The increased money creation discretion of central bankers has had its positive benefits in helping to develop private capital markets, increasing access to capital for a wider range of investors, and funding economic growth around the world. But the desire to stimulate investment with low interest rates means we have been subsidizing excessive credit borrowing as the main source of investment. Fractional reserve banking amplifies credit bubbles through the leveraging of debt. The massive reliance on debt has had a profound effect on the riskiness of the system and how that risk is distributed.
In the end, we face a conundrum. We have developed a financial system that depends on credit creation and debt assumption with the consequence that it has become more far more prone to market volatility and systemic risk. Ironically, the results defy the fundamental logic and purpose of financial markets to diversify and manage risk prudently. We truly need to think outside the box we’ve put ourselves in. Let us consider some policy proposals suggested by our simple analytical model.
1. The Federal Reserve should be tasked solely with defending the purchasing power of the currency and monitoring and regulating the health of the commercial banking system. While Fed policy should assume close political oversight, policy should be driven by price rules that constrain interest rate distortions and insulate the goal of price stability from political interference.
The regulation of the banking system requires two correctives.
2. With every reward comes the risk of failure. If a business entity should become "too big to fail," it is too big to exist with a government guarantee. We should allow large corporations to discover their most efficient scale and diversified product mix. The promise of market success, however, must come with the discipline imposed by possible market failure. Otherwise, we risk the devastating costs of moral hazard. They say nothing concentrates the mind like the prospect of a hanging, and the economic equivalent of a hanging is bankruptcy. The sanction of bankruptcy is crucial to controlling the risks of the shadow-banking industry.
3. Fed policy should monitor and dampen excess debt leverage in the fractional-banking credit creation process. Financial debt bubbles are fueled by excessive leverage. We need to rethink and reform tax policies that favor debt over equity finance. (This issue will be more fully addressed in the tax policy section that follows.)
Even though financial innovation, capital market development and integration has given us stronger and broader economic growth, easy central bank policy through discretionary credit creation has saddled us with volatile capital markets and wrenching economic adjustments. Our policy responses have been driven by the imperatives of campaign politics and accommodative monetary policy, directly affecting the long-term health of our national economy and our own individual life prospects. This is how financial policy has become the tail that wags the dog of international economic performance.
5.2 Fiscal Reform
We have addressed fiscal policy in reference to government stimulus spending, exploding public debt, and the incentives facing politicians. Fiscal policy and monetary policy are two sides of the same coin, so we cannot reform one without the other. As discussed in the section on Financial Alchemy, the Fed and the government are operating on either end of the credit creation—debt issuance equation. If the government spends beyond its means, then the Fed’s mandate to maintain full employment and price stability will force it to find ways to fund the government debt. In the US, total Federal government debt has grown from $10 trillion to over $14 trillion in the last two years alone. Under current budget projections this debt is expected to grow by $1-2 trillion per year for the next ten years. By facilitating credit creation with easy monetary policies, the Fed is enabling profligate public spending. In simple words, we Americans are living beyond our financial means, while the Fed is in the compromised position of signing off on our checks.
If we want the Fed to adopt sound monetary principles, we will have to reform the budgetary process and seek ways to restrain government deficit spending. Unfortunately, because of the arcana of public finance and monetary policy, the need to control spending has been the source of a great deal of misinformation. As of 2011, the major political issue has become the federal debt limit and the projection of future government deficits that will place an unsupportable debt burden on future generations. This may well carry forward into the 2012 presidential election cycle. But, because we are now in a fiat currency regime, we are focusing on the wrong measures. The overall debt limit is now a distraction—uncomfortable perhaps, but still a distraction. Instead, we need to consider the long–term consequences of excess debt on the productive capacity of the U.S. and world economy. This is better measured by the ratio of total debt to GDP. In addition, we can measure the short-term trend with the ratio of the annual deficit to GDP. This ratio shows whether our spending is having the positive effect of increasing our incomes, wealth, and standard of living, or merely impoverishing us in the long term.
The imperative to live within our budgetary means is illuminated by our model—not because we cannot carry the debt, but because budgetary constraints force us to set public priorities and choose prudent policies. Due to debt creation, we, as a nation, have been financing future growth with debt rather than through the difficult trade-offs between present and deferred consumption. This has created excess current consumption as well as excess investment for future consumption. Based on exploding credit creation and debt obligations, this trend is unsustainable. In the private sector, our post-financial crisis economy has been correcting through drastic financial de-leveraging in order to repair balance sheets. At a personal level, this means reducing debt to the level where we can service it out of current income. The difference between personal and public finance, however, is that the government can accumulate debts and never go bankrupt (see footnote #13); it is only required to service its payment commitments by collecting taxes or issuing new debt. Whereas the prospect of financial insolvency restrains our personal borrowing, there is no such restraint on the public purse.
