John Maynard Keynes vs. Friedrich August von Hayek

The tortuous times of the past two years when nations have been embroiled in economic crisis has revived an old battle between macroeconomic theories. Huge differences have evolved between political leaders and economists on matters of public policy to deal with the challenges. The root of these philosophical differences lies in the macroeconomic theory of the last century. It is the dilemma of whether free markets create a more prosperous economy or whether government management of an economy is best.

In the 1930s the idea of government managed or planned economies emerged in the classic “General Theory of Employment, Interest and Money” by John Maynard Keynes. This dominated economic theory until the concept of market economics gained favor, championed by the Austrian economist, Friedrich Hayek. His book “The Road to Serfdom” challenged the merit of socialism and the negatives of government intervention in private sector. It argued the merits of free market capitalism and individual liberty. Hayek’s philosophies were embedded in the thinking of other economists and world leaders, namely Milton Friedman and Margaret Thatcher. A young Milton Friedman attended a series of salons on macroeconomic theory run by Hayek at a resort in Switzerland, known as Mont Pelerin. Hayek was awarded the Nobel Prize in 1974 and Milton Friedman followed in 1976.

Now, it seems that Keynesian ways are back as governments overdose on “stimulus packages” (spending like drunken sailors) and endeavor to aggressively manage economies. Too often political leaders neglect to recognize that it was errant public policy that got us into this mess in the first place. Forgotten is the fact that congress aggressively pushed home ownership for all Americans…regardless of their economic status or their ability to pay the mortgage when the “teaser rate” term ended. Washington encouraged families to use credit (mortgages) to purchase homes they could not afford through low interest rates, low down payments and flooded the mortgage markets with capital through Freddie Mac and Fannie Mae. Keynes never imagined that political leaders could be so reckless and unwise in the economic policies that they pursued.

This caused an “asset bubble” as home prices surged and our nation overbuilt the stock of homes to an excessive level. Homeowners began to use their new home equity as an ATM, tapping it for cash to buy boats, RVs and upgrade their homes. There was an enormous growth in consumer spending and the economy was fueled by the expansion of credit. Certainly Wall Street got on board with this by the expansion of the securitization of mortgage portfolios and the creation of new derivative instruments. It started with bad public policy and was amplified by financial engineering.

The credit “binge”, engendered by bad public policy, caused the US economy to grow at a rate above its natural rate (without the meddling of government in the economy). Oddly, now political leaders are attempting to get the economy going by encouraging consumers to borrow and spend (cash-for-clunkers, mortgage incentive programs, etc.) and, of course, the government is a huge borrower and spender itself. It seems that we are trying to get out of the recession by doing more of what put us into it in the first place.

What must follow is a period of de-leveraging, where the economy will grow below its natural rate until balance sheets are repaired. Without the Keynesian public policy initiatives, the economy would not have become supercharged in the 2002-2007 period, the credit crisis would not have occurred and the nation’s growth during the next decade would be higher and more stable. You will never hear this discussed in our congressional hearings…they will be busy “bashing” business leaders in the private sector. Hayek would say “Just leave it alone and the economy will do fine”. Keynes would say “Intervention by government is essential to avoid disasters”. The “Achilles’ heal” in Keynes’s thinking was the assumption of wise governance.

The pejorative effect of errant public policy during challenging times can be huge. Regardless of who is right, it would benefit us all if members of congress would be required to pass an Economics 101 test.

Compensation Plan for Obama

The compensation plan for the President of the United States has remained unchanged for a long period of time. It is overdue for an overhaul. I look at it in much the same way that I would for any Chief Executive of an enterprise, in this case the “enterprise” is our nation. The shareholders of our nation are its taxpayers. They have bought their shares with tax dollars and are paying for the benefits received by all its inhabitants.

Over the last 30 years I have chaired many compensation committees for companies big and small, public and private. In structuring any compensation plan for a Chief Executive, it is important that it align his/her interest with those of the shareholders of the enterprise. Sadly, the President’s pay plan does not do that and is severely out of date. There is much room for improvement. So it is that I propose the following compensation plan; one that has both contemporary and appropriate features.

Firstly, I propose that we should raise his salary from $400,000 to $1 million per year. His current salary is too low and has not kept pace with his responsibilities.

Secondly, all top executives have an incentive compensation component to their pay which is based on performance. He should have a bonus plan that provides an opportunity for him to earn up to 100% of his salary based on the results that he is able to achieve.

The President is the only American wage earner that does not pay taxes. This seriously misaligns his interest with those of his “shareholders”. Like all other Americans, he should pay Federal and State income taxes and be subject to the Alternative Minimum Tax.

