What really scares the administration is that the nation’s triple-A rating will be downgraded. The downgrade may not be much, maybe to double-A+.

Financial analysts estimate that a downgrade will result in Americans being charged more than $100 billion per year in higher borrowing costs. Interest rates would escalate rapidly on credit cards, mortgages, and car loans.

This would be the equivalent of a large tax increase on Americans, that both parties (they say) are trying to avoid. And, there is no guarantee that there wouldn’t be a tax increase anyway.

How’s that for trickle down economics?

The loss of the triple-A bond rating would force the huge investment funds that are allowed to hold only triple-A investments to sell their holdings as a whole. On a smaller scale, this fire sale will probably cause many smaller investors to dump their holdings as well.

Investors can move their investments to Canada, England, Hong Kong, Singapore, Australia and many other European countries who have the triple-A rating and might be more reliable in delivering safe returns. The United States will no longer be in that club.

The rating agencies are holding their threats high and visible, saying that in addition to raising the debt limit to pay current obligations, they want to see an enforceable agreement to cut $4 trillion from expenses over the next ten years as an assurance that the U.S. is indeed working to get its financial house in order.

An enforceable agreement is tough. Each two-year congressional session is unique with its elected members. Even if a law was passed limiting spending to a certain amount, a future Congress could modify or even repeal it.

Since an overall limit on most federal debt was first set up in 1939, the debt ceiling went up during every presidency with the sole exception of former President Harry S. Truman’s.

Another option that has been discussed in detail is the president invoking the 14^th amendment and raising the debt limit on his own authority if Congress fails its responsibility. 

The 14^th Amendment, Section 4 certifies the debt of the U.S. is irrefutable and it must be paid. It also includes debts for payments of pensions, which would include expenses like Social Security and Medicare, as well as government and military pensions, all validated by Congress.

“Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.”

“Section 5. The Congress shall have power to enforce, by appropriate legislation, the provisions of this article. “

The Supreme Court in City of Boerne v. Flores (1997) said regarding Section 5:

“Any suggestion that Congress has a substantive, non-remedial power under the Fourteenth Amendment is not supported by our case law.”

That is taken to mean that Congressional action (or inaction) is not absolutely final. That would be true especially if Congress, through inaction, puts the interest of the nation at risk.

Former President Bill Clinton said last week that the 14^th Amendment states the “validity” of government debt ”shall not be questioned” means that Obama could simply ignore the congressionally imposed debt ceiling and go on borrowing.

Obama considered the possibility, but for the present appeared to rule it out. “The Constitution makes clear that Congress has the authority, not the president, to borrow money and only Congress can increase the statutory debt ceiling.”

Article 1, Section 8 of the Constitution states that:

“The Congress shall have power

To lay and collect Taxes, Duties, Imposts and Excises,

To pay the Debts and provide for the common defence and general Welfare of the United States; …

To borrow Money on the credit of the United States; …

The vesting clauses establish the principle of separation of powers by specifically giving to each branch of the federal government only those powers it can exercise and no others. This means that no branch may exercise powers that properly belong to another branch.

The president says he will not bypass Congress and cite an obscure part of the U.S. Constitution to prevent a government debt default. Legal experts say it would prove difficult to challenge him in court should he change his mind.

It wouldn’t be enough for a plaintiff to claim that Obama is overstepping his authority or acting illegally. In order to sue, there has to be an injury in fact. That same standard would apply if someone preemptively filed a lawsuit to stop Obama invoking the 14^th Amendment.

Challengers might argue that relying on the 14^th Amendment to raise the debt ceiling qualified as an abuse of executive power, but it would be extremely difficult for them to show that they suffered specific harm such as lost money, property or rights.

In 1996, President Clinton signed the line-item veto act, allowing the president to veto separate parts of a spending bill. Six members of Congress who opposed the law sued the Treasury secretary and the director of the Office of Management and Budget, claiming the law was an unconstitutional over-reach of executive power.

In 1997, the Supreme Court said the members of Congress did not have qualifications to sue, ruling they did not suffer personal injury or that Congress was harmed.

The 14^th Amendment allows the president to pass the ball to Congress. It states we have to continue to pay our debts. As for social security payments and Medicare, they are contracted pension benefits that also need to be paid.

The Treasury secretary must pay all outstanding debts, and when there is no money left, Congress is obligated to borrow more to meet the obligations under the 14^th Amendment (currently $28 billion per week). Only new debts (like highway and bridge repairs) are off limits.

A third, least likely option is a legal minting trick called coin seigniorage. 

Congress provided the authority, in legislation passed in 1996, for the US Mint to create platinum bullion or proof platinum coins with arbitrarily decreed face values having no relationship to the value of the platinum used in these coins.

