I somehow doubt they realize this.

In the real world -- the world of the globalized dollar economy that we've all lived in for decades -- it's still the case, for now, that the rest of the world wants to hold US dollars as a reserve asset.  (Thank God for that.)  For that reason, the US economy will normally run a trade deficit.  For that reason, the US government will normally run a budget deficit.  Indeed, after allowing for the financial position of the private sector, that budget deficit will normally about equal the trade deficit, medium-term.

No commission can change this.

Medical costs help determine the scale and composition of total spending.  They do not determine the budget deficit.  Cutting medical costs may cut the deficit on paper.  It will not cut it in real life. 

If Medicare and Medicaid costs soar, from an economic standpoint that's just another public sector stimulus. It will raise private incomes.  It will therefore raise tax revenues -- until the budget deficit again falls, roughly to the value given by the trade deficit at the new income level. 

Conversely if Medicare is cut, private disposable incomes will fall.  And then, so will tax revenues, until once again the budget deficit and the trade deficit are in approximate balance.

Yes, I agree -- as everybody agrees -- that health care costs should be brought under better control.

If the ten Canutes are serious about health care costs, they could start by making sure that universal health insurance is enacted – to begin with, by vigorously backing President Obama's health plan. And then they could take on the problem of health care costs directly - in both the private and the public sectors.

But to focus attention on Medicare and Medicaid alone, is just to say that health care costs should be cut for the elderly and the poor alone. That is to say, the proposal would cut costs and services for people who need medical care the most -- and can afford it least. 

Where on earth is the morality in that?

Speaker Pelosi is right.   The idea of a deficit reduction commission is political posturing,  and it's rooted in a failure to understand the underlying economics. 

Commission No Silver Bullet, Actually Could Set Back Deficit Reduction Effort

No bipartisan commission on deficit reduction can magically eliminate the deep divisions that exist today among lawmakers over budget issues.  And, while creating a commission in the face of such divisions may seem harmless, it could actually set back the cause of deficit reduction.

To be sure, commissions have sometimes proven useful when a bipartisan consensus existed on the need for, and the rough parameters of, legislation to address a serious budget problem.   When, for instance, President Ronald Reagan and Speaker of the House Tip O’Neill agreed in 1983 that a combination of benefit cuts and tax increases were needed to keep Social Security afloat, they found it useful to appoint a commission to help craft the specifics of such a plan and build public and Congressional support for it.  Consequently, Congress enacted legislation that secured Social Security’s solvency for more than five decades.

With regard to the Base Realignment and Closure Commission, there was strong bipartisan consensus in Congress on the need to reduce the number of military bases across the nation.  The commission provided a useful tool to overcome the politically difficult geographical issues involved — namely, which bases to close — in order to implement the agreed-upon reductions in the number of bases.  The BRAC commission’s decisions, however, are far different from those that will prove necessary for deficit reduction  — decisions, for instance, about the appropriate level of federal revenues, the role of social insurance and safety net programs, and the tradeoffs between funding for domestic and defense activities generally.

If and when, at some point down the road, a bipartisan consensus exists on budget issues, it may be more efficient for the President and Congressional leaders from both parties to eschew a commission and move directly to crafting the details of legislation themselves.  That’s what happened in 1990 when top aides to the first President Bush, Democratic congressional leaders, and most of the Republican congressional leadership negotiated a budget deal that included tax increases and spending cuts and reduced cumulative budget deficits by $500 billion over five years.

When no consensus exists, a commission is no more likely to produce the desired results than direct negotiations among lawmakers.  That’s what happened when Congress in 1994 created a deficit reduction commission, headed by Senators Bob Kerrey and John Danforth.  Despite the best intentions of the co-chairmen, the commission reached no conclusion about how to proceed with deficit reduction because the fundamental differences between Democratic leaders (President Clinton and congressional Democrats) and Republican congressional leaders prevented commissioners from reaching agreement (and, even had they reached agreement, would have made it impossible to gather the necessary votes in Congress to enact it).  Given that differences between the two parties today on budget issues are at least as great as in 1994, it’s hard to see how a bipartisan commission could succeed.  If the commission members reflected the views of their party, they would fail to reach agreement.  If they did not represent the views of their party, then any agreement they reached likely would die in Congress.

