A huge fiscal cliff looms at year-end when massive tax increases, equal to about 3 ½ percent of GDP, and large and arbitrary spending cuts take effect automatically if Congress doesn’t do something before then. You might say the question is whether they will put a fence at the top of the cliff or an ambulance at the bottom. Gridlock will amount to a vote for the ambulance.

This harsh, cold-turkey, approach to our fiscal deficit has the advantage of forcing the issue one way or another. If left in place, it will finally deal with the deficit in a meaningful way, but the cost is likely to be tipping our fragile economy into another recession. Our GDP and job growth have already slowed substantially, and the European albatross is likely to continue to bedevil us.

The tax increases will not only include ending the social security tax break in place today and additional taxes associated with health care reform, but it will include ending the marginal tax rate reductions enacted during the Bush administration. It’s not just the sheer amount of tax increases that will slow the economy, but the adverse incentive effect of higher marginal tax rates that will penalize work, saving and investment.

It may be politically incorrect to say so out loud, but higher taxes on capital gains and dividends, the latter to the same rate level as earned income, would be particularly destructive. Labor productivity and wages depend on the amount of capital labor has to work with. A higher capital to labor ratio means higher wages and income for labor.

Economists generally agree with this, but it is too counter intuitive for most politicians to touch. Instead, they are likely to fall back on the “fairness” argument—that corporations and those who earn dividends and capital gains should “pay their fair share.” This ignores, of course, the fact that taxes on dividends and capital gains are taxes on income that has already been taxed at the corporate level.

Some supply siders argue that higher taxes on any form of income is self defeating since it slows economic activity sufficiently to reduce the tax take to the government. My hunch is that at current tax levels, a higher tax on earned income, and perhaps dividends would increase the tax take but by much less than the percentage increase in the tax rates. That’s probably not true of a hike in the capital gains tax. Higher tax rates on capital gains would likely reduce the total tax collected since capital gains recipients have some control over if and when to realize the gain.

If the government really wanted to generate more tax revenue, the lowest hanging fruit is probably the corporate income tax, which, at 35 percent, is the highest in the world. A substantially lower corporate tax rate would reduce the incentive for American corporations to locate operations abroad and increase the incentive for them to bring their earnings back home.

Whether tax rate increases are totally self-defeating or only partially so, their cost in reduced economic activity is high relative to tax revenue gained. A much more productive way to tackle the budget deficit and debt problem would be to restrain the growth in government spending over time, especially by bending down the cost curves in entitlement programs. Putting sensible programs in place now that would restrain spending growth over time is much better than the cold-turkey approach at year end.

Jim was my first boss as Director of Research at the Federal Reserve Bank of Richmond. In retrospect, he was probably my best boss. He and his counterpart at another Federal Reserve Bank offered me similar jobs at identical pay during the hiring season in late 1967. The other job was closer to home, but the choice wasn’t even close. It came down to wanting to work for Jim.

I arrived at the Richmond Fed in August 1968 as its “international economist,” whatever that meant. It was a good field to have at an interesting time. The late 1960s and early 1970s were good for the career of an international economist. The balance of payments and exchange rates were making news, and the slow break-up of the Bretton Woods fixed-exchange rate system was under way. I was called upon frequently to write memos to the president of the bank, make presentations to the board of directors, and make outside speeches about the latest currency devaluation or revaluation or what was going on with the balance of payments and gold flows.

Milton Friedman was pushing floating exchange rates and saying that they would end the perpetual crisis. He was right. My time in the economics limelight declined when we floated and international issues faded. I was gradually given administrative responsibilities to take up the slack.

What made Jim Parthemos the perfect boss from my point of view was that he knew my strengths and weaknesses better than I did. His assignments usually involved a little stretch, but not too much. He knew better than I what I could handle and what I probably couldn’t. He protected me from total failure.

I guess I wasn’t the best economist, per se, in the department because early on he made me the editor of the economic review and other publications. He gave me his general vision for lines of research and articles and had me assign them and work with the authors to completion—a combination of some economics and lots of nagging and begging to meet deadlines. This meant that I did more rewriting than writing, which suited me because I doubted my creativity when the page was blank.