The Mint’s profit (coin seigniorage) is the credit provided less the cost of producing these coins. The Treasury will book these profits as miscellaneous revenue in the treasury General Account, the same way as tax revenues. Poof! No need to borrow. Plenty of cash. Mostly worthless.

It follows the same concept as the printing of Federal Reserve notes, which we know as paper money, the fiat currency backed by the “full faith and credit of the United States”.

We are getting too close to the borrowing deadline to use this trick, but we should know that it is available, and used by more than several nations as an ongoing way to finance their operations.

The bottom line is that the president has sworn to uphold both the Constitution, which prohibits default, and the laws of the United States which includes a debt ceiling. The Constitution is the final authority of law and trumps any law Congress may pass. We will therefore not have a default.

The downgrade in credit rating is another story.

To explain, Quantitative Easing (QE) is an unconventional monetary policy tool aimed at stimulating the economy when conventional methods have failed.

Normally, a central bank creates money by lowering interest rates on short-term government bonds. But, when interest rates have fallen to zero, a three-month Treasury bond and cash are equivalent; zero-yield government liabilities.

In these anxious times, with deflation staring us in the face, investors look for long-term safe securities. This leaves the short-term rates at zero with no buyers. The economy needs a kick start.

Money supply is created electronically through the process of Quantitative Easing.

This new money is used to buy up long-term financial assets from local banks. This electronic money gives the banks higher reserves to ease credit lending and stimulate the economy.

But what if banks don’t lend out the money locally, or lend it out instead to non-local opportunities or emerging markets?

This is where we are now with QE2 set to end June 30.

The $1.75 trillion the Fed paid out for mortgage-backed bank assets with QE1 as well as the $600 billion in 2 to 10 year Treasury notes under QE2 still sits in bank vaults as excess reserves.

Bankers cringe around their conference tables, burned by previous bad loans, afraid to take any chances on local business lending and reluctant to lend at the current low rates, when in their minds future interest rates should be much higher.

The bank reserve-to-deposit ratio has never been above 4.5 percent in the last 50 years. The ratio is now somewhere above 14 percent.

Local businesses that can pass the high lending requirements, are reluctant to incur debt to expand their business facilities, in case their business model hits a snag, like the impending required healthcare costs and possible tax increases. If they don’t expand their business, they can’t provide new jobs and don’t hire more workers.

On the consumer front, American households lost $14 trillion of their net worth in the recession, based largely on devaluation of their homes and retirement accounts. Consumers are now trying to replenish some of their household wealth, and are limiting their spending

“The [financial] system is clogged” is how Bob McTeer, former president of Federal Reserve Bank of Dallas, described it.

So how can it be unclogged?

The answer is to learn lessons from the past. During the great depression of the 1930s, consumers waited to spend because prices were dropping and promised to be cheaper in the future with deflation. The same thing is occurring today.

If the government does nothing, people and businesses would spend–eventually; but we should remember the depression of the 1930′s lasted well into the 1950′s, and that was with the flood of spending for World War II.

However, if prices promised to be higher in the future, people would be inclined to spend now to avoid the future inflated prices.

If QE is successful, long-term yields will float lower by the government buying up huge amounts of long-term investments; private investors will be herded into short-term notes, stocks and commodities in which to put their money.

Activity in short-term notes, stocks and commodities will, through increased demand and speculation alone, push short-term interest rates higher and create inflation. Banks will see an increase in interest rates and offer loans at the higher profitable rates.

Inflation will also push stocks, commodities and prices (including housing) higher. Consumers will spend to avoid anticipated price increases.

The government will hold down long-term interest rates, which will encourage homeowners to refinance their loans and establish mortgage payments they can afford.

The increase in money supply to the banks will devalue the paper dollar. The devalued paper dollar will help the manufacturing trade, increasing export sales.

Since consumer spending is the key to recovery, rising prices should make consumers feel the economy is improving, and with increased spending, it will improve.

That’s the plan.

QE has already been great for Wall Street stocks. Measured in paper dollars, the Dow has climbed roughly 20 percent from August 2010 to Jun 2011, the duration of QE2. In that time, the flood of cheap money has helped the big banks and commodity speculators rake in huge profits of paper money.

But in real terms, measured against the Swiss franc (an international standard for stability) in the QE2 time period, the US dollar value has dropped more than 19 percent, nearly eliminating the Dow’s increase.

And the ordinary investor? In that same period, they’ve been cashing out to the tune of $52 billion from U.S. equity mutual funds. More than 80 million baby boomers are reducing their exposure to equities as they approach retirement age.

