How to Avoid a Lost Decade (updates ongoing 6/15)

(This post will be updated and/or revisited several times, due to its importance. I prefer to focus on the most important issues and stay with them until all the most valuable aspects are uncovered.)
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updated 2/19 -- refined loan idea
update 2/23 -- Japan article
update 3/3 -- some thoughts on comparing the U.S. and Japan (see "Update")
update 5/11 -- clarifying the broad effects of my proposed solution on national debt
update 6/15 -- loan repayment contingencies
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Martin Wolf brings up a crucial point about recovery from the end of a credit bubble (our big-picture economic situation).

Even if stimulus helps the situation, and banks are fixed so that they are able to make sound loans (instead of being overly restricted), that still doesn't get you out of the fallout of the credit bubble.

Readers of this blog have heard the suggestion we won't get back to a 1999 or 2005-like growth. Martin Wolf offers a explanation of the whole picture. In part, we can't get a rapid recovery because people are over-indebted, and trying to pay off their debts.

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute.* His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the overborrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan’s were, for years, as low as could be – were “pushing on a string”. Debtors kept paying down their loans.

Full article here. Martin goes on to clear up questions about Japanese stimulus and other aspects that have confused many commentators, and explains the huge risk in trying to reduce deficits simultaneous to consumers paying off their own debts. He says we face a very real danger of a lost decade in the U.S. and also for the world. I recommend reading this article.

Readers may recall I pointed out the upside in the inevitable fact that many consumers will use tax reductions to pay down their debt more rapidly (we've all heard the downside already) -- how this would lead progressively to increasing consumer spending over time. Each month would have some contribution of a modest increase in discretionary spending due to more people reaching the end of their credit card debt (to add into the sum of all other factors). These increases will accumulate into more economic strength over time versus the outcome without this effect.

So therefore, the modest Obama income tax reductions that help consumers pay off their debts more rapidly are supportive of economic recovery in complementary way compared to conventional Keynesian stimulus such as infrastructure spending. (Note: We need something more rapid to reduce total public+private debt -- see the key new idea proposed further below.)

In other words, while even larger government spending would be helpful, this alone will not cause an economic recovery until consumers have paid off enough personal debt or saved enough to feel good about spending more.

Further, once frugality becomes ingrained, an economy can become widely trapped in this new habit both by psychology and wage reductions, and finally by a need to secure retirement (see NYTimes article here).

Update:
Having considered differences between the United States and Japan for a while two conclusions stand out for me at this point. 1) No matter how you slice it, having a higher number of young people that aspire to buy houses, appliances, autos and such makes an enormous difference in net domestic demand, and thus employment, in the absence of large external demand for a nation's output. In other words, Japanese manufacturing suffers greatly now that the U.S. consumer is pulling back and its own domestic consumers do not have a large aggregate desire to buy in great quantity the products that Japan produces. The U.S. in contrast has a much higher proportion of young people, and thus will have a natural level of demand for new products, once some economic recovery arrives. Put another way, and this applies in lesser extent also in the U.S., older generations will not be able to maintain rising standards of living unless there are enough young people to help produce the products and especially to drive the economy (demand) upon which "wealth" depends. Of course...a true "standard of living" does not depend exclusively on an increasing quantity of stuff per capita consumed, but is a conglomeration of many factors and aspects, so we need to temper concluding too much about Japanese lifestyles from the outside.

The 2nd observation I have for now is that culture is a major and decisive factor in a nation's economy. Thus there are limits to how many parallels one can draw between the U.S. and Japan. Instead, we can only draw some broad points.

One crucial piece of a good "standard of living" in any case is that young families are in fact actually able to securely feed themselves, house themselves, and clothe themselves, and have some amount of free time in which to enjoy life. If an economy is so unstable as to prevent a significant fraction of young families from having any security at all, then this is indeed a profound and real failure.

Thus, back to the basic economic situation...

While the our new tax reductions are beneficial even when used in paying off consumer debt, and will gradually help us towards a recovery,...might there be another way to get there even faster?


What might help consumers pay off their non-mortgage debt faster?

Once we frame the question clearly like this, more effective economic recovery ideas can be imagined.

