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Daily Archives: December 20, 2008

Bill Miller: victim of value trap

How Bill Miller at Legg Mason consistently beat the market for over 15 years and then lost all his reputation in this crisis. (source: WSJ)

Taylor on the best stimulus to the economy

John Taylor, the author of the famous Taylor rule, discusses how to design fiscal policy to stimulate the economy.  He uses Friedman's permanent-income hypotheis to argue short-term tax rebates won't work because unless tax rebates (cuts) are permanent, consumers won't spend the received money.  The first tax rebate in early 2008 now looked like a failure (see the graph below):
Read the full text:

Why Permanent Tax Cuts Are the Best Stimulus

Short-term fiscal policies fail to promote long-term growth

The incoming Obama administration and congressional Democrats are now considering a second fiscal stimulus package, estimated at more than $500 billion, to follow the Economic Stimulus Act of 2008. As they do, much can be learned by examining the first.

The major part of the first stimulus package was the $115 billion, temporary rebate payment program targeted to individuals and families that phased out as incomes rose. Most of the rebate checks were mailed or directly deposited during May, June and July.

The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand, and thereby get the economy growing again. What were the results? The chart nearby reveals the answer.

The upper line shows disposable personal income through September. Disposable personal income is what households have left after paying taxes and receiving transfers from the government. The big blip is due to the rebate payments in May through July.

The lower line shows personal consumption expenditures by households. Observe that consumption shows no noticeable increase at the time of the rebate. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.

These results may seem surprising, but they are not. They correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased, and by a significant amount.

After years of study and debate, theories based on the permanent-income model led many economists to conclude that discretionary fiscal policy actions, such as temporary rebates, are not a good policy tool. Rather, fiscal policy should focus on the "automatic stabilizers" (the tendency for tax revenues to decline in a recession and transfer payments such as unemployment compensation to increase in a recession), which are built into the tax-and-transfer system, and on more permanent fiscal changes that will positively affect the long-term growth of the economy.

Why did that consensus seem to break down during the public debates about the fiscal stimulus early this year? One reason may have been the apparent success of the rebate payments in 2001. However, those rebate payments were the first installment of more permanent, multiyear tax cuts passed that same year. Hence, they were not temporary.

What are the implications for a second stimulus early next year? The mantra often heard during debates about the first stimulus was that it should be temporary, targeted and timely. Clearly, that mantra must be replaced. In testimony before the Senate Budget Committee on Nov. 19, I recommended alternative principles: permanent, pervasive and predictable.

– Permanent. The most obvious lesson learned from the first stimulus is that temporary is not a principle to follow if you want to get the economy moving again. Rather than one- or two-year packages, we should be looking for permanent fiscal changes that turn the economy around in a lasting way.

– Pervasive. One argument in favor of "targeting" the first stimulus package was that, by focusing on people who might consume more, the impact would be larger. But the stimulus was ineffective with such targeting. Moreover, targeting implied that increased tax rates, as currently scheduled, will not be a drag on the economy as long as increased payments to the targeted groups are larger than the higher taxes paid by others. But increasing tax rates on businesses or on investments in the current weak economy would increase unemployment and further weaken the economy. Better to seek an across-the-board approach where both employers and employees benefit.

– Predictable. While timeliness is an admirable attribute, it is only one property of good fiscal policy. More important is that policy should be clear and understandable — that is, predictable — so that individuals and firms know what to expect.

Many complain that government interventions in the current crisis have been too erratic. Economic policy — from monetary policy to regulatory policy, international policy and fiscal policy — works best if it is as predictable as possible.

Many good fiscal packages are consistent with these principles. But what can Congress and the incoming Obama administration do to give the economy a real boost on Jan. 20? Here are a few fairly bipartisan measures worth considering:

First, make a commitment, passed into law, to keep all income-tax rates were they are now, effectively making current tax rates permanent. This would be a significant stimulus to the economy, because tax-rate increases are now expected on a majority of small business income, capital gains income, and dividend income.

Second, enact a worker's tax credit equal to 6.2% of wages up to $8,000 as Mr. Obama proposed during the campaign — but make it permanent rather than a one-time check.

Third, recognize explicitly that the "automatic stabilizers" are likely to be as large as 2.5% of GDP this fiscal year, that they will help stabilize the economy, and that they should be viewed as part of the overall fiscal package even if they do not require legislation.

Fourth, construct a government spending plan that meets long-term objectives, puts the economy on a path to budget balance, and is expedited to the degree possible without causing waste and inefficiency.

Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market.

Mr. Taylor, undersecretary of Treasury for international affairs 2001-2005, is a senior fellow at the Hoover Institution and a professor of economics at Stanford University.


China 30-year reform series, Part 1

In celebrating 30 years of economic reform in China, I plan to post a series of articles and commentaries on the topic.  Today, David Pilling writes on FT:

China’s ‘warp-speed’ industrial revolution

By David Pilling

Mao Zedong was right all along. Deng Xiaoping was a “capitalist roader”. Thirty years ago this week, at the catchily named third plenum of the 11th party congress central committee, Deng wrested power from the old guard loyal to Mao and launched China on the path of market reform.

