Author: James Pethokoukis

What does it mean that voters in the state voted for higher taxes in companies and wealthier residents? Megan McArdle take a crack at explaining it:

My thoughts:

The fact that Clinton raised taxes, and then the economy recovered, is not proof that raising taxes has no effect on the economy.  Most people thing that there is at least some dampening effect, which is especially problematic in a downturn.

Realistically, income tax response gets more elastic as the tax region gets smaller.  Oregon borders two states with attractive migration possibilities.  California’s taxes are no bargain–but Oregon’s relatively lower tax rates may have attracted wealthy individuals and businesses that will now find it not so attractive.

The Tax Foundation says that pre-tax, it was on the top ten list for business tax climate.  That suggests that it has relatively more room to increase taxes than other states.

The business tax changes apparently include a gross receipts tax, which is really an awful tax, especially during a downturn.  Companies which are actually losing money may still owe taxes, which could hasten their closure, and the evaporation of any jobs they provide.

Trying to close the gap with only taxes on high income makes state revenues very dependent on a very small group of people.  Ask New York and California how that’s going.

Since state income taxes are deductible from federal taxes, this doesn’t entirely raise new tax revenue–much of it will be transferred from the Federal government.

There aren’t that many attractive revenue-raising measures for state budgets during a downturn, nor is cutting services always optimal, since demand for them rises when the economy tanks.  Ideally, states would run surpluses in the good years.  Practically, it almost never happens.

David Goldman lays it all out:

Drastic steps are required to restore credibility and confidence.

1) Ben Bernanke should withdraw from consideration for a second term as Fed Chairman. President Obama should appoint former Fed Chairman Paul Volcker in his place. If Volcker, who is 82 years old, feels unable to accept the nomination for a full term, he should serve as Interim Chairman and head a search committee including bipartisan Congressional representation to find a permanent successor. If Bernanke insists on pursuing a second term, the Senate should vote him out.

2) Treasury Secretary Geithner should resign. Whether or not he engaged in wrongdoing, his capacity to execute his office is damaged beyond repair.

I took issue with Paul Volcker’s proposal to ban bank proprietary trading, but that is a minor issue. Volcker’s distinguished career and unimpeachable integrity make him the man of the hour. I’ll take Volcker’s worst moments over Bernanke’s best.

This is not a partisan issue. The alleged malfeasance occurred under the previous administration, and Volcker became Fed Chairman under the Carter Administration. America can’t afford to heap onto the present economic crisis yet another crisis – of integrity.

Some interesting factoids over at Capital Gains and Games:

Point One:  We often hear that the US government debt load is  lower as a share of GDP than those of many other large, wealthy nations, including Japan, Germany, the UK and France. But a more apples-to-apples comparison, which combines federal, state and local government borrowing, suggests that the US is in worse shape than most other AAA-rated countries.

By that measure, the United States general government totalled 78.6 percent of GDP in 2009 and  will hit 90 percent by the end of 2010, Fitch says.  That would make us the the most highly leveraged of all AAA-rated countries — Germany, France, the UK,  as higher than that of almost all other AAA-rated nations.  (Japan’s debt is still much  higher, but it lost AAA status back in the late 90’s.)

Point Two: the  picture is even grimmer if you look at US government borrowing as a share of revenues.   US goverment debt (federal, state and local) was 330 percent of revenues in 2009 — the  highest ratio of any AAA country.   And that 330 percent doesn’t include additional trillions of dollars in new “contingent liabilities” — bank guarantees, federally insured mortgage-backed securities, and so on.

Great point made by the Heritage Foundaiton:

After building a true budget baseline, the sobering result shows ten-year deficits of $13 trillion. The annual budget deficit never falls below $1 trillion. By 2019, the debt is projected at $22 trillion, or 98 percent of GDP.

These deficits are driven by spending. Even if all the 2001 and 2003 tax cuts were extended and the AMT were patched, 2020 revenues would be just 0.7 percent of GDP below the historical average. Yet 2020 spending would be 5.2 percent of GDP above the historical average. This means that 88 percent of the additional deficits would come from higher spending and only 12 percent would come from lower revenues.

