No Sweat Economics

In a recent Wall Street Journal piece, supply side economics guru Arthur Laffer has a chilling prediction for the US economy.  According to Laffer, the scheduled expiration of the Bush tax cuts at the end of 2010 has companies and wealthy individuals accelerating production and income into 2010 to avoid higher taxes next year.  This generates an artificial boost to economic activity in 2010, but will be a sharp drag on the economy next year.  Laffer says the most likely outcome is the US falls back into recession, the so-called “double dip.”

Few others seem to be talking about this impending financial car wreck. And I have to wonder why.  The Bush tax cuts contained a “sunset” provision because otherwise they would not have passed.  Republicans always assumed no Congress would want to be responsible for a sharp tax hike, and extending the tax cuts would be simple.  But the current congressional leadership has shown little interest in taking up the issue. If Dr. Laffer is right, a last-minute action to prevent a tax increase would be useless:  companies and individuals would already have accelerated production and earnings, borrowing from growth they would have generated in the future so it’s taxed at 2010′s lower rates.  My question:  was this behavior predictable?

Traditionally, economic models assume people act rationally. In recent years this been the source of much debate among economists. Indeed, the very idea that most people act rationally seems preposterous.

Stories of people acting bizarrely are interesting, and pepper news reporting. It’s easy to get the impression that most of your fellow citizens are several ice cubes short of a tray. But I’m convinced the vast majority of the decisions we make are perfectly logical FOR US. This is especially true where our economic well-being is concerned. Studies of street level drug dealers have shown how rational their completely unregulated pricing structures are. Factors such as supply/demand, the likelihood of being arrested, the likelihood of being punished, etc. determine selling prices for drugs that make a lot of sense.

This leads to my thesis that applying a little common sense, one can often predict the result of  government policies. Merely ask yourself “what would I do if I were in this position?” It’s easy. Let’s play.  In 1990 the federal government passed a special luxury tax of 10% on items such as yachts, jewelry, and furs. What would you do if you were shopping for a yacht? You might suck it up and pay the tax. Or you might scale down your purchase to a cheaper yacht. Or you might delay or completely abandon your purchase. No doubt each camp would attract some people, but the inescapable conclusion is that overall yacht sales would be lower than without the extra tax. This is exactly what happened. Many employees at yacht builders lost their jobs. Instead of raising revenue, the drop in sales resulted in less tax dollars for the government. In 1993, the tax was repealed. But what about Laffer’s example?

If I knew my tax rate for 2011 were going up substantially, would I try to accelerate income into this year? As my friends in Nawlins say, “hell yeah!” To the degree they can (and Laffer claims there’s a lot of flexibility), companies and wealthy individuals would be crazy if they didn’t try to pull as much income as they can into 2010 from 2011. And what is the likely result? Laffer mentions two government subsidies from the past year: cars for clunkers and the $8000 mortgage tax credit. Both programs were very popular, and accelerated car and home sales respectively while they were in place. But after they ended, sales plunged. It’s obvious that people who might have bought cars in the next few months made sure to buy them when the lucrative subsidy was in place. And home buyers who might have closed later in the spring or summer jumped to take advantage of the tax credit expiring in April. Perfectly rational, and perfectly predictable.

So is Laffer right about the prospective double dip? There are many factors that determine economic growth. But there’s little doubt that next year’s impending tax hike will cause many companies to accelerate income into this year. As a result, 2011 growth will have a big chain around its neck. Unless Congress gets busy shortly on extending these tax cuts, I wouldn’t bet on any upside surprises next year.

In an attempt to help close the state’s massive budget deficit, a source says NY Assembly Speaker Sheldon Silver wants to push through a tax hike on millionaires.  But in an era when wealthy people are very mobile, another predatory tax hike will likely result in lower revenues, as affected taxpayers get fed up and leave the state.

This post from exactly one year ago discusses Maryland’s experience with such tax hikes.  And there’s a link to a previous post about New York scaring away the wealthy.  NYC Mayor Michael Bloomberg understands that wealthy citizens already shoulder an inordinate burden in high tax states like  NY.  He is on record strenuously opposing more punitive taxes.

The philosophical War on Success has severe implications for our country’s long-term future.  But the War on the Wealthy playing out in many jurisdictions  may very well lead to bankruptcies or bailouts from New York to Los Angeles.  We must hope it is as ineffective as the War on Poverty.

In 1978 Chinese authorities limited couples to one child each in order to slow the growth of the country’s massive population. And like most serious government interventions in citizens’ lives, this policy threatens to unleash far-reaching societal changes far beyond the scope of the original plans.  We call such effects unintended consequences.

More than most social scientists, economists believe it crucial to consider the likely unintended consequences of government actions.  Often this is a lot easier than it sounds. With a little common sense, people can predict some ways a population might react to certain policies. For example, if a company raised overtime wages from 150% to triple the normal wage, many employees would undoubtedly try to work more slowly to scoop up more of this lucrative overtime pay. It’s human nature. If the government mandated a “living wage” of $50K per year, many low paid workers would be fired. And businesses unable to raise prices enough to cover higher salaries would suffer financially, with some going under.

