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Tuesday, October 13, 2009 12:36 PM

Thoughts on the Economy: Problems and Solutions

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John Mauldin has proposed some interesting solutions for fixing the economy in his weekly E-Letter Killing The Goose. Let's take a look, first at the problem, then at various solutions.

Long-time readers know that I think the Fed has been able to get away with its rather large monetization program because of the massive deflationary forces let loose in the world by the credit crisis, which is forcing a monster deleveraging regime all over the world.

And this brings us to our conundrum. You cannot continue to run deficits significantly larger than nominal GDP for too long without risking the demise of the economic system. But we are in a deflationary environment, so the Fed can monetize the debt far more than any of us suppose without risking immediate and spiraling inflation.

How long can we go before there is an upheaval? I don't know. The markets can remain irrational or complacent for a lot longer than most of us think. It could be years. Or not.

Some of my most knowledgeable friends argue for the inflation side, and others take the deflation side. I tend to think the Fed will fight deflation until we get inflation, but the consequences will not be pleasant. There is no benign path.

How can we avoid such an upheaval? The only way is to make some very difficult choices. There have to be some adults making the choices, as the teenagers now in control clearly cannot make them.

It is not a matter of pain or no pain, it is just deciding when and how bad it will be. The longer we wait, the worse the consequences.

First, we must acknowledge the deficit is out of control, and spending must be cut. If we raise taxes by as much as the Obama administration now wants to, we will most assuredly put the country back into a deep recession in 2011. Think what raising taxes in 1937 did to a nascent recovery. A $3-trillion-dollar budget is 20% of the US economy. That is just simply too much.

The most credible studies show that government expenditures exert no multiplier effect on the economy. Actually, they show them to be very slightly negative. This is not just in the US. However, the tax effect has a multiplier of 3! If we raise taxes by $300 billion in 2011, that will slam the economy in the face. Further, we will collect less taxes than projected, as economic activity will fall.

You cannot cure a too much debt problem with more debt. We cannot borrow our way into prosperity. Every crisis of the past decades has been a result of too much debt and leverage and we seem to want to repeat the past mistakes, hoping that this time it will be different. It won't.
Mauldin summarizes the problem very well. What cannot last forever by definition won't. Unfortunately the only options are to pay the piper sometime soon, or have a major global monetary collapse later. There is no realistic middle ground.

Let's now take a look at his suggestions one by one. I will comment on each one individually and add some things that he missed.

Mauldin: We should start with a 5% across-the-board cut in spending in all programs. Federal employees, except for military personnel, should see a 5% cut in pay as part of that program. The average federal worker makes $75,419 a year, while the average in the private sector is $39,751. The rest of us are taking pay cuts in the form of higher taxes. No cost of living increases, etc. We are on an austerity program and need to do what it takes. If a program is deemed too important to be cut, then another program has to be cut more.

Then the next year another 2.5% cut across the board. And then an absolute freeze on the overall budget size until the deficit is 2% or less of GDP.

Mish: The goal must be a balance budget, not deficits of 2% of GDP. Public sector wages are indeed way out of line. In addition, there are entire departments that are redundant or unneeded. We can start by getting rid of HUD, the FHA, the department of Education, the Department of Energy, Homeland Security and numerous other unnecessary departments. Should someone think there are critical functions in those departments, then just cut the budgets by 60-80%.

After cutting the waste, we might not need to cut wages, but should do so anyway to keep government jobs inline with pay in the private sector.

Mauldin: Social Security must be fixed now. We all know that it is going to have to be done, so why not just do it? Means testing should be a part of the mix. As an idea, for every $10,000 in income a retiree has, he gets $1,000 less in SS payments. And increase the retirement age down the road. When SS was launched, retirement age was 65. But the average life span was 65. There are other things we can do, but whatever our poison of choice is, we need to take it.

Mish: Ideally we should find a way to phase out social security completely. Politically that will never fly. As a practical matter, raising the retirement age and placing means tests are about the best we can hope for. Given that the Maximum Social Security Benefit is around $25,400 (an amount that does not go all that far), penalizing people immediately for every $10,000 in income is excessive. For the sake of argument, I propose a starting point at $50,000 then a $1,000 reduction in SS benefits for every $10,000 in income between $50,000 and $100,000, with a $2,000 reduction in SS benefits for every $10,000 in income above $100,000.

Mauldin: Medicare must be revised, with real health-care reform. The national debt is $56 trillion if we count unfunded liabilities, much of which is Medicare. It will become a nightmare around the middle of the next decade. Adding more expenses now without cutting elsewhere makes no sense. If we kill the goose, no one will get anything except very empty promises. There actually is a lot of waste in the system. Software should be written that analyzes every patient and procedure and produces an outcomes-based analysis of what is reasonable, rather than throwing every test at every patient. And the government should make sure, even if it has to spend the money, that the updated system is in place in every hospital and clinic in the country. And doctors should be given access to it so they can decide what type of care is appropriate to prescribe. And health-care reform means tort reform.