According to the new CBO economic and budget forecast,  the US economy will grow at just 2.2 percent next year, keeping unemployment above  10 percent. In fact, it has the jobless rate averaging 10.1 percent vs. 9.3 percent in 2009. As the CBO puts it:

First and most important, output is expected to grow fairly slowly in this recovery. Following the two previous severe recessions in the postwar period, output rebounded particularly rapidly, as did employment. Real GDP grew by 6.2 percent in the four quarters following the 1973–1975 recession and by 7.7 percent in the same period following the 1981–1982 recession. In both instances, all of the jobs lost during the recession were regained within four quarters. In contrast, GDP rose modestly and employment remained much weaker following the two most recent recessions.

Employment changed little during the four quarters following the 1990–1991 recession, when real GDP rose by 2.6 percent. And employment fell by more than 1 million in the six quarters following the 2001 recession, when real GDP grew at an average annual rate of 2.1 percent.

A few thoughts on the Big Budget Freeze:

1) Estimated annual savings of $25 billion over the next decade aren’t much when annual budget deficits will likely average a trillion dollars.

2) The freeze would use current spending levels, elevated to fight the recession, as a reference point. The stimulus gets locked in!

3) The 2011 budget deficit, according to the Congressional Budget Office, will be $980 billion, or 6.53 percent of GDP. With the Obama freeze, the deficit would be 6.43 percent of GDP.  Rounding error!

And while I am on the topic, instead of a budget commission, I would prefer a commission on how to boost economic growth.

Intrade says Beranke is lock, but maybe not, according to the always insightful Dan Clifton of Strategas Research:

Contrary to this morning’s headlines, we believe Chairman Bernanke’s reappointment this week is still far from certain and may become eerily reminiscent of the first TARP vote. After last week’s confirmation vote for Fed Chairman Bernanke was called off due to insufficient votes, the Administration and Congressional leaders are in the headlines this morning claiming he has the votes now and will be confirmed. Intrade odds for Bernanke’s confirmation bumped higher on the news. But our review of the numbers suggests Bernanke still faces a tough road, virtually all of the undecided Senators must break for the Chairman in order for him to secure reappointment.

From AEI’s Desmond Lachman:

Bernanke’s sole claim for a second term rests on the masterful and bold way in which he prevented the U.S. economy from falling into the abyss following the Lehman debacle in September 2008. However, this begs the question as to who led us to the abyss in the first place. Throughout 2006, when the worst of the sub-prime lending was taking place, Bernanke was conspicuously silent in sounding the alarm about the dangers of the U.S. housing bubble. Similarly, he was painfully slow in recognizing how severe the fallout from the bursting of the housing bubble would be and he displayed the poorest of judgments in allowing Lehman to fail in as disorderly manner as it did.

If there is one more item that should sink Bernanke’s bid for a second term it has to be his recent statement that the Federal Reserve’s extraordinarily low interest rate policy between 2001 and 2004 contributed little to the creation of the largest U.S. housing market bubble on record. The Senate would do well to ask itself whether the economy’s interests would be best served by again choosing a Fed chairman who seems to have learned so very little from the Federal Reserve’s past monumental mistakes.

This is part three (part one and part two here and here) of my recent email chat with the Nicole Gelinas, author of the wonderful After the Fall: Saving Capitalism from Wall Street and Washington.

Why should capital standards be uniform across different asset types; why is this important?
Consistent capital standards are an acknowledgment of humility. For example, the next financial crisis could come from government debt. Yet governments around the world say for regulatory-capital purposes that sovereign debt is the safest investment imaginable. They said the same thing about highly rated mortgage-backed securities four years ago.

Regulators should allow financial firms and investors to do their own assessments of risk, rather than decree what debt is safe and what is not. Bottom-up risk assessment would protect the economy as a whole. If one financial firm makes a mistake in thinking that a class of securities is perfectly safe, the rest of the system will survive its failure. But if the government makes a similar mistake in one of its universal decrees of safety, the mistake multiplies itself over the entire financial industry.

Consistent capital requiremens would also make ratings agencies irrelevant – a much easier way of “reforming” them than what Washington is trying to do.

