Topic: Tax and Budget Policy

Paul Krugman’s Fallacious Forecast of a $6-7 Trillion Drop in Housing Wealth

The Case-Shiller index of house prices covers just 20 major metropolitan areas. It shows house prices down by 10.7% between January 2007 and 2008, but that largely reflects the fact that Los Angeles, San Diego and San Francisco account for 27.4% of the index.

In Fortune magazine’s March 17 interview, economist Paul Krugman says “We’re probably heading for $6 trillion or $7 trillion in capital losses in housing.”

Such estimates begin by assuming the S&P Case-Shiller index of house prices (which is now down 12.5% from its peak month) has a lot further to fall, and that it accurately represents the value of all real estate held by U.S. households throughout the 50 states.

The Federal Reserve’s Survey of Consumer Finances (updated with flow-of-funds data by David Malpass of Bear Stearns), shows U.S. real estate worth $22.5 trillion in the fourth quarter—up 2.5% from a year earlier and accounting for 31.2% of household wealth.

If you think the Case-Shiller index will eventually fall by 30% (Krugman said 25%), then 30% of $22.5 trillion would yield an estimate of $6-7 trillion capital losses “in housing.” But the $22.5 trillion is not just single-family homes—it includes commercial property, apartments and farm land. More important, even single-family housing wealth is not located in only 20 major metropolitan areas.

The Office of Federal Housing Oversight (OFHEO) index covers all 50 states, including nonmetropolitan areas, but not the most expensive homes (which is not where Case-Shiller finds the biggest declines). The OFHEO index shows house prices down 3% in January, compared with a year before. But even that average is by no means typical of all housing (much less real estate) in the entire nation.

Between the fourth quarters of 2006 and 2007, house prices rose in all but two of the many states excluded by Case-Shiller, and the increase averaged 3.8 percent.

Economists and journalists who use gloomy predictions about the Case-Shiller index to predict a comparable loss of real estate wealth are making several serious mistakes.

Senator Levin’s War on Taxpayers

In a remarkable display of chutzpah, Senator Carl Levin of Michigan is quoted in the Christian Science Monitor stating that “Tax havens have declared war on honest taxpayers.” This is from a politician who routinely votes for higher taxes and has a rating of “F” from the National Taxpayers Union because he votes against taxpayers 85 percent of the time – a record that puts him below Senators Hillary Clinton and John Kerry. Tax havens, by contrast, have helped taxpayers by forcing governments around the world to lower tax rates. Indeed, a prominent British accountant explains in the story that low tax rates are the appropriate way to deal with global competition. Returning to the theme of chutzpah, an OECD bureaucrat (who receives a tax-free salary!) actually admits that people should have a right to financial privacy – but only if the term is stripped of all meaning by giving governments unlimited snooping rights:

“Tax havens have declared war on honest taxpayers,” says US Sen. Carl Levin (D) of Michigan, who along with Sen. Barack Obama (D) of Illinois is co-sponsoring the “Stop the Tax Haven Act,” introduced last year. … Chas Roy-Chowdhury, head of taxation at Britain’s Association of Chartered Certified Accountants… says… “Governments should open themselves up to the wind of global competition and accept that they need to run efficiently to keep tax rates low.” … Perez-Navarro [of the OECD] adds that individuals should have the right to a certain banking confidentiality, but that when investigators want to see numbers they should be handed over.

Tyler Cowen Thinks Frozen Markets Justify Tougher Regulations?

In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.

Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values… .The results have been a form of financial gridlock.”

To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”

With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e-Trade) are in no hurry to sell at prices low enough to attract borrowers.

This poses a temporary problem for mark-to-market accounting (and Basle’s bureaucratic capital standards), but this seems a failure of accounting rather than markets. Cowen asks “why seek ‘fire sale’ prices when you might lose your job for doing so?” I would ask, “Why seek ‘fire sale’ prices if (unlike Bear Stearns) you are in a position to wait for a better deal once the market calms down?” Cowen says, “Only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities.” But large holdings can often be sold in smaller batches. And we don’t know who might have bought Bear Stearns, warts and all, were it not for favoritism the Fed and Treasury showed to a single bidder (who was shamed into quintupling the offer).

