The Fed: Demystifying the Most Powerful Part of Government

As we discuss the debate over the fiscal cliff, it is important to understand what the government can do in order effect change on the economy.  In this post, we'll concentrate on the Federal reserve, a very powerful, if not the most powerful, part of the US Government.  The Federal reserve uses Monetary Policy, or the control of the money supply, in order to establish low unemployment and low inflation.

Above is a graphic showing how the Federal reserve is set up.  There are many organizations involved in the Federal Reserve, and the important thing to take away is that these organizations work together to establish monetary policy for the United States.  The Board of Governors is the national level of the Federal Reserve.  Ben Bernanke is the chairman of this board.  There are also regional Federal Reserve Banks, which have headquarters in specific cities around the country, as you can see below.

The Federal Open Market Committee is a group that does many actual transactions in order to regulate the money supply.  This group is made up of all the national governors and 5 of the 12 regional heads.  The chairman of the Federal reserve Bank of New York is always on this board, in recognition of New York City as the financial capital of the United States.

Now, the Federal Reserve has no power over fiscal policy, which is the manipulation of taxation and expenditure to promote low unemployment and low inflation.  While the desired end  result is the same, the power over Fiscal Policy resides mostly with Congress and the President.  What the federal Reserve   can do is adjust the amount of money in the economy to promote growth (easy money) or low inflation (tight money).

For example, with an easy money policy, the Federal Reserve will allow the interest rates it charges to other banks to lower.  This effectively lowers the cost of money.  Money has a cost? one might ask.  In a practical sense, it does.  The cost of buying money in the form of a loan is the amount you pay in interest.  By lowering interest rates, it is more attractive to buy money.  Accordingly more people will get loans and more people will be spending that money, fueling the economy.  

Tight Money Policy, on the other hand, raises interest rates, causing the price of money to rise and less people to borrow money.  This seems like limiting the economy, and in effect, it is.  In some cases, especially when there is high inflation, it becomes necessary to slow the economy down by making sure there is less money out in the economy.  The Fed does this by employing a tight money policy.  

Now, while the Fed would like to be able to control interest rates to control monetary policy, in practice, most banks do not get their money from the Federal reserve.  It is much easier to get money from fellow banks, and there is a strong stigma behind borrowing from the government.   They can control rates indirectly, but by far the most commonly used tool or tools are Open Market Operations.  Open Market Operations (OMOs) are activities by a central bank (the fed, in this case) to buy or sell government bonds on the open market.  This helps control the supply of base money, the monetary base, or supply, of a nation's money.

As you can see above, in an easy money policy, more money is put into the economy, as the name would suggest.  Here, the Fed spends money to buy bonds and securities held by citizens, providing them with money to increase the money supply.  In tight money policy, the Fed sells these same bonds and securities, which people pay for with cash, taking that money out of the money supply.  These operations are performed and adopted by the aptly named Federal Open Market committee (see above).

Steelers QB: not the real Big Ben

Now, even though the Fed has no power over taxing and spending, they can still regulate the money supply of the entire nation.  This makes the Federal reserve and its head, Ben Bernanke, very powerful.  they are charged with a great responsibility, and it is important that they get their job done right.  Without guidance, the money supply could go up and up and up, leading to hyperinflation like that of Weimar Germany, where people used money, because it was cheaper than kindling and firewood.

Big Ben Bernanke

It is important to understand how the Federal reserve works, especially since we discuss using fiscal policy (taxation and spending) to fix our nation's budget problems.  We must coordinate our economic efforts, using both monetary and fiscal policy together, not against each other, to get our economy back on track. 

Fiscal Cliff: Part 2-Taxes

If Congress does nothing to act on the expiration of the Bush Era tax cuts, many will see a modest rise in the amount of taxes they must pay.  When planning for the future and trying to work a deal, Congress must balance cutting the deficit with economic recovery, as raising taxes would lead to a decrease in consumer spending, the principle part of Gross Domestic Product (GDP).

In order to balance spending cuts, increased revenue must be on the table for a fiscal cliff deal.  In order to get enough revenue, limiting deductions and raising taxes on millionaires is necessary.

In the campaign this year, Mitt Romney championed limiting deductions as a way to make his proposed tax cuts revenue neutral.  If applied to the fiscal cliff, we can use these same limits on deductions to increase the revenue that the government is able to collect.  Capping total deductions at $50,000, according to the Tax Policy Center, would raise around $750 billion over a ten year period.  Deductions would actually hurt the richest Americans the most, leaving middle class America unscathed.  80 percent of additional revenue would come from top earners in the 1%. Some deductions that are on the chopping block specifically appeal to rich Americans, as you can see in the table below of prospective plans.  A tax break for corporate jets is such a deduction.  Working with the deduction system could bring in even more money, though it would hurt more Americans in the process.