You brings up lots of reform ideas that don’t necessarily coalesce into a specific plan. But a common theme seems to be bright, clear rules instead of regulator judgment? Is that right?
Right. Of course, there’s always some human judgment involved. Back in the Eighties, hen-Fed chairman Paul Volcker, for example, used human judgment when he applied old-fashioned margin rules to limit speculative borrowing to the new-fashioned junk bond markets. Investors – and people in the Reagan administration – howled. But Volcker was humble enough to know that neither he, nor the financial industry, was able to predict the future and obviate the need for consistent rules.

The theme of my book is that free-market principles should govern the financial system. How do we make that happen? Big and/or complex financial firms must operate under a credible threat of failure. Lenders to such firms must know that that failure comes through a consistent, predictable, transparent system, in which losses come according to a creditor’s place in the capital structure – not through arbitrary, opaque government bailouts.

How do we make that happen? We must make the economy better able to withstand financial-industry losses. And we do that through everything that I talk about here and in the book.  Moreover, we know that this works. It worked from the Thirties until the Eighties, until financial innovation began to evade the regulatory system and thus market discipline.

Do you buy the John Taylor idea that the credit crisis escalation in September 2008 was caused not by Lehman but rather lack of investor confidence in Paulson/Bernanke/TARP?
No, although I do not think that Lehman caused the crisis, either. If our “free market” financial system is dependent on “investor confidence” in the competency of government as it executes arbitrary bailouts, then we’ve got a real problem! I do agree, however, that arbitrary government actions starting in 2008 have prolonged the recovery and made it less robust. The answer to that problem, though, isn’t for the government to perfect its arbitrary actions. It’s to make such actions unnecessary by making the economy safer for financial-firm failures.

Would you have let Lehman fail
Yes.  The financial system’s business model was itself a failure. That model was to borrow every last dollar based on Panglossian assumptions multiplied decades into the future. It was fatally brittle even to the slightest wavering in assumptions, and thus worked only in an environment of too big to fail.

When we took that veil of government protection away even for a moment, as we did with Lehman, what was underneath wasn’t pretty. It revealed that a financial system that’s immune from market discipline and exempt from prudent regulations is a system that can destroy the economy.

I hope that Washington learns this lesson, and takes it to heart. If not, the next time the financial system cashes in on its implicit government guarantees, it may overwhelm the government’s ability to bail it out. Markets will work, in such a case – but will exact a cruel economic and social price.

I would not say his support is collapsing, but it is eroding. He is going to need some GOP help to make it. Keep an eye on the “yes” votes from the Banking Commitee to see if they start wavering and how much Obama supports him in the next few days. BB is on the wrong side of the populist wave.

From the great David Goldman:

When Reagan took office in 1981, the baby boomers were in their 20s and 30s, America had a 10% savings rate, the current account was in surplus, and America was the world’s largest net creditor nation. Reagan was able to cut taxes and finance an enormous budget deficit because the world’s demand for US Treasury securities was correspondingly large. In 2010, the baby boomers are in their 50s and 60s, America has saved nothing for a decade, the current account remains in severe deficit and the world is choking on the existing supply of Treasury securities. Cutting taxes to stimulate the economy is not as simple this time round.

Professor Reuven Brenner and I argued in the December 2009 issue of First Things that fundamental changes in American economic policy are required to emerge from the Great Recession. We proposed that the United States fix the dollar to the Chinese yuan and other currencies in order to re-orient trade flows to the developing world. We added, “We have been borrowing in order to consume; we need now to save in order to invest. We need to shift the tax burden, moving it away from savings and investment and toward consumption. We should replace individual and corporate income taxes with consumption-based taxes.”

It seems that support for the renomination of Ben Bernanke is falling by the day, says ABC News. Liberals in Congress want him gone. Then again, they want pretty much the whole Obama economic team gone. But Geithner and Summers aren’t up for a Senate vote. Bernanke is. And if Dems start bailing, don’t expect Republicans to save him. No politician in America gains anything by voting for Bernanke. A “no” vote is a free vote. Wall Street still loves him, though. Geithner, too.

