Much has been deservedly written on the oppression and economic deprivation of the lives of Middle Eastern people. When one thinks about the depths and scope of global poverty, we can look back and see that it was inevitable that a broad and bloody rebellion would take place. However, it is still shocking to see the speed of how oligarchies are crumbling all around the Middle East. The impact is being felt in energy as crude oil prices skyrocket with Nomura Holdings projecting a possible price of $220 per barrel. That is a mind-boggling figure that will have severe implications for the U.S. and global economy.
Crude oil is a key ingredient in providing various sources of energy. In addition to it being refined to make gasoline, it is also used for heating oil and diesel fuel. Right now, it is being traded between $96 and $108 per barrel which is already a high amount. That is one of the primary reasons why we are seeing a significant rise in gasoline and diesel fuel prices. Expect to see an even greater surge as the Middle East crisis expands.
The U.S. recovery will be tested during this crisis. As gas prices rise, consumers will find an increasing portion of their spending going toward transportation at the expense of other items. One can expect that the refinery and energy companies to increase their profitability, but it will be at the expense of other industries. In particular, firms most negatively impacted with be those that rely on large transporation costs in delivering products or utilize significant energy costs in producing their products. If this continues, then the brighter prospects for the U.S. will have to be dimmed.
The global economy will also be impacted by this. China, India, and Brazil have experienced explosive growth recently, but have been hampered by inflation risks. Rising crude oil prices will only exacerbate this issue as firms try to shift costs on to consumers. If not managed properly, then we could see their economies collapse and go into a deep recession. As for Europe, they are better positioned to handle this crisis because they have made significant investments in finding alternative energy sources. However, their significant debt burden can ill-afford events that will burden both consumers and businesses.
Typically, revolutions take years and even decades before stable governments emerge. Meanwhile, the worst part is the general uncertainty and increased political instability risks. As the fighting intensifies, the main concern is the potential damage done to oil fields. Once a victor is established then there is the question of the type of government formed. If it discourages private and foreign investment, then that will negatively impact the global economy. Given these unknowns, it typically leads to more pessimism within the business community and that is certainly an obstacle to creating jobs.
Wednesday, February 23, 2011
Friday, February 18, 2011
Buffett Applies Price Elasticity of Demand
In Friday, February 18th, 2011 edition of Bloomberg, Warren Buffett gives insight on his stock picking analysis. Given the recent exam that is coming up, it is hoped that my Micro students can see applications from the price elasticity of demand here. Specifically, Buffett stated that he focuses on pricing power, rather than management quality, in picking stocks. In other words, he is picking firms that are able to raise prices without losing much business. This concept ties very closely to elasticity of demand and specifically firms that have inelastic demand characteristics.
In Mankiw's Elasticity chapter, he discusses four factors that help us determine the type of elasticity of demand. They include:
In the examples cited by Buffett, we can see why his favored industries appear to have inelastic demand characteristics. His portfolio includes railroads and electricity producers. It should be noted that each of those industries have little competition due to their natural monopoly attributes. Natural monopoly occurs when a single firm can supply a good or service to an entire market at a smaller cost than two or more firms. That is fairly consistent with both railroads and public utilities that both incur extensive upfront investment costs that makes it prohibitive for competitors to enter. Buffett also mentioned Coca Cola and Kraft Foods. By mentioning their strong brand loyalty, he is implying that their customers are less likely to switch from their products even when they increase their prices. If this is true, then that is another example of inelastic demand.
In cases where competition is less, management quality is not as important. When you are the "only game in town", then your weaknesses in delivering or marketing a product will not be punished by market forces. That will only occur when there are a number of competitors that can exploit those weaknesses.
In Mankiw's Elasticity chapter, he discusses four factors that help us determine the type of elasticity of demand. They include:
- Availability of close substitutes
- Definition of market
- Necessities versus luxuries
- Time horizon
In the examples cited by Buffett, we can see why his favored industries appear to have inelastic demand characteristics. His portfolio includes railroads and electricity producers. It should be noted that each of those industries have little competition due to their natural monopoly attributes. Natural monopoly occurs when a single firm can supply a good or service to an entire market at a smaller cost than two or more firms. That is fairly consistent with both railroads and public utilities that both incur extensive upfront investment costs that makes it prohibitive for competitors to enter. Buffett also mentioned Coca Cola and Kraft Foods. By mentioning their strong brand loyalty, he is implying that their customers are less likely to switch from their products even when they increase their prices. If this is true, then that is another example of inelastic demand.
In cases where competition is less, management quality is not as important. When you are the "only game in town", then your weaknesses in delivering or marketing a product will not be punished by market forces. That will only occur when there are a number of competitors that can exploit those weaknesses.
