In a now-famous August 14, 2011 New York Times op-ed, billionaire Warren Buffett called for tax rates to be raised “immediately on taxable incomes in excess of $1 million, including, of course, dividends and capital gains.” The key word here is “taxable.” In Buffett’s case, his taxable income is a mere 0.9% of his income held within Berkshire Hathaway, of which he owns 22%. His share of its 2010 pre-tax income was $4.2 billion dollars, taxes on which amounted to over $1.2 billion—a 29% rate. This income would be subject to tax again at the personal rate if it was taken out of the company, but since he has generously pledged to give away his fortune he would avoid the tax he wants to increase. As the bottom figure above shows, when all taxes are accounted for the U.S. tax code—however poorly designed—is in actuality considerably more progressive than Buffett’s storyline suggests.

Buffett: Stop Coddling the Super-Rich
Spence: Mind over Market
Geo-Graphics: The Payroll Tax Cut and U.S. GDP Growth
Foreign Affairs: The Future of History

China’s economy slowed from a growth rate of 10.3% in 2010 to 9.5% in 2011 (and a 2000s peak of 14.2% in 2007), prompting fears that China could trigger a global slowdown.  Yet at 10% of world output, 2.5 times what it was in 2001, the Chinese economy is now so large that it will continue to make a significantly rising contribution to global growth even if its own growth rate continues to fall off moderately.

Haass: China’s Greatest Threat Is Internal
Mallaby: Conflict and Confusion: China’s Currency Policy
Foreign Affairs: The Inevitable Superpower
Working Papers: The Future of the International Monetary System and the Role of the Renminbi

Many U.S. policymakers, not least at the Federal Reserve and the Treasury, continue to pin hopes for a robust economic recovery on the housing market.  They should consider that one demographic particularly badly hit by its collapse has a long memory.  That’s because they’re young.  They’ll be around for a long time, and will bear its scars financially and psychologically. As the figure shows, the change in homeownership rates from the 1996 trough in the Case-Shiller Price Index to its 2006 peak was by far the greatest among the under-30s.  Total household homeownership rates increased 3.4 percentage points over this period, to 68.8%.  For 25-29 year olds, however, the increase was a much higher 7.1 percentage points – to 41.8%.  For under-25s, it was 6.8 percentage points – to 24.8%.  The rise in homeownership among the young was particularly remarkable given the much lower base from which it started.  What effect did the housing bust have on them?  Household balance sheets among the Facebook generation were the hardest hit: between 2007 and 2009, half of those under the age of 35 lost over 25% of their wealth.  A quarter of those under 35 lost over 86% of their wealth.

Orszag: Winds of Change Blow Away College Degree
Video: Debt-Driven Doldrums or the Promise of Prosperity
Chart Book: The Economic Downturn in Historical Context
Interactive: Household Balance Sheets

U.S. annualized real GDP growth of 1.2% through Q3 2011 was driven by personal consumption, accounting for 91% of it.  Yet only 44% of personal consumption growth was driven by higher incomes.  The other 56% was accounted for by unsustainable items: a decline in savings (36%) and the payroll tax cut (20%).  The latter will expire in two months time unless Congress acts to extend it again.

Orszag: State Lawmakers Can’t Find Common Ground Either
Foreign Affairs: The Democratic Malaise
Analysis Brief: Can Washington Fix Its Debt and Deficits?
Video: World Economic Update

“It is time for a breakthrough to a new Europe,” German Chancellor Angela Merkel said on November 9th.  “That will mean more Europe, not less.” Merkel wants a stronger fiscal union with strict controls on eurozone national budgets.  Yet to date EU fiscal policy, such as it is, has meant ill-considered pro-cyclical spending programs – as shown in the graphic above.  Greece was and is a large recipient of EU transfers, yet those transfers collapsed by 1.3% of Gross Domestic Product (GDP) after it was forced to cut back on its contributions to EU-subsidized projects in an effort to slash government spending.  This additional fiscal squeeze hurt growth; Greek GDP fell an annual average of 3.5% in 2009 and 2010.

Reuters: Italy At Breaking Point; Fears Grow of Euro Zone Split
Mallaby: Franco-German Misstep on Eurozone
Steil: Why Draghi Can’t Be Bernanke
Video: Europe Update

Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs.  When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered.  This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion.  In response, Greek CDS prices plunged 20 percentage points.  Policymakers didn’t seem to care, but they should.  Those who bought CDSs believing that they were prudently insuring their bond holdings now face unexpected losses.  Sovereign CDSs have lost so much credibility that the troubled investment bank Jefferies felt it necessary to state publicly that it was not using them.  This credibility loss has spread to other sovereign CDSs, as shown in the bottom part of the figure above: the correlation between PIIGS debt spreads and CDS prices has plunged, indicating that CDSs are no longer viewed as reliable sovereign credit risk insurance.  Using CDS prices as a measure of default risk is now like setting your watch to a defective clock.  Yet the market is unlikely to die owing to Basel III bank capital regulations, which still treat CDSs as meaningful offsets against certain types of sovereign credit exposures.  This gives banks a perverse incentive to hold them just to reduce their capital requirements.  Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