One possibility is to imagine a federal lending program (which has better long-term monetary and interest-rate consequences than deficit spending) for households to be used in a controlled way against existing personal non-mortgage debt. Consider for instance the 2008 $7500 first-time homebuyer loan, which carries 0% interest and is paid back at $500/year for 15 years, as an initial model. (note below on the profound difference of restructuring debt vs. pure deficit spending) This idea can be modified to fit our purpose here.

For example, this could take the form of an available up-to-$5000 (or even $7000) 0% interest loan to each taxpayer, repayable over 10 years through withholding or at tax time. Even the repayment terms could be responsive to the economy or job status of the borrower. For instance, the starting date for the 10-year repayment schedule could be delayed for each year during which the economy is still in recession or the individual is jobless, or the payments already underway interrupted during periods of joblessness.

A way to make this into a debt-restructuring stimulus would be to require all of the new loan must be paid against existing non-mortgage debt. For instance if an individual has $4700 in non-mortgage debt as of the effective date, they could then request a transfer of $4700 in debt. The U.S. treasury would then directly pay the creditors. The effect is similar to having a balance transfer to a 0% interest account on which one cannot make new charges (note this won't increase total public/private debt much even later -- credit card companies are much more conservative now about extending credit, widely decreasing credit limits instead of holding them steady.)

The point of this debt restructuring is the much better interest rates U.S. treasuries (which after all are tax obligations of all of us) must pay versus credit card interest rates. Households get a much lower interest rate effectively, and this will accelerate household debt reduction, and subsequent household spending recovery.

This would drastically change the debt-service loads that are weighing so heavily against the U.S. economy now. When an increased portion of the total spending power in the U.S. is left in household hands (instead of so much narrowly concentrated in wealthier investor and bondholder hands), the economic fabric of local economies (which in turn constitute the national economy) re-builds faster via the increased circulation of money in local economies.

The implication for U.S. treasury bond interest rates (a function of international confidence in the future U.S. economy) is quite different for a debt-restructuring plan (this idea) versus the outcome of pure deficit spending. Pure deficit spending, which increases the national combined public/private debt load, can be bad or good depending on it's effect in increasing future economic activity -- how well (or poorly) specific federal spending increases the future U.S. ability to pay back the increased national debt. In contrast, a debt-restructuring does not increase the combined public/private national debt load (after all the same households are responsible for both), but does increase economic activity by reducing interest rate burdens. This happens because a restructuring increases bond-investor confidence in a nation, corporation, or household as a good borrower. The net effect is less interest-rate burden (current and future) on U.S. households overall, in sum, on the combination of household debt and future tax obligations (on the same households).

Feeling more secure about debt payments and even about the whole national economy due to the plan, individuals would become less stingy with their discretionary funds, and thus a modest and increasing amount of additional discretionary spending will then flow into our dry-as-a-bone economy. As this stabilizes and supports the economy, job losses would be sharply lowered, and gradually a normal level of confidence would return, allowing a recovery.

Obama's Opening Statement at Press Conference

Barak Obama 2/9/2009

"Good evening. Before I take your questions tonight, I’d like to speak briefly about the state of our economy and why I believe we need to put this recovery plan in motion as soon as possible.

I took a trip to Elkhart, Indiana today. Elkhart is a place that has lost jobs faster than anywhere else in America. In one year, the unemployment rate went from 4.7% to 15.3%. Companies that have sustained this community for years are shedding jobs at an alarming speed, and the people who’ve lost them have no idea what to do or who to turn to. They can’t pay their bills and they’ve stopped spending money. And because they’ve stopped spending money, more businesses have been forced to lay off more workers. Local TV stations have started running public service announcements that tell people where to find food banks, even as the food banks don’t have enough to meet the demand.

As we speak, similar scenes are playing out in cities and towns across the country. Last Monday, more than 1,000 men and women stood in line for 35 firefighter jobs in Miami. Last month, our economy lost 598,000 jobs, which is nearly the equivalent of losing every single job in the state of Maine. And if there’s anyone out there who still doesn’t believe this constitutes a full-blown crisis, I suggest speaking to one of the millions of Americans whose lives have been turned upside down because they don’t know where their next paycheck is coming from.

That is why the single most important part of this Economic Recovery and Reinvestment Plan is the fact that it will save or create up to 4 million jobs. Because that is what America needs most right now.

