Ingredients for round two of economic growth policies:

1) Increase the H-1B visa-limit ten to twenty fold. These are non-immigrant visas that allow employers to essentially cherry pick the best and brightest from across the world, especially in engineering. The limit is currently a ridiculously low 6,500 per year. These highly skilled positons are critical to developing private sector employment and growth.

2) Repurpose $5B from unspent TARP funds and start a revolving government venture fund to seed startup investments. The government could invest anywhere from $10K to $1M in promising businesses and take a flat 25% equity stake. 10 experienced fund managers could be recruited as SES (Senior Executive Service; the highest level of career government employees, who are eligible for bonuses for good performance) to serve on a board to approve applications and provide oversight. Future cash flow from those that succeed would pay down the deficit. The fact of the matter is we live in an information and service-based economy. Unemployment insurance, State aid and new highway spending help with cyclical unemployment, but structural employment is best created with new, sustainable, innovative companies.

3) Enact a larger follow-on investment in next generation transportation. The stimulus bill had a measly $10B for high speed rail. Follow-on with another $50B to buy a lot more cars, build more tracks, and connect major population centers. Through the multiplier effect and contracting a lot of this out, these funds' employment effects could be amplified and drive permanent private sector employment. The U.S. is falling behind in the efficiency with which it can move goods and people, prerequisites for sustainable growth in a global economy. (*Postscript: the White House just announced a $50B transportation package to stimulate the economy.)

4) Revamp, rebrand, and rerelease the Public-Private Investment Program rolled out last year. This program is designed to increase the market for banks' bad mortgage backed securities, as well as mortgage related loans. (More details here - http://www.financialstability.gov/roadtostability/
publicprivatefund.html). Unfortunately, a specific design has stalled and the program has been delayed. The terms and capital levels should be reevaluated in order to make them sweeter for private partners, and then fund managers hired to scale this up and start the auctions.

5) Tax credits/rebates based on purchases. The idea here is to combined tax cuts with smart purchases that will increase aggregate demand. I.e., invest in clean energy or buy an electric hybrid and get cash back, or hire people who are unemployed and get a payroll tax holiday. This would create a strong incentive for both immediate spending, and immediate hiring, while developing new markets. This would essentially build off the phenomenally succesful Cash for Clunkers model. That was one of the most impressive government-private policy team-ups in recent memory and I'm surprised how quickly it has faded from policymakers' collective memory.

6) Reform the Payroll/FICA Tax to increase aggregate demand. Lower income individuals have a higher marginal propensity to consume than the wealthy. Poorer people also pay a larger share of their income in payroll taxes than the rich. In fact, some 75% of Americans pay more in payroll taxes than in income. FICA should be exempted for the first $20,000 of income (thus increasing spending the most) and the current cap on FICA should be raised from $106K to more like $250K. Warren Buffet has had a wager going for years for any executive who can prove they pay more in payroll taxes than their secretary. So far, no takers.

Reverse Time Inconsistency

Recently approval ratings of Barack Obama (whether President or Candidate) have dipped into the negative terrain for the first time since polling has been conducted. Much has been made about this in policy circles and the media, and as usual I think there is way too much trying to be read into the tea leaves. Sometimes a storm comes through and the wind tussles the leaves. Then everything carries on as usual. The tree still stands, the storm comes and goes. As the President said, however less metaphorically, "I have my own pollsters. It's not like I don't have pollsters." In other words, he has been perfectly aware at every decision point, at every sensitive political juncture, of the polling costs and benefits. And the President's pollsters practice the calculus of surveying with a degree of art and complexity without compare. They could provide a range of estimates for what decision ABC will do for the voting proclivities of 80 year olds with a mild head cold this week who live in Duluth and prefer to watch Cold Case instead of Law and Order. The issue just may be that weekly, or quarterly, or even annual polling may not be the correct timeframe (or tool) to measure the President’s accomplishments, or weigh his likelihood for reelection in two years. This comes from the economic principle of time inconsistency.

Wikipedia (I have always wanted to start a sentence this way) defines time inconsistency as:

In economics, dynamic inconsistency, or time inconsistency, describes a situation where a decision-maker's preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time...One common way in which selves may differ in their preferences is they may be modeled as all holding the view that now has especially high value compared to any future time. As a result the present self will care too much about herself and not enough about her future selves.

And this concept applies to essentially all of the President's accomplishments. Except in reverse. Rather than the President offering us tax cuts for a year that may benefit him in the short term, but create still more debt in the long term, he has done the complete reverse- sacrificed his short term political approval rating for long term policy investments that will likely yield approval rating dividends over the years to come. Rather than giving us candy now that will make us like him for the immediate future (but perhaps resent him later when we get a stomach ache) he has made us take our medicine. The benefits won't accrue for some time, but when they do, we will realize what foresight he had.

It will take years for financial regulatory reform to go through the rulemaking process. For specific capital reserves to be decided and set aside. For derivatives to see the light of day. Economic crises happen every 10 years or so historically, so preventing or mitigating future ones is on a time scale wholly irrelevant to the election cycle. Public exchanges from the recently enacted health reform law (of private plans mind you) will not even be launched until 2014. Then it will inevitably experience some growing pains. Millions of people may not see the benefit for several years. The deficit effects won't really come on strong until 2020. EPA's efforts to begin regulating greenhouse gas emissions in 2011 will likely take years to refine and get through legal challenges. Vehicle corporate average fuel economy improvements (which haven't been increased since Jimmy Carter) will require us to buy cars with a $1000 greater sticker price. But they'll save us $3,000in gas, and untold environmental costs, over the next 5 years. All of the costs (in money and time and anxiety and burden) occur now. The benefits are in the future, a future which people, even rationally acting ones, heavily discount. So it is no wonder the President's approval ratings are dropping. But rather than be a signal of distress, I think it might just be a measure of what real political fortitude looks like.

The public may doubt Barack Obama now. But if the President achieves no more major policy victories (say in Energy/Climate, Immigration or Social Security) I think he will still be one of the most popular former Presidents in American history. Yes, up there with the likes of his political hero Lincoln. I mean, we've already run this experiment. Social security and Medicare are two of the most beloved and untouchable programs in government. But in their day too they were subject to the short term vagaries and tremors of confidence that polls are so astute at capturing. If politicians had only listened to the polls in the 1960s we probably wouldn't even have them. Sometimes, leadership means making people do what is best for them, even if it hurts in the present.

Research Note

News just came out that April was the largest U.S. trade deficit in almost a year and a half, putting the U.S. on pace for another $500 billion deficit like 2009. The current account deficit was larger still in 2008 at some $700 billion. There is nothing inherently wrong with deficits, so long as they can be financed with GDP growth. However, if they continue to increase, it could undermine international confidence as doubts linger about the seriousness of long-term U.S. fiscal and trade policy, or drive uncertainty around whether there is high currency risk via the U.S. monetizing the debt by printing money, reducing creditor's purchasing power. Add to the fact that as China grows in prominence over the coming decades, U.S. denominated assets and debt obligations may become less in demand. China will in all likelihood surpass Japan in 2010 as the second largest national economy and is on pace to surpass the United States by mid-century. The U.S. dollar may become the secondary currency for international trade in the long-term. In the short term though, correcting this imbalance could be achieved through the double prong strategies of reducing the fiscal deficit and promoting U.S. exports, thus creating jobs and reducing the need for foreign savings.

The current account deficit is a rough measure of U.S. economic competitiveness relative to the global economy. It is the difference between national saving and national investment, or the net of foreign reserves entering the U.S. economy and U.S. dollars going out. The U.S. buys more (dollars out) than it sells abroad (reserves in), financed mainly by foreign purchases of our debt. The biggest factor in this imbalance is the mutual dependence between the U.S. and China. China depends on U.S. demand for export growth, the largest driver of their GDP growth, while the U.S. depends on China to buy and roll over our debt, used in large part to buy their exports. Each needs the other, and so it is both an unsustainable, and self-perpetuating, cycle. Here are three things the U.S. should do to lower this balance and increase foreign demand:

1) Biggest long term priority should be innovating new products and exporting this trade advantage to the world. This would lead to some dollar appreciation, but the increased demand would create sustainable jobs and generate reserves. The biggest market here, both in terms of marginal return on investment and depth of demand globally, is clean energy technology and services. A domestic price signal on carbon would catalyze the U.S. economy to leap ahead in this area and close the trade imbalance as we export smart energy applications, concentrated solar, consulting services, wind turbines and other carbon neutral or carbon negative technologies abroad. The U.S. could get ahead of the curve by adopting this price signal before other countries.