The President gets many other benefits that misaligns his interest with those of taxpayers, among those is free housing. How can he relate to the issues of homeowners with mortgages if he is not in the same “boat”? He should pay a fair market rate of rent for the housing provided to him by tax payers. His rent should reflect the size, location and quality for the housing provided to him and his family.

In order to align his interest with ordinary Americans, his rent should be characterized as mortgage interest and be deductible in the same manner as other homeowners in his tax bracket.

Any benefits that he receives from the government, such as food, personal travel, healthcare benefits, etc. should be placed on his W-2 in the same manner that it is for other tax payers. As the nation’s Chief Executive, he should have the use of the corporate jet, so long as it is for legitimate business purposes. This makes his valuable time more productive, as it does for any leader. If he uses it for personal travel or campaign travel, he should be charged the standard first class airline rate.

He should be entitled to a 401K or other retirement plan, to which he should contribute, like the rest of us. A matching contribution by his employer would also be appropriate. The amount of his retirement fund should be based on his years of service, as it is for other executives.

Now back to that bonus. Good incentive compensation plans for executives are performance based and his should be also. The bonus payout should include the following criteria:

(a) Executives are not paid bonuses for running businesses that lose money or acquire bad assets on their balance sheet and neither should he. So his bonus should be conditioned on operating his enterprise (the US Government) without losses.

(b) Also, he should be rewarded for running a government that causes the nation to be prosperous (and the citizens to benefit thereby). Accordingly, I propose that his bonus be awarded on a sliding scale between zero and 4 percent in GDP growth at which he would receive his full 100% bonus, conditioned on item (a).

(c) In order to avoid gaming the system (as many Wall Street execs did) the bonus award should be a multi-year program tied to a few years that follow, even if they are on a successor’s administration. The plan should have a claw back and carry forward provisions to assure that good performance in one year is offset/averaged-out by any losses or benefits in the following years.

(d) In regard to item (a) above, if he comes into his job inheriting a loss, he should be given credit for improvement above that level (i.e. reducing the loss).

Such a compensation plan would align the President’s interests with those of his citizen tax payers and reward him for good behavior and good performance. Individuals that are not shareholders (i.e. not taxpayers) should not be entitled to vote, just as people that have no investment in a company’s shares are not entitled to vote on the affairs of the enterprise. If they are entitled to vote, they will always vote for something that provides them with benefits that someone else will have to pay for.

Global Warming: How much do we really know?

It seems these days that everyone has bought into the idea of “global warming. Congress is busy debating a ‘cap & trade” bill and the “Kyoto Protocol” has become the international standard for dealing with greenhouse gasses. Environmentalists are predicting the end of life on the planet, if we do not do anything about it.

So, perhaps the lone voice in the darkness should ask the question “Is it true?”

There is a lot of “hype” over CO2 content in the atmosphere and its effect on the planet’s temperature. Scientists are talking it up in hyperbolic terms because it draws more attention to them and more research dollars to their projects. If global warming was not a concern, they would be relegated to jobs as weathermen. They seize on anecdotal evidence to support their assertions (this is advocacy, not science).

It is important to separate fact from fiction and what we know from what we do not know. To help with this, let me make some observations. First, examine this chart. The chart traces the history of the earth’s temperature for the last 500 thousand years, along with the concentration of atmospheric CO2 and dust. It should be read left to right: the left side being the current day and time-past being to the right. The current day temperature variation is “zero” and historical variations are plotted backward from that point.


It is clear that there is a causal relationship between atmospheric CO2 gas composition and the temperature of the earth. While scientists jump to the conclusion that CO2, a “greenhouse gas” causes the temperature to rise, when we examine the chart closely, we see that the earth’s temperature appears to rise in advance of CO2 content in the atmosphere. That should raise a question: Why? Could there be a more powerful force in the planet’s eco system? Which is the “cause” and which is the “effect”? Another big question that arises once we look at the history of the planet’s temperature and CO2 content is “Since these cycles have occurred before human’s had cars, before the industrial revolution, what causes the temperature and CO2 gas content to rise and fall?”

It is clearly the case that the planet is warmer today than it generally has been. It is also true that the planet’s temperature has peaked at about the present level many times in history…then declined. Once again, that has happened hundreds of thousand years before humans contributed to its “carbon footprint”.

One can make a case for any conclusion that they want by simply selecting the timeframe for the data. During the last 10-12 years, the temperature of the earth has cooled; during the last hundred years the temperature of the earth has warmed; during the last 5,000 years the earth has cooled; during the last 20,000 years the earth has warmed.

Scientists (with a stake in the race) argue that the polar ice cap is receding. This is true, but only for the northern hemisphere; the southern ice cap is growing. They argue that industrialization over the last 150 years has caused the temperature of the planet to warm. At the same time the temperature of Mars has also warmed by about the same (percentage) amount. But there obviously are no people on Mars. Could it be that some more powerful exogenous force has caused it: perhaps flair-ups on the sun?

