Last week, Congressional Republicans walked out of deficit reduction talks hosted by Vice President Biden.  Now President Obama has increased his participation by inviting Congressional leaders to discuss how to break the impasse.  During a Thursday meeting at the White House, the President proposed three options for reducing the deficit over a ten year period – a $2 trillion option, a $3 trillion option, and a $4 trillion option.  The Wall Street Journal gave a general idea of what was included in the $4 trillion option, but we do not have any specifics.  Initially, both President Obama and Speaker John Boehner were described as being in favor of a $4 trillion deal.  However, on Saturday night, Speaker Boehner issued a statement saying that he no longer favored a $4 trillion deal because that would have included “tax increases”, as Republicans call elimination of tax loopholes that favor the rich.

Recent polls indicate that a majority of Americans oppose raising the debt ceiling, but they also oppose any cuts to Social Security or Medicare.  In response to the intransigence of the Congressional Republicans, President Obama needs to explain to the American people that maintaining the full faith and credit of the U.S. government is paramount.  He needs to explain the impact that Republican demands will have on the lives of ordinary Americans. The President also needs to report to his own supporters what options he laid out for the Congressional leaders, and what the impact of those options would be.

The following four options are illustrative of what is at stake for positions of the Obama Administration, the Bowles-Simpson Deficit Reduction Commission, the Congressional Republicans, and the TEA party.  (Since we do not have the advantage of a large staff of economists like OMB or the Congressional Budget Office to score the options, I cannot give precise numbers for the size of the budget savings.)

Debt Ceiling/Deficit Reduction Options

Option I outlines the main features of a proposal that the President laid out in a speech on  April 13, 2011.  President Obama has emphasized some of the points in this list at various times during the first six months of 2011.

I. Increase Debt Ceiling, Invest in Infrastructure and Jobs

• Must pay interest on debt.
• Fund Infrastructure Investments
  • Roads, bridges, ports;
  • Maintain sewers and sewage treatment plants;
  • National electrical power grid.
• Green energy technology development
• Manufacturing innovation laboratories
• Cap defense spending.
• Implement the Affordable Care Act, including support for Medicaid.
• Support states in school improvement projects.
• Eliminate farm subsidies and ethanol production subsidies.
• Eliminate tax breaks for oil companies.
• Eliminate tax loopholes while cutting top corporate tax rate.
• Let Bush-era tax cuts expire as scheduled.
• Tax hedge fund manager fees as ordinary income.
• Tax dividends as ordinary income.

II. Increase the Debt Ceiling, Gradually Reduce Spending, Increase Revenues

Option II outlines the main implications of adopting the recommendations of the President’s Deficit Commission, co-chaired by Erskine Bowles and Alan Simpson.[i] See http://www.taxpolicycenter.org/taxtopics/Bowles_Simpson_Brief.cfm.

• Pay interest on debt.
• Gradually reduce defense and discretionary spending.
• Maintain current levels of green energy development.
• Maintain social security payments at current levels.
• Maintain Medicare benefits at current levels, but aggressively seek ways to reduce health care cost increases.
• Eliminate farm subsidies, ethanol subsidies, and tax breaks for oil companies.
• Eliminate corporate tax loopholes while cutting top corporate tax rate.
• Tax hedge fund manager fees as ordinary income.
• Adopt the Bowles-Simpson Zero Plan to reduce the federal deficit to zero:

1. Eliminate all tax expenditures—for both income and payroll taxes—except for the child credit, the earned income tax credit, foreign tax credits, and a few less common preferences.
2. Eliminate the alternative minimum tax (AMT).
3. Retain personal exemptions (no phase-out).
4. Replace the current six-bracket individual tax rate schedule with a three-bracket schedule of 12, 20, and 27 %.
5. Tax capital gains and dividends as ordinary income.
6. Index tax parameters using the chained Consumer Price Index.
7. Increase the Social Security wage base by 2 percent per year more than the growth in the average wage (making the FICA cap $140,100 in 2015).
8. Phase in an increase in the federal excise tax on gasoline of 15 cents per gallon (13.5 cents per gallon on average in 2015).
9. Eliminate corporate tax expenditures and reduce the corporate tax rate to 27 percent.

We do not have enough details from the Thursday White House meeting to know whether all of these Bowles-Simpson proposals were included in the options presented by President Obama.  The Wall Street Journal reported in a separate story[ii] that the President suggested the adoption of the chained Consumer Price Index as the basis for Social Security Cost of Living (COLA) adjustments and federal pension adjustments as well as for indexing tax parameters.  It is not clear why the President suggested this instead of raising the cap on salaries and wages subject to FICA.

Some economists favor the adoption of a chained Consumer Price Index because it takes into account changes in the quantities of goods and services that consumers buy as relative prices change.  For example, if the prices of French wines go up and the prices of smart phones go down, consumers may buy more smart phones but less French wine.  At present, some tax parameters are adjusted by the CPI-U, which does not take into account changes in quantity preferences as relative prices change.  Social Security benefits and federal pensions are adjusted using CPI-W, which is based on the increase in average wages.  However, over the past decade CPI-U and CPI-W have tracked very closely, whereas the chained CPI increased more slowly.

