Economics

Federal Deposit Insurance: A Banking System Built on Sand

Warren Gibson Economics, History, Law, Liberty ,

Federal deposit insurance grew out of a turbulent time in American history: the Great Depression. During two waves of bank failures in the 1930s an astonishing 9,000 banks closed and millions of depositors lost some or all of their savings. The Federal Deposit Insurance Corporation (FDIC) began operations in 1934, insuring deposit accounts up to $5,000 per person (roughly $80,000 in today’s money).

The bank failure rate then dropped dramatically and never again rose anywhere close to the level of the 1930s. And such bank failures that have occurred have cost insured depositors nothing; many uninsured depositors were made whole as well. Bank runs are a distant memory, revived occasionally by reruns of It’s a Wonderful Life.

Yet it may be premature to pronounce deposit insurance a success. It can take a long time for an unsustainable program to unravel: Witness Social Security and Medicare. Seventy-five years after the start of Social Security and 45 years into Medicare, it’s common knowledge that both programs are headed for a financial cliff. A closer look at deposit insurance will show cracks in its edifice, raising questions about its sustainability as well as the distortions that it has introduced into the economy.

Before we take that closer look we might ask whether, as is widely assumed, the bank failures of the 1930s were an example of unregulated free markets run amok. During that time, as Milton Friedman and Anna Schwarz pointed out in their classic, A Monetary History of the U.S., the number of bank failures in Canada was exactly zero. Canada is closely linked to the United States economically and culturally, making this episode as near to a controlled experiment as any macroeconomist could wish for.

The difference? Canada had just ten nationwide banks with about 3,000 branches, while branch banking across state lines, and often within states, was prohibited by U.S. law. Thus smaller communities could only be served by relatively weak, poorly capitalized banks. A hailstorm might be enough to topple the local bank in a small farming community as surely as if it were built from straw.

The banking system was also caught in the downdraft of a plummeting money supply. When banks hold only a fraction of their liabilities as reserves, deposit inflows cause the money supply to multiply, but the reverse happened during the Depression as worried depositors began to cash out their accounts. The economy could have adjusted to a declining money supply in one of two ways: either by lowering prices and wages or by Federal Reserve injection of new money. Hoover’s jawboning and Roosevelt’s New Deal legislation precluded the first solution, while the Fed, out of ignorance or confusion, failed to inject new money. With economic adjustment prevented by government policies, a vicious cycle of souring bank loans, liquidation of deposits, further declines in the money supply, and more business failures took hold.

Interestingly, Milton Friedman and Murray Rothbard, both free-market economists, reached opposite conclusions about the declining money supply. While Friedman blamed the Fed, Rothbard celebrated what he saw as the people’s attempt to overturn fractional-reserve banking, which he believed is inherently fraudulent. Either way, the fingerprints of government were all over the bank failures of the 1930s and the Great Depression generally.

With the failure of so many banks, U.S. Representative Henry Steagall vigorously pushed deposit insurance legislation. Franklin Roosevelt was among his opponents. Indeed, when asked about guaranteeing bank deposits four days after his inauguration in March 1933, Roosevelt said he agreed with Herbert Hoover:

“I can tell you as to guaranteeing bank deposits my own views, and I think those of the old Administration. The general underlying thought behind the use of the word ‘guarantee’ with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the Government starts to do that the Government runs into a probable loss. . . . We do not wish to make the United States Government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.”

FDR was right. Deposit insurance generates moral hazard: an incentive to engage in more reckless behavior when one’s misdeeds are covered by someone else. Bank managers tend to make riskier loans than they would without insurance, and depositors don’t worry about the lending practices of the banks they patronize. Currently many people, including me, buy bank certificates of deposit through online brokers, perhaps not even learning the name of the bank that got our money. The magic letters FDIC are all we look for.

Savings & Loan and Moral Hazard

The savings and loan crisis of the late 1980s saw a catastrophic explosion of moral hazard. Deregulation had lifted interest rate caps for S&Ls and allowed them to expand from residential mortgages into commercial and consumer lending. Competitive pressures sent managers scrambling into these markets, which were mostly unfamiliar to them, while at the same time they had to compete vigorously for deposits. With deposit insurance offered to all chartered institutions regardless of risk, S&Ls made many preposterous loans. When the dust settled, roughly half had failed. A massive taxpayer bailout followed and, as very rarely happens to failing government agencies, the Federal Savings and Loan Insurance Corporation was abolished in 1989—though its responsibilities were shifted to the FDIC.