There are several possible policy reforms to restrain budgetary deficits. One is a balanced budget amendment to the Constitution. This would require the Federal government to balance its budget much like the fifty states are required to do now. There are two counterarguments to a balanced amendment. First, it would reduce the flexibility of the government to adapt fiscal policy to changing economic conditions, such as the recent financial and banking crisis. Second, it might also feed a desire to raise taxes to maintain or increase spending levels. A different approach would be to restrict government expenditures to a certain percentage of the prior year’s GDP, say 18-20%. Flexibility could be enhanced by allowing temporary departures that would require compensating reductions in future budgets, so that any excess spending in one year would require spending reductions in subsequent years until the budget was back in balance and the outstanding debts repaid. In any policy, greater transparency and Congressional accountability over the budgetary process is necessary.
All budgetary reforms are dependent on tax revenue issues and tax policy, which we turn to next.
5.3 Tax Reform
Tax policy should be guided by how we answer two basic questions. The first question asks how much in tax revenues are needed to fund desired public goods and services. The second question asks how do we fairly and efficiently obtain, or collect, those needed revenues.
The objective of tax policy should be to achieve exactly the correct amount of revenues needed to fund the public budget. If we desire military protection, security against crime, functioning roads, streetlights, etc., citizens need to contribute taxes in one form or another to pay for these public goods. Naturally, our political battles rage over the levels of public goods and services government needs to provide and the most fair and efficient method to fund these needs. (Regrettably, efficiency is usually the last criterion to be considered.)
So, to answer the first question requires us to distinguish bet
ween public and private goods and services. We can hardly expect, or want, the government to provide everything we need in life. First, because of the lack of profit motives and price signals, the public sector is often less efficient than the private sector. Goods socially provided are usually inferior in quality and cost more. If they cost less, it is usually because of subsidies, and the supply is rationed, so the real cost is much higher. (Keep this in mind when discussing public health care and the possibility of getting a heart transplant.) Second, the government as sole or primary provider constitutes a quasi-monopoly that constrains the freedoms and choices that a diversified private market offers. We discussed the differences between public and private goods in Chapter Two in the section on Market Failures.
To answer the second question concerning efficiency and fairness, we need to apply what we know about economic behavior and psychology. The tax system offers the most promising realm for economic policy impact because taxes most directly affect individual behavior by altering the basic risk-return calculation that governs our economic decisions. If we calculate an acceptable expected return from a risky venture and the government taxes that return at 40%, tax policy will alter the entire risk-return trade-off. The more taxes distort economic incentives, the more prices will be distorted in the market, yielding greater misallocation of resources. For this reason, most economists advocate taxes that have the least measurable impact on economic decisions. In other words, they desire tax effects to be neutral. If we tax income too high, for example, people will produce less by diverting their efforts to satisfying activities that can't be taxed, such as leisure time. In this way, higher tax rates will yield fewer tax revenues. This was the basis of the supply-side revolution of the 1980s. Of course, if tax rates are too low, tax revenues and public services will suffer. The goal is to identify the ideal tax rate that maximizes revenue. Unfortunately, arguments over taxes become politicized to justify whatever objective is desired, such as less or more government spending, tax preferences for favored constituencies, social engineering, or expanding bureaucratic power.
In 2008, in developed countries, the total tax revenues as a share of the economy as measured by GDP ranged from a low of 21% to a high of 48%, averaging out to 35%. In the U.S., the range over the past fifty years has been between 24% and 29%, with recent levels around 28%. Of course, when government spending exceeds tax receipts, we get annual deficits that accumulate to total outstanding government debt. The total debts of these countries ranges from 5% to 178% of GDP, the U.S. was last at 60% headed for 80%. Over 100% is considered the danger zone, but these static numbers tell us little as it is the direction in which a country's finances are headed that really matters. The annual deficit as a share of GDP is a good indicator, but the real focus must be on the economic viability of fiscal and tax policy. The concept is not much different than with personal household finances. If wages and incomes are rising and spending increases at a slower rate, debts can be paid off. This means that maximizing the economic growth rate is an important objective of tax policy, and tax policy, in turn, can have a significant effect on that growth rate.
If we consult our economic model, we understand that we should seek the optimal growth rate consistent with sustainability, as opposed to the maximum growth rate. We should be pacing ourselves like a marathon runner rather than trying to race like a sprinter—the destination is the same, but it matters how you get there. The tricky part is that because the optimal rate is a product of accurate price signals that tell us how much to consume, save, invest, and produce, we cannot choose the optimal growth rate in advance and then choose policies to make it happen. The best we can do is to permit the economy to adjust to these price signals with a minimum of distortion or market disruption.
Given the various incentives surrounding the formulation of tax policy, we need to incorporate certain guiding principles to keep policy from being hijacked by narrow interests. Our first principle is:
1. Since taxes are needed to pay for public goods, all goods and services that can be provided by the private economy should not be commandeered by politics and provided less efficiently by the public sector.
