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Archive for April, 2012

ELECTION YEAR POLITICS

AND THE ECONOMY

[Part IV]

The American Economy and Monetary Policy

 

The topic in Part IV of this blog is all about Monetary Policy. As you will see this is the other tool the government can use to influence the economy. Is Monetary Policy any more successful than fiscal policy? Well, let’s wait and see. Due to the complexity of some of the material to be presented, you might like to just puruse the topic of “Types of Monetary Policy.” It is sufficient for your education if you simply understand the 3 main tools the Federal Reserve has to manage the nation’s money supply. This will be very clear and understandable. If you wish to read the section on Types of Monetary Policy by all means go right ahead. Not to be flip I just want to warn you—the material is complex and gave me a headache as I was putting it all together. It’s important information but probably, unless you’re an economist, you could just simply gloss over the material from that section.

Money Supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define “money,” but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions).

Money supply data are recorded and published, usually by the government or the central bank of the country. Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.

What is Monetary Policy?

Monetary Policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it.

Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy:

Target Market   Variable:

Long Term   Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in theCPI
Price Level Targeting Interest rate on overnight debt A specificCPInumber
Monetary Aggregates The growth in money supply A given rate of change in theCPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of gold Low inflation as measured by the gold price
Mixed Policy Usually interest rates Usually unemployment +CPI  change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University. The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Columbia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except thatCPIgrowth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term “dollarization”) is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Gold standard

The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government’s promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of “fixed exchange rate” policy, or as a special type of commodity price level targeting.

The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base.

Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their money supply. The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971.

The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value.

Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

In a nutshell, monetary policy relates to increasing or decreasing the supply of money available in theU.S.Economy. Such actionable policy determines whether the economy heats up (more economic activity) or cools down (less economic activity). In turn, such decisions affect, either way, credit, and, down the road, influences business growth, hiring and employment, as well as everybody’s enemy—inflation.

The Infrastructure for Monetary Policy

While the budget remained enormously important, the job of managing the overall economy shifted substantially from fiscal policy to monetary policy during the later years of the 20th century. Monetary policy is the province of the Federal Reserve System, an independentU.S.government agency. “The Fed,” as it is commonly known, includes 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches.

All nationally chartered commercial banks are required by law to be members of the Federal Reserve System; membership is optional for state-chartered banks. In general, a bank that is a member of the Federal Reserve System uses the Reserve Bank in its region in the same way that a person uses a bank in his or her community.

The Federal Reserve Board of Governors administers the Federal Reserve System. It has seven members, who are appointed by the president to serve overlapping 14-year terms. The most important monetary policy decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven governors, the president of the Federal Reserve Bank ofNew   York, and presidents of four other Federal Reserve banks who serve on a rotating basis.

Although the Federal Reserve System periodically must report on its actions to Congress, the governors are, by law, independent from Congress and the president. Reinforcing this independence, the Fed conducts its most important policy discussions in private and often discloses them only after a period of time has passed. It also raises all of its own operating expenses from investment income and fees for its own services.

The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy. The most important is known as open market operations, or the buying and selling of government securities. To increase the supply of money, the Federal Reserve buys government securities from banks, other businesses, or individuals, paying for them with a check (a new source of money that it prints); when the Fed’s checks are deposited in banks, they create new reserves — a portion of which banks can lend or invest, thereby increasing the amount of money in circulation. On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting reserves from them. Because they have lower reserves, banks must reduce their lending, and the money supply drops accordingly.

The Fed also can control the money supply by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money over night to meet their reserve requirements. The rate on such loans, known as the “federal funds rate,” is a key gauge of how “tight” or “loose” monetary policy is at a given moment.

The Fed’s third tool is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans.

These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U.S. economy. If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business spending and consumer spending tend to rise, and employment increases; if the economy already is operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar. When the money supply contracts, on the other hand, credit is tight. In this situation, interest rates tend to rise, spending levels off or will decline, and inflation abates; if the economy is operating below its capacity, tight money can lead to rising unemployment.

Many factors complicate the ability of the Federal Reserve to use monetary policy to promote specific goals, however. For one thing, money takes many different forms, and it often is unclear which one to target.

In its most basic form, money consists of coins and paper currency. Coins come in various denominations based on the value of a dollar: the penny, which is worth one cent or one-hundredth of a dollar; the nickel, five cents; the dime, 10 cents; the quarter, 25 cents; the half dollar, 50 cents; and the dollar coin. Paper money comes in denominations of $1, $2, $5, $10, $20, $50, and $100.

A more important component of the money supply consists of checking deposits, or bookkeeping entries held in banks and other financial institutions. Individuals can make payments by writing checks, which essentially instruct their banks to pay given sums to the checks’ recipients. Time deposits are similar to checking deposits except the owner agrees to leave the sum on deposit for a specified period; while depositors generally can withdraw the funds earlier than the maturity date, they generally must pay a penalty and forfeit some interest to do so.

Money also includes money market funds, which are shares in pools of short-term securities, as well as a variety of other assets that can be converted easily into currency on short notice.

The amount of money held in different forms can change from time to time, depending on preferences and other factors that may or may not have any importance to the overall economy. Further complicating the Fed’s task, changes in the money supply affect the economy only after a lag of uncertain duration.

 

Monetary Policy and the Presidential Election Cycle

The Federal Reserve sets the monetary policy for the country. Although the Federal Reserve is supposed to be independent of the president and the Congress, monetary policy appears to follow the presidential election cycle as well.

In a paper entitled “The Presidential Term: Is the Third Year a Charm,” prepared by the CFA Institute and published in the Journal of Portfolio Management in 2007, the authors found that monetary policy is more accommodative in the second half of a presidential term and more restrictive in the first term.

These findings suggest that policy makers are reluctant to take a restrictive stance for fear it might slow down the economy in the months leading up to a presidential election. Of the four years, the third year is the year with the most expansionary monetary policy. During that year, the author found that monetary policy was expansionary 65% of the time versus 48% for the other three years.

Stock markets do well in periods of expansionary monetary policy and do relatively poorly when monetary policy is restrictive; therefore, it is no coincidence that the stock market is generally strong in the third year of a presidential cycle, when the Federal Reserve is in an expansionary mood. (For more insight, read Formulating Monetary Policy.)

Although the relationship between the presidential election cycle and the stock market appears to be strong, this does not mean it is going to play out the same way every cycle. However, when combined with other information, it can provide additional insights that investors can use to improve their investment decisions.

Monetary Policy and Fiscal Stabilization

The Fed’s operation has evolved over time in response to major events. The Congress established the Federal Reserve System in 1913 to strengthen the supervision of the banking system and stop bank panics that had erupted periodically in the previous century. As a result of the Great Depression in the 1930s, Congress gave the Fed authority to vary reserve requirements and to regulate stock market margins (the amount of cash people must put down when buying stock on credit).

Still, the Federal Reserve often tended to defer to the elected officials in matters of overall economic policy. During World War II, for instance, the Fed subordinated its operations to helping the U.S. Treasury borrow money at low interest rates. Later, when the government sold large amounts of Treasury securities to finance the Korean War, the Fed bought heavily to keep the prices of these securities from falling (thereby pumping up the money supply).

The Fed reasserted its independence in 1951, reaching an accord with the Treasury that Federal Reserve policy should not be subordinated to Treasury financing. But the central bank still did not stray too far from the political orthodoxy. During the fiscally conservative administration of President Dwight D. Eisenhower (1953-1961), for instance, the Fed emphasized price stability and restriction of monetary growth, while under more liberal presidents in the 1960s, it stressed full employment and economic growth.

During much of the 1970s, the Fed allowed rapid credit expansion in keeping with the government’s desire to combat unemployment. But with inflation increasingly ravaging the economy, the central bank abruptly tightened monetary policy beginning in 1979. This policy successfully slowed the growth of the money supply, but it helped trigger sharp recessions in 1980 and 1981-1982. The inflation rate did come down, however, and by the middle of the decade the Fed was again able to pursue a cautiously expansionary policy. Interest rates, however, stayed relatively high as the federal government had to borrow heavily to finance its budget deficit

(Speaking of interest rates, 1980 was a very bad time where buying homes was concerned. One of our friends bought her first home that year. She paid a mortgage rate of just over 14%. That was a long ways upward from the no-down GI loan rate of 7% my wife and I paid 11 years earlier). Rates slowly came down, too, as the deficit narrowed and ultimately disappeared in the 1990s.