2) In the shorter term, bring the fiscal deficit down.

3) Continue to make progress with the U.S.-China Strategic Dialogues, nudging China to stop suppressing their currency to promote U.S. demand, and to create a stronger domestic credit environment and social safety net to prevent cash hording and exorbitant savings. Freeing up Chinese savings for consumption would help decrease the net trade imbalance between the two economies.

Sit back and enjoy the show

There seemed to be at least two over-riding criticisms of the newly passed healthcare reform law:

1) It would not, contrary to official estimates, reduce the deficit, but rather add to it.

2) It would represent something more or less "un-American"- a significant expansion of government at the cost of free market choice and competition and a general ideological move towards socialism.

What I am perhaps most pleased about with this bill is that over the coming years, certainly the next 5-10 years, we can evaluate these claims with real world results and see who is right. We can test these claims, comparing Congressional estimates of cost with those of the Administration and the Wall Street Journal and Rush Limbaugh and the American Enterprise Institute and Brookings- and we can see who was most correct. Afterall, prejudging outcomes and assuming away complexity in favor of one sized fits all answers and ideology is anathema to science. So let's sit back and see the results of this experiment. These arguments will not linger abstractly out in the ether of public debate and controversy forever, with two sides eternally duking it out over fundamentally unproveable philosophical or moral questions (I'm sure more than a few come to mind). We will get hard data about how many more people get healthcare, on the rate of price growth, on the cost of these new mandatory government spending programs on the budget and tax rates, on the success and replicability of the 27 cost control and quality care pilots this bill establishes, on whether we remain a country of elections and predominantly privately produced and procured goods and services, or whether we become the new Venezuela. All of this, and much, much more, time will reveal.

For instance, the intent of these new pilots is to look for best practices, cost control measures, and general innovation in healthcare delivery. The point is to test new things for proof of concept, cutting funds for what doesn't work, and scaling up what does. Evidence based, pragmatic cost control measures are good ideas whether in corporate America or government. Many (potentially) good, cost-saving ideas are in this bill, and the potential savings weren't even priced into the budget estimates. Stuff like bundling payments across hospitals and outpatient services to reduce administrative costs and create greater negotiating leverage, paying hospitals with higher infection and readmission rates less, sending out undercover inspectors to look for waste and abuse, working on payment systems that reward quality of outcome and care over sheer volume (as is currently the case for the fee for service model) and clearly conveying the state of peer reviewed medical literature to practitioners in the field, so there is no ambiguity about the state of scientific knowledge on what works, and what is a waste, both of treatment and money. After all these assertions and claims that have been discussed the last 14 months during the genesis of this law, we will get to concretely see what savings and best practices come out of these 27 seperate case studies. For economists or researchers looking for good data sets and means to test null hypotheses, it's almost overwhelming to think of all the good analysis that could be done. Yet one thing is for sure, we know what healthcare costs today, we know how much waste there is, we know how many errors there are, we know how many people are covered- and now we are about to discover which way this law pushes all these indicators.

One could spend a great portion of her life reading criticisms and attacks of every aspect of this law (and even criticisms of things not in it!) from countless think tanks, research institutes, lobbies, and yes, gasbag bloggers such as myself. But what is so exciting about this historic piece of legislation, in addition to the potential to provide care for millions and root out inhumane abuses in the insurance industry and expand competition and choice- is that we will get to test these assertions very clearly. I just hope we keep score, and in 2020 if everyone takes for granted that kids can't be denied health coverage, or domestic abuse can't be classified as a preexisting condition, or a consumer isn't forced to buy into an oligopoly because the government now forces companies to post their plans side by side online to drive choice and innovation, or that healthcare costs are growing slightly above inflation rather than 250% of it- that we don't shrug this off as just the natural progression of things, as some inevitable outcome or industry innovation. No, like any good science experiment, we have been operating a good control scenario for about the last 50 years, and now we can compare it to the future. If these changes come about, we can make clear scientific arguments of attribution. Whichever side has it right, it will be a triumphant essay they pen in the National Review or Cato blog- an epic example of "told you so!" In other words, after 40 years of debate, it's finally down to the 4th quarter of a close contest, and we're getting closer to seeing who the winner is.

As a caveat, on the first two criticisms- deficit control and socialism- I would point out that this bill cuts $550 billion from Medicare in the next 10 years by eliminating 15 cents on the dollar of Medicare Part D (because it's 15% more expensive than public run plans and gets no better results). CEOs and turnaround private equity guys gets plaudits for this constantly, ruthelessly cutting waste and ineffeciency to force better results and make hard decisions. Oh, and in this case, it will also fulfill a promise the previous administration made to seniors about prescription drug coverage but didn't actually fund. But cutting medicare funding hardly seems like adding to the deficit to me, and curtailing the size of government payouts hardly seems like expanding government. Also, creating competitive transparent online exchanges, for customers to review and scrutinize plans, none of which will be government programs by the way, hardly seems like something that would be expected to increase prices, and hardly something that is socialist, in fact it seems like the essence of market based capitalism.

And from a behavioral economics standpoint, I've decided to take this new system for a spin, test out all my new government benefits by being a little clumsier here and there. JK

The President's Financial Regulatory Proposal

About two days a week throughout the fall last year there would be a black suburban parked on the street I walk from the red line to work. On these days I’d walk a little slower to see Treasury Secretary Paulson walk from a giant office building into the waiting car. I saw him the day after Lehman failed, the only thing fresh looking about him was his suit- and the day after the inauguration, with 8 foot high metal cage-like fences spilled down Penn Avenue as far as the eye could see, tons of trash blowing surreally in the freezing wind- this time looking more relaxed in his basketball shorts and unbuttoned shirt. It was pretty surreal to wake up and read the Journal or Times chronicling the latest historical market failure and then cross paths with its leading financial firefighter. A year later I’m afraid the sense of urgency of those fall months is fast diminishing. A tragedy of the last year is a terrible thing to waste. From the ashes of a failed regulatory system, that cost 3 million people their jobs and nearly as many their homes, and $7 trillion in wealth, is the promise to build a sleeker, more common-sense, more responsive regulatory system. And here many people will stop me simply with the semantics, “regulation” is a terrible word- so call it what you will. The basic concept though holds true in essentially every aspect of life. We don’t get on a jet plane and just hope the proper safety checks have been done and the pilot isn’t drunk, we “regulate” it, we don’t trust a stranger to deliver our new baby at a whim, we “regulate” it. So those who would notionally dismiss regulation as a bad thing should maybe stop flying or stop having kids.

The legal zeitgeist of these times is the President’s Financial Regulatory Reform proposal (http://www.financialstability.gov/docs/regs/FinalReport_web.pdf). In a little over two short months this entire white paper has been translated to authorizing language and sent to the Hill, where as usual it was met with a startling sense of complacency and criticism without much constructive feedback. If this can pass in some form by 2010 my hypothesis of complacency is proved wrong. If not, a similar asset bubble and burst cycle and all of the capital contraction, income decline and job loss and capital loss (repeat) is not just possible but probable. The impetus to correct a clearly insufficient financial regulatory regime – one that forced the government to choose between catastrophic failure and chaos or injecting huge of amounts of taxpayer dollars- is otherwise lost. Critics can say what they like about the choices made last year, but with Bear, Lehman, AIG, WaMu- those were the options. Here are some core tenets of the President’s regulatory agenda.

1) Capital ratios. A working group is currently drafting the details due out in a couple months. When the banks’ experienced severe asset valuation shocks they were forced to liquidate and perpetuate the cycle. With better loan loss provisioning this cycle could have been prevented. In practical terms, probably means going from tangible common equity ratios of 4% to 8%.

2) Resolution authority. The FDIC can repossess and either break up or auction off bankrupt depository institutions. There is no similar authority for non-depositories or holding companies that own depositories. The Fed can loan money to anyone or anything so long as it is last resort and there is sufficient collateral. If there isn’t, then there is no way to protect innocent bystanders from the consequences of large bank failure. The President’s proposal would permit the Fed with Treasury consent, to seize and efficiently break up large failing firms.

