Author: James Pethokoukis

Bond guru Bill Gross makes this point:

Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits.

Me:  This certainly seems to be the case with Ireland, as it has for most countries trying this path to escape a debt trap. As I point out in this Weekly Standard piece I wrote, the best way to solve a sovereign debt problem is by cutting spending and boosting economic growth.

The American Jobs and Closing Tax Loopholes Act? Really? Even by the disingenuous standards of Capitol Hill, calling the $174 billion spending package making its way through the House “a jobs bill” takes some real moxie.

Die-hard Keynesians, of course, will contend that so long as money gets pushed into the economy, how it gets spent isn’t so critical. But for a government running trillion-dollar budget deficits, at least every billion or so should count. And it’s hard to argue that this bill is optimized for job creation or economic growth.

1) For instance, the bill includes a one-year, $6.7 billion extension of the federal research and development tax credit. By not making it permanent, the credit is less likely to foster long-term investment. The bill also extends tax breaks for NASCAR and Hollywood, ensuring both Red and Blue state residents get fed their respective helpings of pork.

2) More than a quarter of the spending — $47 billion over 10 years — goes toward extending unemployment insurance benefits. Economists worry the increased availability of such assistance may reduce the intensity with which the jobless look for work and lengthen the duration of unemployment by nearly 10 percent. It’s also tough to pin down the job-creating impact of spending $63 billion to increase Medicare payments to doctors and $24 billion for higher Medicaid spending.

3) Even worse, the proposal enlarges the budget deficit. Less than a quarter of the tab is paid for, showing again just how easy it is for Congress to avoid self-imposed limits on deficit spending. And increased Medicare spending was excluded from healthcare reform so the bill could get a better score from the Congressional Budget Office.

4) The White House will argue that given the high unemployment rate, bringing down the deficit is less of a priority. But listen to what economist Carment Reinhart told the president’s deficit panel today (via The Hill):

The gross U.S. debt is approaching a level equivalent to 90 percent of the country’s gross domestic product, the level at which growth has historically declined, said Carmen Reinhart, a University of Maryland economist. When gross debt hits 90 percent of GDP, Reinhart told the commission during a hearing in the Capitol, growth “deteriorates markedly.” Median growth rates fall by 1 percent, and average growth rates fall “considerably more,” she said.

Reinhart said the commission shouldn’t wait to put in place a plan to rein in deficits. “I have no positive news to give,” she said. “Fiscal austerity is something nobody wants, but it is a fact.

5) Barack Obama’s original stimulus plan was $787 billion (though costs have pushed it up to $862 billion). While some advisers argued for $1.2 trillion, the president sided with those who believed an amount of such Brobdingnagian size would alarm financial markets — and probably voters, too. This latest legislation, combined with a $17 billion jobs bill passed in March, would put the tally at around $1 trillion, not counting interest. In due course, the math will be easy enough for the markets to understand.

It’s absurd. Uncle Sam is likely to run up an additional $11 trillion in debt over the next decade. But Washington only replies with minor budgetary tweaks. First, the Obama administration says it wants to freeze some domestic spending for three years. Then it creates a new healthcare entitlement program “paid for” through tax increases and unlikely spending cuts. Next up, the Obama administration creates a deficit reduction panel that not even its members think will work. And now the Obama administration wants new “rescission” authority to cut billions from congressional spending bills — excepts it’s “trillions” that are the problem. None of these measures favorably alters the budget’s perilous trajectory.

Little wonder that many observers think Washington will do nothing substantial about the exploding debt problem without some sort of financial market crisis. It is the bond market vigilantes that will come to the rescue and enforce fiscal discipline. Here is one scenario devised by the Committee for a Responsible Federal Budget:

Under this scenario, at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns. They conclude the United States cannot escape basic economic and financial “laws of gravity” forever. They stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. With the sudden shift and large rise in interest rates, the economy goes into a severe recession. … Unlike the past two years, we cannot, however, borrow to stimulate the economy because the crisis was caused by excessive debt and lost confidence. … Creditors concerned with hyperinflation or even default will not buy U.S. debt.

