National Institute of Health facilities
$1 billion for Head Start Program
$32 million for home-delivered nutrition services
$160 million for volunteer programs at the Corporation for National and Community Service
$500 million earmarked for the SSA National Computer Center in Maryland
$220 million for the International Boundary and Water Commission, U.S. and Mexico
$8 billion for high-speed railways (This amount is 4 times higher than the one voted on Tuesday in the Senate bill)
$1.3 billion for Amtrak

On the tax side of the package, the tax credit for golf carts was retained, along with $300 million for Federal Employee Company Cars. And despite the role that home buying played in putting the economy into recession, the conference report also includes tax credits—up to $15,000—for buying new homes.

Perhaps the worst part, however, appears in Section 1607 of the final bill. This section essentially says that if a governor refuses to accept stimulus funds allocated to his or her state, the state legislature can override the governor's decision by passing a concurrent resolution. It means that governors, such as South Carolina's Gov. Mark Sanford, who have said that they would not accept the money, could be overridden by their state legislative bodies.

It's a terrible bill, in other words, both on its face and in the details. For the reasons I detailed here, it won't stimulate the economy. It violates many of President Obama's promises. Most of the deals that created it were made behind closed doors, meaning that there is virtually zero transparency and no real way to track where, how, or why money is being spent. On top of that, the bill is still packed with items that any vaguely impartial observer would call pork.

But once it hits Obama's desk, we'll be calling it the law.

Veronique de Rugy is a columnist at Reason magazine and an economist at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Why the Stimulus Plan Won't Work

vdereugy@gmu.edu (Veronique de Rugy) — Fri, 13 Feb 2009 16:03:00 EST

President Barack Obama insists that the massive $800 billion stimulus package is necessary to avoid "catastrophe." Indeed, during his first primetime news conference, Obama said bigger was better, and pointed to Japan's failed stimulus packages as a reason to go really big.

"We saw this happen in Japan in the 1990s, where they did not act boldly and swiftly enough," Obama stated. "And, as a consequence, they suffered what was called the lost decade, where essentially, for the entire '90s, they did not see any significant economic growth."

Obama is right to cite the example of Japan. That nation's collapsed housing and stock markets in the 1990s are very relevant to today's recession. Between 1992 and 1999, Japan passed eight stimulus packages, totaling roughly $840 billion in today's dollars. During that time, the debt-to-Gross Domestic Product (GDP) ratio skyrocketed, the country was rocked by massive corruption scandals, and the economy never recovered. All Japan had to show for it was a mountain of debt and some public works projects that look suspiciously like bridges to nowhere.

Will the goods and services in the Democrats' stimulus plan—be they concrete for new highway projects or groceries for hungry families—pump up flagging demand and boost stalled economic activity?

If so, it will be the first time in recorded history.

Take the New Deal. According to the economists Christina Romer, chair of Mr. Obama's Council of Economic Advisers, and David Romer, New Deal spending did not pull the economy out of recession. In a 1992 Journal of Economic History paper, the Romers examined the role that aggregate demand stimulus played in ending the Great Depression. They concluded: "A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods."

Even the massive spending during World War II, long touted for pulling America out of the Depression, didn't necessarily help. In a 2006 paper for the National Bureau of Economic Research, economists Joseph Cullen and Price V. Fisher asked whether the local economies that were the biggest beneficiaries of federal spending on military mobilization during World War II experienced more rapid growth in consumer economic activity than others. Their finding: Military spending had virtually no effect on consumption.

Another economist, Robert Higgs, offered an even more thoroughgoing critique in an excellent 1992 Journal of Economic History paper. After challenging the conventional portrayal of economic performance during the 1940s, Higgs concluded that "the war itself did not get the economy out of the Depression. The economy produced neither a 'carnival of consumption' nor an investment boom, however successfully it overwhelmed the nation's enemies with bombs, shells, and bullets." Breaking windows in France and Germany didn't bring prosperity in America.

Most taxpayers are familiar with the two most recent failed stimulus experiments. The Bush administration passed the Tax Relief Act of 2001 and the Economic Stimulus Act of 2008, two similar tax rebate packages with similar effects on the economy. Which is to say, not much. In 2008, the major component was sending $100 billion in cash to Americans so they would have more to spend and thus jump-start the economy. It failed. People spent little, if anything, of the temporary rebate, and consumption did not recover.

The theory of economic stimuli suffers from several serious problems. First, it assumes people are stupid. Tax rebates, for example, presume that if people get money to increase their consumption, businesses will expand their production and hire more workers. Not true. Even if producers notice an upward blip in sales after the rebate checks go out, they will know it's only temporary. Companies won't hire more employees or build new factories in response to a temporary increase in sales. Those who do will go out of business.