Michael Cox, director of the William J. O’Neil Center for Global Markets and Freedom, SMU: “The Fed is trying to create some inflation. That’s what the economy needs right now. … It’s not that the Fed is trying to get long-term interest rates down. … It sells to say, ‘We’re going into the long-term market and hold down long-term rates … but the real objective is to create some inflation. … This is exactly the right thing to do. The solution is higher interest rates. How you get higher interest rates is inflation. Once the Fed pushes enough base currency into the economy, eventually you’re going to have inflation. A little bit of inflation cures a lot of recession. “

The government’s challenge is to create manageable inflation. Their target is 2 percent.

Inflation is not a painless solution especially to those on a fixed income; but it is the least painful solution. But many think that holding to a consistent 2 percent inflation is like flying a jet plane 10 feet off the ground — it really needs to be higher.

If QE is too successful at unclogging the stream of money, inflation could shift into high gear, forcing the Fed to engage a completely different set of financial mechanisms by raising interest rates to apply the brakes.

However, QE is expected to create a manageable inflation rate that could push the stock market and housing prices higher, stimulate businesses to go ahead with projects and banks to lend funding to them at the higher interest rates.

If the excess reserves resulting from the increase in money supply is liberated by the banks, in the form of business loans, inflation could be traded for a sustained increase in real production.

And how does that electronic money disappear from the system and allow the paper dollar to be once again be valued at its correct level? Each time one of those long-term liabilities is paid off, the government will adjust the QE balance sheet downward.

A little history here.

In 1965, President Lyndon Johnson started increasing deficit spending to fund the Vietnam war. This fiscal policy increased inflation and reduced unemployment.

Business owners, seeing the inflation and fearing more, raised their prices as protection and so created the monster they feared.

In 1973 and again in 1979, OPEC ( the Organization of Petroleum Exporting Countries) boosted crude oil prices to get their piece of the price increases.

This increase, combined with food harvest failures around the world, caused merchants who used trucks to deliver products or imported food to boost prices again.

In the 1960′s the Fed traded higher prices for lower employment, expanding the money supply to keep unemployment down. Businesses quickly learned to keep the money being fed to them and raise prices anyway instead of expanding by hiring new workers. This gave birth to ‘stagflation‘ where unemployment and inflation grew at the same time.

In 1980, President Jimmy Carter nominated Paul Volcker for the Chairman of the Federal Reserve Board. Volker said that the bitter medicine of recession was the only way to make the economy healthy again.

In 1980 and again in 1982, the Fed drastically tightened money supply, raising interest rates as high as 14 percent. This halted employment growth and higher wage demands from workers. Businesses slashed prices just to stay alive. Unemployment soared to more than 10 percent. It was called the worst recession since the Great Depression of the 1930′s. Of course, we know better today.

When inflation looked like it had been stopped, Volker dropped the Fed’s discount rate to 8.5 percent, sharply increasing the money supply flow. Within months, the economy roared to life, with a healthy recovery fueled by the large number of available workers.

The economic policies instituted by Volker under Jimmy Carter were continued under President Ronald Reagan. In addition to controlling the money supply to control inflation, three other pillars of Reagan’s economic policies were to reduce the growth of government spending, reduce taxes, and reduce government regulation in major utility industries such as railroads, banking and telephones.

Within four years the rate of growth of government spending and the federal deficit was cut in half. The composition of tax revenue was changed from capital gains on existing investments and taxing high earners to new investments and payroll with a very small effect on tax revenues. The significant increase in GDP growth caused a significant drop in unemployment.

Volker left the Fed in 1987, but was called to serve as the Chairman of the Economic Recovery Advisory Board under President Barack Obama from February 2009 until January 2011.

QE is meant to allow our financial ship to leave the dock and set sail. And it is working.

A professor of economics and co-director of the Political Economy Research Institute at the University of Massachusetts, is co-author of Green Recovery: A Program to Create Good Jobs and Start Building a Low-Carbon Economy.

This article (written November 6, 2008) appeared in the November 24, 2008 edition of The Nation.

Ed.Note: This article was interesting because it contains many of the points of the Obama Recovery Stimulus of 2009.  The article was slightly reformatted without omission or distortion of meaning to read easier online. 

Bolded passages are of particular interest; italic notes are my notes added for clarity.

A Green Public-Investment Stimulus

Recessions create widespread human suffering. Minimizing the suffering has to be the top priority in fighting the recession. This means expanding unemployment benefits and food stamps to counteract the income losses of unemployed workers and the poor. By stabilizing the pocketbooks of distressed households, these measures also help people pay their mortgages and pump money into consumer markets.

Beyond this, the stimulus program should be designed to meet three additional criteria.

1.      We have to generate the largest possible employment boost for a given level of new government spending.
2.      The spending targets should be in areas that strengthen the economy in the long run, not just through a short-term money injection.
3.      Despite the recession, we do not have the luxury of delaying the fight against global warming.