An important principle to understand is that scientists, activists and political leaders can make any case they want by presenting selected data that supports their advocacy, and leaving out data that refutes it.

Research in this area is important, but it must be done with an objective mind. The drivers for global warming and cooling are very complex and dynamic. Our planet’s eco system is very complex and changing. The study of this needs to be an interdisciplinary pursuit. Atmospheric sciences must consider the interaction of the atmosphere with the ocean (it absorbs about 50% of the CO2) and the interaction with the earth’s surface and its biomaterials (plants, biomass decomposition, etc.) as these are as big a factor (and perhaps overwhelmingly dominant) as the effect of humans and animals.

If these forces are as profoundly causal as they have been in the past, the planet earth may have past the warming peak…and we should worry more about the return of a cooling cycle and another ice age. Mankind may be simply a passenger on the train of the swings warm and cool of our eco system. What we do, or don’t do, may have little effect. We actually know very little about these processes, but we should push on to understand them.

But one thing is sure, these temperature changes are more glacial than the polar ice flows themselves and significant changes will take thousands of years.

Healthcare Reform

America is engaged in a vigorous debate over reforming our healthcare system. That debate has been politicized and dominated by sound bite arguments to the point that no one seems to be thinking clearly about it.

Certainly there is significant opportunity to improve the system. The delivery of health care has become costly and some in our society have inadequate access to care. In this article I seek to address some of the issues and inefficiencies that are critical that would promise to improve the complex economics, access means and quality of care.

Firstly, we should recognize that the huge majority of Americans are relatively happy with the medical care that they get under the current system. Let’s not fix the part of the system that is not broken. This very large majority, particularly seniors, are terrified about changes that might deny them the medical benefits that they now receive. Although it is a costly, bureaucratic and inefficient delivery system; much can be done to improve it.

More government involvement in people’s healthcare is a bad idea. Virtually everything the government runs operates badly and is much more costly to operate than comparable activities in the private sector. Think about the Post Office. Think about the bureaucratic operation of Medicare and the fact that it is “going broke.” Furthermore, do we really want to embark on a path that involves more public service workers in our personal medical decisions?

Myths & Misconceptions
Advocates of healthcare reform often point to statistics such as life expectancy where the US lags many other countries. They argue that, for all that we spend, our system does not deliver better results. Nothing could be further from the truth. Many factors, other than the quality of medical care, drive mortality statistics. Iceland has the highest male life expectancy of any nation, yet they have virtually no deaths from auto accidents, their young men never go to war and cardiovascular disease is very low due to their diet that is dominated by fish. Japan has the best life expectancy statistics for a large nation, but again for reasons that are obvious: a diet rich in fish, a very low crime rate, an absence of military deaths and a population where obesity is, by far, the lowest in the developed world. Poor infant mortality rates for the US are also sometimes quoted as a critique of our healthcare system. The infant mortality problem is largely a result of socioeconomic factors and access to prenatal care by the poor. On this matter, we can do better.

A better test is survivability of patients that enter the health care system and the quality of outcomes for those that receive treatment. On that front Americans do well. Outcomes for patients with cancer, heart disease, diabetes, orthopedic degeneration and other maladies are very good in the US. The rest of the world knows it and individuals, that have the means to be treated anywhere, overwhelmingly choose medical centers in America.

Health Care Economics 101

Our political leaders are promising that the huge expansion on health care coverage to 40-50 million more people will not increase the deficit. This is a naïve and dangerous proposition. Washington claims that they can pay for it through savings from a reduction in “waste and abuse”. Our government does not have a competency in such undertakings and tends, instead, to add on more bureaucracy and waste. If we, as a society, wish to add this entitlement on top of Social Security, Medicare, Welfare and other such social programs, we must realistically be prepared to pay for it. Our elected officials are good at giving away “other people’s money” (taxpayers). According to the impartial Congressional Budget Office, the ambitious expansion of healthcare coverage being proposed will add significantly to the already huge federal deficit. Unfortunately, the burden of paying for this will fall on young people for decades to come.

Our leaders in Washington are also promoting a “public option” as a way to expand coverage and create a competitor for private sector insurance companies. Their proposition is that competition from the lower cost public healthcare insurance option would bring down the cost of private sector premiums. Here again the logic is flawed. Medicare, the biggest government healthcare benefit program pays only about 78% of hospital’s average costs. In order to remain financially viable, hospitals must charge more to private insurance providers. In other words, the private insurers (and their insured population of consumers) subsidize the care of the elderly on Medicare. If another low paying public program is launched, hospitals, doctors and other providers with need to raise their prices to private insurers in order to make ends meet.

There are some things, however that can be done.

