Central bankers this morning flexed a little muscle by, in effect, insuring money markets in Europe.  It was the collapse of money markets and short term interbank lending in 2008 that cratered the North Atlantic economies and brought on the Great Recession.   With that experience fresh in central banker’s minds, this morning’s action avoids a repeat of what happened in 2008.

Professional investors immediately bought equities which have been underpriced due to the anxiety created by Europe’s well chronicled sovereign debt struggles.

Being the lenders of last resort is good, but central bankers still need to attack the underlying problem of sovereign debt by, first, buying the debt en masse.  A couple trillion in sudden purchases, as in one or two days, would send the debt rocketing up in price as leveraged short sellers in the shadow banking system run to cover their shorts.  This would create huge losses in these synthetic markets (the markets use derivatives, not the underlying assets) not only for the shorts, but for the longs as well because counterparties would not be able to make good their side of the derivative contract.

After this ‘shock and awe’ bond purchase has killed the shadowy derivative based market, the central bankers can unwind their positions in the real bond market at their leisure.  And they will have few time constraints because most of the European bonds they bought will have been bought at huge discounts.  As for the derivative market, it won’t come back anytime soon due to the massive losses of its former participants.  These losses, by the way, will be matched in profits by central banks.

Equity and bond markets have evolved into pure casinos over the past couple decades.  The emergence of shadow banking, money markets beyond the reach of central bank supervision, has enabled huge leverage.  Central bankers were caught unawares in 2008 when this shadowy, synthetic derivative market collapsed because the underlying asset (housing) collapsed and central bankers discovered their regulated banks were participating in a big way.  To say these bankers were upset is a huge understatement.  They were, and remain, furious over the matter.

Central bankers have a monopoly on money and speculators in the shadow banking system need to be reminded in a very painful way about this fact of life.  It’s time for central bankers to take out the synthetic, inherently leveraged, markets–particularly in our current context the bond markets.  The same kind of power will need to be applied, sooner or later, to the commodity markets where speculative activity by non-producers/sellers has overwhelmed legitimate purposes and causes expensive and totally uneccessary short term price volatility.

The GOP has long since given up on using facts and mathematics to decide their policies because the facts and the arithmetic show GOP policies to be fantasies.

Nobel economist Paul Krugman, who blogs in the New York Times and forms his opinions after studying the facts and the mathematics, has become possibly the most damaging thorn in the side of the GOP as a result.    His most recent blog dismantles GOP charges that President Obama has somehow promoted more government spending and, as a result of that spending splurge, government spending has grown as a percentage of Gross Domestic Product (GDP).

The Obama Spending Non-Surge

Blogging is a lot like teaching the same class year after year; you’re always encountering the same arguments you’ve refuted in the past, and you want to demand why they weren’t listening the last time.

Anyway, what I’m seeing in comments and reactions, once again, is the claim that Obama has presided over a vast expansion of government — a claim backed not by describing any specific programs, but by pointing to the share of federal spending in GDP. Indeed, federal spending rose from 19.6% of GDP in 2007 to 23.8% in 2010 (it was briefly 25 in 2009, but that was a number distorted by the financial bailouts). So there has been a roughly 4 points of GDP rise in the spending share. What’s that about?

Well, part of the answer is that the ratio is up because the denominator is down. According to CBO estimates, in fiscal 2010 the economy operated about 7 percent below potential. This means that even if what the government was doing hadn’t changed, the federal spending share of GDP would have risen by 1.4 percentage points.

Then, look inside the budget data (pdf), specifically at Table E-10. You’ll see a surge in spending on “income security”; that’s basically unemployment insurance, food stamps, and similar items. In other words, spending on safety-net programs is up because the economy is depressed, and more people are falling into the safety net.

You’ll also see a sharp rise in Medicaid; again, this is because the lousy economy has pushed more people into hardship, making them eligible for the program.

