Supply Side Ignorance

“It” Is a Fiscal Problem

http://tinyurl.com/2dgo3qm
In Kudlow’s analysis of “the problem”, he is unable to look beyond the government. If it’s not a monetary problem, then it must be fiscal problem, concludes Kudlow. It never occurred to him that “the problem” might not be with the government. Maybe the worldwide recession isn’t a result of U.S. government tax rates but an imbalance that had been growing for decades. Maybe the fact that consumers are swamped in consumer debt has something to do with it. Maybe the fact that many homeowners are underwater in their mortgages has something to do with the sluggish recovery.

Kudlow calls himself a “supply-sider”. Like many supply-siders, Kudlow believes that the only engine of the economy is the supply side. Supply-Side Godfather Arthur Laffer writes in a recent book that demand is not a problem. There is never any lack of demand even in poor countries like Bangladesh. The problem is supply. I’d like to see Laffer open up a BMW dealership in a Bangladesh slum and see how high the demand is there.

Whether it fits your pre-drawn conclusions about economic growth or not, consumer demand has been a major engine in not just the U.S. economy but the world economy over the past decade. Look at China. Its double-digit economic growth over the past decade is a result primarily of producing products to be sold in the U.S. and European markets. In the past couple of years as U.S. consumers reduced consumption so much due to high debt levels that China’s economic growth has decreased considerably.

Back in 2002 after September 11 the Fed reduced interest rates to spur the economy. Consumers were able to borrow at extremely low interest rates to fund consumption. Auto dealerships were providing loans at zero percent interest rates. Then housing boomed. Low interest mortgages permitted people to buy more house for less monthly payments. The construction industry boomed as a result of this along with real estate brokers, mortgage brokers, the lending industry and title attorneys. This was all spurred by high demand. As housing values increased, homeowners were able to get low interest home equity loans to finance even more spending thereby fueling electronic, travel and tourism and other industries. President Bush reducing the top personal income tax bracket from 39% to 36% probably had very little to do with the booming economy of the mid-00s.

Then it crashed starting with home values. Those who has low interest adjustable mortgages saw the interest rates on their mortgages adjust upwards. People were able to refinance until real estate values tanked. Then they were stuck with high monthly payments. As real estate values tanked nationwide, consumers lost trillions in wealth. They reduced consumer spending considerably. No more new cars. No more big screen TVs. No expensive cruises or vacations. No new decks or new bathrooms or remodeling.

This is what caused the current depression, and the same parameters exist today. Millions of homeowners are underwater in their mortgages. Millions of people are unemployed. People who are employed are saving just in case they lose their jobs as business and local governments are strapped and looking for areas to cut.

The problem is not monetary. The problem was not caused or worsened by government fiscal inputs. The problem was and is a demand side problem and requires a demand side solution. It’s basically a hole, a deep, wide hole that’s going to take years to turn around and decades to recover from. Those that think that the economy rises and falls based on supply side factors only are only seeing half the picture.

Kudlow's War on Savings

http://tinyurl.com/26gvrwk

In a recent column, Lawrence Kudlow criticizes Treasury Secretary Geithner and Congressional Democrats for policies that discourage saving.

“The great flaw in the thinking of the Democrats,” writes Kudlow, “is that they are ignorant of the economic power of saving and investment.”

Kudlow goes on: “Saving is a good thing. Stocks, bonds, bank deposits, money-market funds, commercial paper, venture capital, private equity, real estate partnerships -- all that saving is channeled into business investment. And whether that capital goes into new start-ups or small businesses or large firms, it finances the kind of new investment in plants and equipment and software and buildings that ultimately creates jobs and family incomes. And that, in turn, spurs consumption… Without saving there can be no investment. And without investment there can be no enhanced productivity, which is the ultimate source of long-term prosperity and wealth.”

Kudlow goes on an on about how the policies proposed by Democrats (i.e. raising marginal tax rates by a mere 5%) is somehow going to doom the economy.

“My answer is to keep the incentives for investment,” writes Kudlow.

Kudlow’s incentives for investment involve low tax rates on investment by extending the W. Bush tax cuts for high income taxpayers. Kudlow is saying in his column that lower taxes on investment income will encourage people to save and invest. But does empirical evidence support it? As tax rates on investment have changed, has the personal savings rate also changed?

Capital gains tax rates have fluctuated over the years. In the 70s the top marginal capital gains tax rate was 39%. In the 80s it was reduced to 20% and then increased to 28% in 1986. In 1997 it was reduced back to 20%. In 2003 it was reduced to 15%. With the marginal tax rate on capital gains declining over 50% since the late 70s, Kudlow would expect the savings rate to have increased over that time as well.

But it didn’t. The Bureau of Economic Analysis keeps this statistic via its National Income and Product Accounts (“NIPA”) savings rate. The U.S. personal savings rate has declined considerably and steadily since the 1980s and is lower than most industrialized nations.

Kudlow’s claim that lower capital gains tax rates encourage savings is without evidence.

Nevertheless, investment in the U.S. has increased. The main reason is because investors from abroad have moved their assets to the U.S. Low marginal tax rates on capital gains can be a factor in this decision. Other things being equal, it’s better if income is taxed at 15% than at 20%. Investors have to ask themselves, “Do we want to invest in Europe or Asia or do we want to invest in the U.S.?” Reducing capital gains tax rate from 39% to 15% is a significant reduction.

But does it increase savings?

How much do I want to save for Chauncey’s education? How much do I want to save for retirement? Is a higher capital gains rate going to factor into the decision as to whether and how much I should save for Chauncey’s education? If the tax rate increases, am I going to decide to save less? If the tax rate decreases, am I going to decided to save more? It probably won’t have much effect. It will play a part into whether I invest my savings in capital assets or income producing assets, but it probably won’t affect how much I need to save or whether I decide to save. For Kudlow to suggest that a decrease in capital gains tax rates encourages people to save more is just not supported by the facts or by theory.

So what caused the savings rate in the nation to decline so dramatically?  There are a few primary causes.

First, the lessened need to save for retirement.  Americans expect to receive a monthly Social Security benefit that will fund at least part of their retirement.  Medicare reduces the need to save for medical expenses during retirement.  Since 2003 people don't even need to worry about prescription drug expenses.  Without these government programs, people would feel the need to save much more for retirement.

The housing boom also reduced the felt need to save.  As home prices skyrocketed, people expected to be able to sell their home and move into smaller, less expensive houses at retirement and use the difference to supplement their retirement.  Without rising home equities, people would feel more of a need to save.  It's not a coincidence that the savings rate increased immediately after housing prices tanked.

Another is the availability of credit.  With the United States as an attractive place for investment, it's no surprise that money poured into our economy from abroad.  Credit was readily available.  A statement often made was that consumers used their homes as ATM's.  Even without home equity, loans could be obtained even by people who had bad credit.  People with good credit could get low interest or no interest credit cards and auto loans.  It was no longer necessary to save up to buy that car or stereo.  Buy now.  Pay later.

It's later. And we're paying big time for our irresponsibility.