Second, the thinking behind stimulus legislation assumes that the government is better at spending $800 billion than the private sector. When President Obama says, "We'll invest in what works," he means, "unlike you bozos." The president's faith in Washington is charming, but politics rather than sound economics guide government spending. Politicians rely on lobbyists from unions, corporations, pressure groups, and state and local governments when they decide how to spend other people's money. By contrast, entrepreneurs' decisions to spend their own cash are guided by monetary profit and loss. That's likely to work better and certain to produce more innovation.

But the biggest problem is that the government can't inject money into the economy without first taking money out of the economy. Where does the government get that money? It can either borrow it or collect it from taxes. There is no aggregate increase in demand. Government borrowing and spending doesn't boost national income or standard of living; it merely redistributes it. The pie is sliced differently, but it's not any bigger.

Stimulus packages—and present or future tax increases that fund government spending—end up burdening the economy. Such was the case in the 1930s, during World War II, and in 1990s Japan. Thankfully, the 2001 and 2008 tax rebates, while ineffective as stimuli, didn't make things worse.

If politicians actually want to do something cost-effective to solve our economic woes, here's some advice: Stay away from spending increases and tax rebates. Instead, focus on real incentives to stimulate work and investment, such as cutting everyone's marginal tax rates, slashing payroll taxes for employees and employers, and ending the corporate income tax.

Veronique de Rugy is a columnist at Reason magazine and an economist at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

800 Billion Reasons To Be Worried

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 10 Feb 2009 15:44:00 EST

How bad is the stimulus bill just passed by the Senate? Well, at least as bad as the one passed last week by the House of Representatives, but probably not as bad as the final bill that will land on President Barack Obama's desk, possibly as soon as the end of this week.

Don't take my word for it. In a report to Sen. Judd Gregg (R-N.H.), the nonpartisan Congressional Budget Office (CBO) laid out in plain English—well, economic language—that the Senate bill would eventually cause not a stimulus but a recession in "the longer run." As CBO's director Douglas W. Elmendorf wrote on February 4:

At your request, the Congressional Budget Office (CBO) has conducted an analysis of the macroeconomic impact of the Inouye-Baucus amendment in the nature of a substitute to H.R. 1 [the House stimulus bill]. CBO estimates that this Senate legislation would raise output and lower unemployment for several years, with effects broadly similar to those of H.R. 1 as introduced. In the longer run, the legislation would result in a slight decrease in gross domestic product (GDP) compared with CBO’s baseline economic forecast.

On the CBO's The Director’s Blog, Elmendorf explains why the Senate legislation would eventually reduce economic output: “The principal channel for this effect is that the legislation would result in an increase in government debt. To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to 'crowd out' private investment—thus reducing the stock of private capital and the long-term potential output of the economy.”

The CBO's latest projection for fiscal year 2009's deficit is that it will reach $1.2 trillion (that’s eleven zeros after the 2) before factoring in any stimulus spending or war spending. That’s 8.3 percent of GDP and far higher than any deficit under President Ronald Reagan in the 1980s (when deficits reached 6 percent of GDP). In fact, you have to go back to World War II to find deficits higher than the projections for FY 2009.

Truly massive deficits won't surprise anyone who has looked at the Senate version of the stimulus bill. Much has been made over the "compromises" and negotiations behind the Senate finally arriving at something that garnered enough support for passage. Here are three large categories of expenditures where senators managed to sort out their differences and find a compromise that they can all live with. If only things were so simple for us taxpayers.

1. Billions of dollars in spending exclusively devoted to benefit federal employees.

$5.5 billion for making federal buildings "green" (including $448 million for the Department of Homeland Security's headquarters)
$198 million to design and furnish the DHS headquarters
$200 million for workplace safety in Department of Agriculture facilities
$75 million for the Smithsonian Institution
$300 million more for hybrid and electric cars for federal employees (see below)
$180 million for construction of Bureau of Land Management facilities
$500 million for wildland fire management
$110 million for construction for the U.S. Fish and Wildlife Service
$522 million for construction for the Bureau of Indian Affairs
$412 million for Centers for Disease Control headquarters
$500 million earmark for National Institutes of Health facilities in Bethesda, Maryland
$100 million for constructing U.S. Marshalls office buildings
$300 million for constructing Federal Bureau of Investigation office buildings
$800 million for constructing Federal Prison System buildings and facilities
$307 million for constructing National Institute for Standards and Technology office buildings
$1 billion for administrative costs and construction of National Oceanic and Atmospheric Administration office buildings

That spending was added to an earlier version of the bill, which also benefited federal employees by splurging on things such as the following:

$600 million to buy hybrid vehicles for federal employees
$125 million for the Washington, D.C. sewer system
$75 million for salaries of employees at the FBI
$6 billion to turn federal buildings into “green” buildings
$88 million for renovating the headquarters of the Public Health Service
$5.5 million for “energy efficiency initiatives” at the Veterans Administration's “National Cemetery Administration”
$60 million for Arlington National Cemetery
$75 million to construct a new “security training” facility for State Department Security officers when they can be trained at existing facilities of other agencies
$110 million to the Farm Service Agency to upgrade computer systems
$200 million in funding for the lease of alternative energy vehicles for use on military installations

2. Wasteful spending that is not directly targeted at federal employees:

Arguably the best item in the Senate bill is a $1,500 tax credit to anyone that purchases “neighborhood electric vehicles”—also known as golf carts. The total estimated cost of that giveback is $300 million. Purchasers of motorcycles and three-wheelers shouldn't despair, however, as there are benefits available for them, too.

And then there are these:

$2 billion for a FutureGen near-zero emissions powerplant in Mattoon, Illinois
$2 billion for manufacturing advanced batteries for hybrid cars
$650 million for the digital TV (DTV) transition coupon program
$1.2 billion for summer jobs for youth
$200 million for public computer centers at community colleges and libraries
$750 million earmark for the National Computer Center
$10 million to fight Mexican gun-runners
$850 million for Amtrak (on top of its regular subsidy)
$100 million for lead paint hazard reduction
$275 million for flood prevention
$65 million for watershed rehabilitation
$650 million for abandoned mine sites
$1.3 billion for NASA (including $450 million for "science" at NASA)
$100 million to clean up sites used in early U.S. atomic energy program
$10 million for urban canals
$1.5 billion for carbon capture projects under sec. 703 of P.L. 110-140 (though the original section only authorizes $1 billion for five years)
$500 million for state and local fire stations

3. Tax cuts and tax breaks that don't deliver anything close to real reform.

The Senate bill supposedly wooed a few recalcitrant Republicans by trimming spending (see above) and throwing in simple, clear-cut, and effective tax cuts. The tax portions of the Senate stimulus bill do contain approximately 40 separate tax-related provisions aimed at boosting the economy, amounting to an estimated $385.3 billion in cuts and government give-backs.

The Senate might have done something straightforward, like cutting the corporate income tax or cutting the payroll tax that all workers pay. Instead, most of the provisions are tax credits, many of which are refundable. In other words, individuals and businesses need to pay their taxes up front and then will get money back from the government. These sorts of programs, aimed incentivizing investment, are better understood as spending programs disguised as “tax cuts.”

Among the various tax provisions are programs such as the following:

The “Making Work Pay” credit: This would provide a refundable tax credit of $500 to individuals making up to $75,000 and a credit of $1,000 for couples making up to $150,000. It is intended to act as a refund of the Social Security payroll taxes paid by workers, though even those with no tax liability would also qualify to receive a check from the government for the amount of the refundable credit. Additionally, workers receiving this tax credit would receive credit as if they had paid into Social Security and thus accrue benefits toward a retirement pension. The Making Work Pay tax credit is the centerpiece of the Obama “tax cuts."

However, they are akin to welfare checks. Such tax credits are not likely to stimulate the economy because they provide no incentive for individuals to be more productive, but would simply pay them whether or not they were productive. Also, the potential consumption that might result from the tax credits will not have an effect on job creation. Business owners might notice a blip in their sales but they know that it is the result of a one-time tax credit. They won’t build new factories or hire more employees based on a blip. The total cost of this is expected to be $140 billion.

Temporary Increase in the Earned Income Tax Credit or EITC: The EITC is a refundable tax credit available to low-income individuals, which increases with the number of children. Those that earn approximately $13,000 per year receive the maximum benefit (currently $5,028) and those who earn higher incomes receive lesser amounts. The stimulus proposal would increase the tax credit for those with three or more children, raising the total tax credit by about $600. EITC is essentially a welfare program, and while it may help shield its recipients from poverty, it is purely redistributive and will not spur economic growth.

Temporary Increase of Refundable Portion of Child Credit: Individuals with children qualify to receive a refundable tax credit of $1,000 per child until 2010, at which point it returns to $500 per child. If the individual does not owe any taxes, the tax credit is refundable only for those that make more than $12,550, which is intended to assist low-income working parents. The stimulus proposal would lower the amount that parents would have to earn to $6,000. By lowering the amount of income to $6,000, it might decrease the incentive for people to be profitably employed, and therefore would have the opposite of a stimulative effect on the economy.