To further all these goals we need a green public-investment stimulus to
1.      defend state-level health and education projects against budget cuts
2.      finance long-delayed upgrades for our roads, bridges, railroads and water management systems
3.      underwrite investments in energy efficiency-including  building retrofits and public transportation-as well as new wind, solar, geothermal and biomass technologies.

This kind of stimulus would generate many more jobs–18 per $1 million in spending – than  would programs to increase spending on the military and the oil industry (i.e., new military surges in Iraq or Afghanistan combined with “Drill, baby, drill”), which would generate only about 7.5 jobs for every $1 million spent.

There are two reasons for the green program’s advantage.

1.      The first factor is higher “labor intensity” of spending-that  is, more money is being spent on hiring people and less on machines, supplies and consuming energy. This becomes obvious if we imagine hiring teachers, nurses and bus drivers versus drilling for oil off the coasts of Florida, California and Alaska.

2.      The second factor is the “domestic content” of spending-how much money is staying within the US economy, as opposed to buying imports or spending abroad. When we build a bridge in Minneapolis, upgrade the levee system in New Orleans or retrofit public buildings and private homes to raise their energy efficiency, virtually every dollar is spent within our economy. By contrast, only 80 cents of every dollar spent in the oil industry remains in the United States. The figure is still lower with the military budget.

What about another round of across-the-board tax rebates, such as the program the Bush administration and the Democratic Congress implemented in April?

A case could be made for this in light of the financial stresses middle-class families are facing. However, even if we assume that the middle-class households will spend all the money refunded to them, the net increase in employment will be about 14 jobs per $1 million spent-about  20 percent less than the green public-investment program (the main reason for this weaker impact is the lower domestic content of average household consumption, i.e. much of the consumption will be for foreign-made goods).

Also, it isn’t likely that the households would spend all their rebate money. Just as with April’s rebate program, households would channel a large share of the money into paying off debts. (paying off debts is not necessarily bad – it releases discretionary income for the family and increases reserves for the banks and credit card companies to extend more credit to others).

The Matter of Size

This is no time to be timid. The stimulus program last April totaled $150 billion, including $100 billion in household rebates and the rest in business tax breaks. This initiative did encourage some job growth, though as we have seen, the impact would have been larger had the same money been channeled toward a green public-investment stimulus.

But any job benefits were negated by the countervailing (counteracting) forces of the collapsed housing bubble, the financial crisis and the spike in oil prices. The resulting recession is now before us. This argues for a significantly larger stimulus than the one enacted in April.

But how much larger?

One way to approach the question is to consider the last time the economy faced a recession of similar severity, which was in 1980-82, during Ronald Reagan’s first term as president. In 1982 gross domestic product (GDP) contracted by 1.9 percent, the most severe one-year drop in GDP since World War II. Unemployment rose to 9.7 percent that year, which was, again, the highest figure since the ’30s.

The Reagan administration responded with a massive stimulus program, even though its alleged free-market devotees never acknowledged as much. They preferred calling their program of military expansion and tax cuts for the rich “supply-side economics.” (supply creates demand – see Trickle, Trickle, Up, Down, part I)

Whatever the label, this combination generated an increase in the federal deficit of about two percentage points relative to the size of the economy at that time. In 1983 GDP rose sharply by 4.5 percent. In 1984 GDP growth accelerated to 7.2 percent, with Reagan declaring the return to “morning in America.” Unemployment fell back to 7.5 percent.

In today’s economy, an economic stimulus equivalent to the 1983 Reagan program would amount to about $300 billion in spending-roughly double the size of April’s stimulus program, though in line with the high-end figures being proposed in Congress. A stimulus of this size could create nearly 6 million jobs, offsetting the job-shedding forces of the recession.

Of course, the green public-investment stimulus will be much more effective as a jobs program than the Reagan agenda of militarism and upper-income tax cuts. This suggests that an initiative costing somewhat less than $300 billion could be adequate to fight the job losses. But because the green public-investment stimulus is also designed to produce long-term benefits to the economy, there is little danger that we would spend too much. Since all these investments are needed to fight global warming and improve overall productivity, the sooner we move forward, the better. Moreover, under today’s weak job market conditions, we will not run short of qualified workers.

How to Pay for All This?

Let’s add up the figures I have tossed around. These include the $700 billion bank rescue operation being engineered by the Treasury, the $540 billion with which Fed chair Bernanke has pledged to bail out the money market mutual funds, along with unspecified additional billions to buy unwanted business debts held by banks. On top of these, I am proposing $300 billion for a second fiscal stimulus beyond last April’s $150 billion program. At a certain point, it is fair to wonder whether we are still dealing with real dollars as opposed to Monopoly money.