It is absolutely true that we cannot depend on government alone to create jobs or economic growth. That is and must be the role of the private sector. But at this particular moment, with the private sector so weakened by this recession, the federal government is the only entity left with the resources to jolt our economy back to life. It is only government that can break the vicious cycle where lost jobs lead to people spending less money which leads to even more layoffs. And breaking that cycle is exactly what the plan that’s moving through Congress is designed to do.

When passed, this plan will ensure that Americans who have lost their jobs through no fault of their own can receive greater unemployment benefits and continue their health care coverage. We will also provide a $2,500 tax credit to folks who are struggling to pay the cost of their college tuition, and $1000 worth of badly-needed tax relief to working and middle-class families. These steps will put more money in the pockets of those Americans who are most likely to spend it, and that will help break the cycle and get our economy moving.

But as we learned very clearly and conclusively over the last eight years, tax cuts alone cannot solve all our economic problems – especially tax cuts that are targeted to the wealthiest few Americans. We have tried that strategy time and time again, and it has only helped lead us to the crisis we face right now.

That is why we have come together around a plan that combines hundreds of billions in tax cuts for the middle-class with direct investments in areas like health care, energy, education, and infrastructure – investments that will save jobs, create new jobs and new businesses, and help our economy grow again – now and in the future.

More than 90% of the jobs created by this plan will be in the private sector. These will not be make-work jobs, but jobs doing the work that America desperately needs done. Jobs rebuilding our crumbling roads and bridges, and repairing our dangerously deficient dams and levees so that we don’t face another Katrina. They will be jobs building the wind turbines and solar panels and fuel-efficient cars that will lower our dependence on foreign oil, and modernizing a costly health care system that will save us billions of dollars and countless lives. They’ll be jobs creating 21st century classrooms, libraries, and labs for millions of children across America. And they’ll be the jobs of firefighters, teachers, and police officers that would otherwise be eliminated if we do not provide states with some relief.

After many weeks of debate and discussion, the plan that ultimately emerges from Congress must be big enough and bold enough to meet the size of the economic challenge we face right now. It is a plan that is already supported by businesses representing almost every industry in America; by both the Chamber of Commerce and the AFL-CIO. It contains input, ideas, and compromises from both Democrats and Republicans. It also contains an unprecedented level of transparency and accountability, so that every American will be able to go online and see where and how we’re spending every dime. What it does not contain, however, is a single pet project, and it has been stripped of the projects members of both parties found most objectionable.

Despite all of this, the plan is not perfect. No plan is. I can’t tell you for sure that everything in this plan will work exactly as we hope, but I can tell you with complete confidence that a failure to act will only deepen this crisis as well as the pain felt by millions of Americans. My administration inherited a deficit of over $1 trillion, but because we also inherited the most profound economic emergency since the Great Depression, doing too little or nothing at all will result in an even greater deficit of jobs, incomes; and confidence. That is a deficit that could turn a crisis into a catastrophe. And I refuse to let that happen. As long as I hold this office, I will do whatever it takes to put this country back to work.

I want to thank the members of Congress who’ve worked so hard to move this plan forward, but I also want to urge all members of Congress to act without delay in the coming week to resolve their differences and pass this plan.

We find ourselves in a rare moment where the citizens of our country and all countries are watching and waiting for us to lead. It is a responsibility that this generation did not ask for, but one that we must accept for the sake of our future and our children’s. The strongest democracies flourish from frequent and lively debate, but they endure when people of every background and belief find a way to set aside smaller differences in service of a greater purpose. That is the test facing the United States of America in this winter of our hardship, and it is our duty as leaders and citizens to stay true to that purpose in the weeks and months ahead. After a day of speaking with and listening to the fundamentally decent men and women who call this nation home, I have full faith and confidence that we can do it. But we're going to have to work together. That's what I intend to promote in the weeks and days ahead. And with that, I’ll take your questions."

Which Tax Cut is Most Progressive and Stimulative?

What do one of our world's wealthiest men, Warren Buffett, and one of America's prominent liberal economists, James Galbraith, have in common?...they both pointedly endorse a certain kind of very progressive tax cut -- a "payroll" tax holiday.

The FICA (payroll) tax is regressive by nature as it taxes only up to a certain level of income, allowing income over $102,000/yr to go FICA-tax-free.