Tuesday, February 15, 2011
Budget Battle: Obama vs Republicans
On Monday, February 14th, President Obama released the 2012 budget that totaled over $3.7 trillion in government spending, but also includes spending reductions of $1.1 trillion over the next ten years. That is in contrast with the Republican Study Committee that lists cuts of $2.5 trillion over the next ten years. A review of both proposals show a distinct difference in priorities. While both emphasized cuts to discretionary spending, the Republican plan will take a much deeper cut on domestic spending. Our budgetary issues are significant and either plan will be distasteful to a number of Americans.
You might be asking why do we have to balance the budget. Actually, the U.S. does not have to balance the budget. One must recognize that most Americans have not balanced their "budgets" and continue to carry credit card and loan balances to maintain their standard of living. However, it is important that the U.S. establish a more responsible path to dealing with rising deficits. Just as an individual's credit rating can decline when their spending patterns become irresponsible, the U.S. can lose their top credit rating unless they can rein in future deficits. If the U.S. continues along this profligate path, then our future economic prosperity will take a hit as borrowing costs rise, which will impact consumers and businesses alike.
Alternatively, you might be asking why not balance the budget NOW. It is the same reason why Americans do not pay off all of their credit card debt in one month. Imagine paying off $14,750 in one year, which is the average balance for households with credit card debt. (Note: By the way, over 51% of U.S. households carryover a balance each month.) Think about how that would impact how they live. Correspondingly, drastically cutting government spending to balance the deficit in a year would have a profound effect on economic activity, social stability, and national security.
While Obama's plan centers on strategic spending initiatives aimed at boosting future economic growth, the focus of Republicans is on lowering government spending and hoping that will spur private investment. Obama hopes to add funding of $148 billion toward research and development with most of that centering on alternative energy. In Principles of Microeconomics and Mankiw's Externalities, there is a concept called technology spillovers where the impact of one firm's research and production efforts can positively impact another firm's activities. He hopes that subsidies and tax credits to specific industries will result in advancement in finding alternative sources of energy. While there is debate among economists over this effect, we can infer that President Obama believes this effect to be relatively significant and eventually lessen our dependence on crude oil and lower energy costs in the future.
On the other hand, Republicans side with economists that think the technology spillover effect is relatively small and they want to unleash the power of capitalism and the private sector. In order to do this, a closer inspection sees the potential for much collaterial damage to ordinary and middle-class Americans. While it seems that simply reverting spending levels from fiscal year 2011 to fiscal year 2008 is reasonable, one must recognize that after adjusting to inflation and population increases that the level of services received by Americans will be lower than what they received three years ago. In particular, giving up federal control of Fannie Mae and Freddie Mac is particularly dangerous because it is key source of financing for many middle-class Americans. Given the toxic state of their balance sheet, it is very questionable whether they would be able to attract enough private capital to remain afloat and that could leave great uncertainty in the housing market.
On the positive side, these spending cuts can fuel future economic growth and greater productivity. Lower deficits will be looked upon favorably abroad and lead to lower interest rates. There also can be room to lower taxes for both consumers and businesses. That can boost investment spending and hopefully result in more job creation. On the downside, they are not well positioned to handle the potential aftereffects of Middle East instability due to large reductions in alternative energy sources. Also, there is scant mention to declining infrastructure needs that the private sector historically underserves.
There are concerns about spending reductions and how it can affect social stability. While one of President Obama's goals is to minimize income inequality, tough choices on specific programs could alleviate those concerns. First, there will be a number of government programs that will either be eliminated or reduced. One proposal will involve a reduction of $2.5 billion in subsidies to the poor to handle rising energy costs, so that will affect their spending for food, transportation, and other activities. Another involves eliminating Pell Grant funding in the summer. Pell Grants are given to low-income students, so its elimination will slow matriculation rates in college for this group. Scaling back community development grants will burden distressed areas that are already having trouble generating jobs and encouraging economic development.
The defunding of these programs will hurt, but would be much larger if not obtaining additional revenue streams from high income households. In particular, Obama would like to limit mortgage interest and charitable deductions on households earning $250,000 or more. This would essentially be a tax increase, but is consistent with his pledge to not raise taxes on the middle class. Though Jerry Howard of the National Association of Home Builders asserts that this is a tax increase on the middle class, one should note that the median household income was $50,221 as of 2009, which is significantly lower than $250,000. On the other hand, this does have the potential to impact home purchases in affluent areas and could spell trouble for non-profit organizations that are more dependent on private fundraising now that government support is trending downward.
Of course, these concerns will be magnified under the Republican plan. All of the above would occur, but at much higher rates. Another potential concern is shifting the costs of Medicare and Medicaid from the federal government to the states in meeting the health care needs of the indigent. States would be forced to find alternative funding sources or decide to not cover health care services for many of their citizens. This has the potential to disrupt the social fabric of the U.S. with many not realizing the actual impact until it is too late.
