The future global role and development of the US economy

Introduction

No man is an island, said the early 17th-century poet John Donne, and the same is true for economies. The breadth of global trade is such that when one major economy is in a recession, other economies are also affected. The development of the US economy is of interest not only to Americans but also to producers and consumers in other countries. Consider that in March, the latest month for which data are available, the US had $151.2 billion of imports and $123.6 billion of exports [17]. A year earlier, when few predicted the severity of this recession, the value of imports was $207.1 billion and the value of exports was $149.7 billion, and the global economy was trillions of dollars wealthier.

That is why it is all the more important that the US solve its economic problems as soon as possible–-not just for itself, but for the global economy. In fact, the US is moving in the opposite direction. The new Congress has passed an expensive ‘stimulus bill’ that is not really a stimulus and would open the floodgates of deficit spending, with ensuing debt that would burden the US far into the future and use up foreign investments that could be better used in other countries. The government has no serious plans to rescue the banking sector and wants to raise taxes and increase spending in many economic sectors, including health and energy. No wonder consumers are troubled, financial markets are volatile and unemployment continues to rise.

To spend or not to spend–-that is the question

How to end the recession and get the American economy expanding again is emerging as a great debate in which both sides invoke the history of the 1930s, a decade of depression and President Franklin D. Roosevelt's New Deal. At the worst moment of the great depression, unemployment reached 25%.

In one corner stand critics of President Roosevelt's actions. One example is Amity Shlaes, senior fellow at the council on foreign relations, Bloomberg columnist and author of The Forgotten Man, a history of the great depression [16]. She points out that federal spending during the New Deal did not restore economic health. Unemployment stayed high and the Dow Jones Industrial average stayed low. Shlaes's book chronicles the sincere yet ineffective efforts of New Dealers to lift the US out of the economic depression. The book might even be entitled The Forgotten US or The Forgotten Economic Depression, so at odds are her findings with the economic catechism on the success of the New Deal taught at many US universities.

In the other corner stand proponents of higher spending, such as Nobel laureate Paul Krugman, a professor at Princeton University and a columnist for The New York Times. Krugman argues that Roosevelt precipitated the recession of 1937 by cutting back on public works spending and raising taxes [11]. In other words, FDR mistakenly listened to the fiscal conservatives. Krugman's primary lament is that the New Deal failed to spend enough money to achieve full employment. He argues that the Second World War, with its massive government spending and borrowing, did that. His advice: spend boldly to lift the country out of a recession.

The New Deal's answer, as Shlaes illustrates, was to raise taxes on the wealthy, attack big business and pillory ‘economic royalists’, as Roosevelt called them. The New Dealers also started new federal programmes, spending unprecedented billions of dollars and employing millions of Americans. The emphasis was then, as now, on infrastructure. These efforts, together with deposit insurance and Social Security, became known as the New Deal and are similar to policy prescriptions being suggested to President Obama now. Yet that recovery failed to materialise.

The school of thought Krugman favours is that of the iconic British scholar John Maynard Keynes, who believed that a government in an economic depression could spend its way to economic health. Over the past quarter-century Keynes and his mode of analysis have lost their monopoly on economic wisdom. Keynesianism did not work in the US or Europe in the 1930s, nor in Japan in the 1990s. This has led Shlaes and many others, such as George Mason University professor James Buchanan [2,3], Arizona State University professor Edward Prescott [14,15] and University of Chicago professor Robert [12]–-all Nobel laureates–-to propose alternatives.

The fight is not big government versus small government. Most sceptics are not even advocating small government, merely a more sober view of the New Deal. Krugman also believes there is value in learning from the New Deal, but he draws different lessons and argues that government spending must take up the slack that has resulted from contractions of consumption and investment spending.

Ultimately, the battle is about how the US Congress will address the economic downturn. Mr. Obama and Congress are taking the side of Krugman and Keynes. Only a few months into his term, Mr. Obama has signed into law a $787 billion stimulus package in an attempt to revive the economy, as well as a $410 billion spending bill. In addition, he has proposed a $2 trillion fiscal stability package to keep banks solvent, a $275 billion housing stability package to rescue the housing sector, a $634 billion health insurance fund, as well as more spending for energy and education. To pay for these, he has called for increases in some individual, business and environmental taxes. The big question remains: will these programmes solve US economic problems?

One reason that stock markets fell over the past month to levels not seen for a decade is that higher spending and taxes erode a country's competitiveness by replacing efficient private investment with inefficient public projects. Investors know this, and flee. Obama's financial, energy and health spending plans all have serious deficiencies, and his proposals to increase taxes would have unintended consequences.

Rescuing the financial sector

Last October, after much debate, Congress allocated $700 billion to the Troubled Asset Relief Program. But TARP, with roughly half the $700 billion disbursed, has not yet delivered on its promises. Then, on 10th February of this year, it was deja vu all over again, except to the tune of $2 trillion, as Treasury Secretary Timothy Geithner declared, ‘Our plan will help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses’ [19]. He did not say how long it would take–-because no one knows.

