TIME FOR BUDGETARY REFORM

Everyone acknowledges that the US is running up an unsustainable debt and clearly the time for budget and entitlement reform is now. There are a number of proposals on the table now, including those of Rep. Paul Ryan, Chairman of the House Budget Committee, the bipartisan group of six senators working on a compromise, what was finally put forward by President Obama, and his own deficit commission headed by Alan Simpson and Erskine Bowles. Unfortunately the President has largely ignored the proposals of the latter, and gave a disappointingly partisan speech outlining his own position, which sounded more like campaign rhetoric than thoughtful consideration of the problem.

Yet somewhere between all of the above there is a solution that ought to be reached by consensus. The timing and window of opportunity will never be better, but it is rapidly closing as we move towards the presidential campaign. The opportunity is here because the government is divided between parties, with Democrats controlling the Senate and Presidency, while Republicans overwhelmingly control the House. Painful choices are going to have to be made, and the only way this can occur is on a bipartisan basis; otherwise one party will attack the other for some inevitably unpopular decisions. Furthermore the baby boomers are starting to retire. That means there will soon be a mass constituency that will be resistant to any kind of Social Security and Medicare reform, even if these only apply to subsequent generations. Demagogues will have a field day and the chances for any meaningful reform will disappear, at least until bankruptcy.

It may be too much to hope that politicians will rise above partisan posturing and come up with some truly bipartisan solutions. Were this to happen on his watch the president would receive a lot of credit, both currently and historically. Unfortunately in his first pronouncement on this he has instead taken the low road rather than rising to the occasion. However, if the congress comes up with a solution my guess is that he will go along with it. For what remains inescapable is that these problems must be dealt with now.

OIL AND FOOD

Since turmoil began in the Arab world the price of oil has steadily risen. This was preceded by a large increase in the price of food, which has been a significant contributing factor to unrest around the world. For the eighth consecutive month the United Nations index of global food prices hit another record high in February. While weather has been a contributing factor, government policies have exacerbated the situation. Corn prices have nearly doubled since a year ago, and corn is a vital element in many commodities such as animal feed, which in turn affects meat prices. This is a direct result of inane government policies that heavily subsidize biofuels such as ethanol, thereby diverting large tracts of agricultural land away from food production, not to mention paying farmers not to grow crops. Today there are growing food shortages around the world, and rising prices affect the poorest populations disproportionately as a much higher portion of their income goes towards food. There is certain to be price inflation at your local supermarket as well.

While oil prices skyrocket our government pursues policies designed to make the cost of fossil fuels high, based on the illusion that vast quantities of green energy are just around the corner. They are not, and our society is unavoidably dependent on fossil fuels. Meanwhile a huge portion of our balance of payments deficit goes towards the import of foreign oil, leaving us dependent on unstable and/or unsavory regimes around the world, even as abundant domestic resources remain unexploited. The EPA has done everything possible to frustrate domestic energy producers. Meanwhile the Interior department continues to maintain a moratorium on offshore drilling, even in defiance of a federal court order, frustrating not only production but costing thousands of jobs in the gulf region. Vast tracts of domestic resources remain off-limits. New technologies make possible the extraction of oil and gas from shale deposits around the country, but those efforts are being frustrated. Meanwhile roadblocks are being thrown in the way of piping in oil from the Canadian tar sands. We have domestic oil resources but production is being frustrated, denying us an essential resource that is bound to become ever more scarce and expensive as Asian demand increases in the coming years.

These increased costs will radiate throughout the economy, increasing the cost of transport of goods as well as the goods themselves, which means the cost of living will rise. That along with loose money policies will result inevitably in inflation, the likes of which we have not seen since the 1970s. It is time for these destructive policies to end and to maximize production to our full potential. Failing that we will pay a heavy price in the not too distant future.

