Transcript of "Lost Decades: The Making of America's Debt Crisis and the Long Recovery"

Washington, DC

Friday, October 14, 2011


GEORGE AKERLOF, International Monetary Fund


MENZIE CHINN, University of Wisconsin, Madison, Econbrowser

JEFFRY FRIEDEN, Harvard University

GAIL COHEN, Joint Economic Committee of the U.S. Congress

DIANE LIM ROGERS, Concord Coalition

SIMON JOHNSON, Massachusetts Institute of Technology, Peterson Institute



Great Recession may cost US economy $5,900 billions

by Gavyn Davies

October 23, 2011 4:11 pm

It has become commonplace for economists to attempt to “nowcast” the growth rate of real GDP from the dozens of sources of activity data which appear during the quarter.

Lately, most of these estimates have suggested that US real GDP has risen at a fairly healthy rate during Q3. For example, Dave Altig at the Atlanta Fednowcasts” that the growth rate may be as high as 3.2 per cent when the official estimate appears next Thursday.

This compares to an average growth rate of only 0.8 per cent in the first half of the year. Although much or all of the rebound has probably been due to temporary factors (notably the improvement in Japanese component supply after the earthquake damage in Q2), it will support the Fed’s expectation that growth will recover somewhat from now on.

However, we need to view this small improvement in the context of the much less satisfactory picture which emerges from a longer term perspective. The Wall Street Journal points out that the level of US GDP remains 6.7 per cent below the CBO’s estimate of potential GDP, which means that the economy could be producing $900 billion more per annum without risking higher core inflation rates. Furthermore, Dave Altig reckons that, at the current pace of job creation, the unemployment rate will remain in a 9-10 per cent range until at least 2017.

The truth is that the US economy seems, at best, to be stuck on a long term path which is very similar to the one which has been followed by previous economies which have suffered deep recessions, along with severely damaged financial sectors. Goldman Sachs recently published the following graph, which tells the story:

The peak-to-trough drop in US GDP relative to trend (ie the change in the output gap) was around 7 per cent in the recent recession, which is slightly larger than the average of 24 recessions associated with housing and financial busts in developed economies since 1970, but is slightly less than the five worst examples. The sluggish and bumpy recovery which the economy now appears to be experiencing is also broadly similar to these previous examples.

If the US is following these past templates, what can we expect to see happening next? One attempt to answer this question was given in a paper from economists at the University of Houston, presented last week at the Boston Fed conference on the long term effects of the Great Recession. This paper contains a statistical analysis of slumps in developed economies, and asks how long it typically takes for these slumps to end. (The end of a slump is defined as occurring when the underlying growth rate of the economy has returned to normal, and the level of output has returned to trend.) The Houston conclusion from previous comparable cases is that, on average, it takes about nine years for this type of slump to end. If that offers any guidance to the current US case, the future for real GDP (expressed in natural logs) might look something like this: 

The good news contained in this graph is that the implied rate of real GDP growth is fairly high, at around 3.8 per cent per annum for the next 5 years. This simply follows from the fact that growth needs to be consistently higher than normal if GDP is to return to trend by 2016, given that the GDP trend is assumed to grow continuously at 2.3% per annum. Encouragingly, this is the path which other economies have managed to achieve in similar circumstances, even though they have been suffering from severely damaged financial sectors, and even though their household sectors have been consistently deleveraging throughout these periods.

So it can be done. And if this growth path is followed, the outcome for equity markets might be a lot better than many pessimists currently believe is possible.

But the graph also contains another message which is far more sobering. Even if the US follows the recovery path shown, GDP will remain far below potential for several more years, and the unemployment rate will remain considerably above the structural unemployment rate. Put simply, there will be a massive further wastage of economic resources. A rough calculation suggests that the cumulative loss of GDP from the Great Recession of 2007-16 will amount to $5,900 billion, of which about $2,200 billion is still to come in the next five years. (These figures are at 2010 prices.)

That implies that the total loss of output from the Great Recession will be equivalent to 41 per cent of the current annual level of GDP. Of this, 26 per cent is now water under the bridge, but another 15 per cent of annual GDP is likely to be lost before the recession is over. These are truly extraordinary losses, which make the GDP losses from virtually any other cause appear almost trivial by comparison.

Another way of doing the calculation is via the amount of excess unemployment relative to its normal or structural rate. This amounts to the equivalent of forcing 23 per cent of the labour force to take a whole year off work, which translates into 35 million wasted years of employment potential.