The growing importance of monetary policy and the diminishing role played by fiscal policy in economic stabilization efforts may reflect both political and economic realities. The experience of the 1960s, 1970s, and 1980s suggests that democratically elected governments may have more trouble using fiscal policy to fight inflation than unemployment. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

One other reason suggests why fiscal policy may be more suited to fighting unemployment, while monetary policy may be more effective in fighting inflation. There is a limit to how much monetary policy can do to help the economy during a period of severe economic decline, such as the United   Statesencountered during the 1930s. The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more. The United Stateshas not encountered this situation, which economists call the “liquidity trap,” in recent years, but Japandid during the late 1990s. With its economy stagnant and interest rates near zero, many economists argued that the Japanese government had to resort to more aggressive fiscal policy, if necessary running up a sizable government deficit to spur renewed spending and economic growth.

Measuring Effect of Monetary Policy

Today, Federal Reserve economists use a number of measures to determine whether monetary policy should be tighter or looser. One approach is to compare the actual and potential growth rates of the economy. Potential growth is presumed to equal the sum of the growth in the labor force plus any gains in productivity, or output per worker.

In the late 1990s, the labor force was projected to grow about 1 percent a year, and productivity was thought to be rising somewhere between 1 percent and 1.5 percent. Therefore, the potential growth rate was assumed to be somewhere between 2 percent and 2.5 percent. By this measure, actual growth in excess of the long-term potential growth was seen as raising a danger of inflation, thereby requiring tighter money.

The second gauge is called NAIRU, or the non-accelerating inflation rate of unemployment. Over time, economists have noted that inflation tends to accelerate when joblessness drops below a certain level. In the decade that ended in the early 1990s, economists generally believed NAIRU was around 6 percent. But later in the decade, it appeared to have dropped to about 5.5 percent.

Perhaps even more importantly, a range of new technologies — the microprocessor, the laser, fiber-optics, and satellite — appeared in the late 1990s to be making the American economy significantly more productive than economists had thought possible. “The newest innovations, which we label information technologies, have begun to alter the manner in which we do business and create value, often in ways not readily foreseeable even five years ago,” Federal Reserve Chairman Alan Greenspan said in mid-1999.

Previously, lack of timely information about customers’ needs and the location of raw materials forced businesses to operate with larger inventories and more workers than they otherwise would need, according to Greenspan.

But as the quality of information improved, businesses could operate more efficiently. Information technologies also allowed for quicker delivery times, and they accelerated and streamlined the process of innovation. For instance, design times dropped sharply as computer modeling reduced the need for staff in architectural firms, Greenspan noted, and medical diagnoses became faster, more thorough, and more accurate.

Such technological innovations apparently accounted for an unexpected surge in productivity in the late 1990s. After rising at less than a 1 percent annual rate in the early part of the decade, productivity was growing at about a 3 percent rate toward the end of the 1990s — well ahead of what economists had expected. Higher productivity meant that businesses could grow faster without igniting inflation. Unexpectedly modest demands from workers for wage increases — a result, possibly, of the fact that workers felt less secure about keeping their jobs in the rapidly changing economy — also helped subdue inflationary pressures.

Some economists scoffed at the notion American suddenly had developed a “new economy,” one that was able to grow much faster without inflation. While there undeniably was increased global competition, they noted, many American industries remained untouched by it. And while computers clearly were changing the way Americans did business, they also were adding new layers of complexity to business operations.

But as economists increasingly came to agree with Greenspan that the economy was in the midst of a significant “structural shift,” the debate increasingly came to focus less on whether the economy was changing and more on how long the surprisingly strong performance could continue. The answer appeared to depend, in part, on the oldest of economic ingredients — labor. With the economy growing strongly, workers displaced by technology easily found jobs in newly emerging industries. As a result, employment was rising in the late 1990s faster than the overall population.

That trend could not continue indefinitely. By mid-1999, the number of “potential workers” aged 16 to 64 — those who were unemployed but willing to work if they could find jobs — totaled about 10 million, or about 5.7 percent of the population. That was the lowest percentage since the government began collecting such figures (in 1970). Eventually, economists warned, the United Stateswould face labor shortages, which, in turn, could be expected to drive up wages, trigger inflation, and prompt the Federal Reserve to engineer an economic slowdown.

Still, many things could happen to postpone that seemingly inevitable development. Immigration might increase, thereby enlarging the pool of available workers. That seemed unlikely, however, because the political climate in theUnited Statesduring the 1990s did not favor increased immigration.

More likely, a growing number of analysts believed that a growing number of Americans would work past the traditional retirement age of 65. That also could increase the supply of potential workers. Indeed, in 1999, the Committee on Economic Development (CED), a prestigious business research organization, called on employers to clear away barriers that previously discouraged older workers from staying in the labor force.

Current trends suggested that by 2030, there would be fewer than three workers for every person over the age of 65, compared to seven in 1950 — an unprecedented demographic transformation that the CED predicted would leave businesses scrambling to find workers.
“Businesses have heretofore demonstrated a preference for early retirement to make way for younger workers,” the group observed. “But this preference is a relic from an era of labor surpluses; it will not be sustainable when labor becomes scarce.” While enjoying remarkable successes, in short, the United States found itself moving into uncharted economic territory as it ended the 1990s.

While many saw a new economic era stretching indefinitely into the future, others were less certain. Weighing the uncertainties, many assumed a stance of cautious optimism. “Regrettably, history is strewn with visions of such `new eras’ that, in the end, have proven to be a mirage,” Greenspan noted in 1997. “In short, history counsels caution.”

In Part V ahead I will review the actual accomplishments of President Obama throughout the lion’s share of his first term in office. This will be followed by Part VI-A . In that segment, I will describe the accomplishments of the Republican Party the last four years and describe the background of their presidential candidate in 2012, Mitt Romney.

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ELECTION YEAR POLITICS

AND THE ECONOMY

[Part III]

 

How the President Views Fiscal Policy

Back in April, 2011 President Barack Obama gave a speech at George Washington University on Fiscal Policy. It was mostly about spending and taxes and the direction he was trying to take the country. I think his speech at that time clearly presents his case and is worth repeating here. It outlines his vision, and he explains (very well I might add) what his fiscal policy is. The following is that speech.

The White House

Office of the Press Secretary

For Immediate Release

April 13, 2011

Remarks by the President on Fiscal Policy

George Washington University

Washington, D.C.
1:48 P.M. EDT
THE PRESIDENT: Thank you very much. (Applause.) Please have a seat. Please have a seat, everyone.

It is wonderful to be back at GW. I want you to know that one of the reasons that I worked so hard with Democrats and Republicans to keep the government open was so that I could show up here today. I wanted to make sure that all of you had one more excuse to skip class. (Laughter.) You’re welcome. (Laughter.)

I want to give a special thanks to Steven Knapp, the president of GW. I just saw him — where is he? There he is right there. (Applause.)

We’ve got a lot of distinguished guests here — a couple of people I want to acknowledge. First of all, my outstanding Vice President, Joe Biden, is here. (Applause.) Our Secretary of the Treasury, Tim Geithner, is in the house. (Applause.) Jack Lew, the Director of the Office of Mangement and Budget. (Applause.) Gene Sperling, Chair of the National Economic Council, is here. (Applause.) Members of our bipartisan Fiscal Commission are here, including the two outstanding chairs — Erskine Bowles and Alan Simpson — are here. (Applause.)

And we have a number of members of Congress here today. I’m grateful for all of you taking the time to attend.

What we’ve been debating here in Washington over the last few weeks will affect the lives of the students here and families all across America in potentially profound ways. This debate over budgets and deficits is about more than just numbers on a page; it’s about more than just cutting and spending. It’s about the kind of future that we want. It’s about the kind of country that we believe in. And that’s what I want to spend some time talking about today.

From our first days as a nation, we have put our faith in free markets and free enterprise as the engine of America’s wealth and prosperity. More than citizens of any other country, we are rugged individualists, a self-reliant people with a healthy skepticism of too much government.

But there’s always been another thread running through our history -– a belief that we’re all connected, and that there are some things we can only do together, as a nation. We believe, in the words of our first Republican President, Abraham Lincoln, that through government, we should do together what we cannot do as well for ourselves.

