1.07% on the 5 year and falling fast

As you know, we are now closing fast on Japan, in the Fed/ECB/BOJ race to the bottom.

The markets this morning gave a massive vote of no confidence to S&P ratings service, as yields plunged on Treasuries.

The real after-tax rate of return on the 30 year Treasury is now negative, assuming a 30% MTR.  That means the tax rate on capital now exceeds 100% in real terms over the next thirty years, which doesn’t seem particularly conducive to capital formation.

Alex Tabarrok sent me an email this morning that linked to the following statement by David Levey:

On Saturday, I sent the following statement via email to several publications (NYT, WSJ, Bloomberg, FT). It is intended to describe why I would vote to maintain the US Aaa credit rating, were I still in my former position. At this time, I have no connection with Moody’s nor any non-public knowledge of what its analysts think about the rating or what they intend to do.
This statement is not a defense of the Administration in its war of words with S&P. I am not a supporter of the Obama team’s economic policies, which have added to the debt and the regulatory burden on the economy. As I see our current situation, the Federal Reserve, with its too-tight monetary stance since the summer of 2008, has allowed nominal GDP to fall far below trend, causing a collapse of output and employment — as described by the monetary bloggers Scott Sumner, David Beckworth, Bill Woolsey, and David Glasner. Had the Fed acted properly, (by, for example, setting a nominal GDP level target) the recession would have been much shallower and fiscal stimulus might not have been undertaken. As it was, the collapse of nominal GDP drove the “fiscal multiplier” to zero, leaving us with more debt and nothing to show for it. Monetary policy always “comes last”.
The solution to avoiding the predicted debt explosion will have to come primarily from major reforms of entitlement programs. Tax-rate increases within our present system are counter-productive and will retard growth. If there is to be some contribution from increased revenue, it should come from structural reforms which reduce the taxation of saving, support entrepreneurship, and eliminate loopholes and exemptions that distort consumption and investment decisions. Despite sharing their fiscal concerns, I see the S&P downgrade as premature for the reasons given below.
David H. Levey
Managing Director, Sovereign Ratings, Moody’s Investors Service (1985-2004)
.  .  .
STATEMENT
The recent S&P downgrade of the credit rating of US Treasury bonds is unwarranted for the following reasons:
1) The US dollar remains the dominant global currency and no viable competitor is on the horizon. The euro is heading into dangerous and uncharted waters while deep and difficult political, economic and financial reforms will be required before the renminbi could become fully convertible for capital flows and Chinese government bonds a safe reserve asset.
2) US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a “safe haven”, due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking “risk-free” reserve assets that they reallocate their portfolios toward these relatively illiquid markets.
3) Despite the above positive factors for the US, it is certainly the case that the US long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system. Failure to reverse that trajectory would eventually make a downgrade unavoidable. But the recent discussions signal to me that — finally — public awareness of the fiscal crisis is growing and beginning to influence Washington. There is still a window of time — perhaps as much as a decade –within which structural reforms to spending programs and the tax system could reverse the negative debt trajectory.
4) The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with a Aaa rating than is the case for other countries, another version of the US’s “exorbitant privilege”. But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. If not, global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.
Needless to say, I agree with Levey’s views.
I picked the worst possible time for a vacation.  Will be traveling today and tomorrow, so no time to read other blogs.  I’ll catch up when I return on Wednesday, if there is still anything left of the western economies to comment on.

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64 Responses to “1.07% on the 5 year and falling fast”

  1. Gravatar of TravisA TravisA
    8. August 2011 at 08:05

    What’s interesting is that the ECB’s decision to buy Italian and Spanish debt should be very bullish as it is defacto monetary easing. I am not sure why the stock markets aren’t seeing it as such. Personally, I think the stock markets are wrong, but it might be another 500 Dow points on the downside before others start to see it my way.

  2. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 08:29

    OK, so *money is in reality tight*, both in terms of the availability and price of credit for real activity, and the volume of conumption of goods & services. (er, “AD” in the “business is crappy so nobody is hiring” sense.)

    But given what seems like a rather large expansion in Fed balance sheet (the buy all things toxic and many things not plan) why is this so?

    Put another way, if easing right now amounts to trying to push a string through a pot hoping it will come out the other side, how does a correct thinking central bank actually expand money in the hands of citizens?

    (Fed plans seem to work at the margins, in the sense that the rate of inflation is stable. Maybe the string is stiffer than it seems.)

    Conjecture: One real problem is that people’s expectations of return are too high. (“I’ll sit on money in a 0% checking account rather than take any risk at all less than R%” and right now R is 4% nominal or some such.) This can easily arise for anybody trying to live on returns.

  3. Gravatar of effem effem
    8. August 2011 at 08:47

    Plenty of liquidity to drive gold up.

  4. Gravatar of DanC DanC
    8. August 2011 at 08:58

    Don’t forget the increased burden of regulatory rules, those incentive distorting taxes are damaging the economy.

    Nor do I like being depicted as the enemy of the economy. I spend 8% of income on housing ( I live very modestly for my income), my car is 11 years old ( but looks showroom new) and I invest 35% of every paycheck. Simply, I have made great sacrifices to grow my wealth, and yet, according to the Obama administration, my reward should be higher taxes because my drive to better things for my family, to live within my means and grow my wealth, is the source of the problem.

    (BTW I grew up in a very poor household with a single immigrant mother and have always preferred savings to status items.) Now I am told that I was a chump.

    (Also I do give about 1.5 to 2% of my income a year to charities that I feel are frugal with the money I give them.)