We need to insure that our fiscal budgets are not overburdened unnecessarily. This does not preclude the fact that certain markets and private industries may require regulatory oversight and legal enforcement. What many ideologues will find objectionable here is the unarguable fact that healthcare and retirement are private, not public, goods. We will address this in the next section on entitlement reform. Our second principle is:
2. A growing economy increases tax revenues, so tax policy should seek to impose the least amount of distortion over economic decisions, especially those of people on the frontline of risk-taking behavior.
Unfortunately this is the principle we violate most egregiously. Different taxes affect economic choices differently. We have taxes on income, we have taxes on retail sales, and we have taxes on property and inheritances. We can categorize these respectively as taxes on production, consumption, and wealth. We have a propensity to tax productive activities, which means these taxes (on wages, incomes, business profits, capital gains) weigh upon investment risk-return decisions before the fact, decreasing investment and channeling it into less productive, but lesser taxed activities. To put it simply, taxes on production are counter-productive.
The most neutral taxes are taxes on consumption (sales or use taxes, value-added taxes or VAT). This logically flows from our initial economic decree that all economic decisions can be reduced to the decision to consume now or later. A consumption tax, imposed either today or tomorrow, has little effect on that time-sensitive decision to consume. Either we pay the same tax today or the same tax tomorrow, the tax does not change our preference for when we choose to consume. Thus, the tax’s effect is neutral. We may defer consumption, but that won't reduce the tax. However, when we tax production we affect the decision of whether to consume now or later since we reduce the amount we can expect to consume later relative to today. When we tax productive activity we get less saving, less investment, and more present consumption. All other things equal, this reduces economic growth. Remember, we only produce in order to affect our consumption levels over time.
A wealth tax is less distorting than an income tax, though not as neutral as a consumption tax. A property tax serves to pay for those public goods associated with landed property or real estate, such as roads, utilities, police and fire security, street lighting, etc. An inheritance tax is often justified in terms of fairness, as it counters the accumulation of economic and political power in a single family over generations, even though the production of that wealth has already been taxed.
Taxes on productive activity (which is any activity that increases wealth, in material or non-material terms) have a negative impact on several of the policy objectives we outlined previously. The distortions introduced by productive taxes directly impact the calculations of risk and return, raising the hurdle rate for investment.[63] More seriously, taxes on production reduce savings and capital accumulation that can serve to insure against the risk of losses. The propensity of politicians to manipulate income taxes for political reasons also increases the overall level of uncertainty in the economy, reducing productive risk-taking. Because businesses and individuals cannot accurately forecast after-tax profits, they postpone or cut investment. As opposed to “the rich,” these risk-takers are the most productive members of society. The overall effect is to tax the "getting" of wealth more than the "having" of wealth. By targeting the most productive members of society, we also harm most the neediest people in society who depend on job growth. This is inconsistent with our constitutional principles of freedom and providing equal opportunity, unnecessarily creating class tensions between the rich and the poor.
We must also consider that any tax regime must compete in a global market and this is particularly critical with regard to taxes on labor and capital. Taxes on wages (payroll taxes) can make U.S. wo
rkers uncompetitive with foreign workers at comparable skill levels. Of course, labor productivity is a function of how we combine labor with capital, but since capital must also compete on the world market, taxes on production disadvantage both domestic labor and capital. Free market competition and the mobility of capital means we need to create the most efficient tax system given the constraints of world markets. We need to meet this objective in order to create a fair tax system. A corporate income tax has two pernicious effects: it makes domestic companies less competitive on the world market, and it encourages political patronage for corporate welfare by creating an incentive to lobby for favorable treatment to reduce tax burdens or shift the taxes to competitors. A VAT tax that substitutes for the corporate income tax would eliminate both these distortions, while still collecting the necessary revenues.
A tax system that relies wholly on consumption taxes would not work ideally because it encourages black markets and cross-border smuggling of consumption goods on a mass scale. It would suffice to find a balance between various sources of revenue, with a minimum of economic distortion. A flat income tax that greatly broadens the tax base would help to simplify the tax code while removing much of the political favoritism for narrow interests.
One particular distortion that has aggravated our recent financial crisis is the differential treatment between equity and debt capital. We allow the expensing of interest payments on debt for corporations and household mortgage debt, which has served to subsidize debt by making it cheaper. In the case of corporations, tax rules favoring debt have tilted financing preferences toward debt away from equity. Excessive corporate debt has several deleterious side effects. It increases and concentrates risk by reducing the financial flexibility of the firm, increasing its financial leverage, and concentrating ownership and the returns to ownership through leverage. When a firm obtains new finance through debt, the existing ownership is merely leveraged by that debt without creating any new equity investors. This means the increased profits accrue to the same owners.
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