And so we’ve built a strong military to keep us secure, and public schools and universities to educate our citizens. We’ve laid down railroads and highways to facilitate travel and commerce. We’ve supported the work of scientists and researchers whose discoveries have saved lives, unleashed repeated technological revolutions, and led to countless new jobs and entire new industries. Each of us has benefitted from these investments, and we’re a more prosperous country as a result.

Part of this American belief that we’re all connected also expresses itself in a conviction that each one of us deserves some basic measure of security and dignity. We recognize that no matter how responsibly we live our lives, hard times or bad luck, a crippling illness or a layoff may strike any one of us. “There but for the grace of God go I,” we say to ourselves. And so we contribute to programs like Medicare and Social Security, which guarantee us health care and a measure of basic income after a lifetime of hard work; unemployment insurance, which protects us against unexpected job loss; and Medicaid, which provides care for millions of seniors in nursing homes, poor children, those with disabilities. We’re a better country because of these commitments. I’ll go further. We would not be a great country without those commitments.

Now, for much of the last century, our nation found a way to afford these investments and priorities with the taxes paid by its citizens. As a country that values fairness, wealthier individuals have traditionally borne a greater share of this burden than the middle class or those less fortunate. Everybody pays, but the wealthier have borne a little more. This is not because we begrudge those who’ve done well -– we rightly celebrate their success. Instead, it’s a basic reflection of our belief that those who’ve benefited most from our way of life can afford to give back a little bit more. Moreover, this belief hasn’t hindered the success of those at the top of the income scale. They continue to do better and better with each passing year.

Now, at certain times -– particularly during war or recession -– our nation has had to borrow money to pay for some of our priorities. And as most families understand, a little credit card debt isn’t going to hurt if it’s temporary.

But as far back as the 1980s, America started amassing debt at more alarming levels, and our leaders began to realize that a larger challenge was on the horizon. They knew that eventually, the Baby Boom generation would retire, which meant a much bigger portion of our citizens would be relying on programs like Medicare, Social Security, and possibly Medicaid. Like parents with young children who know they have to start saving for the college years, America had to start borrowing less and saving more to prepare for the retirement of an entire generation.

To meet this challenge, our leaders came together three times during the 1990s to reduce our nation’s deficit — three times. They forged historic agreements that required tough decisions made by the first President Bush, then made by President Clinton, by Democratic Congresses and by a Republican Congress. All three agreements asked for shared responsibility and shared sacrifice. But they largely protected the middle class; they largely protected our commitment to seniors; they protected our key investments in our future.

As a result of these bipartisan efforts, America’s finances were in great shape by the year 2000. We went from deficit to surplus. America was actually on track to becoming completely debt free, and we were prepared for the retirement of the Baby Boomers.

But after Democrats and Republicans committed to fiscal discipline during the 1990s, we lost our way in the decade that followed. We increased spending dramatically for two wars and an expensive prescription drug program -– but we didn’t pay for any of this new spending. Instead, we made the problem worse with trillions of dollars in unpaid-for tax cuts -– tax cuts that went to every millionaire and billionaire in the country; tax cuts that will force us to borrow an average of $500 billion every year over the next decade.

To give you an idea of how much damage this caused to our nation’s checkbook, consider this: In the last decade, if we had simply found a way to pay for the tax cuts and the prescription drug benefit, our deficit would currently be at low historical levels in the coming years.

But that’s not what happened. And so, by the time I took office, we once again found ourselves deeply in debt and unprepared for a Baby Boom retirement that is now starting to take place. When I took office, our projected deficit, annually, was more than $1 trillion. On top of that, we faced a terrible financial crisis and a recession that, like most recessions, led us to temporarily borrow even more.

In this case, we took a series of emergency steps that saved millions of jobs, kept credit flowing, and provided working families extra money in their pocket. It was absolutely the right thing to do, but these steps were expensive, and added to our deficits in the short term.

So that’s how our fiscal challenge was created. That’s how we got here. And now that our economic recovery is gaining strength, Democrats and Republicans must come together and restore the fiscal responsibility that served us so well in the 1990s. We have to live within our means. We have to reduce our deficit, and we have to get back on a path that will allow us to pay down our debt. And we have to do it in a way that protects the recovery, protects the investments we need to grow, create jobs, and helps us win the future.

Now, before I get into how we can achieve this goal, some of you, particularly the younger people here — you don’t qualify, Joe. (Laughter.) Some of you might be wondering, “Why is this so important? Why does this matter to me?”

Well, here’s why. Even after our economy recovers, our government will still be on track to spend more money than it takes in throughout this decade and beyond. That means we’ll have to keep borrowing more from countries like China. That means more of your tax dollars each year will go towards paying off the interest on all the loans that we keep taking out. By the end of this decade, the interest that we owe on our debt could rise to nearly $1 trillion. Think about that. That’s the interest — just the interest payments.

Then, as the Baby Boomers start to retire in greater numbers and health care costs continue to rise, the situation will get even worse. By 2025, the amount of taxes we currently pay will only be enough to finance our health care programs — Medicare and Medicaid — Social Security, and the interest we owe on our debt. That’s it. Every other national priority -– education, transportation, even our national security -– will have to be paid for with borrowed money.

Now, ultimately, all this rising debt will cost us jobs and damage our economy. It will prevent us from making the investments we need to win the future. We won’t be able to afford good schools, new research, or the repair of roads -– all the things that create new jobs and businesses here in America. Businesses will be less likely to invest and open shop in a country that seems unwilling or unable to balance its books. And if our creditors start worrying that we may be unable to pay back our debts, that could drive up interest rates for everybody who borrows money -– making it harder for businesses to expand and hire, or families to take out a mortgage.

Here’s the good news: That doesn’t have to be our future. That doesn’t have to be the country that we leave our children. We can solve this problem. We came together as Democrats and Republicans to meet this challenge before; we can do it again.

But that starts by being honest about what’s causing our deficit. You see, most Americans tend to dislike government spending in the abstract, but like the stuff that it buys. Most of us, regardless of party affiliation, believe that we should have a strong military and a strong defense. Most Americans believe we should invest in education and medical research. Most Americans think we should protect commitments like Social Security and Medicare. And without even looking at a poll, my finely honed political instincts tell me that almost nobody believes they should be paying higher taxes. (Laughter.)

So because all this spending is popular with both Republicans and Democrats alike, and because nobody wants to pay higher taxes, politicians are often eager to feed the impression that solving the problem is just a matter of eliminating waste and abuse. You’ll hear that phrase a lot. “We just need to eliminate waste and abuse.” The implication is that tackling the deficit issue won’t require tough choices. Or politicians suggest that we can somehow close our entire deficit by eliminating things like foreign aid, even though foreign aid makes up about 1 percent of our entire federal budget.

So here’s the truth. Around two-thirds of our budget — two-thirds — is spent on Medicare, Medicaid, Social Security, and national security. Two-thirds. Programs like unemployment insurance, student loans, veterans’ benefits, and tax credits for working families take up another 20 percent. What’s left, after interest on the debt, is just 12 percent for everything else. That’s 12 percent for all of our national priorities — education, clean energy, medical research, transportation, our national parks, food safety, keeping our air and water clean — you name it — all of that accounts for 12 percent of our budget.

Now, up till now, the debate here in Washington, the cuts proposed by a lot of folks in Washington, have focused exclusively on that 12 percent. But cuts to that 12 percent alone won’t solve the problem. So any serious plan to tackle our deficit will require us to put everything on the table, and take on excess spending wherever it exists in the budget.

A serious plan doesn’t require us to balance our budget overnight –- in fact, economists think that with the economy just starting to grow again, we need a phased-in approach –- but it does require tough decisions and support from our leaders in both parties now. Above all, it will require us to choose a vision of the America we want to see five years, 10 years, 20 years down the road.

Now, to their credit, one vision has been presented and championed by Republicans in the House of Representatives and embraced by several of their party’s presidential candidates. It’s a plan that aims to reduce our deficit by $4 trillion over the next 10 years, and one that addresses the challenge of Medicare and Medicaid in the years after that.

These are both worthy goals. They’re worthy goals for us to achieve. But the way this plan achieves those goals would lead to a fundamentally different America than the one we’ve known certainly in my lifetime. In fact, I think it would be fundamentally different than what we’ve known throughout our history.