  5. Gravatar of OneEyedMan OneEyedMan
    8. August 2011 at 09:00

    Now would be a great time to pre-fund some of our entitlement obligations. Issue some 30 year bonds, buy some cheap private sector assets, and endow a social security / medicare fund with some real assets in it.

    @Scott
    Given all the capital losses people are experiencing right now, I’m not sure 30% is the right MTR for the marginal investor. Between that and the pensions and other tax exempt owners, the MTR on a treasury might be closer to zero than 30%. It is pretty dated but “Some Indirect Evidence on Effective Capital Gains Tax Rates” puts the effective marginal tax rates on capital gains at 3.5-7%

  6. Gravatar of effem effem
    8. August 2011 at 09:00

    DanC…you pain the the wealth issue as black/white. I have hedge fund manager friends who can easily make $10-100m per year and are able to defer their entire tax burden. If they can’t defer it then they simply pay 20% capital gains. Further, the corporate tax rate (in terms of actual taxes paid) is near the lowest EVER. It is simply not true that the wealthy have a heavy tax burden.

  7. Gravatar of effem effem
    8. August 2011 at 09:01

    DanC…you paint the the wealth issue as black/white…i dont believe it is. I have hedge fund manager friends who can easily make $10-100m per year and are able to defer their entire tax burden. If they can’t defer it then they simply pay 20% capital gains. Further, the corporate tax rate (in terms of actual taxes paid) is near the lowest EVER (despite profit margins being near the highest ever). It is simply not true that the wealthy have a heavy tax burden.

  8. Gravatar of Looking at the wrong “gun” | Historinhas Looking at the wrong “gun” | Historinhas
    8. August 2011 at 09:04

    [...] 2: And there´s this statement by David Levey, former Managing Director of Moody´s that Scott Sumner reproduces: On Saturday, I sent the following statement via email to several publications (NYT, [...]

  9. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 09:10

    effem and danc are talking about two different issues, I think.

    One – the tax code is so bizzare as to defy understanding. And at times it pays people to do weird things. Why, pray tell, is managing a hedge fund so special? A much simpler tax code (25% on true earnings period full stop) would solve that.

    Two – it’s really hard to claim that any honest effort at working and managing resources is doing anything but good for the economy. Whether it’s saving lots and living modestly, or taking on debt but using that to pursue worthwhile projects. Outright fraud and theft, in the conventional sense, and looney behavoirs (giving and taking liar loans) with no honest hope of a reasonable outcome, those are the things that damage an economy.

  10. Gravatar of DanC DanC
    8. August 2011 at 09:38

    The super wealthy have many ways to avoid taxes. Tax reform is needed.

    However, I am rich, according to Obama, and must pay higher taxes. I have limited ways to avoid taxes compared to the super rich. Look at Teresa Kerry. John Kerry wants to attack the Tea Party but what about all the ways his wife uses the tax code to avoid taxes?

    I did not say how I invest, nor did I imply that borrowing to fund a worthwhile project was bad. Just that the after tax return to saving and investing continues to decline because of direct and indirect taxes. With increasing levels of taxes coming.

  11. Gravatar of effem effem
    8. August 2011 at 09:40

    DanC, I agree with that. But somehow the super-rich have managed to dominate the political discourse. The cry of “no new taxes” really means “don’t change the current tax code at all because I’m super rich and benefit from it.” The “wealthy” need to split off from the “super-wealthy” and corporate interests that prefer to obfuscate the issue and can hire an army of lawyers/accountants.

  12. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 09:46

    Actually, there seems to me to be a weird kind of curve.

    People in the “super rich” class (warren buffet, say) seem to be arguing that all “rich people” (which means everybody on Earth making more than $250K or so) should pay more taxes.
    This is a little bit like me arguing that the cleaning person should pay more taxes, because she’s richer than 90% of the population of Africa.

    A real problem in this debate is that a certain class of people will never be effectively taxed, because they can do things like store enough cash in vaults to live the rest of their lives. So “tax the rich” is really code for “tax people who don’t vote for me anyway”, and “no new taxes” is really code for “do NOT tax the people who DO vote for ME”. Both suffer from the horrible distortions of tax complexity and the “tax A to provide services to B so B will vote for P” model of government.

  13. Gravatar of Liberal Roman Liberal Roman
    8. August 2011 at 09:47

    @Bryan William,

    “But given what seems like a rather large expansion in Fed balance sheet (the buy all things toxic and many things not plan) why is this so?”

    Scott, had a good post on this awhile back. The Fed can quadruple the monetary base, but if the market expects that the fed will decrease the monetary base at any inkling of inflation, nothing will happen. And that’s exactly what is happening now. The market correctly expects the Fed to tighten at any sign of inflation, so hence there is no inflation. Only by acting “irresponsibly” does the Fed have any chance of getting traction in their monetary policy.

    For example, an open ended QE policy would probably do the trick. Something statement like, “We will continue QE purchases until we are comfortable with the rate of inflation.”

    Of course, nothing like this will happen because if it did, Bernanke would get attacked viciously by our clueless financial punditry. And since Bernanke is a pansy he won’t be able to stand up to the criticism.

  14. Gravatar of malavel malavel
    8. August 2011 at 10:06

    That sounds like a pretty big endorsement. Congrats to all the amazing quasi-monetarist bloggers!

    How about a joint Nobel price in 2035? For their relentless effort that in 2015 made the Fed adopt an official NGDP level target that finally ended the Great Recession and gave us the 20 economically most stable years in history.