THE ARAB AWAKENING

From the Maghreb in North Africa to the Persian Gulf we have witnessed mass protests over the past several days, resulting in regime change in a number of cases, with others on the brink. Where some governments have yielded to the popular will, in Libya we currently see thousands being killed, even as army units and officials defect to the opposition. Largely peaceful uprisings in Tunisia and Egypt have resulted in the departure of long-serving dictators. These revolutions were spearheaded by young, secular activists who made great use of technology and social media to organize, from the bottom up, a spontaneous movement that rapidly gained popular support. They were clearly educated, and middle class by the standards of their country. There was nothing “Islamic” about these movements; indeed the Islamists were caught by surprise. The youthful protests were as much a result as economic malaise as a desire for freedom, given high unemployment and dismal prospects even for the educated. In Egypt the average age is only 24 and there are some 20 million Internet users. They are young people seeking a better life in dysfunctional societies without opportunity, and they have no interest in jihad or clerical rule.

In Tunisia, where the movement began, there is a largely secular society established by its first President, Habib Bourguiba, who once jumped off a stage and ripped a veil from a woman’s face to emphasize secular modernity. However, in Egypt, to put things in perspective, Tahrir Square, the epicenter of the demonstrations can hold about 250,000 people. There are 18 million in Cairo, and more than 80 million in Egypt, most of whom are poor peasants barely living at subsistence levels. The average Egyptian survives on less that $1000 a year, and 40% get by on $2.00 a day. They are a world away from the events in Cairo and Alexandria. It is the same peasantry that has endured for thousands of years as regimes have come and gone. It is not clear what their sentiments are, and how they will respond in a democracy, should one emerge. Power remains in the hands of the Army, which has promised a new constitution to be approved by a referendum, and free elections. The Army is popular and the guarantor of stability in the country. Much will depend on their willingness to cede power to an eventual elected civilian government. Although there appears to be a genuine interest in freedom, in reality economic concerns are equally salient.

Let us hope that the young seeking a better life are not disappointed as their expectations rise. In Egypt there has been something of an Islamic revival. Thirty years ago there were few headscarves in Cairo. Now they are ubiquitous, but this does not equate with radical Islamism by any means. My guess is that Islamism will not ultimately triumph in this situation. Young people want a better life; that is life in this world, not the next, and revolution opens possibilities and optimism that there will be change and opportunity. They have no more desire to be ruled by clerics than we in the west do, especially having seen the results in Iran. Islamism can only take hold when there is desperation, hopelessness, and alienation with the possibilities of this life. The only risk is that reformed governments will be unable to deliver.

Some analysts in the west have worriedly pointed to the fact that revolutions often result in radical extremists taking power, as in France, Russia, and Iran. I do not see that happening in this instance because power ultimately rests with the men with guns, who are part of a professional army.

In Libya the situation is somewhat different. Muamar “Daffy” Qadaffi has turned the guns on his own people, resorting to bringing in mercenaries from African countries as army units defect. The US once had an air force base in Libya until Colonel Qadaffi overthrew King Idris. But it is the flag of the old king that the rebels are now waving. With the east and much of the countryside lost, Qadaffi is left with a base in Tripoli, where his forces continue to slaughter the opposition. The French and British have taken the lead on this as the administration has again been clueless. What needs to be done now is to establish a no fly zone so that Qadaffi cannot attack his own people from the air.

It ought to now be clear that the desire for freedom does exist in the Arab world. Through modern communications young people realize there is a better life elsewhere, that there are alternatives to tyranny, and that opportunity in their own societies can only be realized through change. The clock cannot be turned back.

WHITHER CHINA?

Chinese President Hu Jintao recently completed a triumphant visit to the United States, at least according to the Chinese media. American officials wound up looking like fools as they sat through an anti-American song played by pianist Ling Ling, to the delight and contempt of Chinese nationalists and hardliners. The prevailing narrative these days is that China is rising while America is declining. This may well be the case over the next few decades if we allow it, but there is nothing inevitable about it. If we seriously reduce our deficit and institute pro-growth policies so that the economy grows at 5% this won’t happen. But the government is a long way off from getting the economy on a solid footing. On the other hand there is no certainty that China will continue to grow at a 10% rate indefinitely any more than Japan did.