Administrative Inefficiencies
The paperwork cycle in healthcare is an extremely inefficient process. Innovations can be made that improve the efficiency and quality of care and also the payment processing system. Why is it that we need to fill out the same forms and produce insurance information every time we go to a new doctor or hospital? In a more efficient system, each person could maintain their medical history on a private online site that is password protected and patient controlled. With each visit to a doctor, hospital, diagnostic lab, imaging center or change in insurance coverage, new information could be added to the site which would be available when needed.

Preventative Health
Many, perhaps most, Americans lead an unhealthy lifestyle. This is exhibited mostly in their diet and exercise habits. The highest cost impact area lies simply in the area of obesity. Obesity leads to many costly diseases (cardiovascular, diabetes, cancer and others) that weigh on the economic equation of healthcare. The obesity problem in the US, and the economic burden that it places on our system, is huge. Americans lead the world in obesity at 32.2% while obesity in Japan is a mere 3%. Even in France, the frequency of obesity in their population is less than one third of the rate for the US. The frequency of obesity in America is significantly more than double that of Germany (think beer & Bratwurst). Economic implications: since 32.2% of Americans are obese and obese people cost 36% more than individuals of normal weight, the obese population in America are responsible for about 40% for the nation’s health care expenditures.

To deal with the obesity problem, there need to be strong economic incentives for behavioral change and a well-conceived public communications program like the campaign against cigarette smoking. On the economic front, healthcare insurance should reflect the higher cost of obese patients by charging higher premiums for individuals who are overweight. There could be other incentives such as airlines charging passengers by the pound. Higher sales taxes could be levied on junk food and beverages with high caloric and fat content. As hefty cigarette taxes dissuaded smokers, this could discourage excessive, unhealthy food consumption in the same way.

Needless to say, there are many other preventative medicine strategies that can reduce the cost of care (e.g. regular check ups that provide early detection of the onset of disease and the pre-emptive treatments that are available).

Over Utilization:
Many factors contribute to the over utilization of healthcare facilities and services. Primary among these is the fact that healthcare is paid for by a third party (government or insurance). Thus, consumers are incentivized to overuse the system. They do not need to make a “buy or not buy” decision like everything else in life (a car, house, food, vacation, etc.). The method of payment should be overhauled to provide a first-dollar participation in the cost of every healthcare service. Consumers would then think about whether or not to use the system on each occasion, weighing the merits and costs. Some economists also believe that the tax benefits applied to healthcare insurance may also lead indirectly to over utilization of the system.

The same faulty incentive exists with healthcare providers. The payment system is mostly one based on units of service. Thus, providers (doctors, hospitals, labs, etc.) get paid more for each unit of service provided. Higher utilization of the system generates more revenue for the provider. This system needs to be overhauled to pay for good outcomes. Certainly, the threat of medical malpractice liability, in our litigious society, leads to the practice of defensive medicine…which is costly and does not necessarily lead to quality care.

Insurance:
For some reason that few can explain, health care insurers are restricted from offering plans across state lines. This severely restricts competition and is awkward since many employers have employees in multiple states. Rather than create a “public option” adding to the tax burden, we should simply eliminate the restriction on health care insurers and let the free market work.

Indigent Care:
Mostly, poor people are locked out of the formal healthcare system. However, most people in this category find a way to be treated for illnesses. Unpaid care is provided through emergency rooms and hospitals (mostly charity and public hospitals). However, this system is very inefficient and costly. A patient with the flu shows up at the same “doorstep” as an accident victim or an individual suffering a heart attack. The primary care provided to indigents from emergency rooms is very costly and interferes with the provision of care to those that need it.

This problem could be solved by creating a network of clinics that would provide free primary care to the poor, and triage those in need of complex intervention to appropriate medical centers that are equipped to care for those patients and compensated for it. The cost relief of the burden on emergency rooms would help offset the costs of these clinics and it would be far more efficient than setting up a new Medicare-like system for the uninsured.

Tort Reform:
Heavy political contributions by trial lawyers make legislation in the area of tort reform nearly impossible. Certainly, when there is malpractice, the system should be able to make well-informed and effective judgments and then provide appropriate penalties and awards. The problem is that the defenders of the status quo appeal to public sympathy by raising examples of persons that suffered due to medical malpractice without recognizing the abuses of the system. Unfortunately, all-to-often frivolous lawsuits claiming malpractice are simply opportunistic grabs for money. Insurance companies facing significant legal costs and the possibility of a large award following a jury trial are quick to settle, even when the case is clearly without merit. Awards often are excessive and drive malpractice insurance premiums higher to reflect this cost. This cost alone can be so high as to force many physicians out of the practice of medicine.

This is a complex issue since we would not like to deny a rightful claim, but also frivolous lawsuits and excessive awards need to be curtailed. It must be attacked from both directions: the compensation of trial attorneys and the excessive plaintiff awards. Excessive litigation also drives up costs by causing doctors to over prescribe tests and treatments in the practice of defensive medicine. No one knows how much this really costs, but it is likely to be a big number.