Presumably, that would be the moment when Democrats unveil their “emergency fiscal plan” to calm markets through a massive value-added tax. It would be TARP all over again. But the costs would be many magnitudes higher. But I think the conventional political wisdom is deeply flawed. First, Americans intuitively understand that there is something deeply wrong about running trillion-dollar budget deficits as far as the eye can see. Maybe deficits didn’t politically matter in the 1980s, but debt as a share of GDP was only 50 percent. Now it is 60 percent only its way to 100 percent in a decade.

This is why we didn’t see a second trillion-dollar stimulus. Although plenty of liberal economists though it was needed, even congressional Democrats understood that Stimulus 2.0 would not fly with voters freaked  by all the red ink.

Second, America doesn’t need a domestic debt crisis. Voters can easily track the one happening with Greece and the EU. Runaway spending. Overpaid civil servants. A loss of confidence. Trillion-dollar bailouts. Falling standards of living. National decline.

That all adds up to a pretty compelling case for action in America. And Republicans (along with fiscally responsible Democrats) who want to see true spending reform — of the sort outlined in Rep. Paul Ryan’s Roadmap for America — would do well to frequently mention Greece on the campaign trail. Kind of a “don’t let this happen to us” sort of thing. They should also note that lower spending plus smart tax cuts to boost growth are the best recipe for restoring fiscal order — not massive tax increases which politicians will only divert to more spending.

If I was a U.S. taxpayer or holder of U.S. Treasuries, I would not take much comfort from President Barack Obama’s proposed Reduce Unnecessary Spending Act. Points for effort, I suppose. But fast tracking and streamlining the current fiscal process that allows the White House to submit proposed budget cuts from spending bills would do little.

1. As the Heritage Foundation notes, since 1990, presidents have proposed clawing back only $20 billion of legislated spending, with Congress approving just $6 billion of these rescissions. That’s just .01 percent of all federal spending.

2. A study by Douglas Holtz-Eakin, former head of the Congressional Budget Office, found that an even tougher measure, a line item veto, has a poor track record — at least at the state level. (Here is a good summary of research on the topic via the NY Fed.)

Holtz-Eakin noted that in studying the effect of line-item vetoes at the state level, he found they produced mixed results. He found no major differences in spending between states where governors had this power and states where they did not.

3. Some two-thirds of the budget — mandatory entitlement spending would be off limits.

4. Such expanded powers might work in reverse. It would give the White House power to cajole Congress into supporting its spending policies by threatening to cut the pet projects of individual members.

5. To be fair, this new proposal is just another step in controlling spending – not a solution in and of itself. Obama has already proposed a temporary freeze in some domestic programs and created a deficit panel to suggest more comprehensive solutions. The move also keeps the danger of deficits firm in the public consciousness, though Europe’s woes should be reminder enough. But the White House must be careful about deluding the electorate into thinking that current efforts by the government to trim waste will be sufficient. Investors in Treasuries surely expect bolder fiscal action.

This Strategas chart shows just how badly things have gone off track:

Binyamin Appelbaum of the NYT tries to simply things for me:  ”Broadly speaking, there were two ways for the federal government to respond to the financial crisis. The Obama administration chose more regulation.”

And that is bad news because regulators and their political overlords like bailouts with taxpayer money rather than market discipline. But shrinking the banks, while superficially appealing, is no magic bullet — as this Italian study argues:  ”A world with only small and domestic banks is no safer. The key benefit of multinational banks – being able to mobilise funds across countries – could still be extremely useful for maintaining stability in times of distress.”

David Warsh dismisses reports that Larry Summers may stick around longer than many in Washington expect:

Defense is one possibility. Who wants to be seen as a lame duck while there are eight months to go on the clock – including the mid-term-elections? Offense is equally likely. No doubt the president would like to keep his chief economic adviser for another eighteen months.  Perhaps the administration is lobbying Harvard.