Lastly, national security could be an issue, in particular if Obama's initiatives are passed. Specifically, his budget will call for a 5% reduction and he hopes that this will occur as troops leave Iraq as projected and the Pentagon is able to generate $78 billion in saving. Many communities depend on economic activity from the military, so this will politically difficult to acheive. When looking at the Republican plan, there was no mention of cuts in defense spending, so their emphasis remains on maintaining strong national security. Given the hot spots across the globe, its emphasis can be easily justified.
In summary, it is highly doubtful that either proposal will be fully adopted because the political cost will be too much to bear for much of Congress. However, it is imperative that our political leaders be upfront with Americans on the importance of addressing our deficit problems and how it will negatively impact our future growth, if it goes unaddressed. There are no easy solutions where we can rely on waste and inefficiency to solve our fiscal problems. In particular, changing demographics will be a huge obstacle as Social Security benefits and rising health costs will quickly absorb a large portion of upcoming budgets. Tough choices that involve some combination of reductions in government spending or raising taxes will inevitably cause short-term harm to the economy, but making the right strategic choices now can better position Americans to enjoy prosperity in the future.
You might be asking why do we have to balance the budget. Actually, the U.S. does not have to balance the budget. One must recognize that most Americans have not balanced their "budgets" and continue to carry credit card and loan balances to maintain their standard of living. However, it is important that the U.S. establish a more responsible path to dealing with rising deficits. Just as an individual's credit rating can decline when their spending patterns become irresponsible, the U.S. can lose their top credit rating unless they can rein in future deficits. If the U.S. continues along this profligate path, then our future economic prosperity will take a hit as borrowing costs rise, which will impact consumers and businesses alike.
Alternatively, you might be asking why not balance the budget NOW. It is the same reason why Americans do not pay off all of their credit card debt in one month. Imagine paying off $14,750 in one year, which is the average balance for households with credit card debt. (Note: By the way, over 51% of U.S. households carryover a balance each month.) Think about how that would impact how they live. Correspondingly, drastically cutting government spending to balance the deficit in a year would have a profound effect on economic activity, social stability, and national security.
While Obama's plan centers on strategic spending initiatives aimed at boosting future economic growth, the focus of Republicans is on lowering government spending and hoping that will spur private investment. Obama hopes to add funding of $148 billion toward research and development with most of that centering on alternative energy. In Principles of Microeconomics and Mankiw's Externalities, there is a concept called technology spillovers where the impact of one firm's research and production efforts can positively impact another firm's activities. He hopes that subsidies and tax credits to specific industries will result in advancement in finding alternative sources of energy. While there is debate among economists over this effect, we can infer that President Obama believes this effect to be relatively significant and eventually lessen our dependence on crude oil and lower energy costs in the future.
On the other hand, Republicans side with economists that think the technology spillover effect is relatively small and they want to unleash the power of capitalism and the private sector. In order to do this, a closer inspection sees the potential for much collaterial damage to ordinary and middle-class Americans. While it seems that simply reverting spending levels from fiscal year 2011 to fiscal year 2008 is reasonable, one must recognize that after adjusting to inflation and population increases that the level of services received by Americans will be lower than what they received three years ago. In particular, giving up federal control of Fannie Mae and Freddie Mac is particularly dangerous because it is key source of financing for many middle-class Americans. Given the toxic state of their balance sheet, it is very questionable whether they would be able to attract enough private capital to remain afloat and that could leave great uncertainty in the housing market.
On the positive side, these spending cuts can fuel future economic growth and greater productivity. Lower deficits will be looked upon favorably abroad and lead to lower interest rates. There also can be room to lower taxes for both consumers and businesses. That can boost investment spending and hopefully result in more job creation. On the downside, they are not well positioned to handle the potential aftereffects of Middle East instability due to large reductions in alternative energy sources. Also, there is scant mention to declining infrastructure needs that the private sector historically underserves.
There are concerns about spending reductions and how it can affect social stability. While one of President Obama's goals is to minimize income inequality, tough choices on specific programs could alleviate those concerns. First, there will be a number of government programs that will either be eliminated or reduced. One proposal will involve a reduction of $2.5 billion in subsidies to the poor to handle rising energy costs, so that will affect their spending for food, transportation, and other activities. Another involves eliminating Pell Grant funding in the summer. Pell Grants are given to low-income students, so its elimination will slow matriculation rates in college for this group. Scaling back community development grants will burden distressed areas that are already having trouble generating jobs and encouraging economic development.