With no obvious path to progress today on deficit reduction, lawmakers and others may be tempted to create a commission on the grounds it will “do no harm.”  But establishing a commission at this time could do some harm by encouraging the two parties to use their appointments to it to demonstrate their undying commitment to positions that are not sustainable in the long run (e.g., no cuts in major spending programs, no tax increases).  That could delay the day when serious bipartisan discussions about the spending cuts and tax increases that will be needed to put the budget on a sustainable path can begin.

And too bad some other Democrats, such as Pelosi, are also opposed. 

In both cases, they are ducking their responsibilities unless they come up with specific proposals to reduce long-term projected deficits – which is not happening and is not likely to happen any time soon. In the meantime, we are courting all kinds of trouble from slower growth, to an economic crisis, along with reduced flexibility to get the economy moving again or handle a new international threat. But perhaps even more important than the effects on the economy is the effects on confidence in government.  

A group of us has been going around the country talking about these issues as part of the Fiscal Wake Up Tour.  We find that citizens are much more upset about the failure of their elected leaders to act than they are about accepting the specific sacrifices that deficit reduction implies. If the two parties could join hands and take joint responsibility for proposing some tough actions the public would go along. 

It has happened before: in 1983 on Social Security reform, in 1986 on tax reform, in 1990 and again in 1997 on the budget. Presidential leadership is needed as well. Too many people on the left think that we can solve the problem by controlling health care costs but it is now apparent that we’ll be lucky if health care reform doesn’t dig the hole any deeper. The bills currently under consideration contain very little that will “bend the long-term cost curve.”  And too many people on the right believe that higher revenues lead to an intrusive and inefficient public sector despite the fact that we are now spending about $1 trillion a year on tax preferences for all kinds of activities, most of which would be better left to the market.

Is the Treasury plan mostly politics? A powerful incentive to pay back TARP funds and avoid the risk of future bailouts? Will it be possible to attract competent management at those companies? Can the Fed be trusted to curb compensation when it never recognized that as a problem before?

Wage and price controls are not a new idea.  They are a very old idea with a consistent history of creating more problems than they solve.  There has always been a stain of thinking among those men and women who consider themselves wiser than the market to believe that they know the value of a product or service.  The only real value is what men and women freely choose to pay in a free market.  Everything else is a power play by special interests and the government bureaucrats that serve them.

The men and women who lost billions of other people’s money and who failed to oppose government policies such as Fannie Mae and Freddie Mac’s existence and the Community Reinvestment Act should be “punished” by losing their jobs and assets when “their” companies went bankrupt.  The government interfered with allowing the market to sort out who is responsible for what.  Trying to guess what salaries should be—paid with other people’s money—is hubris.  Stupid hubris.  Done before and always messed things up hubris.

The White House action to limit the amount of pay at the seven firms receiving government assistance, and to reverse pay decisions made only a few weeks ago, is transparently political, and that is the only thing transparent about it. The political objectives are to increase the President's popularity (everyone hates Wall Street these days) and to send Wall Street a message: "stop opposing 'change'". This policy will hobble the ability of these seven firms to attract good management at a time with management is essential to their turnarounds. That is bad for the firms, their stockholders (that includes us taxpayers), and our democracy, which is now asked to accept micromanagement by the White House regarding which employees at these firms get high pay and which don't, which perks are legitimate and which are not, etc. These decisions are based on the pronouncements of a "pay czar" who is subject to no external review and who acknowledges that his objective was, in large part, to create a solution that would be politically acceptable.