3) Preventing regulatory arbitrage. Under current law, thrift holding companies (banks with a higher share of mortgages created to facilitate liquidity in the housing market), industrial loan companies (like GMAC or GE Capital), credit card banks, trust companies and grandfathered non-bank banks are exempt from most supervisory requirements, simply because they were left out of the BHC Act. Firms (like Bear, Lehman, AIG, WaMu) simply owned one of these entities and could simultaneously avoid regulation while having access to the Fed’s lending if they got into trouble. This gave the public no risk management function but sole responsibility should they encounter significant risk. Heads I win, tails you lose. Financial companies should not be able to escape consolidated supervision by technicality.

4) Systemic risk regulation. The proposal creates a new category of Tier 1 financial companies which will be overseen by the Federal Reserve. These would be firms whose failure threatened the entire market, and would be subject to coordinated and robust prudential regulation. Bank holding companies consist of so many separate entities that they can have a dozen separate regulators each and allows firms to arbitrage the differences to their advantage.

5) Consumer financial protection. A central catalyst of the ’08 recession was the set of uninformed and stupid decisions consumers made- like buying houses they couldn’t ever afford or signing up for credit cards with early payback penalties. The proposal observes correctly that finance and economics have a distinct world view, one that does not manage the cultural, psychological and communications challenges inherent in good consumer advocacy. There are bright lines that could be established, but it takes clear authority and communication otherwise it will likely die in the interagency process as it has for decades. Without clear responsibility for common-sense consumer protection there can be no accountability. There are consumer protections for seatbelts, kids toys and lawnmowers, it's time for some for households' budgets too.

6) Office of National Insurance Regulator. The U.S. regulates the insurance industry essentially entirely at the State level and is the only G-20 country without a national framework for insurance oversight. There is clear executive will to do so, now we need legislative consensus.

7) Office of National Bank Supervisor. This would consolidate the Office of the Comptroller of the Currency (which regulates interstate banks) and the Office of Thrift Supervision to oversee all national banks. One office in Treasury would have sole authority for national banks and be able to provide consolidated prudential oversight rather than the current fragmented system.

8) Financial Services Oversight Council. This would force regulators to actually talk to each other and coordinate policy while closing gaps in regulation. In ’08 we saw a fundamentally ad hoc response among the Fed, FDIC, OCC, Treasury and others with predictable turf wars and inefficiencies. Before any major action, like designating a firm a Tier 1 Financial Holding Company or intervening in an institution’s distress, this council would meet to have an integrated approach. It would be a consensus building forum while avoiding the tenuous nature of decision by committee by giving the Treasury Secretary executive authority as the Chairman.

9) Central clearinghouse of derivatives. This would establish a central resolution, clearing and payment exchange for derivates. Most derivatives today are cleared by JP Morgan and Mellon Bank of New York, so creating a consolidated exchange would be eminently doable. By providing transparency in this market, it would not prevent dealmaking, hedging or economically valuable speculation, it would just provide basic information to inform the price discovery mechanism. It was a surprise to most of the world that AIG had a hedge fund grafted on top of it that had drunkenly bet the house on the U.S. housing binge. If people could have seen this, the asset valuation collapse could have been incorporate in prices in near real time and prevented a huge dis-equilibrium and subsequent quick collapse. Contrary to popular misconception, this proposal would not prohibit custom derivatives.

People on the Hill who have better ideas should put them forward, but a system that allowed the consequences of the last year is definitionaly in need of repair. Just ask a harried former Republican Treasury Secretary.

The Audacity of the Grand Bargain

Seventeen years after George H. W. Bush signed the United Nations Framework Convention on Climate Change, committing the U.S. to seek greenhouse gas emissions limits, one chamber of Congress finally passed the first U.S. climate change bill in history. Coincidentally this fell on my birthday- I always thought I was the climate messiah. Too bad the 1300 page American Clean Energy and Security Act of 2009 is full of so many complicated, unnecessary and potentially dangerous provisions. The proposal commits the U.S. to reduce emissions 17% below 2005 levels by 2020 and 83% below by 2050, sets up a 20% renewable energy portfolio standard by 2020, and establishes a menagerie of committees, criterias, offsets, definitions and standards on how to measure and verify everything, all to be figured out later when these regulations are drafted.

This bill hands out all rights to emit carbon dioxide and five other gases to industries for free, in direct contrast to Obama’s campaign pledge. The results are windfall profits and the potential for an energy driven asset bubble. It provides no assurances that the price placed on carbon will actually be one that makes clean energy profitable, which was exactly the experience in Europe when they established the same system in 2005. Credits were handed out for free, and in order to get votes everyone got a big piece of the pie (resulting in more credits being handed out than there were emissions), and the price has hovered at near $0 per ton ever since, while Europe has lived with a huge regulatory bureaucracy and burden while actually increasing its greenhouse gas emissions. And if the price of carbon gets “too high”, well then more permits are handed out for free to lower the price. And if the price is still too high, well then the cap no longer applies, so everyone paid a lot of money for a big complicated system that didn’t reduce emissions. Not to mention that we are in the midst of the worst recession in three generations, largely precipitated by an asset bubble and excessive speculation in the housing market, a market that has been studied and regulated for hundreds of years. This bill sets up a multi-trillion dollar market for the next 50 years, one in which the U.S. has no experience. The same people who pushed this through so voraciously will be the same ones decrying the excesses of carbon credit default swaps and derivatives in 10 years after we have seen another huge unsustainable bubble pop.

Then there is the issue of offsets, new emissions credits that can be generated when firms offset their emissions with something that captures carbon. Except, what exactly that means and who measures it will be figured out later by the Department of Agriculture. This will take years and many lawsuits to resolve, and even then the standards may be overly broad and subject to some very clever abuse by Wall Street, who frankly I put my money on over USDA any day of the week when it comes to cleverness. Not to mention the agriculture community is in large part the regulated party, a slight conflict of interest. Then there are the trade sanction provisions. This will allow the U.S. to bring action in the WTO and UN against countries who “artificially subsidize” their products by not attaching the same carbon price as the U.S. India and China have already drawn a line in the sand and said they will reciprocate any climate change tariff or quota and challenge our actions via arbitration, which typically takes about a decade to resolve. Of course by the time this is resolved we’re already supposed to have reduced emissions nearly 20%, so we’ll either have to march on with significantly high energy costs while India and China walk, or wait until a nasty trade dispute is resolved. And of course the bill raises $650 billion in new tax revenues, not to be recycled back to the American people.

Much superior to this convoluted grand bargain, we should place a price on carbon so it is the cheapest alternative, rebate it back to the American people, and cut out 1000 pages of special interests pay-offs in the process. If we want a clean energy economy, we don’t need the government telling every business and consumer exactly how much carbon they can emit every year for the next 50 years. And we don’t need dozens of new programs and thousands of new bureaucrats trying to figure out how much we’re emitting in the first place. All we need is for clean, renewable energy to be cheaper than dirty finite energy. If clean energy is cheaper, consumers will buy it, there will be demand pull. If clean energy is cheaper, it will represent a larger profit margin and greater return on investment for producers, there will be supply push. The price is the market maker, not the government. This bill could very well result in the grotesque situation of firms producing unprofitable products for consumers who are forced to pay more for them. Many people on the Hill act as though once you acknowledge the reality of climate change, there can only be one way to address it. There is no discussion of the multiple potential approaches and associated tradeoffs. Just one bill, and a lot of gray-haired men ramming it down everyone’s throat. The consequences of such little context for debate could be some very unintended consequences.