Mish: The key problem is there is an unlimited demand for free services. Nearly everyone is concerned about rationing. I am concerned there will not be rationing. Beyond a certain age or likelihood of success of a procedure, services should be denied unless one has private insurance on top of Medicare. A huge percentage of health care money is spent in the last two years' of someone's life, typically only prolonging the agony. This needs to stop.

Mauldin: Each year we allow almost 1 million immigrants into the US, mostly family of people already here. I suggest that for the next two years we stop that. Instead, let anyone who can buy a home, passes basic screening, and can demonstrate the ability to pay for health insurance immigrate to the US and get a temporary green card. If they behave, then the card becomes permanent after four years.

We almost immediately put a floor on the housing market, absorb the excess homes, and within a year the housing-construction market, along with the jobs that are now gone, will be back. That is stimulus that costs the taxpayers nothing.

Mish: Mauldin is optimistic here. How many immigrants have enough income to pay for a home, healthcare, insurance, etc? Enough to matter? Besides, where will that income come from? Where are the jobs? This may not cost much, but it may not gain much either.

Moreover, should the goal be to put a floor on home prices? Calculated Risk offers his opinion in A Policy: Supporting House Prices. I side 100% with calculated risk. However, if someone does have enough money to support themselves, pay for healthcare, etc, by all means let them buy homes, as many as they want.

In the meantime $8,000 tax credits for homes, 3% FHA down payments, and borrowed down payments are all making matters worse. These ill-advised housing programs are making matters worse.

Mauldin: While I can't believe I am writing this, taxes are going to have to rise, if for no other reason than this Congress is hell bent on raising taxes. But rescinding the entire Bush tax cuts, plus adding a 10% surcharge as Congress wants to do in one fell swoop, is an absolute guarantee of a recession. So do it gradually over (say) 4 years, and then reinstitute the cuts when the deficit is under 2% of GDP. Remember the negative tax-multiplier effect of raising taxes. And the definitive work on that was done by Obama's chairman of the Council of Economic Advisors, Christina Romer.

We should consider a VAT tax and a major cut/reorganization of the corporate tax. We need to encourage corporations to hire more, and you do that by taxing less. Let's make our corporations more competitive, not less. Our taxes are much higher than those of any of our major competitors. And please forget that insane carbon tax. If you want to cut emissions, do it straightforwardly by raising taxes significantly on gasoline. Don't back-door it on consumers. (And I am NOT advocating such a policy.)

Mish: I am in favor of elimination of corporate income taxes. Right now we have a peculiar situation whereby corporate profits held outside the US are tax deferred but inside the US they are not. Talk about a perverse policy of encouraging capital flight. Why not turn that around and require corporate taxes on money held outside the US and no taxes on profits held in the US?

Mauldin is correct that the carbon tax is ridiculous. As for the VAT, my big fear would be that in practice, it would become a monster unleashed. In theory, however, some combination of a flat income tax with no deductions and a small VAT to encourage saving vs. spending is reasonable. The VAT should not apply to medical expenses and food (explicitly food purchased at grocery stores). The flat income tax should truly be flat, with no deductions, even for housing.

If we cut enough military and other spending (easily doable as noted below), we need not raise taxes at all, and in fact can probably lower them.

Mauldin: An aggressive tax benefit for new venture-capital money that is invested in new technologies will result in new industries. The only way we can grow our way out of this mess is to create whole new industries, like we did in the late '70s and '80s. (Think computers and the internet and telecom.)

Mish: Our tax code is perverted enough. We do not need tax incentives if we eliminate corporate taxes as suggested. We should get rid of all tax incentives. They are part of the problem. Government has no business picking winners and losers. It needs to get out of the way.

Mauldin: Unemployment is likely to continue to rise and last longer than ever before. We have to take care of the basic needs of those who want work but can't find it. Unemployment insurance should be extended to those who are still looking for work past the time for benefits to expire, and some program of local volunteer service should be instituted as the price for getting continued benefits after the primary benefits time period runs out. Not only will this help the community, but it will get the person out into the world where he is more likely to meet someone who can give him a job. But the costs of this program should be revenue-neutral. Something else has to be cut.

Mish: Can we deal with 15 million volunteers? Somehow I doubt it.

Mauldin: We have to re-think our military costs (I can't believe I am writing this!). We now spend almost 50% of the world's total military budget. Maybe we need to understand that we can't fight two wars and support hundreds of bases around the world. If we kill the goose, our ability to fight even one medium-sized war will be diminished. The harsh reality is that everything has to be re-evaluated. As an example, do we really need to be in Korea? If so, why can't Korea pay for much of the cost? They are now a rich nation. There are budgetary fiscal limits to being the policeman for the world.

