How to rebuild the middle class

The COVID-19 pandemic and the related economic shutdowns and fallout has greatly exposed the deep class divisions in our country. The divisions have been there for decades of course. The “hollowing out” of the middle class has been occurring in waves throughout the long period of economic transformation that began in the early 1970s, as the industrial age gave way to the information age. For most of this period, the hollowing out has been explained away by many as the natural forces of economics at work. The pandemic, on the other hand, is a true “Black Swan”, an event exogenous from the economic system, shining a light on our society from a completely different angle than usual.

The vast iniquities are now on full display. The majority of those in the upper reaches of our economic system work from home and home school on broadband connections with adequate savings to stock up on supplies; large businesses serve us via ecommerce and delivery. The fate of the working class is laid bare for all to see: lack of savings, reliance on school for day care and meals, poor access to health care, no sick leave, high fixed costs tied to rent and debt service, jobs that don’t provide benefits even when employed, the risk of bankruptcy in the event of a personal or health crisis. The small proprietor faces many of the same challenges, with the risk of starting a business so high that entrepreneurship in the United States is a record low levels as a percent of the population.

Yes, these issues have been there for a generation or more, but when endogenous to the economic system the meritocratic elite of the country attributes the disparity to a natural outcome of personal choices and talent in the free market for labor. When the trigger is an exogenous shock like COVID-19, the random nature of fate reveals itself to the fortunate as well.

The U.S. government’s historical role in promoting the middle class

The Founders believed that the fate of the Republic lay in the hands of a virtuous middle class (even though that term was not used at the time). From the Founding forward the government of the United States has usually had a program to promote the middle classes. In the beginning the debate was between Alexander Hamilton’s “American System” of protective tariffs, a central bank and funding of internal improvements and Thomas Jefferson’s vision of an agrarian republic built by yeoman farmers. Both systems had influence over the early republic, with Jefferson’s vision having the upper hand through the Civil War and its aftermath. Eventually, when the Republicans took power following the Civil War, Hamilton’s vision won out, with high protective tariffs, the promotion of railroads and industrial development and eventually restrictive immigration to protect workmen’s wages.

During the Great Depression, Franklin Roosevelt’s New Deal promoted unionization for the working class and the beginning of a social safety net in the form of Social Security, supports for farmers, banking regulation, promotion of single family housing and culminating with Medicare under Lyndon Johnson’s Great Society. The economy was dominated by big manufacturing and consumer products companies that, through a quirk of law and history, became the providers of employee benefits: pensions, health insurance, sick leave, paid vacation, etc. Industries tended to be consolidated into a small number of large companies with strong unions and what was effectively regulated or managed competition.

Today’s hybrid system

In the late 1960’s and early 1970’s the New Deal system became harder to maintain. Why this happened is beyond the scope of this essay, but in the effort to advance our economy in the face of competition from our NATO allies and Japan, the government began deregulating industries, finance and the labor markets. As a share of the economy, manufacturing began to decline, and the service industries began to rise. Many of the larger service businesses, particularly those in higher margin industries like finance, technology and entertainment could afford to maintain the old system of company-provided benefits. But many smaller businesses and those in lower margin sectors like retail, hospitality and restaurants could not, especially as benefits like health insurance became more expensive. The post Cold War period of globalization and high levels of low skill immigration brought many benefits but also accelerated the pressure on the U.S. working class.

During the period from the 1970’s to the 2010’s we have maintained the basics of the New Deal system of employer-provided benefits plus certain universal benefits like Social Security, Medicare and unemployment insurance. Many social safety net programs added in the late 1960’s and later, on the other hand, have been non-universal benefits to support those that fall out of the employer-provided benefit system like Medicaid, welfare and food stamps. Because these programs would benefit only subsegments of the population, they have been easy to scapegoat as political payoff for the undeserving and have therefore never been particularly popular among the general public. Hence the relatively low popularity of the Affordable Care Act, while theoretically available to all, is also seen as benefitting only a few at the expense of many.

The tension between employer-provided benefits and non-universal benefits will continue to grow if the current trends are allowed to go on. Free-market conservatives have traditionally disliked non-universal benefits as they are perceived, with some justification, as paying people not to work. But in the highly-globalized, highly-competitive, free-market economy the pressure on margins, wages and benefits faced by businesses outside of technology, finance and certain large enterprises will continue. Couple this with the highest health care costs in the world and the trend toward service economy work and more people will be forced into the haphazard system of non-universal benefits or no benefits at all…a barbell system of a protected upper middle class, a dwindling cadre of manufacturing workers clinging to the Post World War II system in the middle and a growing class of unprotected service workers.

The way forward

To rebuild the middle class we need to both slow the decline of manufacturing work and make service work pay. The economy is going to keep transforming into a service economy whether we like it or not, and that does not mean that the only good jobs need to be in technology and information. There is no reason that we can’t set up a system to put pride and remuneration into service work, no reason we can’t build a solid middle class that includes not only manufacturing, government and health care workers but also waiters, fitness instructors, hairdressers, hospitality workers, retail and wholesale workers, sanitation workers and so on.

The policies needed to build this middle class are all on the table now and being debated individually, but not as a cohesive program. The program would basically be a fusionism between the policies of Trump and Obama:

  • Core protections for U.S. workers
    • Higher minimum wages, so those who work in service businesses make enough to not have to rely on non-universal benefits while employed;
    • Moderate tariff protection, to encourage more production in North America;
    • Restrict low-skill, particularly illegal, immigration, so there is less competition for low wage or off-the-books labor;
  • Encourage key areas of investment
    • Invest in basic infrastructure, to encourage more construction work and make our economy more productive;
    • Encourage more housing construction, particularly in cities and inner suburbs by reforming land use regulations that discourage construction, thereby keeping housing costs reasonable and encouraging construction work;
    • Create an industrial policy for key sectors to move production to the U.S., as the crisis has exposed the weakness that comes from reliance on global supply chains. There is no long-term economic reason that we can’t produce the medical devices, pharmaceuticals, semiconductors, communications equipment, defense goods, auto and aerospace parts, appliances, furniture, capital goods, aluminum and steel that we need in the U.S. or North America;
  • Beef up the social safety net to add universal, portable benefits
    • Build on the Affordable Care Act, mainly the exchanges, to create a system of universal health care that is portable and not employer-based. Health care premia should remain tax-deductible for all, so there is no disparity between employer-based and ACA policies. The Medicaid portion of the ACA should be reduced to encourage liquidity in the exchanges;
    • Build on the 401k system, to provide a universal system of portable savings accounts with policies that encourage savings among the general public;
    • Provide universal day care and pre-school, to reduce the stress on two-income households or single parents;
    • Create a policy of universal sick leave, to prevent workers from having to come to work sick (but being careful to not encourage abuse, which may be difficult) while also reforming the disability insurance system to discourage abuse;
  • Tackle two areas of extreme inflation that are a result of our hybrid system
    • Regulate health care costs, to rein in health care inflation since Americans already pay more for health care than any country in the world;
    • Reform and regulate higher education funding, to reduce indebtedness and rein in higher ed inflation, including adding training credits to the unemployment insurance system;

I have been a free market capitalist my whole life and am well aware of the economic arguments against the programs highlighted above. The economic transformation of the last 50 years has brought many great benefits, including technological innovation, cheaper consumer goods and a huge reduction in poverty around the world. I have also seen the negative side effects as we have created a winner-take-all economy where vast swaths of our country and people are left behind with declining towns, stagnant wages and soaring costs for necessities like health care and education.

