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Bloomberg ran an article last month in which Boston University economics professor Laurence Kotlikoff makes what appears to be a hugely important argument. In his words, the US is bankrupt. To be perhaps a little more literal but no less disturbing, US fiscal policy is on a path that is profoundly unsustainable. His conclusion is that this will eventually end in one or more of three ways –

The first possibility is massive benefit cuts visited on the baby boomers in retirement. The second is astronomical tax increases that leave the young with little incentive to work and save. And the third is the government simply printing vast quantities of money to cover its bills.

Most likely we will see a combination of all three responses with dramatic increases in poverty, tax, interest rates and consumer prices.

A large part of his argument is based on the impact of rising Social Security and healthcare expenses on the federal deficit and he draws his conclusions largely from analysis contained in two documents –

• The Congressional Budget Office’s 2010 report The Long Term Budget Outlook.
• The International Monetary Fund’s 2010 report United States: Selected Issues Paper (especially Section VI. The US Fiscal Gap: Who Will Pay?).

Each of these reports looks at a couple of different future scenarios for government spending and revenue. I’m currently reading both of them to try to understand and evaluate Kotlifoff’s position.

Incidentally, Kotlikoff is also an advocate of the ‘FairTax‘ reform proposal (essentially replacing all income taxes with a retail sales tax) and also the idea of ‘Limited Purpose Banking‘ (essentially forcing banks to become pure mutual funds and take on no risk of their own).

If you’ve read my “About Me” page linked over on the right hand side, you might recall me writing this –

…I am wholly unimpressed by those who try to dismiss others’ views simply on the basis of a supposed consensus of so-called experts, whether they be scientists, economists or anything else. My goal is to make up my own mind about issues based on my own assessment of the relevant data, not based on someone else’s rhetoric, no matter how much of an expert they claim to be.

Nouriel Roubini followed up the comments at Zeitgeist that I referred to on Thursday with an article yesterday in the Washington Post, again advocating a temporary (two year) cut in payroll tax.

Part of his argument is that some of the recent policy proposals from the Obama administration, such as tax credits for R&D and accelerated write offs of capital expenditure, subsidize demand for capital, whereas he believes that capital expenditure has already been accelerating quite well. However this expenditure essentially allows production to increase without a need for additional hiring.

Payroll tax reduction for employers on the other hand would subsidize the cost of labor and encourage hiring. Additional smaller payroll tax reductions targeted towards lower income employees would provide a boost to consumption while also allowing some household de-leveraging.

In order to make such a plan deficit neutral, he favors paying for it with the expiration of the Bush tax cuts on those earning more than $250,000. He argues that since many of those people are also employers, such a tax increase should not be viewed as penalizing the wealthy. Essentially, for wealthy business owners, he takes with one hand (higher income taxes) and gives with the other (lower payroll taxes).

From his comments at Zeitgeist, I know that Roubini believes that investments in capital that increase productivity are the ultimate source of growth. However I realize his concern here is with protecting the economy and household incomes in the near term. Essentially what I think he wants is to give the economy time to make necessary structural adjustments, but minimize the pain for individuals in the meantime by creating a nett transfer of income from the wealthy who do not own businesses to lower income employees and those currently unemployed.

His proposal makes sense to me, and I think it probably would alleviate some of the current weakness in the economy. However, as a general rule, I dislike policies that seem ad hoc – I prefer policies that explicitly codify clear principles in a straightforward way and provide transparency in exactly what economic costs are being borne by whom. Neither of these is really evident to me here. However, frankly, these are concerns I have about the tax system as a whole, and it’s probably not fair to try to judge a short term proposal like this by standards that the system as a whole doesn’t meet either.

Christopher Rugaber of AP had an article published in a number of outlets yesterday noting that some economic indicators seem to have stabilized in the past month and deflation seems to be less of a danger.

However, what caught my eye was this paragraph –

Also Thursday, the Commerce Department said the broadest measure of the U.S. trade deficit widened for the fourth straight quarter. The current account trade deficit grew to $123.3 billion in the April-to-June period, a 12.9 percent increase from the first quarter. A year of growth could be viewed as a healing sign for the U.S. economy as Americans slowly regain their appetite to spend. That pushes up imports and widens the current account deficit.

(Here is the news release from the Commerce Department).

The notion that an increased current account deficit may be a healing sign for the American economy is surely one of the goofier statements I’ve read lately. Rugaber evidently believes that Americans’ appetite for spending is a good thing. That’s part of what got us into this mess in the first place!