If someone were to retire now at age 62, the future benefits would be less using the chained CPI than using the current formula – 4% less at age 75, 6.5% less at age 85, and 9.2% at age 95.[iii]  The changes would be even worse for younger Americans.  If the chained CPI were really a better formula for showing the cost of living, there might be some justification for adopting it.  However, health care costs are rising faster than general living costs, and seniors are the largest consumers of health care.  None of the proposed CPI formulae take into account the higher costs that seniors incur for health care and long term care.

Increasing the FICA cap is a better way to ensure the solvency of the Social Security System.  There is no reason to stop at $140,000 annual salary.  If FICA applied to wages and salaries up to $200,000 annual income, the Social Security System could remain solvent for the rest of the century.

III. Raise the Debt Ceiling, Reduce Spending, Reduce Taxes on the Wealthy, Eliminate Social Security and Medicare

Option III reflects the mood of Congressional Republicans, including a lot of Republican proposals.   Republicans say repeatedly that the United States does not have a revenue problem, it has a spending problem, and many Republicans in Congress would vote for Option III.

• Pay interest on debt.
• Maintain defense budget.
• Drastically reduce discretionary spending.
• Eliminate Department of Education and drastically reduce Pell Grants (student aid for college education); states are responsible.
• Eliminate spending on green energy development; private sector is responsible.
• Eliminate food stamps and Women, Infants and Children programs.
• Cut 50% of funding for the Securities and Exchange Commission and the Commodity Futures Trading Commission.
• Cut 30% from funding for Food and Drug Administration (FDA).
• Privatize social security for those under 55; individual’s accounts would be invested in the stock market.
• Repeal the Affordable Care Act.
• Privatize Medicare, but with a Federal voucher system; current retirees would keep their current benefits.
• Make Bush-era tax cuts permanent.
• No tax increases:  maintain farm subsidies, ethanol subsidies, and tax breaks for oil companies; hedge fund managers continue 15% tax on their fees; dividend rates are 0% or 15%.
• Cut top corporate tax rate to 27%.
• Eliminate the alternative minimum tax.

IV. No Increase in the Debt Ceiling

The U.S. government reached its statutory debt limit on May 16, 2011.  The Treasury has been using “extraordinary measures” that will allow the government to extend its borrowing authority until August 2.  There is a large amount of debt coming due on August 4, and there will be no way to roll over the debt or pay the interest due unless the debt limit is increased.  Standard & Poors has stated that any U.S. Treasury bond that has a payment due on August 4, 2011 will be downgraded from AAA to D if Congress does not increase the debt limit.  The results of such a debt default would be catastrophic, and many Congressional leaders have stated that it will not happen.

Option IV assumes that Congress fails to come to a long-term deficit reduction deal but enacts a temporary and small increase in the debt ceiling on August 2, 2011.  Clearly, Option IV is not a long-term solution to the problem of balancing the budget, but it would cause so much economic pain that it would quickly get the attention of an apathetic public.

• Government is allowed to spend only its current revenues.
• Must pay interest on the debt as well as fund current operations.
• Drastic reductions in government expenditures until debt ceiling increased
  • Government salaries are cut 50%.
  • Social Security payments are cut 50%.
  • Government retirement pensions are cut 50%.
  • No Medicare payments until debt ceiling is increased
  • All National Parks are closed.
  • FEMA suspends operations.  Reponses to natural disasters, such as hurricanes, earthquakes, floods, fires, and tornadoes, will be the responsibility of the states.
  • Staff positions at foreign embassies are cut 50%.
  • All consular offices are closed.
  • U.S. Passport Office is closed until debt ceiling is increased.
  • Subsidies to the U.S. Postal Service are eliminated.
• Start to sell stored commodities such as gold in Fort Knox and oil in the Strategic Petroleum Reserve.

It should be clear that Option IV would create quite a stir, and if implemented for very long would result to riots in the streets just like in Athens. People need to see where the TEA party recommendations would lead.  It is unlikely that Republicans in Congress could “hang tough” in the face of the public outcry if Option IV were forced on the President.

We should add what the consequences of Option III would be. If the Republican agenda were adopted quickly, if Option III were implemented within a year, it would lead to a new recession.  IMF studies show that a budget cut of 1% of GDP typically reduces demand by about 1%, and increases the unemployment rate by 0.3%.[iv]

Since the Federal Budget Deficit is about 10% of GDP, an immediate or short-term cut in Federal spending to try to balance the budget with no revenue enhancements (as the Republicans demand) would result in a reduction of 10% in domestic demand and a rise in the unemployment rate of 3% to 12.2% This would be worse than the recent recession that officially ended in 2009. The Federal Budget would not in fact be balanced because ensuing recession would result in lower tax revenues.

