Tuesday, December 30, 2008

The Obama Stimulus Plan: We need Policy Reforms as well as a Fiscal Stimulus

In his op-ed piece of last Sunday’s Washington Post, Larry Summers underscored that the Obama administration’s fiscal stimulus package is being designed not only to create “jobs and incomes essential for recovery,” but also to make “a down payment on our nation’s long-term financial health.” He illustrates this point by noting the importance of investments to build classrooms, laboratories, and libraries, spur renewable energy initiatives, modernize our health-care system, and rebuild our public infrastructure. Importantly, he notes “we must measure progress not by the agendas of interest groups, but by whether the American people experience results.*

As someone who has written on the importance of addressing long-term fiscal challenges, how can I be unhappy with this approach? Summers has correctly focused on one important element of long-term financial health, namely, the sources of our competitiveness and of long-term growth And yet a holiday of reading on the challenges facing us in the spheres of health care, energy, food, education, the environment, and infrastructure, convinces me that alone, this strategy might nevertheless be an enormously important, missed opportunity.

Don’t get me wrong. The thrust of the spending priorities that Summers has outlined are all sensible, and his emphasis on ensuring adequate returns appropriate. But what is missing from this characterization of the strategy is recognition that these are all sectors where the government’s role is already extensive and often misdirected, and where we will need a fundamental change in government policy if we are to address our major fiscal weaknesses as well as foster higher growth. Particularly in the spheres of health, agriculture, energy, and infrastructure, government lobbyists and interest groups have heavily influenced government policies. These policies have created enormous rents for particular industries and groups in the economy. Some of these rents have arisen from public spending decisions. Others have arisen from regulatory decisions that have sheltered certain industries, prevented the market from internalizing important negative externalities, or incentivised questionable production activities. Others have arisen by the deliberate underfunding of some important and legitimate and “formally recognized” government activities (see my blog of November 27).**

This is not the place to itemize all the ways, in these different sectors, where reforms in the whole approach to government policy might be needed. A few examples may suffice. Start by reading Eugene Steuerle’s recent blog on the “Breadth of Brokenness ***, where he lists the ways in which policies in a number of sectors are costly, inefficient, and not serving the public interest. Then read Michael Pollan’s brilliant op-ed of October 12, 2008 “Farmer in Chief, ”**** which underscores both the misdirection of government policy in the food sector and the damage such policies are causing in terms of poor health, energy dependence, and climate change. Certainly, you should also read the many recent op-eds by Tom Friedman as relates to the energy sector, and his call for the introduction of some form of carbon tax. In health care, Tom Daschle’s recent book, Critical: What We Can Do About the Health Care Crisis, outlines important first steps toward health care reform, though (as I will argue in a forthcoming blog) his proposals appear insufficient to reduce spiraling long-term health care costs, tackle the ways in which current government policies misdirect resources, or provide distorted incentives to the pharmaceutical industry.

In many of the vital spheres where a fundamental change in government policy is required, it will be far more difficult politically to execute a change in policy than to simply increase spending on meritorious investments. The latter are likely to be of the win-win variety. The former would inevitably involve “losses” to politically powerful groups in these sectors. But also, because the role of government has so shaped the market incentives in these sectors, many others in the economy would also feel the costs of reform (e.g., investors who have relied on government policies in considering their investment strategies across sectors).

I thus see the current financial crisis and the need for an ambitious fiscal stimulus package as an opportunity because there may be value in directing some of the fiscal stimulus to “grease the wheels” of policy reform, in effect, facilitating the transition to a more sensible set of policies. Pollan’s piece certainly suggests that the food sector is one where it might be necessary to provide financial assistance to redirect incentives away from the excessive focus on corn and soy-based products. Again, linking financial support for the auto industry to a program for its retooling for the production of more energy-efficient cars is another example of where fiscal grease might facilitate policy reform.

The President-elect ran on a campaign for a “change that we could believe in.” His policy proposals in many areas clearly underscore his recognition that a fundamental change in policy direction is required. The urgency of addressing the financial crisis argues for a strong and stimulative fiscal policy. But if the long-run financial health of the country is to be addressed and long-term growth reenergized, the focus on “change,” and importantly, the misdirected character of government policies in many sectors, must be tackled in the process. In closing, I recognize that perhaps much of the transformational policies that I hope will be forthcoming may already be on the agendas of the incoming Cabinet and its various transition teams. But what is critical is that such policy reforms are not seen as of secondary importance relative to the fiscal stimulus package.