Waiver of Requirement to Repay First-Time Homebuyer Credit: Current law allows first-time homebuyers to receive an interest-free federal loan of $7,500 (in the form of a refundable tax credit) to purchase a home. The loan has to be repaid over 15 years through an individual's tax returns. The stimulus proposal would waive the repayment requirement, effectively giving all first-time homebuyers a $7,500 credit. This proposal may stimulate the purchase of homes, but do we really need the government to push people toward home purchases? In a time when the housing market is contracting to correct the abuses of the past, it is misguided to assume that additional interventions to spur home purchases will help the economy.

Build America Bonds: The stimulus creates an incentive to invest in municipal bonds that provide financing for public building projects. Like many of the other bonding provisions in the bill, this gives an incentive for private capital to flow toward public investment rather than private. Public investments are only going to promote economic growth if the government decides to use the funds more productively than they would otherwise be used in the private sector. There is no reason to think, however, that the government has suddenly become better at investing people’s money.

There are many more bad policies and spending decisions in the Senate stimulus bill, but even a cursory glance at the parts outlined above give a good sense of the overall legislation—and what is likely to be signed into law by President Obama.

And here is one more thing to consider: There is absolutely no evidence that any stimulus package in the past 80 years has goosed economic activity—not FDR’s during the Great Depression, not Japan’s during the 1990s, and not George W. Bush’s in 2001 and 2008. If anything, the economic evidence suggests that such spending packages actually intensified and prolonged misery.

Instead of rushing through legislation that will likely have no short-term effect on the economy, is guaranteed to have negative long term ones, and that serves the traditional interest groups that politicians are always busy catering to, the Senate should have cut spending like Ireland is now doing and cut marginal tax rates across the board. That would not only have stimulated the economy, it would have been fiscally responsible considering the massive entitlement crisis that is coming our way. But such legislation, alas, will have to wait for another day. Or another crisis.

Veronique de Rugy is a Reason columnist and a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Dissatisfaction Guaranteed

vdereugy@gmu.edu (Veronique de Rugy) — Mon, 09 Feb 2009 14:55:00 EST

Each time an auto company, small business, or homeowner receives a politically motivated loan guarantee, the giveaway creates yet another unfunded liability for future taxpayers. Now, in response to the economic crisis, the feds have provided more than $8 trillion in new guarantees. Aside from attempting to halt an alarming decline in lending, the loans’ supporters give four justifications for the programs.

First, they claim certain entities are being denied access to credit through no fault of their own. Supposedly, even in boom times, lenders pass over many opportunities to issue loans to borrowers who, despite appearances to the contrary, are creditworthy. This argument sounds especially persuasive at a time like now, when interbank lending is frozen and subprime lending has disappeared.

Second, loan advocates argue that the recipients will generate economic growth that otherwise would not occur.

Third, they say additional social goods can be derived from goosing the credit markets. Widespread homeownership, for example, is seen as increasing the country’s stability and prosperity.

Finally, there is the notion that keeping particular firms alive enhances the common good, whether because they provide essential consumer services, add to competition in certain markets, or employ significant numbers of people. In some cases, politicians call for supplying credit to an entire industry (e.g., the banking system) or a huge portion of it (e.g., U.S.-owned automakers).

The federal government guarantees loans to induce banks to lend money to credit-risky borrowers. If the borrower defaults, the government reimburses the lender for either the entire loss that the lender would otherwise sustain or a large fraction of it. With this guarantee, banks are willing not only to lend money to high-risk borrowers who couldn’t get loans without it but also to grant more favorable terms to existing customers.

In a normal year, Washington guarantees roughly $150 billion in loans through more than 20 programs. The Small Business Administration has six loan guarantee programs that total $40 billion. The Department of Energy has a program that places nearly $40 billion in taxpayers’ money at risk each year. The Department of Housing and Urban Development guarantees another $40 billion.

Of course, 2008 was not a normal year. Within just three months, the federal government guaranteed almost $8 trillion in investment, deposits, and loans as part of the financial bailout. On the loan side, Washington will be backing the bulk of Citigroup’s $300 billion portfolio; it will also guarantee an unquantifiable amount of modified subprime loans and lines of credit to the cash-hungry auto industry. In addition, the government will continue subsidizing, through taxpayer guarantees, the expansion of the government-sponsored mortgage buyers Freddie Mac and Fannie Mae.

Before the financial crisis, total taxpayer exposure via loan programs—the cost if every borrower defaulted—was about $500 billion, taking interest into account. With the additional guarantees now totaling more than half of GDP, taxpayers’ exposure has grown exponentially while their ability to repay the loans has if anything shrank.

Such a risk would seem to call for strict oversight of how these loans turn out, both in terms of default rates and social goods. Yet until now the federal government has refused to systematically measure the performance of its 40 existing loan programs. Why? Perhaps because the data show that most of them never deliver any of the promised social and economic value.

