What Happened to the American Dream?

The problem with Mitt Romney's taxes isn't Mitt Romney. He shouldn't be considered a bad person because he works to make a profit, is successful, and pays the legal tax rate on his earnings.

The problem is that if elected, he is not likely to change that particular tax rate structure and improve America's economy.

American capitalism was once based on what was known globally as "the American Dream". It was based on the founding fathers' meritocratic ideals: incentives were built into the system such that people would want to work hard; then society would reap the benefits of the hard work of its citizens.

Those meritocratic incentives had two pillars to them: equal opportunity at the starting gate, and then a competitive environment that would reward merit (a combination of talent and hard work). The human instinct for the pursuit of happiness would take care of the rest.

Equal opportunity means all citizens should have access to the basic tools needed to compete, things like freedom, protection from violence, an education.

Then, a competitive environment with rewards is needed. Soviet communism didn't work because without rewards people don't have a reason to work, to bring forth new ideas, to build. The measure of whether a society has a functional reward system is social mobility; the more people are changing their level of wealth (for better or for worse), the more the society has incentives in place that reward merit. Societies with high levels of social mobility tend to also have high levels of economic growth, such as China today.

Back to Mitt Romney's 15% tax rate. Studies are showing that social mobility has slipped in America. It is harder than it used to be to improve one's status. The 1% are hoarding the wealth, hanging onto it and making it grow for them by lobbying, powerfully, to pay lower tax rates than the middle class (with notable exceptions like Warren Buffett). The rich-poor gap is increasing. The education divide is increasing. Equal opportunity has gotten lost, and the reward system (falsified lately by easy credit, leading to broken dreams) is distorted and dysfunctional.

Tax rates really need to be fair, and need to be structured precisely around a study of how progressive they can be to provide both equal opportunity and rewards for hard work. The American Dream needs to be brought back, and then the economy will work again too.

Italy's Formula

The European debt crisis rages, with the waters (temporarily?) calmed due to a successful strategy by the European Central Bank, with other banks, to keep liquidity flowing and bond issues subscribed.  The governments of Greece, Ireland, Spain, Portugal, and above all Italy (too big to fail?) need to bring debt and deficits down to sustainable levels.  That comes through austerity measures: after decades of loose spending, costs must be reigned in and bills paid. Yet austerity compromises economic growth, the most important ingredient for sustaining interest payments and paying back debt. Noone really has answers as to how European governments can stimulate growth at the same time as administering austerity. The solution is good management. Business schools abound with case studies on how companies on the verge of bankruptcy have been turned around and made successful, in the face of seemingly impossible challenges. Italy's new management has just put forward a bill designed to remove various systems and structures inhibiting growth, unleashing the hidden potential in the economy. The government claims, citing independent studies, that such unleashing of potential could boost annual GDP by more than 10%. The tricky part will be convincing interest groups (taxi drivers, lawyers, pharmacists and so on) to let go of acquired, beloved protectionist mechanisms, to not go on strike, to not take to the streets, to yes roll up their sleeves and get down to work for the good of the nation. The beauty of the government's bill lies in the detail. Lawyers will be required, for the first time, to issue an estimate of their fees in advance. Local governments have been commanded to remove any rules that "condition, impede, or delay the launch of new businesses or the entry of new economic players", by the end of this calendar year. There are many other parts to the package, mainly liberalizing the economy but also pumping money into infrastructure projects that will create jobs and move the economy. Little things like lawyers offering estimates can go a long way. Healthy competition will be created. Consumers will get in the habit of shopping around more. Lawyers will have an incentive not only to charge less, but to offer better quality services. Hard work and talent will mean getting ahead. Young people will have an incentive to work hard, because in a free market hard work pays off (in Italy you tend to have to "know someone" to get ahead; talent doesn't necessarily get you anywhere). The government's bill also takes a stab at improving Italy's judicial system by carving out a section of the courts, to be specifically devoted to company disputes. It aims to get such disputes settled quickly and effectively. There is a great story about how in the land of random justice and never-ending trials, the court in Turin decided to introduce an efficient "first in, first out" policy to push cases through quickly. This had huge repercussions: companies started paying their suppliers because they knew if they didn't they'd be forced to in court. Once laws became enforceable, people started abiding by them. The rule of law is the most basic foundation for a functioning economy. (This, by the way, is the best way to combat the mafia, or corruption: introduce a functioning, clear, effective judicial system.) In the end, freedom to express potential in a fair, meritocratic system should be the key to the conundrum of how we can have austerity and stimulate growth at the same time.

Where are the Ideas?