And remember that all this makes the relatively rosy assumption that the US economy can grow at 3.8 per cent per annum in the next five years, a rate which most forecasters think is far too high. If, instead, the current US episode proves to be more serious than the average of previous slumps – as in the case of Japan in the 1990s, for example – then the eventual costs in lost output and wasted employment could prove even higher.

Macro-economists used to say that there were only two macro questions really worth studying: what determines the long term trend growth rate of GDP, and what caused the huge deviation below trend in the depression of the 1930s? Everything else was comparatively inconsequential in terms of human welfare. But now we have a third great question: how do we bring the Great Recession to the soonest possible end? Nothing in economics matters anything like as much.
Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.

America’s Economic Stalemate

Martin Feldstein


CAMBRIDGE – The United States appears trapped in a dangerous economic stalemate. The refusal by both Republicans and Democrats to give ground on the budget is preventing the government from dealing with its massive fiscal deficit and rapidly rising national debt. Indeed, the Congressional Budget Office projects that the national debt could increase to 82% of GDP over the next ten yearsmore than double the debt ratio as recently as 2008.

That forecast, moreover, is based on quite optimistic assumptions of strong economic growth and low interest rates. With slower growth and more normal interest rates, the debt ratio could easily rise to more than 100% in 2021, and exceed 150% by 2030.

A major reason for the accelerating growth in government debt is America’s rapidly aging population and the resulting increase in the cost of the universal pension and health-care programsSocial Security and Medicare. Most experts believe that limiting the rise in debt will require slowing the growth of these entitlement programs and increasing taxes as a share of GDP.

But President Barack Obama and the congressional Democrats oppose any reduction in future entitlement programs, while the Republican presidential candidates and their party’s congressional delegation oppose any increase in tax revenues. The result is the current stalemate in reducing the fiscal deficit and reversing the growth of the national debt.

Republicans argue that the national debt’s growth should be limited only by cutting government spending. Although some cuts in traditional outlays should be part of efforts to rein in spending, this approach should be supplemented by reducingtax expenditures” – the special features of the tax code that subsidize health care, mortgage borrowing, local-government taxes, etc.. Limiting tax expenditures could reduce the annual deficit by as much as 2% of GDP, thereby reducing the debt-to-GDP ratio in 2021 by more than 25 percentage points.

Republicans generally reject this form of spending reduction, because it results in additional tax revenue. While this method does indeed increase total revenue, the economic effect of limiting tax expenditures is the same as it is under any other method of cutting spending on those programs. But the Republicans’ opposition to anything that raises revenue means that this key to breaking the budget stalemate won’t be implemented.

The budget cost of Social Security pensions could be gradually reduced by substituting annuities generated by investment-based personal retirement accounts for part of the current tax-financed benefits. But even though such a reform could maintain income levels for retirees, Democrats oppose it, because it lowers traditional government benefits. This reinforces the stalemate.

The two parties’ hardline stances anticipate the upcoming congressional and presidential elections in November 2012. The Republicans, in effect, face the voters with a sign that says, “We won’t raise your taxes, but the Democrats will.” The Democrats’ sign, by contrast, says, “We won’t reduce your pension or health benefits, but the Republicans will.”

Neither side wants any ambiguity in their message before the election, thus ruling out the possibility of any immediate changes in tax expenditures or future Social Security pensions. But, for the same reason, I am optimistic that the stalemate will end after the election. At that point, both Republicans and Democrats will be able to accept reforms that they must reject now.

Another post-election route to deficit reduction would be to lower marginal tax rates and balance that revenue loss with cuts in tax expenditures. Official analyses downplay the effect of lower marginal tax rates on taxable income, but experience shows that taxable income rises substantially as taxpayers respond to lower marginal rates by working more, taking more of their compensation in taxable cash than in fringe benefits, and reducing their tax-deductible consumption. Reducing tax expenditures while lowering marginal tax rates can produce substantial revenue by increasing the level of taxable income.

The current economic stalemate is troubling, because financial markets could react adversely, and because delays in addressing the fiscal deficit means a higher national debt. I may be too optimistic, but I think there is good reason to believe that the current budget stalemate reflects election posturing, and that the US political system will prove more effective at making progress on fiscal consolidation once the election is past.

Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers and is former President of the National Bureau for Economic Research.

Copyright: Project Syndicate, 2011.