Summers’ other opportunities weigh in the balance: a successful marriage to Harvard English professor Elisa New (between them they have six children, all from previous marriages); the prerogatives that come with being one of Harvard’s fewer than twenty university professors, including the freedom to teach precisely what and where he wishes (or not at all); membership on the executive committee of an economics department that is one of the three or four best in the nation; and, of course, the famous day-a-week of consulting time that Harvard professors are permitted to spend in the moneyed world.

My pal Bruce Bartlett says U.S. demographics support his position that America will need massive tax increases rather than massive entitlement cuts to get its fiscal house in order:

In short, what we see is that over the next ten years the percentage of the population that benefits from Social Security and Medicare is going to rise significantly and that this group of the population votes in higher percentages than those that pay for these programs. And those that will, over their lifetimes, bear the heaviest burden of paying for entitlement programs–the young–vote at the lowest rate of any age group.

Me: He might well be correct. Then again, most of the reform plans I have seen pretty much leave the current system in place for those who are, says over 50 or 55. I also don’t understand why a broad-based tax increase would be any more palatable to people than getting their expected benefits cuts. Not to mention that getting spending under control is a better way to restore solvency than tax hikes.

Don Rissmiller of Strategas looks at how the lessons of the US financial crisis could instruct policy responses for the EU and its Greece problem:

1) The TARP-like option: this is essentially spending government money to buy bad debt, and the European bailout packages have moved in this direction. The political challenge
was always getting money authorized to help those that appeared to be spending beyond their means. This still appears to be where we are now in the EU, despite some progress
with the German vote.

2) The PPIP-like option: the challenge with spending government money in the U.S. was that the authorization process was burdensome. Hence, the next suggestion was a ”public private investment program” (PPIP). The challenge with PPIP (it never got off the ground) was how to get banks to sell assets in an illiquid market, which presumably would not be as large an issue with government debt. But the key features of the program – including non-recourse leverage and a sharing of profits – were indeed well thought out. No European option of this sort appears on the table currently, however.

3) The Monetization option: When the Fed finally started participating with “all available tools”, including buying mortgage securities, the U.S. market stabilized. This is certainly a politically tough option for the ECB. Should it come to it, however, the option of doing nothing certainly seems like a much worse policy mistake.

4) Cutting Spending: Greece already appears to have lost some sovereignty, as the Lisbon treaty has required sharp adjustments. These cuts can be some of the most politically challenging items, though as the governor of NJ has demonstrated, they are not impossible.

5) Europe Bank Guarantees: the risk of a “run on the bank” seems to be creating additional uncertainty, though the amount of deposits that would have to be guaranteed would presumably be quite large. The FDIC guarantee plan in the U.S. could provide some guidance for Europe, however.

And Larry Kudlow also has some thoughts on that last option of Rissmiller’s:

So it’s my contention that the Europeans must now embark on a similar program. The EU/IMF rescue plan, which consists of $1 trillion in loans and loan guarantees for government sovereign debt, must be expanded to include a blanket loan guarantee for all European bank debt, short term and long term. A Europe-wide, centralized, deposit-guarantee system should also be developed. Right now bank deposits are insured by individual countries, like Greece. This is not credible. (Hat tip to investor David Kotok for this deposit-guarantee thought.)

A loan-guarantee program to backstop the banks in Europe and sovereign debt will put an end to this crazy Greek drama that is pulling down markets everywhere and threatening the economic recovery. As a free-market advocate, I don’t like this sort of government intervention. But we’re talking emergency here. Systemic global emergency. … These bank-loan guarantees would be temporary, perhaps a year in length. And they would buy time for the essential budget restructuring necessary to slash spending and curb the welfare-state excesses in southern Europe, or perhaps all of Europe. These government-shrinking steps will free up private-sector resources to spur growth.

