July 2007 Archives

Okay, I'm back. It will take me some time to catch up. There's lots to talk about.

For starters, let's look at the debate over taxes and private equity compensation. The managers of these private equity funds are making staggering sums of money these days. I saw one figure calculating that the average compensation for the top 25 private equity managers last year was almost $600 million.

Yet the richest workers in the world pay lower taxes on a big chunk of their compensation than the average worker. They do this by treating their share of investor profits (the money managers pocket 20% of fund's profit) as low-taxed capital gains rather than high-taxed ordinary income.

Now, the private equity types and their defenders say that the earnings aren't like a typical salary. It's more like a return on risk capital. But at least one serious financier disagrees: Robert Rubin, former Secretary of the Treasury and former head of risk arbitrage at Goldman Sachs. According to a Bloomberg story, Rubin argued that the private equity partners piece of investor profits is really part of their compensation for "running other people's money." In other words, they are providing a service, and the income on that service should be taxed as ordinanry income at a top rate of 35% rather than a 15% rate on capital gains.

Rubin is right.

However, I want to raise another question: Why do most economists and tax policy makers assume that capital should be taxed less than labor? It wasn't always so. This is a piece I wrote in 2005 for Business Week Online that disagreed with the consensus.

Why Give Capital a Break?

Thanks to the Jobs & Growth Tax Relief Reconciliation Act of 2003, the tax rate on dividends was temporarily slashed from a high of 38% to 15%, and the tax rate on long-term capital gains dropped from 20% to 15%. These two measures were designed to encourage private savings by lowering the tax levy on capital.

Columnists love to proclaim solutions. It's part of the fun of the job. This is a case where I certainly don't have all the answers. But I'd like to see more of a challenge mounted to the economic consensus of capital taxation. Let the debate begin.

The Organization of Economic Cooperation and Development has a good study on globalization. Making the Most of Globalization offers a good economic summary of what we know about the impact of globalization on growth, investment, wages, inflation, and the like in the world's most developed nations. The opening page has a powerful chart: This current wave of globalization is historically large compared to the 1950s and the 1870s, two previous major episodes when the worldwide integration of markets for goods, labor, and capital expanded.The population of the integrating economies--China, India, and the like--as a ratio of that in advanced countries is around 225%. In 1950, with the entry of Japan, the comparable figure was around 20% and in 1870 with the emergence of North America and peripheral Europe, 50%. "In comparison with earlier phases of globalization, the countries now coming in have relatively larger populations," the report says.

Why do we think a 4.5% unemployment rate is too low or, to put it somewhat diferently, is acceptable. Far too many people are unemployed these days. Yet here is a typical headline, this one from a page 2 story from Friday's Wall Street Journal:

Fed Keeps Eye on a Tight Labor Market
Bernanke Tells Congress
Jobless Rate Remains
A Pressure on Inflation
By SUDEEP REDDY
July 20, 2007; Page A2

WASHINGTON -- Federal Reserve Chairman Ben Bernanke suggested the Fed won't be convinced that the risk of higher inflation has subsided until the unemployment rate rises and businesses are operating farther from full capacity.....
I'm not picking on the Journal. You can find similar statements almost everyday in business news.

The reason is that Wall Street economists worry about a tight labor market. Here's the basic dynamic: With labor scarce, companies will be forced to raise wages; higher wages will push management to hike prices to preserve profit margins; higher prices will erode the value of a worker's paycheck and workers will start demanding bigger pay increases; and so on. In other words, the risk of inflation goes up if too many people are employed. Doesn't this mean that Wall Street economists are fellow-travelers with Karl Marx, who believed that capitalism depended on an army of unemployed workers?

The trade-off between inflation and unemployment is flawed. When Jerry Jordan was head of the Federal Reserve Bank of Cleveland he was a well-known known inflation hawk. He was also a hardnosed monetarist deeply influenced by the late Milton Friedman. I remember a talk Jordan gave in the 1990s (I haven't been able to track it down yet on the Internet). has stuck with me: In a paper given several years ago by Jerry Jordan, In essence, he argued the idea that more people working and producing more goods and services leads to inflation—or reduces the purchasing power of money—is highly questionable. If you go back in our history, said Jordan, "the periods with the highest growth in output and employment, with the most rapid rises in the standard of living, are those periods where you have proximate price stability."