Access vs. Capacity:
A serious problem exists in the capacity of our healthcare system to deliver more care. If we expand coverage to a large new population, and if the number of doctors or hospital beds remains static, the overall quality of care and access to care for everyone will go down. Any expansion of “access” must be accompanied by an expansion of the “capacity” of the system.

Increasingly we find ourselves in a time when fewer talented young people are motivated to pursue careers in the profession of medicine. Also, doctors are retiring early from the practice because of the administrative burden, increased malpractice insurance costs, and lower payment/reimbursement for their services. There is a particularly short supply of general practitioners which perform a vital function in the healthcare system. They provide primary care and are the “gate keepers” that triage patients to the specialty care treatment providers. A high payoff solution to this would be to offer low-interest, forgivable loans to medical students who agree to serve as primary care physicians in rural areas or urban clinics that provide care for indigent populations. They could “work off” their debt obligations through such community service.

Preserving Innovation:
The great engine of innovation in medicine that is contributing measurably to the quality of care is facing a threat by public policy leaders that do not understand the economics equation of innovation.

Nowhere is this more obvious than in the debate about reducing the number of years of proprietary protection under US patent laws for new drugs. Also, there is continued pressure on the pricing of these new drugs. New drugs are extremely expensive and risky to develop. During long safety and efficiency trials many fail to deliver the anticipated results and get FDA approval. There must be an attractive incentive to invest in these and other medical innovations.

Basic Principles:
When we examine the means to improve the healthcare system in America and make it more cost effective, the basic principles mostly relate to realigning the incentive system and removing bureaucracy. At the top of the list is to motivate and empower the consumer (patient) to make intelligent decisions on the use of the healthcare system. Consumers should pay a percentage of the cost, starting at dollar one. They should be incentivized to decide: whether or not to use it, how much to spend and to shop for the best value for the best price. Remove the incentive for doctors to practice defensive medicine and reward them for the achievement of desirable outcomes (instead of simply providing units of service). We must provide incentives for people to pursue healthy lifestyles. Also, we must promote innovation that leads to breakthroughs in medicine; incentives for entrepreneurs, companies, and healthcare providers that develop diagnostic methods, pharmaceuticals, therapeutic means and healthcare delivery modalities that improve medical outcomes, reduce costs and improve the efficiency of the healthcare delivery system. Also, we certainly need to increase competition in the healthcare insurance industry by eliminating the restrictions on doing business across state lines. In all of this, we need to simplify the payment and information handling system and the immense bureaucracy that burdens the process of our healthcare delivery system.

Fixing California

We are all aware that the State of California is in a financial mess. What is needed does not require deep intellectual insight…it simply requires common sense.

For almost two centuries, the “golden state” has been the land of opportunity that has drawn people from all over America and elsewhere in the world, seeking a better way of life. Now, even with substantial immigration from Latin America into the state, it is experiencing a net loss in population as its citizens decide to move out. It is not difficult to understand why. As the state with the most unfriendly disposition toward business, jobs are moving out of California to other states. The state’s tax rate is the second highest in America. Its school system, once admired as among the best in the nation has declined to become one of the worst, rivaling Deep South states such a Mississippi. The credit rating of the state has been downgraded to near junk bond status.

All this derives from a totally dysfunctional state government. Our political leaders do not seem to have the wisdom, or the will, to take the actions needed to put the state on a sound financial footing. What is needed is public policy and action that increases tax revenues by making the state, once again, to be an attractive place to live and for businesses to locate and grow…and to reign in its legislature’s excessive spending binge on social programs.

So here is my list of the “tough love” that we need to put our state back in order:


1. Pay cut for all public employees

Firstly, for a very long time the compensation level for public employees has been rising faster than that in the private sector. The Governor’s office has been attempting to deal with these rising cost of labor in public service jobs through a “furlough” system, i.e. employees working less days. This reduces public services without solving the problem. I suggest a pay cut of 10% across the board for all public service employees. That way service levels could be maintained and no one needs to lose their job. They just “tighten their belt” like everyone else. The problem here is that a large number of our public employees are subject to union contracts. Thus, as with the Detroit auto industry, the unions must give back some of the excessive gains that they have obtained over the years.

2. Increase the retirement age

People are living longer and are more productive than decades ago when the retirement age was set. Also, many public service workers become entitled to retirement pay after 20 years of service. They then “retire” (at a young age) and move on to another pubic service job, thus drawing double pay. This is very costly to the public and the under-funded public employees’ retirement funds represent a huge financial liability “time bomb”. California taxpayers will foot the bill for the shortfall in these funds in future years. The retirement age should be increased to 70 for men and 73 for women and indexed to longevity statistics. This would have a huge impact on relieving the financial stress on our public finances.