President Obama should not cave in to Republican demands.  He should explain in a lengthy televised address to the American people what the three options are that he suggested to the Congressional leadership, and what the consequences would be if the Republicans were to force a solution like Option III above.  Then he should make it clear that unless the Republicans compromise, the outcome will be Option IV, which will be a disaster.

While it is true that the voucher-like healthcare system would not start until 2022, the following changes would affect people over 55 immediately on passage:

The proposal would repeal the ACA provision that expanded subsidies for the “coverage gap” in Medicare Part D (a range of spending in which many enrollees have to pay all of their drug costs, sometimes called the doughnut hole).

The proposal would repeal the Community Living Assistance Services and Supports (CLASS) program for long-term care insurance, as well as a number of mandatory grant programs including funds for so-called high-risk pools, reinsurance for early retirees, and prevention and public health activities.[i]

Republicans also say that after taking effect, the proposed legislation would create a healthcare insurance system for seniors like the current healthcare insurance system for federal employees.  This is not true, either.  Federal employees pay a fixed portion of their healthcare insurance costs, but that would not be true for the new Republican Medicare substitute.

Under the House Republican proposal, starting in 2022 new Medicare beneficiaries would receive coverage through private insurance plans, and Medicare would subsidize the cost.   The federal payment for a typical 65-year-old would be set at $8,000 a year in 2022, about the same as what Medicare is expected to spend under current law.

The eligible age for federal benefits would increase two months per year until the eligible age would reach 67 in the year 2034.  Presumably, Ryan expects people between the ages of 65 and 67 to get healthcare insurance from their employers or in the private market.  The CBO did not analyze the extent to which additional people would apply for disability insurance benefits or Medicaid because of the increased eligibility age for privatized Medicare.

Beneficiary costs under the Ryan plan would be higher than under traditional Medicare.  Administrative costs are higher for private healthcare insurance than for Medicare, but that is only the beginning.  The premium support payment would be adjusted for age, health status, income of the beneficiary, as well as general inflation, measured by the Consumer Price Index.  But healthcare costs and insurance premiums have, for years, been rising faster than consumer prices in general.[ii]  So, under the Republican plan, Medicare would pay a shrinking share of beneficiaries’ total health costs, and seniors would pay a growing share. For a typical 67-year-old, that share would be 68% in 2030 versus 25% under current law, the Congressional Budget Office said.  

There is nothing in the Republican plan to reduce the rate of growth of healthcare costs per enrolled beneficiary (“bend the curve”).  Indeed, the House legislation would repeal the parts of the Affordable Care Act that initiate several proposals to try to reduce that rate of growth.  The net result is that the Ryan Plan increases beneficiary costs more than it reduces government costs.  Part of the reduction in overall healthcare costs to the federal government is particularly insidious.  Since the beneficiary share of the total healthcare insurance costs would be higher under the Ryan budget, participation rates for eligible elderly persons would lower than under traditional Medicare.

The Ryan plan includes rules that would govern the Medicare exchange—including requiring insurers to issue insurance to all people eligible for Medicare who apply, requiring that each insurer charges the same premium for all enrollees of the same age, and using a risk-adjustment mechanism. However, the Ryan plan would allow insurance companies to increase premiums with beneficiary age.  Ryan says that the support payments would be greater for the poor, but it is not clear that the increase in federal healthcare support payments would be enough to prevent participants from dropping out of the federal plan as they got older.

Healthcare experts agree that the primary problem with healthcare is health care inflation. The secondary problem is the long-term Medicare deficit.  For decades, the United States has relied on a private healthcare insurance for people under 65, and fee-for-service government healthcare insurance for people over 65.   Neither system has helped to rein in healthcare inflation.  Republicans want to scrap Medicare and revert to a private healthcare insurance system for everyone. However, the free market for healthcare insurance has failed to rein in healthcare inflation for people under 65, just as Medicare has failed to control healthcare costs for the elderly.   Despite the lack of supporting evidence, the Ryan plan would repeal all federal pilot programs designed to reduce the rate of growth of healthcare costs, relying on blind faith in free markets to control costs.  It is foolish to suppose that a solution that has failed repeatedly to control healthcare costs will succeed in the future if we solve the secondary problem of the long-term Medicare deficit.