The Obama Administration is pushing hard on so many mega issues- health care, financial regulatory reform, energy and climate change, the largest budget in the history of the world, and now it looks like immigration too. The implicit tradeoff with this ‘boil the ocean’ approach, in contrast for instance to a more incrementalist one, is it requires engagement with the entire universe of very powerful special interests. You either have to commit to hard slow negotiations with the lobbies, and take very public and potentially damaging defeats in the process, or give them broad sway in order to get votes and flattering headlines, but live with policies you may come to regret. Obama and chief whip Emmanuel have consciously chosen to attempt to complete their entire agenda in what would be a truly historical first term (and guarantee for a second) in exchange for being very willing to play ball with the interests they want to regulate. The stimulus was a prime example. The White House sent a list of broad goals and top line numbers up to the Hill, and like throwing meat to a pack of ravenous dogs said, “fill in the details.” Lobbyists get a bloated bill full of new government contracts, Congress gets the support of their local haymakers, and the White House gets a resounding legislative victory. We also get a lot debt, a still increasing unemployment rate, and a bill the American people are increasingly souring on. If all that bill produces is a few hundred thousand jobs, and nearly a trillion dollars in new debt, that could be just the opening the GOP needs. (*POSTSCRIPT: Excerpt from Fall 2010 Paper: "Mr. Obama is already faced with the reality that voters have, fairly or not, decided that his first big effort to revive the economy, the $800 billion package enacted right after he took office, was a qualified failure, and that anything tagged as further 'stimulus' will be cast by Republicans as throwing good money after bad.")

And if all this climate bill produces is mountains of new regulations, costs, and system gaming, with few emissions reductions (like Europe), then the White House just gave the GOP a gaping hole to meander through. Obama said at the time he was pushing the stimulus, "my job depends on this bill"- he knew the risk he was taking. If politics is the art of the possible, then this is some very fine art. Perhaps it’s impossible to achieve much better, but we won’t know unless we try. The bill that was passed Friday shows more about how many people want to be Rahm Emmanuel’s friend, and who don’t want to cross Henry Waxman, than about who wants to actually usher in a clean economy in the most efficient way.

Stress Testing

Banks do stress tests all the time, you can’t plan for what you don’t understand or measure. And banking supervision is a full-time job. Balance sheets change in value daily, new assets come on the books daily, and the economy is fluid. Banks have full-time examiners who are continuously measuring their loan levels, estimating the potential loss exposure, and then requiring loss reserves accordingly. So the idea that these stress tests were rolled out as a big bold new policy, and then so publicly announced, seems off-base and represents an unnecessary policy risk.

One, the necessity of these “new" tests just show that the regulators failed to begin with, that they didn’t even know the basic exposure of the banks in the first place, and still didn’t. And two, the whole basis for the test is to prepare for contingencies, things that haven’t and very well may not happen. Like a “stress” case and a “worst” case. Chairman Bernanke characterized these cases as “unlikely”, yet they are the basis for requiring firms to raise more capital, either by selling off potentially valuable assets (like Citi did with its Japan brokerage), diluting existing shareholders by converting government loans to common stock, or by taking on more debt. All things that shouldn't be done simply because of unlikely assumptions. In addition, the tests created significant anxiety and hurtful market expectations for weeks preceding the tests. Once the results were leaked and it was clear the banks already had the ability to close the so called gap, the market cheered accordingly. But what if the gap was much larger, then this policy would have created a panic of sorts, causing many funds and investors to dump financials further- tangibly hurting the bank’s ability to raise capital, all because of hypothetical and “unlikely” assumptions about capital they might need should the situation deteriorate. Except that the reason for the deterioration could have been the anxiety created from the tests themselves. Thank goodness the banks had been stockpiling money for months anticipating this- if the gap had been larger this stress test would have just set back a huge rally by throwing its full weight behind assumptions and creating a self-fulfilling prophecy. To minimize this risk, the tests should have been called simulations and been completely internal between the supervisors and banks, so regulators could know exactly how much capital to inject under worsening conditions, and the banks could come up with a plan to execute in such an event. Instead, by forcing the banks to raise the money automatically, and practically broadcasting every discussion with the world, it was akin to evacuating a theatre full of people just as the curtain starts to rise because, well there’s no fire- but there could be.

This policy was a big roll of the dice and continues to show the youth of Treasury Secretary Geithner. These sorts of tests should not be confused with reality, and should be routine functions of the supervisors, not spectacles we all hold our breath for. Additionally, why they used tangible common equity as the definition of capital and not Tier I has yet to be answered. The big banks have 10%+ of capital they could access, but only about a third of it is common stock (considered a safe liquid asset). So, these tests probably understated their true capital level by about 70%. I’m glad this turned out as well as it did. But it’s only because we lucked out and didn’t have a full stampede out the door when the government yelled “fire!” in a crowded room.

The Markets could use some Pepto Bismol

As the stock market continues another whipsaw reversal of recent gains, counter intuitively 90 minutes after the largest deposit institution in the country reported double the profit from a year ago – I have one question: how is it possible that the markets, particularly financials, will not recover? Even disregarding the across the board strong profits of the remaining major financials in the last quarter, I defy anyone to explain how the fundamentals will not lead to a strong rebound in the mid-term (becoming shorter every day). Another interesting question is how much of the major bankruptcy and wealth destruction we’ve seen is a result of the bubble bursting versus people reacting to the bubble bursting? Washington Mutual for instance had significant write-downs on mortgages, but it also had $16b in withdrawals in its final week and a 90% drop in common share value over just 6 months. A situation like this will throw any company into trouble, whether it has a toxic or fortress balance sheet.

This is an especially interesting question because writedowns on assets are not losses. One, they are not realized, they don’t represent an actual outflow of cash, just a revised downward multi-year estimate which effects the current valuation, and two, they only really effect cash flow to the extent the market reacts adversely. Write-downs are serious and hurt balance sheets, but it is generally a very long-term signal with a lot of noise. Long-term because mortgages and bonds typically have a maturity lasting decades, and noisy because the characteristics of these securities as a whole is always changing based on the current underwriting standards of newly issued assets. But the market (read herd) takes this rather broad signal and immediately forces a translation into very short-term price signals. And I’m not sure the conversion factor is always spot on. To date the banks have written off several hundred billion in mortgages from their balance sheets, a significant shock no doubt, while the stock market has shed over $2 trillion in wealth. In other words, the market capitalization losses sustained is something like six times the actual writedowns. This is an even stronger shock when there is a run on existing contracts, from deposits to insurance product. The government realized in the 20s the unnecessary and preventable impact such reactions could have, and the FDIC has largely prevented it in commercial banks. That no such authority existed for multi-unit banking corporations like AIG or Lehman was rather remarkable considering how central to the financial system they had become.

Rather ironically, the only long term threat I see to robust bank recovery is the federal government. Unless people suddenly break a 10,000 year tradition, people will need shelters, likely, I know this is a stretch, in the form of houses. The rate of population growth and replacement dictates that about 1.3 million new homes need to be built in the U.S. as an annual baseline. In the last 12 months something like 400,000 were built. So the actual housing recovery timeframe is just a function of how big one thinks the bubble is, how big the surplus inventory is. I don’t think it’s much above 1 million, and we’ve already burned off about 900,000 of it. The rubber should finally hit the road soon. And once we get back to a supply-demand driven housing market, it’s hard to imagine that all these homes won’t require financing. In fact, 99.9% of them will. Pretty much everyone who doesn’t have a Louis-V with a milli in it like Lil Wayne will need the services of Bank of America or Citi or Wells Fargo. Thus, their first quarter earnings don’t seem to be mirage at all, more like a harbinger.

So there is more recovery in the pipeline, particularly when most of the recent earnings came from fixed-income arbitrage in a historically robust bond market. I have yet to hear anything close to a lucid argument that explains how housing and finance will not recover. And because prices have been falling for 16 months now, when it does turn it will likely have some strong inflection points. Balance sheets could reinflate relatively quickly as sideline homebuyers finally get on the field. The only potential long-term complicating factor here (assuming underwriting standards improve) then is the little issue of either servicing the government’s preferred stock loans, or worse selling off their common stock should they choose to convert it. The government should only consider converting their shares to equity if the stress tests show huge gaps that can absolutely not be filled any other way. And considering Citi, BoFa, JP Morgan, Wells all have 10% plus Tier I capital, and Treasury has $100 billion in the vault from TARP, and Goldman and Morgan already want to payback, I think the extent to which this has already been considered and bantered about as a serious idea is borderline irresponsible. We already know the market’s response to this rhetoric will dwarf the actual effects of any such real action. In fact, if the current sell-off continues investors can literally do whatever they want.