* (http://www.washingtonpost.com/wp-dyn/content/article/2008/12/26/AR2008122601299.html)
** http://petersheller.blogspot.com/2008_11_01_archive.html
*** http://www.pgpf.org/newsroom/tgwd/27/
**** http://www.nytimes.com/2008/10/12/magazine/12policy-t.html?scp=2&sq=Michael Pollan&st=cse

Wednesday, December 24, 2008

The Madoff Ponzi—Where did all the money go (and what does this have to do with our fiscal deficit)?

It is difficult not to wonder about this. When I discuss the matter with my friends, the inevitable point is made that it is really hard to spend $50 billion dollars, even over a 10-15 year period. So where did it all go and what does this have to do with our fiscal deficit? My son Nate, who is an MBA student at Yale, and I were recently discussing these questions and the following is our fairly arbitrary guess. Our estimates are, of course, just conjectures. At some point, investigators will probably be able to come up with a far better estimate, and it will be intriguing to really disentangle this complex scheme.

Several observations on the mechanics of such a scheme can be imagined. First, one must assume that some of the capital simply went to support Mr. Madoff and his life style of an apartment in Manhattan, fancy houses in Montauk and Palm Beach, and if I recollect from the news, a house or apartment in Europe. I also seem to recall yachts with the name of “Bull,” as well as country club memberships in Palm Beach and the Hamptons. All of this does not come cheap, and one may assume that Mr. Madoff pocketed and spent, after tax, at least $25 million a year—or $35 million pretax-- (my ignorance of this standard of living may mean that I have underestimated what such a life style costs by a factor of two or three even). But there is also significant overhead to the production of Ponzi income of this magnitude. Add three floors of rent in the so-called Lipstick building of Manhattan, as well as the overhead costs of the employees and other running costs of his legitimate securities transactions business (presumably including at least two well-paid sons and other relatives), and we can potentially account for another $40 million in expenses (again, my numbers are completely arbitrary). So this would imply that Madoff would have had to have annual inflows of capital to his operation of at least $75 million to cover these costs. Even over 10-15 years, this would have amounted to no more than $1-1.2 billion. But when the scheme collapsed, Madoff estimated that something like $50 billion was the amount of lost capital, leaving us with approximately $49 billion unaccounted for.

So what happened to the rest of the money? Let’s look at how the scheme would have worked in a given year. Let us imagine 2008, this last year of the scheme before it collapsed. At the roughly 10 percent rate that Madoff was offering investors, he would have had to pay out about $5 billion in “dividends and interest” in order for his investors to continue as happy campers. Simply as a guess, let us assume that 60% of the

$5 billion, or $3 billion, stayed with Madoff as a reinvestment and 40% was paid out and spent by his investors. For the latter, this would have included the charitable foundations that paid their employees and made grants with the income; the universities that used this endowment income to pay their teachers and staff; and of course those who lived on their income from Madoff to support their retirement or their life style of consumption. Assuming that Madoff was running the operation with no liquid reserves, this implies that Madoff would have needed roughly $2 billion in capital inflows plus at least another $75 million, as noted above, to cover the payout to investors as well as his own “expenses.”[1]

Including the inflows from new investors (which were added, on paper, to Madoff’s principal even though he was actually using the money to pay off existing investors) to the $3 billion Madoff was supposedly reinvesting, the capital value of the Madoff scheme would have risen by the full $5 billion in 2008, even with zero increase in actual value ($2.1bn in from new investors, $2.1bn out for expenses and payouts, $3bn of fictitious returns). It is also worth noting that Madoff’s reported earnings attributable to investors would have been subject to taxes by their recipients.