My semi-administrative role further morphed and I was given administrative responsibility for other departments in the bank and, eventually, in March 1980, was made the officer in charge of the Richmond Fed’s Baltimore branch.

When I arrived in Richmond in 1968, Jim gave me two pieces of advice. The first was that I should buy a house rather than rent temporarily as I had planned. That advice may not apply to these times, but it applied then. I took it and was glad I did.

His other advice had to do with investing my money. He simply pointed out that the younger you are the more you should invest in the stock market, and, as you get older, you should switch more into fixed income. I meant to take that advice, but I’m afraid that I found fixed income too boring, to my early delight and recent regret.

Jim was a gardener. He always recommended it to me as good exercise. I could never tell if he was serious. I conceded that it was probably good exercise for the soul, but I doubted it would do much for the body. He was 92 when he passed, so I may have been wrong about that.

Jim was a Greek from South Carolina. I was never sure whether he was born here or just came at an early age. In any case, he spoke the language and was steeped in its history—actually all history. He impressed me more with his knowledge of history than his knowledge of economics. That’s not to denigrate the latter. It’s just that, as an economist, he was, above all, a common-sense pragmatist rather than an ideologue of one kind or another against which his purity could be judged. We need a few more of those these days.

After Jim retired, he offered to take those of us interested for a tour of Greece. Those 16 days in Greece in 1988 turned out to be my first major foreign travel. Jim was the general guide, but he’d arranged for special guides for parts of the tour. I think of that wonderful experience every day that the Greek tragedy is in the news. Aside from all the highfalutin sites and lectures, two things I remember from that experience was that Amstel Light seemed to be the beer of choice, and American rock and roll was the background music.

Jim was a scholar and a gentlemen, through and through. I never heard him speak ill of anyone. A petty thought never entered his head. He was always there for his “young bucks” as he called us, including Al Broaddus who later became president of the Richmond Fed and shared all Jim’s characteristics.

It was Al that notified me of Jim’s passing. He reminded me that, when Jim reported back to us after FOMC meetings, he always began by saying the meeting hadn’t been very “edifying.” Given Jim’s high standards, I’m sure that was true for him, but I suspect it was also meant to ease our envy at not getting to attend ourselves. Later in our careers, Al and I became members of the FOMC, no doubt largely because of our early training from Jim.

Most of you never heard of Jim Parthemos, but, trust me, the world has lost one of its best.

I understand and agree (in my head) with the point, often emphasized by Warren Buffet, that the reds may be thought of as buying opportunities. Reds create bargains and give you more for your money than greens; so feel good about the bargains—the multiple opportunities to get in on the ground floor. Greens, logically, are only good at the end—whenever that is—when it’s time to cash in.

The above makes sense to my head, but other body parts react differently. I like greens better than reds, period. Therefore, I don’t like what happened to my JP Morgan Chase and some other bank stocks reacting in sympathy—red all over the place. On the other hand, my head tells me this is a buying opportunity. Maybe the smart move is to double down. I haven’t decided yet.

I guess you might say that my iPhone is marking my portfolio to market instantly and continuously. That’s okay, but I still must decide when to realize a loss or gain. I must confess: that’s my weakness. When they go up, my instinct is to let the gains build. When they go down, contrary to my expectation with I bought them, I’m inclined to wait for the inevitable rebound.

What struck me about Jamie Dimon’s announcement of a $2billion or so loss was his clear statement that it was a “mark to market” loss. In other words, it hadn’t been realized yet and it might get worse. Left unsaid was that it might also get better. The press has focused on the former possibility, but not the latter. Yet, the latter would be consistent with the rationale of taking the position in the first place.