3. Fix the illegal alien problem

California and, to a lesser extent, other border states (Texas & Arizona) carry a disproportionate economic burden because of the migration of Hispanics across the boarder from Mexico. California taxpayers bear a great deal of this load. There is much debate about this at the Federal level, but no solution is on the horizon. The Federal government should solve this problem and/or compensate California for its disproportionate share of the burden.

I think it is best to create a new class of semi-permanent resident. Do not grant citizenship, but make them legal residents. Currently, these immigrants mostly reside here peacefully, work and contribute in our economy, even vote in our elections (since proof of citizenship is not required). Yet they do not pay taxes and live in a shadow economy. California taxpayers pay for their healthcare, welfare, police & fire protection and the education of their children. They should be permitted to register for this new class of residency, be subject to the payment of taxes (perhaps on a simple flat-rate basis), but not entitled to vote or enjoy other privileges of citizenship. If they do not sign up, they should be fined and deported…and serve jail time if there is a second offence.


4. Break the unions’ stranglehold on public service jobs.

Require that all new public employees be hired as “at will” non-union employees. Continue this until the share of public employees is less than 50% of the workforce. At that point forward make the joining of the union voluntary, truly voluntary and pay less for union workers than non-union employees (because of the additional cost and lack of flexibility of union workers). Also, eliminate the requirement that contracts awarded by the state’s agencies be let to companies with union shops.


5. Make California attractive to employers

California is widely known as one of the most difficult and most costly venues in America to do business. This drives companies, jobs and tax revenues out of the state. There is a mass migration of companies and plants/divisions to friendlier states. We must reverse this aggressively by lowering taxes, severe labor laws and bureaucratic regulations on businesses. By keeping more jobs here and helping companies grow and prosper, the state’s tax revenues will rise.


6. Reduce/restructure taxes on individuals

California has one of the highest tax rates in the nation. Individuals in the highest brackets spend enormous effort avoiding exposure to state taxes (buying California tax exempt bonds, avoiding taxable income, etc.). A large number of them simply move out of the state. The state loses a huge amount of tax revenue that would stay here if rates were more moderate. Also, the Federal capital gains rate is lower than the ordinary income rate, but not so in California. Our tax policy should provide a lower rate of tax on capital invested in California businesses, projects and other state-based activities to encourage investment to stay focused here.


7. Restructure public education

The biggest part of the state’s budget is education. While the K-through-12 system in California is one of the nation’s worst, its higher education system (the University of California, Cal State system and the community colleges) is clearly the best in the nation (and probably the world). However, the higher education system in California is at risk of losing its greatness. This is because the state is cutting its subsidy (with no hope of reversal) while continuing to put a lid on the tuition it can charge students. The “access” part of the institutional mission in education is of high value to the California society and must be preserved. “Access” simply means that every individual with the academic ability, but not the economic means should be able to obtain a top quality university education. However, the economic model is broken now that state subsidies are fading. Currently, the UC system charges a little over $8,000 per year for an in-state resident student. The quality of education delivered by UC Berkeley, UCLA and other campuses is clearly on parity, or superior to leading private universities where tuition is above $35,000. There is no good reason for this disparity in price, except for the “accessibility” issue. This can be easily solved by freeing UC campuses to charge a fair market price for the education they deliver, conditioned on the fact that they carve out a large block of scholarship funds to apply to those that need financial support. If one “runs the numbers” you can see that this works amazingly well.

The K-through-12 challenge is an area that commands our best thinking. The answer is not money, but a new way of doing things. On this matter my thinking is not yet developed.

Over the years, the California legislature has increased spending at an unconscionable rate, doubling outlays in the last decade. At the same time, revenue growth has been weak…and will continue to be weak over the next decade. Fixing this year’s budget deficit is simply an ephemeral solution. We must address the inherent problem of our “business model”. We must increase tax revenues by improving the prosperity of our state (not by increased taxes) and must cut the excessive spending spiral.

The Fading American Dream

Years ago, I was having dinner with two young men, one from an affluent American family and one from Holland. I asked the young man from Holland, “Why did you leave your family and friends and come here?” He replied, “To pursue the American Dream.” The other young man responded asking, “What’s the American Dream?”

It was a sobering look into the shifting values of America and the declining appreciation for what has made our nation great…and prosperous. It seems, of late, that there is an accelerating transformation of social values in our nation.

It is important that we all take a thoughtful look back at the basic principles that have made America a prosperous nation. To be sure, our nation is a generous and principled society. To afford continued generosity, a nation must be prosperous. Only when the economic engine of a nation is powerful, can it afford to do good things for its people and others.