The Fed's announced action is different. Compensation is an integral part of risk management at banks because it determines the incentives of decision makers toward risk. It makes sense, therefore, for the structure of compensation (not its amount) to be regulated as part of risk management. The question is whether the Fed will be able to do this successfully. I am keeping an open mind and look forward to seeing the details of how compensation will be regulated. By requiring delayed vesting and/or clawbacks of bonuses based on long-term outcomes, in theory it is possible to encourage managers to maximize long-term firm value, not just short-term profits. So, if the Fed avoids counterproductive limits on pay amounts, and focuses on pay structure, that could be helpful. (The lack of Fed independence at the moment, of course, raises legitimate concerns about whether the Fed's new pay regulation will be implemented in a sensible way.) Another potential problem is that bankers are smarter than their regulators and will find ways to game any regulatory system. But the fact that compensation regulation will not work perfectly does not mean that it will not improve risk management and value maximization incentives. In my view, regulating the structure of compensation to ensure incentive compatibility of compensation is worth a try.

“The government just announced two sets of actions to constrain the compensation that banks pay to their top executives. First, Kenneth Feinberg, the administration’s “special master” for compensation at the handful of companies that were most thoroughly bailed out by taxpayers, just announced the agreed compensation levels for the top 25 executives at each of those firms. Compensation levels were halved compared to the banks’ requests and a very high percentage was redirected into company stock instead of cash. Second, the Federal Reserve (Fed) announced draft guidelines to avoid compensation practices that might encourage banks to take excessive risks. Here are my brief thoughts on both: Continued Below

1. Feinberg's executive pay plan. Since taxpayers have such a big stake in the success of these companies, I think the main test should be whether the actions are those that a smart private owner would have taken. I think they are not, since they send the wrong message to the people working there or considering working there, which is that their pay will not be determined the same way as on the rest of Wall Street and will be considerably lower and more volatile. This risks losing the best people, since the ones that move are always those who have the best options elsewhere. That said, the plan could have been considerably harsher, so this may be the best we could hope for, given the politics.

       2. The Fed's plan is a good one, but I wouldn't expect big changes as a result. They are focused on situations in which the compensation plan fosters excessive risk, which is very different from the populist concern about how overpaid bankers are. There is no attempt to limit total compensation levels, nor do I think the Fed should try.”

“The Treasury executive compensation proposal focuses on compensation for top executives at 7 institutions that have accepted exceptional assistance from the federal government. For any institution that accepts taxpayer dollars, reasonable restrictions are part of the territory. It should be noted that Congress has imposed restrictions on TARP companies by limiting tax deductions and prohibiting any incentive compensation.

The Treasury proposal correctly focus on reducing excessive risk-taking and eliminating those compensation programs that focus on the short-term, rather on the long-term risk horizon. This focus on excessive risk eliminates incentives for executives to maximize quarter-over-quarter profits. This is the correct focus because it benefits the bank, the sales force, and the customer.

While the Treasury has the correct focus, it relies on reducing or banning pay and setting specific dollar limits on all types of pay to achieve its objective. While there are arguments on both sides about whether this is appropriate for the 7 institutions, this approach should not be applied to the broader industry.

The danger created by setting specific pay restrictions is they will be both over-inclusive and under-inclusive at the same time. Each institution and employee is unique and compensation packages need the flexibility to recognize this. Additionally, specific pay restrictions will cause a “brain drain” of executives who will leave the company for compensation based on market forces. Specific restrictions will thus reduce the ability of the company to attract and retain qualified employees, who are needed to help strengthen financial institutions.

The Fed guidance focuses on the entire industry under the Fed’s jurisdiction and potentially applies to all employees working at those institutions. It divides the industry and gives extra levels of scrutiny to the largest 28 banking organizations. The financial services industry did a poor job of managing some of its risks, including ‘compensation risk’, and this contributed to the failure of many institutions.