Steil: ECB Limitations in Addressing Eurozone Crisis
Conference Call: Can the Eurozone Be Rescued?
Analysis Brief: Resolving the Eurozone Crisis
Backgrounder: The Eurozone in Crisis

On September 21st the Fed announced that it would be selling $400 billion in short-term Treasurys and buying $400 billion in longer-term Treasurys to replace them – a maneuver titled “Operation Twist.” Atlanta Fed president Dennis Lockhart explained what it would mean for the economy: “It means lower interest rates – a lower cost of borrowing – across a whole spectrum of loan maturities.” Is he right? Well, China, Russia, and Brazil have conducted their own version of Operation Twist over the past several years, replacing roughly $330 billion in short-term Treasurys with long-term ones. The 10-year Treasury rate went sideways over that period, as shown in the figure above. Whereas the BRIC* Twist may have put some modest downward pressure on longer-term rates, other factors overwhelmed it. Don’t expect much from the Fed’s similar-sized version.

* There are no reliable data for India.

Lockhart: The Economy and Monetary Policy—The Latest “Twist”
Federal Reserve: Maturity Extension Program and Reinvestment Policy
Backgrounder: The Role of the U.S. Federal Reserve
Spence: How to Reverse the Global Economic Slowdown

The eurozone leadership is finally coming around to accepting that a major continent-wide bank recapitalization program is necessary.  Germany wants each country to take care of its own banks.  This approach could buy time, but it won’t work for long.  National bank backstops are untenable in a common currency area, as each sovereign has its own credit risk profile.  Depositors will simply flee toward the better backstops.  This can already be seen in the correlation between bank deposits in Germany and the PIGS (Portugal, Ireland, Greece, and Spain).  Before the financial crisis, those deposits were tightly correlated, as shown in the graphic above, but over the past two years the correlation has flipped – deposits are fleeing the PIGS and flying into Germany.  A stable eurozone banking system will require a unified regulatory, resolution, and rescue regime.

Steil: Europe’s Failings Illuminate Marshall Plan
Analysis Brief: Waiting on the Eurozone
Video: World Economic Update
Analysis Brief: Managing a Greek Default

Chinese Premier Wen Jiabao recently hinted teasingly that China might buy more risky-country European debt; a “helping hand,” he called it.  Yet even if China follows through, it is unlikely to increase its intended purchases of European debt but rather just change the composition.  China’s euro purchases have increased dramatically over the past two years (we estimate these to be ¾ of reserves purchased in excess of the change in China’s U.S. asset holdings).  Most of this can be presumed to have been invested in German bunds, Europe’s closest thing to U.S. Treasurys.  Chinese euro purchases over the coming twelve months equivalent to those of the previous twelve months could cover the entire 2012 net financing needs of Portugal, Ireland, Italy, Greece, and Spain (PIIGS), as the figure above shows.  Every euro China invests in new PIIGS debt, however, can be expected to come at the expense of bunds.  Such a diversion would push up German interest rates—precisely what Germany wants to avoid by resisting eurobond issuance—without giving Germany any greater say over eurozone fiscal policies.  Chancellor Merkel therefore gains little, if anything, in making political concessions to secure Wen’s “helping hand.”

Reuters: China Promises EU Helping Hand With Debt Crisis
Steil and Swartz: Who Would Bail Out the European Central Bank?
Chart Book: Foreign Exchange Reserves in the BRICs
Video: World Economic Update

In its most recent update to the Budget and Economic Outlook, the Congressional Budget Office projects robust GDP growth of 4.4% in 2014 and 5.0% in 2015.  This projected spurt is unexplained, but appears to have been reverse-engineered from the belief that the United States should return to the trend growth it seemed to be following prior to the financial crisis—as can be seen in the figure upper-left above.  There is precedent for this: after the double-dip recession of the early 1980s, strong growth in 1983 and 1984 quickly closed the gap between actual and so-called potential levels of output—as can be seen above, upper-right.  But the CBO would be wrong to assume that economic history is destined to repeat itself.  In the early 1980s, industrial capacity continued to expand throughout the recession, while the labor force remained at the same level.  The recent downturn, however, has seen declines in both industrial capacity and the labor force of 2% and 5%, respectively—as seen in the bottom figures.  There is little justification for believing that potential economic activity has continued to grow while critical inputs to economic activity—labor and capital—have shrunk.  If potential output has shrunk along with them, then the U.S. faces considerably greater fiscal challenges than the CBO’s analysis implies.

CBO: Budget and Economic Outlook
Chart Book: Economic Downturn
Interview: Reviving U.S. Economic Leadership
Steil: U.S. Solvency Rests with 12 Angry Men