Another option is to increase personal income taxes to the pre-Bush tax cut levels.  This would make a modest dent in the deficit, so more revenue is obviously needed.

All in all, we need a balanced approach on revenue increases just like we need a balanced approach on the whole fiscal cliff crisis.  Congress needs to make sure that it is not unduly hurting anyone, especially the middle class and the poor.  We're not out of the woods yet, with our economy in a sluggish recovery.  Prudent fiscal policy is just what we need to continue or recovery and make a dent in our debt for the future.

The Fiscal Cliff Series: Part 1

The term "Fiscal Cliff" is used to describe the problem faced by Congress at present.  A combination of tax cut expiration and automatic cuts will take effect come January 1st if a plan is not produced to avert the situation.  

Because of Congress's failure to come to an agreement in accordance with the Budget Control Act of 2011, which raised the debt ceiling but left open the ways to cut deficit spending.  Since a bargain was not reached, sequestration will occur, which mandates across the board spending cuts.  In addition, the Bush era tax cuts will expire, as will a 2% Social Security Payroll tax cut, and the expiration of federal unemployment benefits.

If Congress doe snot act, as before, the results could be very grim for our country's growth.  It will have a very detrimental effect on an economy that is still shaky.  

The effect of the Fiscal Cliff on GDP

As you can see above, analysts have projected strong negative effects on our nation's GDP if  we run over the Fiscal Cliff.  The Tax Policy Center has stated that middle income families will pay, on average, $2,000 more dollars in taxes in 2013.  The Congressional Budget Office (CBO) also anticipates increased unemployment  where 3.4 million will lose their jobs.

That being said, the country cannot continue on the path it's on with regards to deficit spending.  at least something needs to be done to curb our spending so that we get back on a sustainable debt track as our economy begins to rebound.  Large deficit spending should really only be done it trying economic times, and we should try to steer clear of that now.

The effect of the Fiscal Cliff on Deficit

Now, as we consider the negative effects of the fiscal cliff on growth, we should also note that it would drastically decrease our spending and cause us to run fewer deficits.  The CBO baseline in the figure above shows that effects of the fiscal cliff.  The blue alternative would be the effect of repealing the automatic cuts and extending the Bush Era tax cuts.  Though this also reduces deficits, at least for a while, more would need to be done to put our nation on the track of long term sustainability.  We'll discuss possible solutions to this problem in following posts.

A New Global Policy

A major problem that we face when trying to bring about peace around the globe is education levels in developing and war torn countries.  One way to measure this is by looking at the adult literacy rates, then comparing the rates to other countries.

Literacy Rates by country

The results we see are not promising.  Countries in the Middle East have literacy rates significantly lower than those of developed and even developing nation, especially for women.  This translates into fewer opportunities for members of those societies.  Without strong educational institutions, the youth in Middle Eastern and North African Countries have few opportunities to advance themselves, leading to rampant unemployment.

Without opportunities, often the only choice young people have is to associate with terrorist organizations. These young people have no future and no voice.  These young people need to be given a voice that does not involve setting off bombs.  Perhaps the Arab Spring has allowed the young people to find some way of expressing themselves and helped them vent their anger, but more needs to be done. We need to give them more, the future of a higher education.

So how does this affect our foreign policy?

In order to promote peace throughout the world, we must promote literacy and education.  Young, educated people are forces of change throughout the world.  By providing an education to lower class women, we can empower them more than ever before.  Instead of using bombs, we ought to use books to create a new global policy.  The Middle East has extreme poverty and although we may not think it is our problem, we need to make it our problem.  It is much more effective to bring up a country through education than to use crash and burn tactics of military action.

The United States must work with other countries to promote more NGOs to work inside these countries to promote education reform.  They must work with local governments to provide funding for schools.  Additionally, we must open our own doors to these young people who wish to pursue a higher education within the United States.  Politicians at home may not appreciate this policy, but it is much better in the long run to pursue a strategy of youth empowerment than to simply use military action.  We need to pursue a foreign policy of inclusion if we are to bring about peace in the Middle East, not one of exclusion.

Energy Reform Series: Part 4-The Economics of a Carbon Tax

Considering the rise fossil fuel emissions, especially those of carbon dioxide, something ought to be done in the form of policy change to promote reduction of pollution.  In this post, we will look at one idea, a carbon tax, which would be imposed on industry to promote reduction in fossil fuel use.