Of course these are the figures at the end of the scheme. During all of the previous years, a similar type of operation was occurring, with some of the money being paid out and actually used for real purposes by Madoff’s clientele, and with an important part of the capital growing fictitiously. So in trying to guess where the money went, one might hazard the fairly arbitrary guess that a significant part (perhaps 65 percent) never went anywhere! It represented earnings on capital, reinvested, that never actually existed. It was as if the original money of investors had not been invested but spent, but nevertheless the original sum was kept on the books and a 10 percent return kept being added to it.[2] (Note that if you were to invest $100,000 and earn a 10 percent return that you reinvested every year, you would have roughly $260,000 accumulated at the end of 10 years). So one can easily imagine that if many investors had left their money in the investment scheme for many years, quite a significant fraction of the amount they supposedly held would have simply been the result of smoke and mirrors.

Another significant sum, let us say roughly 30-35 percent, was actually was paid out and used by legitimate people for presumably legitimate purposes. A small share, probably 1 percent, was earned as fees by the feeder funds that took a 1.5 percent management fee on the amounts that they channeled to the Madoff funds. Madoff and his enterprise probably skimmed off about 1-2 percent of the total over the years. As is inevitable with Ponzi schemes, those who invested late in the game were probably the largest losers, never having had the opportunity to avail themselves of the income that Madoff so regularly paid out.

And how does the fiscal deficit enter in? Well, as I noted above, for each $1000 reportedly earned by Madoff for his clientele, at least $150 was presumably paid to the Federal government in taxes (assuming all of it was declared as dividends and subject to the 15 percent tax rate on dividends). However, in many cases, even more was probably paid, since some earnings would have been declared as interest and taxed at the recipient’s marginal tax rate. Most likely, the Federal government received, on average, about 20 percent of Madoff’s fictitious reported earnings for his clients. So most likely, if roughly $47-50 billion was “earned” over the time frame of the Madoff scheme, and this was all declared as taxable income, the Federal Government was probably the beneficiary of about $10 billion. So one could say that this was Madoff’s implicit contribution to preventing the Federal deficit from being even higher over the period. Of course, now that the losses are revealed, it is likely that many of the losers will now be able to write off some of their losses, recouping some of their previous payments in lower tax liabilities in 2008 and 2009, and thus adding to the already high fiscal deficit!

None of this is very pretty as we begin the holiday season.

[1] Most likely, during some years of the operation, Madoff did have liquid reserves which he invested and actually earned some income from; in this last year, one might imagine that capital withdrawals exhausted these reserves and that he was frantically seeking new inflows to cover withdrawals as well as his normal payout to investors at the time the operation collapsed.

[2] One should also note that from the perspective of these investors, the real loss in return is what they would have earned if they had invested in legitimate securities, with the rest of the loss wholly fictional, representing an unreal, above-market return.

Thursday, December 18, 2008

Getting off Square One on America’s Long-Term Fiscal Deficit

As the United States Government seeks to dig the economy out of a recession through a massive fiscal stimulus package, many voices continue to remind us that the larger challenge to be faced is the large and growing long-term fiscal debt. For example, the Center on Budget and Policy Priorities (CPBB) has just issued budgetary forecasts through 2050 (http://www.cbpp.org/). These highlight that under current policies and with historically reasonable assumptions, the federal debt will reach 279 percent of GDP in 2050. “The average amount of program reductions or revenue increases that would be needed over the next four decades to stabilize the debt at its 2009 level…equals 4.2 percent of projected GDP”, “the equivalent of an immediate and permanent 24 percent increase in tax revenues.” These warnings are not new. They follow similar alerts from the Congressional Budget Office, academics, and journalists over the last several years. The Peter G Peterson Foundation is also ramping up for a major initiative to raise the alarm, starting with the airing of its film on the long-term fiscal crisis, I.O.U.S.A (see http://www.iousathemovie.com/), early next year.

Perhaps the more challenging question is why there has been so little traction on this issue, particularly given that these facts are undisputed among America’s political leaders as well as by most economic analysts. There are two simple answers. The first is the most obvious. Addressing the long-term fiscal deficit will be politically painful, requiring significant increases in taxes or cuts in expenditure programs, and the political system does not do pain very well. The second is the difficulty of coming to grips with how to tame the major elephant in the room, that is the largest source of the looming fiscal gap—the rising costs of medical care.