The guidance from the Federal Reserve shares the same goals as the Treasury proposal of reducing risk, however it achieves those goals with a different carrot. The remedy the Fed proposes is the more effective one. It does not focus on setting specific dollar pay caps, but rather, it is search and destroy mission to attack the root of the problem: excessive risk. The proposal seeks to eliminate any compensation practice that encourages any employee- from CEO to loan officer to trader- from engaging in behavior that exposes customers or the institution to excessive risk. The Fed proposal threads the needles of protecting institutions and consumers and attracting and retaining talented employees.

It is important to note that the financial services industry has already moved to eliminate incentives to take excessive risk and to better align compensation practices with the long-term risk horizon. The industry is using claw backs, salary deferrals, stock options, and long vesting schedules for stock options. These devices will align the interests of all employees with the long-term risk horizon of the company and the customer.

Both the Treasury and the Fed proposal focus on long-term risk, they just achieve their goals in different manners. The Fed method will help individual institutions, the industry, the economy, and the consumer better realize the benefits of financial transactions.”

There is no perfect answer to TBIF but the two most promising approaches are as follows:  First, create a resolution authority (or a special bankruptcy court) so that large banks can be closed down in an orderly fashion without excessive disruption to the system as a whole.  The most difficult part of this approach is resolving international banks and that requires cooperation with other countries, especially other financial hubs such as London.  The resolution process should heavily penalize managers and shareholders and make bond holders take losses.  A special fund should be available to make sure the institution is kept operating until it can be sold off or shut down.  This fund should be drawn from a levy on other financial institutions, especially other large financial institutions.

The second approach is that financial institutions should be required to hold more capital the bigger and riskier they get.  The approach should not be punitive but should capture the additional risks imposed by large and complex institutions on the financial system as a whole.  Large banks should also be subject to additional scrutiny from regulators to make sure they are following sound risk management strategies.

The two biggest problems in the financial crisis were, first, that financial institutions did not have adequate risk management rules or did not follow them if they had them.  Second, regulators pored over the books of the banks but never really tested whether they were keeping their risks under control.  These problems were not specifically problems of size, but of poor management and regulatory practices and these must be changed going forward.

There are means other than draconian limits on size to credibly prevent government bailouts of large institutions. And there are large social gains from retaining large, complex, global financial institutions.

As I argue more at length elsewhere, it is worth preserving large financial institutions four reasons. First and foremost, financial institutions need to be large to operate with global scope because their clients are large and global. Small, local banks simply could not provide global corporations the same physical capabilities for trade finance, foreign exchange contracting, and global capital access that large global financial institutions can. 

Second, there are production economies of scope that offer benefits when financial firms combine different products within the same firm. Economies of scope among products implies economies of scale within finance suppliers, since small financial firms cannot afford the overhead that comes from building platforms with many such complex products.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. Among the many examples, perhaps the greatest accomplishment of global finance in the past two decades has been the replacement of crony banking networks in emerging market countries with branches of large global banks. 

Fourth, global financial institutions also have made stock, bond, and foreign exchange markets globally integrated and more efficient.

We can solve the too-big-to-fail problem without destroying global finance.

I am far more comfortable with a regulatory system that gradually penalizes size, however, through progressive higher capital/liquidity requirements. A graduated system of regulatory obligations would more consistent with market-principles, and let the organizations and the market figure out how to best cope with the higher costs their size (and inter-connectedness) impose on the financial and economic system as a whole.

Furthermore, to the extent it does not generate excessive costs of its own, large troubled financial institutions that are being resolved by the authorities (under needed new legislation, giving regulator bank-like resolution powers) should b dismembered so that they don’t come back to haunt us again. But regulators also should have the option not to conduct surgeries if they are significantly more expensive than what they would otherwise do to meet a “least cost resolution” standard.

The closest analogy to the kind of job creation tax incentive now under discussion is the New Jobs Tax Credit (NJTC), which was enacted in 1977 during the recovery from the 1974-75 recession. The goal of the credit was to encourage job growth by providing a generous subsidy for new hires that increased a company’s payroll above 102% of the payroll level in the previous year. The credit gave subsidies to employers for net employment growth in 1977 and 1978. For companies claiming the credit, the NJTC reduced the average compensation cost of a subsidized worker by about 20% to 25%. In other words, the credit reduced by up to one-quarter the net cost to employers of putting subsidized workers on their payroll. Len Burman in his contribution to this discussion has pointed to recent assessments of the NJTC experience in the TaxVox blog (here and here).