Taxes would be levied on carbon use.  Energies such as coal or gasoline would have a much higher rate than solar or wind power.  These clean sources of power would likely not be taxed at all.  Firms have a strong incentive to adopt whatever new technology is necessary to reduce their carbon footprint.

The draw of a carbon tax over Cap and Trade is its simplicity.  Cap and Trade involves the buying and selling of carbon credits with other companies.  The Carbon Tax simply levels a tax on carbon use on all companies.  This would also mean a carbon tax could be implemented much more quickly than a cap and trade system. From a government's perspective, the carbon tax could be more beneficial, as it supplies additional revenue to their coffers.

However, this could also mean higher energy prices for consumers.  The government might have more money, but one way to get around tax for energy companies would be to simply raise rates.  This could be a very negative effect of trying to fix a very important problem.

One way to solve this problem is to change the way the money is allocated once it is collected from the polluters.  Since households would be paying more, it makes sense to alleviate them of a burden that was supposed to be placed on major polluters.

To do this, the government would use the money collected to pay out benefits or provide tax breaks to households that would bear a burden from paying the higher rates.  This makes the whole system revenue neutral.  This would be preferable over simply levying a tax.  This way, consumers can actually make a profit by implementing their own energy saving measures, instead of just holding steady or paying their original bill.

Whether it's the Carbon Tax or Cap and Trade, Congress must act soon on establishing some method of reducing our fossil fuel consumption.  Profit is a huge incentive for businesses, and anything that cuts into that profit is an unwelcome burden on businesses.  We need to use financial incentives for our advantage when it comes to energy policy.  Both Cap And Trade and the Carbon Tax do this: they make it worth a business's while to invest in ways to reduce consumption and increase efficiency. If we do this, we can make sure that our commercial and industrial sector of the economy is clean and efficient, paving the way for energy independence.   

Education Reform

Education is a big area for reform in America.  With the introduction and failure of the No Child Left Behind Act, there is a huge space for new education reform.

                       

While No Child Left Behind highlighted some of the issues in our education system, it did not really fix our problems.

With spending increasing in the education sector of our economy, we have only seen a tiny improvement in scores:
                           

Now, test scores are obviously not everything that matters in education.  The tests that are used no not necessarily measure academic competency.  Even so, with this much money being spent on education, we would expect to see some improvement.  But, in fact, we do not.

Teaching is and will remain some of the most important jobs in America.  The sooner we all realize this, the better we are suited to go about reform.  Teachers instruct and enlighten new generations, driving them towards success.  We need to ensure that those who fill these jobs are both well qualified and well prepared to do this.  One inspiring can make a positive contribution to a students life.  These contributions are often impossible to quantify for wage purposes.  We can, to a certain extent however, pay teachers based on their affect on the students.  Merit based teacher hiring, promotion, and retention will encourage teachers to be the best they can possibly be.
                          

This is not all on the teachers though.  Instructors who teach teachers need to be the best they can be also.  Teachers need to be well prepared so that they can succeed. Ensuring that we have extensive teacher training is essential.  Teachers should be informed on strategies that help motivate students.  They can share their ideas so they all can succeed.  Such collaboration must be encouraged in the education system.

In order to push students to learn more, we must challenge them, but not beyond their limits so that they are overwhelmed.  In our educational system, there are often only two streams: Grade Level and Honors/Advanced Placement.  There is no middle ground.  Often students feel they are unready or unprepared for the most challenging class, but then, devoid of options, are frustrated with the simplicity of the Grade Level Class.

This needs to change.  Teachers in all classes need to asses student skill and willpower to offer or assign tiered assignments varying the challenge that students have.  Some students may not be able to go beyond what Grade Level requires.  Very well.  Others can have a challenge, so that they may still challenge themselves and expand their knowledge without overwhelming themselves.  This would not require any additional "Accelerated" classes from being added to the school course offerings, thus eliminating any additional class/teacher cost.  Though all assignments may not be tiered, as to ensure grade fairness, a significant amount of increased challenged could be added to the courses with this system.  Teachers can assign some tired assignments, and present a choice to the student on others, encouraging students to challenge themselves, but within their limits.  This provides a way for all students, not matter their skill level, to push themselves without increasing their stress level.

We should strive for high standards so America can produce the best and brightest.  It is important for our future as a nation.  We should have more early childhood education opportunities.  Foreign languages should be taught much earlier, such as in elementary school.   Underprivileged children should have the same opportunity to go to and succeed in school as anyone else.  Education is greatly important in our country as we strive for success in the future.  There should be a better system for paying teachers.  Merit pay is one option, but other options could be implicated.  Instead of states “dumbing down” their standards so more kids pass, we should raise standards and make sure we make them.  

