The next crisis

Sponging boomers

The economic legacy left by the baby-boomers is leading to a battle between the generations

Sep 29th 2012

ANOTHER economic mess looms on the horizon—one with a great wrinkled visage. The struggle to digest the swollen generation of ageing baby-boomers threatens to strangle economic growth. As the nature and scale of the problem become clear, a showdown between the generations may be inevitable.

After the end of the second world war births surged across the rich world. Britain, Germany and Japan all enjoyed a baby boom, although it peaked in different years. America’s was most pronounced. By 1964 individuals born after the war accounted for 41% of the total population, forming a generation large enough to exert its own political and economic gravity.
These boomers have lived a charmed life, easily topping previous generations in income earned at every age. The sheer heft of the generation created a demographic dividend: a rise in labour supply, reinforced by a surge in the number of working women. Social change favoured it too. Households became smaller, populated with more earners and fewer children. And boomers enjoyed the distinction of being among the best-educated of American generations at a time when the return on education was soaring.

Yet these gains were one-offs. Retirements will reverse the earlier labour-force surge, and younger generations cannot benefit from more women working. There is room to raise educational levels, but it is harder and less lucrative to improve the lot of disadvantaged students than to establish a university degree as the norm for good ones, as was the case after the war. In short, boomer income growth relied on a number of one-off gains.

Young workers also cannot expect decades of rising asset prices like those that enriched the boomers. Zheng Liu and Mark Spiegel, economists at the Federal Reserve Bank of San Francisco, found in 2011 that movements in the price-earnings ratio of equities closely track changes in the ratio of middle-aged to old workers, meaning that the p/e ratio is likely to fall. Having lived through a spectacular bull market, boomers now sell off assets to finance retirement, putting pressure on equity prices and denying young workers an easy route to wealth. Boomers have weathered the economic crisis reasonably well. Thanks largely to the rapid recovery in stockmarkets, those aged between 53 and 58 saw a net decline in wealth of just 2.8% between 2006 and 2010.

More worrying is that this generation seems to be able to leverage its size into favourable policy. Governments slashed tax rates in the 1980s to revitalise lagging economies, just as boomers approached their prime earning years. The average federal tax rate for a median American household, including income and payroll taxes, dropped from more than 18% in 1981 to just over 11% in 2011.

Yet sensible tax reforms left less revenue for the generous benefits boomers have continued to vote themselves, such as a prescription-drug benefit paired with inadequate premiums. Deficits exploded. Erick Eschker, an economist at Humboldt State University, reckons that each American born in 1945 can expect nearly $2.2m in lifetime net transfers from the statemore than any previous cohort.

Boomers’ sponging may well outstrip that of younger generations as well. A study by the International Monetary Fund in 2011 compared the tax bills of a cohort’s members over their lifetime with the value of the benefits that they are forecast to receive. The boomers are leaving a huge bill. Those aged 65 in 2010 may receive $333 billion more in benefits than they pay in taxes (see chart), an obligation 17 times larger than that likely to be left by those aged 25.

Sadly, arithmetic leaves but a few ways out of the mess. Faster growth would help. But the debt left by the boomers adds to the drag of slower labour-force growth. Carmen Reinhart and Kenneth Rogoff, two Harvard economists, estimate that public debt above 90% of GDP can reduce average growth rates by more than 1%. Meanwhile, the boomer era has seen falling levels of public investment in America. Annual spending on infrastructure as a share of GDP dropped from more than 3% in the early 1960s to roughly 1% in 2007.

Austerity is another option, but the consolidation needed would be large. The IMF estimates that fixing America’s fiscal imbalance would require a 35% cut in all transfer payments and a 35% rise in all taxestoo big a pill for a creaky political system to swallow. Fiscal imbalances rise with the share of population over 65 and with partisan gridlock, according to other research by Mr Eschker. This is troubling news for America, where the over-65 share of the voting-age population will rise from 17% now to 26% in 2030.