I’ve done a bit of number-crunching, and here’s my allocation of the sources of the rise in federal spending as a share of GDP:

So a depressed economy plus safety net programs that have grown as a result of a depressed economy are, overwhelmingly, the real story here.

What’s in that “other” category? Some of it is stimulus spending. Some of it is the leading wave of the baby boomers, who are starting to collect Social Security and enter Medicare. Some of it is rising health care costs.

What isn’t there, no way, nohow, is a massive expansion of government, which is a figment of the right wing’s imagination.

Beezer here.  That darn Krugman!  There he goes again using his arithmetricks.

In a New York Times article by finance journalist Floyd Norris entitled For Business, Golden Days; For Workers, The Dross.

IN the eight decades before the recent recession, there was never a period when as much as 9 percent of American gross domestic product went to companies in the form of after-tax profits. Now the figure is over 10 percent.

During the same period, there never was a quarter when wage and salary income amounted to less than 45 percent of the economy. Now the figure is below 44 percent.

For companies, these are boom times. For workers, the opposite is true.

The government’s first estimate of corporate profits in the third quarter was released two days before Thanksgiving, at the same time it revised the rate of G.D.P. growth in the quarter down to an annual rate of 2.0 percent.

The report showed that effective tax rates, both corporate and personal, are well below where they were during most of the post-World War II era.

Corporate profits after taxes were estimated to be $1.56 trillion, at an annual rate, during the quarter, or 10.3 percent of the size of the economy, up from 10.1 percent in the second quarter. Until 2010, the government had never reported even a single quarter in which the corporate share was as high as 9 percent, as can be seen in the accompanying charts.

The government began calculating the quarterly figures on corporate profits in 1947, but it has annual figures back to 1929. Until last year, the record annual share was 8.98 percent, set in 1929. For all of 2010, the figure was 9.56 percent.

Wage and salary income was only 43.7 percent of G.D.P., the lowest number for any period going back to 1929. That figure first fell below 45 percent in 2009.

Beezer here.  The flood of data showing how corporations have been paying for less and less of America, while shipping jobs offshore to make more and more profits, continues.  Meanwhile, incomes for labor and the middle class labor supports, stagnated or as was the case between 2000-2010, declined in real terms.   Small wonder there’s an Occupy Wall Street movement. 

Over at the economic oriented blog Angry Bear, author Mike Kimel has been in a longer term investigation trying to determine what the top marginal federal tax rate should be.  Kimel’s work tells him that top rate should be at or close to 65%.   This rate, Kimel believes, provides maximum government revenue while also spurring maximum investment in the private sector.

Kimel, who is not an economist, has received some academic support from work by economists Peter Diamond and Emmanuel Saez.  These two academic economists (Diamond is a Nobel prize winner) argue that the optimal top marginal tax rate is about 73%–but unlike Kimel this paper includes all taxes, not just the federal ones.

Kimel also argues that non academics like himself may have some approaches that are superior than those used by academics.

As I noted above, my approach is somewhat simpler, and easier to follow than that of Diamond and Saez. Part of the reason is that they come at it from a point of view of elasticities. But with all due respect to my betters (Diamond and Saez, and Krugman as well considering the explanation in his post) I think this is the wrong way to consider the problem. It requires all sorts of assumptions and generalizations about people’s behavior, some of which are both false and create resistance from folks on the right.

For example, there is a notion that raising tax rates will reduce people’s willingness to work… which is only true above certain thresholds. (That threshold, of course, varies per individual.) As anyone who has ever had a business will tell you (when they’re not busy demanding tax reductions), you don’t pay taxes on income from the business if you turn around and reinvest that income. (An accountant would talk to you about decreasing your tax liability by increasing expenses which amounts to the same thing.) You only pay taxes on that income you take that income out, presumably for consumption purposes.

So to simplify, consider an example…. is a successful businessperson more likely to take money out of the business if his/her tax rate is 70% or if its 25%? In general, a person is more likely to take that money at 25%, as there’s less of a penalty. At 70% tax rates, there is more of an incentive to reinvest in the business, creating more growth in the business in subsequent years, and more economic growth thereafter. 70% tax rates are more likely to generate faster economic growth than 25% tax rates precisely because people are self-interested and the higher tax rates induce people to continue investing in things they do well.