GM/White House need to think outside the box

The auto industry bailout should be a coordinated framework to re-imagine personal transportation in this country- including electricity providers and boutique next generation auto startups, not just two imperiled giants. Focusing simply on making GM and Chrysler cash flow positive with newly innovated offerings and lower debt burdens might do the job, but it ignores how integrated and market-infrastructure dependent the auto industry is. After this perfect economic storm, there will very likely be little space in the future for the government to intervene wholesale across the financial and auto landscape as they have in the last 6 months, and little opportunity to bridge the auto manufacturers and electricity producers’ interests.

The Administration only has so much credibility in lecturing the private sector how to make a buck, and only so much room to leverage the benefits of examining the sector in totality. By focusing on the manufacturers in isolation, the government risks supporting fuel efficient vehicles while leaving electric infrastructure developers on the sidelines. The Energy Department has $100 billion in new loan/grant authority, and could indirectly support the automakers by investing in companies like Better Place and Coulomb that develop the electric fueling stations that are a prerequisite for any true Detroit game-changers. The plug-in electric gas hybrid Chevy Volt will be substantially more expensive than an average car to begin with, curtailing sales and lengthening innovation cycles while stalling recovery. Costs will come down only with significant volume, which is a mere pipedream absent a national charging network. And in a world poised to add a billion new cars in China and India in the next 20 years, this is no longer just a matter of pristine design, but self-preservation. Making sure the market infrastructure is there when the new Volt rolls off the line is just as important as making sure they have competitive compensation agreements or streamlined supply lines.

Similarly, private startups operating today at the forefront of auto development, like Tesla Motors, could benefit from the breadth and relative financial depth of the big automakers, while the big automakers could benefit from their new platforms and next generation technology. Joint operating agreements or tech for equity swaps could speed up the bigs’ innovation while giving struggling and investment heavy startups (Tesla is asking for government cash) the market exposure they need to drive costs down. A note of caution however, this is not to say the government should impose anything. The big prize that awaits in the coming years and decades for clean energy winners, and the fierce competition among private actors it will engender, is a catalyst that should not be muted. However, the government and its auto task force is the perfect forum and moderator for getting these parties in a room to talk and see what pencils out. At a minimum they could talk about the non-exclusive aspects and infrastructure they will all need and brainstorm a general strategy, and at most cut some very lucrative deals.

It’s always the time for bold thinking, but very rarely is there the opportunity to actually implement it. The current public appetite for grand new economic architectures (whether TARP or TALF or the Legacy private-public partnership or the auto bailout or the Housing Plan or the Stimulus) is fast dissipating. Ad hoc investments in whatever the market would bare got the industry to this point, and ad hoc government negotiations and a spattering of tiny grants all over the place will just be further death by a thousand cuts.

Squeezing the Triggers

Former Treasury Secretary Paul O’Neil talks in his book about how in 2001-2 he and Fed Chairman Greenspan preferred a “trigger” approach to the then proposed Bush tax cuts. They wanted to cut taxes in phases depending on the future growth of revenues relative to budget needs. There was a current account surplus at the time, and so they had no problem cutting revenues, but they wanted to do it in parts so that if a budget deficit opened again they could achieve some balance between future needs and tax reductions, by not pulling the trigger on the rest of the cuts. It was a good idea because it was extremely policy neutral. It did not oppose tax cuts at all, and would have let trillions of dollars of them go forward, just so long as they were real cuts, not just an intergenerational transfer. I think the same idea of triggers could have been useful with the American Recovery and Reinvestment Act.

Congress could have developed three $250 billion segments, with only the contents of the first chunk really spelled out in the legislation. The first segment would be spent immediately, and the President and his advisers would submit a plan to spend the other two when they needed them, allowing them to adapt as the economic situation evolves. This would have focused funds on the areas where they can be spent the fastest, made passing the bill even quicker, allowed an opportunity for “lessons learned” in the remaining two sections, allowed the nation to essentially test how well the stimulus worked (for instance by comparing White House job creation estimates to reality), given control over the amount added to the deficit by not spending the whole amount if the economy began significantly rebounding, and essentially improved the package over time by seeing where the most jobs are created for the least amount of money and where investments enhance productivity the greatest.

Now anyone in favor of the stimulus would surely point out that it was so big because the challenges are so big, and two, passing it once was no sure thing, so why repeat it. On the first point, in all actuality there are very real constraints on how fast that volume of money can be spent. Infrastructure grants typically take 5 years to administer, any job in an emerging field (like green energy) by definition has a scarce labor market and so there needs to be new technical training and certification, which can take years. Even just obligating the money, e.g. signing contracts to spend it, is subject to either a formulaic application process, competitive bidding, or the state legislative process – all of which takes time. And then often there is design work or studies that have to be done before people can even be hired. That’s why the White House estimates about 75% of the funds will be spent within 18 months. That’s quick, and about as quick as it could be reliably done, but it’s by no means particularly streamlined. So long as the three triggers are pulled within a year or longer, the funds will get out the door at the same rate as the consolidated version, and because of learning and technology, it might even become more efficient. Right now Energy Secretary Chu, a brilliant Nobel chemist, has over $150 billion in credit authority that he can place basically anywhere he thinks will advance green technology and create jobs. And understandably, he’s still trying to figure out the best way to do it. This inevitably involves wading through thousands of applications from mainly promising sounding companies who applied via their states for a piece of the action. Figuring out which ones to give money is tough. Figuring out how to make all those loans into a cohesive system is tougher. And knowing if you spent the money as well as could be done, for instance that you didn’t deny the next Google of energy, is probably impossible. If the money was spent in waves, and appropriated in triggers, they could adapt their lending based on real results in the field and be surer that they’re making the best investments for the economy and for the future. The worst situation would be to invest in an idea or project that becomes obsolete, then people are unemployed all the same once it’s built, but then are stuck with a less productive economy because of antiquated technology, and now will have to pay higher taxes to pay off the debt from the stimulus. A triggered approach would provide real-time information to make the soundest investments.

On the issue of passing three parts, one has to look no further than the Troubled Asset Relief Program. It had two parts, where the President had to request to use the second half of the funds and get a majority vote to receive the funds. Now I think the TARP has been very successful given its point. There was a clear and present risk of systemic failure of the credit markets in early October. In the course of a week there was a string of huge financial institutions failing, and each one lost weakened the remaining. Since TARP passed and the banks recapitalized, there have been no major failures and now that basically seems out of the question. The point wasn’t to create a boom or solve every firm’s problems (in fact you don't want to do that because it deflates the important value of risk appreciation), it was to ensure the continued operation of the capital markets, and it did. Secretary Paulson and Chairman Bernanke had essentially a weekend to come up with a plan, and I think they did a brilliant job. And they structured it in a way that taxpayers will almost certainly see every dime back. So the stimulus could have been done in the same way, where the President has to submit a plan for spending the remaining section when he wants it, and then a 51% vote is required in Congress. Given the majority’s comfortable cushion, the request could be passed in an afternoon. Only the bill itself authorizing this structure would require 60%.

I also think that the stimulus bill could have been more creative, and not cheesy idealistic creative, but 21st century creative. Basic infrastructure is important. We need bridges and wastewater plants and sidewalks. States and localities already spend enormous sums on this every year and there are large revolving funds provided by the federal government annually in these areas. The stimulus needed $100 billion immediately going to the states to cover current deficits, and it needed money for basic infrastructure and schools and transportation. But how about incentives for new investments? What about a venture fund to invest in new research and companies? In a hyper-competitive and growing (on net over the 21st century the world will almost assuredly see the largest creation of wealth in history, China and India alone are on pace to pull almost half the world into the middle class) we must make long-term investments. As Friedman recently wrote, what about recruiting the best Ph.D’s from around the world by issuing more skilled worker visas, so they can build companies here and create new demand via buying surplus houses and supporting American businesses? The world becomes less brick and mortar every day, yet this bill seems to lay a lot of bricks. This stimulus is probably one of the greatest domestic policy achievements of a President in the first month in office ever. There is no perfect policy, yet this one is quite good. How good is very hard to know, unless you waited for some of the smoke to clear before pulling the trigger again.