So, while I must decide if and when to realize the loss, Jamie is deciding the same thing. Call it double jeopardy. I hope he doesn’t give in to the pressure out there to cave in no matter what. $2 billion, or $3 billion, or $5 billion is big in my world, but not his. These amounts are still fairly modest given the size of his balance sheet. It should be a normal business decision, and it could go the other way. But, either way, government investigations and Congressional testimony, when there is no reason to suspect wrong-doing, is destructive to confidence in our banking and free enterprise system. When will the bank bashing for political reasons stop? I like greens better than reds, but I pay my money and I take my chances. Mark to market is a journey, not a destination.

Is it possible for the sitting president who is up for reelection to manipulate economic figures in order to create a falsely favorable (to him) improvement, or must he rely on promoting a complementary interpretation with stated numbers for a better public image?

He and his surrogates will put the most favorable spin on the numbers, but I doubt overt manipulation. The Civil Servants who create the numbers are very smart people dedicated to producing the most accurate numbers possible and would make a major stink if someone tried to bias that process. The risks and consequences of doing so would not be worth it.

How does the Fed lower its balance sheet?

The Fed shrinks its balance sheet when it sells assets, allows them to mature without replacing them, has loans repaid.

The total assets on the Fed’s balance sheet grew from roughly $800 billion just prior to the financial crisis to just under $3 trillion. The growth was larger than it might have been because the traumatized banking system held onto the reserves created by the Fed rather than making maximum use of them in making loans and investments which create deposit money. The economy and financial system has adjusted to the Fed’s current balance sheet. It won’t be advisable to shrink it until more vigorous lending by the banking system threatens to be inflationary. At that point the expansion of the “money multiplier” will need to be partially offset by the Fed draining reserves, i.e. shrinking its balance sheet.

How much control does the Fed have on interest rates.

It has pretty close control over the Federal funds rate and other very short-term rates. It’s influence (rather than control) over longer term rates depends on market sentiment, which, in turn, is based on economic conditions. Lately, economic circumstances and the credibility of the Fed have given it pretty much influence over longer term rates. That is the point of Mr. Bernanke promising low rates for an extended period of time. If that is believed, longer term rates stay low, as in a 2 percent rate on a 10 year bond. If growth and/or inflation pick up substantially, that rate will rise (and longer rates will rise more) whether the Fed likes it are not.

Recently, Bernanke made some very dovish comments which seems to favor the current political party . . . is the Fed chief politically inclined.

The Fed chief always wants the best economy possible and sustainable; so one might say that it favors incumbents. But, remember that while Mr. Bernanke was reappointed by the Democratic President, he was originally appointed as a governor and later as Chairman (and to the Council of Economic Advisors in between) by a Republican president. He wants the best legacy possible for himself regardless of which party might share the credit.

What was the most interesting/unusual experience you had as a FOMC/Bank President?

On a recurring basis, the most interesting aspect of the job was the FOMC meetings about every six weeks and the preparations with my economists leading up to those meetings. Budgets, other meetings, personnel issues, operation issues were all less fun. I enjoyed particularly some of the creativity we brought to our annual reports. For example, one year I included a picture of myself visiting three graves: Buddy Holly, Adam Smith, and Sam Houston.  There wasn’t room for Evita.

How will the EU troubles, specifically Spain’s, potentially manifest themselves in our economy? What is the best fix? What correlations are there between our own fiscal policy/economic conditions and those of Spain, Greece, and Portugal?

Countries are tied together through both trade (imports and exports) and financial transactions such as bank loans security holdings and the like. As southern Europe drags all Europe into recession, European demand for U.S. exports will decline, thus affecting our exporters. Some U.S. banks may own European sovereign debt, or private debt, and U.S. mutual funds may as well. This train wreck has been so slow moving that I assume that banks and mutual funds and money market funds have lessened their exposure substantially. I don’t expect the direct impacts on us to be substantial. The worrisome thing, however, is the absence of a reasonable way out of the European mess and the jeopardy it puts the Euro in. So far the “remedy” imposed by Germany as a condition to helping financially has been austerity. Austerity measures are shrinking the indebted economies, which hardly helps them with their debt. They need specific measures to curb government borrowing combined with measures to produce economic growth, presumably structural measures like labor market reform, etc. There is no easy way out. Asset sales, or privatization, would generate government revenue without shrinking the economy, but I don’t know what is available to privatize. If they were a family, selling the family jewels would be in order.