A 70 percent cut in clean energy. A 25 percent cut in education. A 30 percent cut in transportation. Cuts in college Pell Grants that will grow to more than $1,000 per year. That’s the proposal. These aren’t the kind of cuts you make when you’re trying to get rid of some waste or find extra savings in the budget. These aren’t the kinds of cuts that the Fiscal Commission proposed. These are the kinds of cuts that tell us we can’t afford the America that I believe in and I think you believe in.

I believe it paints a vision of our future that is deeply pessimistic. It’s a vision that says if our roads crumble and our bridges collapse, we can’t afford to fix them. If there are bright young Americans who have the drive and the will but not the money to go to college, we can’t afford to send them.

Go to China and you’ll see businesses opening research labs and solar facilities. South Korean children are outpacing our kids in math and science. They’re scrambling to figure out how they put more money into education. Brazil is investing billions in new infrastructure and can run half their cars not on high-priced gasoline, but on biofuels. And yet, we are presented with a vision that says the American people, the United States of America -– the greatest nation on Earth -– can’t afford any of this.

It’s a vision that says America can’t afford to keep the promise we’ve made to care for our seniors. It says that 10 years from now, if you’re a 65-year-old who’s eligible for Medicare, you should have to pay nearly $6,400 more than you would today. It says instead of guaranteed health care, you will get a voucher. And if that voucher isn’t worth enough to buy the insurance that’s available in the open marketplace, well, tough luck -– you’re on your own. Put simply, it ends Medicare as we know it.

It’s a vision that says up to 50 million Americans have to lose their health insurance in order for us to reduce the deficit. Who are these 50 million Americans? Many are somebody’s grandparents — may be one of yours — who wouldn’t be able to afford nursing home care without Medicaid. Many are poor children. Some are middle-class families who have children with autism or Down’s syndrome. Some of these kids with disabilities are — the disabilities are so severe that they require 24-hour care. These are the Americans we’d be telling to fend for themselves.

And worst of all, this is a vision that says even though Americans can’t afford to invest in education at current levels, or clean energy, even though we can’t afford to maintain our commitment on Medicare and Medicaid, we can somehow afford more than $1 trillion in new tax breaks for the wealthy. Think about that.

In the last decade, the average income of the bottom 90 percent of all working Americans actually declined. Meanwhile, the top 1 percent saw their income rise by an average of more than a quarter of a million dollars each. That’s who needs to pay less taxes?

They want to give people like me a $200,000 tax cut that’s paid for by asking 33 seniors each to pay $6,000 more in health costs. That’s not right. And it’s not going to happen as long as I’m President. (Applause.)

This vision is less about reducing the deficit than it is about changing the basic social compact in America. Ronald Reagan’s own budget director said, there’s nothing “serious” or “courageous” about this plan. There’s nothing serious about a plan that claims to reduce the deficit by spending a trillion dollars on tax cuts for millionaires and billionaires. And I don’t think there’s anything courageous about asking for sacrifice from those who can least afford it and don’t have any clout on Capitol Hill. That’s not a vision of the America I know.

The America I know is generous and compassionate. It’s a land of opportunity and optimism. Yes, we take responsibility for ourselves, but we also take responsibility for each other; for the country we want and the future that we share. We’re a nation that built a railroad across a continent and brought light to communities shrouded in darkness. We sent a generation to college on the GI Bill and we saved millions of seniors from poverty with Social Security and Medicare. We have led the world in scientific research and technological breakthroughs that have transformed millions of lives. That’s who we are. This is the America that I know. We don’t have to choose between a future of spiraling debt and one where we forfeit our investment in our people and our country.

To meet our fiscal challenge, we will need to make reforms. We will all need to make sacrifices. But we do not have to sacrifice the America we believe in. And as long as I’m President, we won’t.

So today, I’m proposing a more balanced approach to achieve $4 trillion in deficit reduction over 12 years. It’s an approach that borrows from the recommendations of the bipartisan Fiscal Commission that I appointed last year, and it builds on the roughly $1 trillion in deficit reduction I already proposed in my 2012 budget. It’s an approach that puts every kind of spending on the table — but one that protects the middle class, our promise to seniors, and our investments in the future.

The first step in our approach is to keep annual domestic spending low by building on the savings that both parties agreed to last week. That step alone will save us about $750 billion over 12 years. We will make the tough cuts necessary to achieve these savings, including in programs that I care deeply about, but I will not sacrifice the core investments that we need to grow and create jobs. We will invest in medical research. We will invest in clean energy technology. We will invest in new roads and airports and broadband access. We will invest in education. We will invest in job training. We will do what we need to do to compete, and we will win the future.

The second step in our approach is to find additional savings in our defense budget. Now, as Commander-in-Chief, I have no greater responsibility than protecting our national security, and I will never accept cuts that compromise our ability to defend our homeland or America’s interests around the world. But as the Chairman of the Joint Chiefs, Admiral Mullen, has said, the greatest long-term threat to America’s national security is America’s debt. So just as we must find more savings in domestic programs, we must do the same in defense. And we can do that while still keeping ourselves safe.

Over the last two years, Secretary Bob Gates has courageously taken on wasteful spending, saving $400 billion in current and future spending. I believe we can do that again. We need to not only eliminate waste and improve efficiency and effectiveness, but we’re going to have to conduct a fundamental review of America’s missions, capabilities, and our role in a changing world. I intend to work with Secretary Gates and the Joint Chiefs on this review, and I will make specific decisions about spending after it’s complete.

The third step in our approach is to further reduce health care spending in our budget. Now, here, the difference with the House Republican plan could not be clearer. Their plan essentially lowers the government’s health care bills by asking seniors and poor families to pay them instead. Our approach lowers the government’s health care bills by reducing the cost of health care itself.

Already, the reforms we passed in the health care law will reduce our deficit by $1 trillion. My approach would build on these reforms. We will reduce wasteful subsidies and erroneous payments. We will cut spending on prescription drugs by using Medicare’s purchasing power to drive greater efficiency and speed generic brands of medicine onto the market. We will work with governors of both parties to demand more efficiency and accountability from Medicaid.

We will change the way we pay for health care -– not by the procedure or the number of days spent in a hospital, but with new incentives for doctors and hospitals to prevent injuries and improve results. And we will slow the growth of Medicare costs by strengthening an independent commission of doctors, nurses, medical experts and consumers who will look at all the evidence and recommend the best ways to reduce unnecessary spending while protecting access to the services that seniors need.

Now, we believe the reforms we’ve proposed to strengthen Medicare and Medicaid will enable us to keep these commitments to our citizens while saving us $500 billion by 2023, and an additional $1 trillion in the decade after that. But if we’re wrong, and Medicare costs rise faster than we expect, then this approach will give the independent commission the authority to make additional savings by further improving Medicare.

But let me be absolutely clear: I will preserve these health care programs as a promise we make to each other in this society. I will not allow Medicare to become a voucher program that leaves seniors at the mercy of the insurance industry, with a shrinking benefit to pay for rising costs. I will not tell families with children who have disabilities that they have to fend for themselves. We will reform these programs, but we will not abandon the fundamental commitment this country has kept for generations.

That includes, by the way, our commitment to Social Security. While Social Security is not the cause of our deficit, it faces real long-term challenges in a country that’s growing older. As I said in the State of the Union, both parties should work together now to strengthen Social Security for future generations. But we have to do it without putting at risk current retirees, or the most vulnerable, or people with disabilities; without slashing benefits for future generations; and without subjecting Americans’ guaranteed retirement income to the whims of the stock market. And it can be done.

The fourth step in our approach is to reduce spending in the tax code, so-called tax expenditures. In December, I agreed to extend the tax cuts for the wealthiest Americans because it was the only way I could prevent a tax hike on middle-class Americans. But we cannot afford $1 trillion worth of tax cuts for every millionaire and billionaire in our society. We can’t afford it. And I refuse to renew them again.

Beyond that, the tax code is also loaded up with spending on things like itemized deductions. And while I agree with the goals of many of these deductions, from homeownership to charitable giving, we can’t ignore the fact that they provide millionaires an average tax break of $75,000 but do nothing for the typical middle-class family that doesn’t itemize. So my budget calls for limiting itemized deductions for the wealthiest 2 percent of Americans — a reform that would reduce the deficit by $320 billion over 10 years.