Half measures and wishful thinking do not a solution make

Wolfgang Münchau

October 27, 2011

The day may yet come when the eurozone finally agrees a comprehensive package to end the crisis, but this was not the day. What policymakers agreed at 4am Brussels time on Thursday came close to what they set out to do. They secured a “voluntarydeal with the banks, and they agreed the outer perimeters of a system to leverage the European financial stability facility. But none of this is going to end the crisis.

The deal with the Institute of International Finance is for a “voluntary 50 per cent haircut on Greek debt on behalf of their member banks. This would amount to €100bn, and would be supplemented by a contribution from eurozone governments to the tune of €30bn. The goal is to achieve a ratio of Greek sovereign debt to gross domestic product of 120 per cent by 2020.

I do not believe this is going to work. First, the agreement with the IIF is not binding on the banks. The IIF has yet to deliver the voluntary participation. Many banks would be better off if the haircut was involuntary, given their offsetting positions in credit default swaps. The whole point of a CDS is to ensure creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. In other words, there is a significant probability that we will end up with an involuntary agreement – which is precisely the outcome the eurozone governments, except perhaps a small group of northern countries, had sought to avoid.

My second reason for scepticism concerns the forecast of sustainable 120 per cent debt-to-GDP ratio. The European Union has been consistently wrong in its economic forecasts for Greece. They misjudged the impact of austerity on economic growth and public sector deficits. This misjudgement is the reason why the voluntary bank haircut of 21 per cent, agreed in July, has now grown to 50 per cent. What happens if the outlook were to deteriorate further? There is no sign yet of a turnaround.

Third, in the unlikely event that the banks come up with the money, and that Greece manages to hit a 120 per cent debt-to-GDP level in 2020, it is far from clear that Greece can return to the capital markets even then. I believe that Greece will require a much lower debt-to-GDP level, perhaps around 80 per cent, to achieve sustainability and access to market funding. Italy has a debt-to-GDP of 120 per cent now – this number may have served as a benchmark for policymakers. But Italy has a far more solid base of domestic savers than Greece, and this level is not sustainable for Italy either.

On the EFSF, the leaders reached political agreement to leverage it up to about €1,000bn. Herman van Rompuy, the president of the European Council, made a revealing comment following the meeting when he said that banks have been doing this forever. Why should governments not do so as well?

The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European financial stability facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of €210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.

Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop. This would be either in the form of an explicit lender-of-last-resort guarantee by the European Central Bank, or through a eurobond – or ideally both.

Now that is something I would consider to be a comprehensive agreement. It may yet happen, but not for a long time. The crisis, meanwhile, continues.

The writer is an associate editor of the Financial Times and president of Eurointelligence.

Take note America: the public is angry

Moisés Naím

October 26, 2011

Being stuck in traffic is more bearable if the other lanes are moving. If all lanes are jammed for a long time, tempers flare. And if the police eventually arrive and let a few selected cars get out of their lanes and move through a special path, a riot is likely to ensue. This in short is the sentiment that propels the Occupy Wall St protests. We should take note.

The traffic jam metaphor for the political consequences of economic mobility was originally proposed by Albert Hirschman, the noted economist, in 1973 to explain changes in tolerance for income in equality in poor countries. The idea was as simple as it was powerful: even a modicum of social mobilitysparked by economic growthbuys patience and political stability in developing countries. As people see their relatives and neighbours improve their lot they are willing to wait for their turn.

This idea, which was offered to explain the tolerance for inequality in poor countries, is now in theory applicable to some of the world’s wealthiest nationsexcept that the Occupy Wall Street crowds, the protesters in the City of London, or the Italian and Greek protesters are getting out of their “cars”, and clashing with the police not just because they see their “traffic lanehorribly jammed. It’s also because they are moving backwards.

They are also paying more attention to the fact that others are advancing thanks to what they perceive as tricks, special privileges and corner-cutting. This is not about hopes sparked by others doing well, but about the collective rage at an elite doing obscenely well while the rest backslides.

Over a century ago Alexis De Tocqueville wrote that Americans’ higher tolerance for inequality relative to Europe’s was the result of more social mobility in the US.

This is over; at least for now. The long, peaceful coexistence with income and wealth inequality is ending. Americans are now infuriated by the fact that chief executives at some of the nation’s largest companies earned around 340 times more than a typical American worker.

While the numbers are unnerving and US income disparities are growing even more unequal, this is not new. What is new is the intolerance towards the hoarding by the “few” of unfathomable wealth, and also towards their profiting even in the midst of the crisis. The rich are seen to be either benefiting from bail-outs and other stimulus measures, or to be immune to the fiscal austerity that governments in many countries have had to adopt to stabilise their economies.