A sigh of relief is due on Wall Street. The procedural finale for the U.S. Senate’s debate on financial reform came just in time for the big banks. The bill just kept getting tougher as the talk dragged on. But it could have been worse. While banks’ future activities and profitability may get pinched, their core business model appears intact. In the end, Wall Street got nicked, not nuked. Some observations:

1) Wall Street should thank the White House. Had President Barack Obama prioritized bank reform over healthcare at the height of the crisis, the biggest players might have been broken up, hard caps placed on balance sheets, and banking and investing operations separated. More recently, the Securities and Exchange Commission’s lawsuit against Goldman Sachs in April helped re-energize advocates for such changes.

2) Nothing radical here. While the Senate and House bills still need to be blended, it’s safe to say the most radical ideas have fallen by the wayside. A “systemic risk council” of federal regulators will recommend new capital and leverage rules to the Federal Reserve, which will be the most influential bank regulator. The Federal Deposit Insurance Corporation will have the power to wind down any failing large, systemically interconnected institution.

In addition, large, complex financial firms will have to submit plans for their rapid and orderly shutdown should they go under. And for the first time the derivatives that are currently traded privately will mostly be forced to go through clearing houses and in some cases trade on exchanges. Bank lobbyists have defended their corner: it’s not the regulatory reign of terror their clients’ most vociferous critics wanted. But it’s hardly a “light touch” regime, either, and it does involve real changes. Caveat: This assumes the Blanche Lincoln provision on derivatives is softened or stripped in the conference committee.

3) Too Big To Fail is still a problem. As long as regulators and politicians have vast amounts of discretion, a financial crisis will make bailouts an irresistible temptation. The way around this is either breaking up the banks or creating hard, market-based triggers for either regulatory action or a resolution process. Neither is in the bill.

4) Wall Street’s has an enduring PR problem. Yes, big banks are unpopular. But it has gotten so bad that they may not be able to so easily counter their image issues with campaign cash. Getting Wall Street money now has a stigma attached to it like oil and tobacco money. Candidates like Meg Whitman in California and John Kasich are getting hammered for their Wall Street ties. The industry’s continued unpopularity will no doubt spawn further attempts to tax, regulate and restrict the sector.

5) Bernanke trimphant. The Federal Reserve has to be pretty satisfied. It did not lose its role as regulator; in fact, it’s been strengthened. And the central banks was also able to fend off attempts to make it more transparent.  The downside:  The GOP (see Rand Paul)  has soured on the Fed in a big way, particularly at the grassroots. Further economic woes will lead to more calls to change its form and function.

Over at RealClearPolitics, Rep. Paul Ryan of Wisconsin further fleshes out the emerging “free-market populism” meme beginning to emerge in the GOP:

From an ideological perspective, big government can combine with big business to advance a more progressivist society. For self-described “progressives,” the agenda is straightforward: expand government; co-opt big business; direct the capital markets from Washington to pursue “social justice.” Think Fannie and Freddie by much higher orders of magnitude.

Over the past decade, the thinking has been much less clear for conservatives. Being “pro-market” has been fundamentally confused with “pro-business.” Conservatives who came to Congress to defend and promote free enterprise have often been led to believe that pathway lies in bolstering established firms as they navigate the maze of government regulations and taxes. These instincts are correct, but the implementation is often flawed. All too often, the results of these efforts have been to exacerbate crony capitalism – erecting barriers to entry against potential competitors to firms that are currently on top.

For their part, companies seeking such protection have a right to pursue their narrow self-interest; but when these actions involve reducing open competition and transparency for short term gain, they do so to the detriment of the very free enterprise system that made their success possible.

Me: I can see this manifesting in a number of ways, from attacks on corporate welfare to more explicit calls to diffuse financial power. And it would seem to be in the sweet spot of folks like Marco Rubio, Rand Paul and Pat Toomey. This is also a group that would be willing to call for radical change in the U.S. entitlement system.