Where are we in history? We've rolled out Republican ideals, toyed with Libertarianism,  breezed through Marxism, tussled with Anarcho-Sindacalism, accepted the victory of Capitalism. Today formerly Communist and Socialist economies are marching forward with their own varieties of Capitalism, about to beat the West at its own game and sweep the broken pieces under the rug. But economic systems - the ways humans choose to organize themselves in community - never stop evolving. So what is the next wave? Clearly in the West it isn't about the struggle of the Worker anymore. It is, more likely, about the widening of the rich-poor gap, the 1 percent versus the 99 percent. Our finance-weighted capitalism, if left to its own devices, uncurbed, widens that gap. Possible future scenarios range from a magical, never-ending supply side growth trend with happy trickle-down effects that appease the poorest even as the gap is widening, to a day of reckoning when all the debt is called in and dominoeing defaults freeze credit, liquidity, and life as we know it. Or we could see growing frustration, revolution, an Occupy movement engulfing everything. Or globalization accelerating to a gallop and newer parts of the world sucking financial wealth like a vacuum far away to distant lands. In the US the debate is very much focused on large government versus small government. It is somewhat misguided, in the same way purely theoretical ideologies like Marxism or Libertarianism have been misguided: human nature always comes into it and ruins everything. Thus a society with big government will inevitably become unwieldy and corrupt, while too little government provokes injustice and fails to address societal issues that cannot be addressed at the level of the individual. Any group forming a community must have rules, as well as the tools to make sure those rules are respected. Beyond that, there is a crucial role for government: it should pursue the long-term benefits of the society as a whole, benefits such as clean air, education, or infrastructure. Society as a whole can wear different hats. It can be the Consumer. In a country where the Consumer is king, the government might decide that legislation should aim to make a wide choice of products available with prices competing downward. But in certain cases this can have dangerous consequences, such as the lack of a single standard for cellphones across America, or the electricity blackouts in California. It could mean risking product safety, or allowing for abusive child labour. Another hat is the Taxpayer. The government can decide the Taxpayer is king and needs his taxes cut no matter what. Or the government can focus on Constituencies. Lobbies. Interest Groups. One versus the others in a vicious power game involving votes and money. Or society can wear the hat of Future Generations. This would be the wisest way for a government to approach society (though practically impossible within our current political systems). It would mean cleaning up air pollution to save on future health costs. It would mean investing in technological innovation. It would mean lots of training programs and support for entrepreneurial initiative. And it would mean spending money wisely, working together, creating value for all.

Time For a New Economic Model

Commentary on the euro crisis tends to point to what governments should do to get over this hurdle and back to growth. The flaw in the argument is that we cannot go back to the way things were; our model has been based on massive overextension (normally referred to as a 'bubble') and is unsustainable. That was the lesson of Lehman, and this is the prolonged agony. We haven't learned the lessons yet; we haven't changed our model. And so we are bound to bang our head against the wall for more pain, until somehow we become enlightened. In psychology, that turning point often doesn't come until the pain is so great we hit bottom.

Wouldn't it be nice if, instead, we could take a more rational approach: step back from the wall, look around, take stock of all our options, weigh short-term gain versus long-term pain? Maybe switching to a mentality where we are OK with short-term pain because it will bring long-term gain.

Parents try to teach their children to think longer-term, not to focus on immediate self-gratification (such as grabbing a toy from another child), to think about the group as a whole.

Even if Europe quickly pulls itself together, Greeks agree to adopt German retirement ages and fiscal rigor, tax evaders are raked in and European debt is pulled into a single bond market where overall government debt stands at 88% of GDP, that will not be enough.

We need to re-evaluate our business model. I would not want my family to have credit card debt amounting to 88% of our annual income and the constant temptation to refinance and spend more ad infinitum. We have seen that our credit-driven competitive economic model creates huge wealth for a few, exacerbates the gap between rich and poor, favors bubbles with devastating hangovers, and produces anxiety, not happiness.

There are lots of new ideas floating around, models for sustainable development based on cooperation and long-term gain for all. This is our golden opportunity to adopt them.

In Order to Form a More Perfect Union

Many economists are clear on what needs to be done for the eurozone: transition the European bond market from bonds issued by single governments into eurobonds issued by the whole euro area together, pooling risks and rewards. This would work because the eurozone as a whole has less debt in proportion to GDP (88%) than the US or Japan.

It would mean, necessarily, pooling all kinds of economic and fiscal policy-making too. Angela Merkel is in favor of fiscal union, but says it won't work to introduce eurobonds first, before full fiscal union is in place.

Unfortunately the clock is ticking. There is no time left for Germans to worry about lax Southern Europeans failing to pull their weight after Germany has bailed them out. Everyone agrees that the impending collapse of the euro would cause a terrible recession with global repercussions.

Why is it so frightening for Europeans to transfer national sovereignty to a larger Union? People in Europe normally cite cultural differences, national identities, languages, and memories of war as obstacles. But the time has probably come when the choice is really between uniting and sinking.

The first Americans had a similar dilemma. After freeing themselves from British rule, the  States created a weak union under the Articles of Confederation. It didn't work. The central government had little power to collect taxes and a low budget from the States. Trade difficulties were enormous and the government had difficulty representing the Union abroad. The government printed money, but it had no value.

So in 1789, after eight years of muddling through, the States decided to adopted a new Constitution giving real powers to the central government.

With all its flaws, the federal union of the States has made it possible to share risks and rewards on a larger scale. It is time for Europeans to swallow national pride and move in this direction.