Improving, not just saving, Social Security

Yeah, yeah, yeah. You’ve heard it all before. Social security is not looking so secure, but why does it really matter? I think most people would probably say because it would certainly be nice to get that monthly check in the mail once they’ve retired, particularly when 7.5% of every paycheck is taken out for it. Who likes to pay something for nothing? After all, the current system is projected to take in less money than it pays out around 2017, which means it will eat up the budget, which means even tighter capital markets and higher future debt. And then of course it’s projected to go bankrupt in 2040. It’s all very boring.

But the bigger reason we should fix social security - and not just patch it up with a million clever little ideas, say by lowering the inflation index or pushing back the retirement age, which will succeed only in postponing insolvency and making people work harder for less, but not really improve anything - is because of the enormous… opportunity cost! I wish it could cut aluminum cans in half or something, but we’ll have to settle for opportunity cost. Think about the difference between every dollar of your paycheck that goes into the Social Security Trust Fund, and then is subsequently spent immediately and preserved in the form of debt, versus every dollar going going into a well balanced mutual fund and earning interest. And then multiply over, oh, say four decades. Say on average you make a real income of $50,000 a year for the next 40 years, and the standard 7.65% of this is contributed to payroll taxes, this is $153,000 in principal. When that money goes into the Trust Fund, the government at best will nullify the deleterious effects of inflation, and worse yet, may actually lose purchasing power depending on the spread of government bonds versus inflation, or still worse, may decide never to pay it.

On the other hand, pick any ten year period of the stock market, any 10 year performance period of Wall Street, and the average returns will never be below 7%. Not during the Great Depression, not during S & L or dotcom, not now, not ever. Business cycles are real, they happen, but the ups and downs average to a healthy trend. Saying something is reliable because it has never failed is all you can really go on. For instance, people banking on the Social Security Trust Fund paying them out around the middle of this century often cite how much more reliable a Government IOU is because the government has never defaulted on its debt. True, but then the rationale of the safety of Wall Street is no less reliable. The government has never defaulted on its obligations. And Wall Street has never produced less than 7% per decade in returns, let alone a loss. So say over the 40 years you’ve contributed that $153,000 to the government and the market just hits the bottom of that 7% return, you still turn that money into over $600k. Assuming the best, this is a 400% difference from what the government would pay out, a very steep opportunity cost. Now there are no guarantees. And if people would like to play the “more conservative card” of just paying into the fund and getting a government guarantee, they should be able to. But, just like U.S. Senators, people should have the choice to contribute their income into actual funds. The Regular ol’ Person system could be essentially the same design as the Senators’. There would be a pension board that oversees 5 or so broad investment plans, divided by their equity/fixed income ratio, but all diversified and managed by professionals and overseen to regulate leverage and risk (something missing since about 2004 when the SEC removed net capital holding requirements). The point is people couldn’t just invest wherever the mood struck them, there would be a small menu of balanced funds to choose from. And because of the simplicity of the rules - 5 plans, no more than 10:1 or so leveraging, it would be clear whether funds were being abused/Madoffed in any way.

I hope that any future modification to Social Security does not reflexively deny individuals a choice in how their earnings are used. I think this is the compromise that can be struck - people who like the current system (retooled with some painful actuarial adjustments) can stay with it. But not allowing individuals a choice to place their payroll earnings into a balanced fund seems to me to be denying people an awful lot, and for nothing but the concerns of other people who would be unaffected. It would have the added benefits of freeing the government up from a lot of debt and providing much needed private capital injections to our financial institutions. A lot of this could be used to do things like deploy clean energy, build smart grids, in short create good jobs. And of course there are details, there always are. When money from current workers is placed in an investment fund, and not siphoned towards current retirees, there will have to be bridge financing in the form of more debt. Yet so long as much of Asia has a 30% savings rate, and so long as there are sovereign wealth funds, there will be ample capital to absorb a few more government securities. Plus, paying these off in the future will be easier than waiting for the system to slide into debt and paying then, as the pension system will be more sustainable and profitable thanks to new productivity from deeper capital markets and decreased government retirement obligations - meaning a broader economic base. And there will have to be cut off points for when people can make the transition. And there will have to be a little bit of private earnings skimmed by the Board as reserves to provide insurance to people who might pick particularly unlucky times to retire – in this way they would be guaranteed a minimal payment not below the regular system. Bueller?

But the point is, legitimate debate about the system doesn’t have to ruin anything. Those who think the government is the best universal retirement planner and want that legal guarantee can have it. And those who would prefer to fund government managed private investments with their money can do that. Now this is bipartisanship This isn’t a parlor room discussion or a game of gotchya between editorialists (oh how Stiglitz, Krugman, Summers, Brooks et. al. love to seem the smartest guy in the room). It’s a very pragmatic day-to-day kitchen table decision. And I think given the choice, people should be given more opportunity, not less.

On another note, the CBO recently scored the House stimulus bill. It estimates 7% of the energy investments will be spent within 2 years and less than 50% of the transportation dollars spent in 4 years. This is too slow to provide immediate stimulus and generally conforms with what the Council of Economic Adviser's new chair Christina Romer has shown in her work. I think the second half of TARP ($150b to buy up worst assets, $150b for continued recapitalization and $50b for mortgage refinancing, which could save 1m+), combined with a more focused $100b stimulus could have great effect.

Peace in the Middle East

Almost as reliable as the turning of pages on a calendar is the cycle of violence in the Israeli-Palestinian conflict. Here’s to ’09 being a peaceful year in the Middle East, but it’s looking all too predictable. Let’s be clear – the rockets being launched out of Palestinian territory that perennially kill innocent Israelis is completely unacceptable. It is tragic, it is wrong, and it is terrorism. The international community is in agreement that the goal is to stop this scourge (and I would add there are many other goals, but this is the most immediate). The debate among reasonable people seems to be what the best mechanism to achieve this end is. I would argue that there needs to be considerably more effort placed in pulling the rug out from under extremists by drying up their recruitment base and trying to fill the vacuum that is left by poverty and deprivation. The June '07 illiberal democratic election of Hamas is entirely predictable given the extreme living conditions in the West Bank and Gaza. Crippling poverty, hugely underproductive land, overpopulation, disease and little prospect for the future, not to mention connections to many family and friends who have died in previous violence, makes for the perfect platform for extreme ideologies to flourish. Reverse these conditions and you will almost certainly see a considerably more liberal democracy emerge and Israel achieve its objective of not having a terrorist organization ruling across its border. I think we have seen for decades that the current approach (heads of state signing pieces of paper and militaries launching offensives) has not produced a lasting solution. Decrees, promises, foreign observers, summits, envoys, seem to be trying to force a solution in many respects, rather than trying to actually build one . So long as the fundamentals on the ground remain the same for millions of people in Gaza and the West Bank, these top down solutions will likely continue to lack a mechanism capable of enduring stability and peace. It is imperative that sovereign countries protect themselves, yet so long as innocent blood is spilled on both sides, and so long as there is extreme poverty and deprivation (particularly in Gaza and especially under the current blockade) there will be no scarcity of people willing to give their lives for tragically backwards causes. This is exactly why Defense Secretary Gates, in an unprecedented move, lobbied last summer for a doubling of the foreign assistance budget for the State Department, because he knew it would translate into direct security benefits.

The best long-term approach to weakening radical extremists (like elements of Hamas) is to eliminate their resource base. Yes this means more traditional approaches like cutting off supply lines and raiding weapons caches, but even more it means providing an alternative of hope in the face of despair (and just as importantly, being seen as providing an alternative). Extreme poverty and deprivation is a surefire accelerant of extremism. Over a period of years if the international community, perhaps led by Israel, were to step up humanitarian relief and development assistance for its impoverished Palestinian neighbors, I think it is very likely that a vast majority of the extremist recruitment base could be dried up. Clothes, food, medicine, fertilizer, seeds, generators, schools, community centers, hospitals - basics - would help ensure another generation of youth is not caught up in the cycle of a false but often too attractive violent ideology. Extreme ideology feasts on the kind of fatalism brought upon by miserable conditions. Such assistance would literally be the physical embodiment of a neighbor’s compassion and would win hearts and minds from ideological zealots. Building an economy and investing in a viable alternative and moderate political coaltions will engender stability and a 2-state solution infinitely better than a team of pro negotiators and yet another rounds of furious document signing. One approach leverages a concrete mechanism to drive moderation, the other merely ordains it. Political parties are more an appendage of the prevailing situation and desires of the people than an apparatus capable of executing whatever U.S. statesmen broker. In other words, invest in a viable alternative, not simply agreeable language.