In fact, the whole program remains within the realm of affordability, albeit approaching its upper bounds. But major adjustments from the current management approach are needed. In particular, the Federal Reserve has to continue exerting control over the Treasury on all bailout operations. That is, we need more initiatives like Bernanke’s $540 billion program to stabilize the money market mutual funds and less Treasury fumbling with taxpayers’ money to buy either the private banks’ bad assets or ownership shares in the banks.

We need to recognize openly what has largely been an unspoken fact about these bailout operations: that the Federal Reserve has the power to create dollars at will, while the Treasury finances its operations either through tax revenues or borrowed funds (which means using taxpayer money at some later time to pay back its debts with interest).

The Federal Reserve does not literally run printing presses when it decides to inject more money into the economy; but its normal activity of writing checks to private banks to buy the banks’ Treasury bonds amounts to the same thing.

When the banks receive their checks from the Fed, they have more cash on hand than they did before they sold their Treasury bonds to the Fed. Especially during crises, there is no reason for the Fed to restrain itself from making good use (though of course not overuse) of this dollar-creating power.

The Fed is also supposed to be the chief regulator of the financial system. Now is the time to make up for Alan Greenspan’s confessed failures over twenty years in this role.

In exchange for the Fed protecting the private financial institutions from collapse, Bernanke must insist that the banks begin lending money again to support productive investments, while prohibiting them from yet another return to high-rolling speculation.  

Special measures are also needed to keep people in their homes.

The Deficit Looms

When the economy began slowing this year, the fiscal deficit more than doubled, from $162 billion to $389 billion. We cannot know for certain how much the deficit will expand. It could rise to $800 billion, $1 trillion or even somewhat higher, depending on how the bailout operations are managed.  Of course, it would be utterly self-defeating for the United States to run a reckless fiscal policy, no matter how pressing the need to fight the financial crisis and recession.  But in the current crisis conditions, even a $1 trillion deficit need not be reckless.

Let’s return to the Reagan experience for perspective. In 1983 the Reagan deficits peaked at 6 percent of the economy’s GDP. With GDP now around $14.4 trillion, a $1 trillion deficit would represent about 7 percent of GDP, one percentage point higher than the 1983 figure.

Of course, the global financial system has undergone dramatic changes since the 1980s, so direct comparisons with the Reagan deficits are not entirely valid.

One change is that government debt is increasingly owned by foreign governments and private investors. This means that interest payments on that debt flow increasingly from the coffers of the Treasury to foreign owners of Treasury bonds.

At the same time, as one feature of the crisis, Treasury bonds are, and will remain for some time, the safest and most desirable financial instrument in the global financial system. US and foreign investors are clamoring to purchase Treasuries as opposed to buying stocks, bonds issued by private companies or derivatives.

This is pushing down the interest rates on Treasuries. For example, on October 15, 2007, a three-year Treasury bond paid out 4.25 percent in interest, whereas this past October 15, the interest payment had fallen to 1.9 percent (currently 1.125 percent). By contrast, a BAA (investment grade) corporate bond paid 6.6 percent in interest one year ago but has risen this year to 9 percent (currently 8.24 percent).

As long as the private financial markets remain gripped by instability and fear, the Treasury will be able to borrow at negligible interest rates. Because of this, allowing the deficit to rise even as high as 7 percent of GDP does not represent a burden on the Treasury greater than what accompanied the Reagan deficits.

There is, then, no reason to tread lightly in fighting the recession, with all its attendant dangers and misery. Indeed, severe misery and danger will certainly rise as long as timidity-the path of least resistance-establishes the boundaries of acceptable action.

The incoming Obama administration can take decisive steps now to defend people’s livelihoods and to reconstruct a viable financial system, productive infrastructure and job market on the foundation of a clean-energy economy.

Political analysts and reporters keep talking about “trickle-up” and “trickle-down” economics.  What do these terms mean?  Personally, I’m interested only in “trickle to my pocket.”  But as far as taxes are concerned, I pay what the government says to pay.  They decide how to apply the money.

President-elect Barack Obama has spoken in multiple election speeches about trickle-down economics and how it has often had the opposite of its intended result, stating: ” … instead of prosperity trickling down, the pain has trickled up – from the struggles of hardworking Americans on Main Street to the largest firms of Wall Street.”

The trickle-down economics viewpoint cherished by the Republican Party sees tax breaks that benefit mostly the wealthy, who will invest it in companies that will expand operations, increase employment, and produce cheaper goods resulting in a higher standard of living for all.

This economic model relies on each step acting according to plan.  The tax break-generated extra income must be large enough that the wealthy individuals invest it instead of saving it or spending it on personal consumption. 