    Just trying to keep your spirits up. =)

  15. Gravatar of Holy Cow, Lots Going On « feed on my links Holy Cow, Lots Going On « feed on my links
    8. August 2011 at 10:08

    [...] for S&P’s downgrade, here’s Sumner’s take, under the title of 1.07% on the 5-year and falling fast. The markets this morning gave a massive vote of no confidence to S&P ratings service, as [...]

  16. Gravatar of Silas Barta Silas Barta
    8. August 2011 at 10:35

    Wait a sec, how can the real return on capital now be negative, considering that you sheepishly believe the numbers that say inflation is near zero?

    And how would low real interest rates not be conducive to capital formation? That system would reward people for building things that pay implicit rents (a water filtration system instead of hauling in Ozarka each week)? It certainly encourages capital formation in that sense.

  17. Gravatar of Andy Harless Andy Harless
    8. August 2011 at 10:35

    That means the tax rate on capital now exceeds 100% in real terms over the next thirty years, which doesn’t seem particularly conducive to capital formation.

    I disagree. The tax rate on “risk-free” capital exceeds 100%, but the tax rate on the risk premium is much lower. Presumably this situation should encourage the sort of risk-taking that forms real capital rather than merely shifting book-entries between the Fed and the Treasury. Granted, risk is out of favor now: but not because of the tax system.

    Moreover, decisions by individual households to do less “capital formation” (in the sense of putting less money into Treasury bonds and other assets rather than spending it) will almost certainly result in more capital formation in aggregate. That’s the good old paradox of thrift (plus the investment accelerator). I know you will argue this isn’t true if the Fed is targeting inflation and the SRAS curve is upward-sloping, but I think that view misses (1) the amount of noise in the Fed’s feedback from the (rather flat though still upward-sloping) SRAS curve, (2) the role of commodity speculation, (3) the role of uncertainty in investment and monetary policy decisions, and (4) the presence of the Fed’s own balance sheet in its objective function.

  18. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 10:46

    Bryan Willman,

    You are right in the first part, and wrong in the second.

    There is a way to tax the .5% crowd and not touch SMB owners.

    Treat SMB profits as capital gains and given them a a BETTER tax rate than real estate of investor capital gains.

    SMB Capital Gains = 0%
    Real Estate and Investor Class increase = 25%

    Just like relal estate investor do now with 1031s, allow SMB owners to pay no taxes on any profits they reinvest in ANY business.

    Have them only pay income tax on what they don’t reinvest.

    If the Democrats would make such offer to the Tea Party, the ENTIRE GOP would be forced to support it.

    Now that it dawns on people that the Tea Party controls the GOP with an iron fist, perhaps the left will wake up, hold their nose, and give righteous their due.

  19. Gravatar of TVHE » What to watch for during the sovereign debt crisis TVHE » What to watch for during the sovereign debt crisis
    8. August 2011 at 11:01

    [...] things to keep an eye on here are long-term Treasury yields (in part these represent risk, sure, but they also represent a weak outlook for the long-run price [...]

  20. Gravatar of dtoh dtoh
    8. August 2011 at 11:27

    Scott,
    I have said this before, but I am going to say (SHOUT) it again. The only way to address the current economic problem is to give the Fed the ability to set capital (i.e. equity) reserve requirements for financial institutions based on the type of asset held, the term of the asset, the time the asset was acquired and how the long the institution has held the asset.

    The current monetary policy is not working and the prescriptions by you and others will not work because a) they are too complicated for politicians, the public, and even many economists to understand, b) at low interest rates they require asset purchases which are politically unpopular, and c) because banks can simply hold balances at the Fed, asset purchases push at the wrong (long) end of the lever… lot of effort with little movement at the other end.

    The ability to set capital reserve requirements based on asset type is easy to understand, would be politically popular (we are just keeping the banks from hoarding money) and pushes on the right (short) end of the lever.

    That the virtues and efficacy of this approach are not patently self-evident to you and others is giving me the Krugman exploding head syndrome.

  21. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 12:18

    Morgan – Uh, SMB = “small and medium business”?

    (I think you are replying to the 2nd part of my first post, about distortions of the tax system?)

    I take it the gist of your proposal is to distinguish between some kind of “active” investment versus, uh, rentier? investment?

    So, if investor I builds a building and leases it out to investor J, who runs a plumbing supply house out of it, both I and J pay much lower tax rates, either on on income or at sale of the created investments. While investor Q, who stashed a pile of money in a bank that lent money to I and J, would pay some rather higher tax rate? How is this different from some new new form of intermediation in capital formation? (That might be a really good idea, I’m not sure.)

    And as the complex rules for “active” versus “passive” investment already show, this is hard to get right.

    For example, what if investor Z wins the lottery, and goes around buys 50% stakes in a variety of small and medium businesses in Z’s community, some of which are startups. Z then waits for the returns checks. Z would clearly seem to making a worthwhile allocation of capital (in fact I wish some lottery winner would try it), but at one point does Z become a “rentier” again?

    By the way, my personal take is that the Tea Party is about “less government, as in lower tax bills and less meddling” (which is a view I share) rather than about some “best path to economic goodness.” So to get the compromise you think likely, the proposal would have to come with limits on regulations and total spending as well.
    (That all might be good, but it’s not well aligned with how the democrats buy votes. It is well aligned with how the republicans buy votes.)

  22. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 12:23

    Morgan (part II)

    Or are you arguing that the rule is:

    Tax Liability = (Gross – costs – 99% of reinvestment) * tax rate. So that rather than reinvesting with post-tax funds, one would reinvest with pre-tax funds. But only for “active” entites that create wealth. (As opposed to reinvesting dividends or something like that.)