How this get paid for will have to be the topic of another essay, but it should be noted that we are paying for most of these things already anyway, and in the case of health care are paying more than other countries that have universal health insurance. Universal social insurance taxes should be preferred, with subsidies from taxes on higher incomes as the secondary form of funding, rather than the other way around. Such a system, as is used in Europe and in the U.S. for Social Security and Medicare, has proven much more durable and popular than making one group of people pay for the other.

I am not calling for an end to the free market, or even globalism, but am calling for a shift in the balance between economic efficiency and looking out for our fellow countrymen. We should be focused on building a middle class for the information age, one based on remunerative work, healthy families and strong communities.



2012 Election Preview (and quasi-endorsement)

My core theory of US politics can be summed up with two, very optimistic principles. The first is that the US electorate as a whole is very wise, notwithstanding the less-than-wise nature of many individuals. The second is that the US political system, as devised by the Constitution and its collective amendments, is self-healing; it is the greatest application of complexity theory in the history of the world. I realise these two principles go against the grain of much educated thought, but they have proven themselves over time, having really failed only once (in 1860). I can go more into these principles and why I believe in them in some future post.

Previous writings from the Dynamist: from realignment to backlash

Back in 2010, I wrote two pieces analyzing the state of politics. In the first from March 2010, "The GOP will not repeal ObamaCare", I first walked through why I thought the outright repeal of Patient Protection and Affordable Care Act ("PPACA" or "ObamaCare") would not really be a winning political issue for the GOP in the end, even though the nature of the Democrats' overreach on the issue was certainly helping the GOP in the 2010 midterms. I then ran through the laundry list of remaining issues (from the perspective of the electorate) and found 4 favoring the Republicans, 2 favoring the Democrats and 3 mixed. In the second from October 2010, "The Middle Class is Still Up For Grabs", I previewed the Democrats' upcoming defeat (where I believe I was the first to use the term "shellacking", but received no attribution from President Obama). I put that defeat into the context of building political coalitions, and how neither party had built a platform that truly builds up the middle class.

Both of these articles represented an adjustment from my 2008 writings which posited that 2008 might have been a "realigning election" that created a new majority coalition in favor of the Democrats and the northern, "blue" states. If I had to reflect on the realignment theory today, I would instead say it happened in two steps. First, in the late 1960s and early 1970s, when the "New Left" was forming in opposition to Vietnam and Jim Crow and in favor of women's rights, environmentalism and affirmative action, it could just as easily formed within the Republican Party as the Democratic Party. At the time, it was the Southern, socially-conservative Democrats that had gotten us into Vietnam and had defended segregation in the South. The Republican Party made the choice, however, to shortcut a longer term realignment in favor of uniting with Southern conservatives to implement an economically conservative agenda which has since become dominant in our politics, achieving realignment in 1980 with Ronald Reagan and gaining in strength during the 1990s and early 2000s under Clinton and Bush II. While the New Left would become marginalized during the Nixon and Reagan years, it eventually mellowed a bit and strenghened during the Clinton years before achieving realignment status under Obama.

The political framework today – stalemate?

Demographic changes have given the New Left its boost over the top in the Obama years, as the coalition of strong support for Obama among African-Americans, Latinos and single women on social issues will likely outweigh the decay of Obama's support among white men and married white women over economic issues over the past four years. The other factor keeping the Democrats in the game, however, appears to be the holdover of the economic Old Left in the industrial Midwest that is not being won over by the GOPs purist free market orthodoxy, particularly led by a former leveraged buyout impresario.

In many ways, the GOP has become a victim of its own success. It's dominant Presidential or Congressional coalitions of the 1970s through the 2000s faded as the party racked up victories on the wedge issues that divided the Democrats: deregulation, free trade, monetarism and inflation, income taxes, the Cold War and defense, urban crime, gun control, illegal immigration, welfare reform, capital gains taxes, the estate tax, the War on Terror and gay marriage. In each case, either the Democrats conceded the issue (gun control, crime, welfare reform, defense) or the GOP took the issue too far (illegal immigration, the War on Terror). Now the parties have fought to a draw on defense (both basically settling in on the center-right) and social issues (by region, with a slight center-left electoral college advantage to the Democrats).

I continue to believe that the economic agenda of the future is still up for grabs, however. The Republicans have become too rigid in their free market orthodoxy, being overly focused on promoting capital formation while mostly ignoring human capital development, which in the new economy can just as, if not more, important as pure capital formation. This is why the regions that have benefitted the most economically from the new economy like New York, Boston, Chicago, the Bay Area, Los Angeles, greater DC don't favor the GOP even though they have done very well under the era of conservative economics. As discussed above, the nearly complete victory of capital over labor in the old economy in the last thirty years has also weakened the GOP economic argument in electorally-rich Midwestern industrial states like Michigan, Ohio, Pennsylvania, and Wisconsin.

The Democrats, on the other hand, still have vestiges of the Old Left in their approach to economics, favoring the kind of centralized approaches to problem-solving that served them well in the industrial, mass-market world of the 1930s through the 1960s, but that are less appropriate for the decentralized, networked world of today. In the long term, the Democrats have an advantage in that they have more flexibility with their base on economic issues than the Republicans, while the Republicans have an advantage in that their basic philosophy is closer to the ulimate endgame if they can back off their fealty to capital and focus more on the middle class (promoting progressive goals with conservative, market-driven means). Until one of the parties seizes the advantage, we have basic stalemate with plodding progress.

Scenarios and issues

With a pretty evenly divided electorate we can be highly confident that the GOP will retain control of the House. Because of two decades of GOP-friendly redistricting, the Democrats need to win the generic House vote by more than 3% or so to flip control. This is pretty important in that the President really doesn't have that much power on domestic issues, and with a GOP House (particularly this GOP House), there isn't much chance of Obama passing any more big agenda items over the next four years. In addition, the Senate is likely to remain evenly divided, so no matter which party nominally has control, there isn't much chance of a president Romney getting the 60 votes necessary to pass any radical policy changes either.

For the next two years at least, the electorate is not voting for either Obama or Romney's agenda. It is instead voting for the type of compromises it wants to see occur. If Romney is elected, the compromises will be as center-right as the Senate will allow. If Obama is reelected, the compromises will be as centrist as the House will allow. If you think about it, this makes much of the apocalyptic rhetoric we've been hearing from both parties seem pretty silly, doesn't it?

Through that lens, the issues:

  • Foreign affairs – Here is an area the president does control. Obama is operating in the non-ideological conservative internationalist tradition of Dwight Eisenhower, Richard Nixon (perish the thought) and GHW Bush. After the adventurism of the GW Bush years, Obama's approach pretty well suits the country's mood, which is probably why you saw Romney embrace Obama's positions in the third debate. Despite some of Romney's hawkish talk on the campaign trail, I doubt he would differ much from Obama, but you don't really know, so advantage Obama.
  • Social issues – If you vote on social issues, you know who you're voting for. It appears that these issues are helping Obama a bit more, but I'm not going to wade into this, because I don't really vote on social issues and you don't know who won these until you see the turnout on election day.
  • Individual Taxes – Polls say people favor seeing the wealthy pay more, which is why Obama isn't being hurt by his stance. Although we can quibble with the math, I think Romney's general approach of flatter rates with less deductions for wealthy is superior. Since I highly doubt the Senate will pass a 20% cut in nominal rates most of Obama's attacks on Romney's "$5 trillion tax cut" aren't really operative. I also think the odds of a "fiscal cliff" disaster would be much lower under Romney as there would be less of a fundamental standoff between him and the House. By the way, this is under the radar screen but both guys are planning to let the payroll cut lapse this year. Advantage Romney.
  • Corporate Taxes – Both parties realize that the nominal corporate rate needs to come down to be internationally competitive, offset by a reform of loopholes. Romney favors moving to a territorial tax (focusing on domestic activities only), while Obama wants to tax overseas earnings like domestic earnings (as opposed to only when they are repatriated). While Obama's plan sounds better (taxing companies that "move jobs overseas"), it's not very realistic, since no other country does that and it would therefore encourage foreign takeovers of US companies to save on taxes by moving the corporate domicile abroad. In the end, under Obama, the House will either insist on a territorial tax or nothing will happen. Under Romney, I'm pretty confident we'll see reform pass, so advantage to Romney.
  • Fiscal policy in general – I don't think the markets or the economy want a sharp fiscal consolidation in the near term. I think the combination of a slightly revenue-positive tax reform, long term entitlement reform and discretionary spending controls without sharp cuts (aka something like "Simpson-Bowles") is probably the best outcome. While I think Romney would be better at finding a compromise on taxes, I think Obama would have a better chance to craft a broadly-acceptable reform of entitlements if he's willing to do so. Obama has the opportunity to reclaim the Democrats' brand equity on fiscal prudence by crafting a "grand compromise" and a GOP House is likely to go along with it this time around. Advantage Obama.
  • Trade policy – Both candidates would be more activist on promoting US exports than the Clinton and Bush administrations, with Romney promising to get tough on China's currency (which I agree with). In the end I think they would both be fine. Toss-up.
  • Monetary policy – The next president will get to appoint the next Chairman of the Fed. I would be in favor of reappointing Ben Bernanke or someone like him. It is no longer 1980, where inflation was the big threat and taxes were too high. Now deflation is the threat and tax collections are the lowest since before World War II. We need to move from the default of tight monetary policy and loose fiscal policy favored by the Republicans to a default of loose monetary policy and tighter fiscal policy more favored by Democrats. Advantage Obama.
  • PPACA / ObamaCare - The idea of repealing the PPACA with nothing to replace it doesn't seem realistic in the context of our history. Besides, since the Senate is unlikely to repeal the non-budget items, the idea of just starving it seems like a recipe for chaos. While it's a deeply flawed bill, it is probably among the least bad of a bunch of crappy options available to us until we reform the way health care is ultimately paid for. Since the PPACA maintains a "competitive" private system, it leaves the door open for pro-market reforms that could bring costs down while sustaining innovation. If Obama is reelected, keeping the PPACA is place is the only thing that he could really describe as a mandate. Advantage Obama.
  • Medicare reform – Medicare will bankrupt this nation if it is not reformed. I actually like the Paul Ryan voucher approach for Medicare in the long run, but ironically I also think that it would need the PPACA in place to succeed. Basically there needs to be a competitive marketplace for individual coverage that can't deny you for pre-existing conditions (like being old). The only way that really works is to have the individual mandate for the PPACA so everyone is in the pool. Ultimately we need to reform the way Medicare pays for health care to move away from the current fee-for-service if we ever want to use competition to drive down costs, so the Ryan plan and ObamaCare go hand-in-hand. Kumbaya! Toss-up.
  • Social Security reform – We only need to tweak Social Security to make it solvent. Everyone knows the ultimate solution will be a combination of reduced benefits for the wealthy and a gradual increase in the retirement age, so let's just get on with it already. Advantage Romney.
  • Education – Obama and his Education Secretary Arne Duncan have been doing a good job building on Bush's No Child Left Behind reforms, gradually introducing competition to the system. Obama has coopted a bit of the GOPs reform mantle here, but it works. Otherwise, most of the real battles in education reform are at the state and local level. Advantage Obama.
  • Energy – We need to ride the fracking, shale oil and deepwater drilling boom as hard as we can without harming the environment too much. While Romney would let it run harder, Obama gets more cover from environmentalists. While I think the idea of millions of "green-collar jobs" is a joke, I'm not totally against investing in research on green energy (solar and wind, not biofuels) and conservation (electric cars, green architecture). Toss-up.
  • Infrastructure investment – Obama blew his big opportunity here with his boondoggle of a stimulus bill. If he has focused on bread and butter spending like bridges, airports, roads and local transit, he could have built a strong coalition for a multi-year increase in infrastructure spending. Instead the bill was known for esoteric stuff like high-speed intercity rail and poorly-invested green energy loan guarantees that left people scratching their heads. To me this was the biggest disappointment of Obama's first term. Romney doesn't really talk about this, so I'd still say advantage Obama.
  • Financial reform – The Dodd-Frank financial reform bill is a bad bill that can rightly be attacked from both the left and the right. I would have focused on simpler, but more fundamental reforms (like limiting the size of an bank's liabilities relative to GDP and increasing the required capital cushion beyond what is currently contemplated). Instead we have a byzantine mess that was nevertheless better than no reforms at all. Since the GOP hasn't articulated a realistic alternative, I'd have to begrudgingly say advantage Obama.
  • Other stuff – Beyond the above on budget issues I'd prefer the GOP's approach. The Federal government should be made to be better at a smaller number of things, with more devolution of responsibility to the states (or to international bodies, where appropriate). I know not everyone agrees with that, but I think it's more appropriate for the decentralized world we live in today. Advantage Romney.

My quasi-endorsement of Mitt Romney

So looking at the above, it looks like I favor Obama, but I don't. While I voted for Obama last time, I intend to vote for Romney this time around. Personally, I am most focused on macro economic issues where I tend to prefer Romney's approach. I also think he will be better at crafting compromises with Congress and therefore there would be less of a chance of the kind of stalemate disaster scenarios that have a small chance of occuring under Obama. I am also more familiar with Romney's business background than most and so respect his skill and acumen and think he might make a better problem solver than Obama. That said, I also think neither party nor candidate really has a set of policies to build up the actual employment and earnings of the middle class. I like Obama enough and think he has done a good job on some things and I understand why he is favored to win reelection. As I said before, either man would be pretty hemmed in by Congress if elected. So while I slightly favor Mitt Romney, I'm probably one of the few people in the country who thinks it won't really matter that much in the end.

All opinions expressed herein are my own, and are not meant to represent the views of any organization with which I am affiliated.

How to reform the corporate tax code

There has been alot of talk recently in Washington about reforming and simplifying the tax code, trading lower rates for fewer deductions. Frankly, I'm all for that, particularly with regard to the corporate tax code. My general view is that governments (federal, state and local) should concentrate more on creating conditions that are business-friendly in general, rather than friendly to specific businesses. Our current corporate tax system embodies the worst in special-interest politics. It has the second-highest statutory rate in the world, but the effective corporate tax rate is much lower. My studies have shown that we collect about the same percent of GDP in corporate taxes as other countries. That said, just about everything you find on the internet covering this topic is written by someone with an agenda, so it's hard to get it all straight.

Cutting through all the gobbelygook, there are two clear reasons why our current corporate tax system is bad for America.

  • By having a higher statutory rate we discourage non-favored business from establishing productive capacity in the Unites States. There are many areas in which the United States could be a big exporter of durable manufactured goods (where the cost of labor is small relative to the cost of capital), but the tax code basically discourages it.
  • We have a worldwide tax system. Most countries have a territorial tax system. In a worldwide system we tax American multinational profits no matter where they are earned, but allow companies to defer paying taxes earned on income abroad until those earnings are repatriated to the United States. Because we have a higher tax rate, multinational companies are basically encouraged to reinvest that cash abroad.

Thankfully, Obama seems to be moving in the direction of lowering the statutory rate, eliminating loopholes and moving to a territorial tax system. This is far better than the campaign position he took, which was to end corporate tax deferral and encourage companies to reincorporate and move their headquarters to places like Bermuda, Ireland and Switzerland so they could be taxed in a territorial system at a lower rate.