The Ryan Plan would end traditional Medicare to solve the secondary problem of the long-term Medicare deficit, and substitute a system that would increase the burden on the elderly to pay their own healthcare costs and increase the number of uninsured elderly.  James Kwak, who calls the Ryan Plan “ just one bad idea dressed up with the false precision of lots of numbers” has suggested a better and simpler way:  “Index the Medicare payroll tax to actual health care costs. This should automatically solve the Medicare deficit because as Medicare’s costs go up, its funding will go up at the same rate.*

“This may sound like just raising taxes whenever the government wants to spend more. But the key is that the more taxes you pay, the more you get back. To see this, assume for now that Medicare is a pure price taker: it has no impact on health care costs but just has to pay what the market charges. Then, if health care costs go up by 5 percent, your taxes go up by 5 percent, but the expected value of your future Medicare benefits also goes up by 5 percent. You get all the insurance benefits of traditional Medicare, but now that insurance is worth 5 percent more, so you should be willing to pay 5 percent more.**

“Raising taxes can have macroeconomic effects, but anything that solves the Medicare deficit problem will have macroeconomic effects: any solution involves either higher revenues or lower spending. Furthermore, increasing payroll taxes in line with health care costs is no different in substance than increasing premiums for employer-sponsored plans in line with health care costs, which has been going on every year for decades.”[iii]

With that solution in mind, we can reject the Ryan Plan and let healthcare experts discuss various ways to bring healthcare cost inflation under control.

“Why are we paying attention to Standard and Poor’s opinion, a firm that gave favorable [AAA] ratings to junk mortgage funds at the behest of their investment-banker clients? I don’t think the firm has any credibility left.”

Mark Gordon, Tucson

On Wednesday, April 13, 2011, President Obama gave a speech outlining his proposal to reduce the federal deficit by $4 Trillion over 12 years, with more than $2 Trillion in spending cuts including $480 Billion in Medicare savings, $1 Trillion in revenue increases by not extending the Bush tax cuts for upper income taxpayers, and $1 Trillion in savings on interest payments on the federal debt.  The President also proposed a bipartisan panel to simplify the tax code and to reduce or eliminate special tax breaks for individuals and corporations.[i]  He said he would not raise the eligibility age for Medicare.  Even before the president gave his speech at George Washington University, Republicans were blasting the proposal as an unacceptable plan to raise taxes.

House Speaker John Boehner (R-Ohio) said

“I think the president heard us loud and clear. We’re willing to resolve our differences and do something meaningful but raising taxes will not be part of it.”

“We don’t believe that raising taxes is the answer here,” added House Majority Leader Eric Cantor (R-Va.), who also attended the meeting morning meeting at the White House.[ii]

Rep. Paul Ryan, Chairman of the House Budget Committee, said “We don’t have a problem with our budget because Americans don’t pay enough taxes. We have problems with our budget because we spend too much money.”[iii]

Later in the week, the House approved the Ryan Budget, which proposes to cut the top income tax rate to 25% and reduce, but not eliminate the projected budget deficit, by making drastic cuts in many federal programs and replacing Medicare with a voucher-like system for anyone who is now less than 55 years old.

Do we Americans pay too much in taxes?

In 2009, federal, state and local income taxes consumed 9.2% of all personal income, the lowest level since 1950.[iv]  The OECD Center for Tax Policy and Administration studied the ratio of all taxes to national GDP.   In 2007, the United States was 27^th in the ranking of the 30 OECD member countries.[v]  Due to the Great Recession and the Obama tax cuts of 2009, the U.S. fell to 28^th, with only Turkey and Mexico having lower ratios of taxes to GDP.  Do we really want to be like Turkey or Mexico?  If our tax ratio were at the same level as Germany, in the middle of the OECD ranking, we would not have such a difficult problem balancing the federal budget.  And note that Germany now has a lower unemployment rate than the U.S.

Here are a few more numbers to consider: The last time the U.S. federal government was in the black was during the second term of the Clinton Administration.   Even excluding the Social Security surplus, the surplus of federal revenues over federal expenditures was $1.9 billion in fiscal 1999 and $86.4 billion in fiscal 2000. Alan Greenspan (Federal Reserve Chairman) as well as the Congressional Budget Office worried that the federal government was on a path to pay off the entire federal debt.  Instead, the Bush-era tax cuts coupled with major off-budget spending for two wars and a Medicare drug benefit, added $3.2 trillion to the debt.  Then Republican-managed deregulation led to the greatest financial crisis in a century, followed by the Great Recession, which resulted in a sharp drop in tax revenues.  The Republicans try to blame the current deficit on President Obama, but the fact is that stimulus spending since Mr. Obama took office — including large tax cuts — accounts for about $600 billion of the current $14.2 trillion in accumulated debt.[vi]

One of the major factors in grim budget projections is the rising cost of health care.  Representative Ryan says the U.S. cannot afford Medicare, so he proposes to replace Medicare with a voucher-like system that relies on the private insurance industry.  There is nothing in the Republican budget proposal to lower health care costs.  Indeed, the Ryan plan might contribute to increased health insurance costs, since administrative costs of private insurance (12% to 20% of premiums) are higher than the administrative costs of Medicare (2% to 6%).[vii]

The Republican response the President’s deficit reduction proposal is a disappointing reiteration of the tax-cuts-above-all ideology that has gotten this country deeply into debt.   Republican politicians may think this is good politics.  I am not a politician.  I care deeply about this country’s future.  The current federal deficit is unsustainable, and national fiscal salvation will require shared sacrifice.  I am ready to pay taxes at the rates in effect from 1995-2000 during the Clinton Administration.