    Put another way, all business expenditures are 100% deductible in the year they occur. (Or perhaps all payments on them are 100% deductible in the year the payments occur.)

    Is that closer to the gist of what you mean?

    (But all of this is missing Scott’s real point – there is very low effective demand for capital to do real things – either because there are no good risk real projects, or people are afraid, or money is somehow “tight” while real interest rates on 5 year money are negative (?!?!?))

  23. Gravatar of Eric Morey Eric Morey
    8. August 2011 at 12:25

    effem and danc are talking about two different issues, I think. effem is talking about the problem. danc is talking about the way the problem is negatively effecting his life.

    Andy, Thanks for writing my initial thoughts on the capital vs. “Risk Free” capital distinction.

    Morgan, I’m surprised how someone with such an ideologically different perspective from mine can arrive so often at conclusions so similar to mine.

  24. Gravatar of Eric Morey Eric Morey
    8. August 2011 at 12:44

    dtoh, I’ve been a bit frustrated with my attempt to distill Scott’s views on the effect of leverage on systematic risk. I get the sense that because he’s admittedly less knowledgeable about finance that he hasn’t solidified his own views on the topic. However, the effect of such a regulatory tool on monetary policy would seem to be in his wheelhouse. I hope he addresses it clearly at some point.

    Bryan, great feedback on Morgans ideas. Concerning your summation of Scott’s point, is it demand for capital to “do real things” that is low or is it supply of capital to “do real things” at current expected returns relative to perceived risks that is low?

  25. Gravatar of OneEyedMan OneEyedMan
    8. August 2011 at 13:07

    @Silas Barta
    I’m similarly confused. I thought lower inflation meant that after tax returns were higher because taxes are on nominal returns not real ones.

  26. Gravatar of Benjamin Cole Benjamin Cole
    8. August 2011 at 13:13

    Barbabke-san:

    Go to NGDP right away. QE, no interest on reserves (btw, soon the Fed will be the only institution in the world paying interest on deposits).

    Set iinflation target of 4 percent until people are dancing in the streets, then cut back to 2 percent or so.

    Remind people when Reagan left office inflation was 5 percent. We lived and even thrived.

  27. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 13:18

    “Tax Liability = (Gross – costs – 99% of reinvestment) * tax rate. So that rather than reinvesting with post-tax funds, one would reinvest with pre-tax funds. But only for “active” entites that create wealth. (As opposed to reinvesting dividends or something like that.”

    Yes this is it. Only re-investing in private companies that are not real estate plays. You could even require the entities to be newer.

    I just wrote about it again here:

    http://biggovernment.com/mwarstler/2011/08/03/pssst-super-congress-cut-the-tea-partys-taxes/

    50%+ of SMB revenue come from 2% of SMBs (this is obvious because most SMBs are just a consultant).

    I’m only concerned with those 2%, but I’d let the rest have the opportunity to win the Tea Party support.

    Job growth comes almost exclusively from newcos that spring forth from the pool of 2%.

    What’s key is what I get at in the yogurt stand example in BG post, many SMBs are partnerships and under the current tax code the partners have GIANT dis-incentive to fairly judge the growth prospects of their aging company.

    BUT THE PEOPLE who start SMBs that grow, basically lots of big fish in small ponds, lots of Tea Party types, they are EXACTLY the kind of people who will start, another, another, another, another newco.

    They are the entrepreneurs.

    Beyond this, the current tax code pushes best and brightest to Wall Street, not Main Street – and with the kind of tax change I’m talking about, that would end immediately – a marginal revolution.

    Why this is easy to do, is because of rule 1031s (real estate), we have right now a group of investors who pay ZERO capital gains, so there is something deeply cathartic about striping them and Wall Street types of their favored status and handing it the Tea Party.

    Such a change would go a LONG WAY in easing the anger that is out there.

    —–

    The meaning of Sumner’s life ends if this problem is structural.

    I’m pretty sure it is, so we can do his plan as long as we do mine first.

    My plan I KNOW works, because my plan doesn’t require more demand, my plan requires invention / productivity gains.

    What I want to see is 1M newco piranha in the water, that force the Fortune 1000 to spend all the cash they are sitting on, as little guys take the most modern technology (robots), and niche themselves into more and more specialized market solutions.

    I like businesses that keep $1 for every $5 they steal from somebody else’s share, and leave the customers with $4 to spend elsewhere.

    That $4 in savings is the solution to all problems.

    Now sure, I’d point that a bunch of invention at GOV2.0, Education, and Healthcare with lots of deregulation, but that’s just because those sectors are so bloated and full of rentier gravy.

  28. Gravatar of StatsGuy StatsGuy
    8. August 2011 at 13:51

    “The markets this morning gave a massive vote of no confidence to S&P ratings service, as yields plunged on Treasuries.”

    That is not exactly what happened, although from a policy perspective, if you think this is what happened, you get to the same recommended action. It all has to do with relative risk aversion. We observed several telltale signals today – gold went up in divergence with stocks, treasuries surged in price (rates plummeted), lower ranked debt plummeted, oil plummeted.

    I think that at this point, we must conclude we really don’t understand how Central Bankers think. Anyway, we’ll learn more tomorrow after Jackson Hole. So much rich irony today. Russian stock index plummets (funny because they are most critical of dollar). China not sure what to say, caught between being critical of US and being critical of S&P. Don’t think they expected this.

    A great deal of this is political; S&P is right about the spectacle. If, under the microscope of the world and every lever that finance can bring to bear, two parties in DC still cannot get anything even approximating a real agreement, then I suppose we deserve this.