That leaves a third possibility: inflation. Post-war inflation helped shrink America’s debt as a share of GDP by 35 percentage points. More inflation might prove salutary for other reasons as well. Mr Rogoff has suggested that a few years of 5% price rises could have helped households reduce their debts faster. Other economists, including two members of the Federal Reserve’s policymaking committee, now argue that with interest rates near zero, the Fed should tolerate a higher rate of inflation to speed up recovery.

The generational divide makes this plan a hard sell. Younger workers are typically debtors, who benefit from inflation reducing real interest rates. Older cohorts with large savings dislike it for the same reason. A recent paper by the Federal Reserve Bank of St Louis suggests that as a country ages, its tolerance for inflation falls.

Its authors theorise that a central bank could use inflation to achieve some generational redistribution. Yet pressure on the Fed to cease its expansionary actions has been intense, and led by a Republican Party increasingly driven by boomer preferences.

The political power of the boomers is formidable. But sooner or later, it cannot escape the maths.

September 27, 2012 6:33 pm
Fed joins ECB in a high-risk move

The Federal Reserve has now embarked on a very dangerous strategy, buying $40bn of mortgage-backed securities each month for an indefinite number of years. That could lead to high inflation, to destabilising asset bubbles and to legislative changes that limit the Fed’s future powers.

The Federal Open Market Committee has announced that it will continue those purchases for as long as “the labour market does not improve substantially” and will maintain “a highly accommodative stance of monetary policy ... for a considerable time after the economic recovery strengthens”. It specifically noted that its highly accommodative stance would continue at least until mid-2015, implying nearly $1.5tn of increased bank liquidity.

Although economic weakness now prevents inflationary price increases, these conditions will not last forever. At some point, demand will increase and companies will recover the ability to raise prices. Such price inflation has historically been associated with tight labour markets and rising wages. But this time the unprecedented high level of long-term unemployment could cause the unemployment rate to remain high even when product markets tighten.

The Fed has locked itself into a policy of monetary ease for as long as the unemployment rate remains high. Although the FOMC said that its policy would be conducted “in the context of price stability”, it is clear that its real focus will be on unemployment.

And even when the Fed wants to start raising interest rates to reduce inflationary pressures, Congress is likely to object if the unemployment rate is still high. Although the Fed is technically independent of the White House, it is legally accountable to the Congress. The recent Dodd-Frank legislation showed how Congress can limit the Fed’s powers. Faced with the alternative of antagonising the Congress, the Fed might delay in raising interest rates to control incipient inflation. The result could be significant increases in inflation and in inflation expectations.

The FOMC justifies its unprecedented easing by pointing to the persistently high rate of unemployment. Indeed, the current rate would still be at the 9.1 per cent level of a year ago if the number of people looking for work had not declined sharply during the year. But the weakness of the labour market is not a reason for taking the risks of an excessively accommodative monetary policy if the resulting lower interest rates will not stimulate demand and employment.

Under current conditions, the Fed’s new policy is not likely to strengthen the economic recovery. Mortgage rates are at record lows and home sales are already up sharply. Other potential homebuyers are blocked by tough credit standards (that is, by the need for a high credit score) rather than the level of mortgage rates. Lower mortgage rates may spill over to reduce rates on corporate debt but large businesses with enormous cash balances are reluctant to invest and to hire because they fear future tax increases. Many small businesses, which depend on local banks, are unable to secure credit because their banks lack the capital needed to increase lending.

The clear impact of the Fed’s easing has been to raise share prices, a key part of the Fed’s quantitative easing strategy. Ben Bernanke has pointed to this as the “portfolio balance channel” by which monetary easing increases household wealth and therefore stimulates consumer spending.

Although that worked in the fourth quarter of 2010 after the last round of quantitative easing, its favourable effect on gross domestic product only lasted for one quarter, followed by an annual growth rate of less than 0.5 per cent in the first quarter of 2011. The danger now is that an economic downturn or a rise in interest rates to normal levels could cause share prices to decline sharply.