There will be a long debate on how to eliminate the budget deficit.  We will have more comments in coming posts.

There are several ways to do this.  One way is to raise the cap on annual earnings to which the payroll tax applies.

Another way would be to have a doughnut hole of earnings that would be exempt from payroll taxes, and then any earnings above the upper limit would be subject to payroll taxes.

A third way would be to make dividends subject to the same tax rate as payroll taxes, and specify that those taxes would go to the Social Security Trust Fund.  This would recover taxes from owners of closely held companies, like Linda McMahon, who pay themselves in dividends instead of salary.

Erskine Bowles and Alan Simpson, co-chairs of the National commission on Fiscal Responsibility and Reform (Deficit Reduction Commission), have acknowledged the need to restore the Social Security Trust Fund after a temporary payroll tax reduction.  Your Senator or Congressman can use that as the basis for including an amendment to the current tax bill that ensures that the Social Security Trust Fund is not depleted by this bill.

There is a major misunderstanding of the proposal to end (not extend) the Bush tax cuts for top earners.  Media articles are not explaining what “$200,000 per individual or $250,000 per couple” means.  Republicans are exploiting the vagueness to scare small business owners.  The confusion is over the difference between AGI and taxable income.

We know that Michelle Bachmann is one of the most shameless liars to be elected to Congress.  However, some people listen to her.  Yesterday morning, Bachmann said to George Stephanopoulos that President Obama proposed to raise taxes on any small business with gross income of more than $250,000, including a carpet layer with two or three assistants. She says that would be a big job killer.

My understanding is that President Obama proposes to raise taxes on annual taxable income of more than $200,000 for an individual or $250,000 for a couple.  That’s not gross income.  For a business partnership or other unincorporated small business, salaries and other legitimate business expenses would be deducted before computing the taxable income.

There are very few small businesses with annual taxable income of more than $250,000, and the tax increase would be only 3% of the amount above $250,000.

China has 900 million rural dwellers who are still living at a standard of living not that far above subsistence. The pressure to migrate from the countryside to the coastal cities is enormous. China needs to grow at more than 8% per year in order to avoid mass unemployment in the coastal cities. And mass unemployment in the coastal cities is likely to be followed by political collapse and turmoil on a gigantic scale.

Part of growing at 8% per year is to continue to rapidly expand exports to the North Atlantic core of the world economy. But in order to expand exports Chinese-produced goods must look like good values. And if demand for dollar-denominated assets falls and the value of the dollar falls, Chinese-produced goods will no longer look like good values.[i]

The U.S. policy problem is that the undervalued renminbi is leading to weak demand for U.S. goods and services in China.  The U.S. needs to reduce its trade deficit with China.

To reiterate, the five causes of high unemployment in the United States are:

1. Inadequate aggregate demand.
2. Migration of jobs to other countries, especially China.
3. Increased productivity of employed workers.
4. Inadequate credit for small businesses.
5. Uncertainty about future taxes and regulations.

DeLong explains that if we suffered from structural unemployment, then some sector such as construction would have high unemployment but another sector such as manufacturing would be booming and employers would be seeking qualified workers without success.  The actual situation, DeLong argues, is that almost all sectors of the economy have seen significant declines in employment, which is a symptom of inadequate aggregate demand.

Paul Krugman argued as usual yesterday that the $800 Billion American Recovery and Reinvestment Act of 2009 was wholly inadequate, providing mainly tax cuts, unemployment extensions and meager aid to state and local governments that was barely enough to offset declining state tax collections in the short term and not nearly enough to compensate for the precipitous decline in demand in the private sector in 2008-2009.[ii]

This does not mean that we are not in danger of falling into the trap of structural unemployment.  If the current high rate of unemployment persists for two or three more years, the long-term unemployed will lose their skills and become unemployable.  Then we will be in a worse economic mess than we are in now.  That is the danger of electing a Republican majority in Congress, which will block any further proposals by President Obama to stimulate the economy.

I reiterate the reasons for high unemployment in the U.S.[iii]

1. Inadequate aggregate demand.
2. Migration of jobs to other countries, especially China.
3. Increased productivity of employed workers.
4. Inadequate credit for small businesses.
5. Uncertainty about future taxes and regulations.

The United States has ramped up the pressure on China to revalue its currency. Yesterday, Treasury Secretary Tim Geithner reiterated to a gathering in Palo Alto that the Chinese renminbi is significantly undervalued (despite a 3% revaluation over the past month or so).  He said that he is postponing the scheduled report on whether a major trading partner has been unfairly manipulating its currency value; he wants to coordinate his strategy with other aggrieved countries at the coming G-20 meeting in South Korea.

This is not first excuse Geithner has had for not publishing an accusation that China has been manipulating its currency.  Is he afraid of Chinese retaliation?  In the past, there has been speculation that the Chinese could retaliate by selling U.S. bonds, driving down the dollar.  Indeed, the dollar has declined about 7% against the euro and other currencies in the last two months, but not against the renminbi.  Is makes little sense to fear a potential Chinese action that would make the U.S. companies more competitive in international markets.  However, the Chinese have a more effective means of retaliation.