While moving to a territorial tax system would discourage the cash hoarding by companies abroad that has occurred since the end of the recession, there are two other changes that I recommend to encourage domestic investment (and the job creation that coincides with domestic investment):

  • Immediate expensing of R&D and investment. Companies are the most rational actors in the economy, so you can't really encourage investment that companies wouldn't make otherwise. You can, however, encourage them to pull investment forward by increasing investments' net present value by postponing tax expense, particularly for growing companies that are investing heavily. Such a change would also encourage foreign companies to invest in the United States. Obama has included a temporary proposal for investment expensing as part of a stimulus plan, and I would recommend making it permanent.
  • Expensing of dividend payments. The tax code encourages executives to receive option compensation as opposed to cash compensation. Options increase in value when the stock price per share goes up. Thus, when option-rich executives have extra cash, they favor conducting share buybacks over paying dividends. (The reason for this is that share buybacks reduce the number of shares outstanding while increasing demand for the stock. Dividends do neither of these things, but are more directly remunerative to shareholders.) In addition, companies tend to have extra cash when times are good and the stock price is high. If the company overpays for the stock, they are destroying shareholder value. Encouraging dividends would also reduce the tendency for companies to build up cash that they then burn on value-destroying, empire-building acquisitions. Companies should have to convince the capital markets to fund their acquisitions, as a matter of discipline. If we moved to allowing the deduction of dividend payments, the individual tax rate on dividends should be moved back to the income tax rate.

Making these two changes would encourage companies to either use profits for investment or dividends, and would discourage share buybacks, self-funded acquisitions and the needless hoarding of cash that is conducted particularly by so many US technology companies.

Top Tax Rate Fallacies

It looks like we have a deal on taxes for the next two years. While the long term deficit will need to be dealt with sometime in the intermediate term, the deal provides some policy stability on income tax rates, produces a reasonable compromise on the estate tax and creates some legitimate short term stimulus in the form of a payroll tax cut and extension of unemployment benefits. Overall, I view this to be a good deal that will stimulate the economy short-term and set up a debate on long term spending and taxes for the 2012 election.

I am someone who believes that in general the private sector is better at allocating capital (with some spectaular exceptions, like the housing boom) and that government spending and incentives can often create vast distortions in the allocation of capital (like the government policies that encouraged the housing boom). I also believe in the wisdom in the electorate as a whole. The people want a real debate over tax and spending priorities.  It is the politicians at the Federal level aren't yet mature enough to have that discussion.  In the meantime, I'd rather keep taxes low.  Evnentually we need to figure out the right level of spending, and then figure out how to generate the proper revenue to support that level of spending, preferably with some sort of overhaul that improves our competitive position internationally.

That overarching political/strategic argument aside, many of the arguments I hear from conservatives on TV supporting an extension of the top tax rate are pretty weak economically.  Below I discuss a few of these:

  • Tax hikes will hurt small businesses – It is true that most small businesses file taxes effectively as individuals. While it's hard to pinpoint the exact figure, somewhere between 50 and 97 percent of all small businesses would be unaffected by the tax rate change. Even if a small business is affected by the tax rate hike, that won't affect how they hire since employee salaries and benefits are tax-deductable. If anything, it would encourage the business owner to work less hard and hire employees instead.  (I'm not saying that's a good thing, just economic logic.)  Higher taxes would reduce the cash available to make business investments, but that too gets deducted from taxes over time, as would the interest used to finance the investment.
  • Tax hikes will hurt savings and investment – On the margin, reductions in the top rates do result in additional private capital to be available for private investment.  The problem is that tinkering with marginal tax rates only indirectly encourages savings and investment. Such tax cuts directly increase only the reward on investing.  More efficient would be to directly encourage savings and investment themselves. Make savings itself tax deductible and/or allow for the immediate expensing of business investment. Or replace the payroll tax with a consumption tax to reward work while discouraging consumption.
  • Tax hikes will hurt savings and investment (part II) – In addition, if tax rates are cut but not offset with spending cuts, any increased investment must flow into Treasury securities to finance the deficit. Thus no new net private investment is actually created. If the increased number of treasuries are purchased by investors abroad, by accounting identity the amount adds to the trade deficit.  The increased trade deficit directly reduces GDP, offsetting any increase in domestic investment.

It's time for this country to move past empty slogans and work together for the long term vitality of the country. I'm not encouraging tax hikes…just a mature, realistic conversation about taxes and spending.

US Politics – The Middle Class is Still Up For Grabs

On Tuesday, the Democrats face a major shellacking. Looking at online betting site Intrade, the GOP has a greater than 90% chance of taking control of the House of Representatives where it is favored to pick up 55-60 seats. The Republicans also look likely to pick up 8-10 Senate seats (it needs 10 to take control of the Senate). The GOP appears to be a lock to pick up currently democratic seats in Arkansas, Colorado, Illinois, Indiana, Nevada, North Dakota, Pennsylvania, and Wisconsin. Washington and West Virginia are within reach for the GOP, but are favored to remain in Democratic hands. The GOP appears to also have a lock on open GOP-held Senate seats in Alaska, Kentucky, Florida, Missouri, New Hampshire and Ohio. Considering that the Senate seats up for election this year were last elected in the strong Republican year of 2004, gaining this many seats would be quite a feat. In the next two cycles, the Democrats will be defending the wave of seats they won in 2006 and 2008, many of which are in conservative states.

Such an outcome would pretty much bury my theory, posited here and here, that the 2008 election was a "realigning election", ushering in a new era of Democratic dominance. It seemed like a good theory at the time. Obama had a robust agenda and Congressional majorities to back him up while the GOP was generally befuddled, with weak leadership and unclear agenda. The turnaround in the GOP's fortunes has been remarkable, but is explainable. The problem is that neither party has a platform that truly appeals to the middle class. Middle class voters are seeing that the Obama administration has ramped up spending on programs that haven't benefitted them in any way outside of the most abstract sense. In addition, the Tea Party has allowed the GOP to rebrand themselves as fiscal conservatives after years of fiscal laxity under the Bush administration. Obama's problem isn't his inability to promote his platform or irrational rage on the part of the pesky electorate. Obama is suffering from the same structural flaw that has hindered Democratic politics for the past thirty years: failing to present a positive agenda for the middle class.

How to build a successful political coalition

The American electorate can be divided into four groups, two elite groups and two populist (Jacksonian) groups. Right-leaning elites, known as Hamiltonians, tend to vote on fiscal or business issues. Left-leaning elites, known as Jeffersonians, tend to vote on social issues. Jacksonians tend to be economically populist and socially conservative. Right-leaning Jacksonians tend to be suspicious of big government and big business, and are fiercely independent. The Tea Party voters are examples of right-leaning Jacksonians, many of whom were likely Ross Perot voters in the early 1990s. Left-leaning Jacksonians tend to be more communitarian than their right-leaning counterparts, and are often the classic union or machine-politics voters from the urban ethnic North.

Lasting political coalitions tend to marry one of the elite groups with one of the Jacksonian groups and then use wedge issues to peel off a chunk of the opposite elite and Jacksonian group. The wedge issues have to pit subsets of the opposition coalition against one another. Obama the (Jeffersonian) candidate did a good job of winning over a good chunk of Hamiltonians, particularly those in the technology and manufacturing industries and those that would benefit from his clean energy agenda. Obama and the Democrats courted the financial industry, even though it was clear that they were going to implement strong financial regulations. He co-opted many elements of the normally Republican-leaning health care industry into supporting his health reform. In other instances, he has used regulations to hobble Republican industries like for-profit education and energy extraction. His stimulus was geared toward supporting his base in public-sector unions, as well as by spending on clean energy and health care technology. If the electorate consisted of no one but elites and public sector employees, it was a pretty clever strategy. Unfortunately for president Obama, the Democrats have done virtually nothing to fire up the Jacksonian base.

