As Mark Gongloff noted in a column for the Wall Street Journal, “…what the U.S. really needs, if it seeks a real fix to its energy consumption problem, is less demand, not more. Mr. Market says there’s a simple way to do that. Jack up the gas tax. Don’t lower it. Economists call it a ‘Pigovian Tax‘, in honor of the English economist Arthur Pigou, who early in the 20th century examined economic activity that hurts innocent bystanders. To stop behavior that’s not in the public good, you tax it more, not less.

“Of course, a higher tax would hurt working-class Americans who rely on their cars, though other taxes, like the federal payroll taxes or state sales taxes on food, could be lowered to offset it.”

Gongloff then explained that Harvard economist Gregory Mankiw, President Bush’s former chief economic adviser, has proposed increasing the “gas tax” by ten cents a year for ten years in order to give the economy time to adjust. According to Professor Mankiw, who belongs to the Pigou Club, a pro-”gas tax” group, higher gasoline taxes “should lower world oil prices”, as higher prices would curtail demand considerably.

Despite my usual serious reservations about increasing taxes in order to curb demand, I would support higher gasoline taxes in the US (or tax incentives for energysaving engines and heavy penalties for gas-guzzling vehicles) because its implementation would be simple and the revenues obtained from higher gas taxes could be used to improve the entire transportation infrastructure. In particular, a better public transportation system would improve the energy efficiency of the country and lessen its addiction to imported oil. It should also be noted that the US has one of the lowest gasoline taxes in the world

In addition, opinion leaders are increasingly skeptical about the lies dished out by the government. Thomas Friedman opines that Americans “need a president who is tough enough to tell the truth to the American people. Any one of the candidates can answer the Red Phone at 3 a.m. in the White House bedroom. I’m voting for the one who can talk straight to the American people on national TV - at 8 p.m. - from the White House East Room.” And Gongloff concludes that, although higher gas taxes would have all sorts of desirable effects, unfortunately, increasing them “doesn’t win elections. And the only market that matters now is the one for votes.”

At the same time, investors and strategists are becoming more and more skeptical about the economic statistics published by the various agencies. The employment, inflation, and GDP growth figures are highly suspect. According to Martin Feldstein, a former chief economic adviser to President Reagan and now a Harvard economist, “misleading growth statistics give false comfort” because “monthly data since January indicate that economic activity and GDP have been declining since the start of the year” (Financial Times, May 7, 2008).

Feldstein opines that “…although the tax rebates now underway may provide some temporary help, the combination of falling real incomes, declining household wealth and a dramatic drop in consumer confidence suggests further falls in consumer spending and GDP. But the most serious risk is that the rapid fall in house prices - down 12% in the past year and falling at a 25% rate in the past three months - will raise the number of negative equity mortgages, leading to widespread defaults and foreclosures. Because US mortgages are “no-recourse” loans (lenders have no recourse to the house’s owner beyond the value of the house) individuals with negative equity have an incentive to default. There are now an estimated 8 million negative equity mortgages - more than 15% of all outstanding mortgages. Defaults are rising and foreclosures are now at twice the rate of a year ago. A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades.”

According to Feldstein, the government should intervene to “prevent positive-equity mortgages from becoming negative-equity mortgages”. In other words, Feldstein proposes that the government should support the real estate market “by providing low interest loans with full recourse that would allow any homeowner to pay down a significant fraction of his mortgage. Homeowners would be in effect giving up the potential to default on their mortgage loans in exchange for lower interest costs.”

There are, however, some problems with Feldstein’s proposal. For one, it is likely that the majority of homeowners who are burdened with the estimated 8 million negative-equity mortgages (I have seen figures which suggest that there are 15 million negative-equity mortgages outstanding) also have negative-equity car loans and large credit card debts - in short, they have no equity to start with. So, in these cases, “full recourse” loans wouldn’t serve their purpose and would instead amount to a marketdistorting direct government subsidy of imprudent borrowers at the expense of taxpayers. Second, I wonder how Mr. Feldstein would propose supporting the market for unsold condos. In buildings with five to nine units - like a large number of garden apartment buildings - the condominium vacancy rate is at an unprecedented 15.2%. That is up from 12.2% at the end of 2007; whereas prior to 2006, it never exceeded 10%. (For rental units, the vacancy rate is even higher.

According to Floyd Norris, chief financial correspondent with the New York Times, 25.2% - one in four - of the housing units built since 2000 are vacant.) Finally, I very much side with Mrs. Moneypenny who, in a witty Financial Times column dated May 3, 2008, argued that the UK government should not intervene in the housing market, because falling home prices “might be painful for some but what about the benefit for many others? What nurses and teachers and first-time buyers need is for prices to come down.” According to Mrs. Moneypenny, it is not an acceptable excuse from investors that they had not read the disclaimers. “I suspect that borrowers of 110% mortgages are in many cases young and naïve and, in their enthusiasm to buy property, had not read the disclaimers. That’s not an acceptable excuse either. Husbands should carry disclaimers. Your marriage may be at risk if you insist on rationing golf, or some such incomprehensible activity.”

Mrs. Moneypenny then explained that a friend of hers wanted to leave her husband because she found him irritating and because he hardly ever had sex with her. However, “if irritation with one’s husband and a lack of sex were reason enough to walk out, the divorce rate would go through the roof,” she wrote. She told her friend to “hang in there”, because if she went back to the open market and found another husband, how would she know that he would be less irritating and would want to have more sex? “[M]arriage is frequently embarked upon when you are young and naïve and don’t weigh the risks,” she wrote. “But there is no regulator or government that will save you from the pain if it goes wrong. And neither should there be. Any more than for people who take out 110% mortgages.”

Well put! Governments and their agencies around the world - not just in the US - have created asset bubbles by keeping interest rates artificially low and through lax regulatory oversight, which has encouraged the purchase of all sorts of assets with high leverage. These governments should not now compound their earlier mistakes by supporting asset markets with even lower interest rates and fiscal measures in order to prevent the market mechanism from clearing properly at the lower prices. After all, and as Mrs. Moneypenny suggests, there is usually no - or little - mention in the discussions of markets that “inflated asset markets” are making it expensive and difficult for first-time buyers to acquire assets without high leverage. In this respect,

I should like to point out that throughout the 1970s and even most of the 1980s, less than 30 hours of work (total private hourly earnings of production workers) were required to buy one S&P 500. Now, however, despite some decline in this number from its peak in 2000, it requires 78 hours of work to buy one S&P 500. I suppose that, over time, the S&P 500 and other asset markets will adjust to the downside and again become more affordable, or that hourly earnings will increase significantly (inflation).

I would also like to make the point that if the government and its agencies support the equity and residential property markets, a case could be made for it also to support, in future, the prices of commodities, commercial properties, and art and collectibles. In fact, I am concerned that investors haven’t paid sufficient attention to the problems that could arise should these markets decline meaningfully.

Dr. Marc Faber
The Daily Reckoning