Berlusconi, Democracy and the Markets

Everyone I know wanted Berlusconi out, even before he began in politics in the first place. But we had to accept that the majority elected him, fair and square. Luckily Italy is an advanced Western democracy based on representation of the people, armed with a Constitution and loads of checks and balances.

But democracy, even in the great U.S. of A., is proving to be too slow and cumbersome for the markets. Democracy represents everyone, the entire population, from whizz kids to country bumpkins, the young and the old. And it carries an innate contradiction: governments are supposed to represent the Collective, but they are made up of politicians representing as many Individuals as possible. Individuals have short term needs; the Collective is a long-term project.

So what has happened in the West? For too long, governments have ignored the long-term interests of the Collective (clean air, a sustainable economic future for generations to come, building cities that can handle large populations, renewable energy and so on) in favor of the short-term interests of the Individual: their constituencies.

A classic case is how governments, notably in the US, allowed individuals to get rich at the expense of society, pushing them to consume and take on more and more debt, and allowing banks unbridled risk-taking to keep the funds flowing. Who would pay the bill?

In Europe, governments like Italy's, over decades, catered to short-term individual interests by pouring money on here-and now projects, like the infrastructure projects in the Italian South that disappeared into Mafia pockets, or even on just plain comfortable welfare systems. They did this by running up reckless amounts of debt, again, transferring the bill to later generations.

Meanwhile the New York and London financial markets went global and literally took over. The regulatory framework gave them the incentive to create new and more financial instruments and get us globally into a giant Ponzi scheme we are all part of, given that currently global wealth in derivatives trading amounts to nearly 10 times global GDP. Hard to fathom, but I think that means there is a lot of paper (or computer code) money floating around out there that doesn't correspond to the actual material assets wehave here on earth. Right? Doesn't it mean that if all derivatives traders decided to cash in at the same time and buy furniture with that money, someone would be left out in the cold?

But let's get back to Berlusconi. Italy has had public debt of more than its annual GDP forever. That's like a family having credit card debt of more than they earn in a year; it gets expensive to pay the interest. So the Italian government has to keep refinancing, taking out more debt to pay the interest on the existing debt, like every week. But the lenders (led by those unbridled financial players in New York and London) keep raising the interest rates. Oops - Italy is like a family about to default on its credit cards.  Can the guy in charge of that family lead at a time like this? People think not, so an economist is hurriedly brought in.

It is a very, very flawed situation that makes it OK for a non-elected official to be hustled in to run a democracy. The last time this happened in Italy was when the King appointed Mussolini. No comparison there; Mario Monti is an economist with the humility of a public servant, and he will step aside as soon as elections can be held.

But the situation that caused his appointment is very, very flawed and goes back to the fact that the entire Western world needs to pay up, in a hurry, for the short-term thinking of the past and get into a long-term, Collective, mentality. We can no longer afford to put anything at all on the public credit card. We can no longer afford to be focused on which SUV to purchase next, forgetting about clean air for our grandchildren.

In Italy, Mario Monti needs to use his time as Commissioner-with-extraordinary-powers to find a way to pay the bill, but also to try to teach people about Collective urgency. Democracy is a wonderful thing, and we need to get back to the ballot as soon as possible. But we have to stop voting for our short-term needs, or for our own little tribe or constituency, and start voting for the Collective. If we don't, there will only be more Commissioners.

Hedge Fund Regulation

The New York Times reports that the SEC has approved new rules forcing greater disclosure by hedge funds. Oh sorry – only the largest ones. And we don’t really know if it’s true; the report says the SEC is keeping it secret until the Commodity Futures Trading Commission decides whether to approve it too.

So, maybe, the really big hedge funds will have to start reporting, six months from now and far after the fact, how much of their investments have been made on borrowed money.

Thirteen years after the multibillion-dollar collapse of hedge fund Long-Term Capital Management and a few years now after the collapse of so many banks due to risky derivatives trading, the hedge fund business is still totally opaque and unregulated.  

The value of derivates trading overall (not just by hedge funds) is still, today, nearly 10 times all the GDP in the world. Borrowed money used for trading, like any borrowed money, must be either paid back, written off, or passed around. If it is written off, society (in the form of creditors, taxpayers, someone) needs to absorb it somehow, as we have seen. Right now a lot is being passed around. What happens when the music stops?

While the Commodity Futures Trading Commission mulls over whether to require the largest hedge funds (according to the current watered-down, lobbied-down version of the rules) to report that huge percentages of the money they are trading with is really borrowed money they don’t actually have, the Commission has a distraction to deal with. It is having to open an investigation into MF Global, the bankrupt brokerage firm where $600 million in client funds went missing. The Commission’s chairman, Gary Gensler, won’t participate in the investigation due to his dealings with MF Global’s CEO Jon Corzine. But the Commission will go ahead and investigate anyway, and even admit it publicly! “The commission has determined it is in the public interest to confirm the existence of this particular investigation,” the agency said in a statement. Off to a good start?

p.s. This wonderfully transparent agency is the Commodity Trading Commission. Do we really want world food prices to be in the hands of clubby Genslers and Corzines?