The FICA tax does not apply to capital gains or dividends! (!) Wealthy and living off investments? You pay no FICA taxes on those.

This means the richer you are, the lower your FICA tax rate is.

But the poorest workers, on the lowest wages, pay the full FICA tax all the way.

The reason a payroll tax holiday is especially stimulative is because this tax cut goes primarily to lower income households, who by nature must spend more of their tax cut just to get by.

A FICA tax holiday would also help small business owners and individuals working for themselves.

Again, these are people who need the money especially now, and who will spend it soon.

For instance, it's estimated that the multiplier of a payroll tax cut is very nearly as high as the multiplier of federal aid to state budgets which save state jobs as state revenues fall.

How long should a FICA tax holiday last?

Until the economy recovers strongly.

How Obama's Middle Class Tax Cut Will Save Jobs

Debate has intensified in the last few days about whether the Obama tax cut proposals in the stimulus package will be effective as a stimulus.

Among the majority that believe a stimulus package will indeed create and save some jobs on net versus no stimulus, the big issue is whether the stimulus size is enough to counter the large fall in consumer demand, and thus prevent higher and higher joblessness.

Keynesian stimulus in a nutshell is that government spending can increase demand in the economy to replace the fall in demand during a recession, saving jobs and creating jobs.

Several important side debates have been ongoing, and let's quickly dispose with a couple of those and get back to the main question of this post.

Objection A) Government spending does not create new jobs, since it relies on taxing or borrowing which in turn removes money or available investment and discretionary funds from the general economy -- simply shifting spending and investment from one place to another without a net increase.

For investing, this is called crowding out, and it certainly does happen when an economy is running at or near full steam, so that resources (machines, workers, money) are being fully or almost fully utilized, so that all new output of the economy requires new investment dollars. In that situation, private investment competes for those new dollars with government. But when an economy has much slack, as ours does now, so that more money is sitting in money market accounts and short term treasury bills, there is plenty of available money for government borrowing and investing, and still plenty left for any private borrowing and investing the private sector chooses. A similar situation applies to spending -- government spending does not compete so much with private spending during a recession -- concrete prices are down sharply, for instance, so government infrastructure spending on concrete will not be competing much with private demand for concrete to a level that would strain available output.

Objection B) Government spending/investing is top-down, and is thus less informed/knowledgeable than private spending/investing -- less effective at producing the goods and services people actually want for their lives and standard of living.

Example -- Joe would rather buy a new car instead of paying more taxes (or having future taxes) for more city bus service.

This again, as above, is true during a time of economic expansion, but is it true during a time of recession? Currently consumers who have jobs have sharply pulled back in spending, and are saving on the whole, which of course has led to a sharp drop in consumer demand, and thus more and more job losses. Consumers are choosing that they don't want as many consumer goods and prefer instead to pay off their credit cards, or build up their emergency fund.

As they save, more money is available for investing also, and some of it flows into safe US Treasuries. When the Government spends more now, it is not removing money from current consumer spending.

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Ok, now let's consider the Obama Middle Class Tax Cut (MCTC) as a stimulus....

We know that tax rebates of a size like that of summer 2008 are much smaller than average consumer credit card debt, and it's little surprise that much of that rebate was saved (or paid against debt), and yet helped the economy in a dramatic way not widely understood. (see link)

We can surmise that much of the coming MCTC will also be saved, at least for a while.

Until when?

Well, that's an individual level decision.

For someone who's been paying off credit card debt for example, they may continue paying it off at the same rate, or even add in the extra take-home pay from the tax cut and make even larger payments (saving all the tax cut). Until....

Until they have paid off the credit cards to zero.

Then what happens?

If you could imagine celebrating upon paying off a card or the last card, I bet you are like most people.

Might you go out to eat? Might you finally get your car repaired? Might you stop putting off that gym membership?

Yes, when consumers have less debt, they will respond by spending more, resulting in more jobs. Some will spend more, some less, but overall spending will increase in response to debt going down (or savings up). Poorer families will spend more, and the sad truth is many "middle class" families are practically poor.

Even while consumers spend less in 2009 with the new tax cut than they did in 2008, the issue is how much less. A tax cut will make a difference in consumer spending, immediately and progressively, both. Many jobs will be saved, adding to the positive effect of those newly created.