The defunding of these programs will hurt, but would be much larger if not obtaining additional revenue streams from high income households. In particular, Obama would like to limit mortgage interest and charitable deductions on households earning $250,000 or more. This would essentially be a tax increase, but is consistent with his pledge to not raise taxes on the middle class. Though Jerry Howard of the National Association of Home Builders asserts that this is a tax increase on the middle class, one should note that the median household income was $50,221 as of 2009, which is significantly lower than $250,000. On the other hand, this does have the potential to impact home purchases in affluent areas and could spell trouble for non-profit organizations that are more dependent on private fundraising now that government support is trending downward.
Of course, these concerns will be magnified under the Republican plan. All of the above would occur, but at much higher rates. Another potential concern is shifting the costs of Medicare and Medicaid from the federal government to the states in meeting the health care needs of the indigent. States would be forced to find alternative funding sources or decide to not cover health care services for many of their citizens. This has the potential to disrupt the social fabric of the U.S. with many not realizing the actual impact until it is too late.
Lastly, national security could be an issue, in particular if Obama's initiatives are passed. Specifically, his budget will call for a 5% reduction and he hopes that this will occur as troops leave Iraq as projected and the Pentagon is able to generate $78 billion in saving. Many communities depend on economic activity from the military, so this will politically difficult to acheive. When looking at the Republican plan, there was no mention of cuts in defense spending, so their emphasis remains on maintaining strong national security. Given the hot spots across the globe, its emphasis can be easily justified.
In summary, it is highly doubtful that either proposal will be fully adopted because the political cost will be too much to bear for much of Congress. However, it is imperative that our political leaders be upfront with Americans on the importance of addressing our deficit problems and how it will negatively impact our future growth, if it goes unaddressed. There are no easy solutions where we can rely on waste and inefficiency to solve our fiscal problems. In particular, changing demographics will be a huge obstacle as Social Security benefits and rising health costs will quickly absorb a large portion of upcoming budgets. Tough choices that involve some combination of reductions in government spending or raising taxes will inevitably cause short-term harm to the economy, but making the right strategic choices now can better position Americans to enjoy prosperity in the future.
Friday, February 11, 2011
When Republicans Embrace Government Over Markets
In a review of any beginning economics course, one learns about the power of markets. We are often told that the best economic system is one where markets are run with as little interference as possible from the government. In a quick examination of the two major political parties, it is often assumed that Republicans always support market-friendly solutions. They typically frown on government interference and its distortion on market outcomes, but there is one exception to this rule. As the libertarian, conservative-leaning think tank, Cato Institute, points out, why are Republicans hypocritical in the area of farm subsidies?
A simple answer is a dose of political reality that a large majority of Americans implicitly do not favor a pure market economy, especially when market forces can cause job losses. In the case of agriculture, developing countries are showing improvement as they accept more market-based fundamentals. Most of this growth can be attributed to better farming methods and technology, which has resulted in a significant amount of exports throughout the world. While this is good and minimizing global poverty, there is concern that their advances are coming at the expense of farmers in the U.S. and advanced countries. In order to counteract this, they are ironically condoning governmental intervention to protect jobs, even if the result is inefficiency and a waste of resources.
Farm subsidies are inefficient because they reward less productive behavior. It is essentially a price control, more specifically a binding price floor, where farmers receive direct income from the government that range between $15-35 billion a year. By receiving these subsidies, there are concerns that this can lead to a surplus of food production and possibly lead to warehousing cost to the federal government. If ended, then industry would shift to more productive uses. The savings of $15-35 billion could be applied toward paying down the deficit and this can lead to lower interest rates where businesses and consumers can adjust their spending priorities accordingly.
The current farm subsidy system is also not equitable. It is often assumed that farm subsidies are needed to help the ordinary farmer, but a quick overview shows that their share of the windfall is very small. Based on the Environmental Working Group study, we see that mostly large corporations rather than the individual farmer are receiving most of the aid. Even if not eliminated, there are opportunities to restructure the program to cutting funds without impacting low- and middle-income farmers at all.
Another issue is that it can lead to unintended consequences. For instance, our search for alternative energy sources led to legislation of significant subsidies toward ethanol. It was once thought that ethanol would be a cheaper form of energy and yield greater benefits to the environment. However, recent studies show that the opposite is the case. Greater use of ethanol as an energy source has driven up the cost of food prices and potentially damage the environment more than gasoline. If that is the case, then our current efforts in subsidizing the ethanol industry to the tune of $7.7 billion last year may need to be reevaluated if we are truly concerned with improving the environment.