But to reduce the deficit, I believe we should go further. And that’s why I’m calling on Congress to reform our individual tax code so that it is fair and simple — so that the amount of taxes you pay isn’t determined by what kind of accountant you can afford.

I believe reform should protect the middle class, promote economic growth, and build on the fiscal commission’s model of reducing tax expenditures so that there’s enough savings to both lower rates and lower the deficit. And as I called for in the State of the Union, we should reform our corporate tax code as well, to make our businesses and our economy more competitive.

So this is my approach to reduce the deficit by $4 trillion over the next 12 years. It’s an approach that achieves about $2 trillion in spending cuts across the budget. It will lower our interest payments on the debt by $1 trillion. It calls for tax reform to cut about $1 trillion in tax expenditures — spending in the tax code. And it achieves these goals while protecting the middle class, protecting our commitment to seniors, and protecting our investments in the future.

Now, in the coming years, if the recovery speeds up and our economy grows faster than our current projections, we can make even greater progress than I’ve pledged here. But just to hold Washington — and to hold me — accountable and make sure that the debt burden continues to decline, my plan includes a debt failsafe. If, by 2014, our debt is not projected to fall as a share of the economy -– if we haven’t hit our targets, if Congress has failed to act -– then my plan will require us to come together and make up the additional savings with more spending cuts and more spending reductions in the tax code. That should be an incentive for us to act boldly now, instead of kicking our problems further down the road.

So this is our vision for America -– this is my vision for America — a vision where we live within our means while still investing in our future; where everyone makes sacrifices but no one bears all the burden; where we provide a basic measure of security for our citizens and we provide rising opportunity for our children.

There will be those who vigorously disagree with my approach. I can guarantee that as well. (Laughter.) Some will argue we should not even consider ever — ever — raising taxes, even if only on the wealthiest Americans. It’s just an article of faith to them. I say that at a time when the tax burden on the wealthy is at its lowest level in half a century, the most fortunate among us can afford to pay a little more. I don’t need another tax cut. Warren Buffett doesn’t need another tax cut. Not if we have to pay for it by making seniors pay more for Medicare. Or by cutting kids from Head Start. Or by taking away college scholarships that I wouldn’t be here without and that some of you would not be here without.

And here’s the thing: I believe that most wealthy Americans would agree with me. They want to give back to their country, a country that’s done so much for them. It’s just Washington hasn’t asked them to.

Others will say that we shouldn’t even talk about cutting spending until the economy is fully recovered. These are mostly folks in my party. I’m sympathetic to this view — which is one of the reasons I supported the payroll tax cuts we passed in December. It’s also why we have to use a scalpel and not a machete to reduce the deficit, so that we can keep making the investments that create jobs. But doing nothing on the deficit is just not an option. Our debt has grown so large that we could do real damage to the economy if we don’t begin a process now to get our fiscal house in order.

Finally, there are those who believe we shouldn’t make any reforms to Medicare, Medicaid, or Social Security, out of fear that any talk of change to these programs will immediately usher in the sort of steps that the House Republicans have proposed. And I understand those fears. But I guarantee that if we don’t make any changes at all, we won’t be able to keep our commitment to a retiring generation that will live longer and will face higher health care costs than those who came before.

Indeed, to those in my own party, I say that if we truly believe in a progressive vision of our society, we have an obligation to prove that we can afford our commitments. If we believe the government can make a difference in people’s lives, we have the obligation to prove that it works -– by making government smarter, and leaner and more effective.

Of course, there are those who simply say there’s no way we can come together at all and agree on a solution to this challenge. They’ll say the politics of this city are just too broken; the choices are just too hard; the parties are just too far apart. And after a few years on this job, I have some sympathy for this view. (Laughter.)

But I also know that we’ve come together before and met big challenges. Ronald Reagan and Tip O’Neill came together to save Social Security for future generations. The first President Bush and a Democratic Congress came together to reduce the deficit. President Clinton and a Republican Congress battled each other ferociously, disagreed on just about everything, but they still found a way to balance the budget. And in the last few months, both parties have come together to pass historic tax relief and spending cuts.

And I know there are Republicans and Democrats in Congress who want to see a balanced approach to deficit reduction. And even those Republicans I disagree with most strongly I believe are sincere about wanting to do right by their country. We may disagree on our visions, but I truly believe they want to do the right thing.

So I believe we can, and must, come together again. This morning, I met with Democratic and Republican leaders in Congress to discuss the approach that I laid out today. And in early May, the Vice President will begin regular meetings with leaders in both parties with the aim of reaching a final agreement on a plan to reduce the deficit and get it done by the end of June.

I don’t expect the details in any final agreement to look exactly like the approach I laid out today. This a democracy; that’s not how things work. I’m eager to hear other ideas from all ends of the political spectrum. And though I’m sure the criticism of what I’ve said here today will be fierce in some quarters, and my critique of the House Republican approach has been strong, Americans deserve and will demand that we all make an effort to bridge our differences and find common ground.

This larger debate that we’re having — this larger debate about the size and the role of government — it has been with us since our founding days. And during moments of great challenge and change, like the one that we’re living through now, the debate gets sharper and it gets more vigorous. That’s not a bad thing. In fact, it’s a good thing. As a country that prizes both our individual freedom and our obligations to one another, this is one of the most important debates that we can have.

But no matter what we argue, no matter where we stand, we’ve always held certain beliefs as Americans. We believe that in order to preserve our own freedoms and pursue our own happiness, we can’t just think about ourselves. We have to think about the country that made these liberties possible. We have to think about our fellow citizens with whom we share a community. And we have to think about what’s required to preserve the American Dream for future generations.

This sense of responsibility — to each other and to our country — this isn’t a partisan feeling. It isn’t a Democratic or a Republican idea. It’s patriotism.

The other day I received a letter from a man in Florida. He started off by telling me he didn’t vote for me and he hasn’t always agreed with me. But even though he’s worried about our economy and the state of our politics — here’s what he said — he said, “I still believe. I believe in that great country that my grandfather told me about. I believe that somewhere lost in this quagmire of petty bickering on every news station, the ‘American Dream’ is still alive…We need to use our dollars here rebuilding, refurbishing and restoring all that our ancestors struggled to create and maintain… We as a people must do this together, no matter the color of the state one comes from or the side of the aisle one might sit on.”

“I still believe.” I still believe as well. And I know that if we can come together and uphold our responsibilities to one another and to this larger enterprise that is America, we will keep the dream of our founding alive — in our time; and we will pass it on to our children. We will pass on to our children a country that we believe in.

Thank you. God bless you, and may God bless the United States of America. (Applause.)

END
2:31 P.M. EDT

 

 

In Part IV ahead I will describe the American economy and monetary policy. 

 

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ELECTION YEAR POLITICS

 AND THE ECONOMY

 [Part II]

 

Part II has three major divisions: How Economic Cycles Work, American Economy and Fiscal Policy, and The Staggering American National Debt. Originally I was only going to discuss the first two topics but the more I got into Fiscal Policy the more crucial it was for me to also discuss deficits and our national debt.

 

Economic Cycles and How They Work?

Traditional business cycles undergo four stages: expansion, prosperity, contraction, and recession. After a recessionary phase, the expansionary phase starts again. Each of the phases of the business cycle is characterized by changing employment, industrial productivity, and interest rates. Some economists believe that stock price trends precede business cycle stages. Also, the length of each cycle can vary quite a lot showing that economic or business cycles take on a life of their own. Although timing is problematic the cycles are nevertheless predictable. And that means they will occur again and again in the same order.

One might like to have an endless prosperity cycle but that will never happen. The overriding concept of business cycles is that they influence the long-term pattern of changes in National Income (highest during prosperity and lowest during the recessionary phase).

The term business cycle (or economic cycle) more specifically refers to economy-wide fluctuations in production or economic activity (creating goods and services) over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or a recession).

Business cycles are usually measured by considering the growth rate of real gross domestic product. I will emphasize again for your understanding: Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern. However, while varying in duration one thing is always certain:  they always repeat in the same order and have a life of their own.

This is why, in an absolute sense, placing blame on a single individual makes no sense at all. It’s like holding someone responsible because the earth rotates around the sun, or because the four seasons occur in a certain order. No one can alter the seasons or rotational pattern of the earth in space.