China faces a host of internal problems. There is rising inflation and a property bubble that may eventually collapse. There is misallocation of capital by state enterprises, and rising discontent amongst a population that is still overwhelmingly poor. The government’s top priority is maintaining internal order and a “harmonious society” that keeps the Communist party elites in control. This is a bit tricky insofar as they have largely scrapped communist ideology in practice, but to be logically consistent they ought to do so officially, by rejecting Marxism as a foreign ideology and returning to Confucian roots. There has already been a revival of Confucianism, and a full embrace would legitimize the government in accordance with Chinese tradition. If this is accompanied by a merit system, rather than one that favors party functionaries, the government would be on solid ground, even if not democratic.

But in the long run, China will be outpaced by India. India is like a slow-moving elephant that has a long-term consistency once it is headed in the right direction. Its population will eventually pass China’s, and will be considerably younger due to China’s one-child policy. Even at a slower rate of growth in the long-term this means a larger economy. However, neither will be anywhere near the west on a per capita basis. Nor is it inevitable that the United States will be outproduced if we get our fiscal house in order, increase saving and investment, fix our dysfunctional education system, and encourage economic growth without bureaucratic obstacles. For this to happen we need a leadership that is optimistic and inspirational to move this country out of the current doldrums.

FOOT SOLDIERS OF BIG GOVERNMENT

Throughout history there have been groups of people who have either influenced or obtained the actual power of the state to benefit themselves at the expense of others. In ancient times these were frequently oligarchies, who used the government to enrich themselves. In modern times we have organizations that give money to support politicians with the expectation that their interests will be regarded favorably. While this is often associated with business corporations, by far the largest donors are labor unions. Their clout is magnified by the fact that they also bring out voters as well as members to work on campaigns. When it comes to public employee unions they are especially effective in electing politicians who will be extremely pliable in responding to their demands at the expense of the public. I wrote about this almost a year ago (see Pernicious Public Employee Unions). Since then there has been a growing public awareness of the extent to which they are being taken as states face increasingly dire fiscal conditions, owing largely to generous public employee pensions for which there is no equivalent in private industry. The Economist has devoted its current issue to this question.

Not only has this resulted in a bloated public sector, but it has also institutionalized resistance to meaningful reform. This is particularly true of the miserable public education system in the United States despite billions upon billions thrown at the problem. Teacher’s unions resist any kind of change that would reward the best teachers while weeding out the incompetent. Public employees generally, have a vested interest in continually expanding government expenditures and hence higher taxes for everyone else. They are the foot soldiers for the party of big government. The same problem manifests itself throughout Europe as well. Yet despite all the revenue it still takes forever to get a permit when you need one.

More broadly, in addition to the bureaucracy, the party of government includes trial lawyers, the universities, the courts, lobbyists, the mainstream media, some big business, and nonprofit organizations that get government funds. Together they constitute an irresistible force for ever expanding government spending. If you add all those on the bottom who pay no taxes and live off the government you have the makings of a formidable political machine. This is essentially what has governed over the past two years. Worse, when revenues are not enough to support the demands of these constituencies they expand the public debt.

However, all those who are not part of this machine and are continually taxed are increasingly fed up, and in many places have managed to elect governments that will strongly resist these forces and attempt to rollback many of the excesses. There will, however, be fierce resistance by the machine, which will organize and lobby against reform. It is thus necessary to remain vigilant by monitoring those elected officials who are responsible and how they respond to these pressures. The last American election was an open revolt against these forces, but the unorganized citizens must stand fast against the highly organized pressure groups. For better or worse, the machine isn’t going away.