Economic value in a society comes from the private sector. It makes things, creates jobs and income for employees and provides tax revenue to the government. Government adds no value to a nation’s economy. It is like overhead in a business; necessary for certain essential functions, infrastructure and shared services. But, it does not contribute to the welfare of its people since it does not create anything of economic value. A society prospers when public policy supports and nurtures the private sector…and declines when it intrudes too much on that territory. In the 1800s, the author, Thoreau said “Government is best when it governs the least.”

So what did make America great?

Our forefathers and immigrants migrating to this country often referred to it as the “land of opportunity,” that is, a place where one’s hard work, individual initiative and creativity could lead to a better life for them and their family.

Now it seems that America has become the “land of entitlements” and rights. There has been a gradual, pejorative shift of orientation from those that produce (create economic value) in our society, to those that consume economic resources. This is not a sustainable equation. So, if there is a battle between those that want to “take” resources from society and those that want to create resources for a society, who will win?

The pendulum has swung too far to one side. It is a challenge in a democratic society when voters are presented with a choice between self interest and the greater good of society itself. For a democracy to prosper, its people must vote without self interest for what makes that society better. They must also have the level of knowledge to know what makes for a better society for all of its people.

What is going on now that should raise one’s concern? Government activism is on the rise…invading the private sector. It is deeply troubling when we see the long arm of government reaching into the private domain; including a frightening disregard for the rule of law by public officials. I recommend that we all go back and read the Constitution and “Bill of Rights”. It is really good stuff! One key provision is that, “all rights not granted to the government are to be retained by the people”. Political leaders seem to have forgotten the limited powers granted to them by the people.

Recently we have seen the American auto industry turned into a public works project, to be owned and operated by the government and unions. Certainly, Chrysler and GM have been badly managed for decades but, do we really believe that the government has any skill to run a business?

For sure, the banking system needed resuscitation, but government activism was extreme. Last year we saw the public officials force “shot gun weddings” between unwilling financial services firms (e.g. Bank of America’s acquisition of troubled Merrill Lynch and others). Major banks are being nationalized, driving talent out of those enterprises. Public servants are setting executive salaries and eliminating any pay-for-performance incentive. Through government ownership, political pressure is also being applied for banks to lend aggressively to borrowers with marginal credit worthiness …when their own balance sheets are already over-leveraged and feeble.

It is almost unbelievable that we have seen Congress propose the insidiously titled “Employee Free Choice Act” which would eliminate the secret ballot in forming union shops. This would allow old style coercion, deception and harassment by union organizers. Is this America in the 21st century? Under this proposed legislation, if 50% signed union “cards”, all employees would be swept into the union and the government (not the employer) would have the power to set wages and benefits. Why isn’t the public outraged about such legislation?

It is troubling to see the loss of a balance-of-power in Washington which has led to free wheel spending that will mortgage the future of generations to come. While the promise is stated, “no new taxes on 95% of Americans,” the message is silent about the tax burden to be borne in years ahead. With the current year deficit set to exceed the combined deficit for all Presidents in US history (200 years), there will be a price to pay for this lack of fiscal discipline.

Clearly the plan is to tax “producers” at a higher rate, but when that source is exhausted, which will be soon, government will have to apply the burden to Main Street America. There is simply no way to avoid it. This will be exacerbated as the increasing tax burden on the “producers” results in the diminishment of individual initiative, investment and innovation. Discouraging incentive will lead to lower growth in the economy and lower tax revenues. It is a vicious cycle that is certain to adversely affect our nation’s prosperity and the American way of life.
So, is there hope for the future? It is in our hands. We must renew our appreciation for the basic values that have led to our nation’s prosperity. We must relearn to celebrate an individual’s success and recognize that the success of one adds to the quality of life for all. It is not a “zero sum game.” We live in a world where the innovation, leadership, willingness to take risk and personal initiative of any individual can raise the quality of life for many.

A glimmer of hope occurred in the recent (May ’09) election in California, when voters soundly turned down the five propositions placed on the ballot by its legislature. These propositions were designed to let the state’s elected officials “off the hook” from dealing with the self-inflicted budget deficit. Had the propositions passed, Sacramento would have been able to push off the hard work of “living within its means” to a future year.

It would be wonderful if the cycle in society was beginning to turn back towards our basic American values. The California referendum on fiscal responsibility may be just a tax payer revolt and not reflective of a broader shift in social values. But, as California has led the way in so many aspects of this nation’s life, perhaps it may too lead the way back to the renewal of the “American Dream.”

Short Story: The Economy

About two decades ago the expansion of credit in America began to accelerate. In the mid ‘90s consumers commenced what was to become a credit “binge” that would last 15 years. During this period consumer debt grew much faster than incomes. From 2003 to 2008 consumer credit tripled while the economy did not grow sufficiently to support that debt load. The consumer was not the only party that was binging on credit. The US Federal Government dramatically increased its borrowings during this period. In addition the government took on huge amounts of liabilities in the form of a growing Social Security and Medicare burden, neither of which shows up on its balance sheet.