However, one can argue that although a sitting President cannot absolutely control the economy, he or she can Influence some of the variables within a cycle such as changing employment, industrial productivity, and interest rates. Theoretically, such tinkering with these types of variables should speed up or slow down economic activity.

Without going too far astray with explanations, most economists would say whatever influence or leverage any president has to affect change, or to influence the future direction of  economic or business cycles—lies in two major areas. These two areas are Fiscal Policy and Monetary Policy. How these areas of influence are used depends largely on political preferences and both the level of knowledge and assumptions made by those who occupy the Oval Office, among those who sit in Congress, or among those in leadership positions in the Federal Reserve.

The first area to be explored is Fiscal Policy. I am providing a very detailed, informative explanation on how the government influences the economy through fiscal policy. Some of what I’m going to say is general information (albeit mostly recent history). Let’s proceed now down an “economic memory lane.”

The American Economy and Fiscal Policy

The role of government in the American economy extends far beyond its activities as a regulator of specific industries. The government also manages the overall pace of economic activity, seeking to maintain high levels of employment and stable prices. As said above there are two main tools for achieving these objectives: fiscal policy, through which it determines the appropriate level of taxes and spending; and monetary policy, through which it manages the supply of money. Your real education on the economy begins here.

Fiscal Policy

Much of the history of economic policy in the United States since the Great Depression of the 1930s has involved a continuing effort by the government to find a mix of fiscal and monetary policies that will allow sustained growth and stable prices. That is no easy task, and there have been notable failures along the way.

But the government has gotten better at promoting sustainable growth. From 1854 through 1919, the American economy spent almost as much time contracting as it did growing: the average economic expansion (defined as an increase in output of goods and services) lasted 27 months, while the average recession (a period of declining output) lasted 22 months. From 1919 to 1945, the record improved, with the average expansion lasting 35 months and the average recession lasting 18 months. And from 1945 to 1991, things got even better, with the average expansion lasting 50 months and the average recession lasting just 11 months. Inflation, however, has proven more intractable. Prices were remarkably stable prior to World War II; the consumer price level in 1940, for instance, was no higher than the price level in 1778. But 40 years later, in 1980, the price level was 400 percent above the 1940 level.

My wife and I have owned three homes in 44 years of marriage. We bought our first home in 1969 for $16,500—a nice, large 3 bedroom, 2 bath home (with a family room) in a decent neighborhood. Despite the decline in home values the last 5 years, that same home today would nevertheless cost between $225,000 and $247,000. Inflation is wonderful when it works for you, but its terrible when it stabs you in the back through no fault of your own (for example, when young people and new home owners owe more on their home than its worth in a free market economy).

In part, the government’s relatively poor record on inflation reflects the fact that it put more stress on fighting recessions (and resulting increases in unemployment) during much of the early post World War II period. Beginning in 1979, however, the government began paying more attention to inflation, and its record on that score has improved markedly. By the late 1990s, the nation was experiencing a gratifying combination of strong growth, low unemployment, and slow inflation. But while policy-makers were generally optimistic about the future, they admitted to some uncertainties about what the new century would bring.

Fiscal Policy — Budget and Taxes

The growth of government since the 1930s has been accompanied by steady increases in government spending. In 1930, the federal government accounted for just 3.3 percent of the nation’s gross domestic product, or total output of goods and services excluding imports and exports. That figure rose to almost 44 percent of GDP in 1944 (you remember folks—the war industries were going strong), at the height of World War II. However, it dropped back to 11.6 percent in 1948. But government spending generally rose as a share of GDP in subsequent years, reaching almost 24 percent in 1983 before falling back somewhat. In 1999 it stood at about 21 percent.

The development of fiscal policy is an elaborate process. Each year, the president proposes a budget, or spending plan, to Congress. Lawmakers consider the president’s proposals in several steps. First, they decide on the overall level of spending and taxes. Next, they divide that overall figure into separate categories — for national defense, health and human services, and transportation, for instance.

Finally, Congress considers individual appropriations bills spelling out exactly how the money in each category will be spent. Each appropriations bill ultimately must be signed by the president in order to take effect. This budget process often takes an entire session of Congress; the president presents his proposals in early February, and Congress often does not finish its work on appropriations bills until September (and sometimes even later).

The federal government’s chief source of funds to cover its expenses is the income tax on individuals, which in 1999 brought in about 48 percent of total federal revenues.  Payroll taxes, which finance the Social Security and Medicare programs, have become increasingly important as those programs have grown. In 1998, payroll taxes accounted for one-third of all federal revenues; employers and workers each had to pay an amount equal to 7.65 percent of their wages up to $68,400 a year.

The federal government raises another 10 percent of its revenue from a tax on corporate profits, while miscellaneous other taxes account for the remainder of its income. (Local governments, in contrast, generally collect most of their tax revenues from property taxes. State governments traditionally have depended on sales and excise taxes, but state income taxes have grown more important since World War II.)

The federal income tax is levied on the worldwide income of U.S.citizens and resident aliens and on certain U.S.income of non-residents. The first U.S. income tax law was enacted in 1862 to support the Civil War. The 1862 tax law also established the Office of the Commissioner of Internal Revenue to collect taxes and enforce tax laws either by seizing the property and income of non-payers or through prosecution. The commissioner’s powers and authority remain much the same today.

The income tax was declared unconstitutional by the Supreme Court in 1895 because it was not apportioned among the states in conformity with the Constitution. It was not until the 16th Amendment to the Constitution was adopted in 1913 that Congress was authorized to levy an income tax without apportionment. Still, except during World War I, the income tax system remained a relatively minor source of federal revenue until the 1930s.

During World War II, the modern system for managing federal income taxes was introduced, income tax rates were raised to very high levels, and the levy became the principal sources of federal revenue. Beginning in 1943, the government required employers to collect income taxes from workers by withholding certain sums from their paychecks, a policy that streamlined collection and significantly increased the number of taxpayers.

 Most debates about the income tax today revolve around three issues:

  • The appropriate overall level of taxation
  • How graduated, or “progressive” the tax should be, and
  • The extent to which the tax should be used to promote social objectives.

The overall level of taxation is decided through budget negotiations. Although Americans allowed the government to run up deficits, spending more than it collected in taxes during the 1970s, 1980s, and the part of the 1990s, they generally believed budgets should be balanced. Most Democrats, however, are willing to tolerate a higher level of taxes to support a more active government, while Republicans generally favor lower taxes and smaller government.

From the outset, the income tax has been a progressive levy, meaning that rates are higher for people with more income. Most Democrats favor Robin Hood politics (steal from the rich and give to the poor i.e., the famous class warfare scenario) because they believe or argue that it is only fair to make people with more income pay more in taxes. This argument merely points out that assumptions about what is viewed as “fairness” has nothing whatsoever to do with fairness, and everything to do with discrimination and value judgments that rationalize the justification for such discrimination. It’s all about values, not logic, reason, or fairness.

This belief or value judgment occurs despite the fact everyone is entitled to just one vote, and everyone is theoretically equal in the eyes of the U.S. Constitution. However, despite paying lip service to notions like one man, one vote, or belief in the theoretical equality among citizens, Democratic administrations seem (as ideology and as a practical matter)  to favor a plan of income redistribution in order to contribute to social objectives like helping the poor. How pervasive is discrimination against higher income individuals?

In 2003 the following data was released in the Congressional Budget Office Report. It made very clear who really pays our Federal Income Taxes.

For 2003, the estimated share of total individual income taxes paid by:

Wealthiest 1%—-33.6%
Wealthiest 5%—-55.1%
Wealthiest 10%—67.9%
Wealthiest 20%—83.0%
Wealthiest 40%—97.8%
Wealthiest 60%—103.0%

The way to read this is that the wealthiest 10% of taxpayers pay 67.9% of the country’s individual income taxes (or that the top 5% in income pay more than half of all income taxes). And yes, that 103% is not a typo – the bottom 40% in income, as a group, pay negative personal income taxes (because of the EITC).

Many Republicans, however, believe a steeply progressive rate structure discourages people from working and investing, and therefore hurts the overall economy. Accordingly, many Republicans argue for a more uniform rate structure. Some even suggest a uniform, or “flat,” tax rate for everybody. Parenthetically, some economists— both Democrats and Republicans—have suggested that the economy would fare better if the government would eliminate the income tax altogether and replace it with a consumption tax (meaning a national sales tax on goods and services).