Mish: Bingo. We can easily slash our military budget by 70% and still be the most powerful nation in the world. Moreover, it is time to declare the war in Iraq and Afghanistan over, pack our bags and leave. Gradually, over the next 5-8 years we should bring home all our troops from literally every county they are stationed.

This chart shows the absurdity of our spending.

Chart courtesy of Global Issues - World Military Spending.

By the way that chart does not include the latest increase in the US military budget. Please consider US lawmakers pass 680-billion-dollar defense budget bill
The US House of Representatives passed a 680-billion-dollar defense authorization bill on Thursday that includes funds to train Afghan security forces and more mine-resistant troop carriers.

Lawmakers defied President Barack Obama's veto threat and approved 560 million dollars to continue work on an alternative engine for the F-35 fighter jet built by General Electric and British manufacturer Rolls-Royce.

The compromise legislation would also raise military pay by 3.4 percent -- half a percentage point higher than Pentagon recommendations -- and assign 6.7 billion dollars for mine-resistant armored vehicles known as MRAPs, which is 1.2 billion dollars more than the administration had proposed.
Nearly $700 billion dollars of "defense" spending. The amount needed for actual defense is 20% of that at most, and more likely 5%. Balancing the budget is easy if you start here.

Mauldin: Glass-Steagall, or some form of it, should be brought back. Banks, which are subject to taxpayer bailouts, should not be in the investment banking and derivatives-creating business. Derivatives, especially credit default swaps, should be on an exchange, and too big to fail must go. Banks have enough risk just making loans. Leverage should be dialed down, and hedge funds selling what amounts to naked call options in any form, derivative or otherwise, should be regulated.

Mish: What we need to do is get rid of the Fed, FDIC, and fractional reserve lending. Regulation has failed every step of the way. Regulation created Fannie Mae, Freddie Mac, and the Fed. Regulation by the SEC anointed Moodys, Fitch, and the S&P as debt rating companies. We do not need more regulation, we need less regulation, a sound currency, and no Fed. Regulation is clearly the problem, yet the cries for still more regulation come from nearly every corner save the Austrian economists.

Mauldin: Let me see, is there any group I have not offended yet? But something like I am suggesting is going to have to be done at some point. There is no way we can continue forever on the current path. At some point, we will hit the wall. The fight between the bug and the windshield always ends in favor of the windshield. The bond market is going to have to see a credible effort to get back to a reasonable deficit, or we risk a very difficult economic environment. The longer we wait, the worse it will be.

Mish: "Is there any group I have not offended yet?" Yes. You failed to offend those on public pension plans. Not to fear, I did that myself in Five Major Pension Problems - One Simple Solution.

Unsolvable Problems

  • Expecting 8% returns in a 4% world. When 30 year treasury bonds are yielding 4%, the dividend yield of the S&P 500 is 2%, and the S&P 500 PE is 140 (26 if you use operating earnings), 8% returns are from Fantasyland.

  • Pension benefits start too early. People are living longer.

  • Private employees do not receive these kind of benefits. Public employees should not either, especially at taxpayer expense.

  • Indeed, continuing to chase high-yield in a low-yield world is a guarantee those plans will blow up again down the road.

  • Pension plans are so underfunded that it is virtually impossible to catch up, no matter what risks the plan managers undertake. When asked how long it would now take for its investments to put the fund back on track, Ohio officials simply said: "Infinity."

There is a solution of course, it's just not one that anyone wants to hear: The correct plan is to kill all unnecessary services, fire all the government workers and privatize everything remaining.

That is a choice the Washington Post failed to mention. Moreover, it's the only thing that reasonably works.

Mauldin: It is not going to be easy to persuade a majority of Americans that we need to do something now. More realistically, we are going to probably have to begin to experience a crisis of some type to get politicians motivated to do something.

We are not going back to normal, although it is likely we will see some form of Statistical Recovery. But we cannot get complacent. Somewhere out there is the real potential for another crisis, which will dwarf the last one. You will not want to be long much of anything when it happens, except hedged or liquid investments. Though admittedly, this could go on for a long time.

Mish: Obama, Geithner, Congress, Bernanke, the Fed, central bankers in general, and foreign governments are all in the process of rearranging the chairs on the deck of the Titanic right now. Their solution is printing money.

Don't Mistake Printing For A Sustainable Recovery

The plan to date is called Competitive Currency Debasement with the US, China, and Japan as the key players.

As noted in Gold And The Watched Pot Theory, "Every country wants to grow by ramping up exports in a world of decreasing consumer demand. To achieve that end, every country wants its currency to be weaker against every other currency. Of course that is logically impossible. Besides, the US consumer is tapped out. European consumers are tapped out as well. And tapped out or not, the Japanese consumer just does not want to buy."

Neither the G-20 nor G-7 did anything to address the massive global imbalances. Something critical is going to blow sky high, when and what remains to be seen.

Mike "Mish" Shedlock
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