The fact that someone would think that healing the US economy means going back to doing what we were doing before the crisis strikes me as kind of depressing. As Roubini said, we have to spend (consume) less and save (invest) more.

Incidentally, the total deficit for the four quarters to June was $430.9 billion, or around 3% of GDP.

I’ve been watching a video of a couple of interesting presentations by Jim Wolfensohn and Nouriel Roubini at the US Zeitgeist Conference. Here are some of the key points they made –

Wolfensohn

• His main point was that global economic power is moving from the US towards Asia, notably China and India, to a much larger degree than most people recognize, and national leaders are doing nothing about it.
• The wealthy countries’ share of global GDP, historically around 75-80%, has dropped in the past decade by some 10%.
• A critical need in the US is for them to recognize that they are losing ground and to give more emphasis to creating a more well-educated workforce that can compete effectively with Asia. We must deal with the budget deficit.
• He noted that the countries with the greatest foreign reserves are: China – $1.5 trillion, Japan – $1 trillion, Russia – $440 billion, Taiwan – $348 billion, India – $287 billion, South Korea – $270 billion, Hong Kong – $256 billion, Brazil – $241 billion. The US budget in contrast is in bad shape, heading towards debt of 100% of GDP by 2020 to 2030.

Roubini

• His presentation (the main part of which starts at about 19:45) was on the outlook for the US and global economy. I thought his talk had more substance than Wolfensohn’s. Although mainly focused on the medium to long term, he also made some interesting remarks about the current situation and potential policy options. His overall message was that although there are significant positive opportunities for the long term, in the near term if we don’t address serious national and trans-national problems the potential benefits of those opportunities will be not be realized.
• The stimulus was necessary and successful in averting a more serious economic meltdown. However the economy is not out of the woods. De-leveraging has barely started, especially given the massive re-leveraging of the public sector (he suggests a debt of 120% of GDP in a few years). It is inevitable that recovery will be anemic for an extended period.
• There are several reason’s for optimism about prospects for the world economy in the medium to long term – notably (i) globalization (trade in goods and services, global supply chain, mobility of capital and labor, outsourcing, spreading on knowledge), (ii) emerging economies (higher growth, less leverage) and (iii) technological innovation.
• In the long run economic growth comes from improved productivity which depends critically on technological progress, even though we can’t know in advance which areas of technology will eventually yield the most important increases in productivity (alternative energy, life sciences, nanotechnology, telecom, media, IT).
• A shift of economic and political power is taking place from advanced economies to emerging market economies, leading to a multi-polar world.
• The rise of emerging economies will be positive for the world economy in the long run, but in the near term globalization also brings challenges – falling wages of unskilled workers and greater income inequality in advanced economies, higher commodity prices, a global savings glut and current account imbalances. Therefore globalization needs to be managed to make sure that it is good for all and to prevent trade and currency conflicts.
• The Anglo Saxon pure laissez-faire economic model has failed, as has the European social welfare model while the success of the Asian economic model is not yet clear.
• There has been an absolute decline in the performance of the advanced economies, not just relative to the emerging economies.
• Japan has never undertaken the structural reform it requires due to a blocked political system. It is in secular long term decline.
• Failure by the Eurozone to address their problems through coordinated action risks either a breakup of the Eurozone or sovereign default.
• In the last 30 years, the US has only had high growth in ways that have created bubbles – real estate in the 80’s leading to the Savings and Loan crisis; the technology bubble in the 90’s and the sub-prime bubble in the 2000’s. The outcome is that we have crumbling infrastructure, a low skilled workforce, a high fiscal deficit and current account deficit and unfunded liabilities due to aging of the population. Can the US grow in a way that is sustainable?
• We have a culture of instant consumption, a lack of savings, growing income inequality, political stalemate and an attitude of isolationism in immigration policies and attitudes towards Muslims.
• The problems in the global economy are global, but the policies are national. We need global coordination on issues such as trade, the environment, scarce resources, finance stability, current account imbalances, security and peace. However this coordination does not exist.
• We lack a superpower able to force these issues – the US is in decline, others are free-riding – China is free-riding on currency, climate change and political issues. India is free riding on trade
• If don’t resolve these problems in short term we won’t achieve the potential long term benefits of globalization.
• Regarding the current economic situation, the Fed has run out of bullets. Banks have a trillion dollars in reserves but still aren’t lending, so even more quantitative easing won’t help. Another 840 local banks are likely to fail resulting in a further credit crunch. Printing more money will not help much.
• We have to address the budget deficit in the medium term by cutting entitlement spending and raising taxes. If we do not, the ‘bond vigilantes’ will eventually wake up. He recommends a temporary (2 year) cut in payroll tax funded by increased taxes on the wealthy. He believes the current problem is not a lack of investment but the cost of labor.
• We must consume less, save more and de-leverage the public sector. It will be a hard slog. Spending now is only stealing demand from the future. Cutting spending will slow down growth, but it has to take place.