Moral hazard is an aspect of all insurance, public or private. But private insurance companies, if they wish to survive and prosper, must find ways to limit policyholders’ risky behavior. Deductibles, copays, threats of cancellation, and rewards for prudent behavior return some monetary incentive to policyholders. In addition, insurance companies try to educate policyholders about prudent behavior. Crucially, in a free market private insurance companies’ profit-and-loss statements tell whether they’re getting it right. Government agencies lack profit-and-loss discipline and are inevitably subject to political pressure. The FDIC’s legally mandated requirement to hold reserves to back its liabilities may resemble market discipline, but as we shall see, when the mandate was violated, no one lost his job and no investors lost any capital.

Private insurance companies invest most of their reserves in productive activities such as corporate securities or real estate. They count on earnings from these investments to balance low or even negative returns on their pure underwriting activities. The FDIC, by law, holds its reserves in the form of Treasury securities. Any alternative would certainly be riskier and more politically charged. Yet we must recognize that this arrangement, as with the Social Security Trust Fund, is merely a pass-through of the FDIC’s liabilities to U.S. taxpayers.

The FDIC reserve fund is called the Deposit Insurance Fund (DIF). For most of its history, the DIF was kept within its statutory limit, which has varied over time but is currently a range of 1.15 to 1.25 percent of insured deposits. At least, that’s the statutory range. It’s actually essentially zero. But are the statutory numbers the right ones? No one can be sure, but again, the FDIC lacks a profit motive to help get it right.

A spate of bank failures in 2008 and 2009, while far less severe in number and magnitude than in the 1930s, left the DIF with no unencumbered assets at all. The pace of bank failures continued during the first three months of 2010, while the number of problem banks on the FDIC’s secret list jumped 27 percent in the fourth quarter of 2009, to 702. In short, the FDIC is in trouble.

A restoration plan has been proposed to get the DIF back to 1.15 percent of insured deposits by about 2017, a date that has been pushed back more than once. The plan relies heavily on an assumption that the economy will soon resume robust growth and that “only” about $100 billion in failure costs will be incurred between 2009 and 2013, with most of those costs coming in 2010. For the shorter term, the proposal calls on commercial banks to prepay their deposit insurance premiums through 2011. When they do so, a new asset will appear on their balance sheets: a prepaid expense. To gain their acceptance and cooperation, the FDIC proposes that this prepaid expense be counted as an asset that is just as safe as U.S. government securities and therefore does not require additional capital backing. This shuffle will be pretty much a wash for the commercial banks, and the upshot is that the FDIC will indirectly borrow its own future premium income, hoping that income will materialize in amounts sufficient not only to cover future bank failures but also to rebuild the DIF. We shall see.

The DIF is not the FDIC’s only problem. When closing a failed bank, the agency tries to sell as many of the bank’s assets as possible, including branches, loans, and securities holdings. The FDIC’s goal is usually to make all depositors whole, not just insured depositors. It sometimes takes possession of assets for which it can’t get an acceptable bid. In doing so it acquires assets that are difficult to evaluate and thus greatly complicate estimates of future liabilities.

Disguised Risk

Now let’s take a longer look at the business of banking. The very words we use, like “bank” and “deposit,” can distort our thinking. The word “bank” comes from the bench or counter where medieval money changers did business. The word “deposit” suggests something like an ore deposit in the ground: the minerals are there and can be gotten out. We think of banks as custodians of our money, keeping it safe for us and making it available whenever we need it. But present-day banks are not deposit banks, locking our money away in a vault as the term would suggest, but rather loan banks. Most of our deposits are loaned out and not all of them could be redeemed on short notice. This works fine as long as there is no large and sudden short-term demand for withdrawals. But we have come to believe, in part due to misleading terminology, that we can have rewards without risk. Interest paid on bank deposits is now essentially zero but as depositors, we still reap benefits such as ATMs and online banking with no fee and no apparent risk. In short, as in so many areas of contemporary life, we have been led to expect something for nothing.

Thus proper labeling could help rationalize banking. Those who want utmost safety in the form of true deposit banking should be free to pay for it with fees for storage of their currency or gold. Liability insurance for true custodial service should be very cheap. Those who wish to entrust their money to loan banking should accept the risk, and if they want insured accounts, they—not taxpayers—should be prepared to pay for the insurance, at least indirectly.