    I think the Fed wants oil under 70 – but they do try to stick to schedules. They probably would ideally want the announcement a couple days from now to give the markets a chance to drop another 5-10% and oil to go below 70, to help ensure that inflation stays under their precious 2%, but that won’t happen. If they announce only a half-way measure tomorrow, followed by “we’ll review again in 60 days”, then we’re in recession.

  29. Gravatar of Bryan Willman Bryan Willman
    8. August 2011 at 14:17

    @Eric (and everybody else)

    Conjecture1 – a lot of “capital” or “investment” isn’t really either. It’s purely “holding for the future”, or the moral equivalent of hiding money in a mattress. (Which we all do and I do, I don’t mean to be disparaging.)

    In some sense, “investing” in treasuries is a really low precentage of investment, since a large part of it goes to roll over debt, and another part of it goes to programs with very poor multipliers. And yet other parts fund useful programs that are totally supporting consumption (social security.) So it does not grow or maintain capacity. It barely supports consumption.

    Likewise, trading in the secondary market for stocks in some sense isn’t actually “investment” – if I buy shares of MSFT today, Microsoft doesn’t get any more money. That secondary market is of course essential to the functioning of the primary market, but it doesn’t grow or maintain capacity. (Additional offerings of new shares are a different matter.)

    Some holdings (China) are constrained by politics or policy. Are the Chinese really going to go out and buy into a bunch of american startups? Make expansion loans to american manufacturers? How would this be managed? Would it be allowed?

    So perhaps “true capital” is actually in shorter supply than it appears, and Scott is right that “money is really very tight”.

    Conjecture2 – capital is stuck.

    Historically, you put your savings in a bank, which lent it out to people who used the loans to buy things that increased wealth, or capacity to produce wealth. But if banks are trying to fix their balance sheets, or either refuse to see or do not have creditworthy borrowers, no such thing happens. So your savings aren’t savings, they are “parking”.

    So in addition to “there isn’t enough capital” and “there aren’t enough projects”, we could be facing “the capital and debt formation and intermediation system is broken” as a problem.

    [This isn't my blog so I'll shut up now. But Conjecture 2 is the thing I always wonder about when people talk about "easing" - easing only works if the easy money is easy all the way to the real economy, no?]

  30. Gravatar of dtoh dtoh
    8. August 2011 at 17:22

    Morgan, Bryan,

    I think you both make a mistake by trying to distinguish between good investments and bad investments. The money is fungible. Putting money in the bank or into real estate frees up funds for SMBS. Successful SMBs are also highly dependent on the investor class. The solution is not to create a complex tax plan for capital. The solution is to eliminate tax preferences (e.g. 1031), and to move to a consumption tax.

    Also real estate is not just about capital gains. I sit on the Board of a publicly traded REIT, and I can tell you a lot of real estate investment is about generating rental income.

    You need a secondary stock market for the primary market to exist. The effect is to make capital cheaper.

    Finally the reason Wall Street is over paid is not because of taxes. It’s because the industry gets a free implicit government guarantee on its funding and there are very high government created barriers to entry.

  31. Gravatar of Lucas Lucas
    8. August 2011 at 17:29

    @TravisA,
    “What’s interesting is that the ECB’s decision to buy Italian and Spanish debt should be very bullish as it is defacto monetary easing. I am not sure why the stock markets aren’t seeing it as such.”
    The markets are right because these actions don’t signal any real easing of policy:
    “But sterilisation’s a good place to start. Because it really shows the irony here — the ECB could buy all of Spain and Italy’s government debt if it wanted, by fully putting its balance sheet to work, but it won’t. Ostensibly this is of course about the ECB not tolerating any increase in the monetary base through unsterilised buying — “we do not do QE” — but when you think about it, it’s also a bet that the bank can happily avoid a liquidity trap arising from sterilisation.” [1]
    It’s crystal clear to me: the ECB doesn’t want to increase the monetary base. This means tight money.

    1- http://ftalphaville.ft.com/blog/2011/08/08/645091/sterilising-silvio/

  32. Gravatar of Mike Sandifer Mike Sandifer
    8. August 2011 at 17:47

    Lucas,

    More austerity is being forced at the same time, so there’s possibly at least some offset.

  33. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 17:50

    dtoh,

    One your second point, I don’t disagree – the simpler the better. BUT, I think my approach is more politically doable. Based on these assumptions:

    1. The government isn’t going to get to have much more revenue.
    2. SMBs MUST pay less.
    3. Everybody would like to see Wall Street pay more.

    My point is while it is counter-intuitive, I think progressives gain more out of raising up SMBs the same way I think they gain more out of states’ rights.

    And ultimately they are rational, and they will stumble into the truth.

    I’ll also say this on $ being fungible. The best investors are categorically the investors who invest in themselves. They have more specialized knowledge. Gates trumps Buffet.

    In fact, EMH fails the moment you count entrepreneurs as investors.

  34. Gravatar of Jim Glass Jim Glass
    8. August 2011 at 18:14

    The price of oil is falling and the price of renting an oil tanker has plunged by more than 50%.

    Possibly the world economy is heading into another slump, and this is what the markets are showing?

    I mean we all pefer to assume the Fed is responsible for everything, but Europe is screwing up big-time too, and if now a slump hits China, which is the part of the world where the big marginal changes in oil consumption occur…

  35. Gravatar of Liberal Roman Liberal Roman
    8. August 2011 at 18:32

    This is utterly depressing. I am completely out of the stock market, but this is sickening.

    The world’s central bankers whistle as the world burns.