Most supporters of farm subsidies point to concerns with national security if the program was ended. They believe that the U.S. could be vulnerable to global shocks to food supply arising from political instability or regimes supported by terrorists. However, it is reasonable to suggest that this risk is minimized by the diverse sources of agriculture throughout the world. Plus, a portion of those savings can be applied to national defense to better address trouble spots throughout the world. Also, one can say that these artificial price supports from both the U.S. and Europe contribute to global instability and terroristic activities as farmers throughout the world find it more difficult to compete. If South America, Africa, and Asia reverse their economic gains due to unfair trade practices, shouldn't we be concerned about the implications on national security?
Others point to protection for farmers when market conditions are unfavorable. They need government assistance to remain viable when poor weather results in low yields. That is certainly a possibility, but this type of protection distorts incentives for farmers. Through proper planning and storage, your effective farmers can handle the volatility in farming. For those that cannot, then maybe they should devote their energies to another occupation. A capitalist economy regularly punishes inefficient producers, so why should proponents of this system not apply this principle in agriculture.
A transition away from an agriculture to service-based economy could actually generate more economic benefits in the long run. Certainly, there will be a painful transition with a certain segment of farmers losing their livelihood as market forces favor low-cost producing farms from developing countries over food production in advanced economies, like the U.S. Economists call this creative destruction where jobs destroyed are replaced with jobs that pay better. When one thinks about it, we have seen this process take place many times in the U.S. Does anybody remember the milkman, blacksmith, or elevator operator? While it was definitely painful for the families that had to adjust to a new livelihood, the U.S. economy and American worker have successfully made the adjustment in the past.
Even though farm subsidies enjoy broad support across the U.S., that does not make it good economic policy. Given the broad support that this policy enjoys across both political parties, it is not practical to eliminate it altogether. However, it can be adjusted by limiting benefits enjoyed by large corporations and high income farmers. The savings gained from this action can be applied to the deficit, which will lower borrowing costs for firms and consumers. It can also make it easier to fund needed investment in infrastructure and alternative energy that can lead to higher future economic growth. Lastly, the national security issue is a dubious claim, particularly when one sees the damage that U.S. and European price supports can do to economic advancement in developing countries. Surely, our new Republican leaders within the new Congress, who are quick to denigrate government and embrace the market system, will eventually see the light, right?
A simple answer is a dose of political reality that a large majority of Americans implicitly do not favor a pure market economy, especially when market forces can cause job losses. In the case of agriculture, developing countries are showing improvement as they accept more market-based fundamentals. Most of this growth can be attributed to better farming methods and technology, which has resulted in a significant amount of exports throughout the world. While this is good and minimizing global poverty, there is concern that their advances are coming at the expense of farmers in the U.S. and advanced countries. In order to counteract this, they are ironically condoning governmental intervention to protect jobs, even if the result is inefficiency and a waste of resources.
Farm subsidies are inefficient because they reward less productive behavior. It is essentially a price control, more specifically a binding price floor, where farmers receive direct income from the government that range between $15-35 billion a year. By receiving these subsidies, there are concerns that this can lead to a surplus of food production and possibly lead to warehousing cost to the federal government. If ended, then industry would shift to more productive uses. The savings of $15-35 billion could be applied toward paying down the deficit and this can lead to lower interest rates where businesses and consumers can adjust their spending priorities accordingly.
The current farm subsidy system is also not equitable. It is often assumed that farm subsidies are needed to help the ordinary farmer, but a quick overview shows that their share of the windfall is very small. Based on the Environmental Working Group study, we see that mostly large corporations rather than the individual farmer are receiving most of the aid. Even if not eliminated, there are opportunities to restructure the program to cutting funds without impacting low- and middle-income farmers at all.
Another issue is that it can lead to unintended consequences. For instance, our search for alternative energy sources led to legislation of significant subsidies toward ethanol. It was once thought that ethanol would be a cheaper form of energy and yield greater benefits to the environment. However, recent studies show that the opposite is the case. Greater use of ethanol as an energy source has driven up the cost of food prices and potentially damage the environment more than gasoline. If that is the case, then our current efforts in subsidizing the ethanol industry to the tune of $7.7 billion last year may need to be reevaluated if we are truly concerned with improving the environment.
Most supporters of farm subsidies point to concerns with national security if the program was ended. They believe that the U.S. could be vulnerable to global shocks to food supply arising from political instability or regimes supported by terrorists. However, it is reasonable to suggest that this risk is minimized by the diverse sources of agriculture throughout the world. Plus, a portion of those savings can be applied to national defense to better address trouble spots throughout the world. Also, one can say that these artificial price supports from both the U.S. and Europe contribute to global instability and terroristic activities as farmers throughout the world find it more difficult to compete. If South America, Africa, and Asia reverse their economic gains due to unfair trade practices, shouldn't we be concerned about the implications on national security?