The Democrats' political misfire

One of the great conceits of the Democratic Party is that middle class voters that vote Republican are voting against their own economic interest. The basic subtext is that middle class voters are so dumb, or racist, or homophobic, or jingoistic, or angry or afraid that they are repeatedly tricked by the billionaires that back the "Republican attack machine" from embracing the party that has their best interests at heart. (Obama himself continues to blame the voters for their own ignorance.) There never seems to be the introspection that calling the voters stupid may not be politically astute. Or that maybe there is something wrong with the Democratic agenda in the first place.

The Democrats used to be a positive force for the middle class, implementing programs like Social Security, the GI Bill, support for housing finance, and Medicare. Since the late 1960s, however, the agenda has been much more tilted to serve rich liberals and the poor.

Health care is a prime example. Most middle class voters have health insurance, but feel that it is too costly and too complicated. Obama's health reform was more focused on extending coverage to the working poor. To pay for that extension, the bill cut Medicare (a middle class benefit), reduced the tax deduction for "Cadillac" plans (often a union benefit), and raised fees and regulations on small businesses. It was wildly expensive, yet the Obama administration used blatant slight-of-hand to pretend that it paid for itself. The average voter can correctly assume that their health care costs will now accelerate and eat into their wages. In exchange they receive not-so-exciting benefits like being able to keep your kids on your insurance until they turn 26. Universal health care is to the Democrats as the white whale is to Captain Ahab. Even though the economy and housing markets faced, and continue to face, huge problems, the Democrats instead chased the ideological white whale.

The stimulus is another example. The $700 billion price tag delivered no tangible benefits to the average voter. Even though it probably did prevent things from getting worse, it was probably spent in the least politically advantageous way possible. It transferred money to irresponsible state governments to keep their bloated payrolls afloat, which felt like a political payoff for the Democrats' public union supporters. The rest was spent on behind-the-scenes technology investments like green energy projects, electronic medical records and vanity projects like high-speed rail that won't be built for years. I actually think most of these items are decent things to spend money on, but they appeal mostly to eggheads like me. The rest of the country was left scratching their heads at what exactly we spent $700 billion on. To make matters worse, even the tax cuts in the bill somehow escaped the notice of the electorate.

The TARP, of course, was the most egregious self-inflicted wound by the political class. While I can defend the TARP intellectually, the politicians absolutely should not have let it seem like a scot-free bailout for the bankers in charge. While the Bush Administration implemented the first part of the TARP program, the GOP in Congress largely voted against it. They can thus credibly take credit for rejecting TARP with the voters, who view the TARP as an un-American bailout of the politically connected. The voters are basically right about this. The Democratic Party has been courting the financial industry for decades and didn't want to cross the bankers by reining in their pay or power. In fact, the largest banks became even bigger and more powerful during the crisis, while small banks (and small business lending) were left to suffer.

So we have more than $2 trillion spent on the TARP, the stimulus and the health care bill with very little tangible benefit for the middle class. The TARP and the stimulus have undoubtedly helped the economy, but the average voter can credibly wonder if that $1.5 trillion could have been better spent. To make matters worse, the political class got sidetracked on a health care reform that has more downside than upside for middle class voters.

Voting for divided government

The voters are not necessarily looking to put the GOP back in charge. They still mostly blame the Bush Administration for the financial crisis. They just look at the Democrats' agenda and think it needs to be reined in. By taking away the Democrats' control of congress, they put an end to an unsuccessful bout of one-party rule and replace it with divided government. Divided government is better for cutting the deficit and forcing more moderate compromise. It doesn't matter what the Republicans did when they were in charge. The voters are forward-looking. Obama is still president, so we aren't returning to one-party Republican rule. The Republicans don't have a positive economic agenda for the middle-class either. The future is wide open for both parties.

The American electorate as a whole is actually very smart. They have historically made the right choices between the choices that they have had. Obama needs to be reined in, so they will vote Republican in the mid-terms. How 2012 turns out will depend on how the parties act in the next two years. 2010 isn't necessarily a Republican victory any more than it is a Democratic defeat. The middle class is still looking for its long-lost champion.

The GOP will not repeal ObamaCare

Now that ObamaCare has passed, we can mostly put that year's worth of debate and rancor into the rear view mirror.  Contrary to what the GOP seems to be telling itself, the 2010 elections will not be decided based on the potential repeal of the health care bill.  It will be decided based on the array of issues that will be decided in 2011 and 2012, and based on how big a check the people want to put on the Obama administration.

First, with regard to health care:

  • The bill can't be repealed while Obama is still president
  • As I've written before (here, here and here), our exisiting health care system is deeply flawed and preposterously expensive (and getting worse), making it hard to defend the status quo
  • Any bill that comprehensively deals with such a large and complicated system (and has the ability to pass Congress) will be flawed and imperfect
  • Polls have consisently shown over decades that Americans care about this issue, that they are open to governent-run health care, that they are worried about costs, that they would like access to be universal (but not necessarily free), they favored the "public option" right up until the end
  • The people in the middle of the electorate (i.e. the ones that really matter) will prefer to see this bill tweaked rather than have it junked and return to the status quo ante
  • As we have seen with other entitlements, the principle of universal access is now established, and will not be taken away
  • People (rightly) don't believe that the bill will reduce the deficit, and the real threat to long-term solvency of the US come from the $38 Trillion present value of the unfunded Medicare liability (see here, page 70), so health care is now THE deficit issue going forward
  • The Medicare liability can't be reduced without reforming the way medicine is paid for.  It will not be about raising taxes or tweaking benefits.  It will either be about rationing by government edict (a less-sensational version of "death panels") or by using market forces to ration care.  The moral element of health care makes market purity difficult, however.
  • There will also be alot of experimentation around the edges: tort reform, punishing unhealthy eating, promotion of exercise, etc.
  • Health care will be one of the dominant economic issues for a generation…we want to continue to invest in health care innovation, but we don't want it to engulf the entire economy

As for the 2010 election, barring some foreign crisis, the issue set is as follows:

  • Financial reform (favors Democrats; the GOP will be crazy to block this and allow it to still be an issue in the 2011 election)
  • Trade with China (mostly favors Democrats; it is time to stand up to their mercantilistic practice of building currency reserves to promote exports at our expense)
  • The deficit (favors Republicans; divided government is best for fighting deficits; the issue will have more potency if interest rates rise and less if rates stay where they are)
  • Expiration of the Bush tax cuts, estate tax (mostly favors Republicans; although a strict anti-tax position could backfire if they are unwilling to compromise on deficit and entitlement reform)
  • Energy reform (mixed; people want compromise, like more domestic energy coupled with reasonable investments in efficiency and green energy)
  • Health care reform (favors Republicans; as long as they focus on reformist ideas like tort reform and HSAs and don't blather on about lost liberty and creeping socialism)
  • Entitlement reform (favors Republicans; divided government would force the compromises that are required, i.e. raising taxes and cutting benefits)
  • Jobs (mixed; "jobs" is not an actual issue, it is a shortcut taken by lazy pundits; the "jobs" issue favored Obama in 2008 because he was most likely to support fiscal stimulus; the stimulus chamber is mostly empty now, so there is no actual "jobs" issue on the table outside of the economic issues outlined above or other small-bore initiatives that might get brought up as window-dressing)
  • Social issues (mixed; the Democrats elected a good number of social conservatives in swing districts in the last two elections, and the Republicans weren't focused on these issues in NJ, VA and MA, either; it seems to be mostly about economics now)
  • Foreign Policy (not an issue; the President runs foreign policy)

Good news for Republicans, the following issues are now off the table:

  • Iraq
  • Universal health care

Please don't shoot the messenger with this.  I am trying my best to just give you my analysis, with as little personal bias as possible.  In this day and age, with the hyperbole thrown around by both sides (Bush is a Nazi! Obama is a socialist!), we must remember that the actual US electorate is pragmatic and centrist and is just doing the best it can with the choices it has available.