This would tax people on what they spend rather than what they earn. What’s nice about a consumption tax is that you, the individual taxpayer, are in the driver’s seat. What it means is that everyone is free to choose whether to buy or not to buy, thus exercising some degree of control over how much they ultimately spend on taxes. The irony of this plan is that ultimately the rich and the super rich will likely pay more in consumption taxes anyway since they are in a position to afford buying that expensive Cadillac or Mercedes Benz (thus paying a greater consumption tax). And, the poor would continue to pay less taxes because their incomes are small.

Proponents argue that a consumption tax would encourage saving and investment. But as of the end of the 1990s, the idea had not gained enough support to be given much chance of being enacted (think of all those industries and occupations that feed off your responsibility to pay taxes—everything from Turbotax software products, H&R Block, to the highest paid career tax accountants and lawyers doing business in the tax field. A National Sales Tax, while an intelligent and efficient system for generating tax revenues, would nevertheless negatively impact a lot of careers and some tax-related products.

Over the years, lawmakers have created various exemptions and deductions from the income tax to encourage specific kinds of economic activity. Most notably, taxpayers are allowed to subtract from their taxable income any interest they must pay on loans used to buy homes. Similarly, the government allows lower- and middle-income taxpayers to shelter from taxation certain amounts of money that they save in special Individual Retirement Accounts (IRAs) to meet their retirement expenses and to pay for their children’s college education.

The Tax Reform Act of 1986, perhaps the most substantial reform of the U.S. tax system since the beginning of the income tax, reduced income tax rates while cutting back many popular income tax deductions (the home mortgage deduction and IRA deductions were preserved, however). The Tax Reform Act replaced the previous law’s 15 tax brackets, which had a top tax rate of 50 percent, with a system that had only two tax brackets — 15 percent and 28 percent. Other provisions reduced, or eliminated, income taxes for millions of low-income Americans.

Fiscal Policy and Economic Stabilization

In the 1930s during the Depression the government began to use fiscal policy, not just to support itself or pursue social policies, but to promote overall economic growth and stability as well. Policy-makers were influenced by John Maynard Keynes, an English economist who argued in The General Theory of Employment, Interest, and Money (1936) that the rampant joblessness of his time resulted from inadequate demand for goods and services.

According to Keynes, people did not have enough income to buy everything the economy could produce, so prices fell and companies lost money or went bankrupt. Without government intervention, Keynes said, this could become a vicious cycle. As more companies went bankrupt, he argued, more people would lose their jobs, making income fall further and leading yet more companies to fail in a frightening downward spiral.

Keynes argued that government could halt the decline by increasing spending (The preferred Democrat Approach) on its own or by cutting taxes (The Preferred Republican Approach). Either way, incomes would rise, people would spend more, and the economy could start growing again. If the government had to run up a deficit to achieve this purpose, so be it, Keynes said. In his view, the alternative—deepening economic decline—would be worse.

These statements in 1936 by Keynes are very telling when one thinks about the current debate in Congress between Democrats and Republicans. The Republican’s mantra is to lower taxes; in contrast in the last four years the Obama administration enacted an economic stimulus package, tried to improve the country’s infrastructure, signed into law a long needed better health care system, and bailed out successfully General Motors and Chrysler and many financial institutions such as banks and corporations on the brink of disaster. Consequently, the economy not only came back from the brink of disaster, but also began heating up the economy fostering greater job growth and slowly lowering unemployment while holding inflation relatively constant. These economic theories of Keynes continued to have influence long after 1936.

By the 1960s, policy-makers seemed wedded to Keynesian theories. But in retrospect, most Americans agree, the government then made a series of mistakes in the economic policy arena that eventually led to a reexamination of fiscal policy. After enacting a tax cut in 1964 to stimulate economic growth and reduce unemployment, President Lyndon B. Johnson (1963-1969) and Congress launched a series of expensive domestic spending programs designed to alleviate poverty (You remember. They called it the “War on Poverty”). Johnson also increased military spending to pay for American involvement in the Vietnam War. These large government programs, combined with strong consumer spending, pushed the demand for goods and services beyond what the economy could produce. Wages and prices started rising. Soon, rising wages and prices fed each other in an ever-rising cycle. Such an overall increase in prices ( repeated here, but also pointed out as everyone’s enemy in Part I ) is known as inflation.

Keynes had argued that during such periods of excess demand, the government should reduce spending or raise taxes to avert inflation. But anti-inflation fiscal policies are difficult to sell politically, and the government resisted shifting to them. Then, in the early 1970s, the nation was hit by a sharp rise in international oil and food prices. This posed an acute dilemma for policy-makers. The conventional anti-inflation strategy would be to restrain demand by cutting federal spending or raising taxes.

But this would have drained income from an economy already suffering from higher oil prices. The result would have been a sharp rise in unemployment. If policy-makers chose to counter the loss of income caused by rising oil prices, however, they would have had to increase spending or cut taxes. Since neither policy could increase the supply of oil or food, however, boosting demand without changing supply would merely mean higher prices.

President Jimmy Carter (1973-1977) sought to resolve the dilemma with a two-pronged strategy. He geared fiscal policy toward fighting unemployment, allowing the federal deficit to swell and establishing countercyclical jobs programs for the unemployed. To fight inflation, he established a program of voluntary wage and price controls. Neither element of this strategy worked well. By the end of the 1970s, the nation suffered both high unemployment and high inflation.

While many Americans saw this “stagflation” as evidence that Keynesian economics did not work, another factor further reduced the government’s ability to use fiscal policy to manage the economy. Deficits now seemed to be a permanent part of the fiscal scene. Deficits had emerged as a concern during the stagnant 1970s. Then, in the 1980s, they grew further as President Ronald Reagan (1981-1989) pursued a program of tax cuts and increased military spending. By 1986, the deficit had swelled to $221,000 millions, or more than 22 percent of total federal spending. Now, even if the government wanted to pursue spending or tax policies to bolster demand, the deficit made such a strategy unthinkable.

Beginning in the late 1980s, reducing the deficit became the predominant goal of fiscal policy. With foreign trade opportunities expanding rapidly and technology spinning off new products, there seemed to be little need for government policies to stimulate growth. Instead, officials argued, a lower deficit would reduce government borrowing and help bring down interest rates, making it easier for businesses to acquire capital to finance expansion. The government budget finally returned to surplus in 1998. This led to calls for new tax cuts, but some of the enthusiasm for lower taxes was tempered by the realization that the government would face major budget challenges early in the new century as the enormous post-war baby-boom generation reached retirement and started collecting retirement checks from the Social Security system and medical benefits from the Medicare program.

By the late 1990s, policy-makers were far less likely than their predecessors to use fiscal policy to achieve broad economic goals. Instead, they focused on narrower policy changes designed to strengthen the economy at the margins. President Reagan and his successor, George Bush (1989-1993), sought to reduce taxes on capital gains — that is, increases in wealth resulting from the appreciation in the value of assets such as property or stocks.

They said such a change would increase incentives to save and invest. Democrats resisted, arguing that such a change would overwhelmingly benefit the rich. But as the budget deficit shrank, President Clinton (1993-2001) acquiesced, and the maximum capital gains rate was trimmed to 20 percent from 28 percent in 1996. Clinton, meanwhile, also sought to affect the economy by promoting various education and job-training programs designed to develop a highly skilled — and hence, more productive and competitive — labor force.

The way I like to look at fiscal policy is that, in general, there is a very consequential “balancing act” going on all the time. However, there is now a new element lurking in the shadows known as a staggering national deficit. That is, inflation, high unemployment, and huge deficits (all terrible outcomes) balance one side of the scale, while the other side is balanced by choosing, appropriately at the right time, either increases or decreases in taxation, or either increases or decreases in spending (And I bet you thought Albert Einstein’s theories were difficult to grasp).

Now, despite the predictability of the order of economic or business cycles, it does appear currently that negatives like inflation, high unemployment or large deficits are collectively impacting society at the same time. No policymaker in Congress or the White House has a complete grasp of all the relevant elements in this balancing act, much less having notions of when things will occur.

The best that any administration hopes to accomplish is to choose some set of actions (increase spending, cut taxes etc.) and hope to hell the timing will be right. However, the fly in the ointment right now is a 15.6 trillion dollar deficit. John Maynard Keynes said to ignore the deficit. Unfortunately, we can’t do that. Current fiscal policy cannot effectively manage our staggering national deficit and fully run the government without some sort of Draconian approach to doing both.