So says Mr. Lawrence Kudlow:

A new tea party center is forming in the Republican Senate caucus. It will be the first Reagan nucleus in many years, one that will give the GOP a strong limited-government, cut-spending, low-tax-rate, stop-government-controls, and end-Bailout Nation message that will have clarity and gusto and will reverberate throughout the country.

Here’s how it’s going to work: Rand Paul will grab the Senate seat in Kentucky. Marco Rubio will take Florida. Mike Lee will win in Utah. Pat Toomey will finally prevail in Pennsylvania. And Carly Fiorina will knock off Barbara Boxer in California.

Yup. That’s how I see it. And this new tea-party Senate nucleus will join free-market stalwarts like Jim DeMint, Tom Coburn, Jon Kyl, Richard Shelby, Jeff Sessions, and John Thune. I’m probably leaving somebody out in the Senate, and I apologize in advance. But that’s what I’m thinking. It’s a pity Judd Gregg is retiring; he could be part of that group also.

This will be a reformist nucleus, tackling spending, taxes, and even monetary and currency policy. It will unabashedly propose free-market reforms to replace the Obama welfare state and to finally curb the avalanche of debt creation.

The Great One opines thusly:

To be perfectly honest here, as much as I love to dig into all the money-politics issues — including the financial-reform bill — I’m much more interested in these big profits and capital gains. This V-shaped recovery is the most important item on my radar screen. It’s the single-biggest investor issue out there right now. I don’t think the bull market in stocks is over yet. Again, regarding taxes and regulations, I’ll warn about next year. But frankly, I think the prosperity theme is issue number one.

Well, if you define success as having the commission come up with solutions that can pass Congress, then yes. I am watching several commission members at the Peterson Foundation Fiscal Summit.  They are all downplaying what the commission can accomplish, saying that as long as the panel educates the American public on the debt problem, they will consider it a success.  But will bondholders of U.S. debt agree? Downplaying expectations may avoid an adverse financial market reaction to failure, but I am not sure it should. We won’t cut spending. We won’t raise taxes broadly. And we ignore policies that would boost economic growth. What else is there?

Over at Edge, a variety of scientists give their take on the Iceland volcano eruption and its impact on air travel. Two really stood out to me. The first also highlights the problem of defensive medicine; the second shows the downside to action dealing with global warming:

DANIEL KAHNEMAN

Psychologist, Princeton; Recipient, 2002 Nobel Prize in Economic Sciences

Imagine a public official who considers an action that involves a small and ambiguous risk of disaster. Imagine further that the best expert judgment available is that the expected social benefit of the action is large and that the risks are real but tolerably small. Such situations inevitably create a conflict between the interests of society and those of the officials who are charged to decide on its behalf.

Hindsight and personal accountability are the problem. Decision makers can be certain that if the worst happens their decision to act — however justified it was ex ante — will be perceived ex post as a horrendous mistake. They face the possibility of devastating blame and guilt, as well as career-destroying consequences. The risks are asymmetric because the costs of playing it safe are likely to be negligible.

Even if future analyses of the ash cloud incident conclude that flights could have resumed safely much sooner, it is unlikely that any of the officials involved in delaying the flights will lose their jobs. In this situation and in many others — defensive medicine is an example — the valid anticipation of hindsight combines with social norms of personal accountability to produce overly cautious behavior.

The solution?

Where the social good requires taking risks, we need procedures that will reduce personal accountability and diffuse responsibility, perhaps by assigning some categories of decisions to designated groups of experts rather than to individual functionaries.