  36. Gravatar of dtoh dtoh
    8. August 2011 at 18:40

    Morgan,
    Fungibility. I kind of agree… but not really. A lot of success for both investors and entrepreneurs is due to luck, but then in hindsight is credited to genius. In my opinion a good VC brings a hell of lot more discipline and experience to a new venture than your average entrepreneur.

    I’m a big fan of supporting SMBs but I think you need to be careful about trying to pick winners and making judgements about what economic activities are good.

    The only way you take the money out of Wall Street is by imposing strict capital (equity) reserve requirements and lowering the barriers to entry. That being said a lot of banking has a big positive impact on the economy (efficient allocation of capital) so some bankers will always make a boatload of money. I’m probably a little biased on this because I used to work at Goldman.

    The monied classes will always get the politicians to do their bidding. I doubt this will change.

    Why does EMH fail when you count entrepreneurs as investors? Could you elaborate

  37. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 18:58

    A 1 cent per share tax would accomplish some of the same thing. VC are sheep. This isn’t about average VC against average Internet start up guy.

    I’m talking about nuts and bolts local businessmen of all flavors being encouraged to live cheap, and roll their profits from one venture to another.

    I think my model pushes monthly JOLT data up over 6M new jobs and 5.5M job losses. Turnover is what we want. The more turnover historically, the more jobs gained. This isn’t perfect, but nothing says it is wrong.

    I think you have a status quo bias, we haven’t really ever outright FAVORED the SMB investor / owner.

    What I’m after is distriubtism. As in more capitalists.

  38. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 19:00

    Certain entrepreneurs in my experience beat the market over and over and over.

    Their yogurt shop thrives far more often than not.

    Investing might be like gambling.

    Running your own business is like poker.

  39. Gravatar of Daniel Daniel
    8. August 2011 at 19:40

    i mean after you smacked down the MMT’ers with their literal view of banks and systemic actors can we agree that money neither plays a store of value or a unit of account but a linguistic function? money is a language my man, a meta language.

  40. Gravatar of Bababooey Bababooey
    8. August 2011 at 20:30

    …the tax code is so bizarre as to defy understanding…

    “The hardest thing in the world to understand is the income tax.” — Albert Einstein, physicist.

    …hedge fund manager friends who can easily make $10-100m per year and are able to defer their entire tax burden.

    Well, anyone holding an appreciating capital asset is deferring tax by not selling. So? Are you suggesting that the citizens all get taxed on a mark-to-market basis? You hedge fund manager friends are probably having their at-risk compensation taxed on the same schedule as their clients.

    A real problem in this debate is that a certain class of people will never be effectively taxed,

    No, and the problem is notthat the Democrats want to raise taxes on the rich or that the GOP wants to cut taxes on the rich, the real problem is that the Democrats think I’m rich and the Republicans don’t.

    Why, pray tell, is managing a hedge fund so special?

    Why aren’t you doing it and making gazillions?

  41. Gravatar of Bababooey Bababooey
    8. August 2011 at 20:39

    The best tax system for this country is an annual consumption tax and no tax on investment or labor. It works like this:

    1. Submit an annual form showing prior year’s total savings (x), current year income (y) and current year savings (z).
    2. The tax base = y-z-x.
    3. Add a fat exemption (~$50,000)
    4. Apply a progressive rate to the excess, if any
    5. Write a check to the IRS.

    Bang, people work harder and invest more because they keep 100% of the proceeds, and they consume less at the margins.

    I think Scott advocates something like that, but I don’t want to put words in his mouth.

  42. Gravatar of dtoh dtoh
    8. August 2011 at 20:54

    Bababooey,
    Make it even simpler. Get rid of the income tax, implement an across the board 20% consumption tax and give everyone a card that exempts them from the tax on their $50k of purchases.

  43. Gravatar of TravisA TravisA
    8. August 2011 at 21:05

    @Lucas. You make a good point. I would say that even if they were to sterilize it completely, buying the govt debt takes a big problem off of the table — break up of the Eurozone and the resulting huge banking issues. QE2 seems to have been largely sterilized in the US, but it helped.

    Of course, it would be better if the purchases weren’t sterilized. It’ll be interesting to see how much the ECB needs to buy in order to keep Italy’s and Spain’s rates low. If it is large quantities, it might not be possible to sterilize all of it, unless they raised short term rates. I don’t think even the idiot Trichet is dumb enough to raise rates now.

  44. Gravatar of Morgan Warstler Morgan Warstler
    8. August 2011 at 21:51

    dtoh, Bababooey

    Again, who cares about the theoretically best tax system? – yes, yes, progressive consumption.

    Not going to happen. We are closer to a Balanced Budget Amendmentand that’s a long shot.

    What is going to happen in the near term is tax reform, so the question becomes POLITICALLY what is the best the progressive left can get for new revenue, that the Tea Party will accept?

    And my suggesting is they cut taxes on the the Tea Party and extract greater tax hikes on the banksters and corporatists in return. Critique away. Counter plan.

    I’m interested in realpolitik answer, what is outcome that maximizes the the interests of two disparate parties within the boundaries of the possible?

    What is doable and will will cause growth?

  45. Gravatar of Steve Steve
    9. August 2011 at 00:12

    AUSTERITY!!!

    http://www.abc.net.au/news/2011-08-09/london-in-shock-after-night-of-madness/2831646

    Neighbourhoods across London are waking up to scenes of destruction in their streets and face a massive clean-up after a night of heavy rioting and looting left many buildings ablaze and shops smashed.

