What Scott Brown’s Victory Means…………….And What It Doesn’t.

With Republicans and Independents celebrating the return of a small amount of Republican influence to Washington, it is important that Republicans not get carried away in concluding that the public is returning to the Party that it removed from power over the course of the 2006 and 2008 election seasons. While the ability to alter or perhaps entirely scuttle the Democrat’s health reform efforts is the most important outcome of the election, nobody should be under any illusion that this was a GOP win. Rather it was a Democrat loss.

While a Democrat loss is a GOP win practically speaking, this election did not mean that Massachusetts is about to turn into a red state along the lines of a Georgia or a Texas. All it really means is that Massachusetts voters wanted to send the Democrats a message, the GOP being the only practical alternative with which to do so. Despite victories in this election, along with the races in New Jersey and Virginia in November, the GOP still has a huge image problem among the electorate according to some polls.

Over the last 2 election cycles, voters abandoned the GOP largely because of the fact that the GOP became seen as fiscally irresponsible, tone-deaf, and corrupt. The Democrats were swept into office promising to be the opposite. However, the American people are clearly concluding that perhaps they have traded a bad problem for a worse one. Scott Brown’s victory in a deep blue state is not the result of an electorate deciding that the GOP is “good” and the Democrats are “bad”, but rather an electorate deciding that it had better put the brakes on a Party that was in control of the entire government and was pulling it too far in one direction. Many of the words used by voters to describe the Democrats (i.e. arrogant, tone-deaf, etc) were the same words used to describe the GOP congressional majority 4 years ago.

If the GOP wants to build a governing majority capable of bringing needed fiscal and judicial reforms to America, there are some realities that it will have to accept. Firstly, if GOP base expects Scott Brown to govern as a Georgia or Mississippi conservative, then it had better prepare to have that Senate seat return to the Democrats in 2012. Scott Brown was sent to the Senate to represent the voters of Massachusetts, and he will need to stake out positions at least somewhat consistent with those of the voters in his state. By necessity, this makes it likely that he will be closer to the center of the political spectrum than what many in the GOP base are likely to prefer. That being said, Brown was elected as a result of a populist backlash against a government that people are beginning to sense has become too large. Consequently, he is also likely to favor initiatives that reduce the size of government; something which is consistent with conservative governing philosophy.

While the GOP is benefitting from the current political trends, it still has a lot of work to do if it is to repair its brand nationally. Because attracting independent voters (as Scott Brown did) is the key to a Republican revival, it is imperative that Republicans realize that these voters are often looking for practical solutions to problems rather than ideologically based solutions. While many of these voters hold positions that are consistent with conservatism, many of them also distrust ideology. Consequently, a Republican Party that effectively decides to excommunicate Brown because of a couple of votes that he may cast that go against conservative orthodoxy will likely turn off many independents and not serve to make the Republican Party the majority. On the other hand, a Party that shows that it is big enough to allow someone like Brown to provide the necessary representation to his constituents who may not happen to be as conservative as one might like has a good chance of winning races that would ordinarily be considered out of reach.

Two Americas: The Productive And The Unproductive

As the new year dawns with the costs of Obama’s attempt at remaking American society coming into focus for many Americans, conservatives will undoubtedly be able to get some political mileage out of proposals to scale back or repeal much of Obama’s agenda. However, while John Edwards spoke of an America divided between the “haves” and the “have not’s”, conservatives would do well to take note of another political division that appears to be opening up between those who engage in economically productive work and those who do not.

If society is to be wealthy and powerful, it must attempt to maximize the productivity of the resources at its disposal, including human resources. However, there are certain activities that do not produce anything of economic value. For example, a large fraction of government bureaucracy does not foster wealth creation, but rather monitors those who do create wealth through various regulations or transfers wealth from one place to another (think welfare or other government transfer payments). Although some of this activity is necessary, just as some overhead/administrative expense is a necessary cost of doing business in the private sector, it should be noted that overhead cost that exceeds what is absolutely necessary for the smooth functioning of any entity is essentially economically unproductive deadweight.