UPDATE: Count Russ Feingold of Wisconsin as a “no” vote.

UPDATE 2: Boxer of California , too

UPDATE 3:  Nevada’s Reid is non-committal

Mark Calabria of Cato, a supersmart observer of the financial sector in DC, gives me his two cents:

I find it hard to believe that the govt has any clue as to what correct size and level of trading is for banks. Sounds like nothing more than cheap politics.

Ex ante, no one told Bear was too big. So is the size limit going to be even smaller than Bear?

Obama misses one reason for banks becoming so large: their fund advantage due to “too big to fail” – if he were serious he’d come up with a plan to end too big to fail, rather than a plan for permanent bailouts.

And where’s the break-up plan for fannie and freddie? Just seems like just picking winners and losers based on politics.

I don’t see it going anywhere in the Senate [though I’m] not completely ruling it out. House could easily pass something so stupid – it is the House after all.

It does complicate financial reform – Obama might just be killing financial reform – hard enough time reaching agreement.

She emails me on the Obama plan to limit bank activities:

1) I think that they are now panicking and veering from solution to solution. They will roil the markets and just make themselves panic more. Politically, i’m not sure. It will be hard for republicans to be against this, just like it is hard for them to fight the bank tax. Although if markets fall by hundreds of points, it gives the GOP an opening to say that Obama doesn’t know what he’s doing.

2) As for the merits – the problem is, Bear and Lehman didn’t have insured deposits, didn’t have recourse to the Fed, etc., but still posed significant risk. Why? Because by securitizing, derivative-izing and short-term-izing all manner of long-term debt, non-commercial banks made the economy’s store of credit much more vulnerable to market exuberance on the upside and panic on the downside. Mortgage and other credit depended at the margins not on bank balance sheets but on speculative demand.

3) To deal with that, I think we need consistent (and likely higher) margin requirements, capital requirements, clearing rules, etc., no matter who is holding/trading the debt. That would protect the economy more by putting a buffer between the pure, raw market and these debt instruments, just as we did long ago with equity markets.

4) I fear that if we curtail the big banks without doing these other things, the risks will just move, and people will continue to move their savings accounts into money markets to fund these risks. In fact, that is why we got rid of glass-steagall on the first place – to let banks compete fairly with the non-banks that had stolen their business.

5) So, do the margin and capital stuff to recognize the world we live in today … Doing that will make the economy better able to withstand financial failure, anyway, and the market, knowing this, will bring the institutions down to manageable size.

Obama’s plan to limit risky activities at big banks is more about forcing Republicans to take tough votes than preventing another credit meltdown.The Volcker Plan was already rejected by the WH econ team (Summers, Geithner) and this is being pushed by the political team (Rahmbo, Axelrod) in the wake of the Massachusetts Meltdown. (In fact, this may help tamp down pressure from congressional Dems to dump the econ team.)

The WH can’t trumpet the economy, can’t trumpet healthcare, so Plan C is to go after Wall Street and make the GOP look like its best friend. Who cares that some of the worst problem children of the financial crisis were relatively small and undiversified? Wasn’t it regulator pushing for Wells Fargo to absorb Wachovia, and BofA to absorb Merrill? But I think the Dems will be surprised at how many GOPers might go along with this, starting with John McCain who has already advocated the return of Glass Steagall. But he will be far from the only one.

Ed Yardeni expands on my theme:

The political upset in Massachusetts yesterday may very well be one of those bullish Black Swans. In his 2007 book on this subject, Nassim Nicholas Taleb explained: “What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”

Brown’s upset victory certainly wasn’t expected even a week ago. No one seriously expected that the Democrats would lose “Kennedy’s seat” in the Senate. This development is bound to have a major impact on the political balance in Washington. This outcome certainly makes sense after the fact. It wasn’t predictable prospectively, but it is obvious retrospectively.

Last summer, I started to project that Gridlock might win in the Congressional elections on November 2, 2010. I certainly didn’t expect that it might win at the beginning of this year, and just in time to checkmate PelosiCare. The Constitution of the United States of America was written by lawyers. They intentionally designed a political system of “checks and balances” that dispersed political power among three branches of government. We call it Gridlock, which has a negative connotation, but that was the intended outcome more often than not. Our system works best when it doesn’t work for the promoters of policies that are not in the national interest.