Historically, loans guaranteed by the government have a very high default rate. The Congressional Budget Office has calculated that the risk of default on the Department of Energy’s nuclear loan guarantee program, for example, is well above 50 percent. The Small Business Administration (SBA), according to its own Inspector General’s Office, has a long-term default rate of roughly 17 percent. This compares to 4.3 percent for credit cards and 1.5 percent forbank loans guaranteed by the Federal Deposit Insurance Corporation.

Faced with this track record, lawmakers often counter that the programs charge lenders a fee for each loan to offset the costs that defaults impose on taxpayers. But these fees are rarely high enough to cover the true cost of defaults, especially during economic downturns.

Federally backed loans create a classic moral hazard. Because the loan amount is guaranteed, banks have less incentive to evaluate applicants thoroughly or apply proper oversight. Not only are the borrowers high-risk to begin with, but it’s not necessarily cost-effective for lenders to identify the best of these bad applicants.

These bad incentives are among the reasons for the financial crisis to begin with. For years, the government has encouraged banks to extend credit to noncreditworthy borrowers and to make larger loans than a market would normally bear even to creditworthy borrowers. It did this by explicitly and implicitly guaranteeing certain banks’ losses.

It’s irresponsible to keep encouraging banks to lend money to borrowers they wouldn’t assist if their own money were on the line. It is a good thing that banks today won’t lend money to people who can’t afford to pay it back. That doesn’t mean all credit markets are, or should be, frozen. Even in the current housing market, for instance, borrowers with decent credit histories and down payments still have access to mortgages.

It’s also worth noting that interbank lending froze completely when the bailout was announced. Why take the risk when Washington can force taxpayers to take it for you?

Nor are such programs likely to stave off massive job losses. In a 2003 speech to the National Economists Club in Washington, D.C., then–Federal Reserve Governor Edward M. Gramlich argued that loan guarantee programs are unable to save failing industries. Lack of access to credit markets is caused by serious industrial problems, he explained, not vice versa. If an applicant’s business plan cannot be made to show a profit under reasonable economic assumptions, private lenders are unlikely to issue a loan.

Then why is the federal government still guaranteeing loans? Because it serves two powerful constituencies: lawmakers and bankers.

Politicians love loan programs because they’re a wonderful way to reward interest groups while hiding the costs. When the programs are established, the mathematical certainty of future defaults and their potential effect on the deficit are never considered. It’s like buying a house on credit without having a trace of the transaction on your credit report.

But the true beneficiaries are lenders. Take small business loan guarantees. When a small business defaults on its obligation to repay a loan, bankers do not bear most of the cost; taxpayers do. Meanwhile, lenders make large profits on SBA loans by pooling the guaranteed portions and selling investors trust certificates that represent claims to the cash flows.

How profitable is this? Testifying before Congress in April 2006, David Bartram, the president of the SBA Division of U.S. Bancorp, the nation’s sixth-largest financial services company, explained that “return on equity of SBA loans can exceed 70 percent.” A 70 percent return on equity (RoE) is remarkably high. Right now, the five-year average RoEs for the two biggest banks in America—Citigroup and Bank of America—are 16.2 percent and 14.5 percent, respectively.

For years, banks have reaped the profits from loan guarantees, whether for small businesses or homeowners. Now that the skim has been exposed, taxpayers, not banks, are asked not only to pay the cost of the defaults but to bail out the irresponsible lenders. And the government has decided to encourage more lenders to take more chances by guaranteeing yet more loans to high-risk borrowers. The only guarantee for these loans is that our children will be paying billions to cover the losses.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Better Than a Bailout

vdereugy@gmu.edu (Veronique de Rugy) info@reason.org (Philippe Lacoude) — Wed, 31 Dec 2008 14:26:00 EST

What should the federal government have done in lieu of the $700 billion bailout signed into law by President George W. Bush? Here are four common-sense steps that don't involve the partial nationalization of the finance industry:

1) Raise the capital ratio for government sponsored enterprises and other investment banks to at least the level imposed on commercial banks—a cash balance of generally 8 percent of the market value of each firm’s tradable assets weighed for the risk of each asset. In a free banking system, there is no need for artificial, one-size-fits-all Securities and Exchange Commission rules. In such a system the amount of capital on hand should be left up to the banks themselves rather than government regulators. Sadly, we are not in a free banking system. We have a central bank, a lender of last resort, and not only does it implicitly guarantee certain banks’ losses but it won’t let them go under when they make mistakes, which creates some poor lending practices.

In this context, raising the reserve level would force institutions to have enough capital to face sudden increases in their default rates during tight credit markets. The bailout law does nothing to address this question.