However, unproductive activity is not confined to government departments, but is also present in the private sector. For example, the overly complex tax code that results in Americans spending roughly $100 billion a year to ensure compliance helps to employ armies of CPA’s, tax attorneys, and tax preparers in the private sector (not to mention government clerks at the IRS). Given that the current amount of tax revenue could be generated through a properly constructed flat tax or consumption tax system, a certain fraction of these CPA’s, tax attorneys etc. are engaged in economically unproductive work. There is no real economic difference between the current system, and a system that would send $100 billion taxpayer dollars to unemployed CPA’s and tax attorneys that sat at home all day. Another example that the recent financial crisis brought into focus was the fact that many finance professionals were simply engaged in what is termed “churning assets” (simply moving financial assets from one financial institution to another). While some of this activity is necessary for the proper functioning of markets, too much of it results in some practitioners essentially being involved in economically unproductive work.

The underlying problem with the growth of government over the last generation, is that increasing numbers of people have been removed from doing productive work and have built entire careers on performing unproductive tasks. Attempts to significantly reduce the size and complexity of government have foundered because of the many interest groups that have built their structure on a system that happens to reward unproductive work. If conservatives are to have success in reducing the size and scope of government, then they will need to give voice and clarity to the idea that they are fighting the unproductive on behalf of the productive. The various proposals that they make need to be viewed through the lens of whether they will increase the productive workforce or the unproductive workforce. The battle over welfare reform was ultimately won by pitting those who worked against those who sat around. By promoting awareness of the difference between productive work and unproductive work over the long term, conservatives can set the stage for some radical spending reductions that will eventually be necessary to effect the smaller government that they favor.

Ben Bernanke: Four More Years?

While health care reform has received the lion’s share of media attention and analysis as the year comes to a close, the Senate is also taking up the very important matter of whether or not to confirm the reappointment of Ben Bernanke for another 4 year term as the Chairman of the Federal Reserve. While Bernanke’s confirmation is virtually assured given the Democrat majority in the Senate, there is one item that should give serious-minded Senators pause before casting a vote to confirm him.

While many people have been critical of Bernanke’s actions over the last 18 months, one must remember that he was dealing with an extraordinary set of circumstances. While mistakes were made, it is not at all clear that another Fed Chairman would have handled the crisis any better. Far more concerning, however, is that Bernanke appears to have politicized the Federal Reserve in a way that is unprecedented. One particular example occurred last October when Bernanke endorsed a Democrat version of fiscal stimulus, which effectively amounted to an endorsement of Obama, two weeks before Election Day. Historically, Fed Chairmen have always limited their actions in the months leading up to elections so as not to appear as if they are attempting to influence the economy one way or the other (which would invariably be to one Party’s advantage). While Fed passivity was not an option last election season due the magnitude of the global financial meltdown, endorsing a plan put forward by one of the political parties two weeks before the election was unnecessary. Come what may, Fed independence and the appearance of political impartiality is crucial to maintaining the effectiveness of its actions. It is worth noting that the Fed’s actions exert far more influence on the economy than any given President. Proposals floating around Congress to open the Fed to more congressional oversight are unwise as they would undermine this independence. A central bank that comes to be seen as nothing more than a tool of the political party in power has injected an element of political uncertainty into the decision-making calculus of investors and entrepreneurs. Uncertainty resulting from a politicized Fed will lead to increased instability in financial markets, and likely result in higher interest rates and capital costs as investors demand an increase in their prospective return to compensate them for the additional political risk. A higher cost of capital will lead to lower economic growth rates than would otherwise be the case.