Others point to protection for farmers when market conditions are unfavorable. They need government assistance to remain viable when poor weather results in low yields. That is certainly a possibility, but this type of protection distorts incentives for farmers. Through proper planning and storage, your effective farmers can handle the volatility in farming. For those that cannot, then maybe they should devote their energies to another occupation. A capitalist economy regularly punishes inefficient producers, so why should proponents of this system not apply this principle in agriculture.
A transition away from an agriculture to service-based economy could actually generate more economic benefits in the long run. Certainly, there will be a painful transition with a certain segment of farmers losing their livelihood as market forces favor low-cost producing farms from developing countries over food production in advanced economies, like the U.S. Economists call this creative destruction where jobs destroyed are replaced with jobs that pay better. When one thinks about it, we have seen this process take place many times in the U.S. Does anybody remember the milkman, blacksmith, or elevator operator? While it was definitely painful for the families that had to adjust to a new livelihood, the U.S. economy and American worker have successfully made the adjustment in the past.
Even though farm subsidies enjoy broad support across the U.S., that does not make it good economic policy. Given the broad support that this policy enjoys across both political parties, it is not practical to eliminate it altogether. However, it can be adjusted by limiting benefits enjoyed by large corporations and high income farmers. The savings gained from this action can be applied to the deficit, which will lower borrowing costs for firms and consumers. It can also make it easier to fund needed investment in infrastructure and alternative energy that can lead to higher future economic growth. Lastly, the national security issue is a dubious claim, particularly when one sees the damage that U.S. and European price supports can do to economic advancement in developing countries. Surely, our new Republican leaders within the new Congress, who are quick to denigrate government and embrace the market system, will eventually see the light, right?
Tuesday, February 8, 2011
Will U.S. Soon Lose Its Top Credit Rating?
Unless the U.S. economic recovery meets expectations, there is concern that the U.S. will lose their top credit rating. Contrary to popular belief, the U.S. is currently not broke despite recent annual deficits topping over a trillion dollars. This is because our economic activity exceeded $13 trillion in Real GDP last year. However, it is essential that the U.S. acts relatively quickly in addressing future deficits that are projected to balloon due to rising entitlements from Social Security and higher health care costs. If Congress fails to act soon, then it is quite possible that we will lose our Aaa rating soon.
Currently, the U.S. is taking a different tact from Europe in dealing with debt reduction. While Europe's crisis involving Southern Europe has forced them to curtail government spending and raise taxes, it appears that the U.S. is primarily focused on cutting government spending to achieve the goal. When looking at the extension of the Bush tax cuts for both the middle and upper income classes, this actually increased projected budget deficits because previous budget estimates assumed that the tax cuts would expire at the end of 2010. Actually, a reduction in government spending and increasing taxes will negatively impact economic activity in the short run, but both actions might be necessary to ensure that interest rates do not rise in the future for businesses and households.
A downgrade of our credit rating will have ripple effects on our economy in the future. Its first effect will be increasing the cost of deficit spending for the U.S. Treasury. As has been the case historically within the U.S. with limited exceptions, we have spent more than we have collected in tax revenues. Therefore, the U.S. has to issue U.S. Treasury debt. With a Aaa rating, interest costs are minimized. If Moody's or S&P credit agencies downgrade the U.S. credit rating, then it will be more expensive to issue debt. When that occurs, then we could see a rise in interest rates that will dampen both consumer and investment spending.
One only has to look at Japan to see the effects of damaged credit status. In the 1980s, they were seen as a major threat to U.S. economic supremacy. However, weaknesses within their credit underwriting caused their banking and financial industries to collapse. That led to a severe recession and deflation that exists to this day. Starting in 2002, their credit rating from Standard & Poor's fell to from AAA to AA. Now they just recently experienced a reduction to AA-. While they remain the third largest economy to China and the U.S., their high debt levels and corresponding borrowing costs are hampering their current economic growth efforts.
Referring back to the U.S., their immediate fate will probably depend on the status of our current recovery. As of right now, U.S. Federal Reserve Chairman Ben Bernanke still believes that the prospects for 2011 will be better than 2010. If that occurs, we should expect growth rates to be around 3%. On the other hand, slower than expected economic growth will cause tax revenues to fall with jobs not materializing. That will exacerbate our budget deficits and lead to an undesirable result.
Currently, the U.S. is taking a different tact from Europe in dealing with debt reduction. While Europe's crisis involving Southern Europe has forced them to curtail government spending and raise taxes, it appears that the U.S. is primarily focused on cutting government spending to achieve the goal. When looking at the extension of the Bush tax cuts for both the middle and upper income classes, this actually increased projected budget deficits because previous budget estimates assumed that the tax cuts would expire at the end of 2010. Actually, a reduction in government spending and increasing taxes will negatively impact economic activity in the short run, but both actions might be necessary to ensure that interest rates do not rise in the future for businesses and households.