Do we ever worry about inflation again?

Yes, but right now, based on recent and current policies, inflation is not a “clear and present danger.”

What will the Fed look for to actually tighten monetary flows/economic policy.

Right now the Fed’s dual mandate is skewed. Inflation is slightly above the official target, but isn’t likely to accelerate soon, while unemployment is far above the implicit target, whatever that is. The Fed will start easing off the accelerator when those to goals are more evenly achieved. Faster GDP growth and faster employment growth will set the stage for an eventual change in policy.

What key indicators have traditionally signaled a healthy, robust economy that is vital and independent of monetary injections or government subsidy?

I would vote for entrepreneurialism, which the government can’t do much to promote except stay out of the way. A related statistic would be rapid productivity growth, or more output per unit of input, or output per hour worked. Rising productivity is what gives us a higher standard of living, but in the very short run it competes with employment growth.

What do you think of Texas A&M’s move to the SEC?

Beats me. I asked the President of A&M by phone the other day (a good man, by the way) and he said it was a long story.

“Twas a dangerous cliff, as they freely confessed,

Though to walk near its crest was so pleasant;

But over its terrible edge there had slipped

A duke and full many a peasant.

So the people said something would have to be done,

But their projects did not at all tally;

Some said, “Put a fence around the edge of the cliff,”

Some, “An ambulance down in the valley.”

In the remainder of the poem, they had quite a debate back and forth over which was preferable: a fence to prevent the falls or an ambulance to haul them off. In the end, the fence barely won out. From present indications, I’m not so sure we’ll be that lucky.

The price index for gross domestic purchases increased at a rate of 2.4 percent, compared to only 1.1 percent in the fourth quarter—not overly large, but headed in the wrong direction.

Personal consumption expenditure increased faster in the first quarter than overall GDP. PCE grew at an annual rate of 2.9 percent in the first quarter, up from 2.1 percent in the fourth. Unfortunately, real nonresidential fixed investment declined at a 2.1 rate in the first quarter after increasing at a 5.2 percent rate in the fourth. A healthier balance would have been more investment and less consumption (more saving). Perhaps this is made up by the declines in real federal government spending in both quarters–5.6 percent in the first quarter after a decline of 6.9 percent in the fourth.

External trade was a mild positive to GDP growth in the first quarter after having been a mild negative in the fourth. Real exports of goods and services increased 5.4 percent in the first quarter, double the 2.7 increase in the fourth, while real imports increased 4.3 percent after increasing 3.7 percent.

All in all, the first quarter will be reported as weaker than the fourth, but I would argue it was actually stronger—but, of course, not nearly strong enough.

This long week-end might make a fascinating topic for classroom discussion, whether led by efficient market theorists or behavioral economists or cab drivers. Do you remember the old song lyrics: “I was looking back to see if you were looking back . . .”? A chain of reasoning is a little like spelling Mississippi. You never know where to stop.

Simple answers without too much analysis are probably best. The job numbers were bad; so, the market will tank. On the other hand, surely no one expected the proverbial straight line improvement month after month, and we all knew the employment numbers were getting ahead of the underlying GDP numbers. If you didn’t know that, you should have because Gentle Ben told us. So, maybe the three-day cooling-off period will allow cooler heads to prevail.

Or not!

Bank of America, for example, acquired Merrill Lynch and Countrywide, the latter much to its sorrow given the many problems that came with it that still plague Bank of America. Chase grew, in part, by acquiring Bear Sterns and Washington Mutual, with both acquisitions supported by the government. Wells Fargo acquired ailing Wachovia. One thing these acquisitions had in common was that had they not been made by the acquiring banks, the government probably would have had to do it itself. Indeed, the government and the banking regulators encouraged and assisted these transactions, or, should I now say aided and abetted.