Nothing makes people take to the streets in protest like public budget cuts. In a recent study, Jacopo Ponticelli and Hans-Joachim Voth, professors at Pompeu Fabra University in Barcelona, looked at a large data base that tracked political violence in 26 European countries between 1919 and 2009. They found that “expenditure cuts carry a significant risk of increasing the frequency of riots, anti-government demonstrations, strikes, political assassinations, and attempts at revolutionary overthrow of the established order.” While such events have a low probability in normal years, they concluded, they become much more common as austerity measures are implemented.

We know we have entered a new political territory when Mitt Romney, the leading contender for the Republican party presidential nomination, who initially called the Occupy Wall Street movementdangerous”, is quoted as saying: “I look at what’s happening on Wall Street and my own view is, boy I understand how those people feel... The people in this country are upset.” Yes, they are. They will stay that way until their lanes start moving again. Or, at least, those of their friends and neighbours.

The writer is a senior associate at the Carnegie Endowment for International Peace

File photo of gold bars. - File photo of gold bars. | REUTERS

Paper currency has too much bull, not enough bullion

NEIL REYNOLDS | Columnist profile | E-mail
OTTAWA— From Wednesday's Globe and Mail

To put Sir Mervyn’s warning into its historical perspective, it must be noted that “evergoes back a long way. The biblical record cites one calamitous meltdown 4,000 years ago, “when money failed in the land of Egypt.” Did Sir Mervyn deliberately or inadvertently include the financial crashes of antiquity in his portentous warning? Isn’t it the failure of money that now threatens the world?
The governors of major central banks shouldn’t use apocalyptic language without providing a little more detail. Why the Delphic utterances? Were they a sell signal for stocks? Were they a buy signal for gold?
Whatever else you think of gold, it holds its value in times of tribulation. During the Babylonian reign of King Nebuchadnezzar, 2,500 years ago, an ounce of gold (it is said) purchased 350 loaves of bread. The same ounce of gold still bought 350 loaves (at $2 a loaf) in the 1980s (when gold sold for $700 an ounce).
This is superficially interesting but, by itself, means little. What about every other product in the Babylonian supermarket? As a matter of fact, an ounce of gold today does buy 800 loaves (at $2 a loaf). This is a better performance than paper. In 1900, one dollar bought 14 loaves of bread; in 2010, it bought 16 slices from one 20-slice loaf.
The London-based World Gold Council cites a more relevant example of gold’s ability to preserve value. Between June, 2007, when the financial meltdown began, and June, 2009, when it bottomed, gold prices increased 40 per cent (in U.S. funds). In contrast, financial stocks fell 60 per cent and the S&P 500 fell 40 per cent. U.S. Treasury bonds, the safe hideaway for panicked investors, increased 20 per centproviding only half the protection of gold.
The solution appears obvious, although it’s probably too late to help with the world’s worst financial crisis ever: Add some gold to the paper. You don’t need to believe that gold will solve the world’s economic problems. It won’t. But it might help paper hold some of its value. The lesson of 2007-09 is instructive. A gold component to paper currency – as mused briefly a year ago by the Group of 20 – would slow the disintegration of fiat money. (World Bank president Robert Zoellick caused a stir when he publicly proposed that the G20 bring gold back as “an anchor” to the global monetary system – a proposal Russia, for one, endorsed.)
Oddly, Sir Mervyn favours quantitative easing (QE) over gold. QE can be defined as easy money and lots of it. Who would willingly exchange $1,600 in QE paper for an ounce of physical gold? QE debt just doesn’t do it. Gold has a track record that paper can’t touch. In 1717, Sir Isaac Newton, England’s Master of the Mint, pegged the price of gold at roughly $6 an ounce – a price that held (war years aside) for 200 years. Gold is unique. It is no one’s liability. It is no one’s debt. It is no one’s promise. It simply is what it is. As the World Gold Council notes, gold creates no credit risk, no inflation risk, and no debasement risk. Yet our central bankers unequivocally prefer printed paper with its certain risks and frequent debasements.
In his classic 1977 work The Gold Constant, Roy Jastrow, a professor of business administration at the University of California (Berkeley), noted that Great Britain’s wholesale price index, expressed as 100 in 1717, still stood at 100 in 1930. Separated from gold, the index then increased by 2,000 per cent in less than 50 years, when (you might say) money failed in lands of plenty.