Cut the Payroll Tax

How to Kickstart the Economy
By MIKE WHITNEY

On Friday, Fed chairman Ben Bernanke made the case for a second round of quantitative easing (QE) claiming that inflation is presently "too low" to achieve the Fed's dual mandate of price stability and full employment. By purchasing long-term Treasuries, Bernanke hopes to lower bond yields and force investors into riskier assets. That, in turn, will push stocks higher, making investors feel wealthier and more apt to boost spending. (Re: "trickle down", when investors increase spending, it reduces the slack in the economy and lowers unemployment.) Thus, QE is intended to divert investment to where it is needed and to lift the economy out of the doldrums.

That's the theory, at least. In practice, it doesn't work so well. Over a trillion dollars in reserves are still sitting on banks balance sheets from QE1. The anticipated credit expansion never got off the ground; the banks loan books are still shrinking. Bernanke fails to say why more-of-the-same will produce a different result. QE is also risky; in fact, it could make matters worse. Unconventional methods of pumping liquidity into the economy can undermine confidence in the dollar and trigger turmoil in the currency markets. Trading partners like Brazil and South Korea are already complaining that the Fed is flooding the markets with money pushing up their currencies and igniting inflation.

The threat of more cheap capital is causing widespread concern and talk of a currency war. If Bernanke goes ahead with his plan, more countries will implement capital controls and trade barriers. The Fed is clearing the way for a wave of protectionism. Quantitative easing, which is essentially an asset swap--reserves for securities--will not lower unemployment or revive the economy. Low bond yields won't spark another credit expansion any more than low interest rates have increased home sales. The way to tackle flagging demand is with fiscal stimulus; food stamps, state aid, unemployment benefits, work programs etc. The focus should be on putting money in the hands of the people who will spend it immediately giving the economy the jolt that policymakers seek. QE doesn't do that. It depends on asset inflation to generate more spending, which means that we've returned to the Fed's preferred growth formula--bubblenomics.

Quantitative easing is also extremely costly for, what amounts to, modest gains. Consider this, from the Wall Street Journal:

"The Fed's own internal models suggest that a purchase of $500 billion in Treasuries would only reduce the 10-year bond by something like 15 basis points..... This in turn would increase GDP by 0.2% a year and cut the jobless rate by 0.2%. That's not much bang for a lot of bucks."

Bond yields fell more on Friday in reaction to Bernanke's "jawboning", than they will when QE is actually implemented. That's because Wall Street still thinks Bernanke has superhuman powers and can reverse severe deflation and mass deleveraging with a wave of his hand. But it's not true. When households are repairing their balance sheets, they will not take on more debt regardless of how cheap money is, which is why credit will continue to grow at suboptimal levels. In a liquidity trap--when rates are already stuck at zero--interest rates become irrelevant.

Here's a clip from Bernanke's speech that points out the problem with QE:

"One disadvantage of asset purchases is that we have much less experience in judging the economic effects...these factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of other long-term securities."

Isn't this a tacit admission that Bernanke really doesn't know what he's doing? Remember, it was Bernanke, who, as late a July 2005, denied that there was a housing bubble. In 2007, Bernanke claimed that the subprime disaster was "contained". In 2008, Bernanke allowed Lehman Bros. to collapse rather than invoke the Fed's "unusual and exigent" clause which he used willy-nilly for all of the Fed's other so-called “emergency actions”. So, the Fed chairman already has a number of strikes against him, and now he wants to take the country into uncharted waters. This is not a decision that should be left to an unelected bureaucrat whose policies helped trigger the financial crisis.

The threat of deflation should be taken seriously, because once it becomes entrenched it can be difficult to root out. But there's no need for experimentation; the remedies are already known (Keynesian stimulus) and have been used many times before with predictable success. The government needs to expand its budget deficits in order to provide sustained fiscal stimulus until household deleveraging ends and consumers can resume spending. The privately-owned banking system will not generate sufficient credit for another expansion because the banks are still impaired and consumers are huunkering down. It's the government's job to intervene and provide relief where it is needed.

Bernanke should align his bond-buying program with a second round of fiscal stimulus, preferably a two-year suspension of the payroll tax. Instead of inflating equities and commodities, the Fed's liquidity would give the nation's working people a well-deserved raise in pay that they'd use to kick-start the economy. That's the best way to create demand and beat deflation.