Reform the Tax Code Now

The United States has a tax code that encourages borrowing and consumption at the expense of savings and investment. I believe this concept is pretty well understood. What is less understood is that the rest of the world does not. The much-derided (in the United States at least) European-style welfare states actually have less progressive tax systems than the US, as do the developed Asian countries of Japan and South Korea. This means they are more apt to discourage consumption and to promote exports with value-added taxes. Most of these countries have found a policy balance that produces neutral trade deficits. Countries like China and Germany, on the other hand, take it even further and use their tax code to actively promote massive trade surpluses, a key source of the "global imbalances" that are threaten the world economy. Even worse, within the US tax code we discourage domestic investment in general, yet we lavish subsidies on specific old-economy industries like real estate, agriculture and energy extraction and even encourage US multinationals to invest overseas instead of in the United States. Our distorted tax policy is a bipartisan failure that must be addressed soon or our country will begin to lose ground economically while struggling under a mountain of foreign-owned debt.

How we got here

Much of The Dynamist blog is devoted to analyzing long term trends in economic policy, market valuations and political cycles. One of the consistent themes (for examples see here and here) is that the United States needs to focus on reducing its structural trade deficit. When we run a trade deficit, we are importing capital (i.e. borrowing) from abroad. Importing capital is not inherently bad. If the US had a surplus of investment opportunities relative to its pool of savings, investment capital may come in from abroad to make up the difference. In such an event, the investments would presumably increase the long run growth rate of the US economy.

The trade deficits that the US has run since the mid-1990s, and in the 1980s before that can generally be attributed to policy distortion by the Federal Government or by the Federal Reserve. The Fed's policy of high real interest rates in the early 1980s and late 1990s drew in a great deal of capital from abroad. In the 1980s, it funded Reagan's tax cuts and military buildup. In the 1990s, it funded the investment in a large increase in US manufacturing production capacity. In the Dynamist's view, neither of these investments were bad things and they generally made the US stronger.

The problem came when the disinflationary high interest rate policy was unwound. In both the late 1990s and 2000s, the combination of falling real interest rates, a weakening dollar, a surge in liquidity and an upturn in inflation create a ripe environment for a junk bond and real estate boom. Finance-fuelled booms like these tend to leave behind banking crises, overleveraged LBOs and real estate overcapacity. In the 1980s, the S&L deregulation led to a commercial real estate bubble. In the 2000s, the flow of Chinese money into the agency debt of Fannie Mae and Freddie Mac, combined with the policy innovation of "securitizations" and credit derivatives created the housing bubble. While such investments aren't useless, they don't have much of an impact on future US productivity.

I've written before about how US economic policy since the Great Depression has basically promoted consumption and real estate investment at the expense of saving and business investment. Domestic tax policy is skewed toward taxing high earners and lenders and supporting lower earners, borrowers and leveraged equity owners, particularly in real estate and farming (this even after the income tax rate reductions of the Reagan and Bush eras). When examining how domestic policy leads to distortions to the external trade and capital accounts, it is worth comparing how our policies compare to those of our largest competitors.

Global tax rates

A couple of months ago, The Economist had an interesting table outlining the tax policies of various countries (it can be found here, by those with a subscription). I worked with the numbers a bit so we could compare the state's take (including state and local taxes) relative to GDP across various types of taxes. I don't have the underlying data, nor do I know the policy details behind how various countries collect taxes, but in rough terms the data give one a good idea about the thrust of tax policy.

I took the average of five European-style welfare states (Britain, Canada, France, Germany and Italy), two developed Asia industrial powerhouses (South Korea and Japan), the US, China and Germany stand-alone. Their sources of tax revenue relative to GDP are shown below:

Source: The Economist, author's calculations

Unsurprisingly, governments in the United States collect a smaller amount of taxes as a percent of the economy than the four European countries and Canada. To compare apples-to-apples, however, the 6-8% of GDP that flows to privately-funded health care in the US should be added to the relatively regressive "social contributions" line item, for health insurance costs are deducted directly from our compensation just like Social Security and Medicare taxes. That would move US taxes to within 4-6% of European levels.

Surprisingly, the total tax take from "progressive" sources like income, capital and property in the United States is almost identical to that of Europe. The big difference between the two systems is in the "regressive" taxation of consumption. The European-style welfare states use value-added taxes that collect consumption taxes to the tune of 10.4% of GDP. The US taxes consumption, mostly in the form of state sales taxes, at only 4.4% of GDP. In other words, the US has a more progressive tax code than the European-style welfare states. The result is Europe as a whole runs a trade balance and the consumption-driven US runs a trade deficit.

The developed Asia countries of South Korea and Japan tax their economies by a similar percent as the US and have similar percentages for social contributions. The difference is that developed Asia taxes income less and consumption more than the US, with a difference of about 3 percentage points in each category.

Now look at China. It has a weak social safety net, and collects nothing in terms of "social contributions". It then gets nearly two-thirds of its tax base from consumption taxes, with most of the rest coming from taxes on companies. No wonder China has huge levels of savings and investment and low consumption levels. Combine that with a policy to suppress currency values and you have the ideal recipe for large trade deficits.

Germany is another great promoter of global imbalances, particularly within Europe, as has come to light with the recent Greek debt crisis. It collects a huge portion of its tax base from regressive consumption taxes and social contributions, while collecting less than the US in progressive income, capital and property taxes. Additionally, of the developed countries it takes the lowest percentage from companies. By taxing employment so highly via social contributions, and taxing companies at such a low level, Germany is encouraging "capital deepening", or investment in its great export machine. Germany's high consumption taxes have also encouraged the lowest level of consumption of the major developed economies.

Domestic distortions

Even within the US tax code, the US discourages domestic business investment relative to encouraging US multinationals to invest abroad; punishes businesses in general with the second-highest corporate tax rate in the world while it lavishes massive subsidies on individual sectors like agriculture, energy extraction, and real estate; forces companies to write off investments in productive capacity over long periods of time while other countries offer massive incentives for multinationals to invest. In the past 30 years, the US has gotten away with its disincentives to business investment funded by domestic savings by replacing domestic savings with foreign savings flowing through its levered-up capital markets casino.

Reform the Tax Code

It was nice while it lasted. We got lots of investment, bigger houses, a beefed-up military, technological innovation, and debt-fuelled consumption with low domestic savings. Now that the bill has come due, we either need to encourage more saving or live with less investment. Opting for the latter is not the path to long run prosperity. The tax code needs to be reformed to tax more consumption (which could include a carbon tax, an export-promoting value added tax and/or larger deductions for saving), not to increase income taxes and to reform the corporate tax code to replace the subsidies for specific old-economy industries with incentives for investment in domestic manufacturing capacity and R&D.

For corporate taxes, I would propose a general reform that would lower the statutory rate by eliminating special-interest subsidies and the deferral of international income, while also allowing the full, immediate expensing of business investment and R&D. I would also support the deductibility of dividends, while returning the tax rate on individual dividends back to the income tax rate. This reform would discourage corporate cash-hoarding for buybacks and ill-conceived acquisitions. (If you can't convince the capital markets to fund an acquisition, you probably shouldn't do it.)

In a globalized economy, large differences in tax policy cause trade and capital flow distortions. The US can no longer pretend it is an island unto itself. Our tax code is harmful enough to our national interests as it is, it gets even worse when allows the rest of the world to take advantage of us.