(Of course, tax rates can get too high. At 95%, people will reinvest almost every dime… even if they have exhausted every good investment opportunity they have. Thus, to avoid taxes they’ll be making lousy investments which in turn slow economic growth.)

Beezer here.  Of course the steps up to the marginal rates, and how many there are (we’ve had as many as 35 such steps in the past) can dramatically affect the total revenue raised.  So too can deductions and other tax code items affect revenue raised.  But the main point of these excercises is that they aim at maximizing both economic health and social welfare.   If one has no interest in social welfare, and based upon the views of some elected officials we have more than a few in Congress today, then the dual mandate might not apply.  Still all three, Kimel, Diamond and Saez, believe producing the optimal top marginal tax rate elevates social welfare and economic health.  In their view the two can be achieved together.  Kimel puts it this way in the article: ”Simply put, you cannot maximize long run social welfare if you aren’t maximizing economic growth.” 

The way a nation’s bookeeping works is that if the government is running a deficit, then someone else has to be running a surplus of the same amount.  The problem can become that those who are running those surpluses simply don’t want to spend or invest their savings.  But in order to reduce government deficits, they have to spend or invest an equal amount–whether they want to or not.

Our response to this hoarding of money (and it is hoarding) is to tax it if it isn’t spent or invested.   ‘Use it or lose it,’ should be the government policy when idle, hoarded cash cannot otherwise be dislodged so that the government can reduce it’s spending and thus it’s deficit.

Martin Wolf explains this very well in a recent Financial Times article.

If the private sector is seeking to run down its debts, it is hard for the government to do so, too, because everybody cannot spend less than their income. That is the “paradox of thrift”. No, it is not a novel idea…..

Net lending – the difference between savings and investment – of all sectors of an economy must add up to zero. If the government is running a huge financial deficit – that is, spending vastly more than its revenue – then other sectors must be spending much less than their income. And so, indeed, they are.

In the second quarter of 2011, the government ran a financial deficit of 9.3 per cent of gross domestic product. Counterpart surpluses were 1.6 per cent of GDP for foreigners (the inverse of the current account deficit), 1.7 per cent of GDP for households and as much as 6.4 per cent of GDP for corporations. The US picture is similar: in the third quarter of 2011, the deficit of government was 9.1 per cent of GDP. Offsetting surpluses were 3.3 per cent of GDP for foreigners, 2.2 per cent of GDP for households, and 3.7 per cent of GDP for business.

Beezer here.  The two largest surplus components are businesses (who are sitting on a couple trillion in cash at the moment) and foreigners who for the most part are paying us to take their surpluses (negative real interest rates) so they can hold these surpluses in safe dollars.  Rather than simply tax away the corporate surpluses, the government could issue billions of dollars in infrastructure jobs which would, in turn, spur matching corporate investment and the so far elusive hiring of the unemployed or underemployed.    This boost in employment will have the additional positive effect of allowing the private, household sector to deleverage.  The more households delever the more this sector can spend and invest.  And believe it or not, if China stopped sending us their surpluses it would help us trim our deficit.   But China can’t do this because this is how they cheat in the currency markets to keep their currency undervalued, and their exports underpriced.  Trade deficits aggravate this problem because they represents domestic spending that is a deduction from GDP and a corresponding addition to foreign economies.  A major source of these trade deficits comes from our importation of foreign oil.  The less we spend on foreign supplied energy, the more we can reduce government deficits.   The recent domestic growth of natural gas production, coupled with continued growth in non fossil fueled energy and more efficient use of all energy (such as that which comes from higher mpg standards for cars and trucks) will have a major, beneficial longterm effect on government deficit reduction and private sector spending and investment. 

Mark Fiore skewers austerity economics in this clever version of modern pharmaceutical commercials.