Bernanke Ponders the "Nuclear" Option

Rolling the Dice
By MIKE WHITNEY

Ben Bernanke's speech on Friday in Boston could turn out to be a real barnburner. In fact, there's a good chance the Fed chairman will announce changes in policy that will stun Wall Street and send tremors through Capital Hill. Along with another trillion or so in quantitative easing, Bernanke is likely to appeal to congress for a second round of fiscal stimulus, this time in the form of a two-year suspension of the payroll tax. That's what he figures it will take to jump-start spending and rev-up the flagging economy. It could be an extraordinary intervention.

Bernanke laid out the details in a speech he gave in May 2003 to the Japan Society of Monetary Economics, in which he outlined the policies Japan should enact to beat deflation. Here's what he said:

“Rather than proposing the more familiar inflation target, I suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation. Second, I would like to consider an important institutional issue, which is the relationship between the condition of the Bank of Japan's balance sheet and its ability to undertake more aggressive monetary policies.... Finally, and most important, I will consider one possible strategy for ending the deflation in Japan: explicit, though temporary, cooperation between the monetary and the fiscal authorities."

There it is. Bernanke is planning to reflate asset prices, purchase more government bonds, and enlist congress's support to pump liquidity into the broader economy. It's an ambitious strategy that could push the dollar over the edge, but the alternatives are equally bleak. Bernanke knows that "at best" GDP will hover around 1 to 2 per cent through 2011 while the public grows increasingly restless about soaring unemployment. He also knows that when interest rates are stuck at zero the only way the central bank can zap the economy back to life is by increasing inflation expectations. That means, the Fed has to persuade people they've “lost it” and are planning to destroy the currency via the printing presses. It's all baloney. The Fed won't destroy the dollar. They just want to use the element of surprise to give the economy a good jolt. Gold bugs think the Fed is steering the country towards hyperinflation, but they're mistaken. It's all part of a larger calculation.

Bernanke may be a died-in-the-wool class warrior, but he's no moron. His policies are designed to overshoot in order to change expectations and get consumers out of their funk. He even says so in the speech. Here's a clip:

"A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective."

The only way to stimulate economic activity is to convince people that the dollar they presently have in their pockets will be worth less tomorrow. That's what puts the Jones's back into the minivan scuttling off to the mall. But what seems like profligate spending on the Fed's part, (QE) is really just a way of restoring the pre-crisis price level. Call it asset inflation if you want, but the bottom line is, Bernanke is not going to sit back while disinflation turns to deflation, the real value of personal debts rise, and the bankruptcies, defaults and foreclosures continue to mount. He's going to pull out all the stops and carpet bomb the economy with monetary and fiscal stimulus. Here, again, is how Bernanke lays out his thesis:

"One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus."

Good. So Bernanke realizes that he can't go it alone. He has to get congress on board if he wants to succeed. (which is probably why the Fed's meeting was scheduled after the midterms)

Bernanke again:

“... Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but--because the BOJ purchased government debt in the amount of the tax cut--no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices."

This is truly radical, but it could work. And, the quickest way to engage the policy would be by slashing the payroll tax which would, in effect, give every working man and woman in the country a raise in pay.

Bernanke's comments are also a tacit admission that the banking system is still dysfunctional and cannot provide the credit needed for the next expansion, so he is bypassing the privately-owned system altogether and transferring money to consumers directly. Naturally, this will have a positive effect on spending and on any prospects for a recovery.

The cagey Bernanke has even concocted the public relations rationale for fending off the deficit hawks who will undoubtedly point to his plan as an example of wasteful government spending.

Bernanke:

"Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.....More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations."

The Bernanke plan seems to do everything except whiten teeth. But wouldn't it make more sense to restructure the banking system so the toxic assets can be removed and the banks can lend freely again? And wouldn't it be better to strengthen labor unions (so that wages keep pace with productivity) so workers can generate sufficient demand to keep the economy running smoothly without panicky injections of emergency stimulus? Of course, that would mean a truce in the ongoing class war which wouldn't fly with plutocrats who take joy in seeing the unemployment lines wind from one side of the country to the other.

Bernanke's plan could work. Congress could pass emergency legislation to suspend the payroll tax for two years stuffing hundreds of billions of dollars into the pockets of struggling consumers. The Fed could make up the difference by purchasing an equal amount of long-term Treasuries keeping the yields low while the economy resets, employment rises, asset prices balloon, and markets soar. As the economy rebounds, the dollar will steadily lose ground triggering a sharp rise in commodities and an increase in exports that will spark a clash with foreign trading partners. Then what?

Yes, Bernanke's "nuclear option" could help to resuscitate economy, but it could also erode confidence in the dollar leading to the untimely demise of the world's reserve currency. It's all a roll of the dice.