Liquidity refers to the ease with which various assets can be converted to cash without dropping the value of the asset. Hedge fund managers bought gold on margin at $1000 may find it is less liquid than they expected. But what seems terrible to sellers of marked-down assets (e.g., of Las Vegas condos) can seem wonderful to buyers.

Most people think “liquidity drying up” means banks have cut back on lending, which is demonstrably false – bank loans are growing at a 10-11% annual rate since August, and much faster for C&I loans. Consumers and small businesses were never dependent on mortgage-backed IOUs.

There is no “financial gridlock” for most assets, even real estate (31% of household wealth). Auctions for foreclosed properties are drawing plenty of bids.

Mr. Cowen thinks “investors are instead flocking to the safest of assets, like Treasury bills.” Smart investors shun long-term Treasuries and are flocking to stocks, particularly U.S. stocks. The S&P 500 is down less than 10% this year – much better (in dollars) than most other markets, including Europe and China.

Tyler says, “Every step of the way, the pricing of [Bear Stearns] stock has surprised the market.” Really? It didn’t surprise the shorts, who owned a fourth of the shares. I own the SKF exchange fund (ultra-short financials) which, ironically, fell sharply a couple of days after Bear was sold out by omniscient and kindly government regulators.

Nobody ever said housing was a liquid asset, but even housing is far more liquid than the doomsday crowd imagines. The OFHEO index shows that home prices increased in all but 11 states between the fourth quarters of 2006 and 2007. Home prices fell 4% to 7% in California, Nevada, Florida and Michigan, but home prices rose 4% to 9% in 16 other states—most of which are not even counted in the widely-cited Case-Shiller index (which gives California a 27% weight).

The only problem with financial markets is that information is never free, and it sometimes takes time to discover market-clearing prices. The solution is not more regulations, but more patience.

Capital requirements, on the other hand, can cause very serious problems. The 1988 Basle Accord on capital requirements was a heavy-handed reaction to the 1982 LDC debt crisis. It was also one reason Japan’s monetary base shrunk by 2.8% a year in 1991-92 – the start of a period some U.S. journalists are now foolishly comparing to the restoration of sanity in coastal housing prices.

As I explained ten years ago, Basle “required that by the end of 1992 banks had to maintain capital equal to a minimum of 8 percent of risk-adjusted assets, where risk just happened to be defined in a way that favored government bonds over business loans… . Did relatively higher capital ratios in the United States and Great Britain mean they were less exposed than Japan to LDC default? On the contrary, even in the late eighties outstanding LDC loans still amounted to 93-199 percent of the capital of the largest U.S. banks, and as much as 82 percent for British banks, but only 55 percent for Japan. American banks seemed to have more capital. But unlike Japan, all of the capital of U.S. banks, and sometimes much more, was exposed to LDC default.”

Even if markets for a few risky, exotic U.S. securities appears “frozen” for a short while, that is far less problematic than imposing stern, politicized regulation over a wide array of assets and institutions.

The Fed’s “Central Planning” Woes

Given the financial/regulatory system that we have – which is a very important pre-condition – I grant the Fed and Treasury a TEMPORARY “coordinating” role to help tide over the current crisis.  However, the initiatives and actions implemented so far appear unlikely to succeed.

I agree only with its role in the Bear buyout by JPMorgan.  It is, by nature, a one-time action that does not protect Bear’s shareholders and operators but protects the financial system from unraveling further – similar to it’s actions re: LTCM. Even if it is repeated for another investment bank, it does not raise the issue of moral hazard because no such bank wants to end up like Bear.

However, the Fed’s new and almost direct support of mortgage backed securities through its primary dealers introduces another moral-hazard potential – likely to be a huge problem down the road, and especially because of the interest rate policy it is adopting.

Interest rate cuts are being overdone. Large cuts are continuing the Fed’s past mistakes of introducing greater uncertainty in market participants’ expectations. It is using the wrong (inflation fighting) tool to achieve its goal of systemic stability which has arisen from poorer visibility of asset quality. The added uncertainty will prolong the resolution of current credit/liquidity shortages.

The longer that credit/liquidity problems last, the more likely is the introduction of PERMANENT new financial market regulations – which would hinder efficient operation – in the very function that is key to resolving current credit shortage problems – the generation of price information.