The US society, during this period, embarked on a “borrow from tomorrow and spend today” way of conducting business. This caused the American economy to grow faster than the fundamental drivers (productivity and wage expansion) would justify. The result was that we leveraged up our economy.

At the same time, the excessive demand that resulted from credit expansion (and the excessive spending that accompanied it) caused asset values to grow faster than the underlying economic expansion could support in the long run. No place was this more evident than in housing.

Public policy was a major factor in the explosion of credit and unrealistic growth in housing prices. The US Congress and Presidential leaders promoted the concept of expansion of home ownership in America. They dramatically expanded the scope of mortgage financing in the nation. The extraordinary expansion of FreddieMac and FannieMae were central to this public policy adventure. Politicians believed that home ownership should be a right of all Americans, regardless of their economic status or creditworthiness. Consumers bought homes that they could not reasonably afford and refinanced them to higher levels, all of which fueled a spending boom. This metastasized through the economy as consumers spent at a high level on furniture, furnishings, house wares, boats, cars, recreational vehicles and much more.

The private sector contributed to the credit binge also in a big way. The securitization of mortgages added fuel to the fire. This mechanism facilitated the flow of investor funds into the mortgage markets in huge amounts. The creation and proliferation of new instruments also contributed to the credit binge. Credit default swaps provided a form of insurance against borrower defaults that allowed low quality credit to be upgraded and sold to the market. Collateralized Debt Obligations (CDOs) were another “creation” that fueled the flow of funds to the credit markets. Through these instruments portfolios of loans (mortgages, autos loans, credit card loans, etc.) could be bundled and divided into tranches that could be sold to the market. The symbiotic relationship between credit rating agencies and mortgage financing firms was also an unsightly mechanism that contributed to the growth of these debt securities.

For almost two decades this dramatic expansion of credit has fueled a growth in asset values, pumping money into the economy and creating a massive number of buyers (spenders). Home prices grew to levels that were well above the affordability level that could be supported by incomes. The low cost of mortgage debt mask the fact that homeowners simply could not afford the purchases that they made on a sustainable basis. Artificially low interest rates contributed to this problem.

The artificial stimulation of demand lead to an expansion of capacity in the economy that was not sustainable; too many stores, too much auto manufacturing, too many homes built; just too much “stuff”. We now find our economy oversupplied. It must shrink to the level that is required to supply the real demand.

So now comes 2008; the “day of reckoning”. The economy has begun to go through a deleveraging process. Unwinding leverage is a very painful process and can take time to reach a state of normalization. In this process asset values must fall. There are no buyers and all parties seek to sell at the same time. Banks, brokerage firms and consumers must follow this painful course. Fortunately most (non-financial) companies did not fall into this trap and have good balance sheets. Financial firms will make this journey fairly quickly, but it will take a long time for consumers to deleverage. This will curtail their spending and investing for a protracted period.

The backbone of the growth of the American economy in recent years has been the consumer. The consumer has been spending beyond his means for a protracted period of time and has now crawled into a fox hole and will stay there. In a strange way this is intelligent behavior. After partying all night and waking up with a hang over, the consumer must dry out; must live more conservatively; must moderate their spending behavior. Consumers have seen their household wealth disappear. Home equity has vanished, retirement savings and savings for the college education of their children have dropped precipitously in value, unemployment is running at very high levels…and the consumer is afraid. It will be a long time before they feel confident again.

So what about government intervention to “save the economy”? We have just witnessed the “loony tunes” in Washington pass a “stimulus” bill, the size of which is the largest in history. Presumably it will create millions of jobs. Politicians point to a large number of “shovel ready” projects that will be funded. This may help employment in the construction industry, but will not support employment in financial services, retail, manufacturing and virtually all other industries. Somehow I do not see a retail clerk, auto executive or bank executive getting a shovel and going to work.

More importantly, it was a “borrow from tomorrow and spend today” scheme that got us into this mess….and Washington’s solution to get us out is…to borrow from the future and spend it today. This is pure folly. The government, through the Federal Reserve has also attempted to manage the economy through monetary policy. Interest rates were lowered to unreasonable rates in the 2001/2002/2003 time-frame and fueled excessive, unsustainable, economic growth in the years that followed. Now it is happening again. Why can’t these economically illiterate political leaders keep their hands off the “steering wheel” and let the market do its thing.

This would mean that our economy would grow at a slower pace, but at a sustainable rate and perhaps might not go through the big cycles that are created by too much stimulus and too much government meddling in an effort to make things better today than the underlying economic drivers can support over the long haul.