While actions by the Fed have helped to avert a second Great Depression, it is not clear that politics is not influencing Bernanke’s actions. While he has found it easy to increase the money supply in the economy (quantitative easing) in response to the crisis, it is not clear that he will have the nerve to do what is necessary and contract the money supply to head off inflation, especially since this action will likely cause economic pain which will be to the Democrats disadvantage in the upcoming midterm elections. Actions that call the Fed’s independence into question serve to undermine a necessary belief that the Fed will make the best possible decision for the long term health of the economy given the available information. Serious Senators should consider this, and vote against confirming Bernanke for another term.

Healthcare: Price Controls and Shortages

As the final healthcare debate ramps up and certain moderate Democrats (and Joe Lieberman) become the last best hope for a bill that is something slightly less than a complete disaster, it is worth noting that underlying the scrambled mess that reform has become are some basic economic fallacies. The primary underlying problem is the purported view that rising healthcare costs have something to do with either the greed of the healthcare industry or some failure in the market. In this view, increased prices are a sign of moral failure rather than a signal that more economic resources are needed in the healthcare industry. Unfortunately, the rise in costs is not fundamentally a function of lawsuit abuse leading to higher malpractice insurance costs or a flood of illegal aliens crashing our healthcare system. While reforms in these areas would lead to some cost saving and are certainly worth pursuing, the primary drivers of increasing costs are increasingly effective technology and an aging population. All efforts at reform are bumping up against the reality that the population is aging at a faster rate than doctors are being produced (it takes years to produce a doctor or a new drug or a piece of innovative medical technology). This means that healthcare costs would be increasing in the absence of high medical malpractice insurance premiums and illegal immigration, and there is no reason to suppose that the same voices would not be calling for healthcare reform anyway.

Another problem that is being ignored is the effect of price controls, which is effectively what the healthcare bill is attempting to impose when everything is stripped away. While a purely market healthcare system would result in seniors paying a significant fraction of their income and assets to the healthcare industry as they aged (with the accompanying descent into old age poverty which makes this undesirable), government involvement that uses a system of effective price controls (even if it is in the form of a “public option” that artificially drives down prices) simply creates shortages. A staple of basic economics is that lower prices cause producers to produce less of a product. Setting prices artificially low results in less product being produced, but it also results in more of the product being demanded as well. While a government subsidy of healthcare bills for certain segments of the population (senior’s and the indigent) would lead to increased taxes (along with the associated economic cost), such a program would ultimately be less damaging in that it would lessen the political pressure for price control style reform, while allowing healthcare producers to obtain higher prices thereby leading to more healthcare being available.

In the current healthcare reform plan, it appears that we may end up with the worst of both worlds: an effective price control that produces shortages and a government plan that costs the taxpayers money to an extent that they can’t afford. A simple price control that was mandated by law would cause a shortage, but would not cost the taxpayer much. On the other hand, a subsidy of certain healthcare costs would cost the taxpayer money, but would have less of a shortage inducing effect. Unfortunately for the country, Obama has to have a bill and the Democrats control Congress. Even if the moderate Democrats can eliminate the worst aspects of any bill, the final product is going to be one that fundamentally ignores basic economic laws. As with ignoring the law of gravity, the outcome of ignoring economic laws is rarely pretty.

Risks And Opportunities For The GOP

With the Republicans fighting to prevent the wholesale government takeover of healthcare while looking towards the next election in 13 months, the political landscape is changing in ways that present them with some risks and some opportunities. While the last two months have been tough for the Obama Administration and the Democrats, Republicans who think that they can just sit back and let Democrat miscues carry them to victory next November are likely fooling themselves. While Obama’s approval numbers have dropped significantly since the beginning of summer, the Republicans have only really seen a modest improvement in their own numbers. Going forward, the Republicans face some serious, but not insurmountable, risks to their dream of recapturing one or both houses of Congress.