Last Friday, American trade officials announced that they would investigate whether China was violating international trade rules by subsidizing its clean energy industries. The inquiry includes whether China’s steady reductions in rare earth export quotas since 2005, along with steep export taxes on rare earths, constitute illegal (under WTO rules) efforts to force multinational companies to produce more of their high-technology goods in China.  The Chinese did not like that announcement, and they did not wait for the outcome of that investigation.

On Sunday evening, in an extremely rare move for a senior Chinese official, the country’s top energy policy maker, Zhang Guobao, called in reporters from international media organizations and objected to the American announcement.  Hours later, according to the New York Times[i], Chinese customs officials began singling out and delaying rare earth shipments to the West.  Today China denied that it had halted sales of rare earth shipments[ii], but the threat of a future cutoff has been duly noted.

Rare earth production is another example of the failure of American laissez faire economic policy in the face of competition from Asian managed economies.  Rare earths are important in the production of many high technology products, from advanced fighter avionics to high temperature superconductors to windmill blades.  China has about 30 percent of global rare earths deposits but accounts for about 97 percent of production. The U.S., Canada and Australia have rare earths but stopped mining them in the 1990s.

Just as consumer electronic industries moved to Asia, rare earth production moved to China over the last two decades because of lower costs.  Congress is considering legislation to provide loan guarantees for the re-establishment of rare earth mining and manufacturing in the United States, but new mines will probably take three to five years to reach full production.  Meanwhile, China will have an advantage in the production of high technology products, including clean energy products.

In his Palo Alto discussion, Secretary Geithner said he opposed the import tax on Chinese products advocated by Andy Grove (and that would be enabled by legislation that passed the House of Representatives recently) because that would provide subsidies to inefficient American companies as well as raising prices for consumers.  Geithner did not discuss Grove’s analysis of the need to rebuild a manufacturing infrastructure in order to compete in the development and production of new high technology products.

Our trade imbalance with China, largely due to the undervalued renminbi, remains a factor in the high unemployment in the United States.

1. Inadequate aggregate demand.
2. Migration of jobs to other countries, especially China.
3. Increased productivity of employed workers.
4. Inadequate credit for small businesses.
5. Uncertainty about future taxes and regulations.

Aggregate Demand

Aggregate demand is the demand for goods and services from both the private sector and the public sector.  Demand in the private sector declined precipitously in the Fall and Winter of 2008-2009.

During the period from 2001 to 2007, average household income was stagnant, but there was a housing bubble, with housing prices in some areas doubling.  Homeowners felt wealthier and were able to refinance their homes or take home equity loans to maintain and improve their standard of living.  Banks created complex financial instruments based on mortgage loans, which were widely distributed in the belief that spreading the risk would somehow reduce the risk.  When the housing prices started falling, demand fell and the recession started, officially in the fourth quarter of 2007.

Falling housing prices led to financial crisis, epitomized by the bankruptcy of Lehman Brothers in September 2008.  Financial institutions no longer trusted each other, and the shadow banking system collapsed.  Households and businesses could not get loans.  The decline of housing prices and the tightening of loan standards meant that home equity loans became much more difficult to obtain.  Private-sector borrowing plunged from 28% of GDP in 2007 to minus 17% of GDP in 2009.  Layoffs began.   As unemployment increased, people did not have money to spend, and the economy spiraled downward.

The federal government acted to prevent a depression.  The Federal Reserve stepped in as the lender of last resort and provider of liquidity for many types of credit markets, increasing its assets from $900 billion to $2.3 trillion.

At the request of President George W. Bush and his treasury secretary, Hank Paulson, the Congress approved the $700 billion TARP program.  Treasury used the TARP funds to buy preferred shares in major banks, some of which were threatened with insolvency, as well as to rescue AIG, General Motors and Chrysler.   Most of the TARP funds has been or will be repaid to the Treasury.

At the request of President Barack Obama, the Congress passed the American Recovery and Reinvestment Act of 2009.  This act included $288 billion in tax cuts, primarily for the middle class.  The Congressional Budget Office originally scored the cost at $787 billion, but the tax cuts, unemployment insurance and Medicaid cost sharing with states have pushed the anticipated expenditures above $800 billion, of which about $533 billion has already been spent.  The Recovery Act has created or saved 2.5 to 3.6 million jobs.  However, 8 million jobs were lost in the recession that started in 2007, and the federal stimulus from the Recovery Act was not enough to reduce unemployment below its current level of 9.6%.