Mr. Obama's plan is another version of TARP, but with more bells and whistles. Banks would undergo a ‘stress test’, an intensive audit, to measure their capabilities. A Public-Private Investment Fund would purchase troubled assets and provide additional funding to reach the $1 trillion level, although how private investment is to be mobilised is unclear. In addition, the Treasury will use $100 billion to leverage up to $1 trillion in lending from the Federal Reserve [20].

The idea behind TARP was not new. Similar programmes had been successfully put in place during the Asian banking crisis of the late 1990s. A government agency, a so-called bad bank, would buy the toxic assets, paying for them with fresh capital so that the banks could continue to function. By definition, if the government is purchasing distressed assets it is paying more than the ‘market price’, more than a private buyer would pay.

Furthermore, the details of the financial plans are not reassuring, especially on how to take so-called toxic assets–-loans with diminished and uncertain value–-off the banks’ books. Last fall the difficulties of pricing toxic assets caused the Bush administration to switch to infusions of fresh capital by purchasing banks’ preferred stock.

Professor Charles Calomiris of the Graduate School of Business at Columbia University has said that the new Treasury approach is designed to take little risk, economically or politically, but to pretend that it is doing something. In the 21 January issue of Forbes, Professor Calomiris [4] laid out sound principles for a financial stability package, including the following:

So far Geithner and the administration do not appear to have consulted professor Calomiris, much less has Congress. Geithner and an assortment of government agencies instead have embarked on a journey to save the American economy all by themselves with no principles, no standards and no details.

Geithner might be better off just admitting that these assets will have to be purchased by the Treasury at prices higher than market value, and going before Congress and the US people to make his case. He could say up front that this will be expensive, but that this course of action will allow banks to clear underperforming assets off their balance sheet, thereby enabling them to start lending again. In turn, with revived credit markets, the economy can grow.

The myth of energy independence

It is puzzling that Mr. Obama wants to increase spending on alternative energy projects so that the US economy would achieve independence, while at the same time raising fees on carbon emissions ¹ that would fall most heavily on coal, our most important domestic source of energy for electricity generation. The US imports more oil than ever before, but has a larger economy and uses less energy for each dollar of economic activity than in the past. The US has made vast improvements since the 1970s, when President Nixon first called for ‘energy independence’.

Since then, all other presidents except President Reagan have endorsed the same goal, and we are still dependent on foreign oil. President Carter called energy independence ‘the moral equivalent of war’ ² and set up the Department of Energy, which did not fix the problem. No one believed President George W. Bush when he said the US could reduce gasoline use by 20% in 10 years: consumption declined because of high oil prices and the recession.

At a time when oil prices in real terms have fallen to their lowest levels in the last decade, and with the global economy in a recession, Mr. Obama proposes to impose enormous costs on the US economy. Reducing imported oil and ‘harnessing the power of clean, renewable energy’, as the President put it, sounds simple. Why buy from abroad what we can make ourselves?

But such a transformation of technology is practically impossible and would be enormously expensive, which is why other presidents have failed. The US would need either to produce vast quantities of alternative fuels for our cars or move to electric vehicles. Both options result in higher costs and different forms of pollution.

As for electricity generation, wind and solar power, along with other renewable energy sources such as biomass and geothermal, account for 3% of our total power output [8] and are unlikely to increase significantly.

Nuclear power plants do not generate harmful emissions and are a far cleaner source of electricity than oil, natural gas or coal. Yet the US has refused to build them for fear of accidents and because of controversy about where to dispose of spent fuel. Another problem is long delays in winning government licences for new plants. Furthermore, private companies do not want to face litigious American consumers, trial lawyers at the ready, and so do not dare embark on nuclear power plants. Until Congress makes serious efforts to shield companies from liability, nuclear power will not be viable.

It makes no sense for the US to regulate carbon and other greenhouse gases unless emerging industrial giants such as China and India also do so, because carbon emissions are a global problem. Without international cooperation, the US would be raising costs on consumers in the middle of a recession–-all for nothing.

Expanding government-provided health care to the middle class

Reform of the American health care system is long overdue. Those who are unemployed, work for a small business that offers no health plan or who have an existing illness known as a ‘pre-existing condition’ have difficulty getting health insurance. Mr. Obama has proposed a $634 billion fund for health care, drawn from higher individual and small business taxes and lower reimbursements to medical providers. He has also signed into a law a bill expanding government-provided health insurance to children of upper-class families.

In testimony before the Senate Committee on Finance, Congressional Budget Office (CBO) Director Douglas Elmendorf presented options for controlling health care costs. He warned that ‘reducing or slowing spending over the long term would probably require decreasing the pace of adopting new treatments and procedures and limiting the breadth of their application’ [7]. That is rationing by another name, not a comfortable concept to Americans.