The Staggering American National Debt

[What Are Its Implications?]

In the United States, national debt is money borrowed by the federal government of the United States. Debt burden is usually measured as a ratio of public debt to gross domestic product. Debt as a share of the US economy reached a maximum during Harry Truman’s ‘s first presidential term. Public debt as a percentage of GDP fell rapidly in the post-WWII period, and reached a low in 1973 under President Richard Nixon. The debt burden has consistently increased since then, except during the presidencies of Jimmy Carter and Bill Clinton. The president who increased the national debt the most was Ronald Reagon due primarily to reducing taxes and increasing military spending. In recent years sharp increases in deficits and the resulting increases in debt have led to heightened concern about the long-term sustainability of the federal government’s fiscal policies.

 

The Blame Game

If you like playing the blame game, where the national debt is concerned, you might start by looking at yourself in the mirror.

All of us are responsible for where we are now and how we got here. This is particularly true where our national debt is concerned. As the great Thomas Jefferson once said in 1790, “A Nation of Sheep produces a Government of Wolves.” And, it’s not just us and politicians who helped to put all of us in terrible debt. Businesses in America played a major role and have since the 1960s. Those business enterprises that promoted the idea of credit cards (buy now, pay later) gave permission to the American people not to save for something they wanted, but to buy now and pay later. This credit card mentality has permeated the American psyche since the late 1960s, and has influenced how American society has changed fundamentally in its attitudes toward debt in general. I received my first credit card in the mail 3 months before my graduation from college in 1968. I was only a student and I wasn’t even employed yet. Nevertheless, here comes this credit card in the mail encouraging me to buy now and pay later.

What I’m describing here in American culture is the credit card mentality as preparation for things to come when our spending (outlay some people like to call it) needs started to outstrip our receipts or revenues for running the government. Think about it—It was easy for the American people to take a blind eye to what has happened in Washington the last 40+ years. Why? Because we’ve been spending beyond our own personal ability to pay for decades.

 

What is the United States Public Debt?

In the United States, national debt is money borrowed by the federal government of the United States in order to fund all government programs and operations. More specifically, the United States Public Debt is the money borrowed by the federal government of the United States at any one time through the issue of securities by the Treasury and other federal government agencies.

This public debt consists of two components:

  • Debt held by the public comprises securities held by investors outside the federal government, including that held by investors, the Federal Reserve System and foreign, state and local governments.
  • Intragovernment debt comprises Treasury securities held in accounts administered by the federal government, such as the Social Security Trust Fund.

Public debt either increases or decreases as a result of the annual unified budget deficit or surplus. The federal government budget deficit or surplus is the cash difference between government receipts and spending, ignoring intra-governmental transfers. However, there is certain spending (supplemental appropriations) that add to the debt but are excluded from the deficit.

Debt burden is usually measured as a ratio of public debt to gross domestic product.

Debt as a share of the US economy reached a maximum during Harry Truman’s first presidential term. Public debt as a percentage of GDP fell rapidly in the post-WWII period, and reached a low in 1973 under President Richard Nixon. The debt burden has consistently increased since then, except during the presidencies of Jimmy Carter and Bill Clinton. In recent years sharp increases in deficits and the resulting increases in debt have led to heightened concern about the long-term sustainability of the federal government’s fiscal policies.

The public debt has increased by over $500 billion each year since fiscal year (FY) 2003, with increases of $1 trillion in FY2008, $1.9 trillion in FY2009, and $1.7 trillion in FY2010. As of March 29, 2012 the gross debt was $15.589 trillion, of which $10.831 trillion was held by the public and $4.757 trillion was intragovernmental holdings. The annual gross domestic product (GDP) to the end of 2011 was $15.087 trillion (Jan 27, 2012 estimate), with total public debt outstanding at a ratio of 103.3% of GDP. If counted using the total public debt outstanding over the annual GDP in chained 2005 dollars, the ratio reached 115% since Feb. 2012.

In the United States, there continues to be disagreement between Democrats and Republicans regarding the United States debt. On August 2, 2011, President Barack Obama signed into law the Budget Control Act of 2011, averting a possible financial default. Two months earlier in June 2011, the Congressional Budget Office called for “…large and rapid policy changes to put the nation on a sustainable fiscal course.”

What Caused Such a Deficit Problem?

In 2001, the national debt stood at just $5.8 trillion. Why did the government have to borrow so much more in such a short time? There are six major factors that caused a tripling of the national debt in just a little over 10 years:

1. The Bush tax cuts

The biggest culprit? The 2001 and 2003 tax cuts under then-president George W. Bush, reported the Associated Press. These tax cuts added an estimated $1.6 trillion to the national debt. It’s pretty clear, says Brian Beutler at Talking Points, that Bush-era policies, “particularly debt-financed tax cuts,” make up “the lion’s share of the problem.” And they’re ongoing, so the tab for them builds every year.

2. Health care entitlements

Democrats “constantly harp” about the Bush tax cuts, says Peter Morici at Seeking Alpha, but those rates were in place in 2007, and the deficit that year was one-tenth this year’s budget shortfall of $1.6 trillion. So what has changed since then? Added “federal regulation, bureaucracy, and new Medicaid and other entitlements have pushed up federal spending by $1.1 trillion — $900 billion more than required by inflation.” And down the road, says Yuval Levin at National Review, our “health-entitlement explosion” will account for “basically 100 percent” of our debt problem.

3. Medicare prescription drug benefit

Another piece of the pie: George W. Bush’s addition of Medicare’s prescription drug benefit. That has added $300 billion to the debt, according to the AP. Expanding entitlements like Medicare, or last year’s health-care reform package, is a particularly tempting way for Congress to run up debt, says Jagadeesh Gokhale at the Daily Coller. Since lawmakers don’t typically map out a revenue strategy to fund those benefits, they are “shielded from the political costs of actually paying for the new programs.”

4. The wars in Iraq and Afghanistan

The tab for the wars in Iraq and Afghanistan comes to $1.3 trillion, another major chunk of new, unexpected spending over the last decade. “These wars cost us plenty,” says Nake M. Kamrany at The Huffington Post, and they “have to be financed with borrowing, which adds up to national debt.”

5. Obama’s economic stimulus

The 2009 stimulus package enacted by President Obama cost $800 billion. And the 2010 tax-cut compromise between Obama and Republicans, which extended jobless benefits and reduced payroll taxes, added another $400 billion to the debt. Add another $200 billion for the 2008 bailout of the financial industry, and the government’s efforts to soften the blow of the Great Recession amount to one of the largest chunks of the debt build-up. The “federal budget was one good year away from balancing” after 2007, says Tom Blumer at News Busters. But in the years since, Obama and Democrats in Congress put that goal out of reach.

6. The Great Recession

Some of the spending gap came from factors outside the control of Congress and the White House. As the government spent heavily to boost the economy, says the AP, it took in hundreds of billions less in tax revenue than expected, because the Great Recession eroded Americans’ income and spending.

 

Where Are We Now?

Here it is, based on the National Debt Clock, as of April 11, 2012.

 

U.S. NATIONAL DEBT CLOCK

The Outstanding Public Debt as of 11 Apr 2012at01:26:21 AM GMTis:

 $ 15,626,018,571,743.67 (15 Trillion, 626 Billion, plus change)

The estimated population of the United Statesis 312,562,722
so each citizen’s share of this debt is $49,993.21.

The National Debt has continued to increase an average of
$4.00 billion per day since September 28, 2007.

 

As far as our nation’s staggering national debt is concerned, it will take a separate blog to ferret out what to really do about it. At a tentative preliminary level (no-brainer idea) I think it advisable if the next administration raised taxes on everyone, cut spending drastically, and stay the hell out of wars. This, of course, would run counter to achieving greater prosperity and reducing unemployment. This comes back to the tradeoffs I mentioned in Part I. America is headed toward economic disaster nationally and globally if we fail to bring our national debt down. We either face America in bankruptcy and total collapse down the road, or we control and contain our fiscal policies geared toward greater prosperity and low unemployment. You decide!!! What happens when normal people cannot pay their bills, mortgage payments, and do not have any savings? They lose everything.

In Part III ahead I will explain how President Obama views Fiscal Policy.

 

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