Scott Brown’s stunning capture of the Massachusetts Senate seat held for decades by Ted Kennedy was a political black swan, a near-unpredictable event.

The result ends the Democratic supermajority in the Senate and leaves key parts of the Obama agenda in deep trouble. But the biggest loser just might be Wall Street. Desperate Democrats may see anti-bank populism as a way of holding power as the November midterm elections approach.

The last days of the heated Senate race saw the first attempts at that political gambit. Democratic candidate Martha Coakley’s allies in Washington, both the White House and national Democratic officials, used President Barack Obama’s proposed bank tax as a cudgel to bash Brown via emailings and telephone calls.

But the game was probably over by then for Coakley. A combination of high unemployment, an unpopular healthcare reform bill and the candidate’s own lack of charisma and effective experience were more than enough to clinch an easy Brown victory.

A historic victory, really. It is hard to overstate just how “blue” a state Massachusetts is. Obama won it by 26 percentage points in 2008. Until now the state’s 10 U.S House members, two U.S. senators and all statewide officers were Democrats. The state hasn’t had a Republican U.S. senator since 1979. And, of course, the seat Brown captured had been held by the late Edward Kennedy since 1962.

Now Brown’s victory threatens the healthcare reform bill that Kennedy championed on his deathbed. Democrats could still ram it through before Brown makes it to Washington. But potential legal challenges make that unlikely.

As it is, Brown’s election is enough of a systemic shock to freeze the political process on Capitol Hill. Moderate Democrats in both chambers are nervous about their previous “yes” votes for healthcare. They may be unwilling to make any more. The prospects look even bleaker for cap-and-trade energy legislation, a bill with even less support than healthcare.

Financial reform legislation was already likely to get milder rather than stronger. But not so the rhetoric. Unable to trumpet the economy, hitting Wall Street is one of the few political bullets Democrats have left.

So expect the Obama administration to go all out for the bank tax with increasingly harsh words for big financial institutions. Democrats may also be more willing to consider controversial proposals banks hate, like letting judges rework mortgages. But given the Massachusetts precedent, it may not be enough to save the party from a wipeout in the fall.

Live blogging the Massachusetts US Senate race between Democrat Martha Coakley and Republican Scott Brown:

9:30  Scott Brown wins, Martha Coakley loses. Also losing: Wall Street as POTUS, Dems will ramp up attacks. I’m done for tonight.

9:24 Brown has accepted concession call from Coakley (per Fox)

9:22 AP calls is for Brown

9:20 Boston Globe says Coakley calls Brown to concede

9: 18 70 percent of vote in, Brown +7

9:13 All eyes on Boston returns where Coakley seems to be strengthening

9:09 If margin of Brown lead holds up, I can’t see him not being seated ASAP

9:04 60 percent in in, Brown +7

9:02 Coakley get not getting the Boston vote she needs.

9:00 I have yet to hear from or talk to a single political analyst at this point who thinks the race is still in doubt. Brown +5 with 52 percent in.

8:58 45 percent in Brown +5

8:47 Wasserman at Cook Report: Cook Report does NOT officially call races, but if I were working for a network I would have enough #s to project: Brown Wins

8:42 Brown +7 with 21 percent percent in.

8:35 Dave Wasserman of Cook Report: Brown needed 59% in Danvers, he got 63%. Brown consistently overperforming our model by 3-4 % pts

8:32 With 11 percent in, 53-46 Brown

8:26 Brown seems to be overperforming in key counties

8:23 With 4 percent in, 52-47 Brown

8:10 Preliminary election day poll from Rasmussen:

• Among those who decided how they would vote in the past few days, Coakley has a slight edge, 47% to 41%.
• Coakley also has a big advantage among those who made up their mind more than a month ago.
• Seventy-six percent (76%) of voters for Brown said they were voting for him rather than against Coakley.
• Sixty-six percent (66%) of Coakley voters said they were voting for her rather than against Brown.
• 22% of Democrats voted for Brown. That is generally consistent with pre-election polling.