The current belief that there's an inevitable trade-off between economic growth and inflation largely rests on the theoretical foundation of NAIRU, or the "noninflationary accelerating rate of unemployment." The NAIRU idea took root when inflation soared into double-digit territory in the 1970s. Here's the basic idea: In any economy, worker preferences, job changes, labor market institutions, and other factors add up to a "natural" rate of unemployment. The natural rate is defined as the jobless rate consistent with stable wage and price inflation. When the unemployment rate drops below its natural rate, wage pressures build and inflation takes off.

Okay, but where is the natural rate of unemployment? In the early 1990s, many mainstream economists assumed it was somewhere between 6% and 6.5%. But unemployment fell to 3.6 % in 1999. And inflation came down, too.

I tend to agree with the late Robert Eisner, professor of economics at Northwestern University. Eisner's suggested that the unemployment/inflation relationship is asymmetric. High unemployment is associated with lower inflation rates. But low unemployment doesn't tell us much -- if anything -- about the future direction of inflation. "Can I guarantee that measures -- short of war -- to reduce unemployment to 3.4% will not increase the rate of inflation? No!”, said Eisner. “Can anyone be sure it will increase inflation, let alone by how much, or that the inflation will continue accelerating? I daresay no.

I realize that this is getting to be a long post, but one of the originators of the NAIRU idea is Edmund Phelps, the brilliant professor of economics at Columbia University and Nobel laureate. (The Nobel laureate Milton Friedman as his co-idea generator.) Anyway, in recent years Phelps has been working on ways to eliminate unemployment. That's right, he's focusing on "economic inclusion." Work is a central institution in our society, and its one way people gain a sense of self-worth. He also wants to raise the wages of disadvantaged, low skill workers. He has a series of proposals built around subsidies trageted at private sector firms to not only higher low skill workers but to pay them well. (Here is his home page.Here is a link to one of his papers on inclusion. And this is a link to the paperback version of his 1997 book, Rewarding Work.

Phelps is right. In a capitalist society unemployment is unacceptable. Instead of worrying about a too low unemployment rate lets worry about why there are unemployed people in mour society, and what to do about it.

According to the latest Investment Company Institute study total U.S. retirement assets hit $16.4 trillion in 2006. That's up 11% from 2005 and 55% since 2002. Almost two-thirds of retirement assets are held in employer-sponsored plans. Half the savings are in defined contribution plans (401(k)s, 403(b)s and the like, and IRAs.

On April 20, 2005, President George W. Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act into law. Record number of Americans had been filing for personal bankruptcy. The bill was meant to put more money into the hands of creditors, and crack down on filers. The idea behind the law change was that there had been a decline in the traditional stigma about declaring bankruptcy.

On the one-year anniversary of the bill signing, producer Sasha Aslanian and I aired an American Radio Works documentary that looked at the boom in bankruptcies, and the impact of the new law. Bankrupt: Maxed Out in America concluded that a decline in stigma--while real--wasn't the critical force at work. Here's our kicker:

Bankruptcy has long been the last legal option for anyone burdened with too much debt. But bankruptcy has always raised questions that go far beyond money. For society, the struggle is finding the right balance between honoring debts and a fresh start.

As one bankruptcy authority in Memphis put it, Congress only made the bankruptcy door a little smaller and the process of going through that door a little meaner. But odds are the new bankruptcy law won't succeed at closing that door altogether.

Now, Michelle J. White, economist at the University of California, San Diego and a leading expert on bankruptcy, has come out with a new study. We interviewed professor White for our documentary, and she offered up some of the most insightful comments we got while reporting. The abstract from her paper, Bankruptcy Reform and Credit Cards, summarizes the results of her research.

