Now, on to the deficit. Isn't it funny how the deficit goes up during times of economic distress and goes down during the good times?
Right after the dot com bust, the economy began to worsen as hundreds of companies folded and thousands lost their jobs. Revenues immediately started to go down. It didn't matter who was the president at the time but the deficit was bound to go up.
The solution is to get the economy going again. Obama has already admitted that raising taxes during a recession would only damage the economy and is considering postponing his tax increases on the wealthy. Hallelujah! He's admitting that his plan doesn't help the economy. And since the only way to reduce the deficit is to get the economy going again, what's the best way to do that?
The worst thing you can do is to raise the capital gains tax rate, as Obama will still do. Not only does it dry up investment, an important component of Gross Domestic Product (C + I + G = GDP), but it hits almost everyone. These days, there is hardly anyone who doesn't own some sort of security, whether it's a mutual fund, a stock or two, or a bond. The capital gains tax increase would severely damage the economy further.
Note that I'm about to praise Bill Clinton, so don't fall over now. Even Clinton, the pragmatist, understood that capital gains are the keys to investment and therefore economic growth. Along with the Republican Congress, Clinton passed a capital gains tax cut from the maximum 28% to 15%. That resulted in an enormous surge in revenues and a large drop in unemployment, a large contributor to our balancing the budget in the latter years of the Clinton Administration. Back then, the GOP Congress were still real Republicans and restrained spending, unlike what they did when they got power hungry several years later.
John McCain advocates maintaining all of President Bush's tax cuts, including the capital gains cut down to 10%, except for the death tax which he would raise to 15% (Obama advocates returning the death tax to 55%). Even at 10%, our capital gains tax rate is the highest in the industrialized world. Even socialist France has only a 5% capital gains rate. So right off the bat, American companies are operating at a disadvantage, tax-wise.
Obama advocates economy-killing tax increases in the capital gains rate. Every time the rate has been cut, revenue has increased. Every time the rate has been raised, revenue goes down. Why? Because companies perform a cost-benefit analysis. If the return on investment (ROI) is high enough, a company will spend the funds necessary. If it isn't, investment doesn't happen. Taxes are a huge part of the ROI calculation. So that's why revenue moves the opposite direction to the capital gains rate.
So how does this work to reduce the deficit? You reduce it by stoking the economy so that companies are willing to invest and hire again. Once the economy starts working again, the deficit will once again begin to go down.
The other component to deficits is spending. Republicans spent like drunken sailors in the four years they had control of Congress. For that, they earned the wrath of Republican voters, who turned out in large numbers in 2006 to vote for... Democrats in retaliation.
Democrats, encouraged by Republican retirements and the unpopularity of President Bush, are salivating to start spending like drunken sailors themselves since they are almost guaranteed control of both houses of Congress in the 2008 elections despite their 17% approval rating, far lower than Bush's. Chief among them is Barack Obama, who earned the impartial National Journal's rating as the most liberal Senator in Washington. His partner in crime, Joe Biden, was rated as #3 most liberal. Ironically, Hillary Clinton was rated as more conservative than either one of them, despite her reputation for liberalism.
Obama has promised everything under the sun and has spending plans of at least $1 trillion in additional monies. Along with an economy-killing tax increase and $1 trillion in more spending, can anyone guess where the deficit is going to go? Yep, straight up.
McCain has been more vague about what he wants to do. He has promised spending cuts but hasn't really indicated what he plans to cut outside of generalities like "unnecessary spending." He has said he will veto any bill with earmarks, but that adds up to only $16.9 billion in last year's budget according to the CBO. That will make a small dent but will hardly solve the problem.
One thing he has not done is to promise large amounts of additional spending. That is very encouraging in that at least the spending component won't go up nearly as fast as it would under Obama and a Democratic Congress.
So why do we have a huge deficit now? Part of it is the War on Terror. The wars in Iraq and Afghanistan and the rest of the hidden war have easily cost us billions each year. We can argue about whether it was necessary spending or warranted spending but the spending on those wars will continue. Iraq's cost will go down while Afghanistan's will likely go up no matter who is president unless Obama decides to surrender.
The rest of it has to do with the popping of the real estate bubble and its resulting financial crisis. How did we get in that mess to begin with, I hear you ask?