European observers of the Fed’s recent decision may see similarities with the new open-ended strategy of the European Central Bank. The ECB will buy short-term Italian and Spanish bonds without any limit on the amount for as long as those countries have economic adjustment plans approved by the European Commission and the European Stability Mechanism. In doing so, the ECB can substantially reduce the interest rates on the sovereign debt of those countries, helping them to grow but removing the discipline that the bond market has had on their fiscal actions.

Once the process of buying large amounts of sovereign debt has begun, the ECB will face a difficult choice. Italy and Spain may improve their policies but they are also likely to stray, at least to an extent, from whatever plan they have agreed with the commission and the ESM. When that happens, will the ECB stop buying their bonds, allowing their interest rates to rise sharply? Or will it accept the deviations from plans and thus weaken their incentive for fiscal reform?

In short, the ECB, like the Fed, is now locked into a high-risk strategy.

The writer, a former chairman of the Council of Economic Advisers, is professor of economics at Harvard University

Copyright The Financial Times Limited 2012.

Stage Three for the Euro Crisis?
J. Bradford DeLong
27 September 2012

BERKELEYThe first two components of the euro crisis – a banking crisis that resulted from excessive leverage in both the public and private sectors, followed by a sharp fall in confidence in eurozone governments – have been addressed successfully, or at least partly so. But that leaves the third, longest-term, and most dangerous factor underlying the crisis: the structural imbalance between the eurozone’s north and south.

First, the good news: The fear that Europe’s banks could collapse, with panicked investors’ flight to safety producing a European Great Depression, now seems to have passed. Likewise, the fear, fueled entirely by the European Union’s dysfunctional politics, that eurozone governments might default – thereby causing the same dire consequences – has begun to dissipate.
Whether Europe would avoid a deep depression hinged on whether it dealt properly with these two aspects of the crisis. But whether Europe as a whole avoids lost decades of economic growth still hangs in the balance, and depends on whether southern European governments can rapidly restore competitiveness.
The process by which southern Europe became uncompetitive in the first place was driven by market price signals – by the incentives those signals created for entrepreneurs, and by how entrepreneurs’ individually rational responses played out in macroeconomic terms. Northern Europeans with money to invest were willing to lend on extraordinarily easy terms to those in the south who wanted to spend, and ample pre-2007 spending made employers there willing to raise wages rapidly.
As a result, southern Europe adopted an economic configuration in which its wage, price, and productivity levels made sense only so long as it spent €13 for every €12 that it earned, with northern Europe financing the missing euro. Northern Europe, meanwhile, adopted wage and productivity levels that made sense only as long as it spent less than one euro for every euro that it earned.
Now, if, as appears to be the case, Europe does not want its south to spend more than it earns and its north to spend less, wages, prices, and productivity must shift. If we are not to look back in a generation and bemoanlostdecades, southern European productivity levels need to rise relative to the north, and wage and price levels need to fall by roughly 30%, so that the south can pay its way with exports and northern Europe can spend its earnings on those products.
If the euro is to be preserved, and if stagnation is to be avoided, five policy measures could be attempted:
· Northern Europe could tolerate higher inflation – an extra two percentage points for five years would take care of one-third of the total north-south adjustment;
· Northern Europe could expand social democracy by making its welfare states more lavish;
· Southern Europe could shrink its taxes and social services substantially;
· Southern Europe could reconfigure its enterprises to become engines of productivity;
· Southern Europe could enforce deflation.
The fifth option is perhaps the least wise, for it implies the lost decades and EU collapse that Europe is trying to avoid. The fourth option would be wonderful; but, if anyone knew how to bring southern Europe's enterprises up to the productivity levels of the north, it would have happened already.

So we are left with a combination of the first three options, also known as “policies to restore European growth” – a phrase that appears in every international communiqué. But the communiqués never get more specific. Europe’s technocrats understand what adoption of “policies to restore European growthmeans. So do some of Europe’s politicians. But European voters do not, because politicians fear that spelling it out would be a career-limiting move.