From 1980 to 2004, the number of personal bankruptcy filings in the United States increased more than five-fold, from 288,000 to 1.5 million per year. Lenders responded to the high filing rate with a major lobbying campaign for bankruptcy reform that led to the adoption in 2005 of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which made bankruptcy law much less debtor-friendly. The paper first examines why bankruptcy rates increased so sharply. I argue that the main explanation is the rapid growth in credit card debt, which rose from 3.2% of U.S. median family income in 1980 to 12.5% in 2004. The paper then examines how the adoption of BAPCPA changed bankruptcy law. Prior to 2005, bankruptcy law provided debtors with a relatively easy escape route from debt, since credit card debt and other types of debt could be discharged in bankruptcy and even well-off debtors had no obligation to repay. BAPCPA made this escape route less attractive by increasing the costs of filing and forcing some high-income debtors to repay from post-bankruptcy income. However, because many consumers are hyperbolic discounters, making bankruptcy law less debtor-friendly will not solve the problem of consumers borrowing too much. This is because, when less debt is discharged in bankruptcy, lending becomes more profitable and lenders increase the supply of credit. The paper examines the determinants of an optimal bankruptcy law. It also considers the relationship between bankruptcy law and regulation of lending behavior and discusses proposals that would reduce lenders’ incentives to supply too much credit to debtors who are likely to become financially distressed.

It was a bad law.

Does the global market meltdown signal the end of the global boom or, at least, a dramatic slowing in the U.S. economny? I don't think so. The reason is that abrubt downturn is largely a welcome turn of events.

For one thing, the sun is setting on the golden age of private equity deals, and that's all for the good. There was too much money paying too much for increasingly marginal leveraged takeovers. Management and the private equity folks joined forces to drain corporate coffers of cash to line their own pockets (forget about investing the in future). And now we are in this ridiculous situation where multi-millionaire finance gunslingers are claiming all kinds of bad things will happen if they are taxed at the same rate as their secretaries. Right.

For another, even congenitally optimistic real estate industry titans like the head of Countrywide Financial are conceding that the housing market isn't going to turn around anytime soon. But the turmoil in the market won't take down the economy.

Taken altogether, credit sanity is returning. The tightening of credit standards will fall far short of a classic credit crunch, however.

It still seems that the best forecast for the U.S. remains moderate economic growth and lower inflation, especially if the global economy keeps expanding. .

Memory matters in the broad sweep of public policy. I was reminded of this reading the latest newsletter by Peter Bernstein, a market historian and financial advisor.

"History is not a pool of inconsequential happenstances. Each episode is a consequence of the preceding episode. The Great Depression and the obsessive fear of high unemployment prompted the Full Employment Act in the 1950s and the Great Society in the 1960s. Inflation was a secondary consideration to unemployment. Sumner Slichter, Harvard Business School’s most famous professor of the era, even argued that inflation was the right policy for encouraging high em-ployment (a view Chairman Bernanke just recently rejected without qualification) The result was the Great Inflation of the 1970s, in which reducing unemployment dominated controlling inflation as a policy goal. The roles have been reversed over the past thirty years. Now controlling inflation dominates economic policy and worrying over unemployment is a secondary consideration."

The battle against inflation has been won over the past quarter century. Sure, there will always be periodic inflation scares, such as right now with the rising cost of food and energy. But the central banking nomenklatura--the economists at the Fed and other central banks, economists at the IMF and BIS, economists in university departments at home and abroad--have made huge strides in understanding the causes of inflation, the consequences of inflation, and ways of keeping inflation contained.

No, it's the precarious situation of labor that will dominate going forward. I don't think employment will remain a secondary consideration.

Why? It's not one thing. It's the cumulative impact of a quarter century of rising inequality, persistent poverty, and increasingly earnings and job instability. You can see it in the backlash against immigrants and the embrace of policies that would erect trade barriers against Chinese imports. It's not just the worry that a rising tide no longer lifts all boats but only a few yachts, but the very real fear that among a growing number of lower middle class and low income families that their children will not be better off they their parents.

The benefits of globalization, which are considerable (and that's an understatement) have come at a considerable price for many people.

Economists have made a powerful brief against protectionism and trade barriers. And, by and large, the public and policymakers are convinced. But to preserve open borders requires greater efforts to create a better safety net for a hyper-competitive economy. It will demand greater emphasis on employment inclusion--making sure that everyone has a job. And it means devising policies that worry less about the wealthy and more about the economic opportunities of society's disadvantaged members. After all, why can't we have full employment? We should.

The first test: Will we get universal health insurance? And can the public debate move beyond the sterile rhtoric and false choice between between "socialism" and "markets".

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