OIL AND ENERGY IN 2011

The energy picture for the new year seems increasingly dismal. The price of oil continues to rise, making everything more costly, from gas at the pump to home energy to a wide range of industrial uses. Oil, inexpensive oil in particular, is so necessary that life as we know it would not be possible without it. Our dependence is complete, and no amount of clean energy mantra is going to change that any time soon, no matter how many federal dollars we waste in subsidies. The price of oil will escalate over the coming years due to a devalued dollar, rising demand in places like China, and the administration’s virtual prohibition of new oil production in the United States. New production consists primarily of offshore drilling, where there are still plentiful reserves of domestic oil, but which the administration has effectively frozen. In the light of our own needs, the nefarious sources of foreign oil and oil pricing, this is insane. New objections are being raised to pipeling oil from the Canadian tar sands; indeed virtually any new source of oil production is being deliberately frustrated.

Nothing produces electricity as cheaply as coal, which we have in abundance in the United States, yet the EPA is now threatening the entire energy industry with onerous new regulations concerned not with pollution, but greenhouse gasses. Higher electricity prices are thus being deliberately induced by the government. Needless to say, life as we know it would also not be possible without cheap electricity.

The administration wants to wish these things away with vague visions of green energy, and things like expensive electric cars that no one is buying, but which we are all forced to subsidize. Yet despite their aversion to “old” energy sources they have nothing to offer in the way of “alternative energy” that is in any sense practically available now or any time in the near future. These policies are deliberately destructive of our industrial economy, which does not need further blows given stubbornly high unemployment and low growth. We are still the world’s largest industrial economy and ought to make it our business to remain so.

The electorate responded, and will continue to respond to misguided priorities that have nothing to do with economic growth. The top priority of any administration ought to be encouraging economic growth, usually best done by getting out of the way. We also need a cold dose of realism about our true energy sources and needs for the foreseeable future.

RESOLVING THE KOREAN DILEMMA

The North Korean artillery fire into South Korean territory is clearly an act of war. Four people were killed and significant damage was sustained. This is being attributed to internal North Korean machinations as the dictatorship changes hands, but an explanation is not an excuse. North Korea has embarked on a continued path of aggression for years without paying any price. The response so far has been inadequate, particularly from China, which continues to prop up this criminal state, allegedly for fear that refugees would flood into China.

There are 28,500 American troops stationed in South Korea and currently in harm’s way. We have had this burden since the end of the Korean war, which clearly has not really ended. Apart from a show of overwhelming military force, we must be prepared for the possibility that these incidents may escalate, entirely due to the insanity reining in North Korea.

I believe there is a solution to this otherwise intractable problem, and that solution involves a deal with China. One of the reasons China continues to prevent the North Korean regime from collapsing is that it would result in a state containing US forces right on China’s border. This is understandably unacceptable to the Chinese, and pointless for the US if the Korean peninsula is reunited under South Korea. We should offer the Chinese a guarantee that we will remove our forces from Korea if they will pull the plug on North Korea. There is then far less reason to prop up the regime, and it is a win-win all around. The Chinese don’t lose face, we are relieved of the burden of interminably stationing troops in Korea, and the North Korean regime would be history. This has to happen before they get a nuclear weapon, which they are on the verge of doing, with terrible consequences for proliferation around the world. Mopping up and reuniting with the north would then be South Korea’s problem, and that country is wealthy enough to take on that burden.

THE MYTH OF CORE INFLATION

Core inflation is based upon the core consumer price index, which excludes energy and food. The Federal Reserve can feel justified in printing $600 billion because the core index is so low, having risen only 0.6% in October, the lowest rate on record. Energy and food prices are considered to be too “volatile” to include in the index, which removes it from reality. The problem with this is that to anyone living in the real world food and energy prices are rising, and judging by increasing farm and commodity prices will rise a lot more in the future. Real people in the real world spend a substantial portion of their income on food and energy. If these prices are rising the true cost of living is rising as well and people have less to spend on other things.

If the same gallon of gasoline that cost $2.75 a few months ago now runs as high as $3.25 that is price inflation. If a basket of groceries has increased in price while incomes are stagnant, it costs significantly more. If things that people spend a substantial portion of their income on are not included in the price index, how accurate is it? It is obvious that our monetary policy is being predicated upon false assumptions. The true rate of inflation is clearly higher than the “official” estimate. In anticipation of this we should adjust our behaviors accordingly.