2) Extend the capital gains and dividend tax cut past 2010, when it is due to expire under current law. This would raise the rate of return of financial assets at little cost to the Treasury and give a strong incentive to taxpayers to stay in or go back into the market.

3) Lift all Roth IRA contribution and eligibility limits for the rest of 2008. Because Roth IRA contributions are not tax deductible, this measure has no immediate cost to the Treasury, but it would likely pump billions of dollars into a tight market.

Such simple measures would have allowed the market to continue reorganizing its financial sector at absolutely no cost to taxpayers. That being said, if the president and Congress were dead set on directly injecting liquidity into the banking system, they still could have done so in a way that would have exposed taxpayers to far less uncertainty:

4) If Congress is absolutely committed to spending the bailout’s $700 billion, then it should send checks worth $3,600 to the 191 million U.S. taxpayers instead. Such checks would then have to be deposited into some type of retirement account or be subject to the Internal Revenue Service’s premature IRA distribution rules. The most risk-averse people would invest this windfall into relatively safe money market funds, thereby preventing the credit crunch predicted by the pundits. Some would buy instruments such as mutual funds, which would sustain the market. Savvier investors, or at least those with a high risk threshold, would profit from the low prices on Wall Street to purchase stock in distressed banks.

Such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who for years ignored the warning signs of a looming housing crisis. And it would have done so without socializing a big chunk of Wall Street, a risky and unprecedented intervention into markets whose full effects won’t be clear for many years to come.

Philippe Lacoude is the president of the consulting firm Algokian. Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Are You Better off Than You Were 40 Years Ago?

vdereugy@gmu.edu (Veronique de Rugy) — Mon, 24 Nov 2008 15:31:00 EST

In the November 1968 Mechanix Illustrated, James Berry gave an eerily prescient glimpse of life in the typical American household today: “The single most important item in 2008 households is the computer. These electronic brains govern everything from meal preparation and waking up the household to assembling shopping lists and keeping track of the bank balance…handle travel reservations, relay telephone messages, keep track of birthdays and anniversaries, compute taxes and even figure the monthly bills for electricity, water, telephone and other utilities.”

Though Berry was spot-on in predicting the technological advancements of the last 40 years, he didn’t say much about whether such progress would explicitly enhance the cause of freedom. Many libertarians, eyeing the relentless expansion of the state, worry that freedom is marching backward. But are we really worse off than we were 40 years ago?

This is a complicated question to measure. Wealth expands people’s choices, and Americans are fabulously more prosperous than they were in 1968. According to the Census Bureau, income per capita adjusted for inflation has doubled in the four decades since 1968, from $13,374 to $26,804. Non-wage compensation, in the form of employee benefits, has also increased greatly during that time.

There’s a better measure of living standards than raw wealth: consumption. By this measure, the United States is also doing very well. Luxury goods that few could afford in 1968 are now standard in most households, including poor ones. Writing in the July/August 2008 American, Michael Cox and Richard Alm, the senior vice president and chief economist and the senior economics writer at the Federal Reserve Bank of Dallas, reported that in 2005 a full 85 percent of households that are classified as poor by the Census Bureau have air conditioning (compared to only 36 percent in 1971); 97 percent have a color television (compared to 40 percent in 1971); 40 percent have an automatic dishwasher (as opposed to 20 percent in 1971); and almost 100 percent own a refrigerator (a 25 percent increase over 1970).

As Milton Friedman showed in Capitalism and Freedom, such wealth both feeds and is a byproduct of freedom. On one hand, freedom in economic arrangements produces wealth. This, in turn, produces a demand for more liberty, which then produces more prosperity. Thus, increasing wealth is usually correlated with increasing economic freedom. The deregulations of the airline, telecom, and trucking industries in the 1970s, and the marginal tax rate cuts and control of inflation in the ’80s, contributed to the widespread prosperity of the ’90s.

Yet, the wealth accumulation of the last 40 years has also made the government bigger. Real federal spending increased from $774 billion in 1968 to $2.5 trillion in 2008—a 225 percent increase—and federal spending per household grew from $11,800 to roughly $21,000 over that period, in constant dollars. This forms a libertarian paradox: economic freedom and wealth breed not just more political freedom, wealth, and choice but also more government.

While the nominal size of the federal government has exploded, spending and receipts relative to the size of the overall economy have not. So perhaps as the economy grows, the government is mainly tagging along. Figure 1 shows both as a percentage of GDP, one that has remained remarkably constant. Interestingly, marginal tax rates have also fallen drastically over time, raising an interesting question about the impact (if any) of marginal tax rates on the size of government.