While there is nothing inherently wrong with loan banking, we get too much of it when it is disguised as deposit banking and backed by mispriced and politically motivated government insurance. The result is a banking system that is more highly leveraged than it otherwise would be. This in turn increases the severity of business cycles—booms and busts.

FDIC Incentives

Back to the FDIC. As we have seen, banks pay for its service in the form of insurance premiums. Coverage is not mandatory, so the organization looks somewhat like a private business. But in fact it is a monopoly supplier to banks (with a parallel institution serving credit unions). Private competitors are locked out, perhaps not by statute, but by the FDIC’s implicit and explicit backing by the Treasury (explicit in the form of a line of credit). Without a profit motive, the FDIC lacks the incentive to serve its bank customers and its indirect depositor customers by offering innovative services with effective moral-hazard controls.

Though the FDIC lacks market incentives, it is awash in political incentives. Thus in 2008 Congress voted for an increase in deposit coverage from $100,000 to $250,000 with little or no discussion of the costs of this move. This “temporary” increase has been extended once and will likely become permanent. Members of Congress are of course motivated by the campaign contributions of bankers and others, and may not know or care about the long-term consequences of such actions.

Private Options

How might private firms handle bank deposit insurance? Before the government takeover of the banking system, private clearinghouses sometimes provided mutual aid among member banks. The Suffolk Bank in Boston was a notable example in the early 1800s. It supported country banks in New England for many years by clearing their transactions and accepting their currency at par. It earned a profit doing so.

But could private firms ever be big enough to provide bank deposit insurance in today’s multitrillion dollar economy? Reinsurance firms offer evidence that they could. As their name indicates, General Re and other such firms insure insurance companies. Who insures the reinsurance companies? No one. Absent government intervention, these firms would experience diseconomies of scale when they grow too large, provided it is clear that they would not be in line for a government bailout should they get into difficulty.

Failure is an important aspect of the free market. Economist Joseph Schumpeter’s pithy phrase “creative destruction” captures this notion and reminds us that failures, which will always be with us, should be liquidated so that others can pick up the remains and apply them to more promising enterprises. Shouldn’t this idea apply to banks as well? Rothbard actually celebrated occasional bank runs as a way of putting the fear of God into bank managers and depositors alike. Amazingly, Roosevelt’s initial response to the deposit insurance proposal echoed Rothbard’s: “There are undoubtedly some banks that are not going to pay one hundred cents on the dollar. We all know it is better to have that loss taken than to jeopardize the credit of the United States Government. . . .”

Washington-Wall Street Banking Cartel

Make no mistake, our current banking system is, and has long been, a cartel run for the mutual benefit of Wall Street financiers and their regulator friends in Washington. Case in point: Goldman Sachs and Morgan Stanley were allowed to convert to bank holding companies so that they could receive federal bailout money. The $180 billion AIG bailout provided Goldman with 100 cents on the dollar for its holdings of AIG credit default swaps.

Let us not be so naive as to believe that government deposit insurance is any different. Any benefit this system provides to small depositors is incidental to its real objective: to serve the cartel.

The banking system is in need of real reform. More regulation? More virtuous regulators? Only the naive, the ignorant, or the disingenuous can believe these answers in the face of regulation’s long history of failure, the practical impossibility of detailed oversight, and the perverse political incentives that always operate. The solution lies not in wiping out risk—there can be no real economic growth without risk. Instead, we need rational incentives: Let risks be borne by those best able and willing to take them.

[Editor’s note: this essay first appeared in the Freeman on May 20 2010]

The Sales Tax Petard

Fred Foldvary Current Events, Economics, Liberty

For years, the web-based book seller Amazon.com had not been charging sales tax in states in which it did not have a physical presence such as a store. States do not have legal jurisdiction over enterprises that are not located within their territory, although Amazon and other companies have had relationships with affiliate companies, which makes the concept of a physical presence unclear.

Customers who do not pay a sales tax to the seller are supposed to pay a Ause@ tax that is equivalent to a sales tax, but they rarely do this, due to the absence of enforcement. This proves that most people do not consider a tax on goods to be a moral obligation.