A few academic researchers who’ve analyzed the NJTC are optimistic about its effects on employment growth in 1977 and 1978. I am less persuaded the credit had much effect on employment in that recovery. My interpretation is that the credit added $5.7 billion to the 1977-78 budget defict ($18 billion in current prices) while inducing very slight gains in average employment.

At the beginning of the 1980s I worked in the office of the Secretary of Labor. Congress required the Secretaries of Labor and Treasury to submit a joint report on the impact of the NJTC. An economist in the Treasury Department and I were deputized to begin preparing the report. Although I did not remain in the government long enough to finish the report, I remember our initial findings. The final report to Congress, submitted in 1986, can be found here. (I played no role in writing that report.) For proponents of job creation tax subsidies the findings of the Labor-Treasury study are not encouraging.

Of the business firms which filed tax returns, about 10% claimed the NJTC in 1977 and 19% claimed it 1978. Companies’ take-up of the credit was low for two reasons. First, many businesses, including ones that expanded, did not qualify. This is obviously the case for all companies where 1977 and 1978 employment was below 102% of the level in the preceding year. Even among firms meeting the threshold, however, some were not profitable and hence could not claim the credit. A second reason for low take-up was employer ignorance.  Many eligible businesses were unaware they were entitled to claim the NJTC.   The Labor-Treasury report estimates that about 70% of firms eligible for the credit failed to claim it on their tax returns. Even among firms with more than $10,000,000 in annual sales, 42% of eligible companies did not claim the hiring subsidy. This is a shocking number, because nearly all large firms employ tax specialists to prepare their tax returns. If large firms with employment growth entitling them to a tax credit did not claim the NJTC on their returns, it is hard to believe the credit influenced their decision to expand employment.

Among the firms actually claiming the credit on their returns, a large percentage received no tax subsidy for a marginal new hire. Congress imposed limits on the credit to reduce common abuses and to target most of the subsidy on small and mid-sized firms. One result of these limitations was that many expanding firms quickly reached the maximum subsidy they were permitted to claim; they did not receive any additional subsidy for their marginal new hires. The overwhelming majority of all new employment growth that occurred in the companies claiming the NJTC occurred without any marginal subsidy for the last worker hired. Companies received a tax credit that reduced federal revenues, but the subsidy did not cut the companies’ net hiring costs for the last workers they hired. This strongly suggests companies’ end-of-year employment levels were little affected by the credit.

The problems with tax subsidies for marginal employment increases are well known to analysts. Hiring decisions are often made by company employees who are ignorant of the credit. Limits on the credit to reduce employer abuses will also eliminate subsidies for many employers willing to expand employment on the margin. If the credit is designed to give a subsidy to all new hires, an overwhelming fraction of credit payments will go to subsidizing employment that would have occurred in the absence of the credit. Some of the problems can be minimized in a carefully crafted hiring subsidy program. Most of the problems, however, are unavoidable. How effectively can the government disseminate knowledge about a tax subsidy that may only last one or two years? How do we discourage a company from laying off current workers in order to become entitled to a subsidy for the new hires who replace them? How do we structure the tax credit so employers do not receive subsidies for splitting a single well-paid, full-time job into two poorly paid, part-time jobs? And how do we accomplish all of these goals while keeping the cost of the credit manageable?

There are partial answers to some of these questions. But our experience with the NJTC in the 1970s shows that crafting a well-designed subsidy is not easy. It may be impossible.

For a more recent example, U. Florida professor, Sarah Hamersma, found that the welfare to work tax credit and the work opportunity tax credit have mostly subsidized hiring that would have happened anyway. Indeed, many employers often don’t even know about the credit until after their hiring decisions are made. This suggests that a major education campaign aimed at informing employers and workers about the new program is a minimum requirement for success.