Ad hoc security crackdowns or another round of well-branded Summits will unfortunately fall short without treating the situation on the ground. Let's also be clear here - there will always be evil people for whom a military response is the only appropriate solution, and here Israel and the West must remain vigilant. Yet so to must the West realize that there are inherent risk factors that make it relatively much harder or much easier for extremists to operate. Opportunity and hope remains a vastly underutilized weapon in the war against extremism.

A Housecall for Incoming Health and Human Services Secretary Daschle

HHS Secretary-designate Daschle will have a lot on his plate. He will oversee the largest federal agency, administering everything from Medicare to the FDA to global health initiatives, at a time when his boss has promised massive reforms in healthcare. It’s going to be a tough job. To kick things off, Daschle has said he plans to embark on a discussion of healthcare reform with households all across America, a sort of big-tent experiment in brainstorming. This is a genuine and admirable goal, if not hard to understand coming from a man who has spent the last 30 years visiting people as a professional politician. Both Obama and Daschle have literally been on the road for years, and they are not short on (often very personal) stories about healthcare in America. But how could a couple more months of it hurt? I think Secretary Daschle should focus on three key areas if he hopes to simultaneously improve the quality of care Americans receive, and the number who receive it.

One, he needs to contain costs. Healthcare expenses are growing far faster than the revenue base is expanding and at the current trajectory, non-discretionary spending will eat up the entire federal budget in about 25 years. A good model of controlling prices can be found in Japan, where they have half the per capita healthcare costs and twice the per capita utilization rates as Americans. That sounds good. In Japan the government has sole purchasing power of pharmaceuticals and healthcare procedures. They use their massive negotiating power to exert downward price pressure on everything from the cost of antibiotics to the cost of an EKG. Private insurance providers can still design their own policies and set their own prices, but the basic inputs that go into those plans are purchased in bulk by the entire government. The same concept is already pervasive in the private sector, where a few key buyers negotiate entire supply chains. Secretary Daschle’s HHS would be a great place to house the Office of Negotiation, where they set up 5-year forward purchase agreements on the largest and most common drugs and procedures.

Second, just like decoupling in the electric utilities sector, there needs to be decoupling in the medical sector. Utilities over the last decade or so have realized that electric providers in a normal market have no incentive to be efficient; in fact they have an incentive for their customers to use as much energy as possible because it translates into larger profits. This results in excess energy usage and general inefficiency. This has been more or less solved via utilities taking a percent or two out of monthly electric bills and redistributing it based on a formulaic measure of a company’s energy efficiency. Suddenly energy efficiency is monetized and energy providers start paying attention. The same basic idea should be established in the medical industry, where doctors, particularly specialists, have an incentive to carry out, and charge for, expensive procedures. Daschle’s HHS should charge a small fee to existing healthcare providers (maybe .5%) and reward medical providers who are particularly efficient in their utilization. This does not mean doctors will be rewarded for not doing expensive procedures for sick patients who need them; it means they will have an incentive not to do procedures just because they are profitable (which is perfectly rationale). HHS could measure certain key and widely available statistics, like referral and utilization rates and costs per treatment at the institutional level, and then reward those institutions accordingly, decoupling profit from wasteful overutilization.

And three, if Obama and Daschle really want universal coverage they will have to subsidize about the lowest quintile of American households. This is a decision Americans will ultimately have to make, but controlling prices and rewarding efficiency will still not be enough to provide universal coverage. Obama proposes instituting a healthcare tax on employers who do not contribute to their employees’ coverage as a means to fund subsidy programs. This seems like a good idea, as it preserves price parity across the market, as every firm will have to meet the same basic operating costs (chipping in to provide basic healthcare and not free-riding on firms that already do). Revenues here could be distributed by Daschle’s HHS based on a family’s combined income level to provide basic coverage for the uninsured.

I don’t think Secretary Daschle will be knocking on my door anytime soon, but I hope that once he hears from all these households that he starts getting specific soon. Generic goals or hollow bromides have gotten us nowhere with healthcare reform in the past, and today’s no different. Healthcare reform will be a long difficult debate, and policymakers should start working on the nuts and bolts now. None of these ideas is easy or particularly desirable, but neither are higher taxes in the future for worse benefits.

The Next Industrial Boom

Carbon Tax Shift Reflects Broad Consensus

Jamie Dimon, Chairman and CEO JPMorgan Chase & Co. “We don’t have an energy policy, we don’t have an environmental policy, we don’t have an education policy, we don’t have an infrastructure policy. And folks, these are not partisan, ok? These are more long term. We may have, I’m going to call it institutional sclerosis. You’ve seen it happen with huge institutions, with the British Empire. We are unable to make some tough decisions, for example, it would be a shame to let gas go below $3.50 or $3.25 a gallon – we should add the taxes to BTU, charge energy. We’ll all learn to be a lot more efficient, it’s not that big a deal…And then you also have alternative energy, people aren’t gonna put $100 billion into alternative energy if oil can go back to $50. And it’s a commodity, there will be a surplus one day and it will go down. But that fortitude, someone’s gotta say the truth and help us get it done. And you the citizens of this country, I think we’re gonna have to give it back to lower paid people. You know, so they’re losing $2000 a year now on oil and on food, so it’s gotta come out of payroll taxes or low income, and we shouldn’t be selfish about it. We need a real policy, and once you have a real policy, a serious policy of the United States of America, oil future prices will start to come down…I think if we don’t get our hands around this energy issue we could severely damage the future health of the United States.”

Vinod Khosla: “From an investment perspective, the current climate finds businesses in a holding pattern, unwilling to fully commit resources because of what may happen next – carbon pricing and a fuller appreciation of the externalities of our current energy sources has the potential to blow the old investment models out of the water. What sane CEO would bet that no climate change legislation will be enacted in the next fifty years, the typical life of their investments? We must remove this unnecessary risk for our businesses. The devil we know is better than the one we don’t when it comes to climate change legislation.”


They don't come much smarter than Mr. Dimon and Mr. Khosla. And they are dead right that the way to solve climate change, improve our national security, and usher in a real, sustained economic boom for the next couple of decades is to tax income or labor less, and CO2 more. More incentives on good things and you get more of them. Less incentives on bad things, you get less. Just some of the wonders that follow from competitive, fungible markets with efficient price signals (and big externalities like climate change are not efficient!) A green (referring to both dollars and the environment) is by definition more efficient, or Pareto optimal. So let's get into the the details about one proposal that would do exactly what these gentlmen are proposing, the Carbon Tax Center's policy, which advocates a REVENUE NEUTRAL carbon tax - meaning it is not a tax hike! Rather it shifts the burden from income and productivity to dangerous greenhouse gases. CO2 should be taxed as upstream as possible, either at the well-head if it's domestic or the port if it's foreign. A good price signal would be $25/ton CO2. At this rate you could slice some $50 billion a year off income taxes, or the payroll tax, or just mail every American a check for a couple hundred dollars. And at this price, clean coal with carbon capture (IGCC + CCS) is cheaper than current coal, because of the tax savings from not emitting the CO2. Coal currently costs about 2.5 cents/kWh, clean coal about 10 cents/kWh. Prototyped concentrated solar power (CSP, like solar thermal, which is way better than photovoltaic and already has baseload reliability) today costs about 7 cents/kWh. Get it? At this price point solar beats coal! And this means lots of new investments and jobs and growth. And these technologies will not just create more economic opportunities, but better ones. It is estimated for instance that each gigawatt of solar thermal energy will require 3,400 construction jobs and 250 permanent employees, twice the rate as a typical coal or gas plant. (Krupp, 65) So now more digging....

The CTC’s proposed $37 per ton revenue-neutral carbon tax, ratcheted up the same amount each year over the next decade, is consistent with the recommended range of both the U.N. Intergovernmental Panel on Climate Change, and the influential Stern Review on the Economics of Climate Change. A $37/ton carbon tax is equivalent to about a $10 per ton tax on carbon dioxide. CO2 would then have a price of about $100/ton at the end of 10 years under the CTC’s plan, or about $80/ton CO2 when adjusted for inflation.