Now the sales-tax-free era is coming to an end. Book store owners had long complained that it was unjust for them to pay sales taxes while web-based sellers were not charging the tax. In California and some other states, the sales tax rate is about ten percent, a substantial difference when the price of a book is high, and the books can be mailed at the low-cost media rate. Continue reading →

Around the Web

Brandon Christensen Economics, Links , , , ,
  1. What if there really were mutants, X-Men style?
  2. Adam Smith’s anti-imperialism. Grab a cup of tea or coffee.
  3. More environmental destruction in China. We saw the same type of thing happen in eastern Europe and Russia during the Cold War. This destruction is also rampant in post-colonial states that have largely adopted a Leninist approach to state-building. This may just be part of a harsh learning curve that comes with economic development. After all, the property rights regimes that the West now has in place took hundreds of years to develop, and they could all be much, much better. On the other hand, it seems as if Beijing is undertaking many projects without even thinking about the consequences, much less the claims to property by its citizens that are already in place.
  4. Has the Fed Been a Failure? If you read one thing this weekend, let it be this.
  5. More on militias and the second amendment, by –Rick (check out his blog here)

GDP: Who Needs It?

Warren Gibson Current Events, Economics, History, Liberty

“For so it is, oh my Lord God, I measure it, but what it is that I measure I do not know.” –St. Augustine

Gross Domestic Product (GDP) gets a lot of attention these days. It’s fair game for bloggers, talking heads, perhaps your local barber.  While most agree that higher GDP is better than lower, there are problems, some better-known than others. Some theorists have considered the concept hopeless, such as Austrian economist Oskar Morgenstern, who called GNP (the predecessor to GDP) “primitive in the extreme and certainly useless.” Lamenting the idea that the whole of a nation’s economic activity could be captured in a single number, he said that “very few men, even few economists, or should I say regretfully, especially economists, have a real appreciation and understanding of the immense complexity of an economic system.”

Let’s get the formal definition out of the way. GDP is the market value of all final goods and services produced in a particular country in a given year. The federal Bureau of Economic Analysis computes this number and releases it quarterly. The level of GDP is used as a basis for evaluating other things, like the national debt, which currently stands at about 85 percent of one year’s GDP in the United States. GDP growth rates are closely followed. These are inflation-adjusted, seasonally adjusted, and annualized, and are of course supposed to tell us how well the economy is doing.

Simon Kuznets gets credit for the first serious attempt to calculate national income figures, publishing his first work on the subject in 1941. Following in his footsteps, calculation of GDP and other “national income accounts” has become a core area of the economics profession. The explosion of economic and financial news has thrust GDP into the limelight in recent years. Continue reading →

How to Make the New Year Better

Fred Foldvary Current Events, Economics, Politics , , ,

Many economists and financial analysts are making conjectures about when the recession will bottom out and how strong the recovery will be. The speed of recovery depends on the policies of government world wide. With the best policies, the economy could recover within three months. With bad policies, such as occurred during the Great Depression, the economy could stay down for years.

One bad policy that made the depression worse was the erection of trade barriers. The US enacted a high tariff in 1930, and other countries also restricted imports, and world trade broke down. Companies that sold goods abroad could no longer stay in business. Farmers suffered as foreigners could not buy their crops.

Unfortunately, many countries today are repeating this policy error. The German philosopher Hegel was right when he observed that governments do not learn from history. Indonesia is requiring new licenses and taxes for imports. Russia has raised tariffs on imported cars and food. India has levied a tariff on imported soybean oil. The chiefs of each country think that they are protecting their home industries, but they are ignoring the lessons of the Great Depression, as trade limitation is contagious. If political pressure induces them to do something, a money subsidy is preferable to a trade barrier, since that does not distort prices as much. Continue reading →

What is a Fair Share of Taxes?

Fred Foldvary Economics, Liberty

What is fair is different from what is just. What is just is determined by the ethic of natural moral law as expressed by the universal ethic. The universal ethic prescribes that all acts, and only those acts, that coercively harm others, are evil. Justice is the implementation of the universal ethic in law. Justice is applied by prohibiting and penalizing evil acts, and by keeping all other acts free of restrictions or imposed costs.

The premises from which natural moral law derive are the biological independence of thinking and feeling, and the equal moral worth of all human beings. Thus a foundation of justice is equality before the law. People with equal conditions should be treated the same.