A downgrade of our credit rating will have ripple effects on our economy in the future. Its first effect will be increasing the cost of deficit spending for the U.S. Treasury. As has been the case historically within the U.S. with limited exceptions, we have spent more than we have collected in tax revenues. Therefore, the U.S. has to issue U.S. Treasury debt. With a Aaa rating, interest costs are minimized. If Moody's or S&P credit agencies downgrade the U.S. credit rating, then it will be more expensive to issue debt. When that occurs, then we could see a rise in interest rates that will dampen both consumer and investment spending.
One only has to look at Japan to see the effects of damaged credit status. In the 1980s, they were seen as a major threat to U.S. economic supremacy. However, weaknesses within their credit underwriting caused their banking and financial industries to collapse. That led to a severe recession and deflation that exists to this day. Starting in 2002, their credit rating from Standard & Poor's fell to from AAA to AA. Now they just recently experienced a reduction to AA-. While they remain the third largest economy to China and the U.S., their high debt levels and corresponding borrowing costs are hampering their current economic growth efforts.
Referring back to the U.S., their immediate fate will probably depend on the status of our current recovery. As of right now, U.S. Federal Reserve Chairman Ben Bernanke still believes that the prospects for 2011 will be better than 2010. If that occurs, we should expect growth rates to be around 3%. On the other hand, slower than expected economic growth will cause tax revenues to fall with jobs not materializing. That will exacerbate our budget deficits and lead to an undesirable result.
Friday, February 4, 2011
Unemployment Rate Drops, So Why Is That Not Good?
A look at January's job report would appear to suggest improvement since the unemployment rate fell from 9.5% to 9%. However, that's not the key number to look at. In this case, we want to focus on the number of jobs created. When looking at it from that perspective, we can see why this report is less than rosy. That is because only 36,000 jobs were created this month, which is the poorest performance since last September. In order for us to return to employment levels from the pre-recession days we will need at least 9 times that amount for a sustained period of time. This is an example where the unemployment rate is actually not a good indicator of the health of the labor market.
Even though one should classify this report as disappointing, it is premature to classify this as a negative trend. Bad weather hampers shopping activity, so businesses are less likely to increase their job rolls. Also, poor weather makes job seekers less likely to actively pursue a job. This means that there was a rise in discouraged workers, who would like a job but are not actively seeking work. Since they are not counted in the official unemployment rate, the figure is misleading. In February, one would expect weather to not play as much of a role, so that could lead to a different result. As we look to February and beyond, we will have to see if a promising holiday shopping season eventually results in a more sustained recovery or whether poor weather and global events will stall our tepid economic recovery.
Poor weather conditions can also have a carryover effect, particularly as it relates to agriculture and food prices. Abnormally cold weather will probably negatively impact crop yields and this can lead to higher prices. Crops will be more scarce because of the poor weather and could lead to a shortage in the spring. As we learned in economics, a shortage can only be corrected by raising the price. Therefore, higher food prices typically mean that consumers will cut back their spending on other activities. Thus, if significant, this can curtail overall economic growth in the future.
As we look to next month, we should also be mindful of global events. The Middle East situation is still murky and political instability is on the rise there. This will certainly cause investors and analysts angst because they realize that an unstable Middle East region usually results in higher gas and energy prices. If they remain high, that has the potential to dampen consumer spending and worsen profitability of firms.
Admittedly, those two conditions appear grim, but there are still signs that the U.S. economy is getting better. Consumer spending rose during the last quarter as we saw a relatively healthy economic growth rate of 3.2% during the fourth quarter of 2010. Manufacturing activity in 2011 is off to a good start, too. If both indicators remain strong, then they can offset the negative influences of poor weather and uncertainty in the Middle East.
Even though one should classify this report as disappointing, it is premature to classify this as a negative trend. Bad weather hampers shopping activity, so businesses are less likely to increase their job rolls. Also, poor weather makes job seekers less likely to actively pursue a job. This means that there was a rise in discouraged workers, who would like a job but are not actively seeking work. Since they are not counted in the official unemployment rate, the figure is misleading. In February, one would expect weather to not play as much of a role, so that could lead to a different result. As we look to February and beyond, we will have to see if a promising holiday shopping season eventually results in a more sustained recovery or whether poor weather and global events will stall our tepid economic recovery.
Poor weather conditions can also have a carryover effect, particularly as it relates to agriculture and food prices. Abnormally cold weather will probably negatively impact crop yields and this can lead to higher prices. Crops will be more scarce because of the poor weather and could lead to a shortage in the spring. As we learned in economics, a shortage can only be corrected by raising the price. Therefore, higher food prices typically mean that consumers will cut back their spending on other activities. Thus, if significant, this can curtail overall economic growth in the future.