The national recession and weak recovery have produced both declines in state and local revenues and increased need for public programs as residents lose jobs, income, and health insurance. In the 2009 and 2010 fiscal years, the imbalance between available revenues and what was needed for services opened up budget gaps in most states. The Recovery Act gave states roughly $140 billion over a two-and-a-half year period to help fund ongoing programs, including K-12 education, higher education, and health care. However, the federal assistance will run out soon.  Most states have now addressed significant budget shortfalls in enacting their 2011 budgets and even more budget gaps are projected for fiscal year 2012. Total shortfalls for 2011 and 2012 (both those that have been addressed and that have yet to be closed) are likely to reach some $260 billion.  The shortfalls would be even higher in the absence of federal Recovery Act aid and the $24 billion state-aid bill to extend support for education and Medicaid for six more months.  Without additional federal aid and if states continue to cut spending as they have in the current fiscal year, the national economy is projected to lose up to 900,000 public- and private-sector jobs.[i]

To get the economy growing again, four out of five economists interviewed by Bloomberg Business Week agree the federal government should increase infrastructure spending.   There are thousands of unsafe bridges thousands of miles of railroad tracks that urgently need repair or replacement.  Our ports are vulnerable to terrorist attack.  Our national electricity distribution grid is a hodgepodge of outdated equipment, vulnerable to both natural and manmade disasters and urgently in need of redesign and upgrade.  The private sector is not going to take the initiative to do it, but the private sector will benefit greatly if the federal government funds and contracts with private companies to fix the national infrastructure.  Now is the time to do it.  It will provide jobs in the near term, but the benefit will continue.  Like the construction of the Interstate Highway System started by President Eisenhower, rebuilding the national infrastructure will lower costs for the private sector long after the federally contracted work has ended.

In addition, because states are required by their constitutions to balance their budgets even during recessions, the federal government should resume federal-state revenue sharing (first proposed and implemented by the President Nixon and ended by President Reagan).  This could save almost a million jobs.

Migration of Jobs to Other Countries

In 1992, erstwhile presidential candidate Ross Perot warned of a “giant sucking sound” of jobs going to Mexico if we ratified NAFTA.  We now know that the “giant sucking sound” did not come from Mexico, it came from Asia.

While the U.S. trade deficit in goods and services declined from $696 Billion in 2008 to $381 Billion in 2009[ii] because of the worldwide recession, it is rising again at an alarming rate.  For June 2010, the U.S. trade deficit was $49.9 billion, up from $42 billion in May, as exports dropped by the most in a year.[iii] Our trade deficit with China is rising and may reach $290 billon this year.  China accounts for more than half the non-petroleum trade deficit.  According to the Economic Policy Institute, the trade deficit with China has resulted in the loss of 2.4 million jobs over 2001-2008.[iv] An additional one-half million jobs could be lost to China this year.

Some economists say that China benefits from an undervalued currency, which it depresses by buying dollars and euros.  Indeed, China has foreign currency reserves of over $2.5 trillion.  The Chinese Renminbi is estimated to be undervalued by 35% to 40%.  This makes Chinese goods cheaper than they should be on the world market, and makes foreign goods, including American goods, more expensive in the Chinese market.  An exchange rate adjustment would make American goods less expensive in China, which would benefit American exporting companies, but would also benefit Chinese consumers, who have been complaining lately about inflation in China.  The Chinese government promised earlier this year to adjust the exchange rate, but there has been little change.  The Economic Policy Institute estimated that ending China’s currency manipulation could add as much 1.4 percent to economic growth in the U.S., based on calculations made by Nobel laureate Paul Krugman. That would lead to $500 billion in additional federal government revenue–or deficit reduction.  Krugman suggests we threaten a 25% tariff on all Chinese goods if China refuses to revalue its currency.[v] We also need to demand the end to illegal subsidies and other unfair trade practices by China and other countries.  While we should not repeat the mistake of broad Smoot-Hawley-style tariffs, a targeted approach may be in order, so long as it is done within WTO rules.

It is hard not to notice that so many goods we buy are made in Asia – clothing, toys, cell phones, television sets, personal and laptop computers, iPods, iPhones, iPads, and even the internet routers that link all these devices.  One company, Foxconn, employs 920,000 workers in China to manufacture the gadgets that are conceived and largely designed in the United States.  To a large extent, this situation is a result of Chinese mercantilist policies taking advantage of naïve American laissez-faire policies.  However, it also results from American investor pressure to lower costs for their own individual profit without regard to the consequences for American society as a whole.

Andy Grove, former chairman and CEO of Intel, published an excellent article in Bloomberg Business Week in July titled “How to Make an American Job”.  He writes cogently that America needs to reinvigorate its manufacturing base that has eroded so dramatically over the past thirty years.  It is only partially true that small businesses generate more jobs.  Our problem is that small businesses do not grow jobs as they used to, because successful small businesses are expanding overseas, building their manufacturing plants in Asia.  Many companies like Apple have generated ten times as many jobs in Asia as in the United States.  This happens not only because of low wages in Asia, but also because Asian countries like China have policies to encourage certain kinds of industries, especially manufacturing.  When American companies build their manufacturing plants overseas, engineering and management jobs go overseas as well.  The manufacturing experience grows in Asia, not the U.S., making it more likely that new technologies will be developed in Asia rather than the U.S.  Grove makes the point that laissez faire works better than communism, but the Asian model of government encouragement for manufacturing is working better than U.S. laissez faire policies in encouraging job growth.  U.S. government intervention is necessary to stop and reverse the hollowing out of American industry.