This doesn’t mean we shouldn’t worry. The looming entitlement crisis when baby boomers start retiring will result in a massive expansion of federal spending that could shatter the balance between government and freedom. But we may not even have to wait that long for the state to catch up with the economy. The $700 billion bailout of Wall Street threatens to be the most sweeping government intervention into the nation’s financial markets since the Great Depression. And other economic policies being discussed are unlikely to be much better.

It’s not hard to point to other areas where government has grown and liberty yielded. Look no further than your morning routine. The federal government has put its imprimatur on the mattress on your bed (through the Consumer Product Safety Commission). The Federal Communications Commission regulates the transmission and content of your favorite morning show. The Food and Drug Administration (FDA) and U.S. Department of Agriculture (USDA), as well as the Commodity Futures Trading Commission, regulate the coffee you drink and the sugar you add to it. The USDA regulates the milk you pour in the coffee, as well as cheese, butter, and other dairy products you might eat for breakfast. And the FDA has its say about the shampoo, soap, and toothpaste you use with water that’s regulated by the Environmental Protection Agency.

Then there is the explosion in security measures. Airline travel regulations, increased surveillance, and growing databases are a few examples of government’s expansion in our lives. Add in state and local regulations—on smoking, eating transfats, or labeling menus—and you can get the feeling that we’ve lost our freedom.

That’s especially true if you’re behind bars, which a lot more people are these days. A recent Pew Research Center study shows that one out of 100 adults in the U.S. are imprisoned, an exponential increase since the 1960s. Trends in violent crime don’t explain this trend, but the war on drugs might. In a 2004 paper, the Princeton economist Ilyana Kuziemko and the University of Chicago economist Steven Levitt detailed how drug offenders now make up over 30 percent of all inmates in state and federal prisons, compared to less than 8 percent in 1980. The number of inmates with drug crimes as their most serious offense has risen from 24,000 in 1980 to near 400,000 today, a 15-fold increase.

But these vignettes don’t tell the whole story. Looking at the whole social picture, it’s hard to tell blacks, Jews, gays, and women that they are less free today than they were in 1968. As a woman, I can enter and leave the work world freely, whether I have kids or not. I can get an abortion, file for divorce, enter into a lesbian relationship, marry a black guy, or have several lovers, all without worrying about legal consequences (or being drummed out of polite society). While some restrictions persist, the breakdown of social barriers, many of them formerly enforced by government edict, has done much to increase my freedom and that of other once-restricted groups.

So is everyone freer today than in 1968 except for white men? Not exactly. White males—and men in general—are freer in an important way too. Just as it is today, in 1968 the U.S. was engaged in a war. But back then, the country had a partially drafted army, not the all-volunteer force that fights today. Draftees accounted for 30.4 percent (17,725) of combat deaths in Vietnam. The number of draftee deaths in Iraq: 0.

So I think we are freer today than we were 40 years ago. Now if only James R. Berry’s other prediction would come true: “Sensors in kitchen appliances, climatizing units, communicators, power supply and other household utilities warn the computer when the item is likely to fail. A repairman will show up even before any obvious breakdown occurs.” Then life would really be sweet.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Building a Better Bailout

vdereugy@gmu.edu (Veronique de Rugy) info@reason.org (Philippe Lacoude) — Wed, 08 Oct 2008 14:05:00 EDT

Many observers are comparing today's financial situation—crisis is the preferred term—with the Great Depression, which included a four-year period when the American economy contracted by over 40 percent. To put that in perspective, second-quarter growth this year (the latest for which full data is available) was 2.8 percent.

Yet the comparison between today's situation and the Great Depression is apt, though not for the reasons many of those making it suppose: Virtually all economists now agree that the massive government intervention into the economy in the 1930s made things worse and significantly delayed financial recovery.

The $700 billion-plus bailout bill—signed into law in response to recent investment bank collapses and a lack of liquidity in the economy—will likely have a similar effect by distorting basic mechanisms that would allow markets to price securities accurately and efficiently. Packed full of tax breaks and "stimulus" treats to multiple special-interest groups, the bailout wishes away the fact that the current turmoil in financial markets is in large part the result of bad government policy.

In particular, the law does nothing to address easy-money policy by the Federal Reserve and unsustainable subsidies to homeowners and mortgage lenders. Instead, it assumes that bailing out the financial industry will do the trick. Tellingly, even the law's proponents acknowledge they have no idea of whether the bailout will work as intended. As Rep. Barney Frank (D-Mass.) said at the start of bailout negotiations, "We don't have a choice now of debating whether this is a good or a bad thing."

To make matters worse, there are several measures that lawmakers could have adopted—at no cost to taxpayers—that would have actually addressed the underlying causes of the crisis.