MATT RIDLEY
Science Writer; Founding chairman of the International Centre for Life; Author, The Rational Optimist: How Prosperity Evolves

The ash cloud reminds us of the risks of risk aversion. Shutting down Europe’s airspace removed the risk of an ash-caused crash, but it also increased all sorts of other risks: the risk of death to a patient because an urgent medical operation might have to be postponed for lack of supplies, the risk of poverty to a Kenyan farm worker because roses could not be flown to European markets, the risk of a collision between ferries on extra night-time sailings in the English Channel. And so on. Risk decisions cannot be taken in isolation. The precautionary principle makes too little allowance for the risks that are run by avoiding risks — the innovations not made, the existing suffering not alleviated. The ash cloud, by reminding us of the risks of not being able to fly planes, is a timely reminder that the risks of global warming must be weighed against the risks of high energy costs — the risks of poverty (cheap energy creates jobs), of hunger (fertiliser costs depend on energy costs), of rainforest destruction and indoor air pollution (expensive electricity makes firewood seem cheaper), of orangutan extinction in subsidised biofuel palm oil plantations.

Oh, and remember the lessons of public choice theory: if you set up a body called the Volcanic Ash Advisory Centre, don’t be surprised if it over-reacts the first time it gets a chance the demonstrate that it considers itself — as all public bodies always do — underfunded.

Stumbled across some interesting research on government support of startup businesses. First, this new piece on the Vox site:

We are all for policy support for entrepreneurs. But, we believe it must be channelled correctly. An approach that seeks to pick winners ex ante is likely to fail. We base this assessment in part on the very poor performance of policy interventions of this type (Lerner 2009). Our view is also based on the underlying firm dynamics that are observed in the data and discussed above. We instead believe policymakers should focus more consistently on the many small businesses and entrepreneurs that make large and small improvements to the economy. The best support policymakers can provide is to encourage competition among local banks and financiers. Governments should forget about picking winners and focus on picking the right system.

Me: Right, capital access is important. But then I took a look at that Lerner report (Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed — and What to Do About It) by Josh Lerner at Harvard. Here is an interesting bit of a Q&A he did with the NYTimes Freakonomics blog (anything in bold is mine):

Q. Are government interventions to boost entrepreneurship always successful? Why do these programs fail?

A. Sadly, for every successful effort such as those in Israel and Singapore, there are numerous unsuccessful ones.

First, they can simply get it wrong: allocating funds and support in an inept or, even worse, a counterproductive manner. Decisions that seem plausible within the halls of a legislative body or a government bureaucracy can be wildly at odds with what entrepreneurs and their backers really need. When Australia legalized the venture capital limited partnership structure earlier this decade, for instance, legislators worried that foreign funds or firms might exploit the favorable tax treatment these entities enjoyed. So they required that each company backed by a venture partnership have at least half its assets in Australia. The venture funds found that this restriction handicapped the companies in their portfolio. The entrepreneurs could not expand their software development activities in India or their manufacturing operations in China without putting the venture funds’ tax status in danger, even as they competed against American ventures that made heavy use of “off-shoring.”

Q. You write about “The Neglected Art of Setting the Table” i.e. establishing a favorable environment for entrepreneurs. Tell us about the ideal place setting.

A. Often, in their eagerness to get to the “fun stuff” of handing out money, public leaders neglect the importance of setting the table, or creating a favorable environment. Such efforts to create the right climate for entrepreneurship are likely to have several dimensions. Ensuring that creative ideas can move easily from universities and government laboratories is critically important. However, many entrepreneurs come not from academia, but rather from corporate positions, and studies have documented that, for these individuals, the attractiveness of entrepreneurial activity is very sensitive to tax policy (particularly low capital gains tax rates). Also important is ensuring that the law allows firms to enter into the needed contracts — for instance, with a potential financier or a source of technology — and that these contracts can be enforced.

Good luck to the Obama deficit commission. In my heart, I do not believe Congress will pass huge entitlement cuts (preferable)  or tax increases without a  crisis.  (There needs to be a focus on boosting economic growth.) To quote Milton Friedman in Capitalism and Freedom:

Only a crisis—actual or perceived—produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable.