Equality implies that all persons are equal self-owners. If one person imposes his will on another, the victim becomes a slave, and the tyrant becomes a master, in violation of equality. Self-ownership implies that one fully owns one’s labor, and therefore any tax on wages or the products of labor, or the spending of wages, violates self-ownership, and is unjust.  Continue reading →

The Mystique of Hedge Funds

Warren Gibson Economics, History , , , , , , ,

Hedge funds are controversial these days. Though it’s unlikely that the average citizen or the average congressman could say just what hedge funds do, many are certain they must be reined in by additional regulation because they can—and do—cause widespread damage to our financial system. Almost everyone takes it for granted that regulation of some sort is the solution, ignoring the possibility that at least some of the problems are actually caused by regulation.

What is a hedge fund? The name implies hedging, a strategy that reduces risk. If you bet on several horses in a race, you are hedging your bets—spreading your risk. You can buy gold to hedge against inflation. You can sell interest-rate futures to hedge the risk that rising interest rates would pose to your bond portfolio.

The first hedge fund was created in 1949 by Alfred Jones. He believed he could pick stocks that would outperform and those that would underperform the overall market. But Jones didn’t know where the overall market was going, so he would buy his expected outperformers and sell short the expected underperformers. He thereby insulated his portfolio from general market moves, which would affect about half his holding positively and half negatively.

Most present-day hedge funds don’t do much hedging, but the name persists. Instead, they engage in a bewildering variety of trading methods, including buying on margin (using borrowed funds) and selling short (selling borrowed assets so as to profit from a price drop). They trade stocks, bonds, options, currencies, commodity futures, and sophisticated derivatives thereof. Some try to anticipate global political or economic events, while others seek opportunities in specific industries or companies. Continue reading →

The Pigou Club

Fred Foldvary Current Events, Economics , , ,

Professor N. Gregory Mankiw of Harvard University initiated and hosts “The Pigou Club” of economists, journalists, and politicians who have favorably written about pollution levies as an efficient way to reduce emissions. Arthur Cecil Pigou was the economist who was the first to deeply analyze externalities (uncompensated effects on others) in his 1920 book The Economics of Welfare.

Pigou proposed a levy on negative external effects equal to the social cost, so that buyers and users pay the full social cost of products. The most common applications are tolls to prevent traffic congestion, parking meters that vary by time of day, and pollution levies.

The policy of charging those who create negative externalities is named Pigouvian, or Pigovian. Mankiw advocates higher gasoline taxes, but that would also tax those car owners with cars that run quite cleanly and are driven in roads that are not congested. The best Pigovian policy is to focus the charge on the negative element such as harmful emissions.  Continue reading →

Around the Web

Brandon Christensen Economics, Links

  1. Seven Sins of our Forced Education

  2. Growth: Markets Broad and Deep
  3. Going Off the Rawls. A philosophical conversation with David Gordon.

  4. Learning to Love Volatility

  5. Schools for Slavery

The Fiscal Cliff

Fred Foldvary Current Events, Economics, Politics , , , , , , , ,

The “fiscal cliff” is the economic plunge that will occur in the U.S.A. if Congress does not change the big tax hikes and spending reductions that will otherwise start on January 1, 2013. The income tax rate cuts enacted at the beginning of the ozo years (2000 to 2009), as well as the payroll tax cuts that followed the Crash of 2008, were temporary and are scheduled to expire at the close of 2012.

Congress enacted the Budget Control Act of 2011 to require “sequestration” – automatic sharp spending reductions in 2013 – unless it enacted the recommendations of a “supercommittee,” which then failed to achieve a consensus on raising revenues and cutting spending.

Now in mid November 2012 the economy is a train heading towards the cliff, and if Congress does not lay down a track to make the train veer off to the side, the economic train will plunge into another depression. Continue reading →

Around the Web: “I’m Stuffed” Edition

Brandon Christensen Current Events, Economics, History, Links , ,

I’m so full from food and dessert it’s not even funny. I’m back home in NorCal, too. I hope your holiday has been everything that mine has and more.

  1. Immigration: Giant low-hanging fruit.
  2. Have you ever heard of Opera, the browser? I have, and I tried it out at one point, but Google’s Chrome is where its at. Anyway, Opera is the most used browser in Belarus…and no where else. Find out why, in the Atlantic.
  3. Some literary history. From FEE.
  4. China in Revolt.
  5. Contra #4, Hayek in China.

Happy holidays to you all, and tell your moms I said ‘hi’!

 

What Exactly is Profit, Anyway?