The public company receiving the investment must use it to expand existing operations, instead of buying back stock or buying competitors.  The expansion must result in increased domestic employment, rather than outsourcing.  Finally, the business expansion must result in profits on cheaper goods purchased by the public. 

But does it work?

The Richard Nixon administration did not cut taxes.  He thought the incentive for the wealthy to invest in the market was zero.  Instead, the government controlled wage and price increases, but not interest rates.  The economy ground to a halt with high inflation, a condition known as stagflation. 

The Ronald Reagan administration Federal Reserve chairman Paul Volcker, squeezed inflation from the economic system by raising the federal funds rate to 20%, deliberately causing a recession.  As interest rates were gradually lowered, the administration cut taxes by $479 billion over five years, and pulled the economy out of the recession, recouping $476 billion over the five years from increased tax revenues.

The George W. Bush administration avoided an impending recession in 2001, lowering taxes as an economic preemptive strike.  In spite of the bursting of the dot-com bubble just before he took office, the 2001 9/11 attacks, and wars in Iraq and Afghanistan, President Bush managed to keep the country out of recession, until the bursting of the U.S. housing bubble at the end of his second term. 

It has been 17 years of growth.

The $1.35 trillion in tax cuts over ten years was expected to be mostly repaid by the time they ran out in 2011.  The recouping of the ten-year tax breaks is now a new ball game, depending on when the current recession will end, and how close to pre-bubble levels we return.

Does supply-side economics work? 

Tax cuts are the key. 

In the three cases cited, Nixonomics failed due to no tax breaks, Reaganomics and Bushonomics succeeded because of tax breaks, even though Reagan had to pull the country out of deep recession first.

Trickle up

Keynesian economics, also known as the trickle-up effect and favored by the Democrats, is a different type of macroeconomic philosophy that holds that:

1.      Tax cuts can be used as an economic stimulus if spread across the entire economy, not just toward one specific group (like the wealthy). 

2.      Tax cuts should be used to increase demand, not supply, and should be targeted at cash-strapped, lower-income earners, who are more likely to spend the additional income.

3.      Spending on goods demanded by the public will result in business expansion, increased employment, raising of standards of living followed by more demand.

Keynesian or demand-side economics proposes that consumption or demand is the key to economic prosperity and that production or supply follows. 

Percentage-wise, it is obvious the wealthy spend less of their disposable income in the economic market.  Dollar for dollar, the working class will release more into the economic system than the wealthy, simply because there are more of us. 

The trickle-up effect states that directly benefiting the working class will cause them to spend their disposable income, buy more goods, encouraging more product output.  As the supply of goods and services increases in response to increased demand, the wealth of the society as a whole improves and benefits will “trickle up” to the wealthy.

John Maynard Keynes was a British economist who still remains the world’s foremost expert on recessions and depressions.  Although he died halfway through the 20^th century, his findings are still accurate today.  He knew how we got into recession, and he knew how to get out. 

People are conventional.

Keynes developed the theory that increasing government deficits stimulates an economy.  He also developed the theory that rational people in times of uncertainty fall back to conventions that give them comfort and assure them they are doing the right thing. 

Conventional behavior turns into group behavior reinforcing their assurance.  As an example, people think housing prices will return to their original values, and once we are out of this recession, the economy will grow again from the point it left off. 

That is uncertain.

Keynes approach was based on his conception of money as a “store of value” rather than a method of payment.  The desire to hold money with its perceived fixed value is a gauge of our distrust of our own calculations of the future.  We think the more we have, the more we are protected against future uncertainty.

Keynes said that this uncertainty theory extends to banks (and credit card companies), that will raise interest rates to borrowing consumers to increase their own “store of value” heedless of the guiding interest rate charged by the Central bank.

Private banks will eventually follow the Central bank’s leadership and slowly reduce their lending rates, but their reluctance to spend will initially clamp down on credit and liquidity.  This will leave the ball in the government’s hands to spend and stimulate the economy.

Government spending to “prime the (economic) pump” include infrastructure improvement programs (roads, bridges, dams, schools), tax cuts to workers, and the direct application of spendable cash.

Deficit spending

John Maynard Keynes was one of the first economists to advocate government deficit spending as part of a fiscal policy to cure a recession. His theory is that increased government spending in areas that give discretionary income to the worker class will raise demand and increase consumption. 

He argued that the solution to recession  or depression was to stimulate the economy with a combination of two approaches :

• Reduction(s) in interest rates led by the Central bank, to stimulate cash flow
• government investment in repairing, upgrading and improving the nation’s infrastructure employing many thousands, and providing discretionary income for their families. This results in more spending in the general economy stimulating more demand for goods, resulting in a upward cascading cycle of recovery.