First of all, economies have upturns and downturns because people always do things to excess. Upturns are caused by bubbles. Downturns happen when they burst. If people didn't behave that way, we would have consistent growth as far as the eye can see. But it doesn't happen that way.
What about these bubbles? Starting in recent times around 1986 was the S&L bubble in commercial real estate. Government was actually to blame for that bubble in the first place. Tax loopholes made it beneficial for S&L's (savings and loans) to invest in commercial real estate, regardless of demand. Anyone remember all those empty office buildings, yet they still kept being built?
Well, the Tax Simplification Act put together by Dan Rostenkowski (D-IL) and Bob Packwood (R-OR) and signed by President Reagan moved the top marginal rate from 50% to 28% but was revenue neutral by eliminating a myriad of tax loopholes. You can probably see where this is going. The removal of the tax loophole caused a financial crisis as all the investments in commercial real estate dried up and the S&L crisis happened. The economy promptly went into recession and was further exacerbated by the ill-timed $500 billion tax increase agreed to by President George HW Bush and the Democratic Congress who threatened shutdowns without the tax increase.
In came Bill Clinton and the "worst economy of the last 50 years." It was hardly such but people believed it. Ironically, the economy had already begun to recover by the time Bill Clinton came on the scene to win the White House. The fourth quarter of 1992 grew at nearly a 5% rate. Yet the press continued to make us believe the economy was a disaster to help Clinton win.
Clinton, faced with a budget deficit, raised taxes retroactively and nearly killed the economy again. The economy went into neutral, reversing the growth in 4Q 1992 with only a 0.7% growth in the next quarter. Those who claimed Clinton's tax increase saved the economy were wrong. It was the dot com bubble and the rise of the Internet that saved it. That lasted for nearly a decade as companies' stocks went up without any revenue to speak of.
In 2000, the bubble burst as all bubbles do eventually. The NASDAQ fell from a high of over 5,000 to about 1,500. Even today, it is nowhere near its original high. Trillions of dollars were lost and the economy began to tank.
Enter George W. Bush. His tax cuts got things going again, partly avoiding a recession. But then 9/11 happened and the transportation industry practically collapsed and the economy began to dive again. 1 million jobs were lost in two months. Naturally, the deficit began to rise again to over $400 billion.
Fortunately additional tax cuts got us out of the hole and the economy began growing again with the deficit falling in half in only a few short years. So even with the spending on the War on Terror and tax cuts, somehow the deficit fell by half. How can that be? That's because the economy was growing.
Unfortunately, following the bursting of the dot com bubble, another bubble began to form, this time in real estate again. A second, minor bubble also began forming in commodities. In California, real estate was particularly crazy. Homes that normally sold for $200,000 were selling in just a few years for $600,000. Homes that would normally go for $400,000 were now exceeding $1 million.
How did this bubble form? First of all, money is always present so it has to go somewhere. The stock market had just taken an enormous beating, so the money went to real estate. Government again was at fault. First the Federal Reserve, in fighting 9/11-induced problems, reduced real interest rates to negative values. That led to increased home demand, further exacerbated by cheap money, readily supplied by banks and other financial institutions. Even worse, the government was backing up the banks in case things went wrong with institutions like Fannie Mae and Freddie Mac, which would buy many of these poorly performing mortgages. So along with nearly free loans and the riskless aspect of federal insurance, banks lent money they otherwise would not.
As with all bubbles, the real estate bubble burst when the Fed raised interest rates again. Banks began to fail, credit began to tighten in the sub-prime mortgage market, and people could no longer afford their adjustable-rate mortgages. That is the cause of our economic downturn today and the huge increase in the federal deficit. The best thing government could do would be to slash the corporate income tax rates and the capital gains rate even further. But with Democrats in charge of Congress, President Bush's hands are essentially tied. There's not much he can do and he doesn't have the political capital left to promote a tax cut. Tax cuts to Democrats is like sunlight is to Dracula.
If the government can do just two things, control spending and not raise taxes, the economy will eventually sort itself out and the deficit will fall in time.
The Obama plan would do neither and would worsen our recession. I'm not sure what the McCain plan will do without more specifics but if he promises not to raise taxes, that will go a long way to reducing the deficit. McCain has promised a cut in the corporate tax rate. That will help considerably.
P.S. You may have guessed I'm handicapped with an economics degree.