The impacts of China’s policy are mentioned in today’s Washington Times article.  Anyone who understands China’s culture knows that parents value boys far more than girls.  They should have realized millions of people would abort pregnancies when they found their only baby would be female.  Now China has a severe female shortage.  There are not enough potential brides for Chinese men.  This has also spurred a thriving sex slave business.

Because the Chinese succeeded in dramatically slowing the birth rate, they created a demographic time bomb:  a rapidly graying population that will be difficult to support by a much smaller group of working young people.  Contrary to popular belief, China is essentially a 3rd world country.  It’s an economic powerhouse solely due to the size of its population.  Its 2008 GDP per person ranked roughly 100th in the world at less than $3300/person.  The average Chinese citizen would need to see his production rise 20% to catch up with his counterpart in Ecuador. The government has massive currency reserves, but they wouldn’t go very far if they had to support hundreds of millions of gray panthers (or pandas).

It isn’t just totalitarian regimes that ignore unintended consequences. Politicians in western democratic nations see no reason to restrain their proposals by considering long-term consequences. They just want to tout the goodies they’re giving their favored constituencies, and hope most of us don’t realize the potential unintended consequences of their schemes. This pattern is unlikely to change until voters embrace a “use your brain” movement that demands politicians consider the implications of their policies.

According to this Businessweek article, the Commodity Futures Trading Commission (CFTC), the regulatory body for US futures exchanges, is discussing whether to limit the number of contracts traded by speculative investors on the New York Mercantile Exchange.  The stated purpose is to reduce the impact speculators have on energy prices.

As I’ve discussed before, speculators cannot have a sustained impact on prices without leaving a paper trail.  Such a trail was absent at the price peak in 2008, and it’s not there now.

In a rare display of bureaucratic straight talk, CFTC commissioner Bart Chilton admits his ignorance:  “Even if I’m not sure that these new speculators are contorting markets, if there’s the hypothetical possibility, we’re obligated to do something about it,” Chilton said. “To do nothing would be irresponsible.”

Just brilliant.  He’s essentially saying “I don’t know what I’m doing, but I’m a regulator and I’m paid to regulate.”  Using the “government knows best” mindset, Chilton doesn’t consider that perhaps doing SOMETHING would be irresponsible.

When government intervenes in markets, there are always unintended consequences.  Regulatory and legislative fingerprints are all over the mortgage meltdown.  I point you to Thomas Sowell’s book “The Housing Boom and Bust” for an excellent and easy-to-understand recap of that mess.

Perhaps before acting out of ignorance Mr. Chilton should consult someone with a bit of expertise and try to determine whether his cure might prove to be worse than the disease.

The media’s review of President Obama’s recent visit to a Home Depot store focused on him referring to energy efficiency as “sexy.”  What I found far more interesting was the president’s embrace of a simplistic yet dangerous economic principal known as the broken window fallacy.

The broken window fallacy says you can generate economic growth by destroying property.  If someone breaks your window, you must buy a new window, have it installed, and maybe even pay someone to clean up the mess.  All of these actions generate economic activity and income for certain people.  But the fallacy of this analysis is that it ignores the destruction of wealth: if not for the broken window you could have used that money for a far more productive endeavor, which would have generated economic growth and also left you better off.

According to Politico44, Obama said  “The simple act of retro-fitting is one of the fastest, easiest and cheapest things we can do to put Americans back to work while saving money and reducing harmful emissions.”  While he doesn’t suggest smashing things just for the sake of rebuilding, doing unnecessary work to spur “growth” is just another version of the broken window fallacy.

If you think more insulation or retrofitting your house with new technology will be beneficial to you, then great.  But touting it as a means of putting Americans “back to work” temporarily is bad economics.  Money spent on make-work propositions gets diverted from productive endeavors that may actually lead to sustained economic growth.  If you want new windows, by all means get them.  But don’t break your windows for the good of the rest of us.

Today’s Thomas Sowell column tackles a concept few politicians and MSM types seem to understand:  government can’t create jobs.  Sure, it can tax and borrow big bucks, using some of the proceeds for hiring government workers.  But productive jobs come from wealth, and government doesn’t create wealth; it redistributes it.  The more efficient private sector would likely create far more jobs than government if the latter didn’t extract so much money to pay for its schemes.  Government merely transfers workers from the private to public sector (with some no doubt lost in the shuffle) and takes credit for the jobs it “created.” Dr. Sowell notes FDR’s massive government jobs programs never put a dent in the unemployment rate.

Sowell continues that government makes hiring much more expensive with its many mandates on employers.  The health care bills being considered in Congress will send the cost of private sector hiring soaring.  Econ 101 teaches us that when you raise the price of something, people normally demand less of it.  This is no different for labor.  If government mandates make new workers cost more than they produce, a company won’t hire them.  And current employees who become a drag on profits will be fired.  If private sector workers become an endangered species as companies shrink, just who will be paying all those taxes to support an ever-expanding government payroll?

Here’s an excellent Caroline Baum column about the Obama administration’s blame game regarding why the public is resisting health insurance “reform.”  I want to focus on one point she makes that is a crucial concept of basic economics.