But if Europe does not adopt some combination of the first three options as policy goals over the next five years, it will face a stark choice: either lost decades for southern Europe (and perhaps northern Europe as well), or continued north-south payment imbalances that will have to be financed through fiscal transfers – that is, by taxing the north.

Northern Europe’s politicians should become more explicit about whatpolicies to restore European growth” actually mean. Otherwise, ten years from now, they will be forced to confess that today’s dithering imposed enormous additional tax liabilities on northern Europe. That might turn out to be the ultimate career bummer.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

Europe needs to look at sharing more of Greece’s pain

Mohamed El-Erian

September 28, 2012

If you want to cause major discomfort at a meeting of European policymakers, just try mentioning OSI”, or official sector involvement. The notion that official creditors, and by that I mean governments and regional/multilateral institutions, may need to accept a reduction in their contractual claims on Greece is anathema to many. Yet the issue will surface repeatedly, and more frequently, given the current overly-constrained approach to solving Greece’s deep problems.
Official creditors have good reasons to resist OSI. Their sizeable lending to Greece was not a commercially-based decision but rather an emergency intervention. The aim was both to stabilise Greece and to limit destabilising spillover for other European economies.
They came in at a time when private creditors were exiting Greece en masse, and in a highly disorderly fashion. Their financing was extended at concessional interest rates. Loan maturities extended well beyond what a private creditor would envisage. And, when push came to shove, the official sector provided even more funding to Greece so that the country could meet its debt-servicing obligations.

None of this would have occurred if the official sector did not think of itself as a “preferred creditor”. That is what a lender of last resort reasonably expects, especially when it is stepping in to counter a disorderly financing implosion (and thus limit the losses to be incurred by private creditors). And it is what many parliaments in creditor countries believe as they encumber domestic tax receipts with actual or contingent Greek liabilities.

Yet the story is not that simple for two distinct reasons: there are precedents; and without further debt reduction, Greece has little hope for restoring growth, jobs and, therefore, financial solvency.

It is not so long ago that western countries willingly engaged in debt and debt service reduction for developing economies under the auspices of the Paris Club. This was often combined with the type of private sector involvement that has already occurred in Greece, and that has wiped out more than half of the contractual claims of most private creditors.
Even multilateral institutions, known to fanatically guard their preferred creditor status, have found ways in the past to de facto provide concessions to over-indebted countries. Indeed, just a few weeks ago, the European Central Bank used a clever mechanism to channel money to Greece so that it could be recycled as a debt service payment from the country to the central bank.
Then, and even more importantly, there is the urgent reality of Greece’s repeatedly faltering adjustment and reform effort.
More than three years into a series of troika-supported programmes, Greece has consistently failed to generate growth, to control its explosive debt dynamics and to attract new capital. Indeed, when it comes to outcomes, virtually all of the programmed targets have been missed.

Failing to see any light at the end of a very long and painful tunnel, the result has been an unprecedented level of rejection by the populationeconomic, financial, political and social. And who would blame the Greek people for their disillusionment?

Most economists would agree that, given the conditions on the ground, the situation could well get even worse unless there are fundamental changes to Greece’s debt and/or competitiveness parameters. Put another way, no realistic amount of domestic austerity and structural reforms – even if socially and politically palatable, which is a big if – would work unless Greece regains greater degrees of operational flexibility. In most scenarios, another round of debt reduction constitutes a necessary, though not sufficient, requirement for a sustainable solution to a very difficult situation.

Without a substantial decline in its debt overhang, Greece will find it virtually impossible to attract new capital inflows. Why should new creditors come in when the risk of concerted principal haircuts is so high? And without fresh capital, private sector activity will continue to collapse, arrears will increase further, and growth and employment will remain elusive.

The time has come for European creditor governments to think long and hard about the cost-benefit of OSI for Greece, as well as the broader regional implications. The longer they wait and curtail sensible analyses, the greater the likelihood of an unplanned and badly managed debt reduction, and the lesser eventual benefits for Greece and Europe as a whole.

The writer is the chief executive and co-chief investment officer of Pimco