Finally, Prof. Cowen’s recent NYT oped (“It’s Hard to Thaw a Frozen Market”) compares market pricing under capitalist and socialist systems.  In brief, the argument is that socialist systems’ poor market pricing abilities appear to be reflected in the current credit-market woes of the American “capitalist” system. This comparison appears misplaced to me. The general U.S. economy may be relatively free and capitalist – but financial and credit markets are not quite so free.

Current credit market problems are not the result of pure and free market operation/competition.  We have a fiat currency whose supply and purchasing power is controlled by Fed interest rate policies. And it appears to have made serious mistakes in the process. This involves larger issues of whether asset prices should be objects for setting Fed policy and whether and how the Fed should respond to supply/oil shocks. Fundamentally, however, financial market participants naturally don’t look to “the free” market to set their expectations about the dollar’s future purchasing power. Those expectations are set by a “central planner” – the Fed.

Obama and the Cost of War

Thursday in West Virginia, Barack Obama gave a speech laying out the economic costs of the Iraq War, which he estimated as up to $3 trillion (Linda Bilmes and Joseph Stiglitz’s estimate) and $10 billion a month. He listed the many things that money could have bought. Robert Menendez made similar points in the Democrats’ weekly radio address.

Americans disagree on whether to stay in Iraq and the best use of the money we’d save by leaving, but everyone should acknowledge that this is the way to argue about the war. The questions that consume the media, whether the surge worked, whether we’re making progress, and so on, are important, but they alone cannot determine whether we ought to continue the occupation. That depends primarily on cost-benefit analysis, however uncertain. (Moral questions matter too but are not meaningful when divorced from consideration of costs and benefits.)

Since the cost of staying is enormous, the backers of continuing American participation in the war should enumerate the benefits that justify it (along with the deaths and the shifting of our constitutional design towards unbalanced executive power). War boosters seem to understand the terrible burden of their position, as evidenced by their tendency toward wild, worst-case accounts of the consequences of American departure. In my view, the war wouldn’t be worth continuing even if the surge were working, which it isn’t.

But since we’re talking opportunity costs, what about the rest of the national security budget – you know, the other 80 percent of American security spending, now approaching three quarters of a trillion dollars, which is mostly spent to defend us against a couple weak conventional enemies? Like most other Democrats, Obama not only avoids complaining about regular defense spending, but backs the ongoing plan to expand the ground forces, which will add $15-20 billion in annual defense costs in the name of better executing future occupations like Iraq. I understand the political calculus here, but let’s not give the guy too many medals for political courage.

Democrats like Obama and Menendez also argue that Iraq is a reason that we are shortchanging state-building efforts in Afghanistan. This talking point illustrates the trouble with conventional foreign policy thinking on the so-called left. By saying that Afghanistan needs the medicine Iraq is getting, Democratic foreign policy leaders are rushing to repeat a mistake they rightly condemn. As Harvey Sapolsky, Chris Preble and I have argued, this thinking shows that the hubris that brought us into Iraq is essentially intact.

Defending American interests in Afghanistan requires nothing more than the absence of haven for international terrorists and an example made of those who offer it. The latter is a lesson well taught. Should it fail, a small ground force can target terrorist camps and supporters via raids and air strikes guided by intelligence, even if Taliban militias gain power in some regions. Those missions never required that Afghanistan become a modern nation, democratic, or even stable.

Instead of this realistic approach, the next President will probably expand a second no-end-in-sight war, one meant to assert the control of a statelet in Kabul over an unruly territory offering little historic basis for the word “nation.” Afghanistan is full of arms and grievances. It lacks the basics of statehood: a road network, a national energy grid, widespread patriotism, and tax collection. The notion that a 30 or 50 percent increase of Western forces and investment can transform Afghanistan into a peaceful, centralized state shows idealism of stunning tenacity. Obama talks more sensibility about these matters than John McCain, but he should apply some cost-benefit analysis to that spending too.