Brandon Christensen Economics , ,

Co-editor Fred Foldvary explains over at FEE’s revamped website:

We also need to distinguish economic revenue from accounting revenue.  Suppose a thief enters a house and steals $1,000 of loot.  To break into that house he bought a tool for $100.  Ignoring the opportunity cost of his time, the thief’s accounting revenue is $1,000, and his cost is $100.  Is the $900 net gain a profit in the economic sense?

Stolen loot is not real profit because it is a forced transfer of goods or money from the victim to the thief.  True profit is a net gain from production and exchange.  If someone gives you a gift of $100, it too is just a transfer.

If instead of directly stealing wealth someone uses the government to forcibly take money from some and give it to others, the gain is also not true profit.

Read the rest here.

Methodological Individualism

Brandon Christensen Books, Current Events, Economics, Links

That’s the title to co-blogger Warren Gibson’s latest piece in the Freeman. I wish I could copy and paste the whole thing, but you’ll have to settle for this juicy tidbit:

Let’s start with what methodological individualism is not.  It has nothing to do with “rugged individualism.”  It is not ideology at all.  It is a term that describes the essential nature of human thought and action.  It is a bedrock principle on which Mises grounds his entire exposition of economics.

“The Hangman, not the state, executes a criminal.”  This is Mises’s pithy summary of methodological individualism […]

When we think about the hangman from the point of view of praxeology (Mises’s name for the science of human action) we are not concerned with the social or psychological factors that may have influenced his action, nor the neural firings in his brain, nor the musculoskeletal actions in his arm.  We are simply observing that actions are always initiated and carried out by individuals and are always motivated by the individual’s expectation of being better off as a result of the chosen action rather than some alternative.

Do read the whole thing.

Warren Harding’s Fiscal Cliff

Warren Gibson Economics, History , , , , , , ,

The economy is in rough shape right now but suppose it were even worse: unemployment at 12% rather than 8%; GDP falling at a 17% annual rate rather than rising slowly.  A close advisor to the President counsels an array of interventions to stimulate the economy but is ignored.  Instead, the President cuts Federal spending in half and engineers drastic reductions in income  tax rates for all groups.  Meanwhile the Federal Reserve, rather than cranking up the printing presses for a round of monetary stimulus, snoozes through the whole year.

Now there’s a fiscal cliff for you.  If today’s thinking about the fiscal cliff of Jan. 1, 2013 held true, surely such policies would tank the economy big-time.

The foregoing scenario actually happened.  The year was 1920, the President was Warren G. Harding and his close advisor was none other than Herbert Hoover, who as President from 1929 to 1933 would have his way – raising taxes, jawboning wages, and slapping a killer tariff on the economy, thereby doing a great deal to turn the rather mild downturn of 1929-30 into the Great Depression which, with lots of help from Franklin Roosevelt, would plague the nation for another decade.

So what happened in Harding’s time?  Things were pretty rough for a while but by the summer of 1921, signs of recovery were already visible.  The following year, unemployment was back down to 6.7% and hit 2.4% by 1923 (source: Thomas Woods, “The Forgotten Depression of 1920″).  A budget surplus arose resulting in a noticeable decline in the national debt.  Business confidence soared and the 1920’s boom was off and running.

President Harding has gotten a bad rap from history because of the scandals that erupted during his administration as well as his chronic womanizing and his passion for the bottle.  But in the countdown of 20th century Presidents that I might do for this blog should I ever get ambitious, I will start with Harding as the least bad President of that sad century and work my way down from there.  I’ll let you  guess who I will honor as the Worst President of the Century.

How does the looming fiscal cliff compare with the policies of 1920?  In case you’ve been hiding under a rock lately (not a bad way to ride out the election campaign!), the fiscal cliff is the set of automatic tax increases and spending cuts that were agreed to when the debt ceiling was raised in 2011.  Congress decided to force its future self to act by lighting a time bomb that it would surely – surely! – defuse before it could go off.  The fuse has now burned to within 1/8 inch of the bomb.

The bomb’s tax increases and spending cuts would reduce the deficit by an estimated $600 billion in one year.  That may be the most accurate estimate but it’s only an estimate.  Congress can set tax rates but tax revenues depend on the size of the tax base.  If highly productive people, those who would take the biggest hit, decide to Go Galt, the tax base could shrink.  And as Jeff Hummel likes to point out, tax rates, particularly the top marginal rates, have varied drastically over the years and yet tax receipts have not varied much from 20% of GDP, excepting the World War II years.