Invest in infrastructure to stimulate jobs

Clearly, today most Americans would identify the weak job market as the biggest problem facing the country today. While the job market will recover on its own eventually, there is a desire in many quarters to roll out a second stimulus package to promote job growth. As Paul Krugman noted in a recent NYT opinion piece, the standard American approach to stimulus is to focus on expanding the economy as a whole with the assumption that jobs will follow. The traditional approach makes a great deal of sense during a run-of-the-mill recession. The problem today is that some of the dislocations in the economy and job market are so large, it could take many years to retrain and relocate the unemployed, particularly among the large pool of unemployed manufacturing and construction workers. In addition, the downturn in employment in construction and manufacturing are the result of long term or secular trends, not purely cyclical unemployment. To stimulate jobs among this large pool of unemployed workers, we should increase our investment in infrastructure on a sustained, multi-year basis.

"Blue collar" job losses

Of the 6.7 million jobs lost in the United States since 2007, nearly 58% were lost in construction and manufacturing. These largely male, "blue collar" occupations have seen such large losses that women now make up more than 50% of the workforce for the first time in history. Over 2.2 million jobs have been lost in manufacturing, but as can be seen in the chart below, the decline of manufacturing (dark green line) as a share of employment is in line with the historical trend. Manufacturing employment as a percent of total non-farm employment has fallen pretty much in a straight line from about a third at the end of World War II to under 10% today. As I have written previously (see here), this decline is due primarily to the consistent increase in manufacturing productivity. Manufacturing production has continued to grow and has largely maintained its share of GDP, even while employment has plunged. In other words, even if there was a large rebound in manufacturing, the vast majority of manufacturing jobs that have been lost in the last decade are never coming back.

Chart 1: Employment by Sector as a % of total Non-Farm Employment

                    Source:, author's calculations

Construction employment (the maroon line) has consistently run at around 5% of the total workforce since World War II. The 5% number makes sense, and is in line with the long term trend in real estate investment, which has run at about 5% of GDP as well.

Chart 2: Private Investment to Nominal GDP


                   Source:, author's calculations

Chart 2 shows the annual numbers through 2008, and 2009 will show a further plunge in private investment in both business equipment and real estate. In addition, given slower demographic growth and the large overhang of unsold homes, potential foreclosures and homeowners in negative equity situations, there is no reason to expect a strong rebound in real estate investment anytime in the next five years.

Where will new jobs come from?

On Chart 1 we can see that there has been a secular increase in the share of jobs going toward "white collar" occupations like health & education (orange line), business & professional services (office & tech jobs, pink line) and leisure & hospitality (light purple line). Of these careers, health, education and non-administrative office jobs tend to require time-consuming and expensive training, and it's hard to envision the government laying out a vision of promoting employment in leisure & hospitality jobs as the route to a strong America.

Having a large pool of angry, unemployed men does not for pleasant politics make. The traditional US government approach of using tax cuts and interest rate cuts to stimulate private spending and investment will not work in the near term (for reasons I outline here). For reasons I won't get into in this article, it also appears that the world economic system is not quite ready to be geared toward stimulating US export growth and trade surpluses. That leaves the US government directly stimulating demand.

Invest in infrastructure

In normal circumstances, I am not one to argue for more government intervention in the economy. However, these are certainly not normal circumstances. I am advocating the government committing to a sustained, multi-year program of increased investment in the nation's infrastructure as a way of both directly creating demand and stimulating private investment. I am not advocating a boondoggle like the stimulus bill from early this year. The US needs to target infrastructure investments that directly improve the long-term productivity of the US workforce by laying out a long-term plan and set of priorities. The investment should have the following goals:

  1. Reduce the amount of time and energy Americans spend commuting (investment in commuter rail, highways and bridges)
  2. Increase the efficiency of moving people and goods around the country (investment in rail, a new air traffic control system, highways, bridges)
  3. Reduce our reliance on imported energy (investment in wind, solar, nuclear, transmission grid, battery technology)
  4. Increase broadband capacity and penetration (invest in rural and wireless broadband)

If carried out in a thoughtful way (i.e. not driven by parochial real estate interests), such a program would make America stronger in the long term while creating near term construction jobs and stimulating domestic manufacturing.

Stratfor on Obama’s Choices in Iran and Afghanistan

I am on the record as someone who thinks the war in Afghanistan, as currently contemplated, is a waste of US blood and treasure.  I was also someone who was hopeful that Bush could have figured out some way to pull a "Nixon-goes-to-China" by opening relations with Iran.  He did not live up to that hope.  Obama has suggested the he would reach out to Iran, but it usually doesn't work that way.  Iran views Obama as a dove and thus is plowing ahead with its nuclear program figuring it will not face any real consequences.

George Friedman of Strategic Forecasting ("Stratfor") lays out Obama's choices in the article attached below.  He also thinks Afghanistan is basically unwinnable in the near term.  He also thinks that Obama is being backed in to making his choice soon.

1. He can attack Iran and increase forces in Afghanistan (still leaving us stuck in Afghanistan)
2. He can withdraw from Afghanistan and ignore Iran (leaving all our allies in the lurch)
3. He can increase forces in Afghanistan and ignore Iran (the worst outcome)
4. He can withdraw from Afghanistan and attack Iran (the most logical strategy, politics aside)

Neither of these options seems particularly attractive.



By George Friedman

During the 2008 U.S. presidential campaign, now-U.S. Vice President Joe Biden said that like all U.S. presidents, Barack Obama would face a foreign policy test early in his presidency if elected. That test is now here.

His test comprises two apparently distinct challenges, one in Afghanistan and one in Iran. While different problems, they have three elements in common. First, they involve the question of his administration's overarching strategy in the Islamic world. Second, the problems are approaching decision points (and making no decision represents a decision here). And third, they are playing out very differently than Obama expected during the 2008 campaign.

During the campaign, Obama portrayed the Iraq war as a massive mistake diverting the United States from Afghanistan, the true center of the "war on terror." He accordingly promised to shift the focus away from Iraq and back to Afghanistan. Obama's views on Iran were more amorphous. He supported the doctrine that Iran should not be permitted to obtain nuclear weapons, while at the same time asserted that engaging Iran was both possible and desirable. Embedded in the famous argument over whether offering talks without preconditions was appropriate (something now-U.S. Secretary of State Hillary Clinton attacked him for during the Democratic primary) was the idea that the problem with Iran stemmed from Washington's refusal to engage in talks with Tehran.

We are never impressed with campaign positions, or with the failure of the victorious candidate to live up to them. That's the way American politics work. But in this case, these promises have created a dual crisis that Obama must make decisions about now.


Back in April, in the midst of the financial crisis, Obama reached an agreement at the G-8 meeting that the Iranians would have until Sept. 24 and the G-20 meeting to engage in meaningful talks with the five permanent members of the U.N. Security Council plus Germany (P-5+1) or face intensely increased sanctions. His administration was quite new at the time, so the amount of thought behind this remains unclear. On one level, the financial crisis was so intense and September so far away that Obama and his team probably saw this as a means to delay a secondary matter while more important fires were flaring up.

But there was more operating than that. Obama intended to try to bridge the gap between the Islamic world and the United States between April and September. In his speech to the Islamic world from Cairo, he planned to show a desire not only to find common ground, but also to acknowledge shortcomings in U.S. policy in the region. With the appointment of special envoys George Mitchell (for Israel and the Palestinian territories) and Richard Holbrooke (for Pakistan and Afghanistan), Obama sought to build on his opening to the Islamic world with intense diplomatic activity designed to reshape regional relationships.

It can be argued that the Islamic masses responded positively to Obama's opening — it has been asserted to be so and we will accept this — but the diplomatic mission did not solve the core problem. Mitchell could not get the Israelis to move on the settlement issue, and while Holbrooke appears to have made some headway on increasing Pakistan's aggressiveness toward the Taliban, no fundamental shift has occurred in the Afghan war.