In the old days, the U.S. manufactured radios, television sets, hi-fi music systems, and personal computers.  However, production of all these products has shifted to Asia under the laissez faire economic policies of the past thirty years.  Some economists welcome the transfer of the production of these “commodity” products to “less developed” countries.  However, we have lost manufacturing skills that have made it difficult to compete in newer technologies.  Flat panel LCD display technology was invented in the United States, but the manufacturing base to support production was not here, so production of flat PC and TV displays scaled up in Asia.  Touch screen display technology was invented in the United States, but American companies went to Asia for mass production.  When Apple developed the iPhone, the production facilities for the main components were in Asia, so it was logical to give the production contract to Foxconn in China.  Semiconductor solar cells were invented in the United States, but now China is dominating the production of lower-cost solar power panels.  As the manufacturing skill shifts to Asia, engineering jobs go to Asia as well.

The United States cannot hope to maintain the American dream of full employment and a vibrant middle class without manufacturing.  Andy Grove says we need to stop the venture capitalist practice of encouraging every new technology startup to plan for production in China.  The government needs to offer financial incentives to keep new product manufacturing in the United States.  “The first task is to rebuild our industrial commons… Tax the product of off-shore labor.”  Use the resulting tax revenues to fund companies that will scale up their new product manufacturing operations in the United States.  We should encourage businesses to consider it their duty to support our industrial base as well as the American Society that made their business possible.

Increased Worker Productivity

Companies are investing in manufacturing equipment and information systems to increase the productivity of the workers they already employ, rather than investing in more employees.  Equipment and software sales increased 24.9 percent in 2Q10 after an increase of 20.4 percent in the first quarter.[vi] Many workers also report that, after deep cuts in their workforces, companies have not been hiring after their business started improving, leaving the existing employees with more work to do for the same salaries.

We don’t want to discourage greater efficiency, as long as it does not come from employee exploitation, because increased worker productivity should lead to improved living standards in future.

Inadequate credit for small businesses.

Small businesses are often said to be the engines of our economy.  In mid-2010, 45% of small businesses reported inadequate credit to support their needs.  The unavailability of credit constrains these small businesses from hiring new employees, and may jeopardize the jobs of existing employees.  The recently-enacted Small Business Jobs and Credit Act establishes a new $30 billion fund for community banks, which will leverage up to $300 billion in new private sector lending to small businesses.  The new legislation provides more than $12 billion in tax relief provisions and creates eight new small business tax incentives aimed to encourage expanded business planning for investments in operations and hiring additional workers.[vii]

On Business Uncertainty Constraining Hiring

Verizon CEO Ivan Seidenberg has said that uncertainty about future taxes and regulation is constraining hiring.[viii] While we have heard this assertion repeated by Republican leaders, we find little compelling evidence to support it.  Uncertainty about the economic expansion is a credible constraint on hiring.  Companies may not feel the need to hire if their markets are only expanding 1% or 2% annually.  However, business leaders are accustomed to making decisions in the face of uncertainty.  Launching satellites or drilling for oil in a new area involves uncertainty, but businesses make those decisions.  Anytime a new product is introduced, there is uncertainty about the size of the market and whether customers will buy it.  Remember New Coke?  How about the Edsel?  Who knew Google would be so successful selling online advertisements?  On April Fools Day 2009, what would the reaction have been if you had said that Susan Boyle’s recording sales were about to make a dramatic change?  When Apple was looking for a wireless carrier partner, there was uncertainty as to the market for the new iPhone.  It might have been a money loser for the carrier who partnered with Apple.  Mr. Seidenberg did not know that AT&T would gain market share and profit from the deal.  (AT&T had to hire many people to sell iPhones and expand its network to keep up with the demand for its services.)  Business leaders who don’t like to make decisions under uncertainty will always have difficulty competing.

[ii] http://www.census.gov/foreign-trade/statistics/highlights/annual.html

[iii] http://www.bloomberg.com/news/2010-08-11/u-s-trade-deficit-unexpectedly-widens-to-49-9-billion-as-exports-decline.html

[iv] http://www.epi.org/publications/entry/bp260/

[v] http://www.nytimes.com/2010/03/15/opinion/15krugman.html?_r=2

[vi] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.html

[vii] http://www.suite101.com/content/nuts-and-bolts-of-the-small-business-jobs-and-credit-act-of-2010-a289622

[viii] http://www.washingtonpost.com/wp-dyn/content/article/2010/06/22/AR2010062205279.html (Mr. Seidenberg was more reticent to talk about Verizon charging its wireless customers for services they had not contracted for and were not using.)