The administration’s and Congress’ latest tactic has been to demonize insurance companies.  Health care reform suddenly became health insurance reform.  This is a clever strategy.  Although most of us are very satisfied with our health care, it’s easy to get people to trash insurance companies.  After all, they get rich by taking in premiums, but denying us care for frivolous reasons whenever possible.  But there’s a problem with this commonly held belief.  It doesn’t match the facts.

My pat response to people complaining about some company or another that “exploits” us is simple:  buy their stock.  If they’re really earning the “obscene” profits you believe, this will be reflected in earnings growth and higher share prices.  Looking at the long term charts of insurance companies, it’s hard to make the argument that they are money making machines. And if their executives were keeping all the money via inflated pay packages, believe me you would have heard about it by now.

Baum quotes compensation expert Graef Crystal, who studied five major insurers for evidence of “gouging.”  According to Baum, “’There’s no case here for undue enrichment of shareholders’ or over-compensating CEOs, Crystal finds.”  The study actually found below market execcutive pay and shareholder returns.

I understand why politicians ignore the facts.  It makes it easier to demonize insurance companies.  But next time a friend goes on a rant about greedy insurance companies (or oil companies), simply respond “Why don’t you just buy their stock?  If they’ve got such a great scam going you’re sure to be rewarded with fantastic profits!”

My initial reaction to the Democrats’ way-over-the-top trillion dollar plus health care monstrosity was glee.  I was confident the American public, overwhelmingly happy with their personal health care,  would soundly reject this hideous government intrusion and its obscene price tag.  Most of us understand that you don’t assume massive new liabilities at a time when you’re struggling financially.  This is a time for belt tightening, both for people and governments.

It’s true Americans are no longer the rugged individualists of a bygone era.  Many enjoy forcing strangers to pay our bills.  But the Democrats seemed to forget the first rule of the Fabian socialists:  gradualness.  Don’t try to go from Adam Smith to Karl Marx overnight.  Win your little battles, and over time you can accomplish dramatic change.  The public is the proverbial frog in the pot of cold water, slowly heating over the fire.  The capitalists have won the war without even dirtying our uniforms.  Or have we?

Call me paranoid, but I’m beginning to worry the Democrats might have something else up their sleeves.  In “Influence: The Psychology of Persuasion,” psychologist Robert Cialdini discusses the contrast principle.  This principle affects the way we view things presented one after the other.  Cialdini uses the example of a man entering a trendy clothing store looking for a suit and a sweater.  The customer might balk at paying $175 for a sweater.  But if  he’s already committed to buying a $900 suit, he’s much less likely to object to the price of the sweater.  The salesman knows this, and will always show him the suits first.

Another example of the contrast principal in action was G. Gordon Liddy pitching his Watergate plans to members of Nixon’s administration.  Initially he presented a wide-ranging scheme that left his audience with gaping mouths.  At the next meeting the group agreed to let him go ahead with a significantly scaled-down plan, which is the one he eventually used.  The only person to object to the latter plan was a gentleman who missed the first meeting.  He was aghast.  The contrast principal was not in effect, since he didn’t hear the first plan.  The rest of the group was relieved they halted the first plan, and figured they’d throw Liddy a bone.

It’s clear (at least to me) that there’s no way the current House health care plan will become  law at this time.  Public opposition seems to grow every day.  Blue dog Dems from conservative districts have no intention of losing their seats after one term.  So are Democrats using the contrast principal?  Do  they understand they’ll never get this plan enacted?  Perhaps they just intend to pass a few pieces of legislation that dramatically increase government interference in medicine, but don’t yet result in a takeover.  Opponents will breathe a sigh of relief, thinking they’ve won a great victory.  I hope I’m being paranoid…but it’s not paranoia if everyone is against you.

Somebody in the US Congress has a sense of humor.  I don’t mean that the Democrats’ planned “millionaire” surcharge will kick in at an income of $350,000.  That’s classic Newspeak.  I’m talking about the part of the House Democrat health care bill where in 2012 the White House budget office will estimate the savings from this plan.  If they exceed $175 billion, all tax surcharges will be canceled.  Awesome!  We all know that government reforms always save us gobs of money.

Not funny?  Laugh and the world laughs with you…

Fannie Mae and Freddie Mac lost mega-billions guaranteeing bad mortgages.  I’m guessing most people reading this are aware that US taxpayers spent a bundle bailing out the two agencies.  That would seem to put you ahead of congressmen Barney Frank and Anthony Weiner.

With no trace of irony, these two are calling on Fannie and Freddie to relax new, tougher lending standards.  Previously the agencies would guarantee mortgages on condos in new buildings where at least 51% of units were sold.  In March Fannie raised the minimum to 70%, and Freddie is set to follow suit in July.

In a letter to Fannie’s and Freddie’s CEOs, the two professional politicians argue that the tougher standards will keep buyers away from new developments.  The mortgage giants did not comment immediately, but safe to say they didn’t adopt this new rule arbitrarily.  They see a building with heavy vacancies as having unacceptable risk.  Considering it’s my money at risk, I applaud them.  I just wish they took more actions like this over the past 30 years.