We know that a critical mistake was made by allowing financial institutions such as Freddie Mac, Fannie Mae, and investment banks to hold significantly smaller capital ratios than commercial banks, while implicitly guaranteeing certain banks' losses. Over the years, a series of rules were created allowing the Securities and Exchange Commission (SEC) to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. The capital ratio rule requires that firms value all of their tradable assets at market prices and maintain a cash balance equal to a percentage of that price weighed for the risk of each asset.

In 2004, the SEC allowed five firms—Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley—to reduce their capital ratio by letting them keep more assets on their balance sheet while subjecting them to less reporting requirements. They now had an incentive to invest in riskier assets since their expected cost was reduced significantly.

Additionally, the only reason why the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac were able to guarantee nearly $5 trillion in home loans with merely $100 billion in net equity is that both their management and other market operators knew that the government would step in if things took a turn for the worse. Acting as lenders of last resort, the Federal Deposit Insurance Corporation (FDIC), the Treasury Department, and the Federal Reserve Bank fueled the crisis by encouraging a decade of careless lending.

Under these circumstances, the capital ratio for GSEs and other investment banks should be raised at least to the level imposed on commercial banks—an average of 8 percent, depending on regulators' assessment of the bank's financial strength and the type of capital in question. Raising the reserve level would allow institutions to weather tight credit markets by having enough capital to face sudden increases in their default rates. The bailout bill does nothing to address this question.

What it does do, however, is bail out banks, raise FDIC limits to $250,000 (from the current $100,000 per account), and otherwise increase explicit and implicit federal guarantees. While these measures might prevent a panic in the short run, they are the seeds of the next financial meltdown.

Virtually all economists agree that one of the reasons for the current situation is that banks assumed too much risk by lending money they should not have. When the federal government guarantees bank loans or assets, banks have less incentive to evaluate loan applicants thoroughly, but they do have an incentive to engage in riskier behavior than they would otherwise undertake. When things are good, they make high profits and, in the case of a downturn, it is the taxpayers, not the banks, who foot the bill. Congress should return to more a disciplined banking regime devoid of guarantees by moving toward market-based deposit insurance.

One bit of good news is that the bailout bill reminds the SEC that it has the authority to suspend the Financial Accounting Standard 157, or "mark-to-market," which requires that companies value the assets on their balance sheets based on the latest market indicators of the price those assets could immediately be sold for. It's a sensible rule in prosperous times, but it puts otherwise solvent banks in a difficult position when they fail and sell their assets at low prices. Under mark-to-market, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them becomes worth much less. Congress should have blocked them from going into effect in their stricter form last November and should have removed them formally in the bill.

The federal government could also have fostered savings and investment in the stock market by extending the capital gains and dividend tax cut past 2010 (when it is due to expire under current law). This would raise the rate of return of financial assets at little cost to the Treasury and give a strong incentive to taxpayers to stay in or go back into the market. Congress could also lift all Roth IRA contribution and eligibility limits for the rest of 2008. Because Roth IRA contributions are not tax deductible, this measure has no immediate cost to the Treasury, but it would have likely pumped billions of dollars into a tight market.

Such simple measures—raising the capital ratio requirements of investment banks, eliminating implicit guarantees to government-sponsored enterprises, suspending mark-to-market accounting back in 2006, and extending tax cuts on capital gains and dividends into the future—would have allowed the market to continue to reorganize its financial sector at absolutely no cost to taxpayers.

That being said, if the president and Congress were dead set on addressing the lack of cash in the economy, they still could have done so in a way that would have achieved the goal of injecting liquidity into the banking system while exposing taxpayers to far less uncertainty.

How? By taking the $700 billion they plan to give to Wall Street and sending checks worth $3,600 to the 191 million U.S. taxpayers. Such checks would then have to be deposited into some type of retirement account or be subject to the IRS's premature IRA distribution rules.

The most risk-averse people would invest this windfall into relatively safe money market funds, thereby preventing the credit crunch predicted by the pundits. Some would buy instruments such as mutual funds, which would sustain the market. Savvier investors, or at least those with a high risk threshold, would profit from the low prices on Wall Street to purchase stock in distressed banks.

Less than 30 days from the presidential election, such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who ignored the warning signs of a crisis and contradicted themselves constantly. And it would have prevented the socializing of a big chunk of Wall Street, a risky and unprecendented intervention into markets whose full effects won't be clear for many years to come.

Philippe Lacoude is the president of the consulting firm Algokian. Contributing Editor Veronique de Rugy is an economist at the Mercatus Center. This column first appeared at Reason.com.

Correction: The original version of this piece stated that the bailout bill has suspended rules such as the Financial Accounting Standard 157, or "mark-to-market."