Elmendorf pointed to the current employer-based health insurance system, where health insurance premiums are untaxed income to workers, as one of the main causes of price increases. He suggested replacing the tax exclusion or restructuring it, so that patients have more incentives to control costs. In that way the purchase of health insurance would be similar to the purchase of home insurance or auto insurance, services that consumers appear able to purchase without major problems.

Mr. Obama has proposed setting up a new health insurance plan, similar to the Federal Employees Health Benefits Program. It would be open to all, with ‘affordable’ premiums and co-payments. In addition, he has proposed a new National Health Insurance Exchange to set standards and regulate private insurance underwriters. Those who could not meet the standards would close.

Furthermore, some employers who offer health insurance now would have to pay higher premiums in order to raise benefits to the level of the new public plan. Those employers who do not offer health insurance would be required to pay into the new plan, a new tax.

Equally important for the American economy in the long run was the passage of the Children's Health Insurance Program (CHIP) in early February 2009, originally enacted in 1997 as an addition to Medicaid. The programme was increased by $32-$39 billion over 5 years, according to estimates by the CBO, almost tripling the programme by 2013 [6]. This moves the government towards national health insurance that would be like national defence–-available to everyone and paid for by the taxpayers, as in Europe and Canada.

The bills are costly because they would insure more children by raising income eligibility well into the middle class. The past limit was 200% of the poverty line, or $44,000 for a family of four (although individual states can and do fund higher levels without the Federal share). The new law raises the limit to 300%, or $66,000. An exception for New York would include families at 400%, or $88,000. Last year, the programme covered about seven million low-income children [18] and Medicaid covered an additional 23 million. CBO estimates that the proposed bills would add another 6.5 million children to the State Children's Health Insurance Program (SCHIP) and Medicaid–-and, according to Census Bureau data, 42 million children would be eligible.

In 1965 Congress created Medicare to cover health care for the elderly regardless of income. Today it is an enormous programme, gradually eating up the Federal budget, with trillions of dollars in unfunded liabilities. Medicare reform is a top priority on Obama's to-do list. But it will do little good to solve Medicare's finances if Congress expands public spending for health care, increasingly heedless of income. This increases the deficit, making the US a less attractive place for investors.

Taxing efficient production

Potentially the most harmful part of Mr. Obama's proposals is the plan to raise taxes on the most productive sectors of the economy. In Obama's new budget for 2010, he outlined plans to allow the top two tax rates to rise from 33 to 36% and from 35 to 39.6% in 2011. Taxes would rise for singles with taxable income over $172,000 and married couples with income over $209,000.

In addition, taxpayers in these brackets would not receive the full value of their itemised deductions, further exacerbating the fiscal disadvantages of marriage for some couples. At the same time, as part of the stimulus package, Congress has passed a series of temporary tax cuts, not permanent cuts that would hasten economic recovery.

Mr. Obama and his advisers evidently believe that a temporary tax cut spread out over 52 weeks would induce more extra spending than one delivered all at once. The problem is that tax cuts that are temporary have limited effects on spending behaviour. Milton Friedman won a Nobel Prize for his permanent income hypothesis, which showed that spending decisions are made not by the amount of money in consumers’ pockets, but by their expectations of future income.

Another tax would come in the form of a complex system of emissions allowances that companies could buy and sell, known as ‘cap-and-trade’. This would essentially mean that energy-intensive companies would have to pay the government to emit carbon above a certain limit. Coal (a domestic energy source) and automobiles (the recipient of government largesse) would be particularly hard hit.

This tax would be passed on to consumers, even those earning under $250,000 per year, who use the companies’ products. Those companies that could switch from carbon-based energy to new forms would face higher prices for the new technology, prices that would also be passed on to consumers.

The goal of tax systems, in addition to raising revenues that governments need, should be to encourage work and investment, and thereby production of national income. Income effects are critical when it comes to assessing the effects of changes in tax rates on government revenues and the inefficiencies associated with different taxes.

The most effective measure would be a permanent cut in individual tax rates and an increase in business expensing, paid for by a permanent cut in spending when the recession is over. The tax cuts of 2001 through 2003 would have been more effective if spending could have been cut in subsequent years.

Economists such as Jonathan Gruber of MIT have found that households earning more than $100,000–-typically containing two middle class professionals–-are highly responsive to changes in tax rates [10]. When tax rates rise, their work declines.

Others, such as William Gentry of Williams College [9], found that higher marginal tax rates discourage entrepreneurs from starting new businesses, which involves much risk. Additional investment in new ventures creates jobs, encourages innovation and enables people to reap further benefits from economic creativity.

Conclusion

With jobs at risk now and personal assets shrinking, people are concerned about economic conditions. A growth-enhancing programme would restore confidence and help the American economy, as well as repairing the balance sheets of American banks. Global economies would profit due to increased American consumption, which would result in more exports to the US, and more global liquidity available for investment. It is time to move beyond Keynesian solutions that have not worked. Lower taxes and spending could mean a shorter recession and improved lives for millions around the globe.