Stimulus savings

The upward recovery cycle can be short-circuited with excessive saving throughout the population, reversing the upward cycle.

Excessive saving decreases investment and demand, causing companies to cut back, increasing unemployment and completing the circle by cutting  back on saving. 

Advocates of Keynesian economics hold that economic stimulus should be directed towards the lower-income worker class, as they are more likely to spend the money than to save it.

The purpose of the stimulation is to get the economy moving again. 

Economics against the tide

Keynes promoted countercyclical economic policies that act against the tide of the business cycle of economic expansion and contraction.  This means embracing deficit spending when a nation’s economy is in recession and unemployment is relentlessly high. 

We have already seen that fiscal stimulus increases the market for business output, raises cash flow and profitability, sparks employment and business optimism, and encourages investment, increasing gross domestic product (GDP).  This accelerator effect means that government and business can be complements of each other rather than substitutes. 

Government spending and investment in public goods not provided by profit-seekers, such as public healthcare, education, and infrastructure upgrade and repair will also encourage the private sector’s growth in suppliers and employment.

On the reverse side of the business cycle, in boom times with excessive demand-side growth, reducing government spending for public goods, raising taxes and interest rates to suppress inflation will cool the economy.

Herbert Hoover‘s 1932 tax increase making the Depression deeper, and Franklin D. Roosevelt‘s fiscal policies of public projects are examples pointing to the potential success of the trickle-up approach as a way out of our dismal economic situation.

Let’s hope a policy that works to dig us out comes soon. 

Political analysts and reporters keep talking about “trickle-up” and “trickle-down” economics.  What do these terms mean?  Personally, I’m interested only in “trickle to my pocket.”  But as far as taxes are concerned, I pay what the government says to pay.  They decide how to apply the money. 

The current administration largely uses supply-side economics.  In a phrase, money is applied to the top level of the economy, with the hope placed in the fairness of industry controllers that it will trickle down to the worker class.

Supply-side economics as an economic definition is a macroeconomic philosophy that holds that:

1.      Lowering income taxes and capital gains tax rates will encourage the wealthy to invest in stock market companies.  Wealthy would describe people in the higher tax brackets, who would benefit most from these tax breaks by gaining more disposable income.

2.      These investments made by the wealthy (if they make the investments) will encourage businesses to expand and produce an increased supply of goods and services at lower prices. 

3.      That expansion in turn, will result in economic growth, increasing employment, disposable income for more workers, and demand for these goods.

Supply-siders feel that in a high tax rate environment, lowering taxes to the right level can raise revenue by causing faster economic growth.

This philosophy is also referred to as “trickle-down economics.” 

·        Proponents argue economic growth will flow downward from top to bottom, indirectly benefiting those workers who do not directly benefit from the tax changes. 

·        Opponents argue that “trickle-down” policies, if they work at all, provide a very slim benefit by the time they reach the worker, due to the benefits taken out at every level.

Advocates of the trickle-down effect believe that a free market, unrestrained by heavy taxation, regulation and other forms of government controls, will cause an increase in wealth for society as a whole, part of which will “trickle down” benefits from the wealthy to the worker class, increasing their standard of living.

Increasing taxes reduces trade between businesses and discourages investment like an international trade barrier or tariff, meant for that purpose.

Nixonomics

In 1971, Republican President Richard Nixon ended the the U.S. Gold standard, where the value of the U.S. dollar was pinned to the fixed value of gold.  Almost immediately,commodity prices such as oil and gold, spiked up. Actually, the value of commodities remained constant while the dollar was devalued. 

As a result, the stock market lost half of its value between the market peak of 1972 and its bottom in 1982, with investors seeking better returns in commodities and real estate. 

Decreasing market investment caused companies to cut back, increasing unemployment. Unions influenced business owners to keep raising prices, fearing more wage hikes, causing inflation.  Nixon refused to cut taxes since he said the incentive to invest in the market was zero.  The result was a stagnant economy with high inflation, better known as stagflation.

Wage and price controls were put into effect, but interest rates were allowed to run free.  The result was rapidly rising interest rates and tight credit.  Inflation caused wage earners to creep into ever higher tax brackets, losing wage increases to taxes.  The number of households able to afford mortgages diminished.

This was an example of supply-side economics gone bad.  High taxes, high inflation and uncontrolled interest rates in a free market economy caused the economy to grind to a halt.

Reaganomics

Skip ahead to 1981 when Republican Ronald Reagan became President.  Unemployment was at 7.5% and inflation was at 13.5%. 