    Prime minister David Cameron has cut short his holiday in Italy and will hold a crisis meeting on how to bring about an end to the unprecedented wave of domestic unrest.

    The British capital has endured three nights of unrest by masked and hooded youths across many parts of the city, with riots spreading to other major centres including Liverpool, Birmingham and Manchester…

  46. Gravatar of W. Peden W. Peden
    9. August 2011 at 00:27

    Steve,

    Mass riots are a very old phenomenon. There were New York riots before Koch, for instance.

  47. Gravatar of W. Peden W. Peden
    9. August 2011 at 00:28

    I don’t see how anyone can attribute this sort of behaviour to austerity, as opposed to a break-down of law & order-

    http://www.youtube.com/watch?v=6Gex_ya4-Oo&feature=player_embedded

  48. Gravatar of MikeDC MikeDC
    9. August 2011 at 04:57

    Hope parliament is repealing the raft of gun control laws that make it impossible for people to defend themselves and their property.

    So anyway, who’s gonna be the straight man to this post and point out that the S&P downgrade was right on the money and that Levey’s reasons against were absolutely laughable. They basically break down to:

    1. All the other options are uglier. Yes, but that doesn’t mean the best of a set of bad options is good.
    2. OK, there are better options out there, but they’re not in enough supply to satisfy people who are scared. Gresham’s Law! :)
    3. Things really are bad in the US, but really, I’m sure they’ll get it together. Really! I mean, they have to, right?
    4. OK, really, the US is the world’s central economy, so no matter how messed up it is, we ignore it until it’s too messed up to do anything about it.

    Seriously? This is just a monumental pile of BS. Being as generous as possible, it’s obvious that none of these reasons are incompatible with saying that the risk of lending to the US is getting higher. Which is what credit ratings are supposed to assess, irrespective of whether it’s center of the global economy.

    But hey, at least he didn’t throw in the Greenspan style “we can just print more money” to pay back bondholders, which, you know, is a really good way to demonstrate we’ve got our act together and they have nothing at all to worry about.

  49. Gravatar of Bryan Willman Bryan Willman
    9. August 2011 at 05:49

    @Bababooey – “Why aren’t you doing it and making gazillions?”

    Uh, I was complaining about special parts of the tax code, which I find hard to understand (we seem to agree on that), which seem to give a special break to “carry trade” earnings.
    If hedge fund managers paid taxes on earnings and capital gains the same way as the rest of us, I’d be happy.
    (I’ve done quite well investing in hedge funds by the way…)

    @all-of-you-arguing-for-consumption tax
    Given that the current economy is suffering from an apparent shortage of *demand*.
    AND
    We are moving to an era when the number of people required to provide everything *required* to live is an ever smaller part of the population
    WHY
    Does anybody think that anything that restrains consumption is a good idea, or that long term unemployment can be restrained by anything other than a great deal of consumption, most of it of “luxury” goods?

    Back to Topic – @dtoh points out the “good investment versus bad fallacy” in part of this thread. I wish to point out that I don’t *judge* buying in the secondary stock market versus buying treasuries versus opening a new new business. I merely *observe* that the “total quantity of money that might in theory be applied to growth producing investment” may not be merely as big as we might think. And that the mechanisms by which it flows to needed places may be broken. And of course, there may not be enough good places for it to go. And I’m wondering how one would sort these 3 cases out.

    More on topic – as of this morning, at *current* inflation rates (never mind greater future inflation), the real return on treasuries is *negative* up to at least *7* years out.
    (Before taxes) The real returns bloomberg lists on munis is negative up to 10 years out (after tax)

    Either the markets really expect deflation (gulp), or *nobody can find a better place to allocate money*. No place better than a negative return? (Treasuries are a special market, but still…)

  50. Gravatar of Bryan Willman Bryan Willman
    9. August 2011 at 05:58

    @Daniel

    “money is a language my man, a meta language.”

    I agree money is not a “store of value”, though it’s often used in that way.

    Money is a socially enforced claim on the output and holdings of other people, and by convention an accepted way of settling many obliations. (But not all – you still have to show in person for jury duty.) Money is of no use *except in trading with other people.* When you buy land you do not give the money to the land – you give it to a human land holder, and pay a tax to government to help enforce your right to hold it. When you buy a car, neither the welding wire, nor the iron ore, nor the rubber tree get any of it. All of it goes to holders of resources or providers of labor, or people who mediate distribution or markets. All of it.

    If you stash currency in your mattress (or safe), you are making a bet that “later”, people will still agree to give you stuff (say, food), in exchange for said currency. In case of collapse, that might not be true.

    (Which is also why gold is of no use in a survivalist circumstance – it’s of very low (but not zero) use and so has no particular trading value in a total collapse. Which is why survivlists tend to favor canned goods, medical kits, and ammunition…)

  51. Gravatar of W. Peden W. Peden
    9. August 2011 at 06:00

    Bryan Willman,

    Private domestic consumption is not the same thing as demand.

  52. Gravatar of Bababooey Bababooey
    9. August 2011 at 07:52

    @bryan

    There is no special provision of the tax code for hedge fund managers. The IRS did issue two clarifying revenue procedures in 1993 and 2001 likening profits interests to stock incentives, but they never mentioned hedge funds or PE. treasury has some proposed regulations along the same lines.

  53. Gravatar of Eric Morey Eric Morey
    9. August 2011 at 08:37

    Morgan,
    I agree that changes to tax laws is a political issue. But I refuse to recommend based on political assumptions. I can support stepping toward improved policies but I won’t recommend them as a goal. My interest is in measuring the doable against the ideal.