In theory, an incremental subsidy could boost hiring by making new labor cost less than the value of what it produces. But there are a lot of practical problems. For one thing, business credits are typically not refundable. That means that they are of little or no value to companies suffering losses, but these are of course the companies most likely to have slashed jobs. A refundable credit creates issues of its own. For one thing, it costs a lot more. And, would we make the credit available to nonprofits? I'm very troubled by the notion of entities that have opted out of the tax system filing returns only for the purpose of collecting credits. (This may seem like a theoretical concern, but I remember testifying in 1999 opposite the president of Goodwill, who argued passionately that the work opportunity tax credit should be made available to that nonprofit.)

And defining the qualifying incremental job is complex and can create bad incentives, as Greg Mankiw has explained.

There are problems with timing. A company suffering losses, with restricted access to capital markets, is unlikely to spend a credit that won't be received until possibly a year after the hiring is done. To make use of new labor, a company has to be able to sell more, but that might require price cuts during a recession. In that context, it is not just marginal cost that matters. And, the fact is, companies are going to be very reluctant to add to payrolls until they see clear evidence that the economy is recovering. A well-timed tax credit might speed up that process a bit, but it's a clumsy and inefficient mechanism to do that.

A better option would be a temporary cut in payroll taxes, as suggested by Mankiw and many other Republicans. It works for companies suffering losses and nonprofit entities (and most state and local governments, which are also hurting) and would be relatively easy to implement. It would boost companies’ cash flow and raise workers' after-tax income. It should boost spending and would provide a small inducement to additional hiring—and reduce the pressure on struggling companies to eliminate more jobs.

And, it could be a rare bipartisan effort to address what is still a very scary economic situation.
 

Last year’s Great Panic abruptly reminded US baby-boomers how ill- prepared they are for retirement. Following that Panic, there would now seem to be a number of compelling reasons to expect the US saving rate to steadily increase over the next few years from its presently low level by historic standards.

            The most compelling of these reasons is that US household balance sheets have been seriously impaired by years of unusually low saving rates and by the ravages of the financial crisis. In this context, one has to be struck by the fact that US household debt today amounts to approximately 135 percent of US household incomes, or more than double the ratio that prevailed in the late 1980s. At the same time, despite the substantial bounce in equity prices from their March 2009 lows, US household wealth is some US$12 trillion, or around 85 percent of GDP, lower than it was at the start of 2008 as a result of substantially lower US home and equity prices.

            A second reason for expecting US households to attempt to increase their saving rate is the high degree of job insecurity that presently characterizes the US labor market and that is widely expected to continue characterizing that market in 2010 as the economy experiences a very sub-par recovery. Including part-time workers unable to find full-time employment, the US unemployment rate has already risen to a staggering 16 ¾ percent. At the same time, the extraordinarily large gaps in the US labor market are resulting in an extraordinary squeeze in household income growth as illustrated most vividly by declining wages over the past year.

            A third reason for expecting higher US household savings is that the US consumer is now highly credit constrained. Mortgage Equity Withdrawal, which in the housing market’s boom years reached a peak of 8 percentage points of US household income in 2005-2006, has now totally evaporated as a direct result of the US housing bust. At the same time, consumer card credit and home equity lines have been reduced substantially and there is every expectation that consumer credit will continue to be cut in 2010 as part of the financial system’s ongoing attempt to strengthen its capital position.

            An increase in US household income is to be welcomed as part of the adjustment process of the large US external payment imbalances. It is also to be welcomed as an important source of financing for the extraordinarily large US budget deficits that are in prospect for many years to come. However, if a higher US household saving rate is not to thwart the nascent recovery in the US and world economies, it will need to be accompanied by policies promoting higher consumption in China, Germany, and Japan, the world’s high savings countries. If recent history offers any guide, one would not want to hold one’s breath waiting for those countries to promote household consumption.