Most important, no major shift has occurred in Iran's attitude toward the United States and the P-5+1 negotiating group. In spite of Obama's Persian New Year address to Iran, the Iranians did not change their attitude toward the United States. The unrest following Iran's contested June presidential election actually hardened the Iranian position. Mahmoud Ahmadinejad remained president with the support of Supreme Leader Ayatollah Ali Khamenei, while the so-called moderates seemed powerless to influence their position. Perceptions that the West supported the demonstrations have strengthened Ahmadinejad's hand further, allowing him to paint his critics as pro-Western and himself as an Iranian nationalist.

But with September drawing to a close, talks have still not begun. Instead, they will begin Oct. 1. And last week, the Iranians chose to announce that not only will they continue work on their nuclear program (which they claim is not for military purposes), they have a second, hardened uranium enrichment facility near Qom. After that announcement, Obama, British Prime Minister Gordon Brown and French President Nicolas Sarkozy held a press conference saying they have known about the tunnel for several months, and warned of stern consequences.

This, of course, raises the question of what consequences. Obama has three choices in this regard.

First, he can impose crippling sanctions against Iran. But that is possible only if the Russians cooperate. Moscow has the rolling stock and reserves to supply all of Iran's fuel needs if it so chooses, and Beijing can also remedy any Iranian fuel shortages. Both Russia and China have said they don't want sanctions; without them on board, sanctions are meaningless.

Second, Obama can take military action against Iran, something easier politically and diplomatically for the United States to do itself rather than rely on Israel. By itself, Israel cannot achieve air superiority, suppress air defenses, attack the necessary number of sites and attempt to neutralize Iranian mine-laying and anti-ship capability all along the Persian Gulf. Moreover, if Israel struck on its own and Iran responded by mining the Strait of Hormuz, the United States would be drawn into at least a naval war with Iran — and probably would have to complete the Israeli airstrikes, too.

And third, Obama could choose to do nothing (or engage in sanctions that would be the equivalent of doing nothing). Washington could see future Iranian nuclear weapons as an acceptable risk. But the Israelis don't, meaning they would likely trigger the second scenario. It is possible that the United States could try to compel Israel not to strike — though it's not clear whether Israel would comply — something that would leave Obama publicly accepting Iran's nuclear program.

And this, of course, would jeopardize Obama's credibility. It is possible for the French or Germans to waffle on this issue; no one is looking to them for leadership. But for Obama simply to acquiesce to Iranian nuclear weapons, especially at this point, would have significant diplomatic and domestic political ramifications. Simply put, Obama would look weak — and that, of course, is why the Iranians announced the second nuclear site. They read Obama as weak, and they want to demonstrate their own resolve. That way, if the Russians were thinking of cooperating with the United States on sanctions, Moscow would be seen as backing the weak player against the strong one. The third option, doing nothing, therefore actually represents a significant action.


In a way, the same issue is at stake in Afghanistan. Having labeled Afghanistan as critical — indeed, having campaigned on the platform that the Bush administration was fighting the wrong war — it would be difficult for Obama to back down in Afghanistan. At the same time, the U.S. commander in Afghanistan, Gen. Stanley McChrystal, has reported that without a new strategy and a substantial increase in troop numbers, failure in Afghanistan is likely.

The number of troops being discussed, 30,000-40,000, would bring total U.S. and NATO forces in Afghanistan to just above the number of troops the Soviet Union deployed there in its war (just under 120,000) — a war that ended in failure. The new strategy being advocated would be one in which the focus would not be on the defeat of the Taliban by force of arms, but the creation of havens for the Afghan people and protecting those havens from the Taliban.

A move to the defensive when time is on your side is not an unreasonable strategy. But it is not clear that time is on Western forces' side. Increased offensives are not weakening the Taliban. But halting attacks and assuming that the Taliban will oblige the West by moving to the offensive, thereby opening itself to air and artillery strikes, probably is not going to happen. And while assuming that the country will effectively rise against the Taliban out of the protected zones the United States has created is interesting, it does not strike us as likely. The Taliban is fighting the long war because it has nowhere else to go. Its ability to maintain military and political cohesion following the 2001 invasion has been remarkable. And betting that the Pakistanis will be effective enough to break the Taliban's supply lines is hardly the most prudent bet.

In short, Obama's commander on the ground has told him the current Afghan strategy is failing. He has said that unless that strategy changes, more troops won't help, and that a change of strategy will require substantially more troops. But when we look at the proposed strategy and the force levels, it is far from obvious that even that level of commitment will stand a chance of achieving meaningful results quickly enough before the forces of Washington's NATO allies begin to withdraw and U.S. domestic resolve erodes further.

Obama has three choices in Afghanistan. He can continue to current strategy and force level, hoping to prolong failure long enough for some undefined force to intervene. He can follow McChrystal's advice and bet on the new strategy. Or he can withdraw U.S. forces from Afghanistan. Once again, doing nothing — the first option — is doing something quite significant.

The Two Challenges Come Together

The two crises intermingle in this way: Every president is tested in foreign policy, sometimes by design and sometimes by circumstance. Frequently, this happens at the beginning of his term as a result of some problem left by his predecessor, a strategy adopted in the campaign or a deliberate action by an antagonist. How this happens isn't important. What is important is that Obama's test is here. Obama at least publicly approached the presidency as if many of the problems the United States faced were due to misunderstandings about or the thoughtlessness of the United States. Whether this was correct is less important than that it left Obama appearing eager to accommodate his adversaries rather than confront them.

No one has a clear idea of Obama's threshold for action.

In Afghanistan, the Taliban takes the view that the British and Russians left, and that the Americans will leave, too. We strongly doubt that the force level proposed by McChrystal will be enough to change their minds. Moreover, U.S. forces are limited, with many still engaged in Iraq. In any case, it isn't clear what force level would suffice to force the Taliban to negotiate or capitulate — and we strongly doubt that there is a level practical to contemplate.

In Iran, Ahmadinejad clearly perceives that challenging Obama is low-risk and high reward. If he can finally demonstrate that the United States is unwilling to take military action regardless of provocations, his own domestic situation improves dramatically, his relationship with the Russians deepens, and most important, his regional influence — and menace — surges. If Obama accepts Iranian nukes without serious sanctions or military actions, the American position in the Islamic world will decline dramatically. The Arab states in the region rely on the United States to protect them from Iran, so U.S. acquiescence in the face of Iranian nuclear weapons would reshape U.S. relations in the region far more than a hundred Cairo speeches.

There are four permutations Obama might choose in response to the dual crisis. He could attack Iran and increase forces in Afghanistan, but he might well wind up stuck in a long-term war in Afghanistan. He could avoid that long-term war by withdrawing from Afghanistan and also ignore Iran's program, but that would leave many regimes reliant on the United States for defense against Iran in the lurch. He could increase forces in Afghanistan and ignore Iran — probably yielding the worst of all possible outcomes, namely, a long-term Afghan war and an Iran with a nuclear program if not nuclear weapons.

On pure logic, history or politics aside, the best course is to strike Iran and withdraw from Afghanistan. That would demonstrate will in the face of a significant challenge while perhaps reshaping Iran and certainly avoiding a drawn-out war in Afghanistan. Of course, it is easy for those who lack power and responsibility — and the need to govern — to provide logical choices. But the forces closing in on Obama are substantial, and there are many competing considerations in play.

Presidents eventually arrive at the point where something must be done, and where doing nothing is very much doing something. At this point, decisions can no longer be postponed, and each choice involves significant risk. Obama has reached that point, and significantly, in his case, he faces a double choice. And any decision he makes will reverberate.

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Copyright 2009 Stratfor.