As we look to next month, we should also be mindful of global events. The Middle East situation is still murky and political instability is on the rise there. This will certainly cause investors and analysts angst because they realize that an unstable Middle East region usually results in higher gas and energy prices. If they remain high, that has the potential to dampen consumer spending and worsen profitability of firms.
Admittedly, those two conditions appear grim, but there are still signs that the U.S. economy is getting better. Consumer spending rose during the last quarter as we saw a relatively healthy economic growth rate of 3.2% during the fourth quarter of 2010. Manufacturing activity in 2011 is off to a good start, too. If both indicators remain strong, then they can offset the negative influences of poor weather and uncertainty in the Middle East.
Thursday, February 3, 2011
Finding The Right Balance in Corporate Tax Reform
Given the difficult terrain for jobs, businesses have been able to leverage our vulnerability for their benefit. Through use of tax credits and other loopholes, they have been able to limit their tax liabilities and enjoy advantages in infrastructure, resources, and services that enable their company to grow. The U.S. is commonly referred to as not being business-friendly with many citing a very high corporate tax rate that ranks among the highest in the world. However, that distinction might be misleading, as reported by David Leonhardt's "The Paradox of Corporate Taxes" in the New York Times Economix blog. In order to ensure that revenue sources are enhanced to improve the fiscal conditions for all forms of government, it is essential that our corporate tax code be revised.
Many economists believe that tax reform is necessary. Certainly, we do not advocate tax levels being so high that they are overly burdensome and lead to job destruction, rather than job creation. However, it is fair to suggest that business might not be paying their fair share in infrastructure needs. New highways, more accessible roads, sewer, and electrical connections are all essential drivers to economic growth. Their construction will lead to more business activity and facilitate higher market shares and profitability. By reforming the tax code and limiting the amount of loopholes, we can generated needed revenues, while also lowering tax rates.
Even though this appears to be a sensible solution, there is significant backlash against this type of reform. Of course, the business community favors a lower tax rate, but they are not willing to sacrifice closing any loopholes. Given the tenuous recovery, they have been able to effectively frame the debate in terms of facing an onerous tax code that prevents them from expanding operations, rather than looking at the strain this method puts on our federal, state, and local economies. If infrastructure needs are to be met, then they are increasingly being financed through debt financing at the federal level and higher property and sales taxes at the state and local level.
While there is significant debate within economists regarding whether our tax code should be geared more toward equality or efficiency, most will agree that loopholes and excessive tax credits are bad policy. By limiting the use of loopholes, one can expand the base of businesses to pay for taxes. If one favors a corporate tax code that will enhance economic growth and job creation, they will want the tax rate to be low. Sufficient revenues can be collected through low tax rates, but that can only happen through closing loopholes. Then there is another segment that argues that businesses are receiving a benefit through enhancements to roads, facilities, and other resources, so they should pay for these services. This can be done by a combination of closing loopholes and maintaining similar tax rates. If this occurs, then more equality will be achieved and the end result could be lower debt spending and more tax relief for consumers and property owners.
Many economists believe that tax reform is necessary. Certainly, we do not advocate tax levels being so high that they are overly burdensome and lead to job destruction, rather than job creation. However, it is fair to suggest that business might not be paying their fair share in infrastructure needs. New highways, more accessible roads, sewer, and electrical connections are all essential drivers to economic growth. Their construction will lead to more business activity and facilitate higher market shares and profitability. By reforming the tax code and limiting the amount of loopholes, we can generated needed revenues, while also lowering tax rates.
Even though this appears to be a sensible solution, there is significant backlash against this type of reform. Of course, the business community favors a lower tax rate, but they are not willing to sacrifice closing any loopholes. Given the tenuous recovery, they have been able to effectively frame the debate in terms of facing an onerous tax code that prevents them from expanding operations, rather than looking at the strain this method puts on our federal, state, and local economies. If infrastructure needs are to be met, then they are increasingly being financed through debt financing at the federal level and higher property and sales taxes at the state and local level.
While there is significant debate within economists regarding whether our tax code should be geared more toward equality or efficiency, most will agree that loopholes and excessive tax credits are bad policy. By limiting the use of loopholes, one can expand the base of businesses to pay for taxes. If one favors a corporate tax code that will enhance economic growth and job creation, they will want the tax rate to be low. Sufficient revenues can be collected through low tax rates, but that can only happen through closing loopholes. Then there is another segment that argues that businesses are receiving a benefit through enhancements to roads, facilities, and other resources, so they should pay for these services. This can be done by a combination of closing loopholes and maintaining similar tax rates. If this occurs, then more equality will be achieved and the end result could be lower debt spending and more tax relief for consumers and property owners.
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