Of course, history is never so clear-cut. Struggle and counter-struggle had been raging within the Communist party since Mao had died two years earlier. Deng, forced to work at a tractor factory during the Cultural Revolution because of his “rightist” tendencies, had long believed rigid communist ideology and overweening state interference were leading the economy down a dead end.

Yet today is as good a time as any to take stock. Deng’s China, to this day a pragmatic blend of capitalism and communist state control, has lasted 30 years. That is one year more than Mao’s China, born in 1949 with the victory of the Red Army and subsequently dragged through the madness of the Great Leap Forward and the Cultural Revolution. What have those 30 years brought to China and to the world?

A degree of economic prosperity, undoubtedly. By 1978, China had begun to recover from the brutal distractions of the later Mao years. By dint of its sheer scale, it was already the world’s 10th largest economy. But annual income per capita was still pitifully low at $190, making it, according to the National Bureau of Statistics, 175th in the global pecking order. Three decades of compounding nearly 10 per cent annual growth has brought income per head to about $2,500, and much higher than that on the prosperous eastern seaboard. Although that still ranks only 132nd – other countries have not stood still either – China has become the world’s fourth biggest economy, second on a purchasing power parity basis.

As a trading nation, China has gone from 27th to third. It runs trade surpluses with the US far larger than those Japan mustered in the late 1980s when one US congressman made a show of smashing a Toshiba radio cassette recorder in protest at the rising economic threat from Tokyo.

China’s warp-speed industrial revolution – “a compression of developmental time” in the phrase of James Kynge, whose book China Shakes the World captures the historical significance of its rise – has transformed the global economy. Its foreign reserves, at nearly $2,000bn, are easily the largest in the world, providing the liquidity that helped inflate the global bubble. Its export of cheap goods has allowed the world to consume far more than it once did. On the demand side, China’s ravenous appetite for steel, iron ore, coal, petroleum, grains, oilseeds and so on pushed prices to vertiginous heights until its abrupt economic slowdown this year helped bring them crashing down again.

Yet the process by which these astonishing changes have occurred owes as much to accident and experiment as to grand design. Deng likened his non-ideological, gradualist approach to “crossing the river by feeling for the stones”. Many of the so-called market reforms were little more than giving space – often by turning a blind eye – to what China’s entrepreneurial citizens were already doing. The month before Deng seized control, 21 farmers in Xiaogang village in eastern Anhui province concluded a secret pact to divide their communal land into individual farms. So daring was their act that they made provision to look after each other’s children should they be arrested. A few years later an estimated 300m rural households were parcelling out land, often regaining control over plots to which their ancestors had held title for generations.

The same happened in industry, where so-called “red hat” capitalists set up private businesses in the guise of state enterprises. Many raised capital from family or underground banks. As long as such freedom created wealth and did not challenge party authority, Deng was prepared to let a hundred flowers bloom.

He and the leaders who followed him did take some top-down decisions that helped unleash China’s economic potential. In 1980 he set up the special economic zones, such as Shenzen, which became magnets for foreign capital and expertise from Taiwan, Hong Kong and other free-market economies China was seeking to emulate. But other reforms went wrong. When Deng freed prices in 1988, it triggered the high inflation that was at least a proximate cause of the Tiananmen Square protests.

The Communist party appears to have brought 30 years of spectacularly smooth growth, even allowing for the statistical manipulation that sometimes occurs. But that obscures often desperate flailing as the party cranks this lever and that to produce the economic progress on which its survival ultimately depends. Beneath these shifting policies lies one inalienable understanding: “We’ll give you growing prosperity, if you don’t question our right to absolute power.” Yet there is an inherent contradiction between exerting unyielding political control and trying to unshackle entrepreneurial creativity.

That does not mean the arrangement is under imminent – or even mid-term – threat. Both Singapore and Japan offer evidence that one party can maintain power, even without the benefit of force. But for all China’s impressive economic progress, the past 30 years have owed much to cobbling together policy and struggling to reconcile contradictions. The problem with fumbling from slippery rock to rock is that there is always the danger of falling in.

Country diversification

If history and the current crisis teach us anything, one of the most important lessons is: country's development should not focus on one or two narrow strategies; just like investment portfolio, diversification in development strategies can significantly reduce country risk, putting the country on a smooth growth path.

For this reason, China should move out of its current export-led manufacturing intensive development strategy and allocate more resources to human capital development and improving the quality of its domestic institutions;  Russia should not rely too much on its natural resources; India should avoid over-specialization in services.

Because of its heavy reliance on energy export, with crude oil falling over 75% from its peak, Russia is apparently in big trouble now.

[Russia's Crisis of Confidence Chart]

Adam Smith told us specialization is good;  but over-specialization reverses the benefits of specialization.