More money can be spent in education, but overall, it should be spent more efficiently. We need to evaluate what programs really work in engaging kids, and funding those programs.  With better education, our children will be our future. They will be able to create better renewable energy resources, increase the US front on science and technology, and reach greater achievements on the economy. We must also include a larger range of foreign languages and arts in the studies. This will increase respect for the nation, and our future people will be able to meet with foreign people in an easier fashion. In terms of teachers, they must receive a higher pay. In these times, with huge lay-offs, we must remember, talent not tenure.  

Our education system is broken.  We have students that are struggling and we are locked into a system that rewards teachers for hanging in there the longest, not ones that effectively teach and inspire their students.

W.B. Yeats once said, "Education is not the filling of a bucket, but the lighting of a fire." By challenging our students, we can light student's intellectual fires so they burn bright and powerful into adulthood, catalyzing and illuminating their futures.

A Changing of the Guard: US policy change in the Middle East

As the saying goes, the biggest export for America is freedom, and with thousands of US military personal and years of involvement, no other region has been on the receiving end of more American "freedom" than the Middle East.  However, this exporting has gotten extremely unpopular at home and abroad.  This change in opinion combined with the dramatic political changes in the region over the past two years has left many wondering what the new role for the United States is in this volatile region of the globe. The implications of our policies are huge, with the billion dollar question being who steps up to be the power player if the US goes into retirement.

One player who seems eager to step up to the Broadway stage is Egyptian president Mohamed Morsi.  Recently elected after the fall of the formerly US backed Mubarak regime.  He has been shrewd thus far, balancing his base in the Muslim Brotherhood and as a leader in the predominantly Muslim Middle East but also extending a more friendly hand to Israel to balance western interests. But just days ago, he announced that his decisions would be immune from review by law, a power grab that is angering citizens whose experience of Mubarak are fresh in their minds.  Also, how well will the US be able to work diplomatically with Egypt, as conservative members at home consider the Muslim brotherhood to be a terrorist organization.  

Mohamed Morsi

With respect to sovereign governments, the US needs to stop it's double standard of committing on face value to the pillars of democracy while blatantly controlling the governments.  Instances such as the installation of the shah in Iran in 1953 lead to future hard feelings.  The US needs to instead back the right of self determination for all people.

That being said, the US should not necessarily stand by, though we should not get overly involved.  Overextended empires fail, so we cannot over commit resources to unnecessary problems.  Using our own interests as a measure for criteria,  we then can use our diplomatic bargaining power to look out for our interests without compromising the integrity of a sovereign government.  If we get too involved in a country, we might break it, and if we break it, we own it.  That is one of the problems setting us back in Afghanistan:  we're stuck if we leave and we're stick if we don't.

The United States needs to adopt a foreign policy that is more in tune with the times we are in.  We should opt for engagement, instead of containment  and use diplomatic means whenever possible.  We should avoid overextending our resources and seek to empower other nations instead of setting up democracy for them.  If we maintain an open and inclusive foreign policy, perceptions on the United States might, over time, change for the better, and we can better work with other nations to make the world a better place.  This policy change is incredibly important, especially in dealing with an area as volatile as the Middle East.

Energy Reform Series: Part 3-The Case For Cap and Trade

In an effort to reduce carbon emissions, there are a few policies that the governemnt could enact that would greatly help to achieve this.  Some methods are better than others and each has its own merits, as well as drawbacks.

The first policy we will analyze is the Cap and Trade approach, championed by many Democrats, as well as flip-flopping Republicans.  Cap and Trade's main goal is to steadily reduce carbon emissions and other pollutants across the nation in a cost effective manner.

Each company or polluter will have a limit, or a cap, on the amount of pollution they can emit.  They are issued pollution permits up to that amount.  If need be, restrictions on pollution can get tighter for more greenhouse gas reduction.  They key part of cap and trade is that companies that efficiently and cheaply cut their pollution levels are free to sell their extra credits to the companies that cannot reduce as easily.  Companies have large flexibility in buying and selling permits, achieving the same total reduction, but at a lower overall cost to the economy.

How is this so?  Well, to start out with, we have to consider the alternative command and control policy.  In command and control, each factory is required to make the necessary reductions, regardless of what the overall cost might be.  The government sets clean air regulations, and companies must either upgrade their facilities, bearing whatever costs are involved, or break the law.