The case of Bank of America seems particularly unfortunate since it had buyer’s remorse regarding Merrill, but was “encouraged” by the government to go through with the deal anyway. I suppose the law requires an acquirer to be responsible of the debts and deeds of the acquiree, but the alacrity with which Bank of America has been vilified, threatened and sued for the sins of others that might have been inherited by the government seems unseemly to me.

I own stock in the banks mentioned above as well as others. Large bank stocks are undervalued, you know.

The second and third estimates both had real GDP growing at an annual rate of 3 percent in the fourth quarter, the largest growth rate of last year. Unfortunately, they also both showed that inventory accumulation, a.k.a “inventory investment” accounted for almost two-thirds of the growth. Removing the inventory buildup left real final sales up at only a 1.1 percent annual rate, well below the satisfyingly round headline number of three percent.

By contrast, inventory liquidation actually pulled down the headline estimate in the third quarter, making it a stronger quarter in terms of real final sales than the fourth. Real final sales in the third quarter were up 3.2 percent, above the headline real GDP number of 1.8 percent. While acknowledging that the reasons for inventory accumulation make them tricky to interpret, I would nevertheless argue that the economy weakened considerably in the 4^th quarter of 2011. We’ve all been so hungry for good news that most have chosen not to notice the setback

Here’s how the WSJ put it in the first two paragraphs of its story on March 8:

“Federal Reserve officials are considering a new type of bond buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead.

Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up the money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation, a fear widely expressed by critics of the Fed’s previous efforts to aid the recovery.”

The odd thing is that unintended sterilization is exactly what happened during the so-called QE1 and QE2. The Fed purchased bonds, which created an equal amount of bank reserves and deposits (money). Normally, because of fractional reserve banking, this would lead to a further multiple expansion of bank deposits and the money supply. That mostly didn’t happen because the banks held onto the excess reserves created rather than lend or invest them. Multiple money expansion did not happen and expectations of accelerating inflation were not met.

Banks now get a 25 basis point interest rate return on their reserve deposits with Federal Reserve Banks, including their excess reserves. So, in effect, the Fed has already been borrowing them. Those reserves are assets to the owning banks but are liabilities of the owing Fed. In other words, these reserves created by QE1 and QE2 have already been largely sterilized by the Fed borrowing them back at low rates. This is why the Fed’s operations haven’t been as effective as hoped in stimulating the economy nor as inflationary as the critics feared.

In addition to the unintended sterilization of bond purchases under QE1 and QE2, the more recent “operation twist” is on its face a sterilization effort—that is purchases of longer dated debt is matched by sales of shorter dated debt. That doesn’t just sterilize new reserves; it avoids creating new reserves.

By the way, I believe the word “sterilization” got the meaning we are using for it in this context in foreign exchange intervention. If a central bank buys foreign currency to hold down the exchange rate of the domestic currency, it creates more domestic money. Central bank net purchases of any asset, or services for that matter, tend to create money. If more money creation is considered not desirable then the purchases of foreign exchange are matched by sales of some other asset, usually bonds, hence offsetting or “sterilizing” the purchases.

The WSJ report said that the Fed hoped to “subdue worries” about future inflation, not prevent future inflation. In other words, it would sterilize in some different way just to give a greater appearance of sterilization. I know it must be frustrating for the Fed to have it’s critics continue to charge that it is stoking inflation while inflation falls instead, but I would think Mr. Bernanke could find a way to explain the sterilization that is already taking place and not have to create a new program simply for the optics that has the same effect.

The WSJ article did not quote any sources by name, but the tone implied that the author got his information from some Fed policymaker. I’m surprised and disappointed that such a conversation took place and also disappointed that Fed policymakers seem to be actively planning a new round of quantitative easing. While it’s important that they keep the balance sheet growing slowly to provide for continued modest money growth, that can be done without a new Q program. What they should be focused on, in my opinion, is how to allow interest rates to rise a bit in the context of a generally accommodative policy. Interest rates have already been too low for too long in my opinion and the end of 2014 is a long time more.