8:07 Politico: Sr. Dem on Boston ‘High turnout in more conservative wards. Not high enough in Af-Am, Latino and more progressive wards.’

8:03 Brown source: Cautiously confident

7:51 Dem meme for the night is that Coakley was a lousy candidate in a bad environment; any other major Mass. Dem would have won by double-digits

7:44 TheHyperFix: From a Dem operative in Mass. : “Boston turnout numbers not good for Coakley.”

7: 40 On MSNBC: Pat Buchanan  says Brown victory means GOPers should run as populist, Tea Party in 2010

7:34 Pundit Review: Very upbeat atmosphere here at Brown HQ.

7:30 Chris Matthews: Could be a “sad night, a tragic night” for those who want healthcare.

7:20 Polls in MA close in 40 minutes

7:17 WSJ poll finds only 35 percent approval of Obama agenda, though his personal approval ratings are above 50 percent.

7:09 Intrade betting market puts Brown at 80 percent and steady. Waiting for hard numbers.

7:02 MSNBC’s Chris Matthews says Brown election would be “deliberate, pre-meditated” murder of healthcare reform

This is the second edition of my chat with the fabulous Nicole Gelinas, author of the phenomenal must-read, must-own After the Fall: Saving Capitalism from Wall Street and Washington.  (Part one is here.)

What was a reasonable alternative to TARP?

We were never going to escape this debacle without pumping massive amounts of taxpayer money into the financial system. By 2008, the erosion of market discipline and prudent regulations (which go together) had left the economy vulnerable to a historic financial disaster. The proverbial black swan would have been if we not gotten the crisis.

Washington could have deployed TARP funds better than it did, though. Bush-era Treasury Secretary Henry Paulson’s first mistake was in thinking that he could use TARP finds to hide financial-industry losses. That is, he wanted TARP to buy up bad securities from banks at higher-than-market prices. As the S&L crisis proved nearly two decades ago, the economy can’t recover until bad assets find their real market price. Yet more government distortion just delayed that process.

What Paulson and, later, Geithner eventually did was better: pumping capital into banks so that they could withstand at least some of their losses on mortgage-related securities and other investments. Still, though, Washington used TARP to shield bondholders to the TARP banks from their losses – meaning that “too big to fail” lives another day.
How would a conservatorship of a TBTF firm work?

No firm should be “too big to fail – so it really would be a conservatorship for failed financial firms.

We learned in the Great Depression that some firms cannot fail through the normal bankruptcy process. Bank failures caused unacceptable economic panic and social harm. The FDIC was the elegant solution. It protected small depositors from losses and from service interruption, muting financial panic in a crisis. But it also allowed markets to discipline bad banks, because uninsured lenders still took their losses.

The task of a conservatorship for failed financial firms should be the same: to enforce market discipline of failed financial firms in an orderly manner – with creditors taking their losses – while protecting the economy from the disordered panic that we saw after Lehman.

A conservatorship could carry on operations at a failed financial firm, just as the FDIC does with failed banks when it cannot find a buyer. But lawmakers must make clear that the conservator’s goal is liquidation: to spin off good assets into more competent hands, with creditors responsible for any shortfall, just as they are in bankruptcy.

With AIG, the government has never made clear whether it’s trying to save AIG or wind it down. So we have the bizarre situation of AIG executives saying that the company stock is worthless even as it trades on public markets in the double digits. Meanwhile, private-sector insurance companies must compete against a government-guaranteed behemoth.

A conservatorship won’t work, though, unless lawmakers and regulators enact other rules to make the economy better able to withstand financial-industry failure. I talked about some of this in my answers to your other questions. The main goal is to insulate the economy somewhat from the natural excesses of financial-industry optimism and pessimism, without micromanaging finance. Borrowing limits mute optimism, because they prevent investors from bidding assets up with no money down (think housing in 2005, stocks in 1928).

Other regulations can mute pessimism. When the old uptick rule governed “short sales,” stock sellers couldn’t sell a stock down to zero. Pushing financial instruments onto exchanges, too, can mute panic — again, look at AIG.