"The welfare of humanity is always the alibi of tyrants" - Albert Camus

Friday, December 10, 2010

A Raw Deal For Republicans?

The President and the congressional Republicans reached a deal on Tuesday regarding extending the Bush era tax rates for all Americans.  The deal now faces stiff challenge in both legislative bodies since it drew the ire of the president's hard left, wealth redistibutionist constituency including key congressional Democrats.  Republicans, on the other hand, mostly seem to be content since the deal signals at least a temporary departure from the Keynesian policies of the administration.  Ditto with most right leaning pundits and analysts.  But, are they being a little too hasty in their glee?  Lets examine.

The conventional wisdom among those who support the deal is that it will boost economic growth and job creation as an extension of it.  Republicans got what they wanted: a two year extension of the tax rates for everyone, unchanged 15% dividend and capital gains rates, and a one year 100% expensing for business investments.  The President got his wish list: a thirteen month extension of the unemployment benefits, a one year 2% payroll witholding tax cut in return for doing away with the "making work pay" tax credits, and a partial return of the estate tax (35% on estates over $5 million as opposed to the 55% the rate would have reset at).  On the down side, there were no deals made to curb the out of control spending the government has been on for the past two plus years.

Overall, the short term winner will be the tax payers and, I would argue, the President who looks to be moderating to the independents who had deserted him and his party.  The deal, however, is full of potential pitfalls for the Republicans.  If it fails to make a substantial dent in the unemployment figures, it will put Obama in the position to be able to say that the supply side policies not only failed to work but increased our debt by almost another trillion dollars, and that will only help the Democrats in 2012. 

It is entirely possible that this deal will not be the silver bullet for our woes, thus hurt the Republican prospects in 2012.  We are in midst of a jobless recovery for a simple reason.  We do not have a credit liquidity crisis.  As also evidenced by nearly $2 trillion sitting on the sidelines, job creators - the entrepreneurs - do not have the necessary confidence in the future to expand.  Numerous surveys done by State Street Investor Confidence Index, the Conference Board, and other business groups like NFIB (that indicate continued weak, albeit somewhat improving, confidence) bear this out.  The reasons for this entrepreneurial pessimism are:

Consumer confidence - CCI remains low.  The average American consumer is still worried about job security and, until spending ramps up in a meaningful way, businesses will be in a wait-and-see mode as far as hiring permanent employees is concerned.  Jobs and spending depend on each other, thus making the current situation a temporary catch-22 until the vicious cycle can be broken.

Uncertainty of the tax picture - Temporary two year extension of the Bush tax rates for the upper bracket, which most small businesses formed as LLCs or S corporations pay their taxes on, is not a reason for any wise entrepreneur to make any significant investment requiring many more years than two to amortize.  The corporate tax rate, which is the highest effective rate among developed nations, remains the same therefore there is no added incentive for bigger businesses to expand or not to move their operations overseas.  The value of temporary tax cuts and different tax credit schemes is minimal at best.  Permanence of such tax incentives is the only surefire way of incentivizing the private sector.

Worsening regulatory environment - Regulations, except for the most essential few, are primary killers of innovation and job creation.  They often result in curbing business activity or in some cases moving them overseas to countries with more business friendly environments.  New anti-business regulations - environmental and otherwise - under the Obama administration are surging.  Come January 2011, progressives will still be in charge of the executive branch and one of the legislative branches, therefore it would be overly optimistic to expect industry to grow except in cases of cronyism with companies like G.E.  We saw the latest example of this last week with the drilling ban off the Atlantic and Pacific coasts as well as most of Gulf of Mexico waters - a purely ideological decision that will cost tens of thousands of jobs.

Possible inflation -  The only reason we do not have price inflation at the moment (other than in energy, healthcare, and some food stuffs) is that inflation is a function of not only the money supply (M2 which includes M1 plus all the savings) but velocity (economic activity) of the money supply.  In simple terms, faster the expanded money supply circulates in the economy, higher the prices will go as supply and demand principles dictate.  If this deep recession accomplished anything, it changed the spending habits of many Americans.  Extensive and persistent joblessness, a daily news item, has driven those still employed in to reevaluating their spending/saving habits.  Unemployment, combined with more savings conscious consumers, account for the relatively low velocity of the money supply.

Another way that an import based, consumption oriented economy can suffer higher prices is through the destruction of its currency.  A weak dollar means more expensive imported goods, and since we consume a lot more imported goods than domestic goods, consumers would suffer the crippling effects of price inflation irregardless of M2 or velocity variables.  This, in turn, can be corrosive to the job generating capability of our economy, as it was the case during stagflation of late1970s.

The decision of the Fed chairman Bernanke to monetize our debt under the guise of QE2 will only hasten the destruction of the dollar, which at the moment is being prevented on the most part thanks to the relative weakness of key currencies from the Euro to the Yen.

The national debt and government policy -  The U.S. national debt is at $13.8 trillion and counting.  We are running annual deficits of over a trillion dollars and the projected 10 year budget deficits looks grim without major government reforms.  Many states are also in fiscal trouble, with California (the 7th largest economy in the world) running $40 billion plus annual deficits and its humongous state pension funds going broke.  To top it all, unfunded liabilities for social security and Medicare are estimated to be around $110 trillion.

Business investment, by nature, is a long term proposition.  Robust business investment requires reasonable confidence in the future course of the economy.  To attain it, following must happen:
  • Government must get serious about reforming entitlements
  • A low tax, low regulatory environment is required for a more competitive U.S.
  • To allow a low tax environment, government spending has to be realigned consistent with a smaller, more constitutional government
  • Overall, government must become more efficient and free market oriented.
Quite contrary to the above, the administration as well as congress seem bent on trying the old and proven Keynesian policy failures, having learned nothing from Japan.

Perhaps more importantly, the current crop of politicians, including many establishment Republicans, are simply not willing to kill the goose that is laying the golden egg as they all benefit from the corrupt system of crony capitalism that we are mired in.  It remains to be seen if the new TEA Party Republicans can accomplish a bloodless coup of sorts.  Forces in Washington being what they are (special interest groups, lobbyists, etc.), the odds are stacked against them.

E.U. woes -  Finally, the debt troubles of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) threaten not only further expansion of massive social unrest that almost all EU countries are experiencing but contagion among their economies.  U.S., through their disproportionate financial support of IMF, stands to be pulled in much deeper than expected.  In fact, just last week unnamed administration officials hinted at possibility of expanding the IMF's EU bailout fund despite reservations from Germany.  This, due to our fragile fiscal situation, obviously would do further harm to our struggling economy - another in the long list of factors casting doubt on a healthy and sustained recovery on the part of entrepreneurs.

All the above reasons why the private sector is nervous and lacking confidence point to one inescapable conclusion regarding the deal struck with the President: Job creation over the next two years is likely to be insignificant barring major reforms.  Since the players, with the exception of a Republican House of Representatives, will be the same ones who, to borrow a phrase, "drove the bus in to the ditch", why would any reasonable observer expect a different result? 

I fear that overzealous, 'half a loaf is better than none' thinking congressional Republicans may just have made a raw deal for themselves and it may take the progressive wing of the Democrat party to bail them out by voting it down.

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