Federal Reserve chairman Paul Volcker squeezed inflation from the economic system, by raising the federal funds rate to 20%, forcing the prime interest rate up to 21.5%.  This extremely tight monetary policy intentionally plunged the U.S. economy into a deep recession and wiped inflationary psychology and expectations out of the system.

Economist Robert Mundell convinced the President to reduce upper bracket and capital gains taxes to increase national output and tax revenue, and that would bring inflation under control.

The ensuing tax cuts, reducing taxes by $749 billion over five years, drew the country out of recession, and the tax receipt level quickly returned, then surpassed previous levels.

This was an example of supply-side and trickle-down economics that worked.  After the economy was intentionally put into a coma, it was restored to health with lower unemployment levels and higher wages, as well as lower prices for consumers.

There are arguments whether the tax cuts actually paid for themselves in the Reagan era.  Take away natural increases due to inflation, increased FICA taxes and corporate taxes, tax revenue in constant dollars decreased by $2.77 billion in that time period.  And recouping $746 billion is not bad.  But one thing is clear, that Reaganomics dramatically reversed the American economic decline of the 1970s.

Trickle-down supply-side economics is the model cherished by the Republican Party.

Shortcomings

The supply-side of the argument has its shortcomings.  The conditions must be correct and  the trickle-down stream must be entirely without blockages in order to work:

1.      Taxes must be high enough that economic expansion is currently stifled.

2.      The lowering of taxes must be noticeable enough to the wealthy that they will consider investing the extra money and not save it or spend it only on personal consumption.

3.      The stock market must be attractive enough for the wealthy to consider investment there, as opposed to, for example, foreign investments, commodities (like oil), or real estate.

4.      Stock market companies who receive the investment must, in turn, invest in expansion and increased employment, with the goal of increased production and lowering prices of their products.

5.      The demand for the products must increase as production increases so the company still makes at least the same profit as before the expansion.

The economy must continue to expand, with people buying an increasing number of the lower cost product. 

Supply-side economics proposes that production or supply is the key to economic prosperity and that consumption or demand is secondary. 

In other words, supply will influence demand.

Bush-onomics

Skip ahead again to 2001, with our current President George W. Bush. 

Bush inherited an unsteady economy from Democratic President Bill Clinton.  Over the three quarters prior to March 31, 2001, the economy grew only at a 1.1% annualized rate.  Much of this was credited to the bursting of the the dot-com bubble.

With threats of impending recession from Federal Reserve Chairman Alan Greenspan, Bush argued with Congress for a $1.35 trillion tax cut over ten years to stimulate the economy and create jobs.  It was approved.

The early 2000s recession (which was not technically a recession) following the 1990s boom was not as bad as was predicted, but was still characterized by outsourcing followed by large layoffs, and recovery without strong employment growth. 

Despite the resultant effects of the 2001 9/11 attacks, President Bush managed to keep the country out of recession.

Large numbers of economists were against the tax cuts, saying they will fail as a stimulus and “will worsen the long-term budget outlook … [and] generate further inequalities in after-tax income.”  The President claimed the tax cuts paid for themselves through economic growth, but it took them until FY2006 to surpass the 2000 level and will take until 2011 to recover all the funds advanced. 

Economist Arthur Laffer stood alone in stating that the tax cuts were “what was right,” because after the 9/11 attacks and threats of recession, the President “needed to stimulate the economy and spend for defense.”

Side note: Even with the tendency of the business cycle to produce periodic recessions,  under Bush’s administration the length of time between recessions has extended to a record-breaking 17 years of sustained growth, in employment, personal income and Gross Domestic Product (GDP).  In addition, there were decreases in the government deficit for years 2005, 2006, and 2007.  Deficits however, still add to the public debt. 

The previous record between recessions was 11 years, 1958 – 1969. 

The supply-side economics of the Bush administration shows that he acted prior to a recession taking hold. 

1.      Taxes were not stifling to business investors, even though the economy was struggling.

2.      Tax cuts issued up to 2003 resulted in a 20% increase in income of the top 1% income households. 

3.      The stock market received a great deal of investment, rising  nearly 32% from January 2001 (10,686) to October 2007 (14,093). 

4.      Production expanded, reducing unemployment from a high of 6.3% in 2003 to 4.4% in March 2007, with an average of 5.2%.

This was an example of supply-side and trickle-down economics that worked for seven years, prior to the ‘economic downturn.’  The President executed a preemptive strike and kept the nation out of recession for most of his two terms in office. 

Recession of 2008

The economic downturn is a harsh reality of economic cycles.  It is now up to our President elect to lead us back to prosperity.

This recession, started by the bursting of the U.S. housing bubble, leaves businesses with their expansions hanging like a stone around their necks with no customers and sharply reduced stock value. 

But that is the subject of another post.