AN EMBARRASSMENT IN ASIA

Who could ever have imagined that the US would take a position to the left of the rest of the world on economic affairs, even to the left of China and Brazil? But this is what has occurred on the President’s Asia trip, culminating in the G20 summit, which has largely been a failure. The “world” wanted Obama, and has him now, but the US is now coming across like a weak sister, rather than the world’s leading economic power. We have the improbable situation of the Chinese lecturing the US on free markets, and the Germans on currency stability. Unfortunately they are right.

The President attended these meetings already weakened by the election results, and further diminished by failure to gain agreement on a single objective. No one should want the President of the United States to be weak vis a vis the rest of the world, but that is where we are now, and we can only pray that no major international crisis erupts over the next two years, considering the hand we have been dealt. From its apex in recent years American power is now at its nadir.

The position the government has taken makes us look ridiculous and hypocritical. How can we possibly expect complaints about currency manipulation to be taken seriously when we ourselves are printing money to inflate the economy and weaken the currency? How should the rest of the world react to the world’s reserve currency being manipulated for political ends, while they are stuck holding trillions of dollars? We are the ones introducing instability into the world economy rather than stable predictability. It is no wonder that all of the administration’s proposals were rebuffed by the G20, with foreign governments uniformly taking the more conservative position. This is a major embarrassment. Never has the US been so diminished. It reinforces the notion that American power peaked with the Bush administration, and now is on an inexorable decline. We have an administration that actually wants to push this process along, while remaining clueless about international as well as domestic problems.

But there is nothing inevitable about American decline. It is the result of destructive fiscal and monetary policies that are taking us in the wrong direction. This can still be rectified by very strong budgetary restraint with an eye towards reducing our debt burden, and an end to funny money policies that are certain to induce inflation. Prices of commodities are already increasing steeply and higher prices for consumers are a virtual certainty. We need a government that will be committed to price stability, a strong dollar, and maintaining America’s pre-eminence in the world. That can’t happen fast enough.

RULE BY EDICT?

Last week’s elections already seem remote although there are still some unresolved contests. Results show there are not really red states and blue states, as the outcomes were nationalized. Even here in New York despite weakness at the top of the ticket, at least five house seats changed hands, with one pending, and Republicans recaptured the state senate, putting them back in the game. The oddity is California, once the trend-setter for the country, now the exception and in inexorable decline due to government excess. Even there, after spending $140 million Meg Whitman should have been elected, but was undone by a sleazy lawyer parading an illegal housekeeper who was paid $23 per hour complaining about her employer.

Notwithstanding the results the administration is in denial, attributing defeat to a “communications failure” rather than policy rejection. As polls have indicated, this was not a vote for Republicans, but a vote against the Democratic congress. Republicans now have to prove themselves by sticking to principle. But even with a majority of governorships, state legislatures, and the house, the possibility of reversing course is limited. It is unlikely that this President is going to moderate given his attitude, which means we can look forward to two years of gridlock. Gridlock at least puts the brakes on moving in the wrong direction, but won’t do much to resolve long-term problems.

But this administration is not out of options, given its ideological extremism. My guess is that it will try to do an end run around the states and congress by attempting to rule by fiat- that is to say Executive Orders, that vastly expand the powers of the Presidency and pre-empt the congress. We have already seen a bold power-grab by the EPA in its claim to regulate carbon as a threat to the environment, which covers just about everything. The administration could attempt to expand bureaucratic power comparably in other areas simply by issuing decrees. The congress and the states will have their hands full simply in resisting these efforts, most of which will wind up in the courts. With an administration hell bent on getting its way despite public opinion, and a congress likely to be resistant, not much of substance is likely to be resolved until after the 2012 elections. Meanwhile we will have to muddle through the uncertainty and an economy that is unlikely to strengthen much as a result.