What has been missing in this litany of fiscal warnings, and which perhaps best explains why there has been so little political groundswell for action (including in the recent Presidential campaign), is any significant discussion of how this fiscal mess will be resolved, and who will bear the burden of its resolution. And here the CBPP’s note does highlight one important observation, which was first made in a joint op-ed by former Treasury Secretary Robert Rubin, incoming OMB head Peter Orszag, and economist Allen Sinai. Long before we get to 2050, it is likely that the edifice will crumble—that the capacity of the US government to continue to run large fiscal deficits and to service its growing debt will implode. Interest rates will begin to rise, further aggravating the debt service burden, and foreign buyers of US debt obligations will begin to be wary of too large a portfolio exposure to the US government.

In effect, markets will force action sometime in the next decade or so—this might occur through tax increases, draconian cutbacks in government programs, or by cutbacks in coverage or benefit eligibility. It also might occur through inflation, if the government were to erode the real value of its debt by printing money (though it is doubtful that in today’s globalized financial markets that this can be a successful strategy for very long). But action will take place because there will be little alternative. This will be painful and will have real consequences. The need for action, when pushed by markets, will not occur at a time of our choosing; indeed, one could imagine scenarios where the timing is simply awful in terms of the global economy or national security interests.

The current financial crisis is illuminating in this regard. We have just experienced (during a Republican Administration no less) an enormous unexpected and untargeted wealth “tax” of roughly 20 percent, borne largely by homeowners and by those with portfolio wealth (that has sunk in value). Unlike a tax increase, where at least the government would receive the associated revenues, few (and certainly not the government) have benefited from this current loss of wealth. Others are feeling or will feel the ripple effects of this loss in the form of lost wage earnings, lower benefits at the State level, higher taxes and fees, and lower interest incomes. A year ago, few would have imagined the starkness of the crisis that we now face.

Who will bear the financial burden of how this larger long-term fiscal debt problem will be resolved remains to be determined. One can imagine a number of equally plausible scenarios. The most desirable would be one that arose from a well-thought out strategy entailing many “politically difficult” measures sequenced over time: with some increases in tax rates and revisions in the tax code (e.g., reducing some present tax subsidies), significant efforts at rationalizing how and what medical services are provided, adjustments in coverage and eligibility for medical benefits, cutbacks in inefficient or less meritorious government programs, adjustments in the social security system in the form of higher payroll taxes or delayed ages for benefit eligibility (see Eugene Steuerle’s recent blog for some obvious candidates for reform ttp://mail.google.com/mail/?shva=1#inbox/11e4b24bf419a3e9). Another scenario might entail a far more comprehensive revision of the way in which medical care is delivered and financed, coupled with some less dramatic revisions to taxes and expenditures. Still another might reflect a far less strategic approach, involving ad hoc tax increases, brutal expenditure cuts, and ad hoc adjustments in the Medicaid or Medicare system. And finally, of course, using inflation to reduce the real value of a government’s debt is an approach many governments have used in the past, with large and long-term harm, both to individual households and to the government’s financial credibility. Regrettably, these latter solutions have been the outcome too often in the past.

How individual American households—of different income groups, from different generations, and from different sectors—would be affected by these very different ways in which the problem might be resolved would need to be analyzed carefully. A major part of these effects would be reflected in higher taxes, lower benefit incomes, a higher cost of public services, and a need to defray some costs that had been previously been financed by the government. But another important part of the effect would be reflected, say, in diminished access to real and useful government services or reduced availability of some medical care that had heretofore been provided by the government. Some groups in society might be affected far more than others—for example, if there were a major restructuring of the medical care system. Equally, some approaches—such as an increase in inflation--would certainly affect creditors and, as we have long known, would disproportionately affect those with a more limited ability to adjust their assets to an inflationary environment. What is important to acknowledge and clarify is that different approaches would affect different households in different ways, but the effects would be real and substantial.

Perhaps the best way to motivate political action would be to explore a few alternative scenarios and to illustrate specifically and transparently who would bear what part of the burden. Let the American public come to grips with the stark reality of the possible consequences of a well-thought-out strategy as opposed to an ad hoc, unplanned approach or recourse to inflation. The chips will fall, but they do not have to fall in an unintended way. Equally, some policy solutions will involve far less harm to America’s long-run interests. Others will not only be costly, but inefficient and damaging to America’s security and long-term interests.