The figure above illustrates this point.  In the traditional command and control approach, the government, for example, mandates a 30% reduction in emissions, or 300 tons of CO2.  The cost to reduce for both plants together is $12,000.  In the case of Cap and Trade, on the other hand, the cost to reduce overall is cheaper.  This is because the revenue made from selling pollution permits to another plant adds additional profit.

Cap and Trade is known as a market-based policy, as opposed to a carbon tax, which would be called a corrective tax.  Market-based policies work within the free market system to provide price incentives for companies or even individuals to reduce consumption.

Cap and Trade could prove an effective tool at reducing pollution if adopted.  We encourage Congress to consider using these market-based policies to effect change in the environmental and energy policy reform.  We can use economics to work for us by providing incentives to do the right thing, while still reducing overall costs.

Energy Reform Series: Part 2

There are  numerous problems with how electricity is distributed.  As you can see in the graphic below, which shows a typical summer day's energy demand in California, energy use in households and businesses varies substantially during the day.  California, as the nation's largest state, can serve as a valid sample for how a large community uses energy.  As energy use continues to rise, the problem of how to apportion energy when use varies so much will only get compounded.

Scientists and economists have brought up this problem multiple times.  As stated in a Technology Review article, published by MIT, simply building more power plants will not solve the problem of so much more demand.  The need for energy is growing so much that too many power plants would have to be built to even provide enough energy for everyone, and setting up a power plant is not cheap.  This creates the problem of what to to to get more energy if building more power plants is not economically viable.

The solution to this problem might lie in smartgrids.  Smartgrids transform an otherwise "dumb" energy allocation system into an intelligent, self optimizing  network.  Tapping into internet based innovations could provide the system with a much needed boost in organizing power.  By bringing the smartgrid to the power industry, we can bring about change similar to that of the Internet on the total economy.

The need for a smartgrid is apparent when we consider a new technology, plug-in hybrids, that are now being used to help ease our oil-addiction woes. According to a study by Oak Ridge Laboratory, 160 new power plants would need to be built if everyone plugged in during the early evening, the peak electricity time.  This is an expensive proposition.  Instead, with a smartgrid, the local utilities could stagger charging times and change rates for off-time power.  With smart technology helping out, virtually none, if any, new power plants would have to be constructed.

Upgrading our nation's grid to become more technologically updated is an expensive public works project.  Though it would be a significant cost, it is likely to pale in comparison to the savings and benefits generated from the change.  The Electrical Power Research Institute estimates that poor reliability and outdated mechanics of the grid costs $100 billion.  With a similar investment, a smart grid, according to their findings, generate trillions in extra annual GDP for the U.S.  By working with legislators, on a local, state and federal level, as well as bringing in consumers and private companies, we can find a way to upgrade our grid and secure prosperity in our future.  The innovation and technology is there.  All we need now is the political willpower.

Energy Reform Series: Part 1

The United States has a huge energy problem.  Gas price fluctuations throughout the year show us the fragility of our oil supply and our unhealthy dependence on petroleum for energy.  Coal mining accidents, very tragic occurrences, also force us to question our attachment to a resource that pollutes the environment so much.

The United States uses far too much resources like coal and oil and far to little of resources like solar and wind.  Yes, part of the reason is the price of the energy, but these polluting resources also have an unquantifiable environmental price.  Additionally, with government and private sector help, we can make these forms of energy cheap and efficient.

world oil production has increased in recent decades

Conservatives who wail that the government should not get involved should take a history lesson.  A lot of change has come out of government action, and for the better.  NASA, for a while, was the sole consumer of major computers, sustaining an infant industry that has now led to a huge tech sector in the United States.  A form of the Internet was started by the Department of Defense.  Government investment has lead to University funding and the Space Race.  Therefore, we can safely say that there is a place and time for government investment.

We need to make sure that we, as a country, jump ahead and capitalize on energy reform.  If America does not take the lead, some other country will do so, and we will have to buy it from them.  Coming up with and manufacturing the new clean energy technology does not require vast oil reserves or coal mines.  All it requires is an innovative spirit, ingenuity, a bit of private capital, and political will.  We have all of these, to varying extents, right here in America.  The only thing lacking in any regard would be political will.  We need leadership in Washington and around the country to kick-start a clean energy revolution.

By bringing in government investment and private capital, we can diversify our energy sources and make sure  it is affordable and the industry is sustainable.  The US can then become a leader on the world stage, exporting this technology to the rest of the globe.  By being a leader in clean energy, the US could mitigate the influence OPEC countries like Iran wield simply because they have oil.  By acting now, the US can secure its place in the energy hierarchy of the globe.