USA Today Story on Corporate Tax Blames the Victim

Compared to other nations, the United States has a medium-sized tax burden. Most of Europe has harsher taxes, but there are plenty of place in the world that have lower tax burdens. But there is one area where America is behind almost every other nation, and that is the taxation of corporate income. The combined federal/state corporate rate is nearly 40 percent, exceeded by only Japan. Not only does the U.S. have a high tax rate, but the IRS taxes the “worldwide” income of companies, which means that it is especially hard for American companies to compete in foreign markets - particularly since almost every other nation relies on the common-sense approach of territorial taxation, which means they do not tax the “foreign-source” income earned by their companies. The only silver lining to this dark cloud is that American companies have some ability to postpone when they pay the additional layer of tax on their foreign-source income. In the minds of greedy politicians (and sloppy reporters), however, this “deferral” of a discriminatory tax is a loophole. Here’s what USA Today reported:

Democratic presidential contenders Hillary Rodham Clinton and Barack Obama have cast it as an outrage that should be a key target for the next president: a tax break they say encourages employers to ship American jobs abroad. The charge could be dismissed as typical campaign-trail exaggeration during a Democratic primary season marked by populism, except for one thing. Many analysts say it’s true. “The U.S. tax system does provide an incentive to locate production offshore,” says Martin Sullivan, a contributing editor to Tax Notes, a non-profit publication that tracks tax issues. At issue is the U.S. tax code’s treatment of profits earned by foreign subsidiaries of American corporations. Profits earned in the United States are subject to the 35% corporate tax. But multinational corporations can defer paying U.S. taxes on their overseas profits until they return them to the USA — transfers that often don’t happen for years. …”If you had two companies in Pittsburgh that both were going to expand capacity and create 100 jobs, our tax code puts the company who chooses to put the plant in Pittsburgh at a competitive disadvantage over the company that chooses to move to a tax haven,” says former White House economist Gene Sperling, a Clinton adviser.

But Senators Clinton and Obama, not to mention Martin Sullivan and Gene Sperling, have things backwards. It is America’s high tax rate that creates an incentive for jobs to be overseas. Deferral simply means that American companies are only somewhat disadvantaged in their efforts to earn market share in other nations. The USA Today story does acknowledge that America has a high corporate tax rate, but the reporter is surprised that this high rate means low revenue, even though it is actually a sign of “Laffer Curve” responses to punitive taxation:

The U.S. has one of the highest corporate tax rates in the world, and its corporate tax code has a well-earned reputation for complexity. But despite the high rate, the U.S. takes in less annual revenue from corporate taxes, measured as a percentage of economic output, than almost all other major economies.

The current system is bad for America, but critics have the wrong solution. Instead of making the U.S. tax code even more punitive by ending deferral, America needs a big reduction in the corproate tax rate. So long as America’s rate is far higher than other nations, companies will have an incentive to create jobs abroad. Ending deferral would not alter that incentive. All that would happen is that foreign companies would be creating a larger share of those jobs. The story does quote a couple of economists who have starkly different estimates of employment implications, but both agree the current system causes job losses:

Kimberly Clausing, a professor of economics at Reed College in Portland, Ore., says the corporate tax code may account for up to 3 million jobs being abroad. Gary Hufbauer, an economist who has written a book on international taxation, puts the number at just 200,000. …The Bush administration warned last year that U.S. corporate giants are at a competitive disadvantage in world markets because foreign rivals pay lower taxes in their home countries.

The article also notes that U.S. companies that create jobs abroad also create jobs in America. In other words, successful, growing firms tend to expand in all markets. A lower corprorate tax rates, needless to say, is one of the keys to a pro-growth environment for American companies. Ireland is a good example of a nation that reaps large benefits from a low corporate tax:

Matthew Slaughter, a Dartmouth College economics professor who worked in the Bush administration, says that historically, multinationals that have added jobs at their foreign affiliates also have expanded hiring in the USA. As U.S.-owned foreign units prosper, their corporate parents must add accountants, marketing specialists and other managers at their U.S. headquarters. In 2004, Slaughter released a study, based on employment data for the decade ending in 2001, which concluded that U.S. multinationals created two jobs in the USA for every job they added abroad. That comforting conclusion broke down in more recent years. From 1991 through 2005, multinationals created almost as many jobs abroad (3.6 million) as they added at home (3.8 million). …Evidence of legal tax-shifting can be seen in government statistics. In 2005, U.S. multinationals’ units in Ireland, which levies a corporate tax of just 12.5%, reported profits that were twice as large as the profits of all U.S. affiliates in Germany, France and Italy combined.