This price point is consistent with the range of recommended prices provided by the IPCC and Stern review, and close to the conclusions of the Inter-Academy Council of Sciences. It is the consensus of these reports that such a level would provide the long-term price signal necessary for renewable technologies, from solar-thermal to carbon capture and storage, to be deployed at scale. It is also the consensus that it would stabilize CO2 concentrations at the threshold level of 550 ppm by century’s end. Absent such a price signal, CO2 levels under “business as usual” scenarios are projected to triple from pre-industrial levels to around 840 ppm. The last time CO2 levels were that high was about 40 million years ago when crocodiles roamed the North Pole.

The Intergovernmental Panel on Climate Change cites a range of $20-80 per ton of CO2 equivalent by 2030 as the necessary level to stabilize emissions at 550 ppm. (IPCC Working Group III Report Summary for Policymakers, 19) The Stern Review cites a review of 103 separate estimates of the social cost of carbon gathered from 28 published papers. It determines the mean abatement cost from these estimates to be $29 per ton CO2 equivalent. (Stern, 287) However, the Review goes on to develop an economic model that more accurately incorporates the market valuation of risk from potential catastrophic climate change, concluding, “We would therefore point to numbers for the ‘business as usual’ social cost of carbon well above (perhaps a factor of three times) the Tol mean of $29/tCO2.” (Stern, 287) The report recommends a real CO2 price of $85/ton CO2 equivalent. The $80/ton real price of CO2 advocated by the Carbon Tax Center is then consistent with both the IPCC and Stern Review estimates.

The $80/ton CO2 price signal is also generally consistent with the conclusions of the Inter-Academy Council of Arts and Sciences. As the Inter-Academy emphasizes, it is far more critical that such a price signal be certain and long-term than it is to mandate emission cuts year by year, as a cap would do. As they write in their recent report, Lighting the Way: Toward A Sustainable Energy Future, “establishing in every market that there eventually will be an emissions price – in the range of US$ 27-41 per ton of carbon dioxide equivalent – is more important than establishing exactly the number of years in which such a transition will occur.” (Chapter 4, 131) The Carbon Tax Center’s policy would put the price of CO2 in this range over a period of three or four years. It would then continue to ratchet up the price of CO2 as the transition costs to clean energies decreased alongside the renewed incentive for the development and deployment of such technologies. These reduced transition costs would act to mute the economic costs of further CO2 price increases.

It is notable that all three reports, reflecting the consensus of the scientific community, determine that there is a clear threshold price level necessary to induce widespread clean technology development. Such a price level is far from guaranteed under a cap and trade system, where prices can exhibit significant volatility. Under the Chicago Climate Exchange for example, the largest traded market in the world for greenhouse gas emissions allowances, the price per ton of CO2 has fluctuated between $1-7 over the past five years since its founding. This falls $13 below the lowest recommended level mentioned in the Stern Report, IPCC or the Inter-Academy. Such a low price level per ton does not make clean energies cost-competitive, nor does it provide the necessary incentive to prevent harmful anthropogenic climate change. A carbon tax shift guarantees price-competitiveness for renewable energies.

It is estimated that in the long-term carbon dioxide will need a price per ton of at least $30 to make the vitally important technology of carbon capture and sequestration (CCS) cost-competitive. This is no small matter. As Stern notes, without CCS the world will need a “dramatic shift away from existing fossil fuel technologies” (Stern, 368). With atmospheric concentrations of CO2 already at 380 ppm, and almost certainly to reach at least 450 ppm in the coming decades, some scientists say we cannot reduce concentrations below 550 ppm without carbon capture and storage. Given the pervasiveness and entrenched interests of coal producers in both the United States and emerging economies like China, it is unlikely any mitigation legislation could move forward without meaningfully incenting CCS technology.

Dr. Klaus Lackner, Professor of Geophysics and Director of the Lenfest Center for Sustainable Energy at Columbia University, estimates the long-term cost of capturing and storing CO2 to be at or below $30 ton. He has pioneered a technology that can suck CO2 out of the air and store it safely underground in an inert solid form. As he comments, “With off-the-shelf items we have right now, I can drive the cost of CO2 capture from air below $100 per ton of CO2. And I feel that, if you pursue this longer, the ultimate end game will be below $30 per ton of CO2.” (http://www.pbs.org/newshour/bb/environment/jan-june06/globalwarming_06-08.html) If his forecast proves correct, a real price of about $80/ton CO2 makes widespread deployment of CCS a no-brainer. If CCS cost reductions prove harder to come by, $80/ton CO2 makes carbon capture technologies essentially cost-competitive at current prices. The Carbon Tax Center’s plan provides the necessary incentive for the deployment of CCS under either scenario.

The bottom line is that an $80/ton long-term real price on CO2 reflects a broad scientific consensus. It is the level needed to incent the critically important long-term deployment of carbon capture and sequestration technology. Without CCS, hundreds of new coal plants in developing countries will pour tens of billions of tons of CO2 into the atmosphere in the coming decades. Without CCS you will be ignoring 55% of current CO2 emissions in the United States. CCS is a game changer. With a cap system there is no guarantee, to firms or developers or society, that CCS is an investment that will pay off. At an average price of some $4/ton CO2, like we see in the Chicago Climate Exchange or the European Union, it would be much cheaper for energy providers just to purchase allowances (or not comply) than retrofit plants with carbon capture technologies.

A tax shift is not just better for the climate and emerging clean technologies than cap and trade, it also offers the greatest potential for political compromise. These political strengths were on full display during the recent U.S. Senate debate of the Liebermann-Warner Climate Security Act. Critics of the Act correctly pointed out that the cap and trade system represents an over $4 trillion tax increase, as about 50% of the revenues raised over the next 40 years via auctioned permits are kept by the Treasury.

Add on a “safety-valve” provision (which would put a price ceiling of about $12-22 per ton CO2 via the government releasing (worthless) permits as necessary to maintain the ceiling) there is no clear price signal for carbon capture and sequestration deployment, or solar for that matter. Additionally, with a safety-valve market participants would be forced to purchase and trade permits that don’t even maintain the stated emissions reduction goals, as they are above the cap. Throw in the potential for massive volatility, and it is unclear what the adjustment and abatement costs for regulated firms will ultimately be under a cap system. And this uncertainty will only keep more clean energy capital waiting on the sidelines. As the Wall Street Journal points out, The Climate Security Act would represent the largest income redistribution since the advent of the income tax. With a tax shift from income or labor onto carbon this potent and effective argument against tackling global climate change disappears overnight.

Additionally, by returning the revenues of a carbon tax to the private sector, foreign companies that do not yet have to similarly comply will not gain a competitive advantage as domestic tax levels will remain unchanged. Such concerns could also probably be offset with WTO compliant (particularly GATT Articles 3, 11 and 20 - paper I wrote on this) cross border adjustments (tariffs) for countries that have less stringent standards than the U.S. This however would lead to long and unpleasant arbitration and probably result in retaliation by large U.S. trading partners for years to come. The fact is that with a meaningful price on carbon the United States will see huge new economic investment and growth. Jobs and capital will flow to areas like direct current transmission lines, so called “smart grids” that allow consumers to sell clean energy back to utilities via feed-in tariffs, carbon capture retrofitting, and proven renewable energy sources, among many others. Once it is apparent that a revenue neutral price on carbon is a win for the economy, the environment and national security, other countries will not be able to jump on the bandwagon fast enough. With SO2, ozone and particulate pollution it was either the EU or U.S. who first led and lesser developed countries, like China and India, who soon followed. The same would happen if the U.S. led by putting a real price on carbon. The opportunities stare the United States in the face.

The CTC’s plan has the science right. It is consistent with every major international consensus report on the economics of climate change. It is consistent with the incentive needed for critically important carbon capture and renewable energy technologies. It is revenue-neutral, unlike the fatally-flawed Climate Security Act. And with the potential for commensurate tax offsets, ranging from corporate to personal income taxes, to the FICA payroll tax, to straight dividends returned to every household – it offers a tremendous opportunity for both increased economic efficiency and political compromise. Oh yeah, and it could save the planet too.