Here is one crisis scenario, as outlined by the Committee for a Responsible Federal Budget:

If low interest rates lead to continued debt accumulation and then suddenly, creditor preferences shift, we could experience a “catastrophic budget failure” as set out in a recent paper by Len Burman of the Maxwell School at Syracuse University and his colleagues at the Tax Policy Center.

Under this scenario, at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns. They conclude the United States cannot escape basic economic and financial “laws of gravity” forever. They stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. With the sudden shift and large rise in interest rates, the economy goes into a severe recession. (“The longer it takes for the crisis to occur, the worse it will be.”) Unlike the past two years, we cannot, however, borrow to stimulate the economy because the crisis was caused by excessive debt and lost confidence. “In the extreme case, the U.S. may not be able to borrow at any interest rate.” Creditors concerned with hyperinflation or even default will not buy U.S. debt.

Again, it isn’t just Republicans making the charge that the Dodd bill does not end Too Big To Fail. So are a quartet of regional Fed bank presidents:

1) Thomas Hoenig of the KC Fed (in a chat with the Huffington Post):

As for Dodd’s treatment of Too Big To Fail, Hoenig said the bill puts too much power in the hands of regulators. “What I worry about [is] if you have a large institution, and it got into very serious trouble and you only have a weekend to take care of it, the procedures under the Dodd bill would make that very difficult,” Hoenig said. “Let’s say you were coming into Monday morning and you didn’t have the ability to get to the judges in time to get this thing approved, and you had to get to another day. What you would tend to do is lend to that institution — if it were not a commercial bank, you would even use the [Fed’s] so-called 13-3 authority… and you would lend to it,” he said in a reference to the legal authority that the Fed claimed gave it the power to lend taxpayer money to AIG. “So you would still have it as an operating bank, you would not have taken control of it, not put it in receivership yet, and yet you would be bailing it out. That’s what we have to avoid.
“There’s still this desire to leave discretion in the hands of the Secretary of the Treasury, and while I understand that desire — because you never know what the circumstance is going to be — the problem is in those circumstances you always take the path of least resistance because of the nature of the crisis.

“You don’t want to be the person responsible for the meltdown, so you take the exception and you move it through.

“But if you had a good firm rule of law, and the markets knew… there were no exceptions… you would be in the long run much better off. It does affect behavior,” he said.

2) Richard Fisher of the Dallas Fed (in a speech):

The dangers posed by TBTF banks are too great. To be sure, having a clearly articulated “resolution regime” would represent steps forward, though I fear they might provide false comfort in that a special resolution treatment for large firms might be viewed favorably by creditors, continuing the government-sponsored advantage bestowed upon them. Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size—more manageable for both the executives of these institutions and their regulatory supervisors.

3) Jeffrey Lacker of the Richmond Fed (in a CNBC interview with Steve Liesman):

Lacker: The issue of our time has to do with the government safety net for financial firms. And it’s grown tremendously, and containing that, establishing clear boundaries of that, is the number one priority. As I read the Dodd bill and the mechanism it sets up for the resolution authority, it doesn’t strike me that it’s likely to help us there. And in fact, it seems to me like a major danger is that there’s going to be more instability in financial markets instead of less.

Liesman: The Dodd bill allows for a three-bankruptcy judge panel to declare insolvency. It allows losses to go to unsecured creditors; it allows management to be replaced and shareholders to be wiped out. How much clearer could the government be in this bill that there will be real losses to investors?

Lacker: It allows those things, but it does not require them. Moreover, it provides tremendous discretion for the Treasury and FDIC to use that fund to buy assets from the failed firm, to guarantee liabilities of the failed firm, to buy liabilities of the failed firm. They can support creditors in the failed firm. They have a tremendous amount of discretion. And if they have the discretion, they are likely to be forced to use it in a crisis.

