TARP Won't Cut It: Immediate 'Payroll Tax Holiday' Needed

I see this crisis differently than most. We have two things happening at once.

First, by 2006 the federal deficit had once again become too small to support the credit structure as financial obligations ratios reached limits, all due to the counter-cyclical tax structure that works to end expansions by reducing federal deficits as it works to reverse slowdowns by increasing federal deficits.

At the same time, while the expansion was still under way, delinquencies on sub prime mortgages suddenly shot up and it was discovered that many lenders had been defrauded by lending on the basis of fraudulent income statements and fraudulent appraisals.

Substantial bank capital was lost due to the higher projected actual losses reducing the present value of their mortgage-based assets. This is how the banking model works. The banks were, generally, able to account for these losses due to projected defaults and remain solvent with adequate capital.

Outside of the banking system (including bank owned SIVs - one of many failures of regulation) market prices of these securities fell, and unregulated entities supported by investors (who took more risk to earn higher returns) failed as losses quickly exceeded capital. And with this non-bank funding model quickly losing credibility, all of the assets in that sector were repriced down to yields high enough to be absorbed by those with stable funding sources - mainly the banking system.

But the banking system moves very slowly to accommodate this 'great repricing of risk', and all the while the fiscal squeeze was continuing to sap aggregate demand. The fiscal package added about 1% to GDP, but it hasn't been enough, as evidenced by the most recent downturn in Q3 GDP, which is largely the result of individuals and businesses petrified by the financial crisis.

So yes, there are both issues: the financial sector stress and the lack of demand. While they were triggered by two different forces (loan quality deteriorating due to fraud and the budget deficit getting too small), it is the combination of the two that is now suppressing demand.

The TARP may eventually alleviate some of the lending issues but only addresses the demand issue very indirectly and even then with a very long lag. Just because a bank sells some assets (at relatively low prices) doesn't mean it will suddenly lend to borrowers who want to spend. Nor does it mean they will want to fund euro banks caught short USD that have no fiscal authority behind their deposit insurance and bank solvency, and now appear to be in a worse downward spiral than the US. The slowing US economy has reduced the world's aggregate demand, which was never sufficient to begin with due to too small budget deficits, via reduced exports directly or indirectly to the US.

In other words, I don't see how the TARP will restore US or world aggregate demand in a meaningful way.

Yes, the US budget deficit has been increasing, but not nearly enough. It's only maybe 3% of GDP currently, while the US demand shortfall is currently maybe in excess of 6% of GDP.

Cutting the payroll taxes (social security and medicare deductions, etc.) is large enough (about 5% of GDP) and returns income to the 'right' people who are highly likely to immediately support demand as they spend and also make their payments on their mortgages and other obligations to thereby support the financial sector in a way the TARP can't address.

It is the 'silver bullet' that immediately restores output and employment. But we all know what stands in the way - deficit myths left over from the days of the gold standard that are now inapplicable with our non-convertible currency.

The line between economic failure and prosperity is 100% imaginary.

And not to forget that if we do restore output and employment (without an effective energy policy) we increase energy consumption and quickly support the forces behind much higher energy prices, which reduces are real terms of trade and works against our standard of living.

Disclosure: None

Comments

[whidbey:]

Ok, a tax holiday is likely to be welcomed, but the value of the dollar goes to a new low. Nothing is free. These are dire times. The Treasury has only half a plan, the targets for the bail-out, but no means of execution in mind, and if one thinks it over, there is not simple plan available. The money must enter the markets fast, and half of it should go to consumer-home buyers who are illiquid and willing to give the government a call on their house in the future. It could be part of other plans to stimulate consumer spending without deepening the bankruptcy of state and national governments.

2008 Oct 06 09:18 AM

[Moon Kil Woong:]

That's the dumbest thing ever. Our bonds will go to junk and the US will default when no one wants to buy our excessive debt. Just another fiscally irresponsible Republican dream. Please go back to school and take an economics class although simple math will do as well.

2008 Oct 06 09:34 AM

[Smarty_Pants:]

Why stop part way? Why not eliminate ALL government taxes?

Why not shut the government down for the next 5 years and see what happens? They've made such a mess of things it couldn't be much worse without them.

Note to author: Google "Austrian Economics" and then re-educate yourself away from the Keynesian concepts which got us into this mess in the first place.

2008 Oct 06 10:03 AM

[Warren B. M...:]

whid: yes, the tax cut 'inflationary' but the issue now is to halt the 'deflation' and support agg demand. and the payroll tax cut is a weekly event, that can be readily reversed if congress so desires

constu: there is no solvency risk for the US govt or any other govt with a non convertible currency/floating fx policy. all sov. defaults are due to fixed fx policies gone bad and/or debt in external currencies. the risk is inflation, which is going the other way. at the moment!

smart: it 'savings desires' were 100% you could do that. but they are not. japan's currency has been more than stable with deficits of 8% of gdp. we currently probably need something like that as well.

see 'soft currency economics' at moslereconomics.com under 'mandatory readings'

2008 Oct 07 09:03 AM

[Moon Kil Woong:]

Actually, Iceland just went to fixed FX policy because they are essentially bankrupt with Russia giving them a few billion dollar bridge loan. As for inflation, yes it is going to deflation right now unless the US becomes a default risk or inflate the money supply in a irrational system that doesn't produce any real increase in goods or services. Cutting tax to 0 certainly puts the US at risk of default and consequently if i was a foreign bond holder I'd demand either higher interest rates or just won't buy your bonds. That would equal inflation (even if the fed lowers the fed funds rate to 0% if it must pay 5% to sell bonds then their system is pretty much broken), default (in which your money becomes (cloth toilet paper), or both. So yes, this plan of no taxes is ridiculously stupid. No sane economist would ever endorse it.

2008 Oct 08 03:53 AM

[Warren B. M...:]

Cutting tax to 0 certainly puts the US at risk of default
NO, THERE IS NEVER ANY SOLVENCY RISK WITH NON CONV. CURRENCY/FLOATING FX POLICY

and consequently if i was a foreign bond holder I'd demand either higher interest rates or just won't buy your bonds.

WON'T MATTER. WHAT MATTERS IS IF YOU CHOSE OR NOT CHOSE TO HOLD $US FINANCIAL ASSETS, AND THAT ONLY MATTERS FOR INFLATION AND REAL TERMS OF TRADE, NOT SOLVENCY

2008 Oct 12 10:27 PM