In his Friday press conference, President Obama made some comments about the causes of the recession, both in his opening remarks and in response to the first question from the press. You can see it here –



Starting at 8:22, talking about the policies of the previous administration he says this –

These policies of cutting taxes for the wealthiest Americans, stripping away regulations that protect consumers, running up a record surplus to a record deficit, those policies finally culminated in the worst financial crisis we’ve had since the Great Depression.

It’s not surprising that he would want to tie the entire financial crisis to the the Bush administration and without doubt plenty of blame rests there. However, over the last week I’ve been reading Mihm and Roubini’s Crisis Economics, which addresses in Chapter 3 precisely the issue of the causes of the economic crisis, and they paint a much more complex picture that doesn’t really match the President’s diagnosis very closely. Let me try to briefly summarize their account here…

They maintain that the financial crisis was caused by a combination of six primary factors:

1. Financial innovation – the practice by banks of creating and selling mortgage-backed securities emerged in the 1970’s and became more and more prevalent over the decades that followed. This resulted in two things: (i) a reduced incentive for the original lenders to ensure that their borrowers were in a sound financial position, (ii) difficulty assessing how risky these mortgage backed securities were, which led to excessive reliance on mathematical models that turned out to be highly optimistic.
2. Moral hazard – employees of financial firms responsible for dealing in mortgage, investment and insurance products had more to gain by making short term profits than by taking seriously the medium to long term risks of these products. This was accentuated by the magnitude of bonus payments available to these people. Further, because financial firms were themselves so highly leveraged, their own shareholders had little incentive relative to the total assets of the companies they owned to exert any discipline on them. Even more importantly, creditors who loaned money to these companies also lacked incentive to force them to moderate the risks they took because of (i) Government-run deposit insurance schemes and (ii) an assumption that the Government as lender-of-last-resort would always bail them out if things turned very bad.
3. Government action and inaction – (i) excessively loose monetary policy, notably by Federal Reserve Chairman Alan Greenspan in the wake of the dot-com crash of 2000 leading to the housing and mortgage bubble later in the decade. (ii) Alan Greenspan’s failure to use the provisions of the Home Ownership and Equity Protection Act of 1994 to regulate subprime lending and crack down on predatory lending. (iii) the Financial Services Modernization Act of 1999 which repealed the Glass-Steagall Act of 1933, enabling finance companies to combine investment banking, commercial banking and insurance businesses. (iv) the Commodity Futures Modernization Act of 2000, which eliminated regulation of much of the derivatives market, including credit default swaps that provided insurance against defaults on complex mortgage-backed securities. (v) Government subsidies for home ownership in the form of tax deductions for mortgage interest payments and property payments and the involvement in the mortgage market of government-sponsored enterprises such as Fannie Mae, Freddie Mac, the Federal Housing Administration and the Federal Home Loan Banks.
4. Shadow banks – From the 1980’s onward a wide range of non-bank investment vehicles emerged that typically financed themselves with predominantly short term debt but invested in long-term illiquid assets. These entities were not subject to the risk-limiting regulations that banks must submit to and were not eligible for deposit insurance or lender-of-last-resort support from the Federal Reserve. Yet they grew in the amount of money they lent to rival the conventional banking system.
5. Foreign cash – a surplus of savings in a number of other countries, notably Japan and China, found its way into the US where they were used to purchase both Government bonds and private securities. The authors suggest that “40 to 50% of the securities generated by US financial institutions ended up in the portfolios of foreign investors”. This ‘easy money’ fueled a boom that enabled Americans to live beyond their means for a very long time.
6. Excessive leverage – Over a period of several decades there was a huge increase in the level of debt in all parts of the economy. It’s worth quoting some of the numbers the authors mention in order to underscore this point – Bank leverage increased by 50% from 1960 to 1974. From 1981 to 2008, private sector debt increased from 123% of GDP to 290%. Of that, corporate debt increased from 53% to 76% of GDP, household dept from 48% to 100% (in 2007) and the finance sector’s debt from 22% to 117%. Further, much of this debt was compounded in ways that were difficult to recognize – people borrowed to invest in entities that would themselves borrow more, and so on. The result was a financial system that was incredibly sensitive to a drop in asset prices.