Not only might tax receipts fall short, but expenditures could rise if additional welfare payments such as unemployment benefits or food stamps were to rise.

But let’s assume the fiscal cliff happens and the deficit is indeed reduced by $600 billion. Using figures for the fiscal year just ended, we would still have a $400 billion deficit which would have to be financed by borrowing.  As always, this would be new borrowing, on top of the borrowing needed to roll over the daily stream of maturing debt.  And we mustn’t forget the Social Security Trust Fund which until last year has mitigated the deficit by “investing” its surpluses (FICA tax revenues minus benefit payments) in Treasury securities.  Those FICA surpluses have now turned to deficits which for the present are offset by interest payments on Trust Fund holdings but will eventually require the Trust Fund to stop rolling over maturing securities and, should the trend continue, to deplete its holdings entirely.  All of these developments exacerbate the main federal deficit.  The same applies to the much smaller Medicare Trust Fund.

So I say, with a glance over my shoulder at 1920, bring on the fiscal cliff!  Let the cuts happen, thereby ending a lot of wasteful and harmful spending – particularly “defense” spending.  Let tax rates rise; people will work around them.

But it won’t happen because too many special interests will rise up to prevent it:

  • There are enough military personnel, military contractors, their suppliers, relatives and hangers-on to prevent significant cuts in defense spending.
  • The 27% cut in Medicare physician fees will lead doctors to brush away their Medicare patients like flies, sending those patients hobbling off to howl at their their Congressmen.
  • Millions of middle class people will gasp when their tax preparer tells them they’ve been caught in the dreaded Alternative Minimum Tax trap.  Others will escape the trap only to find that their ordinary income tax rates have risen substantially.
  • Still more millions will see their FICA (Social Security) tax rate revert to the 2010 rate of 6.2% from the current 4.2% “stimulus” figure.

The fiscal cliff won’t happen, at least not all of it, except perhaps for a brief period in January which will be fixed retroactively.  And so, though I hate to say it, I think the longer-term odds of pulling out of our fiscal death spiral are pretty slim.  Many think the government will resort to the time-honored remedy of the printing press, but Jeff Hummel has made a solid argument as to why this option won’t work and why there will be a default on Treasury securities instead.

Hummel also urges economists to do whatever they can to warn people not to count on government largess.  Most young people have written off Social Security for their future and that’s a good thing.  (Not so good for Social Security recipients like me who are increasingly unemployable yet hope to live another 25 years.)  We must take responsibility for our own health care, first by watching our health habits and second by cultivating a personal relationship with a physician, perhaps offering him or her cash payments.  We should be leery of Treasury Securities or of banks, mutual funds, etc. that rely heavily on these securities.  Sock away a few gold and silver coins.

We’re in for a rough ride, I fear, over the next few years.  But the sun will still rise and tangible assets will remain.  Provided enough of us have taken precautions, social unrest will be manageable and maybe, just maybe, the cancer that is called Social Democracy will be shaken off once and for all.

National Economic Systems: An Introduction for Intelligent Beginners – 3

Jacques Delacroix Current Events, Economics, Liberty , ,

My Debt, your Debt and Future Poverty.

I told you in previous installments of this series of essays that we, in the USA, are not facing one economic crisis but two.

The fist crisis is a recession. It’s a common event in the long run of market economies. Recessions are defined by serious people (according to me) as two consecutive quarters or more of economic shrinkage. Recessions go away whether any government does anything about them or not. One school of thought (Keynesian), to which the Obama administration belongs, maintains that large government spending – stimulation- can lessen or shorten a recession. I argued that the Obama stimulus package of several months ago cannot possibly stimulate, even if you believe in the stimulation scenario.

The second crisis, by far the most serious, is the abnormally high debt the federal government has incurred since President Obama came to office. It disturbs me because the people, you and I, will have to pay interest on the debt for a long time, and eventually re-pay the principal. Else, the government will have to repay its debt in bad currency, in devalued or in eroded currency. If this happens, we will simply all be poorer, in real terms, If your dollar is worth half in ten years of what it is worth now, you will simply have to pay two dollars for what you buy today for one dollar. There is no reason to assume your income will automatically follow. This is a common fallacy (perhaps the topic for another essay): It takes about forty Indian rupees to buy a US dollar today and the same mountain bike that costs 400 US dollars in this country costs 600 US dollars in India. A good income in India would be 12,000 dollars per year. (That’s about twelve times the national average.)  Continue reading →