Firstly, the Republicans have not made any serious attempt to present an alternative health care reform plan. While they have been very successful pointing out deficiencies in the various plans and offering important suggestions for certain piecemeal reforms, the lack of a comprehensive reform package that they are willing to promote strongly and loudly makes the Republicans appear (whether fairly or not) that they are not really contributing any ideas. The Republican’s allowing themselves to be branded as the Party of No (as the Democrats will attempt to do) is not a strong argument for turning over the reins of government to them next November. A second risk is that the economy appears to be improving. While this won’t matter if unemployment stays high, the likelihood of unemployment going down increases as the economy improves. Ben Bernanke has generally not done a bad job considering the circumstances in which he was operating, and I don’t expect him to make a serious mistake that will negatively impact the economy over the short-term. An improving employment picture lessens the potential damage to the Democrats in next year’s election.

However, the recent shifting of the political winds has also presented the Republicans with some opportunities. Firstly, Obama’s radical lurch to the left has made the electorate more receptive to Republicans that at any time in the last five years. Secondly, in addition to the fact that off-year elections typically favor the party out of power, 49 Democrat House Members now sit in districts that were won by John McCain. While this advantage is tempered by the fact that 34 Republicans sit in districts won by Obama, that these Republicans survived the Obama surge makes it unlikely that many of them would be thrown out at a time when Obama’s popularity is hovering around 50%. Thirdly, Obama’s constant talking to the American people through various media appearances and press conference has likely overexposed him, meaning that people are beginning to tune him out. The fact that he has been shown to be untruthful regarding health care reform and his attempt to ram reform through without much debate in July and early August has likely damaged his credibility. Finally, an improving economy presents the Republicans with an opportunity to argue that the rest of the stimulus money (the majority of which has not yet paid out) should be canceled to save money. That this suggestion would be acted upon by Congress is unlikely, but it presents the Republicans with an opportunity to present themselves as more fiscally responsible than the Democrats.

If the Republicans are to win back Congress, they are going to have to present a coherent case to the American people that they should be given control. Although the political landscape is shifting in the Republican’s direction and will allow them to pick up some seats, it likely will not be enough by itself to carry them to a majority in at least one chamber. To take back one of the chambers, the Republicans are simply going to have to want it next November more than the Democrats and spend every moment from now until then working for it.

The Importance Of Federal Reserve Independence

As the Obama administration continues to shape the regulatory overhaul that is being conducted as a result of the financial crisis, one oversight measure that appears to have gained some support across party lines is giving the General Accounting Office broader authority to examine the Fed’s conduct of monetary policy. Of all of the actions that have been proposed in the aftermath of this crisis, decreasing the independence of the Federal Reserve by increasing congressional oversight is perhaps the one that has the potential to be most damaging to the long term health of the U.S. economy.

Contrary to popular perception, it is the Federal Reserve rather than the President that exerts the most powerful direct influence on the direction of the U.S. economy. While a President can propose policies and tax changes (which must then be approved by Congress), it is the Federal Reserve that controls the money supply and exerts influence on interest rates throughout the entire economy with no input from Congress or the President being required. The Fed uses monetary policy to try and fulfill two of its major goals which are to promote full employment and maintain price stability (i.e. mitigate inflation). Unfortunately, any action that the Fed takes to control one has the effect of exacerbating the other. For example, the Fed’s response to the current crisis has been to flood the U.S. economy with dollars (i.e increasing the money supply) in an effort to get the economy going again (and thereby increase employment). However, actions of this sort tend to increase inflationary pressures. At some point in time, it is likely that the Fed will have to begin contracting the money supply to combat inflation.

Given that the Fed must walk this tightrope, it is imperative that the Fed not be subjected to the political pressures that increased congressional oversight would likely bring. The power that the Fed exerts over the economy means that politicians will necessarily attempt to use their power to shape Fed policy actions in a way that the politicians believe will enhance their electoral prospects, rather than what is necessarily best for the long-term health of the economy as a whole. The potential for congressional meddling will inject another element of uncertainty into financial markets and business decisions as investors will need to engage in political calculations (along with the normal economic analysis) when making an investment/business decision based on macroeconomic factors. This additional uncertainty will likely lead to higher interest rates than would otherwise be the case as investors demand compensation for the additional risk, which will likely have the effect of lessening economic growth over the long run.