  54. Gravatar of James in london James in london
    9. August 2011 at 12:57

    I know it’s getting a bit emotional out there but the USA did just get pretty close to a default on its debt, whatever the reason. S&P have to be reasonably concerned that next time it does happen. A downgrade seems prudent, not political, and banking should be about prudence above all else.

  55. Gravatar of Interest rate insanity « azmytheconomics Interest rate insanity « azmytheconomics
    9. August 2011 at 14:08

    [...] below 3.56% for the 30 year average. Combine that with Scott Sumner’s assertion that “That means the tax rate on capital now exceeds 100% in real terms over the next thirty years“, you’ve got to think that the market expects: 1. Extremely low inflation. 2. Extremely [...]

  56. Gravatar of Morgan Warstler Morgan Warstler
    9. August 2011 at 14:20

    James my god, why are you people not out shooting looters?

  57. Gravatar of James in london James in london
    9. August 2011 at 23:06

    Morgan

    First, I am on vacation out of the country. Second, it is bad but TV always makes things look far worse than they really are. Third, we live in a liberal democracy and the price we pay for not having police routinely carrying guns and shop windows most places rather than metal grilles everywhere is occasional mayhem. And, of course 60 years of the welfare state.

  58. Gravatar of Morgan Warstler Morgan Warstler
    10. August 2011 at 01:08

    Mark my words, this is going to work out for UK conservatives.

    Still you ought to let anyone who owns a business own a gun.

  59. Gravatar of Scott Sumner Scott Sumner
    10. August 2011 at 16:00

    Everyone, I’m way behind on comments, so these will be quick. Bring up any important points into a newer post.

    Travis, Aren’t the bond purchases being sterilized?

    Bryan, Lot’s of reasons, including the high demand by banks for excess reserves (partly due to interest paid on reserves.)

    DanC, I’m also a high saver. The tax rate on capital should be zero.

    oneEyedman, The real tax rate on T-bonds is now over 100%.

    effem, The tax rate on capital should be zero.

    Thanks Malavel.

    Silas, You said;

    “And how would low real interest rates not be conducive to capital formation?”

    Never reason from a price change.

    And I never said inflation was zero, it’s slightly below 2% in the TIPS markets.

    Andy, You are right about the risk premium. As for the other comments, obviously it’s very debatable. I think the Fed’s policy is pretty close to inflation targeting, but I can certainly understand your point of view.

    dtoh, Keep pushing your idea–but I don’t see where my proposal requires massive asset purchases–that seems to be the Bernanke zero rate trap policy.

    Eric, I admit that finance isn’t my area. But I’m having trouble understanding what’s wrong with my intuition that the size of the financial crisis is basically equal to the losses on primary debt contracts like mortgages and commercial loans. Doesn’t leverage just move risk around?

    Ben, Good point about Reagan. Inflation’s way lower under Obama.

    Statsguy, You said;

    “If they announce only a half-way measure tomorrow, followed by “we’ll review again in 60 days”, then we’re in recession.”

    Then are we in recession?

    Jim Glass, You said;

    “I mean we all prefer to assume the Fed is responsible for everything,”

    I am just asking them to steer US NGDP, nothing more. But I do see your point about Europe.

    Liberal Roman, I agree.

    Bababooey, I’d like a progressive payroll tax (which is a consumption tax) and a VAT (which is a consumption tax.) Also a carbon tax and a land tax.

    Steve, The worst American riots in my lifetime were around 1965-68. A time of great economic progress for the poor.

    MikeDC, I don’t see how the US would ever default–unless we run out of paper and green ink.

    Byran, You said;

    “@all-of-you-arguing-for-consumption tax
    Given that the current economy is suffering from an apparent shortage of *demand*.
    AND
    We are moving to an era when the number of people required to provide everything *required* to live is an ever smaller part of the population
    WHY
    Does anybody think that anything that restrains consumption is a good idea, or that long term unemployment can be restrained by anything other than a great deal of consumption, most of it of “luxury” goods?”

    Let me know when we are all living at Bill Gates lifestyle, and no more consumption is “required.”

    In any case you are confusing consumption and demand, two unrelated concepts. Aggregate demand includes all types of output (C+I+G+NX.)

    James, I wonder what the point of “ratings” are. Is this S&P decision telling us something we didn’t know?

  60. Gravatar of Interview: Retired Moody’s Sovereign Ratings Director David Levy «  Modeled Behavior Interview: Retired Moody’s Sovereign Ratings Director David Levy «  Modeled Behavior
    10. August 2011 at 17:49

    [...] the wake of the S&P downgrade, Scott Sumner featured some comments by a former Moody’s Director of Sovereign Ratings David Levy. Despite his agreement that the [...]

  61. Gravatar of Interview: Retired Moody’s Sovereign Ratings Director David Levey «  Modeled Behavior Interview: Retired Moody’s Sovereign Ratings Director David Levey «  Modeled Behavior
    10. August 2011 at 17:54

    [...] the wake of the S&P downgrade, Scott Sumner featured some comments by a former Moody’s Director of Sovereign Ratings David Levey. Despite his agreement that the [...]

  62. Gravatar of MikeDC MikeDC
    11. August 2011 at 05:21

    Printing money to pay creditors = default.

  63. Gravatar of Rebuilding the Economy Rebuilding the Economy
    12. August 2011 at 05:37

    [...] Scott Sumner’s blog: The real after-tax rate of return on the 30 year Treasury is now negative, assuming a 30% MTR. [...]

  64. Gravatar of ssumner ssumner
    13. August 2011 at 11:49

    MikeDC, Not according to S&P

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