4) Charles Plosser of the Philly Fed:

In order to end TBTF, we must have a way that credibly convinces large financial firms and the markets that firms on the verge of failure will, in fact, be allowed to fail. If the resolution mechanism is either too vague or allows for too much discretion by regulators or Congress to rescue firms through subsidies or bailouts, then troubled firms will surely argue that the risks of failure are so severe and systemic that they must be bailed out. This is what we saw in the recent crisis. A credible commitment by government not to intervene or bail out firms must be the centerpiece of the resolution mechanism.

I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court. I recognize that the current bankruptcy code does not adequately address the inherent challenges in liquidating large financial institutions without risks to the market, but I believe a modified bankruptcy process would eliminate discretion and strengthen market discipline, by permitting creditors as well as regulators to place the firm into bankruptcy when it is unable to meet its financial obligations.

The online conversation between Gary Becker and Richard Posner is one of my favorite things on the web. Currently they are taking on the the idea of the US implementing a value-added tax. First a bit from Becker, as excerpted by me:

1) A flat VAT tax would be more efficient for two reasons than a progressive income tax that raises the same revenue: it does not discourage savings relative to consumption, and it induces fewer distortions on other behavior because it has flat rather than rising tax rates. A flat income tax eliminates the effects of rising tax rates, but still distorts savings behavior.

2) The downside of a value added tax to anyone concerned about growing government spending and taxing is very much related to its upside; namely, that a VAT is a more efficient and relatively painless tax. … For example, the VAT rate in Europe started low but now ranges from 15 to 25%, and averages about 20%. In Denmark, for example, the VAT rate was 9% in 1962, but quickly rose to 25% by 1992, and has remained at that level.

3) However, the problems is that a VAT would be introduced not as a partial or full substitute for personal and corporate income taxes, but rather as an additional tax. This would make it much easier to close the fiscal gap by maintaining or increasing government spending and overall tax levels.

4) Since high taxes and high levels of government spending would discourage economic growth and raise rather than lower the overall distortions in an economy, I am highly dubious about introducing a VAT into the federal tax system unless accompanied by a major overall of this system. One big improvement that does not involve a VAT would be to flatten the present income tax rates and greatly reduce the various exemptions, so that the tax basis is widened. Even then it is necessary to be vigilant about combating the incentives government officials have to increase flat taxes over time, whether they are flat income taxes or flat value added taxes.

Now Posner:

1) Because (assuming no exemptions) the tax base for a VAT is so broad—all goods and services—a VAT can generate enormous tax revenues at a low tax rate, which reduces the distortionary effect of the tax. … The VAT also avoids the double taxation of savings under a corporate plus individual income tax system, further encourages savings by making consumption more costly, and reduces the disincentive effects of heavy income taxation. … Of course the benefits of the VAT are greatest if it is substituted for income taxes and other inefficient taxes rather than being added to the existing tax system to generate additional tax revenues.

2) Becker’s main objection to the adoption of the VAT by the federal government, which is similar to the objection to taxes on Internet sales and indeed any new taxes that do not merely replace existing taxes, is that by increasing government revenues it will increase the size of government relative to the private economy, and if (as is doubtless true) government is less efficient, the result will be a reduction in economic welfare. … I agree but on the other side of the issue is our awful fiscal situation.

3) In light of the nation’s fiscal bind, the imposition of a federal VAT becomes a more attractive prospect. One immediate beneficial effect, provided that the VAT was not entirely additive to existing taxes but was coupled with some reduction in corporate and payroll taxes, would be a reduction in export prices and therefore an increase in exports and hence a reduction in our trade deficit, which is a contributor to our public debt. The General Agreement on Tariffs and Trade permits VAT to be rebated on exports, thus lowering the cost to the foreign buyers.

4) More important, the VAT would increase federal tax revenues with minimal distortion because it is an efficient tax. To the extent (even if modest) that it replaced less efficient taxes, it would increase economic efficiency and thus increase the rate of economic growth. Most important, by discouraging consumption in favor of savings, a VAT would reduce the interest rate on our public debt and the Treasury’s dependence on foreign lenders.