While there is no doubt that policy mistakes by the Fed (i.e. keeping monetary policy too loose for too long) helped to fuel the real estate bubble and contributed to the ensuing crisis, these mistakes were made while the Fed was trying to do the best job that it could in fulfilling its mandate. The idea that increased congressional oversight would improve monetary policy is doubtful at best. Federal Reserve independence is too important to be tossed aside in the political turmoil of a crisis period that will eventually pass. Increasing congressional oversight of the Fed is an idea that should be scrapped.

Obama’s North Korean Challenge

Over the last 2 months, the world has been treated to a familiar pattern of North Korean saber-rattling. From conducting a nuclear test, to firing off missiles, to declaring that it no longer considers itself bound by the 1953 armistice agreement, the North seems determined to see how far it can push Obama. In the past, bad behavior from North Korea has been rewarded with concessions in an effort to entice the government of Kim Jong Il back to the negotiating table. While the Obama team has been vigorously trying to blame the problems that the U.S. is currently facing on failings of the Bush Administration, few people believe that a Democrat administration would have done anything substantially different to try and stop North Korea from obtaining nuclear weapons. Indeed, Obama’s policy on this issue has been substantially the same as Bush’s was in the last two years of his tenure in office. Whether he realizes it or not, Obama’s foreign policy will be judged in large part on how he deals with North Korea.

If Obama wants to be judged more favorably than his predecessor on this issue, then he needs to accept some realities that many on both sides of the political aisle do not yet appear to have accepted. While the recent passage of a U.N resolution condemning North Korean actions signals Russian and Chinese displeasure with Kim Jong Il, those in the Obama administration who believe that it also signals that Russia and China intend to get serious about these issues are bound to be disappointed. What should be abundantly clear now to everyone is that China and Russia do not consider it in their interest to solve the North Korean issue. While the rest of the world would cheer a collapse of Kim Jong Il’s regime (like East Germany in 1989), neither China nor Russia (nor even really South Korea) relish that thought. Such a collapse would likely lead to a massive refugee exodus into China and South Korea , with all of the headaches that would result from it in the short run. In the long run, a reunited Korea would likely put a U.S. ally on China’s doorstep, something that China probably views as a threat. As for Russia, their foreign policy calculus seems to be “if it is good for the U.S., then it is bad for us”. Consequently, while they may not want to see an all-out war on the Korean peninsula, a nagging foreign policy problem that continues to be a distraction for the U.S. is probably seen as desirable by them.

Until Russia and/or China see that it is in their interest to disarm North Korea, they are probably not going to be much help in this endeavor. Consequently, the Obama administration needs to prepare for a Cold War-style containment/military preparedness strategy, with regime change as its ultimate goal. On the diplomatic front, the Obama administration should consider making diplomatic gestures in favor of rearming Japan. Not only would such a move send a message to North Korea (as they haven’t forgotten 40+ years of Japanese occupation), but it will also put China on notice that a no longer pacifist Japan may be welcome once again in the community of nations. A rearming of Japan in the face of the North Korean threat might just be the incentive that the Chinese (who also haven’t likely forgotten their own occupation by the Japanese) need to convince them to provide assistance in the removal of that threat.

In dealing with North Korea, success requires that the Obama administration be forceful and purposeful. Ironically, Obama has more leeway to be tough with North Korea, since the adoring media likely won’t unleash a storm of criticism and opposition like it would have done in response to tough actions by Bush. In dealing with this challenge, Obama has an opportunity to help his Party alter its image of weakness on foreign policy by accepting the current realities and making the proper decisions. On the other hand, if Obama decides to continue to operate under the fictions of the past, then he will deserve all of the criticisms that Republicans and others will heap upon him. The next few months should be very interesting.